Micro Economics

Economic Schools of Thoughts

Economic Schools of Thoughts are divided into three classes:

1. Schools of Political Economy (Ancient times – 1871 A.D.),

2. Neoclassical Schools (1871 A.D. – today), and
3. Alternative Schools.

1. Schools of Political Economy: Schools of Political Economy can be traced back from Ancient times to 1871 A.D. The
Schools of Political Economy can be further divided into two:

(a) Pre-Classical Thoughts: The Pre-Classical Thoughts consist of the contributions made by the following:

(i) The Ancients and Scholastics, including the great Greek philosophers Aristotle and Xenophon, and the Islamic
philosopher Ibn Khaldun

(ii) The Salamanca School initiated by Francisco de Vitoria around 1536

(iii) The First Economists

(iv) Sir William Petty and the Mercantilists

(v) Richard Cantillon, Jacques Turgot and the Enlightenment Economics

(vi) François Quesnay and the Physiocrats

 (vii) David Hume and Scottish Enlightenment

(viii) Giliani and the Italian Tradition, and

(ix) Social philosophers and commentators

(b) Classical Thoughts: The classical thoughts consist of the contributions made by the following:

(i) Adam Smith

(ii) David Ricardo, John Stuart Mill and the Classical Ricardian School

(iii) T. Robert Malthus and British Anti-Classical Economists

(iv) Jeremy Bentham and the Utilitarians

(v) Jean-Baptiste Say and the French Liberal School

(vi) Jules Dupuit and the French Engineers

(vii) Continental Proto-Marginalists

(viii) Karl Marx and the Marxian School

(ix) The Bullionist Controversies

(x) The Manchester School

(xi) Piero Sraffa and the Neo-Ricardians

(xii) The Neo-Marxians

2. Neoclassical Schools: Neoclassical Schools of thought starts from 1871 A.D. till today. Neoclassical Schools is further
divided into two:

(a) Anglo-American Neoclassicism: consists of the contributions of the following:

(i) W. Stanley Jevons and the Anglo-American Marginalists

(ii) John Bates Clark and the American Apologists

(iii) Alfred Marshall and the Cambridge Neoclassicals

(iv) Lord Robbins and the London School of Economics.

(v) Frank H. Knight and the Chicago School

(vi) Milton Friedman and the Monetarists

(vii) Robert Lucas and the New Classicals

(viii) New Institutionalist Schools

(b) Continental Neoclassicism: consists of the contributions made by the following:

(i) Léon Walras and the Lausanne School

(ii) Carl Menger and the Austrian School

(iii) Knut Wicksell and the Swedish School

(iv) Paul Samuelson, John Hicks and the Paretian Revival.

 (v) The Vienna Colloquium

(vi) Tjalling Koopmans and the Cowles Commission

(vii) Kenneth Arrow, Gérard Debreu and the Neo-Walrasian General Equilibrium School

(viii) Robert Aumann and the Edgeworthian Revival

3. Alternative Schools: can be divided into two schools of thoughts:

(a) Heterodox Traditions: consist of the contributions by the following:

(i) Utopians and Socialists

(ii) The Fabian Socialists

(iii) Gustav Schmoller and the German Historical School

(iv) The English Historical School

(v) The French Historical School

(vi) Thorstein Veblen and the American Institutionalist School.

(vii) Joseph Schumpeter and Evolutionary Economics.

(viii) The Soviet Planning Economists

(ix) The Neo-Marxians/Radical Political Economy

(x) Economics at the New School for Social Research.

(b) Keynesians: School of Thought initiated by John Maynard Keynes. He revolutionized economics with his classic book, ‘The
General Theory of Employment, Interest and Money’ in 1936. This is generally regarded as probably the most influential social
science treatise of the 20th Century, in that it quickly and permanently changed the way the world looked at the economy and the
role of government in society. No other single book, before or since, has had quite such an impact. Following are the
contributors followed and improved his theory:

(i) Joan Robinson and the Cambridge Keynesians

(ii) Franco Modigliani, James Tobin and the Neo-Keynesian Synthesis.

(iii) Abba Lerner and the American Post Keynesians

(iv) Robert Clower, Axel Leijonhufvud and Disequilibrium Keynesianism

(v) Joseph E. Stiglitz and the New Keynesians

(vi) The Mandarins

 François Quesnay & the Physiocrats
François Quesnay Tableau
François Quesnay (1694 – 1774), a French surgeon, born in Méré to a family of laborers. Quesnay was orphaned at thirteen. He
learned to read from a household medical companion and quickly acquired a voracious appetite for more books and more
learning. After a brief apprenticeship, some schooling at Saint-Côme, and marrying a Parisian grocer's daughter, Quesnay a
huge step up in social status and became a surgeon in Mantes. Through his rapid self-education and skills, he gradually climbed
up and finally entered into the service of local aristocrats. He became physician in King Louis XV’s court and the leader of a sect
of ‘enlightenment’ thinkers also known as ‘physiocrats’and ‘économistes’.

Quesnay's interest in economics arose in 1756, he was asked to contribute several articles on farming to
the Encylopèdie of Diderot andd'Alembert. Quesnay delved into the works of the Maréchal de Vauban, Pierre
de Boisguilbert and Richard Cantillon and, mixing all these ingredients together, Quesnay gradually came up with his famous
economic theory. In 1758, Quesnay wrote his Tableau Économique -- renowned for its famous "zig-zag" depiction of income
flows between economic sectors. It became the founding document of the Physiocraticsect -- and the ancestor of
the multisectoral input-output systems of Marx, Sraffa and Leontief and modern general equilibrium theory.

Quesnay’s Tableau set out three classes of society, and showed how transactions flowed between them. The three classes
were:

(a) landowners,
(b) the farmers and farm-labourers, and
(c) others, called ‘sterile class’

According to him, only the agricultural sector produced any surplus value, the rest only reproducing what it consumed. He
anticipated Malthus’sfear of under consumption arising from excessive savings. Net income would be reduced if the flows in the
Tableau were interrupted by delays in spending. This was the first attempt to construct a macroeconomic input-output model of
the economy. In fact, progress in this field had to await the application of matrix algebra and
computerization. Quesnay suggested a single tax, ‘l’impôt unique’, on the net income from land, arguing that the nation would
thereby save tax-collecting costs. Only agriculture yielded a surplus, and therefore ultimately it bears all taxes anyway.

The Physiocrats
The Physiocrats were a group of French Enlightenment thinkers of the 1760s led by the French court physician,
François Quesnay. The founding document of Physiocratic doctrine was Quesnay's Tableau Économique (1759). The members
of Physiocrats were Marquis de Mirabeau, Mercier de la Rivière, Dupont de Nemours, La Trosne, the Abbé Baudeau and
others. To contemporaries, they were known simply as theéconomistes.

The cornerstone of the Physiocratic doctrine was Quesnay's axiom that only agriculture yielded a surplus – known as ‘net
product’. Manufacturing, the Physiocrats argued, took up as much value as inputs into production as it created in output, and
consequently created no net product. Contrary to the Mercantilists, the Physiocrats believed that the wealth of a nation lies not
in its stocks of gold and silver, but rather in the size of its net product.

French agriculture at the time was trapped in Medieval regulations which shackled enterprising farmers. The monopoly power of
the merchant guilds in towns did not permit farmers to sell their output to the highest bidder and buy their inputs from cheapest
source. An even bigger obstacle was the internal tariffs on the movement of grains between regions, which seriously hampered
agricultural commerce. Public works essential for the agricultural sector, such as roads and drainage, remained in an awful
state. Restrictions on the migration of agricultural laborers meant that a nation-wide labor market could not take shape. Farmers
in productive areas of the country faced labor shortages and inflated wage costs, thus forcing them to scale down their activities.
In unproductive areas, in contrast, masses of unemployed workers wallowing in penury kept wages too low and thus local
farmers were not encouraged to implement any more productive agricultural techniques.

It is at this point that the Physiocrats jumped into their laissez-faire attitude. They called for the removal of restrictions on internal
trade and labor migration, the abolition of the corvée, the removal of state-sponsored monopolies and trading privileges, the
dismantling of the guild system, etc.

On fiscal matters, the Physiocrats famously pushed for their "single tax" on landed property -- l'impôt unique. According
to Physiocrats, any tax levied throughout the economy will just passed from sector to sector until they fall upon the net
product. As land is the only source of wealth, then the burden of all taxes ultimately bears down on the landowner. So instead
of levying a complicated collection of scattered taxes (which are difficult to administer and can cause temporary distortions), it is
most efficient to just go to the root and tax land rents directly.

A general laissez-faire policy and the "single tax" were the speediest, least distortionary and least costly ways of arriving at the
natural state. ThePhysiocrats believed that net product of the natural state was the maximum net product sustainable over the
long run. The policy measures advocated by the Physiocrats went very much against the interests of the nobility and the landed
gentry. But because Quesnay was the private physician to Madame de Pomapadour, the mistress of King Louis XV,
the Physiocratic clique enjoyed a good degree of protection in the French court. The Physiocrats became so influential that even
after the death of Pomapadour, they remain a furious publisher of different journals and articles that promote their ideas.
 Equilibrium
The term equilibrium has often to be used in economic analysis. In fact, Modern Economics is sometimes called equilibrium
analysis. Equilibrium means a state of balance. When forces acting in opposite directions are exactly equal, the object on which
they are acting is said to be in a state of equilibrium.

Types of Equilibrium

Basically, there are three types of any equilibrium:

(a) Stable Equilibrium: There is stable equilibrium, when the object concerned, after having been disturbed, tends to resume
its original position. Thus, in the case of a stable equilibrium, there is a tendency for the object to revert to the old position.

(b) Unstable Equilibrium: On the other hand, the equilibrium is unstable when a slight disturbance evokes further
disturbance, so that the original position is never restored. In this case, there is a tendency for the object to assume newer and
newer positions once there is departure from the original position.

(c) Neutral Equilibrium: It is neutral equilibrium when the disturbing forces neither bring it back to the original position nor
do they drive it further away from it. It rests where it has been moved. Thus, in the case of a neutral equilibrium, the object
assumes once for all a new position after the original position is disturbed.

When the word equilibrium is used to qualify the term value, then according to Professor Schumpeter, a stable equilibrium value
is an equilibrium value that if changed by a small amount, calls into action forces that will tend to reproduce the old value; a
neutral equilibrium value is an equilibrium value that does not know any such forces; and an unstable equilibrium value is an
equilibrium value, change in which calls forth forces which tend to move the system farther and farther away from the equilibrium
value.

In the following figure 2, the stable equilibrium is shown. When in equilibrium at point P, the producer produces an output OM
and maximises his profits. In case the producer increases his output to OM2 or decreases it to OM1, the size of profits is
reduced. This automatically brings in forces that tend to establish equilibrium again at P.

Figure 3 represents the case of unstable equilibrium. Initially the producer is in equilibrium at point P, where MR = MC and he is
maximising his profits. If now he increases his output to OM1, he would be in equilibrium output at point P1, where he will obtain
higher profits, because, at this output, marginal revenue is greater than marginal cost. Thus there is no tendency to return to the
original position at P.

Figure 4 represents the situation of neutral equilibrium. In this case, MR = MC at all levels of output so that the producer has no
tendency to return to the old position and every time a new equilibrium point is obtained, which is as good as the initial one.
Other Forms of Equilibrium

(a) Short-term and Long-term Equilibrium: Equilibrium may be short-term equilibrium or long-term equilibrium as in case of
short-term and long-term value. In the short-term equilibrium, supply is adjusted to change in demand with the existing
equipment or means of production, there being no time available to increase or decrease the factors of production. However, in
case of long-term equilibrium, there is ample time to change even the equipment or the factors of production themselves, and a
new factory can be erected or new machinery can be installed.
(b) Partial Equilibrium: Partial equilibrium analysis is the analysis of an equilibrium position for a sector of the economy or for
one or several partial groups of the economic unit corresponding to a particular set of data. This analysis excludes certain
variables and relationship from the totality and studies only a few selected variables at a time. In other words, this method
considers the changes in one or two variables keeping all others constant, i.e.,ceteris paribus (others remaining the
same). The ceteris paribus is the crux of partial equilibrium analysis.

The equilibrium of a single consumer, a single producer, a single firm and a single industry are examples of partial equilibrium
analysis. Marshall’s theory of value is a case of partial equilibrium analysis. If the Marshallian method (i.e., partial equilibrium
analysis) is to be effective, even in its own terms, when applied to a hypothetical and idealised market, it necessary that the
market should be small enough so that its inter-dependence with the rest of the hypothetical economy could be neglected
without much loss of accuracy.

(i) Consumer’s Equilibrium: With the application of partial equilibrium analysis, consumer’s equilibrium is indicated
when he is getting maximum aggregate satisfaction from a given expenditure and in a given set of conditions relating to price and
supply of the commodity.

(ii) Producer’s Equilibrium: A producer is in equilibrium when he is able to maximise his aggregate net profit
in the economic conditions in which he is working.

(iii) Firm’s Equilibrium: A firm is said to be in long-run equilibrium when it has attained the optimum size when
is ideal from the viewpoint of profit and utilisation of resources at its disposal.

(iv) Industry’s Equilibrium: Equilibrium of an industry shows that there is no incentive for new firms to enter it
or for the existing firms to leave it. This will happen when the marginal firm in the industry is making only normal profit,
neither more nor less. In all these cases; those who have incentive to change it have no opportunity and those who
have the opportunity have no incentive.

(c) General Equilibrium Analysis: Leon Walras (1834-1910), a Neoclassical economist, in his book ‘Elements of Pure
Economics’, created his theoretical and mathematical model of General Equilibrium as a means of integrating both the effects of
demand and supply side forces in the whole economy. Walras’ Elements of Pure Economics provides a succession of models,
each taking into account more aspects of a real economy. General equilibrium theory is a branch of theoretical
microeconomics. The partial equilibrium analysis studies the relationship between only selected few variables, keeping others
unchanged. Whereas the general equilibrium analysis enables us to study the behaviour of economic variables taking full
account of the interaction between those variables and the rest of the economy. In partial equilibrium analysis, the determination
of the price of a good is simplified by just looking at the price of one good, and assuming that the prices of all other goods remain
constant.

General equilibrium is different from the aggregate or macro-economic equilibrium. General equilibrium tries to give an
understanding of the whole economy using a bottom-top approach, starting with individual markets and agents. Whereas, the
macro-economic equilibrium analysis utilises top-bottom approach, where the analysis starts with larger aggregates. In macro-
economic equilibrium models, like Keynesian type, the entire system is described by relatively few, appropriately defined
aggregates and functional relationships connecting aggregate variables such as total consumption expenditure, total investment,
total employment, aggregate output and the like. In macro-economic analysis, many important variables and relationships tend
to be disappeared in the process of aggregation.

There are two major theorems presented by Kenneth Arrow and Gerard Debreu in the framework of general equilibrium:

(i) The first fundamental theorem is that every market equilibrium is Pareto optimal under certain conditions, and

(ii) The second fundamental theorem is that every Pareto optimum is supported by a price system, again under
certain conditions.

Uses of General Equilibrium

1. To get an overall picture of the economy and study the problems involving the economy as a whole or even large
segments / sectors of it.

2. It shows that the quantities of demanded goods / factors are equal to the quantities supplied. Such a condition implies
that there is a full employment of resources.

3. It also provides with an ideal datum of economic efficiency. It brings out the fact that long-run competitive equilibrium
is a standard of efficiency for the entire economy. Only when the competitive economy obtains general equilibrium shall its
economic efficiency be at its peak and there shall be no further gains made by any reallocation of resources.

4. General equilibrium also represents the state of optimum production of all commodities, because there can be no
over-production or under-production under such conditions.
 5. It also provides an insight into the way the multitudes of individual decisions are integrated by the working of the price
mechanism. It, therefore, solves the fundamental problems of a free market economy, viz., what to produce, how to
produce, how much to produce, etc. This analysis shows that such decisions with regard to innumerable consumers and
producers are co-ordinated by the price mechanism.

6. The general equilibrium analysis also gives us the clue for predicting the consequences of an economic event.

7. It also helps in the field of public policy. The formulation of a logically consistent public policy requires a complete
understanding of the various sector markets and aspects of individual decision-making units, and the impact of policy on
the whole economy.

Limitations of General Equilibrium Analysis

1. The Walrasian general equilibrium system is essentially static. It treats the coefficient of production as fixed. It
considers the supply of resources to be given and consistent. It also takes tastes and preferences of the society as fixed.

2. It ignores leads and lags, for it considers everything to happen instantaneously. It is supposed to work just in the
same way as an electric circuit does. In the real world, all economic events have links with the past and the future.

3. Walrasian general equilibrium analysis is of little practical utility. It involves astronomical volumes of calculations for
estimating the various quantities and practices. This makes its application practically impossible. Even the use of
computers cannot be of much help because such a system cannot aid in collecting and recording the innumerable sets of
prices and quantities that are required to formulate these equations. The critics further argue that even if such a solution
exists, the price mechanism may not necessarily cover it.

4. Last but not least, the general equilibrium analysis falls to the ground as its star assumption of perfect competition is
contrary to the actual conditions prevailing in the real world.

General Disequilibrium (Keynesian Theory)

Neoclassical economics thinks in terms of a market system in which supply equals demand in every market, so that no
unemployment could ever occur. But this is an assumption. Keynes suggests a market system in which Disequilibrium can
occur in some markets, including labour market, and in which the disequilibrium can spread contagiously from one market to
another. Keynes’ idea was that, when this spreading disequilibrium settles down, there would be a kind of equilibrium – not
supply and demand equilibrium, but often termed as ‘general disequilibrium’.

Take an example of a commodity, say cellular telephone sets, its equilibrium of demand and supply is shown in the following
figure:

In the above figure, MC curve is the marginal cost curve for the commodity. Originally, the market is in equilibrium at price
P1 with demand curve D1. Then, for any reason, demand for that commodity decreases to D2, Neoclassical economists tells us
that the new equilibrium will be at price P3. But, in fact, the prices do not drop quite that far, instead, prices drop to P2. Perhaps
this is because the businessmen do not know just how far they need to cut their prices, and are cautious to avoid cutting too
much. At a price P2, the seller can sell only Qd amount of output. By producing Qd amount of output at price P2, the producers
are not maximising their short-run profit. We have ‘disequilibrium’ in the sense that production is not on the marginal cost
curve. At P2, the sellers can sell Qd amount of output, but they cannot produce the same amount of output. Here is a
qualification. Producer might temporarily produce more that Qd, in order to build up their inventories. But there is a limit to how
much inventories they want, so they will cut their production back to Qd eventually.

With a reduction of demand for cellular phones, any economist would expect a reduction in the quantity of that commodity
produced. Neoclassical economics leads us to expect that the price would drop to P3 and output cut back to Qe. At the same
time, a certain number of workers would be laid off and would switch their efforts into their second best alternatives, working in
other industries, perhaps at somewhat lower wages. But the ‘disequilibrium model’ states that the production and layoffs would
go even further, with output dropping to Qd. A reduction in income does not only reduce the demand for cellular phones, but it
also reduces the demand for all other normal goods as well. This disequilibrium will spread contagiously through many different
goods markets, through the effect of disequilibrium on income. So every other industry will face a reduction in demand because
of the reductions in productions in many other industries.
 Utility Theory
In economics, utility is a measure of the happiness or satisfaction gained from a good or service. The concept is applied by economists in such topics as the
indifference curve, which measures the combination of a basket of commodities that an individual or a community requests at a given level(s) of satisfaction.
The concept is also used in utility functions, social welfare functions, Pareto maximization, Edgeworth boxes and contract curves. It is a central concept of
welfare economics.
The doctrine of utilitarianism saw the maximisation of utility as a moral criterion for the organisation of society. According to utilitarians, such as Jeremy
Bentham (1748-1832) and John Stuart Mill (1806-1876), society should aim to maximise the total utility of individuals, aiming for 'the greatest happiness for
the greatest number'.
Utility theory assumes that humankind is rational. That is, people maximize their utility wherever possible. For instance, one would request more of a good if it
is available and if one has the ability to acquire that amount, if this is the rational thing to do in the circumstances.

Cardinal and Ordinal Utility

There are mainly two kinds of measurement of utility implemented by economists: cardinal utility and ordinal utility.
Utility was originally viewed as a measurable quantity, so that it would be possible to measure the utility of each individual in the society with respect to each
good available in the society, and to add these together to yield the total utility of all people with respect to all goods in the society. Society could then aim to
maximise the total utility of all people in society, or equivalently the average utility per person. This conception of utility as a measurable quantity that could be
aggregated across individuals is called cardinal utility.
Cardinal utility quantitatively measures the preference of an individual towards a certain commodity. Numbers assigned to different goods or services can be
compared. A utility of 100 units towards a cup of coffee is twice as desirable as a cup of tea with a utility level of 50 units.
The concept of cardinal utility suffers from the absence of an objective measure of utility when comparing the utility gained from consumption of a particular
good by one individual as opposed to another individual.

For this reason, neoclassical economics abandoned utility as a foundation for the analysis of economic behaviour, in favour of an
analysis based upon preferences. This led to the development of tools such as indifference curves to explain economic
behaviour.
In this analysis, an individual is observed to prefer one choice to another. Preferences can be ordered from most satisfying to least satisfying. Only the
ordering is important: the magnitude of the numerical values are not important except in as much as they establish the order. A utility of 100 towards an ice
cream is not twice as desirable as a utility of 50 towards candy. All that can be said is that ice cream is preferred to candy. There is no attempt to explain why
one choice is preferred to another; hence no need for a quantitative concept of utility.
It is nonetheless possible, given a set of preferences which satisfy certain criteria of reasonableness, to find a utility function that will explain these
preferences. Such a utility function takes on higher values for choices that the individual prefers. Utility functions are a useful and widely used tool in modern
economics.
A utility function to describe an individual's set of preferences clearly is not unique. If the value of the utility function were to be, for e.g., doubled, squared, or
subjected to any other strictly monotonically increasing function, it would still describe the same preferences. With this approach to utility, known as ordinal
utility it is not possible to compare utility between individuals, or find the total utility for society as the Utilitarians hoped to do.
 Theory of Demand
There are three theories of demand or there are three theories of measuring demand:

(a) Marginal utility analysis;

(b) Indifference curve techniques; and
(c) Revealed preference theory.

Marginal Utility Analysis:

Also known as ‘Utility analysis of demand’.

Basic Assumptions:
(i) Cardinal measurement of utility,
(ii) Utilities are independent,
(iii) Constant marginal utility of money,
(iv) Introspection – drawing reference about a person from one’s own experience.

(a) Law of Diminishing Marginal Utility:

It refers to the additional benefit, which a persons derives from a given increase of his stock, diminishes with every increase in his
stock.

Characteristics:
(i) The marginal utility diminishes which every increase in stock,
(ii) The total utility is maximum when the marginal utility is zero,
(iii) Each particular want is stable,
(iv) Goods are imperfect substitutes and consumed in appropriate portions.

Units Total Marginal

of Utility Utility
Stock (Units (Units
of of
Satisfaction) Satisfaction)
1 20 20
2 38 18
3 53 15
4 64 11
5 70 6
6 70 0
7 62 -8
8 46 -16
Assumptions/Limitations:
(i) Consumption is continuous,
(ii) The commodity is taken in suitable quantity,
(iii) The commodity is taken at certain time interval,
(iv) The greater the quantity of commodity is taken, the greater the utility,
(v) Rational behaviour of consumer,
(vi) Constant income of consumer,
(vii) Change in other people’s stock,
(viii) Possession of other related commodity,
(ix) Trends in fashion not changed,
(x) No change in the price of commodity,
(xi) The marginal utility of rare collections does not diminished,
(xii) The units of commodity taken are of same quality,
(xiii) This law is not applied to the utility of money.

Definition of Marginal Utility:

It refers to the addition in total utility resulting from a one-unit change in the quantity consumed. The consumer stops purchasing at a point
where the princes and the marginal utility are just equal. Above this point, the marginal utility will be negative.

Marginal Utility of Money:

The marginal utility of money increases with the increase in quantity of money. But the law of diminishing marginal utility also applies to
money. As the amount of money increases it brings lesser and lesser pleasure to the recipient of money.

Marginal Utility and Price:

(i) The consume stops purchasing when the marginal utility and price are equal,
(ii) The marginal utility indicates the prices. For example, it is the marginal utility not the total utility that determines prices;
otherwise the price of water should have been high, and that of gold low.

Marginal Utility and Supply:

The greater the marginal utility, the lesser the supply, and vice versa. The marginal utility is equal to zero when the supply is super-abundant.
Marginal Utility of Related Goods:
(a) Imperfect Substitutes:
The marginal utility increases with the decrease in quantity of substitute goods, and vice versa.
(b) Complementary Goods:
The marginal utility increases with the increase in the quantity of complementary goods, and vice versa.

Importance of Law of Diminishing Marginal Utility:

(a) Taxation:
It provides the basis of the laws and practices of taxation. Since the marginal utility of money to a richer person is lower than poor
person, therefore, higher tax rates are levied on him, and vice versa.

(b) Price Determination:

It refers to a decrease in the value of a commodity with an increase in its supply, and vice versa.

(c) Household Expenditure:

Larger the purchase, lower the marginal utility, and vice versa.

(d) Downward Sloping Demand Curve:

This law also provides the reason for downward sloping demand curve.

(e) Value-in-Use and Value-in-Exchange:

It also study the divergence between value-in-use and value-in-exchange. For example, air has a higher value-in-use (utility) but a very
little value-in-exchange.

(b) Law of Equi-Marginal Utility:

The law of equi-marginal utility or the law of equilibrium utility is known by various names. It is also known as ‘law of substitution’, ‘law of
maximum satisfaction’, ‘law of indifference’, ‘the proportionate rule’, and ‘Gossen’s second law’.

The consumer compares the satisfaction which he obtains from the purchased commodity and the price he pays. If the utility of commodity is
greater or at least equal to the loss of utility of money price, the consumer buys that commodity. As he buys more and more of that
commodity, the utility of successive units begins to diminish. He stops further purchases at a point where the marginal utility of the
commodity and the money he paid is just equal. Beyond this point the marginal utility is negative. And this can be stated as the point of
equilibrium, where the consumer derives maximum satisfaction from a given commodity. If the consumer finds that a particular expenditure
in one use is yielding less utility than that of other, he will try to transfer a part of his purchase from the previous commodity to the new one
yielding higher utility. With two commodities, the consumer is in equilibrium at a point where the marginal utility of each commodity is in
proportion to the price, and the ratio of the prices of all goods is equal to the ratio of their marginal utilities. It can be mathematically
expressed as follows:

or

Units of Marginal Marginal

Money Utility of Utility of
(Rs.) Tea Cigar
1 10 12
2 8 10
3 6 8
4 4 6
5 2 3
Total Utility 30 39

Expenditure (Rs.) Rate of Marginal Utility

On Tea On Cigar Marginal On Tea On Cigar Total
Utility
5 0 N/A 30 0 30
4 1 2.3:4 28 12 40
3 2 1.1:1.5 24 22 46
2 3 0.6:0.7 18 30 48
1 4 0.3:0.2 10 36 46
0 5 N/A 0 39 39
Assumptions/Limitations:
(a) This law becomes inoperative when the consumer demand is influenced by fashions and customs;
(b) Consumers do not usually measure the utility of the purchased commodity;
(c) This law becomes inoperative when the unit of expenditure is not divisible;
(d) Again the law is inoperative when the people have no freedom of choice to choose between various alternatives.

Practical Application of Law:

(a) Consumption:
Substitution of two commodities’ utilities in order to achieve maximum marginal utility;
(b) Production:
Substitution of two factors of production in order to maximise total profit;
(c) Exchange:
Substitution of any two things in order to achieve the desired things;
(d) Price Determination:
Substitution of less scarce good for the more scarce good in order to minimise the scarcity of more scarce goods.
 (e) Distribution:
The use of each factor of production is pushed by the entrepreneur to the margin of profitableness till the marginal product in each case
is equal;
(f) Public Finance:
Substitution of various public expenditures in order to maximise the benefit.

Demand Curve:
A fall in price has the following effects:

(i) Income Effect:

The real income of a consumer increases when the prices are decreased. Now the consumer can afford more purchases within the
unchanged income.
(ii) Substitution Effect:
When the price of a product decreases, it tends to be substituted for other commodities.
(iii) Cumulative Effect:
A commodity with decreased price is put to more uses before; and therefore, it has a cumulative effect when the commodity is more
purchased and used by the consumer.

The Law of Diminishing Marginal Utility (LDMU) is the basis of the Law of Demand (LD). The consumer will buy more only if the price
falls because more he buys the lower is the marginal utility.

Demand is the function of price:

D = f (P)

In constructing the demand curve, we only consider the factor of price, and we ignore other factors, i.e., changes in fashion, wealth
distribution, changes in real income, etc.

Assumptions of Law of Demand:

(a) The consumer’s tastes, habits, income, etc are remain unchanged;
(b) Prices of substitutes and complementary goods are remain unchanged;
(c) No expectations for further changes in commodity’s price;
(d) No new substitute commodity has entered into the market.
Relationship between LDMU and LD:
(a) Law of diminishing marginal utility states that larger the quantity, less is the utility;
(b) Law of demand states that larger the quantity, lower is the price, because the utility of the successive units is less;
(c) This means that each addition to the quantity demanded, marginal utility of the consumer will be diminished;
(d) Each additional unit of a good consumed within a given time period yields diminishing utility;

Theory of Benham – Relationship between LDMU and LD:

(a) According to Benham, when the price of a commodity falls a divergence is created between the marginal utility and price, and it
must be rectified;
(b) According to Benham, it must be rectified, so as to equalise the marginal utility from the last paisa that the consumer spends in
different ways. And it can be done by purchasing more of the commodity, thus bringing the marginal utility to the level of price.

Exceptional Demand Curve – Giffen Paradox:

Sometimes the demand curve instead of sloping downward may tend to rise upwards from left to right. This situation is represented by more
purchases at a rise in price. In other words, people buy more when the price rises. This situation is imaginary and was first observed by Sir
Robert Giffen. His theory is commonly known as ‘Giffen Paradox’. Benham has mentioned four seasons/cases for this imaginary situation:

(a) In case of war, hyper-inflation, draught, a serious shortage is feared and people may be panicked to buy more even if the prices are
rising;
(b) When the use of a commodity confers distinction, then the wealthy people will buy more when the price rises, to be included
among the distinguished personages. Conversely, people tend to cut their purchases, if they believe the commodity to be inferior;
(c) People may buy more, when the price rises, in sheer ignorance;
(d) If the prices of necessary commodities go up, the consumer will ready just his expenditure, in order to maintain his previous
quantity of purchases by reducing the purchases of other unnecessary commodities.

Difference between Movement and Shift of Demand Curve:

(i) Movement along demand curve refers to extension and contraction of demand. It means that the change in demand is the
result of a change in price instead of a change in other factors.
(ii) Shifting in demand curve refers to the increase or decrease of demand. It means that the change in demand is the result of a
change in the factors other than price.

Elasticity of Demand
Kinds of Elasticities of Demand:
(a) Price Elasticity,
(b) Income Elasticity,
(c) Cross Elasticity, and
(d) Substitution Elasticity.

(a) Price Elasticity:

It is the price elasticity, which is commonly referred to as elasticity of demand. The law of demand indicates the direction of demand,
however, it does not tell us the amount of quantity demand in response to a change in price. Price elasticity of demand, particularly,
tells us the responsiveness of demand in reaction to the change in price of a commodity. It tells us the amount or the extent by which
the demand will change in response to a change in the price.

Degrees of Price Elasticity of Demand:

(i) Perfectly Elastic Demand (e = ∞)

(ii) Perfectly Inelastic Demand (e = 0)
(iii) Unitary Elasticity of Demand (e = 1)
(iv) Relatively Inelastic Demand (e < 1)
(v) Relatively Elastic Demand (e > 1)

Measurement of Price Elasticity:

(i) Total Outlay Method

(ii) Proportional Method
(iii) Geometrical Method

(i) Total Outlay Method:

This method analyses the relationship between the price of commodity and total revenue earned by the seller. Under this method,
the elasticity of demand can be expressed in three ways, i.e., unitary elasticity, greater than unity elasticity, and less than unity
elasticity.

a. Unitary Elasticity:
 Under the total outlay method, the unitary elasticity of demand is represented by the situation when, even though the price has
changed the total amount spent or total revenue (from seller’s point of view) remains the same. This situation is represented by a
‘rectangular hyperbola’, where the elasticity is unity throughout the demand curve at different price stages.

(e = 1) P ↑ O ↕, P ↓ O ↕

b. Greater-than-unity Elasticity:
Under the total outlay method, greater than unity elasticity of demand refers to the situation when with the fall in price, the total
amount spent by the consumer increases, and with the rise in price, the total amount spent by the consumer decreases.

(e > 1) P ↑ O↓, P ↓ O ↑

c. Less-than-unity Elasticity:
Under the total outlay method, less than unity elasticity of demand refers to the situation when the total amount spent or total
revenue increases with the rise in price and the decreases with the fall in price.

(e < 1) P ↑ O ↑, P ↓ O↓

Price Quantity Total Elasticity

(Rs.) Demanded Outlay /
(Kgs) Revenue
(Rs.)
10 100 1,000 e<1
9 110 990 e < 1, e = 1
8.5 115 990 e = 1, e >1
10.2 125 1,275 e>1
11 130 1,430 e>1

(ii) Proportional Method:

Under this method, elasticity of demand is measured in terms of a ratio of the percentage change in the quantity demanded to the
percentage change in price. It can be mathematically expressed as follows:
Under this method, the elasticity of demand is always negative, although by convention, it is taken to be positive. It is negative
because the fall in price is followed by a rise in demand. Again, the elasticity is stated in three forms, i.e., greater than unity
elasticity, unitary elasticity and less than unity elasticity of demand.

(iii) Geometrical Method:

Geometrical method of measuring elasticity of demand can measure elasticity of demand at any point on the demand
curve. Elasticity is stated in terms of fraction and in three forms, i.e., greater than unity, unitary and less than unity elasticity of
demand. The middle of the curve represent unitary elasticity, below to which, elasticity is less than unity, and above to which,
elasticity is greater than unity:
Point and Arc Elasticity:
1. The point elasticity refers to elasticity of demand at any point on a demand curve. Point elasticity considers small changes in
demand and price. The elasticity of demand on a particular point of demand curve can be mathematically calculated as below:

2. According to Baumol, arc elasticity of demand is a measure of the average responsiveness to price changes. This could be measured
through finite stretch of a demand curve. Therefore, any two points on a demand curve forms an arc, and between these two points, the
arc provides measurement of elasticity of demand over a certain range of price and quantities. This can be simply plotted into the
following mathematically formula:
(b) Income Elasticity of Demand:
It is generally observed that there is an inverse relationship between the quantity demanded and price of a commodity. Therefore, the
demand curve slopes downward from left to right. Whereas, this is not in the case of the relationship of income and quantity
demanded. The higher the income of the consumer, the more units of commodity will be bought by him. Thus, the demand curve in
the income elasticity slopes from right to left. Income elasticity of demand refers to the degree of responsiveness of quantity demanded
to a change in the income of the consumer. It can be mathematically expressed as follows:

Measurement of Income Elasticity:

The income elasticity can be measured through the above mathematical formula. The resulting figure can be classified into the
following:

(i) Greater-than-unity:
The elastic demand of a commodity is expressed in the figure greater than 1. (e > 1)
(ii) Unitary elasticity:
The unitary elasticity of demand means that the change in consumer’s income is followed by proportionate change in
quantity demanded. (e=1)
(iii) Less-than-unity:
The less than unity means inelastic demand of a commodity and expressed in the figure less than 1. It means that the degree
of change in quantity demanded is less than to the change in consumer’s income. (e < 1)

(c) Cross Elasticity of Demand:

When the quantity demanded of a commodity changes in response to the change in price of another commodity, it refers to cross
demand elasticity. These two commodities may either be substitutes of each other, or one may be a complementary good for
another. Therefore, the cross elasticity of demand is measured in accordance with these two types of inter-related goods, i.e., the
substitutes, and complementary goods. Cross elasticity of demand is expressed as the percentage change in quantity demanded of good
X to the percentage change in the price of a related good Y. Mathematically it can be measured as below:

The cross elasticity of demand can be further bifurcated into:

(i) Cross elasticity of substitute goods, and

(ii) Cross elasticity of complementary goods.

(i) Cross elasticity of substitute goods: The examples of substitute goods are: tea and coffee, motor car and motor cycle,
cigarette and pipe, pen and pencil, telephone and mobile phone, business and service or investments in marketable securities,
lease hold property and free hold property, etc. Suppose the prices of motor cars significantly rise, there will be a shift of
demand from motor car to a cheaper substitute, i.e., motor cycle. It should be remembered that the elasticity of demand of
substitutes will always positive. The cross elasticity of substitute goods can be in three forms:

a. Greater-than-unity: Greater than unity elasticity means that the change in price of a good, say, motor cycle leads to
more proportionate change in the quantity demanded of the substitute, say, motor cycle. (e > 1)
b. Unitary elasticity: of demand refers to the proportionate change in price of a good followed by equal proportionate
change in quantity demanded of the substitute. (e = 1)
c. Less-than-unity: elasticity of demand refers to less proportionate change in quantity demanded of the substitute good
leaded by the change in price of a good. (e < 1)

(ii) Cross elasticity of complementary goods: The examples of complementary goods are: pen and ink, motor vehicle and
petrol/gas, house and paint, fertiliser and seeds, aeroplane and internal equipment, computer and internet products, mobile
phones and charging adopter, etc. Complementary goods are jointly demanded by a consumer. Therefore, with a rise in the
price of a commodity will lead to a fall in demand for its complementary goods. In this case the elasticity of demand is negative.
(d) Substitution Elasticity of Demand:
The substitution elasticity of demand refers to the fact that to what extent one commodity can be substituted for another without
making any change in the total satisfaction of the consumer. The underlying concept is the ‘marginal rate of substitution’ as studied in
‘Indifference Curve’. From the definition of substitution elasticity, it can be concluded that the consumer is to remain on the same
indifference curve at various combinations of substitution commodities. It is the substitution effect that measures the substitution
elasticity of demand, just as in the price elasticity of demand, measured by price effect.

Following are the forms of substitution elasticity of demand:

(i) Elasticity of substitution is infinite,

(ii) Elasticity is equal to zero,
(iii) Greater-than-unity,
(iv) Lower-than-unity, and
(v) Unitary elasticity.

(i) Elasticity of substitution is infinite: means that the substitution of one good for another is extremely difficult, that even
a small change could bring huge instead infinite variations in the marginal rate of substitution (MRS). (e = ∞)
(ii) Elasticity of substitution is zero: refers to the perfectly inelastic demand substitution. It means that any variation in the
proportions of commodities will not bring much change or no change. This situation leads the elasticity of substitution is zero.
(e = 0)
(iii) Elasticity of substitution equals to/not equals to unity: There are two extremes discussed above, i.e., infinite and zero
elasticities. Between these two extremes, there are number of variations.

The elasticity of substitution can be measured with the help of following formula:

Where qx/qy is original proportion between quantities of X and Y;

∆(qx/qy) is change in the proportion of X and Y;
∆y/∆x is initial MRS of X and Y;
∆(∆y/∆x) is change in MRS of X and Y.
Relationship between Price Elasticity, and Substitution Elasticity and Income Elasticity:
1. The price effect consists of two components, viz., the income effect and substitution effect;
2. Therefore, the price elasticity depends on income elasticity and substitution elasticity;
3. The relationship between price elasticity, and income and substitution elasticities is expressed in the following formula:

Where, ep = Price elasticity;

ei = Income elasticity;
es = Substitution elasticity;
KX = Proportion of consumer’s income spent on X.

4. Thus, the price elasticity of demand depends on:

(i) Income elasticity (ei)

(ii) Substitution elasticity (es)
(iii) Proportion of income spent on the goods other than X

Indifference Curve Analysis

Properties of Indifference Curve:
1. Indifference curve slopes downward from left to right telling us that a consumer is having the same level of satisfaction at any point on the indifference
curve.
2. Indifference curve cannot be a straight line and sloping upwards from left to right.
3. Two indifference curves cannot intersect each other. How can one combination of two commodities yield two different levels of satisfaction?
4. Indifference curve is normally convex to the origin.
5. Indifference curve cannot be a straight line sloping downward and a concave line.
6. Convexity to the origin means that more of one unit of a commodity is consumed, the consumer is prepared to forego a smaller number of other
commodity.

Marginal Rate of Substitution:

MRS is the ratio of prices of two substitutes. According to J.R. Hicks, MRS of x for y is the quantity of y which would compensate the
consumer for the loss of marginal unit of x. This concept is parallel to the concept of marginal utility.
Price Line:
Price line has several names, viz., price opportunity line, price-income line and budget line. It depicts the highest level or the maximum limit
of the consumer’s income that can be spent on two commodities (in fact). It may also show the prices of the goods in the market.

Consumer’s Equilibrium:
For consumer’s equilibrium is necessary that indifference curve must be:

(i) Concave to the origin, and

(ii) Tangent to the price-line.

Following assumptions are made for consumer’s equilibrium:

1. There must be scale of preferences for various combinations of two goods.

2. There must be a given and constant amount of money to be spent on two goods.
3. Prices of goods in the market are given and constant.
4. Goods are homogeneous and divisible.
5. The purpose is to maximise satisfaction at any cost.

Income Effect:
Income effect refers to the situation that with every change in consumer’s income, there is either increase or decrease in his satisfaction
attained from the consumption of purchased goods.

Substitution Effect:
As we know that when there is a change in the price of a commodity, the real income of the consumer automatically changes in
contrast. Whereas in substitution effect, in such a case, the real income is to be adjusted, in order to maintain the same level of real income as
it was before the price changes. As a result, the quantity demanded increases or decreases in contrast to the price changes. Or in other words,
there should be a change in the combination of the two commodities. This shift from one point to another point on the same indifference
curve is to be mentioned here as ‘substitution effect’.

Price Effect:
Price effect refers to the change in consumer’s equilibrium as a result of a change in the price of a commodity, while his income and price of
other commodities remaining the same. The price effect is depicted with the help of price consumption line.

Price Effect = Income Effect + Substitution Effect

Giffen Goods:
Sir Robert Giffen, in the middle 19th century, had observed that when the price of bread rose, the poor bought more bread and less meat and
less of some other more expensive food stuff. Giffen goods are inferior goods. Their quantity demanded falls with every decrease in the
price. The income effect of Giffen Goods are negative. Whereas in case of ordinary inferior goods, the income effect is not as powerful as
substitution effect, as a result, when the price falls, the quantity demanded increases. The demand curve of Giffen Goods slopes upward from
left to right.

Analysis of Price Effect:

Indifference curve analysis enables us to analyse the price effect, income effect and substitution. When the price of a commodity falls,
besides price effect, these are two reasons for an increase in demand:

(i) Income effect – the real income rises which also tend to increase the quantity demanded.
(ii) Substitution effect – more consumers will shift their demand from expensive substitutes to a cheaper substitute.

This is also known as the technique of compensating variation in income.

Exception Cases of Consumer’s Equilibrium:

For consumer’s equilibrium on indifference curve, it is usual that the indifference curve must be convex to the origin and tangent to the price
line. But here are some exceptional cases, where the consumer is still in equilibrium:
Figure (a): gives concave indifference curves. The consumer is in equilibrium at point P, where the consumer is buying only good y; or at
point L where he is buying only good x. He is not in equilibrium at point Q.

Figure (b): is not convex to the origin and tangent to the price line. The equilibrium point is P.
Figure (c): is similar to figure (b). The indifference curve has lower slope than price line PL. The equilibrium point is L.

Figure (d): represents the case of complementary goods. The indifference curve 2 is tangent is price line PL. Therefore, the consumer is in
equilibrium at point C.
 Price Determination under Monopoly
Monopoly is that market form in which a single producer controls the whole supply of a single commodity which has no close
substitute.

From this definition there are two points that must be noted:

(i) Single Producer: There must be only one producer who may be an individual, a partnership firm or a joint stock
company. Thus single firm constitutes the industry. The distinction between firm and industry disappears under conditions
of monopoly.
(ii) No Close Substitute: The commodity produced by the producer must have no closely competing substitutes, if
he is to be called a monopolist. This ensures that there is no rival of the monopolist. Therefore, the cross elasticity of
demand between the product of the monopolist and the product of any other producer must be very low.

PRICE-OUTPUT DETERMINATION UNDER MONOPOLY:

A firm under monopoly faces a downward sloping demand curve or average revenue curve. Further, in monopoly, since average
revenue falls as more units of output are sold, the marginal revenue is less than the average revenue. In other words, under
monopoly the MR curve lies below the AR curve.

The Equilibrium level in monopoly is that level of output in which marginal revenue equals marginal cost. The producer will continue
producer as long as marginal revenue exceeds the marginal cost. At the point where MR is equal to MC the profit will be maximum
and beyond this point the producer will stop producing.
It can be seen from the diagram that up till OM output, marginal revenue is greater than marginal cost, but beyond OM the marginal
revenue is less than marginal cost. Therefore, the monopolist will be in equilibrium at output OM where marginal revenue is equal
to marginal cost and the profits are the greatest. The corresponding price in the diagram is MP’ or OP. It can be seen from the
diagram at output OM, while MP’ is the average revenue, ML is the average cost, therefore, P’L is the profit per unit. Now the total
profit is equal to P’L (profit per unit) multiply by OM (total output).

In the short run, the monopolist has to keep an eye on the variable cost, otherwise he will stop producing. In the long run, the
monopolist can change the size of plant in response to a change in demand. In the long run, he will make adjustment in the amount
of the factors, fixed and variable, so that MR equals not only to short run MC but also long run MC.

COMPARISON OF PRICE DETERMINATION UNDER PERFECT COMPETITION AND MONOPOLY:

The key points of comparison of price determination under Perfect Competition and Monopoly is as below:

Perfect Competition Monopoly

(i) The demand curve or average (i) The demand curve or average
revenue curve is perfectly elastic and is revenue curve is relatively elastic and a
a horizontal straight line. downward sloping from left to right.

(ii) The firm is in equilibrium at the level (ii) The firm is in equilibrium at the level
of output where MC is equal to MR. of output where MC is equal to MR.
Since in perfect competition MR is
equal to AR or price, therefore, when
MC is equal to MR, it is also equal to
AR or price at the equlibrium position,
i.e., MC=MR=AR (Price)
(iii) In equilibrium position, the price (iii) In equilibrium position, the price
charged by the firm equals to MC. charged by the firm is above MC.

(iv) The firm is in long-run equilibrium (iv) The firm is in long-run equilibrium
at the minimum point of the long-run at the point where AC curve is still
AC curve. declining and has not reached the
minimum point.

(v) The firm is in equilibrium at the level (v) The firm is in equilibrium at the level
of output at which MC curve is rising, of output at which MR curve is sloping
and is cutting MR curve from below. downwards, and MC curve is cutting it
from below or above. (See figure 1)
(vi) In the long run, the firm is earning (vi) The firm can earn abnormal or
normal profit. There may be super supernormal profit even in the long run,
normal profit in the short run but they as there is no competitor in the
will be swept away in the long run, as industry.
new firms entered into the industry.

(vii) Price can be set lower at greater (vii) Price is set higher and output
output in case of constant-cost and smaller by the monopolist. (See Figure
decreasing-cost industries. 2)
PRICE DISCRIMINATION IN MONOPOLY:
Price discrimination may be (a) personal, (b) local, or (c) according to trade or use:

(a) Personal: It is personal when different prices are charged for different persons.
(b) Local: It is local when the price varies according to locality.
(c) According to Trade or Use: It is according to trade or use when different prices are charged for different uses to which
the commodity is put, for example, electricity is supplied at cheaper rates for domestic than for commercial purposes.

Some monopolists used product differentiation for price discrimination by means of special labels, wrappers, packing, etc. For
example, the perfume manufacturers discriminate prices of the same fragrance by packing it with different labels or brands.

Conditions of Price-Discrimination: There are three main types of situation:

(a) When consumers have certain preferences or prejudices. Certain consumers usually have the irrational feeling that
they are paying higher prices for a good because it is of a better quality, although actually it may be of the same
quality. Sometimes, the price differences may be so small that consumers do not consider it worthwhile to bother about such
differences.
(b) When the nature of the good is such as makes it possible for the monopolist to charge different prices. This happens
particularly when the good in question is a direct service.
(c) When consumers are separated by distance or tariff barriers. A good may be sold in one town for Re. 1 and in
another town for Rs. 2. Similarly, the monopolist can charge higher prices in a city with greater distance or a country levying
heavy import duty.

Conditions making Price Discrimination Possible and Profitable: The following conditions are essential to make price
discrimination possible and profitable:

(a) The elasticities of demand in different markets must be different. The market is divided into sub-markets. The sub-
market will be arranged in ascending order of their elasticities, the higher price being charged in the least elastic market and
vice versa.
(b) The costs incurred in dividing the market into sub-markets and keeping them separate should not be so large as to
neutralise the difference in demand elasticities.
 (c) There should be complete agreement among the sellers otherwise the competitors will gain by selling in the dear
market.
(d) When goods are sold on special orders because then the purchaser cannot know what is being charged from others.

Price Determination under Price Discrimination:

(i) First of all, the monopolist divides his total market into sub-markets. In the following diagrams, the monopolist has
divided his total market into two sub-markets, i.e., A and B:

(ii) The monopolist has now to decide at what level of output he should produce. To achieve maximum profit, hence, he will
be in equilibrium at output at which MR=MC, and MC curve cuts the MR curve from below. In the above diagram (c) it is shown
that the equilibrium of the discriminating monopolist is established at output OM at which MC cuts CMR. The output OM is
distributed between two markets in such a way that marginal revenue in each is equal to ME. Therefore, he will sell output
OM1 in Market A, because only at this output marginal revenue MR’ in Market A is equal to ME (M1E’ = ME). The same condition
is applied in Market B where MR” is equal to ME (M2E” = ME). In the above diagram, it is also shown that in Market B in which
elasticity of demand is greater, the price charged is lower than that in Market B where the elasticity of demand is less.
 Price Determination under Oligopoly

Oligopoly is that market situation in which the number of firms is small but each firm in the industry takes into consideration the reaction of the rival firms in the
formulation of price policy. The number of firms in the industry may be two or more than two but not more than 20. Oligopoly differs from monopoly and
monopolistic competition in this that in monopoly, there is a single seller; in monopolistic competition, there is quite a larger number of them; and in oligopoly,
there are only a small number of sellers.

CLASSIFICATION OF OLIGOPOLY:
The oligopolistic industries are classified in a number of ways:

(a) Duopoly: If there are two giant firms in an industry it is called duopoly. Duopoly is further classified as below:
(i) Perfect or Pure Duopoly: If the duopolists in an industry are producing identical products it is called perfect or pure duopoly.
(ii) Imperfect or Impure Duopoly: If the duopolists in an industry are producing differentiated products it is called imperfect or impure duopoly.

(b) Oligopoly: If there are more than two firms in an industry and each firm takes consideration the reactions of the rival firms in formulating its own price
policy it is called oligopoly. Oligopoly is further classified as below:

(i) Perfect or Pure Oligopoly: If the oligopolists in an industry are producing identical products it is called perfect or pure oligopoly.
(ii) Imperfect or Impure Oligopoly: If the oligopolists in an industry are producing differentiated products it is called imperfect or impure
oligopoly.

Types of Market Structures

Structure No. of Producers & Part of economy Firm’s degree Methods of
Degree of Product where prevalent of control over price Marketing
Differentiation
 Many producers, Financial markets, & None Market exchange
Perfect competition Identical products Some agricultural products or auction

Imperfect
competition:
Monopolistic competition Many producers, Retail trade Some Advertising and
Many real or perceived (Gasoline, PCs, etc.) Quality rivalry,
differences in product Administered prices

Oligopoly Few producers, Steel, chemicals, etc.

No differences in product.

Few producers, Autos, aircraft, etc.

Some differentiation
of products

Single producer, Local telephone, Considerable but Advertising and

Monopoly Product without close electricity, and gas usually regulated Service promotion
substitutes

CAUSES OF OLIGOPOLY:
1. Economies of Scale: The firms in the industry, with heavy investment, using improved technology and reaping economies of scale in production,
sales, promotion, etc, will compete and stay in the market.
2. Barrier to Entry: In many industries, the new firms cannot enter the industry as the big firms have ownership of patents or control of essential raw
material used in the production of an output. The heavy expenditure on advertising by the oligopolistic industries may also be a financial barrier for the
new firms to enter the industry.
3. Merger: If the few firms in the industry smell the danger of entry of new firms, they then immediately merge and formulate a joint policy in the pricing
and production of the products. The joint action of the few big firms discourages the entry of new firms into the industry.
4. Mutual Interdependence: As the number of firms is small in an oligopolistic industry, therefore, they keep a strict watch of the price charged by rival
firms in the industry. The firm generally avoid price ware and try to create conditions of mutual interdependence.

CHARACTERISTICS OF OLIGOPOLY:
 1. Every seller can exercise an important influence on the price-output policies of his rivals. Every seller is so influential that his rivals cannot
ignore the likely adverse effect on them of a given change in the price-output policy of any single manufacturer. The rival consciousness or the
recognition on the part of the seller is because of the fact of interdependence.
2. The demand curve under oligopoly is indeterminate because any step taken by his rivals may change the demand curve. It is more elastic than
under simple monopoly and not perfectly elastic as under perfect competition.
3. It is often noticed that there is stability in price under oligopoly. This is because the oligopolist avoids experimenting with price changes.He knows
that if raises the price, he will lose his customers and if he lowers it he will invite his rivals to price war.

EFFECTS OF OLIGOPOLY:
1. Small output and high prices: As compared with perfect competition, oligopolist sets the prices at higher level and output at low level.
2. Restriction on the entry: Like monopoly, there is a restriction on the entry of new firms in an oligopolistic industry.
3. Prices exceed Average Cost: Under oligopoly, the firms fixed the prices at the level higher than the AC. The consumers have to pay more than it
is necessary to retain the resources in the industry. In other words, the economy’s productive capacity is not utilised in conformity with the consumers’
preferences.
4. Lower efficiency: Some economists argued that there is a low level of production efficiency in oligopoly. There is no tendency for the oligopolists
to build optimum scales of plant and operate them at the optimum rates of output. However, the Schumpeterian hypothesis states that there is high
tendency of innovation and technological advancement in oligopolistic industries. As a result, the product cost decreases with production capacity
enhancement. It will offset the loss of consumer surplus from too high prices.
5. Selling Costs: In order to snatch markets from their rivals, the oligopolistic firms may engage in aggressive and extensive sales promotion effort
by means of advertisement and by changing the design and improving the quality of their products.
6. Wider range of products: As compared with pure monopoly or pure competition, differentiated oligopoly places at the consumers’ disposal a
wider variety of commodities.
7. Welfare Effect: Under oligopoly, vide sums of money are poured into sales promotion to create quality and design differentiations.Hence, from the
point of view of economic welfare, oligopoly fares fairly badly. The oligopolists push non-price competition beyond socially desirable limits.

PRICE DETERMINATION UNDER OLIGOPOLY:

The price and output behaviour of the firms operating in oligopolistic or duopolistic market condition can be studied under two main heads:

1. Price and Output Determination under Duopoly:

(a) If an industry is composed of two giant firms each selling identical or homogenous products and having half of the total market, the price and
output policy of each is likely to affect the other appreciably, therefore there is every likelihood of collusion between the two firms. The firms may
agree on a price, or divide the total market, or assign quota, or merge themselves into one unit and form a monopoly or try to differentiate their
products or accept the price fixed by the leader firm, etc.
(b) In case of perfect substitutes the two firms may be engaged in price competition. The firm having lower costs, better goodwill and clientele will
drive the rival firm out of the market and then establish a monopoly.
 (c) If the products of the duopolists are differentiated, each firm will have a close watch on the actions of its rival firms. The firm good quality product
with lesser cost will earn abnormal profits. Each firm will fix the price of the commodity and expand output in accordance with the demand of the
commodity in the market.

2. Price and Output Determination under Oligopoly:

(a) If an industry is composed of few firms each selling identical or homogenous products and having powerful influence on the total market, the
price and output policy of each is likely to affect the other appreciably, therefore they will try to promote collusion.
(b) In case there is product differentiation, an oligopolist can raise or lower his price without any fear of losing customers or of immediate reactions
from his rivals. However, keen rivalry among them may create condition of monopolistic competition.
There is no single theory which satisfactorily explains the oligopoly behaviour regarding price and output in the market. There are set of theories like Cournot
Duopoly Model, Bertrand Duopoly Model, the Chamberlin Model, the Kinked Demand Curve Model, the Centralised Cartel Model, Price Leadership Model,
etc., which have been developed on particular set of assumptions about the reaction of other firms to the action of the firm under study.

COLLUSIVE OLIGOPOLY:
The degree of imperfect competition in a market is influenced not just by the number and size of firms but by how they behave. When only a few firms operate
in a market, they see what their rivals are doing and react. ‘Strategic interaction’ is a term that describes how each firm’s business strategy depends upon its
rivals’ business behaviour.

When there are only a small number of firms in a market, they have a choice between ‘cooperative’ and ‘non-cooperative’ behaviour:

 Firms act non-cooperatively when they act on their own without any explicit or implicit agreement with other firms. That’s what produces ‘price wars’.
 Firms operate in a cooperative mode when they try to minimise competition between them. When firms in an oligopoly actively cooperate with each
other, they engage in ‘collusion’. Collusion is an oligopolistic situation in which two or more firms jointly set their prices or outputs, divide the market
among them, or make other business decisions jointly.

A ‘cartel’ is an organisation of independent firms, producing similar products, which work together to raise prices and restrict output. It is strictly illegal in
Pakistan and most countries of the world for companies to collude by jointly setting prices or dividing markets. Nonetheless, firms are often tempted to engage
in ‘tacit collusion’, which occurs when they refrain from competition without explicit agreements. When firms tacitly collude, they often quote identical (high)
prices, pushing up profits and decreasing the risk of doing business. The rewards of collusion, when it is successful, can be great. It is more illustrated in the
following diagram:
The above diagram illustrates the situation of oligopolist A and his demand curve DaDa assuming that the other firms all follow firm A’s lead in raising and
lowering prices. Thus the firm’s demand curve has the same elasticity as the industry’s DD curve. The optimum price for the collusive oligopolist is shown at
point G on DaDa just above point E. This price is identical to the monopoly price, it is well above marginal cost and earns the colluding oligopolists a
handsome monopoly profit.

PRICE DETERMINATION MODELS OF OLIGOPOLY:

1. Kinky Demand Curve: The kinky demand curve model tries to explain that in non-collusive oligopolistic industries there are not frequent changes in the
market prices of the products. The demand curve is drawn on the assumption that the kink in the curve is always at the ruling price. The reason is that a firm
in the market supplies a significant share of the product and has a powerful influence in the prevailing price of the commodity. Under oligopoly, a firm has two
choices:

(a) The first choice is that the firm increases the price of the product. Each firm in the industry is fully aware of the fact that if it increases the price of
the product, it will lose most of its customers to its rival. In such a case, the upper part of demand curve is more elastic than the part of the curve lying
below the kink.
(b) The second option for the firm is to decrease the price. In case the firm lowers the price, its total sales will increase, but it cannot push up its sales
very much because the rival firms also follow suit with a price cut. If the rival firms make larger price cut than the one which initiated it, the firm which
first started the price cut will suffer a lot and may finish up with decreased sales. The oligopolists, therefore avoid cutting price, and try to sell their
products at the prevailing market price. These firms, however, compete with one another on the basis of quality, product design, after-sales services,
advertising, discounts, gifts, warrantees, special offers, etc.
In the above diagram, we shall notice that there is a discontinuity in the marginal revenue curve just below the point corresponding to the kink.During this
discontinuity the marginal cost curve is drawn. This is because of the fact that the firm is in equilibrium at output ON where the MC curve is intersecting the
MR curve from below.

The kinky demand curve is further explained in the following diagram:

In the above diagram, the demand curve is made up of two segments DB and BD’. The demand curve is kinked at point B. When the price is Rs. 10 per unit, a
firm sells 120 units of output. If a firm decides to charge Rs. 12 per unit, it loses a large part of the market and its sales come down to 40 units with a loss of 80
units. In case, the producer lowers the price to Rs. 4 per unit, its competitors in the industry will match the price cut. Its sales with a big price cut of Rs. 6
increases the sale by only 40 units. The firm does not gain as its total revenue decreases with the price cut.
2. Price Leadership Model: Under price leadership, one firm assumes the role of a price leader and fixes the price of the product for the entire industry. The
other firms in the industry simply follow the price leader and accept the price fixed by him and adjust their output to this price. The price leader is generally a
very large or dominant firm or a firm with the lowest cost of production. It often happens that price leadership is established as a result of price war in which
one firm emerges as the winner.

In oligopolistic market situation, it is very rare that prices are set independently and there is usually some understanding among the oligopolists operating in
the industry. This agreement may be either tacit or explicit.

Types of Price Leadership: There are several types of price leadership. The following are the principal types:

(a) Price leadership of a dominant firm, i.e., the firm which produces the bulk of the product of the industry. It sets the price and rest of the firms
simply accepts this price.
(b) Barometric price leadership, i.e., the price leadership of an old, experienced and the largest firm assumes the role of a leader, but undertakes
also to protect the interest of all firms instead of promoting its own interests as in the case of price leadership of a dominant firm.
(c) Exploitative or Aggressive price leadership, i.e., one big firm built its supremacy in the market by following aggressive price leadership. It
compels other firms to follow it and accept the price fixed by it. In case the other firms show any independence, this firm threatens them and coerces
them to follow its leadership.

Price Determination under Price Leadership: There are various models concerning price-output determination under price leadership on the basis of
certain assumptions regarding the behaviour of the price leader and his followers. In the following case, there are few assumptions for determining price-
output level under price leadership:

(a) There are only two firms A and B and firm A has a lower cost of production than the firm B.
(b) The product is homogenous or identical so that the customers are indifferent as between the firms.
(c) Both A and B have equal share in the market, i.e., they are facing the same demand curve which will be the half of the total demand curve.
 In the above diagram, MCa is the marginal cost curve of firm A and MCb is the marginal cost curve of firm B. Since we have assumed
that the firm A has a lower cost of production than the firm B, therefore, the MCa is drawn below MCb.

Now let us take the firm A first, firm A will be maximising its profit by selling OM level of output at price MP, because at output OM the firm A will be in
equilibrium as its marginal cost is equal to marginal revenue at point E. Whereas the firm B will be in equilibrium at point F, selling ON level of output at price
NK, which is higher than the price MP. Two firms have to charge the same price in order to survive in the industry. Therefore, the firm B has to accept and
follow the price set by firm A. This shows that firm A is the price leader and firm B is the follower.

Since the demand curve faced by both firms is the same, therefore, the firm B will produce OM level of output instead of ON. Since the marginal cost of firm B
is greater than the marginal cost of firm A, therefore, the profit earned by firm B will be lesser than the profit earned by firm A.

Difficulties of Price Leadership: The following are the challenges faced by a price leader:

(a) It is difficult for a price leader to correctly assess the reactions of his followers.
(b) The rival firms may secretly charge lower prices when they find that the leader charged unduly high prices. Such price cutting devices are rebates,
favourable credit terms, money back guarantees, after delivery free services, easy instalment sales, etc.
(c) The rivals may indulge in non-price competition. Such non-price competition devices are heavy advertisement and sales promotion.
(d) The high price set by the price leader may also attract new entrants into the industry and these new entrants may not accept his leadership.

ECONOMIC COSTS OF IMPERFECT COMPETITION AND OLIGOPOLY:

(a) The cost of inflated prices and insufficient output: The monopolist, by keeping the output a little scarce, raises its price above marginal
cost. Hence, the society does not get as much of the monopolist’s output as it wants in terms of product’s marginal cost and marginal value. The same
is true for oligopoly and monopolistic competition.
 (b) Measuring the waste from imperfect competition: Monopolists cause economic waste by restricting output. If the industry could be competitive,
then the equilibrium would be reached at the point where MC = P at point E. Under perfect competition, this industry’s quantity would be 6 with a price
of 100. The monopolist would set its MC equal to MR (not to P), displacing the equilibrium to Q = 3 and P = 150. The GBAF is the monopolist’s profit,
which compares with a zero-profit competitive equilibrium. Economists measure the economic harm from insufficiency in terms of the deadweight loss;
this term signifies the loss in real income that arises because of monopoly, tariffs and quotas, taxes, or other distortions. The efficiency loss is the
vertical distance between the demand curve and the MC curve. The total deadweight loss from the monopolist’s output restriction is the sum of all such
losses represented by the grey triangle ABE:

In the above diagram, DD curve represents the consumers’ marginal utility at each level of output, while the MC curve represents the
opportunity cost of the devoting production to this good rather than to other industries. For example, at Q = 3, the vertical difference between
B and A represents the utility that would be gained from a small increase to the output of Q. Adding up all the lost social utility from Q = 3 to Q = 6 gives the
shaded region ABE.

EMPIRICAL STUDIES OF COSTS OF MONOPOLY:

1. Economists have studied impact of the overall costs of imperfect competition to an economy. These studies estimate the deadweight loss of
consumer surplus in ABE for all industries. Early studies set the total deadweight loss from monopoly at less than 0.1% of US GDP. Now, in modern
days, it would total only about $7 billion.
2. The next important reservation about this approach is that it ignores the impact of market structure upon technological advance or ‘dynamic
efficiency’. But according to Schumpeterian hypothesis, imperfect competition actually promotes the invention and technological advances which offset
the efficiency loss from too high prices.
 3. Some skeptical economists retort that monopolists mainly promote the quiet life, poor quality and uncivil service. Indeed, a common complaint
about companies with a dominant market position is that they pay little attention to quality of product.
4. Most people object to imperfect competition on the grounds that monopolists may be earning supernormal profits and enriching themselves at the
expense of hapless consumers.

INTERVENTION STRATEGIES:
According to a Nobel Prize winner Milton Friedman, basically there are three choices – private unregulated monopoly, private monopoly regulated by the
government, or the government operation. In most market economies of the world, the monopolists are regulated by the State.There are several methods and
tools for controlling the power misuse by monopolistic and oligopolistic firms:

1. Anti-trust Policy: Anti-trust policies are laws that prohibit certain kinds of behaviour (such as firm’s joining together to fix prices) or curb certain market
structures (such as pure monopolies and highly concentrated oligopolies).
2. Encouraging Competition: Most generally, anticompetitive abuses can be avoided by encouraging competition whenever possible.There are many
government policies that can promote vigorous rivalry even among large firms. In particular, it is crucial to keep the barriers to entry low.
3. Economic Regulations: Economic regulation allows specialised regulatory agencies to oversee the prices, outputs, entry, and exit of firms in
regulated industries such as public utilities and transportation. Unlike antitrust policies, which tell businesses what not to do, regulation tells businesses
what to do and how to do.
4. Government Ownership of Monopolies: Government ownership of monopolies has been an approach widely used. In recent years, many
governments have privatised industries that were in former times public enterprises, and encouraged other firms to enter for competition.
5. Price Control: Price control on most goods and services has been used in wartime, partly as a way of containing inflation, partly as a way of keeping
down prices in concentrated industries.
6. Taxes: Taxes have sometimes been used to alleviate the income-distribution effects. By taxing monopolies, a government can reduce monopoly
profits, thereby softening some of the socially unacceptable effects of monopoly.
 Game Theory

GAME THEORY AND OLIGOPOLY BEHAVIOUR:

Game theory analyses the way that two or more players or parties choose actions or strategies that jointly affect each
participant. In other words, game theory determines rational behaviour of players whose interests are mutually dependent on one
another’s decision. Its objective is to find mathematically complete principles which define rational behaviour for the participants
in a social economy, or to derive from them the general characteristics of that behaviour. The theory was developed by John von
Neumann (1903-1957), who was a Hungarian born mathematician.

By game we mean any situation in which the interests of the participants conflict. While taking decision each party must consider
what probably will be the decision of the other so that he may make a choice most profitable to himself. This what usually
happens in a game of chess or cards.This is applicable to situations arising in an oligopoly.

There are two common games, i.e., constant-sum game and zero-sum game:

 Constant-Sum Game: is the game in which the participants take share of the total gain.
 Zero-Sum Game: is the game in which the winnings of one are matched exactly by the losses of the other.

In the following example, the dynamics of price-cutting will be analysed, so lets the game begin! Suppose there are two rival
firms in an industry, viz., Berney & Max:

At present the Berney’s Motto: “We will not be undersold”

Currently, the Max’s Motto: “We sell for 10% less”
In the above diagram, the vertical arrows show Max’s price cuts; the horizontal arrows show Berney’s responding strategy of
matching each price cut. By tracing through the pattern of reaction and counter-reaction, you can see that this kind of rivalry will
end in mutual ruin at a zero price.Because the only price compatible with both strategies is a price of zero; 90 percent of zero is
zero. If one party cut the price, the other party will match the price cuts, and it will continue until the price of zero is attained. Now
the Berney will start ‘what-if’ analysis. What Max will do if Berney charge price A, price B, and so forth. The novel element in the
duopoly game is that the firm’s profits will depend on the rival’s strategy as well as on its own.

The useful tool for representing the interaction between two players is a two-way ‘payoff table’. A payoff table is a means of
showing the strategies and the payoffs of a game between two players. In the payoff table, a firm can choose between the
strategies listed in its rows or columns. For example, Max can choose between its two columns and Berney can choose between
its two rows. In this example, each firm decides whether to charge its normal price or to start a price war by choosing a low price:
* Normal price strategy is the dominant price strategy.

The above payoff table shows the price war game between Berney and Max. The amounts in rupees inside the cells show the
payoffs of the two firms; that is, these are the profits earned by each firm for each of the four outcomes. The lower left amount
shows the payoff to the player on the left, i.e., Berney; the upper right shows the payoff to the player at the top, i.e., Max. Just
like Max, Berney has two choices, i.e., either to opt for normal price or go for a price war. In cell C, the Berney plays normal price
and Max plays price war. The result is that Berney has a profit of – Rs. 100 while Max has a profit of – Rs. 10. Thinking through
the best strategies for each player leads to the dominant equilibrium in cell A, where both the players avoid price war.

Dominant Strategy: The simplest strategy in game theory is ‘dominant strategy’. This situation arises when one player has a
best strategy no matter what strategy the other player follows. The firm’s best price strategy is to follow normal price. In the
above case, charging the normal price is a dominant strategy for both firms in the ‘price-war game’. When both or all players
have a dominant strategy, the outcome is said to be ‘dominant equilibrium’ because each player is having its own dominant
strategy.

Nash Equilibrium: This theory presented by a mathematician John Nash. Nash equilibrium applies to the situation when all the
participants in a game are each pursuing their best possible strategy in the knowledge of the strategies of all other
participants. For example, imagine a two-person country where both the people have to decide the side of the road on which to
drive. The payoffs are as follows:

(i) No crash: happens when both drive on the left or right. It is Nash equilibrium. There are two possible Nash equilibria, i.e.,
either both driving on the left, or both driving on the right.
(ii) Crash: happens when one drives on the left and the other drives on the right. If one drives on the left and the other drives on
right, it is not Nash equilibrium because, given the choice of the other, each would change their own policy.
Now take our previous example of Bernie and Max. Suppose each firm considers whether to have its normal price or to raise its
price toward the monopoly price and try to earn monopoly profits. It is a rivalry game, which is shown in the following diagram:

In the above game, it is shown that the firms can stay at their normal price equilibrium that we found in the price-war game, or
they can try to raise their price to earn some monopoly profits.

Cell A: Each firm follows high price strategy and both firms have the highest joint profit of Rs. 300. It is the situation where both
the firms behave like a monopolist for having high prices.

Cell D: Each firm follows normal price strategy and both firms have the lowest joint profit of Rs. 20. It is the situation of normal
price equilibrium that we found in the price-war game.

Cell C: Max follows a high price strategy but Burney undercuts. So Burney takes most of the market and has the highest profit of
any situation, while Max actually loses money.

Cell B: Berney gambles on high price, but Max’s normal price means a loss for Berney.

Conclusion: In the above example of the rivalry game, Berney has a dominant strategy; it will profit more by choosing a normal
price no matter what Max does. On the other hand, Max does not have a dominant strategy because Max would want to play
normal if Berney plays normal and would want to play high if Berney plays high. In the above game, the best policy for Max is to
play normal price. This situation illustrates the basic rule of basing your strategy on the assumptions that your opponent will act
in his or her best interest. This is Nash equilibrium. Nash equilibrium is one in which no player can improve his or her payoff
given the other player’s strategy. The Nash equilibrium is also sometimes called ‘non-cooperative equilibrium’, because each
party chooses its strategy without collusion or cooperation, choosing that strategy which is best for itself, without regard for the
welfare of society or any other party.

EXAMPLES OF GAME THEORY:

To Collude or Not to Collude:
(a) The duopolists may decide to collude, which means that they will behave in a cooperative manner. A cooperative
equilibrium comes when the parties act in unison to find strategies that will benefit their joint payoffs. They may decide to
form a cartel, setting a high price and dividing all profit equally between the firms. Clearly this will benefit the duopolists at
the expense of consumers.
(b) If the cooperative equilibrium is not possible, the firms would quickly gravitate to the non-cooperative or Nash
equilibrium. This is also known as a ‘perfectly competitive equilibrium’ because each firm and consumer makes
decisions by taking the prices of everyone else as given. In this equilibrium, each firm maximises profits and each
consumer maximises utility leading to zero-profit outcome in which price equals marginal cost. According to Adam Smith,
there is an invisible hand that makes perfectly competitive equilibrium socially efficient, even though each person is
behaving in a non-cooperative manner. By contrast, if some parties were to cooperate and decide to move to the
monopoly price, the efficiency of the economy would suffer. That is why governments intervene to enforce antitrust laws
that contain harsh penalties for those who collude to fix prices or divide up the markets.

The Pollution Game: In many circumstances, non-cooperative behaviour leads to economic inefficiency or social misery. One
notable example is the arms race, where non-cooperative behaviour between the United States and the (former) Soviet Union,
and Pakistan and India led to massive military spending and development of weapons of mass destruction, makes the continents
unsafe. Another example of pollution game is shown in payoff table as follows:
* Nash equilibrium

In the above diagram, an example of two steel manufacturing concerns, namely, US Steel and Oxy Steel, operating in the United
States is taken.In this world of unregulated firms, each individual profit-maximising firm would prefer to pollute the earth’s
environment rather than install expensive pollution-control equipment. In such a world, if a firm behaves altruistically and cleans
up its wastes, that firm will have higher production costs, higher prices, and fewer customers. If the costs are high enough, the
firm may even go bankrupt. This is a situation in which the Nash equilibrium is inefficient. When markets or decentralised
equilibria become dangerously inefficient, governments may step in. By setting efficient regulations or emissions charges,
government can induce firms to move to outcome A, the Low pollute/Low pollute world. In that equilibrium, the firms make the
same profit as in the high-pollution world, and the earth is a healthier place to live in.

Monetary-Fiscal Game: The game theory is also important to understanding a nation’s economic policies. Economists and
politicians have argued that monetary policy and fiscal policy are skewed in an undesirable direction; fiscal deficits are too high
and reduce national saving, while monetary policy produces interest rates that retard investments. It is customary in a modern
economy to separate monetary and fiscal functions.A country’s central bank determines the monetary policy – interest rates, and
the fiscal policy – taxes and spending – is determined by the executive and legislative branches. But the monetary and fiscal
authorities have different objectives. The central bank takes a stance that emphasises austerity and low inflation. The fiscal
authorities worry about full employment, popularity, keeping taxes low, preserving spending programs, and getting re-
elected. Thus they pick high deficits. The central bank wants minimise the inflation and chooses high interest rates.Thus the
outcome is the non-cooperative equilibrium between fiscal authorities and monetary policy makers at cell C:
* Nash equilibrium
† Cooperative equilibrium

Perhaps the best strategy of monetary fiscal game is to lower the deficits, lower interest rates and raise investment, which was
adopted by President Bill Clinton for the survival of US economy.
 Price Determination under Monopolistic Competition

Imperfect competition covers all situations where there is neither pure competition nor pure monopoly. Both perfect competition and pu
monopoly are very unlikely to be found in the real world. In the real world, it is the imperfect competition lying between perfect competi
pure monopoly. The fundamental distinguishing characteristic of imperfect competition is that average revenue curve slopes downward
throughout its length, but it slopes downwards at different rates in different categories of imperfect competition. The monopolistic comp
one form of imperfect competition.

FEATURES OF MONOPOLISTIC COMPETITION:

Monopolistic competition refers to the market situation in which many producers produce goods which are close substitutes of one ano
important distinguishing features of monopolistic competition are:

(a) Product differentiation, and

(b) Existence of many firms supplying the market.

(a) Product Differentiation: In contrary to perfect competition where there is only one homogeneous commodity, in monopolistic c
there is differentiation of products. In monopolistic competition, products are not homogenous nor are they only remote substitutes.
the products produced by competing monopolists that have separate identity, brand, logos, patents, quality and such other product
features. Product differentiation does not mean that goods are completely different. Rather it means that products are different in so
but not altogether so. These imaginary differences are created through advertising, marketing, packaging and the use of trademarks
names.
(b) Existence of Many Firms: Under monopolistic competition, there is fairly large number of sellers, let say 25 to 70. Each individ
relatively small part of the total market so that each has a very limited control over the price of the product. And each firm determine
price-output policy without considering the reactions of rival firms.
(c) In monopolistic competition, in the long run, there is freedom of entry and exit.
(d) The commodity sold in a monopolistic competitive market is not a standardised product but a differentiated product. Hence com
no longer exclusive on price basis. Buyers are buying a combination of physical product and the services which go with it.
(e) Because of consumers’ attachment to a particular brand, the seller acquires a monopolistic influence on the market. Thus, the d
curve facing a firm under monopolistic competition is a downward sloping curve, i.e., if he wants to sell more, he has to lower his pr
demand curve or AR curve under monopoly also slopes downwards, but there is a difference between demand curves facing under
monopolistic competition and pure monopoly. The demand curve faced by a ‘competing monopolist’ is more elastic than the deman
faced by the ‘monopolist’, because there are no close substitutes available for the monopolist commodity.
PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION:
Under monopolistic competition, the firm will be in equilibrium position when marginal revenue is equal to marginal cost. So long the m
revenue is greater than marginal cost, the seller will find it profitable to expand his output, and if the MR is less than MC, it is obvious h
reduce his output where the MR is equal to MC. In short run, therefore, the firm will be in equilibrium when it is maximising profits, i.e.,
MC.

(a) Short Run Equilibrium: Short run equilibrium is illustrated in the following diagram:

Diagram: Monopolistic Competition Short Run Equilibrium

In the above diagram, the short run average cost is MT and short run average revenue is MP. Since the AR curve is above the AC cur
therefore, the profit is shown as PT. PT is the supernormal profit per unit of output. Total supernormal profit will be measured by multip
supernormal profit to the total output, i.e. PT × OM or PTT’P’ as shown in figure (a). The firm may also incur losses in the short run if it
AR curve below the AC curve. In figure (b) MP is less than MT and TP is the loss per unit of output. Total loss will be measured by mu
per unit of output to the total output, i.e., TP × OM or TPP’T’.

(b) Long Run Equilibrium: Under monopolistic competition, the supernormal profit in the long run is disappeared as new firms are en
the industry. As the new firms are entered into the industry, the demand curve or AR curve will shift to the left, and therefore, the super
profit will be competed away and the firms will be earning normal profits. If in the short run firms are suffering from losses, then in the lo
some firms will leave the industry so that remaining firms are earning normal profits.
The AR curve in the long run will be more elastic, since a large number of substitutes will be available in the long run. Therefore, in the
equilibrium is established when firms are earning only normal profits. Now profits are normal only when AR = AC. It is further illustrated
following diagram:
Normal Price (Under Perfect Competition)
Normal Price:
According to Professor Marshall, Normal or Natural Price of a commodity is that which economic forces would
bring about in the long run. Professor Marshall referred the short-period normal price as Sub-Normal
Price. Therefore, the normal price has been bifurcated into:

a. Short-Period Normal Price

b. Long-Period Normal Price

(a) Short-Period Normal Price: Short period of time refers to the time which is not sufficient for supply to adju
to demand completely. Supply can be adjusted completely if there is enough time for the factors of productio
in accordance with the increase or decrease in demand.

In short run, a firm is in equilibrium at the output at which price equals marginal costs. In short run, the fixed
not considered for decision-making. It is the average variable cost which is considered for determining wheth
produce or not. If the price falls below the maximum average variable cost, then even in the short run, all the
the industry will shut down to minimise loses. Thus the minimum average variable cost is the minimum limit t
price. The short-run supply curve of the industry is the lateral summation of the all the marginal cost curves o
firms. The short-run supply curve of the industry slopes upward from left to right.D
In the above diagram, the short period supply curve is divided into two: short-run supply curve (SRS) and mark
period supply curve (MPS). In the above diagram, it is depicted that in the market period, if the demand incre
from DD to D’D’, the market price will rise sharply from OP to OK, while the supply will remain unchanged at O
MPS. However, in the short-run, the increased demand will also increase the production by making intensive
the fixed capital equipment and increasing the amount of variable factors. It should be remembered that in th
run the fixed capital or the fixed costs couldn’t be increased or decreased. While in the market period, neithe
costs nor variable costs can be varied. The market period is referred to a very short period. Therefore, the su
curve of the market period is a straight vertical line and the supply curve of a short period is upward sloping c
left to right. If the demand increases from DD to D’D’, the price will decrease from OK to OR and the supply w
increase from OM to OM’ in the short period.

Now if there is a decrease in demand from DD to D”D”, the market price will fall sharply from OP to OL, the su
commodity remaining the same. But in the short run, firms will contract output by diminishing the variable fa
as a result the quantity supplied will fall. The short-run normal price will be OT. At price OT firms would be in
losses. Price cannot fall below OD, since at price below D, firms would not produce any amount of the commo
the quantity supplied will be zero.

(b) Long-Period Normal Price: In the long run, every cost is variable cost. In this period, all costs ever incurred
firm must be recovered. Price, in the long run, or normal price under perfect competition, therefore, must be
the minimum long-run average cost. A firm under perfect competition is in long-run equilibrium at the outpu
price = MC = minimum LAC.

If the price is above the minimum long-run average cost (LAC), the firms will be making ‘super-normal
profits’. Therefore, new firms will enter the industry to compete away these extra profits and the price will fa
level where it is equal to the minimum LAC, where the firms are making ‘normal profits’. If the price is below
minimum long-run average cost (LAC), the firms will be making ‘losses’. Therefore, some of the existing firms
from the industry to avoid losses and the price will rise to the level where it is equal to the minimum LAC or at
normal price.
(i) Long-run Normal Price in Increasing-cost Industry: In increasing-cost industry, due to certain external diseconomies brings about an upward sh
cost curves of all firms. The increasing cost industry is the most typical of the actual competitive world. The following are the diagrams showing n
in an increasing-cost industry:

Suppose that there is a sudden and once-for-all increase in demand from DD to D’D’. In the market period or the very short period, the firms can
what they have already produced. The total amount supplied will remain unchanged at output OM. Thus, as a result of increase in demand from
the market price will rise sharply from OP to OP’. In the short period, however, the firms will increase output along the short run marginal cost
curve. Therefore, the price in the short run will fall to the level OP” at which the new demand curve D’D’ intersects the short-run supply curve SRS
the lateral summation of the short-run marginal cost curves of the firms. The total amount supplied will be increased to OM’ at price OP”. In this
equilibrium position, firms would be having abnormal profits. Lured by these super-normal profits, new firms will enter into the industry in the lo
increasing cost industry, as new firms enter, the cost curves of all the firms will shift upwards due to net external diseconomies. As the output of t
increases as a result of the entry of new firms, price in the long run will fall to OP”’ at which the demand curve D’D’ intersects the long-run supply
LRS. Thus, OP”’ is the long-run normal price and the output will be OM”. This long run normal price OP”’ must be equal to the minimum LAC, sinc
will continue entering the industry until all are earning only normal profits.

In essence, in the long run, in case of increasing cost industry, more quantity of the product can be got only at a rather higher price.

(ii) Long-run Normal Price in Constant Cost Industry: The long-run supply curve of the constant cost industry is a horizontal straight line or perfect
the level of long-run minimum average cost, i.e., the bottom of the U-shaped LAC:

To begin with, DD is the demand curve and it intersects the market period supply curve MPS at price level OP. Thus OP is market price with OM o
if the demand increases from DD to D’D’, there will be a sharp rise in the market price from OP to OP’, the supply remaining unchanged. In respon
increased demand the firms in the short run will increase production. Therefore, in the short-run equilibrium price will fall to OP” (and output OM
the short-run supply curve SRS intersects the new demand curve D’D’. In the long run, the output will increase further to OM” and the price will f
original level OP. At this equilibrium point every firm will be producing at the long-run minimum average cost as in the original equilibrium positio
earning only normal profits.

(iii) Long-run Normal Price in Decreasing Cost Industry: This is the case of a young industry in its early stages of growth, in which the external eco
outweigh the external diseconomies as it undergoes expansion. This phenomenon of net external economies lowers the cost curves of all firms.
decreasing cost industry, the additional supplies of the product will be forthcoming at reduced prices and therefore the long-run supply curve of th
will slope downwards from left to right:

DD is the original demand curve which intersects the market period supply curve MPS at price OP at output OM. Now suppose that there is a sud
permanent change in demand from DD to D’D’. As a result of the increased demand, the market price will rise sharply from the original price OP t
output remaining the same, i.e. OM. In the short run, the firms will manage to increase the output and therefore, amount supplied will be increas
OM’. As a result the price in the short-run will slip down to a new level i.e. OP”, at which new demand curve D’D’ intersects the short-run supply c
the long run, however, new firms will be attracted and will enter into the industry and cause downward shift in the cost curves of all the firms. Th
run price will be determined at the level OP”’ at which the new demand curve D’D’ cuts the downward sloping long-run supply curve LRS. As it wo
evident from the above diagrams that more output can be produced at a lower than original price in a decreasing cost industry, where the supplie
produce more at reduced prices.
 Rent

Rent refers to that part of payment by a tenant which is made only for the use of land, i.e., free gift of nature. The payment made
by an agriculturist tenant to the landlord is not necessarily equals to the economic rent. A part of this payment may consist of
interest on capital invested in the land by the landlord in the form of buildings, fences, tube wells, etc. The term ’economic
rent’ refers to that part of payment which is made for the use of land only, and the total payment made by a tenant to the
landlord is called ‘contract rent’.

In economics, the term ‘rent’ is being increasingly used in the sense of a surplus, i.e., what a factor of production earns over and
above what is essential to maintain its supplies in its present occupation. In this sense, rent can arise only when the supply of a
factor of production is less than perfectly elastic, and this is the case with most of the factors. In case the supply of a factor is
perfectly elastic, it cannot earn any surplus over and above its supply price. Because whenever such a factor is found to be
earning more than its supply price, more units of this factor will rush in and the surplus earning will disappear. This is so
because, under perfect competition, the market price of a factor must equal its supply price.

The supply of land in general is absolutely inelastic, and its supply is independent of what it earns. The higher rent cannot attract
more of it and a lower rent cannot drive it out. That is why, the land has no supply price.

Economic rent is the surplus which remains to the supplier of a factor after he has paid all the expenses of production and has
remunerated himself for his own productive effort.

Another way of explaining rent is transfer earnings. Transfer earnings represent the amount which a factor can earn in its next
best paid alternative use. Suppose a piece of land yields in its present use Rs. 500,000 a year and suppose further that if it is
transferred to its next best use, it will yield Rs. 400,000. In its present use, it yields Rs. 100,000 more than its next best use. This
sum of Rs. 100,000 is a sort of surplus that the land is yielding in its present use. This surplus is called rent.

Ricardian Theory of Rent:

More than a century ago, David Ricardo presented the Theory of Rent. According to him, rent is that portion of the produce of the
earth which is paid to the land for the use of the original and indestructible powers of the soil. Economic rent, according to
Ricardo, is the true surplus left after the expenses of cultivation as represented by payments to labour, capital and enterprise
have been met.

Suppose a country has four kinds of land, i.e., A, B, C and D. Some pieces of land are more fertile than others and some areas
are more advantageously situated as regards centres of population and means of transport, etc. A is most superior land and B, C
and D are 2nd, 3rd and 4th grade lands, respectively. Further, suppose that standard units of labour and capital called ‘doses’ of
labour and capital, when applied to these categories of land, produce wheat as given in the following table:

Doses Return in Quintals of Wheat per Acre

A B C D
st
1 10 9 8 7
2nd 9 8 7 6
3rd 8 7 6 5
4th 7 6 5 4
5th 6 5 4 3
6th 5 4 3 2

Suppose class A is enough and it can meet the entire demand for food at the prevailing price. In this situation, land will command
no rent. It will be like a free gift of nature. Now suppose that population has increased to such an extent that the whole of the
class A land is brought under cultivation, and still it is not enough to meet the growing demand for food. In order to meet the
increased demand for food, more labour and capital will be put into lands of class A, and of class B will also be brought under
cultivation. This will happen only when the price of wheat rises so much as to make it worthwhile putting one more dose (i.e., two
doses in all) of labour and capital into land A and putting first dose of labour and capital into land B. The price of 10 quintals of
wheat produced on land A in 1st dose of labour and capital is just equal to the cost of labour and capital. Therefore, there is no
surplus on land A in the first dose. Similarly, the price of 9 quintals of wheat produced on land B is just equal to the cost of labour
and capital put into this land in the 1st dose. Therefore, there is no surplus on land B in the second dose. But on the land A,
2nddose of labour and capital gives a return of (10 + 9) 19 quintals, whereas, the cost of two doses labour and capital is just
equal to (9 quintals × 2 doses) 18 quintals. The difference of 1 quintal (19 – 18) is the surplus on land A. Thus the cultivators of
land can either cultivate land B free of rent and get 9 quintals of wheat per dose of labour and capital per acre, or they can pay 1
quintal of wheat per acre to the owners of land A as ‘rent’.
As the demand for food still grows and the price of wheat rises, this process will continue. More and more units of labour and
capital will be applied to the superior lands on the one hand, and still inferior lands will be brought under cultivation, on the
other. The available doses of labour and capital will be applied in such a way as to get equal returns at the margin of
cultivation. For example, if there are 10 doses available, 4 will be applied to land A, 3 will be applied to land B, 2 will be applied
to land C, and 1 dose will be applied to land D. In this way, the marginal or the last dose applied to each class of land will give
the same return, i.e., 7 quintals of wheat. The total production under these conditions will be 34 + 24 + 15 + 7 = 80 quintals of
wheat. No other arrangement can give an output more than this. It is clear that rent of each class of land is equal to the surplus
output over and above the cost of production, which is equal to 7 quintals of wheat. Under such circumstances, rent per acre of
the various kinds of land will be:

Rent of A = Total Produce of Land A – Total Cost of Production from Land A

= (10 + 9 + 8 + 7) – (7 quintals × 4 doses)
= 34 – 28
= 6 quintals

Rent of B = (9 + 8 + 7) – (7 quintals × 3 doses)

= 24 – 21
= 3 quintals

Rent of C = (8 + 7) – (7 quintals × 2 doses)

= 15 – 14
= 1 quintal

Rent of D = 0 quintals

When marginal produce is 7 quintals, there will be no rent of D grade land. It is then the marginal land or land on the margin of
cultivation. This is also called the ‘no-rent land’ or ‘marginal land’. It produces no surplus over cost of production. Its produce is
just enough to cover production expenses on it. The rent of all superior lands is measured upwards from, and with reference to,
the marginal land. Now the marginal land may not be the worst or poorest land. It may have other alternative uses. The land
which is best for cultivation of cotton may also be best for cultivation of wheat.
The following diagrams illustrates the Ricardian Theory of Rent:

In the above diagram, it will be seen that the minimum average cost of production on D grade land is LH. If this D grade land is to
be cultivated then the price of the produce (wheat) must be equal to OP. In other words, when the demand for wheat increases
so much that price OP is determined, only then will this land be cultivated. At price OP, OL quantity of D grade land will be
cultivated. For land D, the total cost of production is equal to the total value of the produce obtained (because price OP =
Average Cost of Production, i.e., LH). Thus there is no surplus above the cost of production or rent on land D. Grade D land is
‘no-rent land’ or ‘marginal land’.

In case of land C, the price will also be OP, because under perfect competition, price in the market must be the same whatever
land may be producing that commodity. But the average cost is QS. Hence there is GS per unit surplus, or total surplus above
total cost is equal to the area GPTS. GPTS is the rent on land C. Similarly, rent on land B is represented by FPZK and rent on
land A is represented by EPJR.
The rent paid may not be economic rent, but scarcity rent. This happens in an old economy with a growing population. Then,
even the marginal land pays some rent which is scarcity rent. The superior lands will pay, besides scarcity rent, economic rent,
due to the natural differential advantages enjoyed by them.

Besides economic rent, there is also a ‘scarcity rent’. As the price of wheat rises, the worst land is also subjected to intensive
cultivation and it yields a surplus over cost. This surplus is not a differential one compared to no-rent land, which does not
exist. It is due to the scarcity of land as such. Hence it is called ‘scarcity rent’.

The rent yielded by superior lands thus contains two elements:

(i) Differential surplus over marginal land, and

(ii) Payment due to scarcity of land as such.

Criticism of Ricardian Theory:

The Ricardian Theory of Rent has been widely criticised on the following grounds:

(i) According to Ricardian Theory, rent arises because some lands are superior and others inferior. But modern
writers assert that it is a matter of indifference to the general principle of rent whether the land is uniformly good,
uniformly bad or gradable. The essential factor of rent is the relative scarcity of the products that land can yield. The
scarcity of land is in fact derived from the scarcity of its products. If the problem is approached from this point of view,
the necessity of assuming different grades of land disappears.
(ii) The second fact that Ricardian Theory has pointed out is that rent is measured from the no-rent margin. No-rent
margin is the starting point of measuring rent according to this theory. It is contended by the modern writers that the no-
rent margin may exist in some cases, but it is not fundamental to the emergence of rent. For instance, some lands may
be fit only for a specific use, e.g., growing corn. If it is not profitable to grow corn on them due to fall in the price of corn,
such land may go out of cultivation, or they may just pay for the cost of the crop grown on them. Such lands may have
significance from the point of view of rent but in a different sense than held by Ricardo. If such lands are cultivated, they
tend to increase the supply of corn and thus lower rents, and if they go out of cultivation, rent rises due to a decrease in
the supply of corn. The existence of such marginal land does not give any ultimate explanation of rent.
Modern Theory of Rent:
Modern theorists view rent as a payment for the use of land. According to the modern view rent is determined by the demand for
and the supply of land. Now lets take the demand for land first:

Demand for the Use of Land: The demand for land is a derived demand. It is derived from the demand for the products of
land. If the demand for these products rises or falls, the demand for the use of land will correspondingly rise or fall leading to
increase or decrease of rents. For instance, if population of a country increases, the demand for food will increase, resulting in
increased demand for land and rise in its rent, and vice versa. The productivity of land is subject to the law of diminishing
marginal productivity. That is why, the demand curve for land slopes downward from left to right, as shown in the following
diagram:

Thus, on the side of demand, rent of land is determined by its productivity, not total productivity, but marginal productivity.

Supply Side: On the supply side, the supply of land is fixed so far as the community is concerned, although individuals can
increase their own supply acquiring more land from others or decrease its supply by parting with land. Land is a case of perfectly
inelastic supply which means that whatever the rent, the supply remains the same. That is why it is said that land has no supply
price. In other words, the supply of land in general is absolutely inelastic and as such its supply is independent of what it earns.
Interaction of Demand and Supply: The interaction of these two forces is shown in the above diagram. We assume that land is
homogeneous and it is used for raising only one crop. Only then there can be one demand curve and on supply curve. We also
assume perfect competition. SS, supply curve, a vertical straight line, indicates the fixed supply of land. These two curves
intersect at point E. In this OR (=SE) is the rent. If the rent is less than OR, say OR” (=SE”), the demand for land will increase;
but the supply is fixed, hence rent will again rise to OR. If, on the other hand, rent rises above OR to OR’ (=SE’), the demand for
land will decrease and bring the rent back to OR.

Suppose now that on account of increase in population or otherwise, demand for land has increased from DD to D’D’. Supply
curve is still the same SS. The new point of intersection will be E’, and, therefore, the rent will be OR’ (SE’). If demand falls to
D”D” then the demand and supply curves intersect at E” and the rent will be OR” (SE”). In case, the country is entirely new and
land of good quality is surplus, then there will be no rent. This condition is shown by D”’D”’.

Land for an Individual / Particular Use: We have analysed above the total demand and supply of land for the community as a
whole. Now lets consider an individual’s case. For a particular use or particular industry, the supply of land cannot be regarded
as fixed. By offering more rent, the supply can be increased, the supply will decrease if the rent in this particular case goes
down. The supply is thus elastic and the supply curve will rise upward from the left to the right as is shown in the following
diagram:

Modern theory of rent does not confine itself to the determination of the reward of only land as a factor of production. Rent
according to the modern sense can arise in respect of any factor of production. It is a surplus payment in excess of transfer
earnings of that factor. Economic rent of a factor of production is the excess over its transfer earnings, i.e., what a factor may be
earning in its present employment over what it could earn in its next best employment. In other words, transfer earnings of a
factor mean what a unit of factor can earn in its next best alternative use, occupation or industry. We can also define transfer
earnings as the minimum earnings which a unit of factor of production must be paid in order to induce it to stay in its present use
or industry or occupation. If a factor is getting less than this minimum, it will give up its present employment and shift to its next
best alternative employment. But if a factor in its present employment is earning more than the minimum necessary to keep it in
that employment, the excess is called ‘economic rent’.

Let us take some examples, suppose a lecturer in Economics is getting Rs. 10,000 salary per month in a college. His next best
employment can be in a bank where he can earn Rs. 9,000 salary per month. If he cannot get Rs. 9,000 salary from college, he
will take up a job in a bank. But since he is actually earning Rs. 10,000 as lecturer in a college, it means he is earning Rs. 1,000
per month more than his next best employment.This Rs. 1,000 is an economic rent for him. Take another example, suppose a
piece of land is devoted to the cultivation of rice with Rs. 15,000 earning per month. In the next best alternative use, the owner
can earn Rs. 12,000 per month by cultivating cotton on it. It means he is earning Rs. 3,000 more than the next best alternative
use of land. This excess / surplus of Rs. 3,000 is economic rent.

How Economic Rent Arises?

The determination of Economic Rent depends on the elasticity of supply of factors of production. There are three possibilities:

(a) Perfectly elastic supply of factors

(b) Less than perfectly elastic supply of factors
(c) Inelastic supply of factors

(a) Perfectly elastic supply of factors: When the elasticity of supply of factors of production is perfectly elastic, there will
be no surplus or economic rent, and the actual earnings and transfer earnings are equal. If there is any difference, it will be
swept away, when new factors are entered into the factor market. When the supply of factors of production is perfectly
elastic, it means that entrepreneurs can engage or employ any number of factor units at a given price or
remuneration. Thus no factor can earn more than its transfer earnings, and there will be no rent or surplus earnings. This
situation is shown in the following diagram:
In the above diagram, the supply curve of the factor of production is a horizontal straight line indicating perfect elasticity. All the
factor units are available at the given price OS. The transfer earnings of each factor is equal to OS. DD is the demand curve and
it intersects the supply curve SS at point P. OM is the equilibrium quantity of the factor used. Total earnings are equal to
OSPM. But since the transfer earnings are equal to total earnings, therefore, the transfer earnings are also equal to OSPM. If
this firm does not pay the price OS, the factor units will be shifted to some other use.

(b) Less than perfectly elastic supply: When the elasticity of supply of factors of production is less than perfectly elastic
(i.e., it is somewhat elastic), the transfer earnings of all the factors are not equal. As the price of the factor increases, more
and more of the factor units will be employed in the industry. Suppose, in a particular industry, a factor unit can earn Rs.
5,000 per month. It is obvious that only such units of the factor will offer their services to this industry whose price in other
alternative occupations is less than Rs. 5,000, or in other words, the transfer earnings are less than the present
earnings. In this manner, as the price paid for a factor in a particular industry or occupation increases, the supply of the
factor will increase if the transfer earnings are less. It is clear that the supply of a factor of production depends on its
transfer earnings. The following diagram illustrates the situation:
The supply curve SS in the above diagram indicates the quantities of the factor available at various prices. It shows the transfer
earnings of different factor units, for example, the transfer earning of A unit of the factor is AQ, whereas the price is
OP. Therefore, the surplus or economic rent is HQ. In the same manner, the other units earn surplus or rent. It is assumed all
factor units are equally useful for this industry. Hence the price of all factor units in the industry will be the same, i.e., OP. The
supply curve cuts the demand curve DD at point N. The transfer earnings of each factor unit are less than the price OP, except
for G unit of the factor. Total earnings are equal to OGNP and the total transfer earnings are equal to OGNS. PNS represents the
surplus or economic rent.

(c) Inelastic Supply: When the elasticity of supply of factors of production is absolutely inelastic, it means that it is the
case of supply of land for the community as a whole. The supply of land for community is fixed and it cannot be increased
or decreased whatever the price is offered. That is why the land has no supply price:
In the above diagram, SS’ is the supply curve and DD’ is the demand curve. Both the curves intersect at point R. SS’ is a vertical
straight line indicating the perfectly inelastic supply of land. OP represents the factor price, i.e., the price of land. Even if the price
of the use of land is zero, the supply of land will remain the same. This means that from the point of view of the community as a
whole, the transfer earnings are zero, since the land cannot be transferred to any other place.

The total earnings of land is equal to OPRS. Since in this situation the transfer earnings of land are equal to zero, the entire
earning of land, i.e., OPRS, is economic rent. From the point of community as a whole, there are two alternatives, viz., either the
land should be cultivated or it should be kept idle. Hence, for the community, the transfer earnings of land are zero and whatever
earnings are made in any use thereof constitute its rent or surplus.

Quasi Rent:
The concept of ‘Quasi-Rent’ was first introduced in Economics by Professor Marshall. According to him, quasi-rent is the surplus
earned by the instruments of production other than land. The term ‘Rent’ is applied to income from land and other free gifts of
nature, and ‘Quasi-Rent’ to the income derived from machines and appliances with the help of human efforts. It is earned during
the period when their supply cannot be increased in response to the increase in demand. It is a short-term concept.

The basis of distinction between rent and quasi-rent is the fact that the supply of land is fixed forever, and the other instruments
of production, i.e., building, machines, etc, is fixed temporarily and can be altered after some time. Thus, the quasi-rent is a
temporary surplus. With the increase in the supply of other instruments of production, i.e., buildings, machines, etc., it
disappears. The earnings from such durable goods like machines must, in the long run, equal the prevailing rate of
interest. Temporarily, however, due to shortage, they may yield surplus earnings which are called ‘quasi-rent’.

Quasi-rent has also been defined as the excess of total earnings in the short run over the total variable cost:

Quasi Rent = Total Revenue – Total Variable Cost

In the above SS is the absolute inelastic supply curve of machines. It intersects the DD demand curve at E. That is, at OP (=SE)
price, OS machines are supplied. If in the short run, demand increases to D’D’, the price will go up to OP’ instead of increase in
supply. Since the number of machines is fixed in the short run, the transfer earnings are zero, the price is quasi-rent. It was OP
before and it has become OP’ now. But, in the long run, the supply is perfectly elastic and is represented by PL so that any
number of machines will be supplied at OP. Supply having now increased to OM, the price comes down again to OP
(=ME”). Now the quasi-rent has vanished and the price ME” just covers the supply price (or transfer earnings) which is OP. Thus,
it is clear that in the short run, the capital goods earn quasi-rent, which is disappeared in the long run when the supply becomes
perfectly elastic.

Rent and Prices:

There are two views regarding the differences in the rent and prices:

(a) Ricardian View: According to Ricardian theory of rent, rent cannot enter into price. It is not an element of cost of
production. According to Ricardian theory, rent rises because of the rise in price and not the other way round. According to this
theory, rent is a surplus over cost. Price is determined by the cost of production at the margin where there is no rent. Hence, rent
does not enter into price. The marginal dose of labour and capital just pays for itself and leaves no surplus.

In fact the position of the margin, according to the Ricardian theory, is determined by price and not price by the position of the
margin. Rent is price-determined and not price-determining.

But it is not to be understood that rent has nothing to do with price. When price rises, margin of cultivation will descend; and
inferior lands, which it was not worthwhile to cultivate before, will now become worthwhile. The land, which was marginal or no-
rent land before, begins yielding a surplus, and hence rent. The lands next inferior to it become the marginal lands. As the
margin of cultivation descends, the difference between the superior land and the marginal land becomes greater. This difference
is the measure of economic rent. Therefore, we see that when price rises, the rent also rises. This is true even from
commonsense point of view. For example, when price of wheat rises, there will be greater demand for land to cultivate wheat
and the farmer must offer higher rents to bring more land under the plough.

Thus, rent follows prices but price does not follow rent. Price is the cause and rent is the effect.

(b) Modern View: Modern theorists point out certain cases in which rent will enter into price. When we are thinking not of all
the land of the country but of the land available for particular uses, rent does form an element of price. This is clear from the
concept of opportunity cost. Most of the land is capable being put to alternative uses. If it is put to one use, it is not available for
another use. The minimum price that has to be paid for the use of land is the amount which this land could earn in its most
profitable ‘alternative use’. This is called ‘opportunity cost’ or ‘transfer price’.
From the point of view of an individual firm, prices paid for all factors (including the price for the use of land) must of course be
included in the cost of production, and must, therefore, enter into price. If a farmer is using land belonging to someone else, the
rent that he pays is obviously a cost for him. In the case of an owner-cultivator too, the rent as a cost is there, only its presence is
obscured. The payment that he could have received, if he did not cultivate himself, is the opportunity cost of this land.

The problem may be approached in another way. Prices are determined by the scarcity of the product in relation to demand. The
rent that an entrepreneur pays is a part of his cost of production. If the rent is high the entrepreneur will tend to hire less land
and, conversely, he will use more land if rent is low. If he uses more land, the supply of land for other purposes is diminished. If
he uses less land, the supply available for other purposes is increased. This rent by influencing relative scarcity of land for
different uses effects the prices of different products.
 Wages
The term 'wage' has been defined as a sum of money paid under contract by an employer to a worker for services rendered. A
wage payment is essentially a price paid for a particular commodity, viz., labour services. According to the classical wage theory,
labour supply was considered a function of real wages. But according to Keynes, the workers acted irrationally and generally
bargained for money wages and they sharply reacted against any cut in money wages. The money wage has also been called
nominal wage. But money wages alone may not give us a correct idea of what a worker really earns, it is the real wage that
determines the standard of living of a worker

Factors determining Real Wages:

Following are the factors that determine the real wages or the standard of living of a worker:

(a) Purchasing Power of Money: The purchasing power of money is used to compare wages at different places and at different
times. It varies inversely with the price level, i.e., higher the prices, lower the purchasing power, and vice versa. A part of high
wages in England and North America may be due to higher prices prevailing in those countries/regions.

(b) Subsidiary Earnings: Subsidiary earning is the income in addition to the regular money wage, an employee has in the form
of money or goods. For example, free board and lodging are provided to the domestic servants or peons; professors earning
additional income by marking examination papers, etc.

(c) Extra Work without Extra Payment: If an employee is required to do extra work without any compensation, his real wage is
reduced by that extent.

(d) Regularity or Irregularity of Employment: Regular or more secure employment may be given money wages, but their real
earning may be higher than irregular and unsecured employees receiving higher money wages.

(e) Conditions of Work: Some occupations are healthier than others, and in some the hours of work are shorter than in
others. All these things are taken into account in evaluating real wages.

(f) Future Prospects: A low money income will be considered a high real wage if there are good prospects of a rise in the future.

Theories of Wages:
(a) Subsistence Theory: This theory was originated with the Physiocratic School of the French economists and was developed
by Adam Smith and the later economists of the classical school. The German economist Lassalle called it the Iron Law of Wages
or the Brazen Law of Wages.Karl Marx made it the basis of his theory of exploitation.

According to this theory, wages tend to settle at the level just sufficient to maintain the worker and his family at the minimum
subsistence level. If wages rise above the subsistence level, the workers are encouraged to marry and to have large
families. The large supply of labour brings wages down to the subsistence level. If wages fall below this level, marriages and
births are discouraged and under-nourishment increases death rate. Ultimately, labour supply is decreased, until wages rise
again to the subsistence level. It is supposed that the labour supply is infinitely elastic, that is, its supply would increase if the
price (i.e. wage) offered rises.

Criticism: This theory is almost completely outdated and has no such practical application, especially in advanced
countries. The theory was based on the Malthusian Theory of Population. It is inappropriate to say that every increase in wages
must inevitably be followed by an increase in birth rate. An increase in wages may be followed by a higher standard of living.

(i) Ricardo was one of the exponents of the subsistence theory. He stressed the influence of custom and habit in determining
what was necessary for the workers. But habits and customs change over time. Hence, the theory cannot hold good for a longer
period of time, especially of a world characterised by fast changing habits. Ricardo, therefore, admitted that wages might rise
above the subsistence level for an indefinite period in an improving society.

(ii) The second criticism against this theory is that the subsistence level is more or less uniform for all working classes with
certain exceptions.The thoery, thus, does not explain differences of wages in different employment.

(iii) The third criticism is that the theory explains wages only with reference to supply; the demand side has been entirely
ignored. On the demand side, the employer has to consider the amount of work which the employee gives him and not the
subsistence of the worker.

(iv) The fourth criticism is that the theory explains the adjustment of wages over the lifetime of a generation and does not explain
wage fluctuations from year to year.

(v) The fifth and the final criticism is that the term 'subsistence' has a very vague impression. Does it refer to the minimum
requirements of a modern man or of a tribal savage?
(b) Wages Fund Theory: This theory is associated with the name of J.S. Mill. According to Wages Fund Theory wages depend
upon two quantities, viz.:

(i) The wage fund or the circulating capital set aside for the purchase of labour, and
(ii) The number of labourers seeking employment.

Since, the theory takes the wage fund as fixed, wages could rise only by a reduction in the number of workers. According to this
thoery, the efforts of trade unions to raise wages are futile. If they succeeded in raising wages in one trade, it can only be at the
expense of another, since the wage fund is fixed and the trade unions have no control over population. According to this theory,
therefore, trade unions cannot raise wages for the labour class as a whole.

Criticism: This theory has been widely criticised and stands rejected now. Even J.S. Mill himself recanted it in the second edition
of his book 'Principles of Political Economy'. Mill thought that wages were paid out of circulating capital alone. Whether the
source of wages is capital or the present products, has been the subject of a keen controversy in the past. The fact is that in
some cases, where the process of production is short (e.g., final stages of the productive process), wages are paid out of the
present production. On the other hand, when a process of production is long, the labourer obviously does not obtain wages from
the product of his labour either directly or through exchange. In such cases, wages mainly come out of capital. This theory is
inapplicable in highly industrialised countries, but, it is applicable in an under-developed country suffering from capital deficiency,
where the wages cannot be increased unless national income is increased and capital accumulated through industrialisation.

(c) Residual Claimant Theory: The Residual Claimant Theory has been advanced by an American economist
Walker. According to Walker, wages are the residue left over, after the other facts of production have been paid. Walker says
that rent and interest are governed by contracts but profit is determined by definite principles. There are no similar principles as
regards wages. According to this theory, after rent, interest and profit have been paid, the remainder of the total output goes to
the workers as wages.

This theory admits the possibility of increase in wages through greater efficiency of employees. In this sense, it is an optimistic
theory, the subsistence theory and wages fund theory were pessimistic theories. Though this theory has been rejected by most
economists on several bases.

(d) Marginal Productivity Theory of Wages: This theory state that, under the condition of perfect competition, every worker of
same skill and efficiency in a given category will receive a wage equal to the value of the marginal product of that type of
labour. The marginal product of a labour in any industry is the amount by which the output would be increased if a unit of labour
was increased, while the quantities of other factors of production remaining constant. Under perfect competition, the employer
will go on employing workers until the value of the product of the last worker he employs is equal to the marginal or additional
cost of employing the last worker. Further, under perfect competition, the marginal cost of labour is always equal to the wage
rate, irrespective of the number of workers the employer may engage. Since every industry is subject to diminishing returns, the
marginal product of labour must start declining sooner or later. Wages remaining constant, the employer stops employing more
workers at that point where the value of marginal product is just equal to the wage rate:
It is not true, as it is assumed above, that the quantities of other factors remain constant while that of labour alone increases. To
allow for this, a term 'marginal net product of labour' has been used instead of 'marginal product of labour'. The value of marginal
net product of labour may be defined as being the value of the amount by which output would be increased by employing one
more worker with the appropriate addition of other factors of production, less the addition to the cost of the other factors caused
by increasing the quantities of other factors.

Limitations/Criticism of Marginal Productivity Theory: This theory is true only under certain assumptions such as perfect
competition, perfect mobility of labour, homogenous character of all labour, constant rates of interest and rent and given prices of
the product. It is a static theory. The actual world is dynamic. All assumptions are unrealistic. The following are the criticism
against this theory:

(i) According to this theory, the labour is perfectly mobile so that they can be moved from one employment to another
employment, which is not true in the real world.

(ii) According to this theory, there is unified wage rate across the market, which is impossible. Workers of the same skill and
efficiency may not receive the same wages at two different places.

(iii) In case of monopsony, i.e., one buyer and many sellers, the employer has a grip on wages and can pull down the wages
below the value of the marginal net product of labour. If the employees are collectively organised, the wage rates can be
bargained. Therefore, the wages are not only determined by the number of workers employed but also by the relative bargaining
strength of the labour union and the employer.

(iv) Another assumption of this theory is that there is an existence of perfect competitive market for products, which is also
an unrealistic assumption. In the real world, the market for goods is characterised by imperfect competition. This also unsettles
the theory.

(v) The productivity of workers is also dependent on factors such as the quality of capital and efficient management, which is
outside the scope of this theory.

(vi) It should be borne in mind that the marginal net product of labour depends not merely on the supply of labour but also on the
supply of all other factors of production. If other factors are plentiful and labour relatively scarce, the marginal product of labour
will be high, and vice versa.
(vii) This theory takes the supply of labour for granted. Productivity is also a function of wages. Low productivity may be the
cause of low wages, which may tell on the efficiency of the worker, lower his standard of living and ultimately check the supply of
labour.

(e) Taussig's Theory of Wages: The American economist Taussig gives a modified version of the Marginal Productivity Theory
of Wages.According to him, wages represent the marginal discounted product of labour. According to Taussig, the labourer
cannot get the full amount of the marginal output. This is because production takes time and the final product of labour cannot be
obtained immediately. But the labourer has to be supported in the meantime. This is done by the capitalist employer. The
employer does not pay the full amount of the expected marginal product of labour. He deducts a certain percentage from the
final output in order to compensate himself for the risk he takes in making an advance payment. This deduction, according to
Taussig, is made at the current rate of interest.

Criticism: Two weaknesses of the theory have been recognised by Taussig himself, i.e., (i) a dim and abstract theory remote
from the problem of real life. To this he replies that this weakness is common to all economic generalisations. (ii) The joint
product is discounted at the current rate of interest, but according to his own analysis, the rate of interest is a result of the
process of advance to the labourers. To meet this difficulty, Taussig suggests that we determine rate of interest independently of
marginal productivity by the rate of time preference, and with the interest thus determined discount the marginal product of
labour.

This theory is also rejected by most economists.

Modern Theory of Wages:

According to this theory, the wages are determined by the interaction of demand and supply as in the case of ordinary
commodity. Thus, this theory is also referred to demand and supply theory.

Demand for Labour: According to the modern theory of wages, the demand for labour reflects partly labourer's productivity and
partly the market value of the product at different levels of production. Following are the factors that determine the demand for
labour:

(a) Derived Demand: The demand for labour is a derived demand. It is derived from the demand for the commodities it helps to
produce.Greater the consumer demand for the product, greater the producer demand for labour required to produce that
commodity. It may be observed that it is expected demand and not existing demand for the product that determines demand for
labour. Hence, the expected increase in the demand for a product will increase the demand for labour.
(b) Elasticity of Demand for Labour: The elasticity of demand for labour depends on the elasticity of demand for
commodity. According to this theory, the demand for labour will generally be inelastic if their wages form only a small proportion
of the total wages. The demand, on the other hand, will be elastic if the demand for product is also elastic or if cheaper
substitutes are available.

(c) Prices & Quantities of Co-Operating Factors: The demand for labour also depends on the prices and the quantities of the
co-operating factors. If the machines are costly, the demand for labour will be increased. The greater the demand for the co-
operating factors the greater will be the demand for labour, and vice versa.

(d) Technical Progress: Another factor that influences the demand for labour is technical progress. In some cases labour and
machineries are used in definite proportions.

After considering all relevant factors as discussed above, the employer is governed by one fundamental factor, viz., marginal
productivity.

The change in wage rate determines the direction of change in the demand for labour but the degree of this change depends on
the elasticity of demand for labour. In case of elastic demand, a small change in the wage rate will lead to a considerable change
in demand for labour, and vice versa. Whether the demand for labour is elastic or not will depend on (i) the technical conditions
of production, and (ii) elasticity of demand for the commodity which that labour produces. Generally the short term demand for
labour is less elastic than the long-term demand. That is why the employers and trade unions adopt a stiff attitude in wage
negotiations.

Demand for Labour under Perfect Competition: Under perfect competition, each firm constitutes a very small portion of the
entire industry that it cannot influence wages appreciably by employing more or less of labour. The supply curve of labour
confronting each employer is perfectly elastic, i.e., horizontal straight line at the level of the market wage rate. The individual
demand curve is determined by marginal productivity. The individual employer hires as many labourers as will equate the
marginal productivity of labour with the rate of wages in the market.
It is the demand of the entire industry, not an individual firm, determines the wage rate. The individual firm has to accept the
market rate of wages and adjust its own demand for labour accordingly.

Supply of Labour: The supply of labour depends on:

(a) The number of workers of a given type of labour which would offer themselves for employment at various wage rates, and

(b) The number of hours per day or the number of days per week they are prepared to work,

The labour may be supplied to three destinations:

(i) Supply of Labour to a Firm: To a given firm, the supply of labour is perfectly elastic because at the current wage rate, it can
engage as many workers as it wants. Its own demand constitutes only a very small fraction of the total supply of labour. Hence
the supply curve of labour for a firm is a vertical straight line.

(ii) Supply of Labour to an Industry: For the industry as a whole, the supply of labour is not infinitely elastic. If the industry
wants more labour it has to attract it from other industries, by offering higher wage rates. The supply of labour for the industry is
subject to the law of supply, viz., supply varies directly with price, which means low wage small supply and high wage large
supply. Hence the supply curve of labour for an industry slopes upwards from left to the right.

(iii) Supply of Labour to an Economy: The supply of labour for the entire economy depends on economic, social and political
factors or institutional factors, e.g., attitude of women towards work, working age, school and college age and possibilities of
part-time employment for students, size and composition of the population and sex distribution, attitude towards marriage, size of
the family, birth control, etc.

Over a short period of time, reduction in wages may not cause any reduction in the supply of labour. But if wages are driven too
low, competition among employers themselves will push them up. Even over a long period, the supply of labour is not very
elastic.

There is a certain minimum wage below which labour will not work at all. Once this minimum is exceeded, supply of labour will
increase as the wage rate goes up. But this will happen only up to a point beyond which wage increase will lead to a reduction in
the supply of labour. Again, after a point, this tendency will be reversed when the worker thinks that he can move to a higher
level of living. Hence a rise in wages may lead to rise or fall in the supply of labour. It will depend on the worker's relative
valuation of goods and leisure.

Thus, the supply of labour will depend on the elasticity of demand for income which will vary according to the worker's
temperament and social environment. When the workers' standard of living is low, they may be able to satisfy their wants with a
small income and when they have made that much, they may prefer leisure to work. That is why it happens that sometimes
increase in wages leads to a contraction of the supply of labour. This is represented by a backward bending supply curve of
labour as shown in the following figure:
For some time this particular individual is prepared to work longer hours as the wages go up (wage is represented on OY-
axis). But beyond OW wage, he will reduce rather than increase his working hours.

Interaction of Demand and Supply:

In the above diagram, figure (a) represents the supply curve faced by an industry, and figure (b) represents the supply curve
faced by an individual firm. W-AW is an extended line that cuts the MRP (marginal revenue productivity) curve of the firm at E ' in
figure (b). At this level, the ARP (average revenue productivity) is MR which is greater than the wage OW in figure (b). Hence, all
the firms (since this firm represents all the firms in the industry) are making supernormal profit at this wage level. This will lead to
entry for new firms in the industry; the demand for labour will increase and the wage level will go up. Thus, supernormal profits
will be competed away in the long run by the entry of new firms.

The new demand curve D'D' cuts the supply curve SS in figure (a) at point F. The wage level in this situation will be OW' which is
higher than the original wage level OW. This is how the interaction of demand and supply determines the wage. When the wage
is OW, the firm is in equilibrium at E' and when the wage rises to OW', the equilibrium is at F'. At this point, average revenue
productivity (ARP) and marginal revenue productivity (MRP) are equal, and the average wage OW' is equal to both of them. It
means the individual firms are earning normal profits.

It may also happen that the occurrence of supernormal profits attracts some firms from outside, which may further increase the
demand for labour to D"D". The wage level will then be OW". Here the ARP is less than the wage OW", i.e., the firms are
suffering from losses. The result will be that some firms will leave the industry and the wage will come down to the level of OW'.

Long Run: Under perfect competition, wages are, in the long run, equal to the marginal as well as to the average productivity of
labour. If marginal productivity is greater than average, it will be worthwhile to employ more labour till marginal productivity falls
to the level of average productivity. On the other hand, if marginal productivity is less than average productivity, less labour will
be employed and the marginal productivity will rise to the level of average productivity. Marginal productivity and average
productivity thus tend to be equalised. Since wages are equal to marginal productivity, they are also equal to average
productivity in the long run. This is shown in the following diagram:
OR is the wage level, AP is the average productivity curve and MP is the marginal productivity curve. They intersect at P which
shows that wages are equal both to the MP and AP. When AP is rising, MP > AP, and when AP is falling, MP < AP. But when AP
is neither rising nor falling, MP = AP. Hence, at equilibrium point: Wage = MP = AP.

Wages Under Imperfect Competition:

Imperfect competition may result:
(a) Bilateral Monopoly: When strong employers' associations are confronted with strong labour organisations.

(b) Monopsony: When an industrial employer or a group of employers occupy a very strong monopolistic position as compared
with labour.

(a) Bilateral Monopoly: The term 'bilateral monopoly' is applicable both to commodities and labour. It is applied to a situation
when a monopoly of purchase is matched with the monopoly of sale, i.e., a single monopolist facing a single monopsonist. The
monopolist wishes to operate on a scale where the marginal cost is equal to marginal revenue, because that will bring him the
maximum monopoly profit. On the other hand, the monopsonist wishes to purchase an amount at which marginal cost is equal to
marginal utility. This indicates one optimum price for the buyer and another for the seller. There is no economic principle to
determine an equilibrium price.

It is not possible to indicate definitely the output and the price which will rule. The price will depend on the circumstances of each
case. In some cases, it will be a compromise price which may be influenced by the bargaining power of each party. Therefore,
under bilateral monopoly, the price and output are 'indeterminate'.
In bilateral monopoly, each side wants to get the better of the other through bargaining skill. The monopolist will like the
monopsonist to behave, as if he were one of the many buyers as in perfect competition, so that he (i.e. buyer) may accept the
price fixed by firm (the monopolist producer). Similarly, the monopsonist will like the monopolist to behave as if he were a perfect
competition producer (i.e. one of so many) unable to influence price, so that he (the monopsonist buyer) can purchase at his own
price. Now nothing can be said as to who will succeed and how far. Most probably, there will be a compromise between the two
extremes.

According to the above diagram, the monopolist will be maximising his profit (MR=MC) if he sold OM' output and charged
OP1 (M'Q) price, since Q1 is a point on the demand curve DD showing what the purchaser will be willing to pay under perfect
competition. On the other hand, the monopsonist will like to buy OM at OP price, since Q2, where DD and MC1 intersect, is a
point where buyer's marginal valuation equals marginal cost of purchase. There will be a compromise between both the parties,
i.e. the employer and the employee. Hence, factor price will be somewhere between OP and OP1, and the output between OM
and OM' depending on the relative bargaining skill of the parties.

(b) Monopsony: This is the most general situation of imperfect competition, where the employer embodies in his person
concentrated monopoly power of being the sole purchaser of labour, whereas labour occupies a very weak position in
comparison. Monopsony also occurs when a big employer employs proportionately a very large number of a given type of labour
so that he is in a position to influence the wage rate.In the following diagram, a situation is depicted where a monopsonist exploit
the labour:
In the above diagram, the MRP is the marginal revenue productivity curve representing demand for labour. The supply curve of
labour is AW (Average wage curve) which is rising to the right which shows that higher wages have to be paid to engage more
labour. MW is the marginal wage curve corresponding to the AW curve. These two curves, i.e., MW curve and the MRP curve
intersect at point E. It is the point where the monopsonist is in equilibrium. Here the marginal wage is equal to marginal revenue
productivity of labour at the level of labour employment ON, at wage level NH (=OW).

It can be seen that this wage, i.e., NH is less than marginal revenue productivity which is NE. Thus each worker gets EH less
than this marginal revenue product. This is the measure of labour exploitation under monopsony. This is called by Mrs. Robinson
as 'monopsonistic exploitation'.Thus, under monopsony, wage is lower and employment is less than under perfect competition in
the labour market. Under perfect competition, the equilibrium would have been at C where the supply curve AW cuts the demand
curve MRP. At this point, the wage would have been higher at OW’ (=N'C) and the labour employed would have been larger at
ON'.

Exploitation of Labour:
There are three types of labour exploitation:

(a) Monopsonistic Exploitation: Where the single employer has the strongest influence on the wage rate.

(b) Monopolistic Exploitation: In this condition, there is perfect competition in the labour market but there is an imperfect
competition in the product market. In equilibrium, the firm will equate wage with marginal revenue product. This means that
labour is paid less than the value of the marginal product which shows exploitation:
(c) Double Exploitation: It occurs when there is imperfect competition both in the labour market (monopsony) and in the product
market (monopoly). Thus there is double exploitation of labour both monopsonistic and monopolistic and labour is exploited the
most.

Remedies: Following the remedial steps or the weapons to stop labour exploitation:

(i) Government intervention, and

(ii) Trade union action.

Wage Differentials:
Wages everywhere tend to approximate to the marginal productivity of labour. But, the marginal productivity of labour is different
in different employments and grades. It varies with the degree of scarcity of each kind of labour in relation to the demand for
it. Following are the causes of differences in wages in different employments, professions and localities:

(a) Differences in efficiency: that is, differences in education, training, and conditions under which the work is performed.

(b) Existence of non-competing groups: These groups arise because of the difficulties in the way of mobility of labour from
low-paid to high-paid empolyments. These difficulties may be due to geographical, social and economic reasons.
(c) Difficulty of learning a trade: The number of those who can master difficult trades is small. Their supply is less than
demand for them, and their wages are higher.

(d) Differences in agreeableness or social esteem: Disagreeable employments must pay higher wages in order to attract
labourers. If disagreeable work are performed by unskilled workers, who cannot do anything better, wages may be quite low,
e.g., sweepers.

(e) Future prospects: If an occupation provides opportunities for future promotion, people will accept a lower star in it, as
against another occupation offering higher initial rewards, but no chances of promotions in the future.

(f) Hazardous and dangerous occupations: generally offer higher emoluments.

(g) Regularity or irregularity of employment: also exerts a strong influence on the level of wages.

(h) Collective Bargaining: The differences in the strength and militancy of trade unions also account for differences in wages in
different industries.
Public Finance
 Public Finance
Introduction to Public Finance:

Before we begin with the public finance, we would like to point out the major functions of a modern government:

(a) Improving economic efficiency

(b) Making the distribution of income less unequal

(c) Stabilising the economy through macro-economic policies

(d) Representing the country internationally

It is duty of the government to bring economic and social justice in the country. And this can only be done by properly utilising
the funds raised through taxes and other sources of public finance.

The famous American Economist J.M. Keynes has revolutionised and changed the meaning of public finance. According to
Keynes, public finance should be used as an instrument for achievement of certain economic and social objectives. Before
Keynes, the concept of public finance was to raise sufficient revenues for meeting public expenditure. In other words, before
Keynes, public finance was concerned with the raising of financial resources for the State. But Keynes made a fundamental
change in the nature and scope of public finance. Keynes and his followers emphasised that public finance is to help in the
achievement of certain social and economic objectives and finance some essential economic activities.

Keynes underlines the fact that the taxation and public expenditure policy of the State vitally affects the level of income and
employment in the country. Keynes showed that during depression, how a government could reduce the depression from the
economy by increasing its public expenditure and raise the level of employment. When the government increases its investment
expenditure on public works, then the level of income and employment in the country increases more than the ratio of increase in
initial investment. This is Keynes' Income Multiplier.

Generally, the level of full employment in the economy is impossible. This is so because whenever there is lack of effective
demand, the production remains unsold which ultimately leads the entrepreneur to loss. Thus investor will reduce the level of
investment resulting more unemployment and a situation of depression in the economy. In depression, the purpose of budgetary
policy is to provide investment opportunities and increase employment level in the economy. The government should increase
public expenditure during depression more than the public revenue. The deficit can be covered by deficit financing, i.e., by
creating money. The result of deficit financing is that the purchasing power with the people increases and aggregate demand for
goods and services increases. Owing to increase in aggregate demand and the operation of multiplier, the depression will tend
to disappear and the economy will move towards full employment.

On the contrary, whenever, there is a higher effective demand and when the money supply is increased, there will be a
generation of inflation in the economy. In such a situation, the purpose of fiscal policy to reduce money supply in the economy
so as to reduce the inflationary pressure and so people can save more and consume less. When there is inflation in the
economy and the prices are soaring higher and higher, the government should levy heavy taxes and in this way withdraw
purchasing power from the people and should also reduce its own expenditure. The demand having been reduced in this way,
prices would tend to come down. It is clear that to fight inflation, the government should frame a 'surplus budget'. A surplus
budget means that the government should collect more money from the public by imposing more taxes but keep its expenditure
less than the revenue raised. The result will be that less purchasing power will be left with the people and the aggregate
demand for goods will be reduced. Consequently, the prices will have a tendency to fall.

The above situation is mostly existed in economically advanced and rich countries. The less developed countries, like Pakistan,
Bangladesh, India, China, Myanmar, etc. are caught up in the vicious circle of poverty and their main problem is to break this
circle and move towards economic development so that poverty is removed and the living standard of the people is raised. The
objectives of public finance in less developed countries are to give a fill up to capital formation, encourage industrialisation,
encourage productive investment, and foster economic growth. Thus the objectives of public finance in less developed countries
are different from those in the developed countries. Whereas in developed countries, the function of public finance is to
accelerate economic growth so that the widespread unemployment and poverty prevailing in the country are removed.

Causes of Market Failure / Reasons of Government's Intervention in Market Economy:

The market economic system operates under Price Mechanism. Consumers show their will or desire to buy a commodity at a
given price in order to maximise their utility. On the other hand, the producers are aimed at maximising their profit for what they
produce. In market economy, there is no justification for state intervention but there are some reasons that necessitate the
government's intervention in the economy as discussed below:

(a) To avoid Monopoly: Monopoly is a situation in which one seller rules over the whole industry. The buyers are compelled to
purchase commodity at the price fixed by the monopolist. Therefore, the government interferes for the benefits of the
consumers. The government interferes in pricing of the commodity, and/or encourages new firms to enter into the
market/industry.

(b) To maintain Price Mechanism: There may be possibilities of prevailing an unjustified price mechanism even in the presence
of perfect competition in the market. The government can monitor the prices fixed by the market and protect the consumers from
the burden of unjustified prices.

(c) To meet Externalities: Externalities represents those activities that affect others for better or worse, without those others
paying or being compensated for the activity. Externalities exist when private costs or benefits do not equal social costs or
benefits. There are two major species, i.e., external economy and external diseconomy. In such situation, government intervene
the market with its different policies.

(d) Increasing Social Welfare and Benefits: Another strong reason of government's intervention in the market economy is the
social welfare and benefit. It is one of the duties of an elected government to work for the common welfare of the nation; to
provide social goods and services, like hospitals, education facilities, parks, museums, water and sewerage, electricity, old age
benefits, scholarships, etc; and the protect the people from the evils of a laissez faire economy.

(e) To meet Modern Macro-Economic Issues: It is the duty of the government to ensure that the country is in a right direction
of economic development. Government must ensure controlled inflation, greater employment opportunities, rapid technological
advancement, adequate capital formation, and higher economic growth rate.

Governmental Activities / Actions taken by the Government:

Intervention of government in the economy takes a number of forms. The government may undertake the conduct of production,
or may influence private economic activity by subsidies or taxes, or they may exercise direct control over behaviour on the
private sector. Finally, governments may transfer purchasing power from some persons to others. The government activities
can be broadly classified into four groups:

(a) Allocative Activities: These activities alter the overall mix of gross national product. The allocative activities arise out of the
failure of the market mechanism to adjust the outputs of various goods in accordance with the preferences of society. The
ultimate goal of the government is to maximise per capita income.

(b) Efficiency in Resource Utilisation: Maximum efficiency in the use of resources requires the attainment of three conditions:
 (i) Attainment of least cost combinations

(ii) Operation of the firms at the lowest long-run average cost

(iii) Provision of maximum incentive for developing and introducing new techniques.

While the private sector is presumed to be less deficient, on the whole, in attaining optimal efficiency than in attaining optimal
allocation of resources, nevertheless in several situations governments may be more effective.

(c) Stabilisation and Growth Activities: are those activities reducing economic instability and unemployment and increasing
the potential and actual rates of economic growth.

(d) Distributional Activities: are those activities altering the pattern of distribution of real income.

Approaches of Government Actions:

Following are the approaches or tools of government action plan against the malfunctions of market economy:

(a) Governmental Conduct of Production: The public goods such as defence, law enforcement, etc are supplied by the
government, since their inherent character they cannot be produced and sold on a profit-making basis by private enterprise.

Government may also undertake education. In order to adapt the nature and quality of education to meet community goals,
governments produce the services directly, although allowing private enterprise to provide them as well for persons who prefer
the private product.

Government conduct of production may also be undertaken for efficiency reasons - to avoid collection costs, to obtain
advantages of longer-term investments, or to attain economies of scale.

(b) The Subsidy Approach: An alternative to governmental production is subsidisation of private producers to induce them to
increase output or to undertake investments that they would not otherwise make. Thus private schools could be subsidised to
provide additional education at prices less than those equal to marginal cost. Subsidies might also be used to increase
investment to lessen unemployment or to lower output when carried beyond the optimal figure.
(c) The Control Approach: For some purposes, direct control of private sector activity, with no governmental production except
the limited amount involved in administration of the regulatory rules, is a satisfactory solution. Activity that gives rise to significant
external costs, such as pollution, may be subjected to controls, such as requirements for adequate waste disposal. Monopoly
may be broken up by antitrust laws or monopoly firms may be subjected to detailed regulation of rates and services. This form of
regulation creates a continuous clash of interest between government and the firms.

(d) Aggregate Spending: Prevention of unemployment and attainment of the potential rate of economic growth or prevention of
inflation may require fiscal and monetary policies that influence aggregate demand in the economy. To eliminate unemployment
the government may raise the level of public spending and the scope of its activities beyond the levels as warranted, or may
reduce taxes below the optimal levels.

(e) Transfer Payments: Transfer payments are made by the government for bringing down the inequality in income distribution
more closely in line with the desired one. Transfer payments may be 'specific' or 'non-specific', for example, scholarships in
universities are specific, and provision of education and parks free of charge is non-specific. Non-specific transfer payments or
general transfer payments are made on the basis of the income status of the recipients in conjunction with various criteria of
needs. For example, old age benefits, aid for dependent children, direct relief, or negative income tax.

Pareto Optimality / New Welfare Economics:

The New Welfare Economics represents a break with the utilitarian tradition in Economics. The new welfare economists claim to
arrive at optimum conditions of production and exchange without adding the utilities of different persons or comparing the
satisfactions of different individuals. The new welfare economics is claimed to be objective and scientific and not ethical. It is
said that welfare economics furnishes an analysis of the causes governing the measure of welfare or an increase or decrease
thereof. Italian born Vilferdo Pareto is said to be the pioneer of new welfare economics, although there have been introduced
some subsequent refinements since then.

The Italian Economist Vilferdo Pareto has laid down the conditions for maximising social welfare or for achieving a social
optimum. A Paretian optimum refers to a situation in which it is impossible to make any one better off without making some one
worse off. For judging such a situation, Pareto has enunciated a very simple and straightforward criterion thus: "Any change
which harms no one and which makes some people better off (in their own estimation) must be considered to be an
improvement."

In the following diagram, an example of a community is taken, in which there are only two persons X and Y:
The utility of X is represented along horizontal axis and that of Y along the vertical axis. The Pareto criterion states that if we
start off from a situation which is represented by a point like A, then a policy change by the Government is an improvement if it
results in a move to any point like B or C which lies to the right of A or above. At B, X is better off than at A with Y as well off as
before, whereas the move to C benefits Y without harming X and the move to D, benefits both the persons.

Conditions of Paretian Optimum:

The conditions of Paretian optimum are given below:

(a) Optimum Allocation of Products: Allocation of products to be optimal must be such as to make it impossible for any pair of
individuals to exchange any quantity of any pair of consumer goods resulting in increase in one's satisfaction without decreasing
that of another. That is, if any alternative allocation can increase some one's satisfaction without decreasing another's, it is not
optimal. To put in terms of indifference curve technique, the marginal rate of substitution (MRS) between any two good must be
same for any pair of owners of the same two goods. We know that MRS is the rate at which units one good can be exchanged
for the units of another without lowering the level of satisfaction.

This can be explained with the help of an Edgeworth Box diagram. The Edgeworth diagram for consumption shows the
indifference curve preference maps of the two individuals and their derived levels of satisfaction from the various combinations of
goods. The indifference curve preference maps of both A and B have been combined and shown with the help of an Edgeworth
Box in the following figure:
The indifference curve preference map of A starts from origin O, whereas the indifference curve preference map of B starts from
origin O'. I1 to I8 represents the indifference curves of individuals A and B. I1, I2, I3 and I4 represent the indifference curves of
individual A, and I5, I6, I7 and I8 represent the indifference curves of individual B. The slope of an indifference curve, as we know,
at any point is the marginal rate of substitution between commodities X and Y (MRSxy). The point would be optimal where the
MRSxy of both individuals are same. If the MRSxy is not the same, then with the help of exchange, it is possible to increase the
level of satisfaction of one without diminishing that of the other. Now if we joint the points L, M, N, P where the different sets of
indifference curves of individuals A and B are tangent to each other, we get a curve known as 'Contract Curve', i.e., cc'. The
points L, M, N and P lie on the contract curve cc'. At each of these points, the MRSxy for A and B is the same. Therefore, each
point along a contract curve cc' represents a point of Pareto-optimality. In other words, any redistribution of the goods X and Y
between A and B will yield a lower level of satisfaction.

(b) Optimum Degree of Specialisation: It refers to the condition that the marginal rate of transformation (MRT) between any
two goods must be the same for any pair of firms producing both of them. The MRT between two goods is the amount of one
good which would have to be sacrificed to produce one unit of another good. This only means the ratio of marginal opportunity
cost of the two goods. Obviously, if MRT is not the same for any pair of producers, it would be possible to increase the
combined output of the two goods or increase the output of one without decreasing that of another. This will mean that the
present degree of specialisation is not the optimum.

(c) Optimum Factor Utilisation: This represents optimum relationship between the factor and the product. The utilisation of a
factor will be optimal if the marginal rate of transformation (MRT) between any factor and any product is the same for any two
firms using the factor and producing the product. If MRT is not the same, it will be a departure from the optimum.
(d) Optimum Allocation of Factors: All factors of production must be so allocated among the various uses that the marginal
production in each use is that same. If it is not the same, it will pay to shift some units of a factor from one use to another. In
terms of new economics, the marginal rate of technical substitution (MRTS) between any pair of factors must be the same for
any two firms using both to produce the same product. Only then, the allocation will be optimal. If it is not, it will be possible to
increase the total product by shifting a factor from one firm to another.

(e) Optimum Direction of Production: Another condition for maximising welfare is that the marginal rate of substitution
between any pair of products for any person consuming both must be the same as the marginal rate of transformation for the
community between them. In terms of utility analysis, it means:

(i) That the ratios of marginal utilities of the two goods must be the same for all consumers, i.e.,

MU of A = MU of B and so on.
Price of A Price of B

This will represent maximum satisfaction of the consumer.

(ii) The ratio of their marginal costs must be the same for all producers producing them, i.e.,

MC of A = MC of B and so on.
Price of A Price of B

(iii) These ratios must be equal.

This condition relates to the maximum efficiency of the economic system. The goods must be produced in such combinations
that they not only conform to consumers' preferences but are also produced at the minimum average cost. If it is technically
possible to substitute one good for another and make one better off without making another worse off, the production is not
optimal.

Let us take a community producing two goods. The quantity of each good it produces will depend on its factor endowments and
on its existing technical knowledge. By factor endowments we mean the amounts of factors of production the community
possesses. Let us assume that the community can produce either 100 bushels of wheat or 100 yards of cloth when all its factors
are fully and most efficiently employed in the production of either wheat or cloth respectively. The various combinations of wheat
and cloth that it can produce are shown by the 'production possibility curve' or the 'transformation curve'. If the community
chooses to produce wheat only, it can produce 100 bushels. If it would also like to produce cloth, it must forgo the production of
some of its wheat. The amount of wheat, which the community foregoes in order to have an extra unit of cloth, is known as the
'opportunity cost' of wheat in terms of cloth.

In the following diagram, the community's production possibility curve drawn on the assumption of increasing opportunity
cost. The meaning of increasing opportunity cost is that the amount of extra wheat the community produces by decreasing
production of cloth with given factors is steadily increasing.

Let us superimpose the indifference curve preference map, i.e., I1 and I2 of an individual A on AB production possibility
curve. Now the Pareto-Optimal point would be where the slope of production possibility curve AB and of the indifference curve
(A) is the same or tangent. In this diagram, point P is the optimal point, as the slope of the indifference curve I2 and PB on curve
AB is the same. The point Q is not the point of optimum.

(f) Optimum Allocation of a Factor-Unit's Time: The owner of a factor unit has the option of using the factor to render him a
direct service or hiring it out to others for aiding in production. Hence, the problem for the owner of a factor is to allocate the time
of factor rendering direct services or working for a money reward in an optimal manner.

(g) Inter-Temporal Allocation of Assets: Every individual firm has to bring about an optimal allocation of factor inputs and
product output over time. A firm may produce a given output stream with various time patterns of factor inputs and conversely, it
may have various time patterns of outputs with a given input stream of factor services. It refers to the allocation of products or
factors that may relate to different moments of time. In this case, the allocation will bring maximum welfare when the marginal
rate of substitution between any pair of moments is the same for every pair of individuals or firms.

The above-discussed conditions are also known as 'First-Order Conditions'. From the above first-order conditions, the Pareto-
Optimality can be attained. But the fulfilment of these first-order conditions may not be enough to lead to welfare optimality. To
achieve an optimum welfare position, it is very necessary that the 'Second-Order Conditions'along with the first order conditions
should also be satisfied to achieve the maximum welfare. These second order conditions are no other than the stability
conditions for equilibrium position. The fulfilment of second order conditions means that all the indifference curves and the
production possibility curves should have the right curvature in the neighbourhood of any position where marginal conditions are
satisfied. In the neighbourhood of maximum welfare, all indifference curves must be convex to the origin and all transformation
curves must be concave to it.

In the following figure, AB is the production possibility curve of the community, I1 and I2 are the indifference curves of an
individual. The point b is a point of optimum welfare as the indifference curve I2, is a tangent to the production possibility curve
AB. At point a, the indifference curve I1 is also a tangent to the production possibility curve AB but it is not a point of optimum
welfare, as by moving from a to b, the community reaches on a higher indifference curve I2.

Relation between Pareto Optima and Perfect Competition:

(a) Equality of Marginal Rate of Substitution: Under conditions of perfect competition, the consumer in order to maximise
satisfaction makes the marginal rate of substitution between any two goods equal to the ratio of their prices. At equilibrium, the
MRS between two goods is equal to the ratio of their prices for any consumer. Therefore, the first condition of optimum allocation
of goods of Pareto-optimality is satisfied under perfect competition.

(b) Equality of Marginal Rate of Transformation b/w Two Factors: Under conditions of perfect competition, in order to have
minimum cost combination of the factors to produce a given output tries to equate the marginal rate of transformation (MRT)
between two factors to the ratio of their prices. At equilibrium, this condition of equating MRT between two factors to the ratio of
their prices is satisfied. Hence, the condition about the optimum allocation of factors is also satisfied.

(c) Equality of Marginal Rate of Transformation b/w Two Commodities: The producer under perfect competition, in order to
maximise the profits, tries to equate the marginal rate of transformation (MRT) between two commodities to the ratio of their
prices. At equilibrium, this condition of equating MRT between two commodities to the ratio of their prices is satisfied. Hence,
the condition about the optimum utilisation of a factor is satisfied.

(d) Equality of Marginal Product of Each Factor: The producer in order to maximise his profits tries to equate the marginal
product of each factor to its price and, at equilibrium, this condition is satisfied. Therefore, the condition of optimum factor-
product relationship is satisfied.

(e) Equality of MRS to MRT b/w Two Commodities: Under perfect competition, at equilibrium, the marginal rate of substitution
(MRS) between the two commodities is equal to the marginal rate of transformation (MRT) between the two commodities and
both are equal to the ratio of their prices. Therefore, the condition about the optimum direction of production is also satisfied.

(f) Equality of MRS & MRT: Under perfect competition, a factor will be utilised to the point where the marginal rate of
substitution (MRS) between employment of the factor and its leisure equals the rate of payment made to it. Similarly, with a view
to maximising his profit, a producer equates the MRT between the factor and its product. Since the price of the product is the
same for all the producers and rate of payment is the same for all the factor units, the condition of optimum allocation of a factor
unit's time is also satisfied.

(g) Equality of Marginal Productivity of Asset: An owner of an asset makes the MRS between present income and future
income equal to his rate of time preference. In the same way, a borrower of the asset equates the cost of borrowing with the
MRS between the present asset and future asset. Since under perfect competition, the rate of payment for all similar assets is
the same, as also the cost to the borrowers, it is equal to the marginal productivity of the asset. In this way, the condition of inter-
temporal optimum allocation of assets is also fulfilled under perfect competition.

From the above it is clear that under perfect competition all the marginal conditions of Paretian-optimum are satisfied.
Obstacles to Welfare Maximisation:

If maximum welfare is to be attained, optimum allocation of factors of production is essential. This allocation must be in keeping
with the consumer's preferences. For this purpose, there must prevail perfect competition. But, in the real world, there is no
perfect competition, instead there is imperfect competition. This constitutes a big obstacle in the way of the attainment of
maximum welfare. We shall see how different forms of imperfect competition stand in the way of welfare maximisation:

(a) Monopoly: By pursuing restrictive price and output policies, the monopolists exploit the consumers' weakness by charging
exorbitant prices and by restricting output. They reduce the national income. In all these ways, they reduce social welfare,
especially because they cause misallocation of productive resources.

Under monopoly, the monopolist faces a downward sloping demand curve (instead of horizontal straight line as under perfect
competition). Hence, the marginal revenue is less than average revenue / price. In order to maximise profit, the producer will
equate marginal cost and marginal revenue. His marginal cost is less than the price or price is kept higher than the marginal
costs. Thus, the monopolist does not operate at the optimum output level. This means higher prices for the consumers and
lower remuneration for the factors of production. By creating a divergence between factor price and the value of its marginal
product, a monopoly distorts factor allocation. Too little resources are used in monopolised industries, which is not in conformity
with consumer's preferences.

(b) Monopsony: It is a buyer's monopoly. Firstly, take the case of monopsony in factor market, where a firm is compelled to pay
higher prices for factors in use. Hence, the marginal cost of the factor will exceed its price per unit. For profit maximisation, the
factor will tend to be used up to a point where its marginal cost is equal to its marginal revenue product. But as said above,
marginal cost exceeds price. Hence, the price paid to the factor is less than marginal product. Thus, the factor is not being paid
its worth, which shows a faulty allocation of factors which in turn militates against welfare maximisation.

Take the case of monopsony in product market. In this case, the marginal cost of the product will be higher than the price paid
by the monopsonist. The quantity purchased will be smaller and the price paid lower than under competition. This represents
misallocation of resources in the economy.

(c) Monopolistic Competition: In this case, there are too many firms in the industry operating at less than optimum scales of
output having excess capacity which is socially wasteful. Product differentiation compels waste. Hence there is a reduction in
social welfare.
(d) Oligopoly: In pure oligopoly (without product differentiation), there is a misallocation of resources and hence a reduction of
social welfare. In this case, a dominant firm determines the price and output policy. In order to maximise profit, the firm equates
marginal cost with the marginal revenue. But the price will exceed marginal cost and distort resource allocation.

Market Structure and Social Welfare:

In the Paretian sense, if a policy change makes at least one individual better off without making any one worse off it is said to
maximise social welfare. Let us see how this social optimum can be attained under different market structures:

(a) Social Welfare under Perfect Competition: To achieve maximum social welfare under perfect competition, the allocation of
resources needs to be efficient. For allocation of resources to be efficient, it is necessary that the MRS between any two
commodities for a consumer is equal to the MRT between these two commodities is equal from producer's point of view. This
would lead to:

 The equality of the ratio of marginal utilities and the ratio of commodity prices for the consumers, which would result in
maximum satisfaction; and
 The equality of the ratio of marginal costs and the ratio of commodity prices for the producers, which would result in
maximum profit.

This situation is possible only in perfectly competitive market.

The conditions of perfect competition also bring about the equality between the private marginal product and social marginal
product. The basic condition for maximum welfare is that social marginal utility be equal to social marginal cost:

Maximum Social Welfare = Social Marginal Utility = Social Marginal Cost

The equality between private marginal utility and social marginal utility will depend upon the distribution of money income in the
community. The distribution must be such as would equalise its marginal utilities for all the consumers. The marginal cost of
producing any alternative commodity would be the same as for the one that is being produced. This will lead to equality between
private marginal cost with private marginal utility and hence the social marginal utility and social marginal cost. This is how
conditions of perfect competition result in the attainment of maximum social welfare.

(b) Monopoly: The conditions of efficient allocation of resources do not exist in a condition of monopoly, therefore, the maximum
social welfare cannot be attained under monopoly. The monopoly equilibrium is based on the equality of marginal revenue and
marginal cost. Under conditions of monopoly, price is greater than marginal revenue of output and also the marginal cost. The
inequality of price and marginal cost represents the violation of basic condition of efficient allocation of resources and hence
maximisation of social welfare. Following things are happened under monopoly:

 Under monopoly, the entrepreneur neither achieves optimum levels of production nor does he like to achieve it.
 A productive factor is not paid according to its marginal productivity because, simply under monopoly, the price exceeds
the marginal cost of a commodity.
 Since productive factors do not get paid according to their marginal productivity under monopoly, they are not attracted to
this form of business enterprise / industry to the fullest extent; whereas in the interest of maximum social welfare, it is
necessary that the factors must be employed where their marginal productivities are at their highest points.

It is thus clear that monopoly form of business is not consistent with the maximum social welfare. Whatever the form of
monopoly, whether in the commodity market or in the factor market (monopsony), it works as a hindrance to the achievement of
maximum social benefits.

(c) Monopolistic Competition: Under monopolistic competition, efficient allocation of resources is not as possible as compared
to perfect competition. Under monopolistic competition, in the short run, the demand curve is not tangential to the average cost
curve at its lowest or optimum point. On the other hand, the demand curve is tangential to the average cost curve at a point
higher than the optimum scale point. It is shown in the following diagram:

Since the levels of output are not optimum, the allocation of productive resources under monopolistic competition cannot be
termed as efficient as in the case of perfect competition. If social welfare is to be maximised there must be fullest use of installed
capacity. However, in the long run, the total efficiency achieved can be summed up to the level of maximum social
welfare. Because in the long run, the long run average revenue curve or the demand curve is tangent to the long run average
cost curve at its lowest point or the optimum point. Which is because of greater divisibility of the factors of production in the long
run. In the long run, the indivisible factors of production can be used more economically because, in the long run, they are, in
fact, to extent, divisible. In the long run, the cost curves depend on 'returns to scale'. In the long run, the amount of capital can
be altered and the management can be arranged differently. If all the factors of production can be used in varying proportions, it
means that the scale of operations of the firm can be changed. Consider the following diagram:

In the above diagram the industry is said to be producing at its technically optimum output level, i.e., OM. Output is optimum in
the sense that average cost is at a minimum.

In short, under monopolistic competition, the maximum social welfare can be sufficiently attained, but not as much as compared
to the perfect competition. So far as there is product differentiation, monopolistic competition offers greater product variety as
compared to perfect competition. Under perfect competition, the products are homogenous, where the distinctive characteristic
of monopolistic competition is product differentiation on bases of design, style, quality, income, age, sex, etc. Each product
variety represents different taste and temperament of consumers, and gives better satisfaction to different classes of consumers.

(d) Oligopoly: Under oligopoly, there is misallocation of resources. Under oligopoly, few producers/sellers often form a cartel to
have a tight grip on the market and a super-normal profit. Consumers and labourers are the worse victims of this form of market
structure. The sellers may almost destroy the social interest and may work for their own interests. There are various global
examples of oligopoly including OPEC (Organisation of Petroleum Exporting Countries). That is why oligopoly is not considered
as the best companion of the governments around the world to achieve social welfare. Misallocation of resources is due to the
fact that the market leader determines the price of the commodity for the entire industry. This price is calculated to yield
maximum profit, i.e., where firm's marginal cost is equal to marginal revenue. Since price is higher than marginal cost, it results
in misallocation of productive resources.
 Public Finance
The Principle of Maximum Social Advantage:
According to Dalton, the best system of public finance is that which secures the maximum social advantage from the operations which it
conducts.

Attainment of maximum social advantage requires that:

(a) Both public expenditure and taxation should be carried out upto certain limits and no more,

(b) Public expenditure should be utilised among the various uses in an optimal manner

(c) The different sources of taxation should be so tapped that the aggregate sacrifice entailed is the minimum

(a) Limits of Public Expenditure and Taxation: Pigou has stated that expenditure should be pushed in all directions up to the point at which
satisfaction obtained from the last shilling expended is equal to the satisfaction lost in respect of the shilling called up on government service. In
Pigou's statement there is a balancing of utility of expenditure with the disutility of a tax. This is the same principle by acting on which a
consumer maximises his satisfaction and a producer maximises his profit. A consumer's satisfaction is maximised when the marginal utility of
the last unit of a commodity purchased is equal to its price. In the same manner, a producer maximises his profit when he has equalised the
output of the marginal unit of a factor of production with the payment he has made for it, i.e., when marginal productivity is equal to price.

In case of public finance, the government should try to maximise the benefit to the community as a whole from its public finance. The
community's welfare is maximised when marginal social utility of an item of expenditure has been equated to the marginal social disutility of the
tax imposed for the purpose. Obviously, expenditure confers a benefit and the tax entails a sacrifice and the two must be balanced against one
another.

(b) Public Expenditure: Maximum Social Welfare: Achieving maximum social advantage also involves the use of the principle of equi-marginal
utility. The government should act on the principle of equi-marginal utility in order to maximise social advantage from the alternative modes of
expenditure.

Public expenditure has to be incurred on numerous items. No government can just heedlessly go on spending its revenues. It knows of the
various demands on public revenue. A wise government should exercise all possible discrimination between the various uses in which public
revenue can be put. It should arrange a list of priorities, just as a prudent consumer does.

(c) Distribution of Tax Burden: Minimum Social Sacrifice: The tax burden should be such distributed in the community so that the sacrifice
entailed is the minimum (or the advantage is maximum). A wise government should see that this suffering or sacrifice is not unnecessarily
increased. The sacrifice entailed by the various taxes should be compared and optimum combination of taxes should be found out.
For instance, it is felt that raising of the income tax and corporation taxes further will result either in increasing the sacrifice entailed or in the
discouragement of productive enterprise, it will be better not to put extra burden on the income tax payers.

In the above diagram MSS represents marginal social sacrifice, and MSA represents marginal social advantage. As more and more funds are
collected from the people by way of taxation, MSS increases. The MSS curve rises upwards from left to right, and MSA slopes downward from
left to right. The net social welfare will be maximum where the MSS from taxation is equal to MSA from public expenditure.

Role of Public Finance in a Developing Economy:

In a developing economy, the State must play a very active role in promoting economic development and public finance is the instrument that the
State uses in this regard. This instrument has to be used to break the vicious circle of poverty and to accelerate economic growth. Hence, there
is a great importance of public finance in under-developed countries desirous of rapid economic development.

There are various reasons why the State must play an important role in a developing economy:

(a) As an instrument of Capital Formation: Capital formation is of strategic importance in the matter of rapid economic development and the
under-developed economies suffer from capital deficiency. People in less developed countries are extremely poor and they can hardly make two
ends meet, not to speak of making saving and investment. It is, therefore, necessary to achieve a higher ratio of savings to national income,
which is the government's responsibility to see how savings can be generated and capital formation promoted. This can be best done through
fiscal measures. There is another problem that in under-developed nations the increased incomes arising from whatever little economic
development is made are spent under the demonstration effect in imitating the higher standards prevailing in the developed nations.

(b) As an instrument for Regulating Consumption and Production: There are other methods also, besides public finance or fiscal policy, by
which capital formation can be promoted, e.g., taking the various means of production under government control. This system had been adopted
by many nations like Russia (Former USSR), China, Czech Republic (former Czechoslovakia), Yugoslavia, Mongolia, Cuba and North
Korea. But the system proved to be a failure when addressing public needs. By the end of 1980s, the socialist countries of Eastern Europe
including Russia were ruins, with long lines for bread and other necessities in the stores, low and declining living standards, outdated
technologies, and deteriorating environmental conditions.

(c) Matching Physical Development: In any plan of economic development, a physical plan must be matched by a financial plan. The balance
has to be achieved both in real terms and in financial terms. Money incomes are generated in the process of production and supplies are utilised
in response to money demands. It is important, therefore, to operate upon and modify money income flows so as to maintain a balance between
the supply of consumer goods and the purchasing power available for being spent on them, between savings and investment and between
receipts and payments abroad.

(d) Influencing Rates of Saving and Investment: Public Finance can exercise an important influence in increasing the rate of saving and
investment. For example, the tax system can be so devised as to discourage the consumption of less essential goods and thereby release
resources for being employed in more productive channels. Further, the tax system can be used to increase public saving which in turn can be
used to finance an increase in public investment.

Divisions of Public Finance:

Public Finance can be studied under the following divisions:

(a) Public Expenditure,

(b) Public Revenue,
(c) Public Debt, and
(d) Budgeting.
 Budget Policy
Introduction:
According to Paul A. Samuelson, a budget shows, for a given year, the planned expenditures of government programmes and
the expected revenues from tax systems. The budget typically contains a list of specific programmes (i.e. education, welfare,
defence, etc.), as well as tax sources (i.e., individual income tax, social-insurance taxes, etc.).

According to John F. Due, a budget may be defined as a financial plan that serves as the basis for expenditure decision-making
and for subsequent control.

A 'budget surplus' occurs when all taxes and other revenues exceed government expenditures for a year. A 'budget deficit' is
incurred when expenditures exceed taxes. When revenues and expenditures are equal during a given period, the government
has a 'balanced budget'.

When the government incurs a budget deficit, it must borrow from the public to pay its bills. To borrow, the government issues
bonds, which are IOUs that promise to pay money at some time in the future. The government debt (sometimes called the public
debt) consists of the total or accumulated borrowings by the government from various sources including public, banks,
businesses, foreigners, and other non-federal entities.

Functions of Budget Policy:

According to Musgraves, the major functions of the Public Finance or the governmental programmes can be grouped into three
major classes, relating to allocation of resources, to efficiency in the use of resources and attaining economic stability and
growth, and redistribution of income.These are discussed as follows:

(a) Allocative Function: The allocative function or activity arises out of the failure of the market mechanism to adjust the outputs
of various goods in accordance with the preferences of society with the goal of maximising per capita real income. Allocative
function refers to the process by which total resource use is divided between private and social goods and by which the mix of
social goods is chosen. This is done by the budgetary policy. The budget policy ensures the optimum allocation of resources
which will result on production and determination of public and private goods on optimum quantity or level. Also it will cause to
remove the evils or shortcomings of price mechanism. As in price mechanism, the motive of profit maximisation is so strong that
public and social welfare is altogether ignored, and the production of social goods and services, i.e., libraries, parks, schools,
hospitals, etc., are avoided. Because in production of such goods and services the entrepreneur earns limited profit. Therefore,
in these circumstances the government intervention becomes very necessary.
But to determine an optimum quantity of public goods is to some extent a difficult task because no one wants to pay the price for
public goods rather they wants to be as a 'free rider'. But this problem is solved through decision of taxes or expenditures. Such
decision may be centralised or non-centralised.

Thus the problem of optimum allocation of resources for the production of social goods is resolved through budget policy.

(b) Distributive Function: The budgetary policy also affects the distribution of income in the community. The tax and
expenditure measures are adopted to modify the existing distribution with a view to reducing economic inequalities. In this way
optimal income distribution is brought about.

Through budgetary policy, the resource distribution and the optimum distribution of income and wealth can be ensured. Through
government measures such steps can be taken whereby the resources can be diverted to the poor and depressed segments of
the society. To remove inequalities, government mostly levies heavy taxes on rich people's income and provides subsidies on
the goods of basic needs, i.e., food, housing, education, health, etc.

(c) Stabilisation Function: The budgetary policy can also be used to maintain a high level of employment, a reasonable degree
of price level stability, an appropriate rate of economic growth and stability in the balance of payments.

In the stabilisation function of budget policy, we see the performance of the economy. In this function we trace the measures that
how can the objectives of full employment be obtained. This function also ensures that inflation or deflation is controlled, and the
GDP growth rate is higher or at least stable.

Importance of Budget:
(a) Assessment of Economic Conditions: Budget provides us the economic conditions of the concerned country, for example,
if economy is growing, it means that all the sectors of the economy are growing. If the production of the economy is increases the
incomes of the people will also increase. Thus when government assess the economic position of the economy and increase the
expenditures, they will have multiplier effects pushing the level of income and employment.

(b) Financial Resources' Information: From budget, we come to know the financial position of the country, as it tells us about
the total revenues, total expenditures, surplus or deficit. Moreover, it also tells us about how much revenue from direct and
indirect taxes, from fees and surcharges to be earned. It also tells us about the extent of development expenditure to be spent on
public sector development.
(c) Assessment of Budget Conditions: Through budget, the government can also assess the surplus or deficit in monetary
terms to be attained next year. If the budget is deficit, the government will have to decide how these deficits could be
met. Moreover, it could be observed from budget whether the provinces will be able to meet their expenditures or they will have
to depend upon federal government.

(d) Expenditures' Distribution: What will be the proportion of expenditures on different sectors of the economy, this will be
assessed through government budget. Moreover, the relative importance of different sector of the economy can also be judged
from budget.

(e) Assessment of Income and Wealth Distribution: The budget gives us knowledge regarding income distribution in the
country. Thus government can mobilise the resources through different policies and tools, i.e., taxes, expenditures, rebates,
subsidies, etc., to the needy sectors and sections of the society through budget. Thus inequalities can be removed, when the
assessment is easy regarding the incomes and wealth distribution in the economy.

(f) Indication of Economic Policies and Strategies: Budget also provides us knowledge regarding economic policies and
strategies of the government. As from budget estimates, we can see whether the government is spending more on
developmental purposes or on non-developmental purposes, whether the tax policy is encouraging or discouraging the
entrepreneurs, etc. Similarly, it also assess whether the government preferences regarding expenditures are confined to one
area or various sectors of the economy.

(g) Indication of Foreign Trade Sector: From the budget, we can see the direction of foreign trade of the economy, whether the
government is providing facilities and rebates to exporters or import substitution strategy is being followed. The budget tells us
whether the foreign loans are being used and what will be their repercussions on the economy.

(h) Importance for Consumers: Budget is a great matter of concern for the consumers, because the incidence of tax imposed
by the government is on final consumers. Government generally imposes direct taxes (i.e., income tax, and corporate tax) on
individual and corporate incomes; and avoids indirect taxes (i.e., sales tax) on consumer goods as it directly affects the
consumers' purchasing power.

(i) Importance for the Producers: In under-developed countries, the entrepreneurs and the producers largely depend on the
fiscal announcements in the budget policy. Government's tax cuts can boost the investment level in the economy; and
encourage the private sector to come forward and invest in order to improve the employment level and the productivity level in
the economy. Tax exemptions, rebates, tax holidays, and reduced import duties on industrial goods can achieve the employers'
confidence in the economy and provide them the opportunity to achieve cheaper raw material and lower cost of production.

(j) Importance for the Employees: The working class of the society has also a keen interest in the government's
announcements regarding increase in salaries of government employees and the overall increase in wage rates and
pensions. The employees wait for the budget in anticipation of an increase in wages, salaries, and pensions with the fall in taxes.

Operation of Budgetary Process:

A budget is designed to improve adjustment of government activities in terms of the preferences of society by facilitating the
comparison of conflicting programs and methods in the attainment of the goals as defined by preferences and to facilitate
attainment of greater efficiency in the use of governmental resources. This, especially for the federal government, is an
extremely complex one, particularly in establishing priorities for competing goals, for example, priorities for defence and the
elimination of poverty. The task is extremely complex, even with the aid of the most modern systems analysis and computers.

As a consequence of these complexities, the operation of budgetary process has inevitably developed many shortcuts in order to
be workable, which take several forms:

(a) Specialisation: The various agencies play a key role in determination of actual expenditure levels; each is concerned only
with its own specialised work, with which its officials are familiar. The budgetary authority examines the requests. Furthermore,
the government considers the direct needs of the particular activity as well as other activities.

(b) Fragmentation: the overall budget is fragmented into small pieces for most of the work, both at the level of preparation and
at the committee level.

(c) Incremental Nature of Action: Existing programmes are not reviewed in detail each year. No one considers each year the
questions of antitrust regulations, restructuring of postal department, etc. The presumption is that existing activities will continue
unless there is strong evidence that their existence should be reconsidered.

Programme Budget / Traditional Budget vs. Programme Budget:

A primary function of the budget system is to facilitate evaluation of proposals and to compare the relative merits of various
requests.Unfortunately, the traditional presentation of budget lacks the fulfilment of this task. Following are the disadvantages of
a traditional budget:
(i) The usual budget is organised on the basis of agencies, without any related work coordination among them.

(ii) The budgets are organised in such a fashion as to stress inputs, without reference to outputs. The relationships between
inputs and accomplishments are not established.

(iii) The typical budget is on a strictly one-year basis, without regard to future prospects or commitments arising out of the
proposals included in this year's budget.

The programme budget is the replacement of the traditional budget, in which emphasis is given on performance. The local
governments and to some extent the federal governments have also been introducing program features into their
budgets. Following are the features of a programme budget:

(i) The programme approach stresses the end product, such as eliminating poverty, increasing employment, increasing
agricultural production yield, or aggressive approach regarding the achievement of the community goals, rather than the inputs of
various types of materials and manpower.

(ii) The programme budgeting stresses the relationship between various outputs or programmes and the inputs
necessary to produce them, facilitating the use of techniques to analyse alternative programmes that will attain the goals and
various alternative means of implementing them.

(iii) The programme approach seeks to be all-inclusive, recognising all contributions that the activity makes and all costs
incurred, regardless of the organisational structure.

(iv) It provides a more useful basis for evaluation of agency requests by department, and the Federal Government by
concentrating on end products instead of inputs and by providing better information on costs and all benefits.

Planning-Programming-Budgeting Systems (PPBS):

The Planning-Programming-Budgeting Systems (PPBS) seek to integrate long-range planning of governmental activities and
programming of specific activities with annual budgeting, making use of the programme-budget structure and of various
quantitative techniques in the evaluation of proposals. Systems analysis and cost-benefit techniques are employed, with
quantification of costs and benefits to aid in the selection of the best alternatives. This approach seeks to aid in defining the
goals and in choosing among the goals, in specifying alternative programmes to attain the goals, in choosing the best
alternatives, and, subsequently, in measuring performance. Planning is extended forward for several years, rather than focusing
attention on the current year. Programming involves the statement of the relationship of inputs and outputs, under various
alternatives, to accomplish the desired objectives.

The Planning-Programming-Budgeting Systems (PPBS) are extensively used in all federal units especially in defence.

Cost-Benefit Analysis:
Governments presumably consider both the benefits and the costs of programmes. But this consideration has often been
haphazard, with little serious effort to quantify benefits or to include all costs and benefits. Governments' decision making is
sometimes dominated by the 'absolute needs' approach, i.e., certain expenditure is imperative and must be undertaken
regardless of cost. Sometimes it is dominated by the 'money first' approach, i.e., only a certain amount of revenue is available for
the purpose and expenditures are therefore confined to this amount.

In recent decades, to some extent concurrently with the development of programme budgeting and PPBS activities, systematic
analysis of benefits and costs has increased in importance. The first major applications were in the field of water resources (i.e.,
building up canals, dams, etc.), characterised by long-term investments and strong pressure groups.

'Cost-benefit analysis' can be defined as a systematic examination of the benefits and costs of a particular governmental
programme, setting out the factors that should enter into the evaluation of the desirability of the programme and frequently
analysing several alternatives for the attainment of the objective. Cost-benefit analysis is designed to ascertain the optimal
alternative for the attainment of the desired goals, and to rank other alternatives.

Elements in a Cost-Benefit Study: Cost-benefit studies are typically undertaken within a particular governmental department
as a preliminary to budget preparations, or as a continuing program to ascertain optimal expenditure patterns and budget
recommendations. A cost-benefit study involves several major steps:

(i) Statement of Objectives: Obviously, the goals of the particular programmes must be defined. The goal may be very specific,
such as that of an irrigation project, with the immediate objective of bringing 2,000 acres under cultivation by providing adequate
water. The goal may be long term, such as to increase the country's potential food supply, may be much less well defined,
especially in a situation of crop surpluses. Other projects have multiple goals; dams may have flood control, irrigation, navigation,
electric generation and recreational objectives. The more sharply the goal can be defined, the greater the contribution that cost-
benefit analysis can make to decision-making.
(ii) Statement of Alternatives: With many types of activities, there are various alternative ways of attaining the goals: different
locations for irrigation facilities, different timing for parts of the project, different methods of construction. Cost-benefit analysis
seeks to ascertain relative benefits and costs of the major alternatives.

(iii) Analysis of Benefits: With objectives defined and alternatives established, analysis proceeds to a consideration of the
benefits. With many activities, this analysis involves determination of the physical units of 'output' from the activity and valuation
of these units. Only those benefits should be included that alter the physical conditions of production or consumption for common
persons or businesses; and those benefits should not be included in the benefits that reflect changes in prices and incomes
arising out of the use of activities.

(iv) Analysis of Costs: Analysis of costs involves the same type of problem as that of benefits, although costs are more easily
calculable. The direct costs included both capital costs and operating costs over the years. Indirect costs include those created
for other governmental agencies, and overall costs to society not directly borne by the government. These are in a sense
negative benefits. Without cost-benefit analysis indirect costs are often not taken into consideration. Air pollution provides an
excellent example.

(v) Interest Rate: With many governmental programmes, especially those of types that lend themselves to cost-benefit analysis
such as water and transport development, the benefits will be obtained over a period of years. Likewise some of the costs will be
incurred at the time the programme is undertaken while others will be incurred in subsequent years. But a rupee of benefits now
is worth more than a rupee of benefits 10 years from now because of the interest phenomenon. In order to evaluate a particular
project and to compare alternatives, therefore, an interest factor must be used to determine the present value of future benefits
and costs; in other words the stream of consumption benefits and the stream of costs must be discounted back to the present for
a comparison to be made.

(vi) The Criteria for Judgement: With estimates of benefits and costs discounted back to present value, the final question in
cost-benefit analysis is the selection and use of criteria for evaluation. The basic comparison is between two streams: those of
benefits and those of costs, both discounted back to the present. The alternative that provides the maximum excess of benefits
over costs may be regarded as the optimal one, and any particular project that is the best for attainment of the goals and has
discounted present value of benefits equal to the discounted present value of costs is warranted.

Essentials of A Good Budget / Balanced Budget:

Budget policy or fiscal policy has three major objectives:
  To insure that the actual rate of growth of the economy coincides with the potential rate of growth through maintenance of
full employment;
 To attain a reasonably stable general price level; and
 To increase potential rate of growth if possible without interfering with attainment of other objectives of society.

Budget policy making depends on the economic conditions of the country. The level of expenditure on public works depends on
the level of employment in the economy. If the country is facing financial depression, the country needs a boost in investment,
which can be achieved through more development expenditure. In any circumstances, there are three standards of a good
budget, i.e., optimal allocation of resources, distribution of resources, and stabilisation of the economy.

A good budget is one in which the assurance of optimal allocation of resources and factor should be maximum so that an
optimum quantity of public good is obtained. In addition, a good budget should be in accordance with the conditions of demand
and supply. Besides these considerations a good budget should possess the position of stability in the economy, i.e., the
existence of inflation and deflation in the economy should be minimised if not removed.

Budget - Balanced or Unbalanced:> There are two ways of balancing a budget, i.e., to cut the spending to match taxes or
raising taxes to match spending:

(a) Cuts in government spending can be done in two ways:

(i) Either by reduction of purchases, or

(ii) By reduction of personnel.

Both options result in unemployment. Reduced purchasing would force government suppliers to lay off people. Lay-off of
government workers likewise increases unemployment, obviously. More unemployment means fewer incomes to tax and more
demands for government services such as unemployment compensation, food, medical aid, etc. Cutting welfare spending
likewise reduces sales for food, medical service, rent, etc.

(b) Raising taxes is politically unpopular. However, the economic effects of raising taxes may be less evident. Increased
taxation, particularly federal taxes, takes money from local communities. Government economists may argue that the
government spends the money back into the economy so there is not a net loss in the general economy. At least two things
mitigate against economists' theories. One is that money spent to maintain the huge federal establishment of the country does
not circulate back to local communities. Another is that the theory contains no time factor for how long it takes for the money to
return, and how much money inputted will be returned back. Sending taxes to the Federal Government and expecting them back
is like giving oneself a blood transfusion from the right arm to the left and spilling half of it on the floor.

Balancing the budget by either methods, or any combination, would result in hardship on the people.

This is the most complicated and controversial issue of public finance. Every government faces heavy criticism from social and
political organisations regarding the public spending and taxation. In a period of inflationary pressures, fiscal policy seeks to
lessen total spending, but its task is complicated by the wage-rate problem; the reduction in total spending must be
accomplished in such a way as to minimise the additional pressure placed upon wages and thus upon prices from the cost side.

According to Professor Jack Winner, it is a wrong concept that government should present a balanced budget every year without
considering overall circumstances of the economy. When the country is under heavy debt burden, it is quite often that the
government paid off her debts by collecting more taxes. In such a situation, a surplus budget is desirable, but collecting taxes in
excess of expenditures to reduce the debt is highly deflationary.

Rational fiscal policy calls for deficits when an expansionary stimulus is desirable, surpluses and debt reduction only when fiscal
constraints are called for in a full employment and inflationary situation. From the above discussion, it would be evident that more
employment, more public welfare and a balanced budget have no mutual relationship and cannot be attained at a time.
Merit Goods
Merit Goods:
The concept of merit goods is introduced as a result of public and private goods. The term 'Merit Goods' is defined as those goods representing the aggregate value
circumstances, culture, environment and social behaviour of the society. Then it becomes the duty of the government to provide these goods.

Merit goods may be public or private, but the provision of merit goods may lead to distort the choices of individuals. But as these goods represent the preferences of
people, hence, they are called as 'merit goods'.

In case of merit goods, efforts have been made to establish a relationship between public and private goods, which are generally opposite to each other. The govern
management in such a manner that the individual choices of the society may not be affected.

It is being observed that the merit goods are being introduced at governmental level in the countries like Iran and Saudi Arabia. As in these countries adulterer is giv
sentence. While in Western countries, the merit goods are being brought forward with the help of legislation, referendum, budget policy, media and educational
development. Here the prostitution is being discarded because of the spread of AIDS.

Thus merit goods motivate the people to defend their own interests as well as their countries also.

Externalities:
Externalities are those activities that affect others for better or worse; without those others paying or being compensated for the activity. Externalities exist when priv
benefits do not equal social costs or benefits. The two major species are 'external economies' and 'external diseconomies':

External Economies: External economies are those economies which accrue to each member firm as a result of expansion of the industry as a whole. Expansion o
may lead to the availability of new and cheaper raw materials, tools and machinery, and to the discovery and diffusion of a superior technical knowledge. Moreover,
expansion of an industry, certain specialised firms may come into existence which work up its waste products. The industry can sell them at a good price. The entry
enlarging the size of an industry may enable all firms to produce at lower cost. There is every possibility of external economies to be reaped when a young industry g
territory.

There are various types of external economies that are broadly classified into three categories discussed as below:

(a) Economies of Concentration: These economies relate to advantages arising from the availability of skilled workers, the provision of better transport and credit fa
stimulation of improvements, benefits from subsidiaries, and so on. Scattered firms cannot enjoy such economies. These are the advantages of a localised industry
economies are of special importance in the countries like India and Pakistan which has not yet been fully industrialised.
(b) Economies of Information: These economies refer to the benefits which all firms engaged in an industry derive from the publication of trade technical journals a
central research institutions. In a localised industry, research and experiments are centralised. Each individual firm need not incur expenditure on research. It can d
benefits from common pool.

(c) Economies of Disintegration: When an industry grows, it becomes possible to split up some of the processes which are taken over by specialised firms. For ex
number of cotton mills located in a particular locality may have the benefit of a separate calendaring plant.

External Diseconomies: When an industry expands, the firms enjoy external economies. But too much expansion will result in greater external diseconomies than
economies. As a consequence, the cost of production goes up instead of falling.

It is common experience that, when an industry in an industrial centre expands, there is a keener competition among the firms for the factors of production and the ra
materials. As a consequence, the prices of raw materials and of the factors production go up. All firms have now to pay higher wages, higher rents and higher rates
besides higher prices for the raw materials. Suitable labour ceases to be available; and capital also becomes scarce. The result is that, with the expansion of an ind
of production go up instead of falling. Too much expansion of industries may cause other social costs, like pollution, use of very cheap (even harmful) materials in fo
products, etc.

The main point is that the additional factors of production, the employment of which becomes now necessary, are less efficient and they are obtained at a higher cos
manner that diseconomies result as an industry expands.

Policies to Correct Externalities:

What weapons the government can use to combat inefficiencies arising from externalities? The governments today combat externalities using either direct controls o
incentives to induce firms to decrease harmful externalities or to increase beneficial activities. The government steps to restrain pollution and other harmful activities
external diseconomies are:

1. Government Programmes:
(a) Direct Controls, i.e., through social regulations or direct regulatory controls, usually enforced by the Federal Department of Environmental Protection.

(b) Market Solution, i.e., through economic incentives instead of direct regulatory controls. One of the approaches may be to charge 'emission fees' which would re
to pay a tax on their pollution equal to the amount of external damage. This in effect internalised the externality by making the firm face the social costs of its activitie

2. Private Approaches:
(a) Negotiation and the Coase Theorem: A startling analysis by Chicago's Ronald Coase suggested that voluntary negotiations among the affected parties would in
circumstances lead to the efficient outcome. Coase's analysis does point to certain cases where private bargains may help alleviate externalities - namely, where pro
are well defined and where there are only a few affected parties who can get together and negotiate an efficient solution.
(b) Liability Rules: A second approach relies on the legal framework of liability laws or the tort system rather than direct government regulations. Here, the generat
externalities is legally liable for any damages caused to other parties. Thus, if you are injured by a negligent driver, you can sue for damages. Or, if, through neglige
company causes illness to its workers, the workers can sue the company for compensation.

Public Finance and Private Finance:

Similarities:
(a) Both have to balance their incomes and expenditure;
(b) Both try to maximise the benefit with the minimum use of resources;
(c) Both have to borrow to bridge gap between their current revenue and current expenditure; and
(d) Both can increase their income by increasing their investment expenditure.

Differences:
(a) Adjustment of Income and Expenditure: For an individual, there is a general note: "Cut your coat according to your cloth". But a government first settles the di
coat and then proceeds to arrange for the cloth required. In other words, the individuals have to adjust their expenses according to their income. Whereas, the publi
adjust their incomes according to their expenses, which is, however, not always true.

On the whole, we can say that there is a real difference in approach towards the finance of an individual and that of a government. The government first calls for an
expenditure from the various departments, settles the total expenditure, and than levies the taxes accordingly.

(b) Budgeting: For the public authorities, the unit of time for the budget is one year. But the individual attaches no special sanctity to the period. He need not balan
by a particular date or during a given period.

(c) Internal Borrowing: In their resources, a government and an individual differ. When hard-pressed, a government can borrow both at home and abroad, i.e., it ca
an internal loan or an external loan or both. But the only way open to an individual is external loan. There can be no internal loan for an individual.

(d) Deficit Financing: There is another source of income open to a government, i.e., deficit financing. A government can obtain more money by printing more curren
individual cannot print his / her own currency note to be acceptable in the market.

(e) Different Objectives: An individual tries to maximise his satisfaction or profit from the consumption or production from a given amount of resources. Whereas th
objective of a government to maximise the social welfare. The government spends money in order to attain the level of maximum social benefit. Further, the govern
achieve full employment, an equitable distribution of income and rapid economic growth or economic stability through their fiscal operations. But these objectives ha
parts in individual finances.

(f) Deliberate and Changes in Finance: For an individual, big and deliberate changes either in income or in expenditure are not so easy. But governments are in b
to make big and fundamental changes in the scheme of public income and public expenditure for future prospects.
(g) Provision for the Future: In the matter of providing for the future, a government is much more liberal and far-sighted. Governments spend large amounts of mo
schemes of afforestation, public works or social security schemes, and developmental projects which will ensure in future, faster and stable economic growth, more s
more employment opportunities, etc. The individual, on the other hand, may be anxious to reap quick returns. Human life is so uncertain that some individuals disco
at a very heavy rate.

(h) Surplus Budgeting: A prudent individual must spend less than he earns. He must have a surplus budget. But for a state, it depends on the economic situation
country. Deficit budgeting during times of a depression may stimulate effective demand. On the other hand, during periods of inflation, the emphasis is on surplus b
to reduce the level of effective demand.

(i) Individual Finance is Concealed: An individual, for security reason, may conceal his income or wealth. Whereas a government annually publishes its budgetary
revealing national income, expenditure, resources in use, etc. This shows the strength of an economy and the capability of nation as a whole.

(j) Coercive Authority: The private individual lacks the coercive authority which a government has. A government has simply to pass a law and compel the citizens
subscribe to a compulsory loan (i.e., a compulsory deposit), but an individual cannot do raise his income in this way.
 Public Expenditure
Causes of Increase in Public Expenditure

1. Increase in backward area and population

2. Growth of state functions
3. Higher price-level and rising cost of public services
4. Increase in national wealth
5. Increased ability to tax
6. War and prevention of war (defence)
7. Provision of public utility services
8. Expansion in social services
9. Technological changes call for larger or new production in public sector
10. Global environmental factors, including, IT, import & export requirements, international political changes, and
terrorism
11. Expansion of public sector
12. Defective financial and civil administration (including corruption, red tapism, and malicious bureaucracy)
13. Political and social factors
14. Economic development (esp. for developing countries)

Principles of Public Expenditure

1. Principle of maximum social benefits

2. Principle of economy, i.e., wasteful expenditure should be avoided
3. Canon of sanction, i.e., authorized expenditure
4. Principle of balanced budget
5. Canon of elasticity, i.e., fairly flexible
6. Avoidance of unhealthy effects on production and distribution

1. Principle of Maximum Social Benefits: According to Dalton, the best system of public finance is that which secures the
maximum social advantage from the operations which it conducts.
Attainment of maximum social advantage requires that:
(i) both public expenditure and taxation should be carried out up to certain limits and no more,
(ii) public expenditure should be so utilized among the various uses in an optimal manner:
(iii) the different sources of taxation should so tapped that the aggregate sacrifice entailed is minimum

In the above diagram, MSS curve represents Marginal Social Sacrifice curve and MSA curve represents Marginal Social
Advantage curve. The MSS curve rises upward from left to right, and MSA slopes downward from left to right. As more and
more funds are collected from the people by way of taxation, MSS increases and MSA decreases. As more and more collected
funds are utilized in public welfare, MSA increases and MSS decreases. The equilibrium point is where both MSA and MSS are
equal. At this point the net social welfare will be maximum.
2. Principle of Economy: It means that extravagance and waste of all types should be avoided. Public expenditure has great
potentiality for public good but it may also prove injurious and wasteful. If the revenue collected from the taxpayer is
heedlessly spent, it would be obviously uneconomical.
To satisfy the canon of economy, it will be necessary to avoid all duplication of expenditure and overlapping of
authorities. Further, public expenditure should not adversely affect saving. In case government activity damaged the
individual’s will or power to save, it would be repugnant to the canon of economy.
3. Canon of Sanction: Another important principle of public expenditure is that before it is actually incurred, it should be
sanctioned by a competent authority. Unauthorised spending is bound to lead to extravagance and over-spending. It also
means that the amount must be spent on the purpose for which it was sanctioned. Allied to the canon of sanction, there is
another, viz., auditing. A postmodern examination is equally important. That is, all the public accounts at the end of the
year should be properly audited to see that the amounts have not been misappropriated or mis-spent.
4. Principle of Balanced Budget: Every government must try to keep its budgets well balanced. There should be neither
ever-recurring surpluses nor deficits in the budgets. Ever recurring surpluses are not desired because it shows that people are
unnecessarily heavily taxed. If expenditure exceeds revenue every year, then that too is not a healthy sign because this is
considered to be the sign of financial weakness of the country. The government, therefore, must try to live within its own
means.
5. Canon of Elasticity: Another same principle of public expenditure is that it should be fairly elastic. It should be possible
for public authorities to vary the expenditure according to the needs. A rigid level of expenditure may prove a source of
trouble and embarrassment in bad times. Alteration in the upward direction is not difficult. But elasticity is needed most in
the downward direction. It is not so easy to cut down expenditure. When the economy axe is applied, it is a very painful
process. Retrenchment of a widespread character creates serious social discontent. Perfect elasticity is out of question. But
a fair degree of elasticity is essential if financial breakdown is to be avoided at the time of shrinking revenue.
6. Avoidance of Unhealthy Effects on Production or Distribution: It is also necessary to see that public expenditure
exercises a healthy influence both on production and distribution of wealth in the community. It should stimulate productive
activity so that the volume of production in the country increases and it may be possible to raise the standard of living. But
this object of raising of the standard of living of the masses will be served only if wealth is fairly distributed. If the newly
created wealth goes to enrich the already rich, the purpose is not served. Public expenditure should aim at toning down the
inequalities of wealth distribution. These two objectives may be in conflict when attempts at reducing inequalities of income
and wealth distribution adversely affect production. This it can do by adversely affecting:
(i) power to work and save, and
(ii) will to work and save
Public expenditure can also benefit production through diversion of resources from less productive to more productive
occupations.
As for (i) power to work and save, it may be pointed out that much of the socially desirable public expenditure incurred by
modern governments undoubtedly increases the community’s productive power and, consequently, also the power to
save. Such expenditure includes provision of means of communication and transport; education, public health, scientific and
industrial research; controlling of human, animal and plant diseases and expenditure on social insurance, like health
insurance, unemployment insurance and old age pensions.
As for (ii) the will to work and save, much depends on the character of public expenditure and the policy governing it. By
giving the people expectations of future benefits from public expenditure, it may blunt the edge of the desire to work and
save. The granting of old age pensions, insurance against sickness and unemployment and provision of education of state
expense must make the people indifferent towards the future and make them neglect savings. People will work less. But if
such expenditure is kept within proper limits and if it helps the really helpers, the check on savings may be mitigated. But
when taxes are too heavy, the people’s will to work and save may be discouraged and their power to do so reduced. That
limit should not be reached.
Effects of Public Expenditure
1. Effects on Production: Some people are of the opinion that expenditure on military warheads is unproductive. It is not
true. A short and successful war may bring to the country much economic gains.
If the private consumption and investment expenditure is not sufficient in sustaining the national income at its highest level,
the government comes forward and fills up the gap between actual spending and the full employment spending by arranging a
series of public works programme.
2. Effects on Distribution: Public expenditure can greatly help in toning down the inequalities of income and wealth
distribution in the country. The government by taxing the rich people at progressive rates reduces their high incomes. The
raised money is spent for the benefit of needy class of the society. State provides free education, free medical aid, free or
cheap housing facilities, subsidised necessities of life, etc. When the government is trying to make distribution of national
income more even and fair by public expenditure, it should be very cautious in implementing such a policy.
3. Effects on Level of Income and Employment: According to Keynes, the government can remove widespread
unemployment during periods of depression through liberal public expenditure on public works. It can thus raise the level of
income and employment in the country.
Keynes observed that when government increases its investment expenditure on public works, then the increase in level of
income and employment will not be merely equal to the increase in those activities, but it will be many times more than this
what he has called the ‘Income Multiplier’.
The value of multiplier depends on the marginal propensity to consume. Suppose the mpc is 5/6 the multiplier will be 6.
Multiplier = 1 .
1 – mpc

In the diagram above, the aggregate demand curve C + I cuts the aggregate supply curve OZ at E according to which
OY1 national income is determined. Now if consumption and investment remains constant and government does not increase
its expenditure, then OY will remain the national income and correspondingly the level of employment. Rather, it is possible,
and it happens during depression, that this level may go down owing to decrease in aggregate demand and there may be
widespread unemployment in the country.
Now, according to Keynes, the government should increase its expenditure in such a situation so that the level of national
income and employment in the country may increase. In the above diagram, if the government increases investment
expenditure by EH, the aggregate demand curve moves upwards as shown by the curve C + I + G. Now this new aggregate
demand curve C + I + G cuts the aggregate supply curve at F and accordingly the national income increases to OY2. It will be
seen that even though the government has increased its investment expenditure by EH, the national income has increased by
Y1Y2 which is many times more than the increase in investment.
Role of Public Expenditure in A Developing Country
1. Social and Economic Overheads: Economic development is handicapped in under developed countries due to deficiency of
capital and infrastructure. Economic overheads like roads and railways, irrigation and power projects are essential for
speeding-up economic development. Social overheads like hospitals, schools, and colleges and technical institutions are
essential. Capital for such overheads cannot be sufficiently come out of private sources. Public expenditure has to build up
the economic and social overheads.
2. Balanced Regional Growth: It is considered desirable to bring about a balanced regional growth. Special attention has to
be paid to the development of backward areas and under-developed regions. This requires huge amounts for which reliance
has to be placed on public expenditure.
3. Development of Agriculture and Industry: Economic development is regarded synonymous with industrial development
but agricultural development provides the base and has to be given the priority. Government has to incur lot of expenditure
in the agricultural sector, e.g., on irrigation and power, seed farms, fertilisers factories, warehouses, etc., and in the
industrial sector by setting up public enterprises like the steel plants, heavy electrical, heavy engineering, machine-making
factories, etc. All these enterprises are calculated to promote economic development.
4. Exploitation and Development of Mineral Resources: Minerals provide a base for further economic development. The
government has to undertake schemes of exploration and development of essential minerals, e.g., gas, petroleum, coal,
etc. Public expenditure has to play its pivotal role in the exploration and development of mineral resources.
5. Subsidies and Grants to Provinces, Local Govts, and Exporters: The central government gives grants to State
governments and the State governments to local governments to induce them to incur some desirable expenditure. Subsidies
have also to be given to encourage the production of certain goods especially for export to earn much needed foreign
exchange.
Classification of Government Expenditure
The older classification of expenditure is into ‘Current Expenditure’ and ‘Capital Expenditure’:
1. Current Expenditure: The main sources of financing current expenditure or revenue expenditure is the current revenue of
the government which mainly consists of taxes and certain non-tax revenues like profits, incidental incomes, fees and some
other extra-ordinary items.
Current revenue and current expenditure are appeared in the ‘Revenue Budget’ of the government. Such expenditure is
incurred on day-to-day functioning of the government machinery including civil administration, police, judiciary and current
expenses of beneficient departments like education, health, agriculture, etc. These heads are controlled by provincial
governments.
The federal government is responsible for defence, foreign affairs, currency and certain supervisiory and coordinating
functions. Local governments have their own budgets with certain revenue sources of local nature, e.g., octroi, terminal
taxes and cesses.
2. Capital Expenditure: The expenditure in the capital budget is incurred on building assets of a lasting character, like
construction of canals, dams, water storage, roads and railway lines, public buildings of various kinds, ports, etc. such
expenditure is of such a magnitude that it is not possible to meet it from current revenues. It is mostly financed by raising
loans, internal or even external.
A more recent classification in developing countries is into ‘Development Expenditure’ and ‘Non-Development Expenditure’:
1. Development Expenditure: Following are the characteristics of development expenditure:
(a) It should be designed to keep intact or enlarge and improve the physical resources of the country.
(b) It should improve the knowledge, skill and productivity of the people.
(c) It should encourage efficiency with which available resources are used.
Development expenditure is further defined as the expenditure that results in the replacement or in the creation of new
capacity in the field of agriculture or industry. The expenditure on ordinary maintenance and running of existing facilities
would be ‘non-development expenditure’.
2. Non-Development Expenditure: The main heads of Government Expenditure in Pakistan are:
1. General Administration, i.e., expenditure on various departments of Federal Govt.
2. Defence Expenditure
3. Law and Order
4. Community and Economic Services, e.g., expenditure on road, railways, water supply, sewerage, broadcasting,
transport and communication, etc.
5. Subsidies on selected commodities like fertilisers, seeds, wheat, etc.
6. Debt Servicing, i.e., interest paid on internal and external borrowings
Public Revenue
The public revenue can be broadly classified into two:
(a) Tax Revenue: It is the most important and major source of public revenue. Government may require the members of the
community to contribute to the support of governmental functions through the payment of taxes. An individual has no right
to directly demand social services in return to his payment of tax nor has he any other choice except to pay the tax when it is
levied on him.
Taxes, in general, serve both functions of a revenue system:
(i) they provide funds, and
(ii) they reduce private consumption and investment.
(b) Non-Tax Revenue: Non-tax revenue is derived from public undertakings called ‘Prices’ and other miscellaneous
receipts. It also raises loans, short-term and long-term, to augment its revenues. Other minor revenue sources are fees,
special assessment, fines, forfeitures and escheats, tributes and indemnities, gifts and grants.
Adam Smith’s Canon of Taxation
Adam Smith’s contribution to this part of economic theory is still regarded as classic. His presented theory on taxation is still
considered as the foundation of all discussions on the principles of taxation. There are four essentials of his theory of
taxation, i.e., equality, certainty, convenience and economy. The first canon is ethical and other three are administrative in
character:
1. Canon of Equality: means the principle of justice, i.e., in accordance to ‘ability to pay’. This is the most important canon
of taxation. It lays the moral foundation of the tax system. The cannon of equality does not mean that every taxpayer should
pay at the same sum. That would be manifestly unjust. Nor does it means that they should pay at the same rate, which
means proportional taxation, for a proportional tax is also not a very just tax. What this canon really means is the equality of
sacrifice. The amount of the tax paid is to be in proportion to the respective abilities of the taxpayers. This clearly points to
progressive taxation, i.e., taxing higher incomes at higher rates.
2. Canon of Certainty: means the tax which each individual is bound to pay ought to be certain, and not arbitrary. The time
of payment, the manner of payment, the quantity to be paid, ought to be clear and simple to the taxpayer. According to
Adam Smith, uncertainty in taxation encourages insolence or corruption.
3. Canon of Convenience: Every tax, according to Adam Smith, ought to be levied at the time or in the manner in which it is
most convenient for the taxpayers to pay their dues. The canon of certainty says that the time and the manner of payment
should be certain. But the canon of convenience states that the time of payment and the manner of payment should be
convenient. For example, if a tax on land or house is collected at a time when rent is expected to be received, it satisfies
the canon of convenience. If the tax can be paid through cheque, or credit card, or internet, the manner is convenient, but
not so if it is to be paid personally to the taxing authority. In the latter case there will be a lot of inconvenience and
harassment.
4. Canon of Economy: The tax will be economical if the cost of collection is very small. If, on the other hand, the salaries of
the officers engaged in collecting the tax eat up a big portion of the tax revenue, the tax is certainly
uneconomical. Similarly, such other huge and unnecessary administrative costs will make the tax collection an extravagant
task. If there is corruption or oppression involved in the frequent visits to the income tax office and the odious examination
by the taxing officer the canon of economy is not satisfied.
In broader sense, the canon of economy means a tax must not obstruct in any manner the ultimate prosperity of the
country. It would infringe the canon of economy if it retards the development of trade and industry in any manner. If
incomes are subjected to a very heavy tax, saving may be discouraged, capital will not accumulate and the productive
capacity of the community will be seriously impaired.
Other Canons of Taxation
1. Fiscal Adequacy or Productivity: The State should be able to function with the revenue raised from the people by means
of taxes. The government should be free from financial embarrassments. It will be necessary, therefore, that the tax
proceeds should adequately cover the government expenditure and the government does not run into a deficit. But at the
same time, the government should also not err on the side of excess. In their zeal to raise more revenue, they should not
cripple, in any manner, the productive capacity of the community.
2. Canon of Elasticity: The canon of elasticity is closely connected with that of ‘fiscal adequacy’. As the needs of the State
increase, the revenue should also increase otherwise they will cease to be adequate. To meet an emergency or a period of
stress and strain, the government should be in a position to augment its financial resources. Income tax is considered to be
an elastic tax, as it can be considerably increased when needed.
3. Canon of Flexibility: There is a difference between flexibility and elasticity. Flexibility means that there should be no
rigidity in the tax system so that it can be quickly adjusted to new conditions; and elasticity means that the revenues can be
increased. The presence of flexibility is a condition of elasticity. A tax system cannot be altered without bringing about a
revolution or without much flexibility in the tax system.
4. Canon of Simplicity: According to Armitage Smith, a system of taxation should be simple, plain and intelligible to the
common understanding. This canon is essential if corruption or oppression is to be avoided.
5. Canon of Diversity: Another important principle of taxation – diversity. A single tax or only a few taxes will not do. There
should be a variety of taxes so that all the citizens, who can afford to contribute to the State revenue, should be made to do
so. They should be approached in a variety of ways. There should be a wise admixture of direct and indirect taxes. But too
great multiplicity will be bad and uneconomical.
6. Social and Economic Objectives: In modern times, economists emphasised that the tax system should be based on the
principle that the effects of taxation should be compatible with the economic and social objectives and preferences of the
community. The social and economic objectives of a standard tax system are:
(i) Reduction of inequalities in the distribution of income and wealth: For this purpose, progressive taxes must be
levied instead of proportional taxes.
(ii) Accelerating economic growth: For this purpose, the tax system must be so designed as to raise the rates of saving
and investment. This is a very important objective for less developed countries (LDCs), where there is a deficiency of savings
and investments.
(iii) Price stability: to ensure stable economic growth. When LDCs launch economic development programme they have
to face inflation or soaring prices. An integrated tax policy would solve this problem.
Objectives of Taxation in Developing Economies
(a) Ability to contribute to economic development: Each person should be made to contribute to economic development,
according to his ability to do so. All his unused capacity must be utilised, through appropriate tax measures, for purposes of
economic development. Suppose a person is making a large saving but he lets it lie idle. Such saving must be mobilised and
channelised into investment.
(b) Mobilisation of economic surplus: In all backward countries, a significant portion of national output goes to the big
landlords and other idle rich people. A large portion of their income is spent on conspicuous consumption, e.g., building of
palaces, etc. This is unproductive expenditure and a waste from the point of national development. Economic growth can be
accelerated if an appreciable portion of this ‘surplus’ income is mobilised and made available for productive investment.
(c) Increasing the incremental saving ratio: As economic development proceeds apace, incomes rise. But there is a
danger that propensity to consume may also increase so that extra incomes generated in the economy are utilised in
consumption rather then invested in production. This has to be prevented. In other words, the consumption is not allowed to
increase in proportion to increase in income. For this purpose commodity taxes are quite effective.
(d) Income elasticity of taxation: In backward economies, the share of taxation out of the national income is less than
10%. This share must be progressively raised as national income increases as a result of economic development. This needs
built-in flexibility in the tax system. Progressive taxation of income provides this flexibility. Taxation of goods having a high
income-elasticity of demand also imparts to the tax system much needed flexibility.
(e) Equity: The canon of equity demands that the burden of economic development must be distributed among the
different sections of the community equitably. That is why the richer classes are prevented from increasing their
consumption in proportion to the rise in their incomes. This is how they make a sacrifice for the economic development of
their country. The poor people also make a sacrifice because rising prices curtail their consumption. In this manner,
sacrifices in consumption are shared by all sections of the society. Thus, the burden of economic development is equitably
distributed among all. This is also known as‘horizontal equity’.
Characteristics of A Good Tax System
(a) Simple, financially adequate and elastic: The tax system should be simple, financially adequate and elastic. In other
words, the system should be easily intelligible; it should be sufficiently productive of revenue; and the tax structure should
be adaptable to meet the changing requirements of the economy.
(b) Broad based: The tax system should be as much broad-based as possible. It should be multiple tax system. There
should be diversity in the system. But too great multiplicity in tax system should be avoided.
 (c) Administratively efficient: The tax system should be efficient from the administrative point of view. It should be
simple to administer. There should be little scope for evasion or accumulation of arrears. It should be foolproof and knave-
proof. Chances of corruption should be minimised.
(d) Balanced and harmonious: Another important characteristic of a good tax system is that it should be a harmonious
whole. It should have a balanced structure. It should be truly a system and not a mere collection of isolated taxes. Every
tax should fit in properly in the system as a whole so that it is a part of a connected system. Each tax should occupy a
definite and due place in the financial structure.
(e) Ensuring the reduction of economic inequalities: A good tax is that it should be an instrument for the reduction of
economic inequalities. The purpose of public finance is not merely to raise revenues for the State but to raise the revenue in
such a manner as to reduce the economic inequalities. In this manner, the State may also be able to divert idle resources in
bank balances or lockers to more productive areas.
(f) Ensuring economic stability: From the point of view of ensuring economic stability, it is necessary that the tax system
must be progressive in relation to changes in the national income. This means that when national income rises, an increasing
part of rise in income should automatically accrue to the tax authorities and when national income falls, as in a depression,
the tax revenue should fall faster than the fall in national income.
(g) Ensuring that national income is increasing: The tax system should ensure that the national income is increasing
during boom periods. Similarly, in depression, tax revenues should fall faster than income so that the purchasing power of
people does not fall as fast as their pre-tax income. Thus, an overall progressive tax system is an important factor in ensuring
stability.
(h) An instrument of economic growth: For developing economies, the tax system has to serve as an instrument of
economic growth. Economic development rather than economic stability is the objective of under-developed
countries. Their tax system must be so shaped as to accelerate economic development. For this purpose, it must mobilise the
required resources and channelise them into investment. It must, in short step up savings and investment and raise the level
of income and employment in the economy.
(i) Socially advantageous: The tax system should be socially advantageous and promote general economic welfare. From
this point of view, taxes on goods of mass consumption should be avoided. The burden of tax on basic items should not be
excessive.
 (j) Optimum allocation of resources: The tax system should be so framed as to ensure that the productive resources of
the economy are optimally allocated and utilised. For this purpose, it is essential that the tax system should be economically
neutral. In other words, it should interfere as little as possible with the consumers’ choices for consumption goods and the
producers’ choices regarding the use of factors.
Classification of Tax
Some classifications of taxes are as follows:
1. Proportional & Progressive Tax: A proportional tax is one in which, whatever the size of income, same rate or percentage
is charged.
On the contrary, progressive tax refers to the tax system in which the rate of tax increases with the increase in table
income. It is based on the principle ‘higher the income, higher the tax’.
2. Regressive & Digressive Tax: A tax is said to be regressive when its burden falls more heavily on low-income earners /
poor than the high-income earners / rich. It is opposite of progressive tax.
A tax is called digressive when the higher income does not make a due sacrifice, or when the burden imposed on them is
relatively less. This tax may be progressive up to a certain limit beyond which a uniform rate is charged.
3. Specific & Advolarem Tax: A specific tax is according to the weight of the commodity. An advolarem tax is according to
the value of a commodity.
4. Direct & Indirect Tax: Direct tax is one which is paid by the person on which it is charged. The examples of direct taxes
are income tax, wealth tax, etc.
On the contrary, the indirect tax’s is paid by one person and its burden is fall on other, generally the consumer. The
examples of indirect taxes are sales tax, central excise duty, custom duty, recreational tax, etc.
Sources of Tax Revenue / Major Types of Tax
1. Income Tax: It is a form of direct tax which is levied on individual’s total earnings. It is the most effective tax vehicle for
attaining equity, particularly if it is progressive tax. Following are the requirements for an optimal income tax system:
(a) All incomes should be treated uniformly and all rupees of income should be accorded equal tax treatment regardless of
the source.
 (b) Just as ‘equals’ should be treated ‘equally’, ‘unequals’ should be treated ‘unequally’.
(c) The tax structure should be sensitive to changes in economic activity in order to dampen the changes
(d) The tax structure should be designed in such a fashion as to facilitate compliance and in enforcement, consistent with
the attainment of the other objectives.
2. Corporate Tax: The following are the primary tax consequences of the existence of the corporation:
(a) The corporation’s earnings are accumulated as reserves giving rise to capital gains.
(b) The division between initial earning of the income and subsequent payment of dividends encourages government to tax
both the corporation and the dividend earners.
(c) The division between ownership and top management in a large corporation may cause the reactions to the tax to be
different from the personal income tax.
Under perfectly competitive markets the corporate tax shifted to reduce the real income of stockholders. Under imperfectly
competitive markets the firms use mark-up price for shifting the tax burden on consumers.
3. Wealth Tax: A wealth tax is a levy upon individuals not corporations, on the basis of their net wealth. Corporate property
is reached via securities outstanding in the hands of the owners and creditors. The wealth tax can take form of either
progressive or proportional tax. Wealth tax is not a major source of revenue and in most countries they form 1 to 2% of the
total tax revenue.
4. Sales Tax: Sales tax is applied to all or a wide range of commodities and services. It is collected from vendors rather than
individual consumers. The sales tax is finally borne by consumers. The sales tax is often refer to regressive tax relative to
income.
5. Excise Duty: It is actually imposed on the manufacturers but the consumers have to pay it. It is a form of indirect tax
imposed on widely used commodities often regarded as non-essential such as cigarettes, liquor, tobacco, etc.
6. Custom Duty: Custom duties are of two types:
(i) specific, and
(ii) advolarem.
Specific custom duty is fixed per physical units of goods, e.g., television, CD players, computers, etc. The advolarem custom
duty is according to the value of a good and charged at a certain rate.
As industrial and commercial development continues the increased use of custom duties lessens the revenue potential.
7. State Duties: There are several other duties imposed by the government broadly classified as ‘state duty’. These include
the tax on the earnings of commercial deposits and on sales and purchase of properties. These are some what different types
of tax as:
(a) the taxes imposed by the federal government and used by itself,
(b) the taxes imposed by the federal government and distributed among provinces, and
(c) the taxes imposed by the provincial governments and used by themselves.
8. Other Sources:
(i) Fee: It is also a compulsory payment but made only by those who obtain a definite service in return from the
government. The fee covers the part of the cost of service provided to the consumer / client. The licence fee, however, is
much more than the cost of service and there is not much of a positive service in return.
(ii) Price: A price is the payment of a service of business character, for example, charges for travelling on railway. The
price is different from fee. The fee is for public interest. You can escape a price by not purchasing the said service /
commodity.
(iii) Special Assessment: According to Professor Seligman, special assessment is a compulsory contribution, levied in
proportion to the special benefit derived, to defray the cost of a specific improvement to property undertaken in the public
interest. Suppose the government build a road or bridge or provide mass transport system or makes suitable sewerage and
water supply arrangements, all the property will appreciate in value. The State has the right to levy a special tax on the
owners of land or property known as ‘special assessment’.
(iv) Rates: Rates are levied by the local bodies, municipalities and district boards for local purposes. They are generally
levied on immovable property of the residents, but not necessarily for any special improvements effected or special benefits
conferred.
Sources from Non-Tax Revenues
In Pakistan, following are the sources of non-tax revenue available for Federal Government:
1. Income from Property & Enterprise: The Government receives income from the owned lands, forests, mines, canal
water and various public enterprises.
2. Profit from Post Office and TNT: The Government also receives income from its Post and Telegraph departments
3. Trading Profits: The Government of Pakistan earns trading profits from exports of rice, cotton and edible oil
4. Interest Receipts: It is the most important head in the NTR source. The interest and the return from investment
received from various autonomous bodies, and central bank and state-owned banks come under this head
5. Surcharges: The difference between the sales price and the production cost / import price of petroleum products, gas
and fertilisers represents the surplus profit or the surcharge, which is used to iron out the fluctuations in the prices of these
essential commodities.
6. Other Sources of Non-Tax Revenue: The other minor heads of non-tax revenue are:
(i) Dividends and returns
(ii) Receipts from civil administration and other functions
(iii) Miscellaneous sources, which includes passport, CNIC (Computerised National Identity Card), copyright fees
and other receipts.
 Equity in Taxation
Principles of Equity in Taxation
1. Cost of Service Principle: This principle states that it would be just if people are charged the cost of the service rendered to them. This principle has
no practical application. The cost of service of armed forces, police, etc. – the services which are rendered out of tax proceeds – cannot be exactly
determined. Only in those cases, where the services are rendered out of prices, e.g., supply of electricity, railway or postal service, a near approach can
be made to charging according to the cost of service.

2. Benefit or Quid Pro Quo Theory: This theory suggests that the taxes should be levied according to the benefit conferred on the tax-payers. But its
practical application is also difficult. Most of the public expenditure is incurred for common or indivisible benefits. It is impossible to calculate how much
benefit accrues to a particular individual. There are a few cases only where the benefit to one individual is ascertainable, e.g., old-age pensions. The
benefit theory violates the basic principle of tax. A tax is paid for the general purposes of the State and not in return for a specific service. Moreover, it
is commonly believed that the poor benefit more from the State activities than the rich. If that is so, then the poor has to contribute more than the
rich. This would be absurd. However, the idea of benefit stands out prominently in the case of fees, licences, special assessment and local rating.

3. Ability to Pay or Faculty Theory: This is the most popular and the plausible theory of justice in taxation is that every tax-payer should be made to
contribute according to his ability or faculty to pay. The difficult task is to determine a person’s ability to pay tax. There are two approaches for this
theory – subjective and objective:

(i) Subjective Approach: In the subjective aspect, the inconvenience, the pinch or the sacrifice bear by tax-payer is considered. There are three
distinct views in this regard:

(a) The Principle of Equal Sacrifice: According to J.S. Mill, equality of taxation, as a maxim of politics, means equality of sacrifice. According to this
principle, the money burden of taxation is to be so distributed as to impose equal real burden on the individual tax-payers. This would mean proportional
taxation.

(b) The Principle of Proportional Sacrifice: According to the principle of proportional sacrifice, the real burden on the individual tax payer is to be
not equal but proportional either to their income or the economic welfare they derive. This would mean progressive taxation.

(c) The Principle of Minimum Sacrifice: The minimum sacrifice principle considers the body of tax-payers in the aggregate and not
individually. According to this principle, the total real burden on the community should be as small as possible.

(ii) Objective Approach: Under objective approach, a man’s faculty to pay may be measured according to:

(a) Consumption: Consumption, as a criterion of ability to pay, is not a sound criterion, because consumption or utilisation of the services of the State
by the poor is considered to be out of all proportion to their means, and, as such, it cannot be taken as a practical principle of taxation.
 (b) Property: Property also cannot be a fair basis of taxation, for properties of the same size and description may not yield the same amount of
income; and some persons having no property to show may have large incomes, whereas men of large property may be getting small incomes. Thus, to tax
according to property will not be taxation according to ability.

(c) Income: Income, however, remains the single best test of a man’s ability to pay. But even in the case of income, the tax will be in proportion to
faculty. The principle of progression is satisfied under this criterion.

Proportional vs. Progressive Taxation

Proportional Taxation:
Case for:
1. Equitable rate for taxation, i.e., equal contribution
2. Simpler taxation system
3. Tax is charged in proportion to the tax payers’ income
4. It encourages saving and drives in capital
5. Investment is encouraged and in the long run increases the level of income and employment
6. The tax-payer has the motivation to pay tax as it is simple and has less burden on high-income earners

Case against:
1. The burden of tax under proportional tax system is heavily fall on low-income earners, i.e., it is regressive
2. It does not entail equal sacrifice. All the tax payers have to pay tax at the same rate or equal proportion. The sacrifice should be in proportion to
the tax payers’ capacity
3. The government cannot raise substantial tax revenue which is used for public welfare
4. Increased use of luxuries
5. Less productive
6. Economic instability as a result of weakening purchasing power of the people
7. Economic inequalities cannot be reduced

Progressive Taxation:
Case for:
1. As income increases, the utility of each addition to the income decreases. Hence, the payment of the tax by the rich entails much less sacrifice
than by the poor. The rich people should be, therefore, taxed at higher rates
2. By taxing affluent class more, its expenditure on luxurious goods is curtailed.
3. Progressive taxation yields much greater revenue and hence it is more productive.
4. Progressive taxation is more economical and equitable. The cost of collection of the taxes does not increase when the rate of tax increases. It
calls forth a proportional sacrifice from the tax payers. It places the heaviest burden on the broader shoulders.
 5. The principle of progression gives to the tax system much-needed elasticity or flexibility. When there is an emergency, only a little raising of the
rates may be sufficient to meet the situation.
6. Progressive taxation promotes economic stability and checks cyclical fluctuations. The government can easily control the inflationary and
deflationary pressures by checking the purchasing power of the people through progressive taxation.
7. Progressive taxes are badly needed for reducing economic inequalities and for bring about more equitable distribution of wealth in the community.
8. Progressive taxes may increase the desire to work, save and invest.

Case against:
1. The degree of progression is settled by the finance minister on no definite and scientific basis. It is purely his personal opinion.
2. It is pointed out that the principle of progression cannot be advocated on the ground of promoting welfare, because welfare is subjective and
cannot be measured.
3. Heavy progressive taxation will discourage saving, drive out capital and thus hamper trade and industry.
4. Risky investments which yield high returns are discouraged because the proportion of tax increases as income increases. Reduction of investment
will reduce the level of income and employment in the country.
5. Progressive taxes put premium on idleness and leisure since they penalise those who work hard and make more money. It amounts almost the
graduated confiscation of rich man’s income.
6. Progressive taxes are more vulnerable to tax-evasion. But the possibility of evasion in proportional taxation is not less. It all depends on the social
conscience.

Taxable Capacity
The taxable capacity can be used in two senses:

(a) In the absolute sense, and

(b) In the relative sense.

(a) Absolute Taxable Capacity: It means how much a particular community can pay in the form of taxes without producing unpleasant effects. There are
two extreme views about absolute taxable capacity:

(i) The capacity to pay without suffering, and

(ii) The capacity to pay regardless of suffering

Sir Josiah Stamp defines taxable capacity as the margin of total production over total consumption or the amount required to maintain the population at
subsistence level. It is the maximum amount of taxation that can be raised and spent to produce the maximum economic welfare in that community.

(b) Relative Taxable Capacity: On the other hand, relative taxable capacity means the respective contribution which the communities should make
towards a common expenditure, for example, provincial contribution to control expenditure. Dalton says the absolute capacity is a myth and relative
taxable capacity is a truth. A relative limit may be reached without reaching the absolute limit.
Factors Governing Taxable Capacity: Following are the factors governing taxable capacity:

(a) Number of inhabitants: It is quite obvious that the larger the population the greater is the taxable capacity of the community to contribute
towards the expenses of the government.

(b) Distribution of wealth: If wealth is more equally distributed, the taxable capacity will be correspondingly reduced. But if there are large
accumulations of wealth in a few hands, the government can raise more money by taxing the rich.

(c) Method of taxation: A scientifically constructed tax system with a wise admixture of the various types of taxes, direct and indirect, is sure to
bring a larger yield.

(d) Purpose of taxation: If the purpose of taxation is to promote welfare of the people, they will be more willing to tax themselves. But if the bulk of
the public funds is to be spent on the maintenance of foreign armed forces and for the upkeep of a costly civil service, in which foreign element is
predominant, as was the case in Pakistan, the taxable capacity must correspondingly shrink.

(e) Psychology of tax-payers: The taxable capacity much depends on the people’s attitude towards a government. A popular government can
galvanise the spirit of the people and prepare them for greater sacrifice. Psychology of the people is an important factor, and unless they are properly
approached, they may be unwilling to tax themselves.

(f) Stability of income: If the income of the citizens is precarious, there will be not much scope for further taxation.

(g) Inflation: High inflation rate lowers the purchasing power of people and it cripples many; it has an adverse effect on taxable capacity.

(h) Level of economic development: The level of economic development attained by a country is an important determinant of its taxable
capacity. Undoubtedly, all highly developed countries of the world have greater taxable capacity than the under-developed countries.
Incidence of Taxation
Incidence of Taxation
Taxes are not always borne by the people who pay them in the first instance. They are often shifted to other people. Tax incidenc
the final placing of a tax. Incidence is on the person who ultimately bears the money burden of tax. According to the modern theo
incidence means the changes brought about in income distribution by changes in the budgetary policy.
Impact and Incidence: The impact of a tax is on the person who pays it in the first instance and the incidence is on the one who fin
it. Therefore, the incidence is on the final consumers.
Incidence and Effects: The effect of a tax refers incidental results of the tax. There are several consequences of imposition of tax
example, decreased demand.
Money Burden and the Real Burden: The money burden of a tax is represented by the total amount of money received by the trea
example, the consumer has to spend Rs. 50 more on sugar monthly, it is the money burden that he has to bear. But if he has to red
consumption of sugar it means there is a reduction in economic welfare. This inconvenience, pinching, sacrifice or in short the loss
economic welfare is the real burden of tax.

Theories of Tax Shifting and Incidence

1. Earlier Theories: The earlier theories may be classified into:

(a) Concentration or Surplus theory: According to concentration theory, each tax tends to concentrate on a particular
people who happen to enjoy surplus from their products.
(b) Diversion or Diffusion theory: The diffusion theory states that the tax eventually got diffused in the entire society.
the final placing of tax is not one but multiple. The process of diffusion took place through shifting or through process
exchange.
 2. Modern Theory: According to modern theory, the concentration and diffusion theories are partially true. Actually there are
concentration and diffusion of taxes according to the conditions present. The modern theory seeks to analyse the conditions w
about concentration or diffusion.

Factors determining Tax Incidence

(a) Elasticity: While considering incidence we consider both elasticity of demand and elasticity of supply. If the demand for the
taxed is elastic, the tax will tend to be shifted to the producer but in case of inelastic demand, it will be largely borne by the consu
case of elastic supply, the burden will tend to be on the purchaser and in the case of inelastic supply on the producer.
(b) Price: Since shifting of the tax burden can only take place through a change in price, price is a very important factor. If the
the price unchanged, the tax does not shift.
(c) Time: In short run, the producer cannot make any adjustment in plant and equipment. If, therefore, demand falls on accoun
rise resulting from the tax, he may not be able to reduce supply and may have to bear the tax to some extent. In the long run, how
adjustment can be made and tax shifted to the consumer.
(d) Cost: Tax raises the price; rise in price reduces demand and reduced demand results in the reduction of output. A change in
of production affects cost and the effect will vary according as the industry is decreasing, increasing or constant costs industry. Fo
if the industry is subject to decreasing cost, a reduction in the scale of production will raise the cost and hence price, shifting the b
the tax to the consumer.
(e) Nature of tax: The incidence of taxation will definitely depend on the nature of tax. For example, an indirect tax’s burden
the consumer.
(f) Market form: Another factor determining the incidence of taxation is the market form. Under perfect competition, no single
or single purchaser can affect the price; hence shifting of tax in either direction is out of the question. But under monopoly, a prod
position to influence price and hence shift the tax.
Distinction between Direct and Indirect Taxes
A direct tax is not intended to be shifted, whereas an indirect tax is so intended.
Taxes on commodities are generally called indirect taxes as they completely or partially shifted consumers. But it should be remem
all the commodity taxes are not indirect taxes. A tax is said to be indirect if its burden is shifted finally to the consumer.
Direct tax is the tax in which the commodity is taxed by the government, yet its price remains unaffected or changed. In this case
not shifted to consumer and the tax will be called direct tax. If the tax is shifted, the tax is indirect, otherwise indirect.
Merits and Demerits of Direct and Indirect Taxes
Merits of Direct Tax:

1. Equitable, i.e., the principle of progression is applied

2. Economical, i.e., the cost of collection is small
3. Certain, i.e., the direct tax can be calculated with a fair degree of precision
4. High degree of elasticity, i.e., the direct tax can be raised much easily
5. Civic consciousness, direct tax creates civic consciousness among tax-payers
6. Reduction of inequalities, i.e., the objective of direct tax is to reduce economic inequalities by taxing higher income earner
progressive tax rates.

Demerits of Direct Tax:

1. Inconvenient: for the tax payer to pay and file the income tax return
2. Unpopular tax system
3. Tax evasion is common
4. Unarbitrary tax rates

Merits of Indirect Tax:

1. Convenient: for the tax payer to pay and it requires no filing of returns
2. No tax evasion
3. Unified tax rate
4. Beneficial social effects (in case of harmful drugs and intoxicants)
5. Capital formation
6. Re-allocation of resources
 7. Wide coverage

Demerits of Indirect Tax:

1. Uncertain
2. Regressive
3. No civic consciousness
4. Inflationary
5. Loss of economic welfare

Incidence of Some Taxes

Taxes on Personal Income:
1. Income tax, super tax and excess profit tax are all direct taxes and generally cannot be shifted.

2. However, the business is in a strong position and can shift a part of his tax burden to his customers. But this situation is rarel
and the income tax payer must bear the burden of tax.

3. If the income tax is extremely heavy, it may discourage saving and investment. However, it will mainly depend on whether th
on average income or marginal income, the effects would be adverse. If the increase in tax is fall on marginal income, it will
positive discouragement to the earning of that income.

Corporate Tax:
1. Corporate tax discourages investment, level of national income and employment.

2. A corporation tax, by reducing the earnings of the existing firms, discourages the entry of new firms into the industry which m
in a monopoly or a semi-monopoly for the existing firms with all the attendant evils.

3. A part of corporate tax may be shifted to the buyers through a price rise.

Tax on Profits:
 1. Some economists are not of the view that the tax on profit should be shifted to buyers. It should be borne by the seller who

2. The second view does not subscribe with the above approach. It is argued that normal profit is a part of the cost and when th
entrepreneur is able to influence the price, the tax is generally shifted to the consumer.

3. However, the tax on profit in the form of a licence duty will be borne by the producer.

Wealth Tax:
1. Wealth tax is imposed on value of a person’s stock of wealth

2. By enabling the government not to raise the income tax rates too high, the wealth tax encourages investment in modern indu

3. Another obvious effect of wealth tax is the reduction of economic inequalities by reducing the size of inherited wealth

Property Tax:
1. The wealth tax is imposed on the net worth of the individual. Whereas, the property tax is levied on the gross amount of asse

2. There is no shifting of tax and the incidence is on the person on whom the tax is levied. However, the tax on productive prop
be shifted to consumers.

Land Taxation:

1. The value of land depends on two sets of factors:

(a) Natural factors like the fertility of the soil, the situation of the land, some other natural conditions, and
(b) Investment of capital in drainage schemes, anti-erosion measures, irrigation facilities and other measures necessary to
and sustain productivity
2. The tax on the first set is a tax on economic rent and has a tendency to fall on the owners

3. But when the owner can vary his investment when the tax increases, he can shift the tax burden to the consumer.
Tax on Buildings:
1. If the tax is imposed on the owner, he will try to raise the house rent and thus shift the tax to the occupier or tenant. But he
this during the currency of the lease.

2. A heavy tax will check building activity and the remuneration of the builder and of other people engaged in the trade may fal

3. The tax may fall partly on the owner, partly on the builder and partly on the occupier

Death Duty:
1. Death duty may take two forms, i.e., Estate Duty and Succession Duty

2. The Estate Duty is levied on the total value of the estate (i.e., movable and immovable property) left by the deceased irrespe
the relationship of the successor

3. The succession duty varies with the relationship of the beneficiary to the deceased. It takes into consideration individual sha
successor and not the total value as in the estate duty.

Tax on Monopoly:

1. The monopoly tax may be:

(a) Independent of the output of the monopolised product, or

(b) It may vary with the output, i.e., increase or decrease with the output
2. When the tax is independent of the quantity produced, it may either be lump sum tax on the monopolist or a percentage of th
monopoly net revenue (profits). In both cases it will be borne by the monopolist and he cannot shift the same to the consume
the monopolist is already on a price with maximum beyond which his profit will decline

3. In the second case, the price of the commodity or incidence of taxation will depend on the elasticities of supply and demand,
influence of laws of returns.
 4. Taxing of the commodity, therefore raises the price which will tend to reduce the demand

5. If, however, the demand is inelastic, it cannot be appreciably reduced and the tax will be borne by the consumer.

6. If the demand is elastic, the consumers may buy less when the tax has raised the price. Instead of facing a decline in demand
monopolist may reduce the price and decide to bear the tax himself.

Commodity Tax:

1. Taxes on commodities may take several forms:

(a) Tax on manufacture or production of a commodity called excise duties,

(b) Tax on sale of a particular commodity known as sales tax, and
(c) Import or export of commodities known as custom duties.
2. The commodity tax is tended to be shifted to the consumer and from consumer to the producer

3. Tax on production tends to raise the prise and will therefore be normally borne by the consumer

4. But the consumption tax is likely to check consumption and tends to be shifted backward to the producer.

5. Therefore, the tax on commodity will be partly borne by the producer and partly borne by the consumer

6. The portions of commodity tax to be borne by the producer and consumer depends on the degree of elasticity of demand and

Elasticity Incidence

Elastic demand More tax burden on the supplier / producer

Inelastic demand More tax burden on the buyer / consumer
Elastic supply More tax burden on the buyer / consumer
Inelastic supply More tax burden on the supplier / producer
 7. As a rule, the consumer bears a smaller part of the tax when the demand is more elastic than the supply

8. This may happen that the price may not rise at all. This is because the consumers have been able to discover an untaxed sup
commodity or substitute. In this case, the tax burden will fall on the producer.

DD and SS intersect at point P and MP is the price determined. Now suppose a sales tax per unit is levied. As a result the supply cu
commodity will rise upward equal to the tax per unit. The new supply curve will be S’S’. The distance between the two supply cur
represents the tax per unit of the commodity. S’S’ cuts the demand curve DD at Q and, therefore, now TQ is the price determined
higher than the old price PM by RQ. Hence RQ is the burden of tax borne by the consumer even though the tax per unit is LQ. Ther
(LQ – QR) is the burden of the tax borne by the seller or he has RL price less than before (PM being the first price).

10. Therefore the commodity tax is distributed between the buyers and sellers according to the ratio of elasticities of dema
supply:

RL = Burden of the tax on the seller (producer) .

RQ Burden of the tax on the buyer (consumer)
 Ed = Proportionate decrease in quantity demanded
Proportionate increase in price

---------------------------------- (i)

Es = Proportionate decrease in quantity supplied

Proportionate decrease in price

------------------------------------- (ii)

= Elasticity of Demand (Ed)

Elasticity of Supply (Es)
 11. In the above equation, RL is the burden of the tax on the seller and RQ is the burden of tax on the buyers. Hence:

RL = Burden of tax on the seller

RQ = Burden of tax on the buyer

= Elasticity of demand (Ed)

Elasticity of supply (Es)
Sales Tax:
1. The sales tax is levied on the turnover, profits or no profits. It covers a wide variety of commodities.

2. The sales tax may make heavy inroads into profits which may lead to retrenchment in the staff and management, restrict ent
employment and hamper utilisation of resources.

3. Thus, its incidence may fall upon employees, management and landlords.

Import Duties and Export Duties:

1. Import Duties are generally borne by the home consumer

2. If the demand for the imported product is elastic and the supply is inelastic and the foreign producer has no alternative mark
such a case the burden of tax may be shifted to foreign seller. This situation is rarely present.

3. Export duty is borne by the exporter. The price in the world market is fixed and no individual exporter is in a position to influ
world price.

4. There are certain exceptional situations in which the purchaser may bear the burden of export duty. For example, the supplie
producer has the monopoly of the supply of a commodity.
Effects of Taxation on Production, Consumption and Distribution
Effects on Production:

1. Production is affected by taxes in two ways:

(a) By affecting the ability to work, save and invest

(b) By affecting the desire to work, save and invest
2. A tax on necessaries of life, will obviously affect the workers’ productivity and hence reduce production. A heavy tax on inco
to reduce the ability to save and invest on part of individuals. A decrease in investment is bound to affect adversely the leve
in the country

3. Normally taxation induces people to work harder, earn more, save more and invest more to increase their income and enjoy t
income after tax

4. Some taxes has no adverse effects, for e.g., import duties, tax on monopolists, etc.

5. High marginal rates of income tax are likely to affect adversely the tax payers’ desire to work, save and invest

6. The reaction varies from individual to individual. It depends on the individual’s elasticity of demand for income. When it is f
elastic, the tax will lessen his desire to work and save

7. Entrepreneurs may avoid the production of goods which are taxed. There is likely to be a diversion of resources from some se
economy to others

Effects on Income Distribution:

1. The effects of taxes on income distribution depends on the type of taxes and rates of taxes

2. Taxation of goods of mass consumption is regressive and redistributes incomes in favour of rich.
 3. But if such commodities are exempted and luxuries are taxed, and the taxation is made progressive, then the income will be
redistributed in favour of poor.

Effects on Consumption:
1. By imposing tax on a consumable good which is injurious to health, its consumption can be checked.

2. Similarly the tax on luxury goods can decrease their consumption and resources diverted to the production of mass consumpti
 Public Debt
Public debt refers to borrowing by a government from within the country or from abroad, from private individuals or
association of individuals or from banking and NBFIs.
Classification of Public Debt
(a) Internal and External: When a state finds that it is not possible to obtain further money by taxation, it resorts to
borrowing from citizens and financial institutions within the country. This is ‘internal borrowing’. The state may
accumulate funds by raising short-term loans or long-term loans or by both. If the state is passing through a very critical
period, then it can borrow all the money which the nation saves. In that case trade and industry will suffer a lot
because no money is left to finance them. In the normal period, however, the state can borrow only surplus funds
which are left with the businessmen after meeting all the needs of the business.
External loan is that which is raised from international money markets, foreign governments, and from international
agencies like International Monetary Fund. When a state is in need of money, it tries to get as much loan as it can from
other states. The foreign governments do not advance loans without a limit. They minutely study the budgetary
position of the borrowing country, the tax-bearing capacity of the nation, the per-capita income of the people and the
purpose for which the loan is desired. If the position of the budget is sound and the taxable capacity of the nation is
high, then a foreign government may advance sizable loan to the borrowing country.
(b) Productive and Unproductive: The debt that is expected to create assets which will yield income sufficient to pay
the principal amount and the interest on it, is known as ‘productive debt’. In other words, they are expected pay their
way; they are self-liquidating. J.L. Hanson has referred such a debt as ‘reproductive debt’.
On the other hand, unproductive debt is the debt that is raised for financing unproductive assets or heavy unproductive
expenditures. Such a debt is a deadweight debt. Debt invested on wars or prevention of war is a deadweight debt.
(c) Short-term and Long-term: The loans that are repayable within a period of one year, they are termed as ‘short-
term loans’ and if they are taken for more than one year, they are referred to as ‘long-term loans’. Following are the
reasons for raising short-term loans:
1. If, at any time, the expenditure of the government exceeds the revenue, then she takes recourse to short-
term borrowing.
 2. If, at any time, the rate of interest in the market is very high and the government is in need of large fund to
finance her various projects, then it raises loan for a short-period of time only and waits till the prevailing high
rate of interest comes down.
3. The commercial banks find a very safe and profitable opportunity to invest their surplus funds in the
government short-term loans.
If the government is in need of large funds and the short-term loans are not enough, then she takes recourse to long-
term borrowing. Long-term loans entail following advantages:
1. Long-term loan provides an opportunity to the state in undertaking large projects like construction of canals,
hydroelectric projects, buildings, highways, etc. As these loans are not to be repaid at a short notice, so the
government safely spends them on productive projects.
2. Long-term loans are also unavoidable for strengthening country’s defence.
3. Long-term loans provide good opportunity for commercial banks and insurance companies to invest their surplus
funds. As the rate of interest on long-term loans is higher than on the short-term loans.
4. Long-term loans can be repaid by the government by the time which is favourable or convenient to her. She can
also convert these loans at a lower rate of interest later on.
5. If at any time, the rate of interest is low, the government can contract a long-term loan and with the amount
thus raised some public work programmes at lower cost.
Causes of Increase in Public Debt
1. War or war-preparedness, including nuclear programmes
2. To cover the budget deficits on current account
3. To undertake public welfare schemes
4. Urge for economic growth
5. Inefficiencies of public organisations and corruption
Purposes of Public Debt

1. Bringing gap between revenue and expenditure through temporary loans from central bank. In Pakistan, the
Government issues what are called ‘Treasury Bills’ which are repayable within one year.
2. To reduce depression in the economy and financing public works programme.
3. To curb inflation by withdrawing the purchasing power from the public.
4. Financing economic development esp. in under-developed countries.
5. Financing the public sector for expanding and strengthening the public enterprises.
6. War, arms and ammunition financing.

Methods of Debt Redemption

1. Utilisation of surplus revenue: This is an old method and badly out of tune with the modern conditions. Budget surplus
is not a common phenomenon. Even when there is a surplus, it cannot be used for making any substantial reduction in
the public debt.

2. Purchase of government bonds: The government may buy her own stocks in the market, thus wiping off its obligation
to that extent. This may be done by the application of surplus revenues or by borrowing at low rates, if the conditions
are favourable.

3. Terminable annuities: When it is intended completely to wipe off a permanent debt, it may be arranged to pay the
creditors a certain fixed amount for a number of years. These annual payments are called ‘annuities’. It will appear
that, during the time these annuities are being paid, there will be much greater strain on the government finances than
when only interest has to be paid.

4. Conversion of high-interest-rated loans to low-interest-rated loans: A government may have borrowed when the rate
of interest was high. Now, if the rate of interest falls, it can convert a high-rated loan into a low-rated one.

5. Sinking fund: This is the most important method. A fund is created for the repayment of every loan by setting aside a
certain amount every year out of the current revenue. The sum to be set aside is so calculated that over a certain
period, the total sum accumulated, together with the interest thereon, is enough to pay off the loan.
Burden of Public Debt
If the debt is taken for productive purposes, for e.g., for irrigation, transportation, railway, roads, information technology,
human skill development, etc., it will not mean any burden. Infact, they will confer a benefit. But if the debt is
unproductive it will impose both money burden and real burden on the economy.
(a) Burden of internal debt: Internal debt involves a series of transfers of wealth within the country, i.e., from lender to
government and then later on at the time of redemption from government to lender. Money is thus transferred from one
section of the community to other sections. In this case the money burden on the economy is zero.
But there may be real burden on the community. In order to repay the interest and the principal amount of the debt, the
government has to levy taxes. What the taxpayers pay the lenders receive. The lenders are generally rich people and tax
burden is fall on poor especially in the case of indirect taxes. The net result may be that the wealth is transferred from poor
to rich. This is the loss of economic welfare.
(b) Burden of external debt: External debt also involves a series of transfer of wealth from the foreign lender to the
borrowing country, and when it is repaid the transfer is in the opposite direction. As the borrowing country paid interest to
the foreign lenders, a direct money burden is fall on the whole community.
The community is also suffered from real burden of external debts. Government has to cover the amount of interest to be
paid to the foreign lender by heavily taxing the income of the community. As a result the production, consumption and
distribution of income is badly affected. Moreover, the foreign lender has direct involvement in the economic activities of
the country.
Role of Public Borrowing in a Developing Economy

1. Taxation should cover at least current expenditure on normal government services and borrowing should resort to
finance government expenditure which results in creation of capital assets.
2. Public borrowing for financing productive investment generates additional productive capacity in the economy
3. It is used as an instrument to mobilise resources which would otherwise hoarded in real estate or jewellery
4. It provides the people opportunities to hold their wealth in the form of safe and stable income-yielding assets, i.e.,
government bonds
5. The management of public debt is used as a method to influence the structure of interest rates.
6. Public has become a powerful tool of developmental monetary policy
7. There are two ways in which the governments of under-developed countries raise resources through public loans:
 1. Market borrowing, i.e., sales to the public of government bonds (long-term) and treasury bills (short-term) in the
capital market
2. Non-market borrowing, i.e., issue to the public of debt which is not negotiable and is not exchange in the capital
market, for e.g., National Saving Certificates
8. There are two forms of loans, i.e., voluntary and forced loans. Forced loans or compulsory borrowing is a compromise
between taxation and borrowing. Like a tax it is a compulsory contribution to the government but like a loan, it is to
be repaid with interest.

Difficulties of Public Borrowings in UDCs

1. In UDCs there are no or very small organised capital and money markets. The resources are too inadequate to fulfil the
capital needs of the economy.
2. Resources are hoarded in non-productive sections of the economy, for e.g., real estate jewellery.
3. The savings in rural areas cannot be mobilised effectively because rural incomes do not move through monetary
channels
4. The response to government securities is also poor because of rising prices.

Effects of Public Debt on Production, Consumption, Distribution and Level of Income and Employment

1. Effects on Production: Public debts are raised to finance productive enterprises of various kinds, e.g., steel works,
cement, multipurpose projects, construction of ships, railway lines and highways, heavy electrical and engineering
works, mining, oil refining, etc.
2. Effects on Consumption: When people subscribe to government loans, they generally have to curtail
consumption. Since investment of funds raised by borrowing raises the level of employment and as a result raises the
level of consumption.
3. Effects on Distribution: Public loans transfer money from rich to government. The fiscal operations of the government
are to benefit the poor primarily. The incomes of the poor increase directly through increased employment or it
benefits them in directly through the enlargement of social services.
4. Effects on the Level of Income and Employment: In modern times, public borrowing is resorted to in order to raise
funds for financing agriculture, industry, mining, transportation, communication, etc. It increases employment
opportunities, the level of income and standard of living.
Hicks’ Classification of Public Debts

1. Deadweight Debt: Deadweight debt is one which is not covered by any real assets. In the words of Hicks: “Deadweight
is that which is incurred in consequences of expenditures which in no way increase the productive power of the
community, yielding neither money revenue nor a future flow or utilities.” The loan raised during war period is a
deadweight debt because for such debts no real assets exist to balance them.
2. Passive Debt: Sometimes government raises loans for spending on such projects which neither yield money income nor
help in raising the productivity of the country. They simply provide enjoyments to the citizens such as public parks,
museums, public buildings, etc.
3. Active Debt: Active debt is one which is spent on those projects that directly help in yielding money income and
increasing the productive power of the community.

Hanson’s Classification of Public Debt

J.L. Hanson has classified public debt into four main classes:

1. Reproductive Debt: When a debt has assets to balance it, it is called reproductive debt. For instance, if a state
borrows money for spending it on the construction of canals, railways, factories, etc, it is then able to repay the loan
from these self-liquidating projects.
2. Deadweight Debt: A debt which is not covered by any real assets is called deadweight debt. Debt invested on wars or
prevention of war is a deadweight debt.
3. Funded Debt: Funded debts are long-term debts. The government continues paying the annual interest on such loans
but makes no promise to pay the principal sum to the lender on any specified date. The examples of funded debts are
long-term government stocks, war loans and console.
4. Floating or Unfunded Debt: Floating or unfunded debt comprises of short-term loans. It is payable to the lender with
interest on or before a fixed date.
 Deficit Financing
Deficit financing is practised whenever government expenditure exceeds government receipts from the public such as taxes,
fees, and borrowings from the public. Such an excess of government expenditure can be financed either by drawing down the
cash balances of the government or by borrowing from the central bank.
Two Aspects of Deficit Financing
Deficit financing as an income generating expenditure has two aspects:

1. Pump priming: Pump priming means the power of deficit financing in stimulating private investment through giving
small doses of investment in the economy.
2. Compensatory spending: Compensatory spending means that deficit financing can be used for compensating and
neutralising tendencies towards over-saving and under-investment.

Deficit Financing and Deficit Budgeting

1. Deficit budgeting refers to the situation when current expenditure exceeds current revenue. In this situation no item
on capital account is taken into consideration.
2. On the other hand, when we take into consideration not only current receipts but also receipts on capital account, e.g.,
public borrowing, and the gap between receipts and expenditure is covered by deficit financing.

Uses of Deficit Financing

1. For prosecuting a war: During the state of war, the government has to finance the purchase of arms and ammunitions
through deficit financing. Deficit financing during war is very injurious for the economy. Private investments and
savings are at their worst level.

2. For fighting depression: Deficit financing can be really helpful for the government during the period of depression. It
can stimulate private consumption and investment. The government can increase its own expenditure on public works
programme. The government’s tax revenue remains constant but its expenditure has gone up, therefore, the deficit
has to be met by borrowings. In this case, as government investment rises, the level of national income and
 employment also increases by more than the proportionate increase in government investment. Deficit financing can be
used to create additional employment, when the economy is suffering from a deficiency of effective demand.

3. For financing economic development: The economic problems faced by underdeveloped countries are different from
that of advanced countries. In advanced countries, the task of capital formation is in the hands of private
entrepreneurs but in poor countries there is a dearth of people willing and able to undertake entrepreneurial
functions. Therefore, it is the government’s responsibility to boost up investment in public sector, generate revenue
from it and encourage people to save and invest. But, in a country, where a majority of people are living at the
subsistence level, the margin between income and consumption is very low so that the voluntary savings cannot provide
sufficient resources for development. The government may attempt to increase the volume of resources by additional
taxes. Because of extreme poverty of the great mass of the people, additional taxation beyond a point raises problems,
both economical and political.

Consequences of Deficit Financing

1. Increase in the money supply with the public

2. Rise in the level of income, and
3. Rise in the general price level.

Deficit Financing and Inflation

The inflationary implications of deficit-financing is divided into two parts:

1. Inflation in a full-employment economy, and

2. Inflation in an under-developed country or less than full-employment economy.

1. The first part is related to the inflationary impacts of deficit financing in a full employment economy. In this regard
some writers hold the view that even under the conditions of full employment, in the long run, there is no problem of
inflation, particularly in economically advanced countries. However, infact, at full employment a further increase in
aggregate demand through deficit financing results in raising the general price level instead of adding to aggregate
output and employment.

2. In the second part, there are five reasons by which the deficit financing results into inflation:
 (a) When there is a variety of channels into which increased money supply can flow
(b) Non-homogeneity in skills or efficiency
(c) Supply of resources is perfectly inelastic
(d) Increase in wage rates
(e) Increasing marginal cost
Precautions in the Use of Deficit Financing

1. Deficit financing should be used in moderate doses

2. Constant watch on price index
3. Prices of consumer goods and essential raw materials should be effectively controlled
4. Ensure a corresponding increase in the availability of goods
5. Concentrate on quick yielding projects
6. In order to keep down the prices of food grains, food imports should be arranged well in time and in adequate
quantities.
7. Rise in wages and salaries should be checked lest the country be caught in a vicious circle of poverty
8. Excess money supply should be mapped up through taxation and borrowings
9. Ensure clean and efficient administrative system tackling the difficult economic situation with whole hearted
cooperation from the people

Measures to Minimise Inflationary Pressure of Deficit Financing

1. Proper disinflationary fiscal policy,

2. Restrictive monetary policy to control non-essential private investment,
3. Economic controls through selective credit control, physical and fiscal controls, in order to influence the behaviour of
private investment and channelise it into desirable lines,
4. Proper allocation of resources with major focus on agriculture and small and medium scale industries, and
5. Developing import surpluses for increasing the supply of goods.
Anti-Inflationary Fiscal Policy
Fiscal policy with respect to inflation includes all the measures of a monetary nature which the executive branch of the
government adopts in connection with:
(a) Government spending
(b) Taxes, and
(c) Public borrowing
Fiscal policy has come to be recognised as the potentially most powerful instrument of economic stabilisation.
(a) Government spending: During inflation the government is supposed to decrease its own spending to counteract an
increase in private spending. The government must simultaneously reduce expenditures and increase revenues to achieve a
cash surplus to be used in an anti-inflationary manner.
(b) Taxes: It is axiomatic that during inflation the existing tax structure should be retained, that tax cuts should be resisted,
and the new taxes should be adopted or tax rates increased, if possible – to reduce the amount of spendable money in the
hands of general public. But care must be taken not to deflate the money incomes of the country via taxation so much as to
provoke a recession of economic activity.
(c) Savings: Saving is a type of public borrowing which has a deflationary effect on the money supply and effective
demand. The most effective anti-inflationary public borrowing takes the form of compulsory saving.
(d) Debt Management: Public debt may be managed in such a way as to reduce the money supply or to prevent further credit
expansion. Anti-inflation debt management often refers to the retirement of bank-hold debt out of a budgetary surplus. It
includes the retirement of public debts of the following categories:
(i) Retirement of public debt by central banks out of a budgetary surplus is most deflationary
(ii) Retirement of bank-held debt (i.e., commercial banks) is neutral in its effects
(iii) Retirement of a maturing portion of debt held by the non-bank public, which has also neutral effect.
(e) Gold Sterilisation: Whenever the gold inflow is deemed too dangerously inflationary in effect, the government may decide
to sterilise gold in order to keep bank reserves from increasing gold acquisitions.
(f) Overvaluation: In order to control domestic inflation, a country might maintain the overvalued exchange value of its
currency, that is, an expensive currency relative to foreign currency. An overvalued currency is anti-inflationary in effect for
three reasons, namely:
(i) Because of its discouraging effect on exports and decreasing effect on domestic money incomes
(ii) Because of its encouraging effect on imports and increasing effect on import expenditure
(iii) Because of its cheapening effect on the price of those foreign materials which enter into the domestic cost of
product of its preventive effect on the upward-cost price spiral.
Concepts and Principles of Federal Finance
Federal finance seeks to maximise total welfare. The economic welfare in an under-developed region in a federation can be
increased by the diversion of resources from the developed regions.
The general principle to maximise economic welfare is that each regional or state government should try to equate marginal
social benefit (MSB) with marginal social cost (MSC). The federal government will try to do so for the whole country. Thus
the principle of federal finance would be:
MSBa = MSBb = MSBc = ………………
MSCa = MSCb = MSCc = ………………
Equalising of MSB and MSC would require a substantial inter-area transfer of resources in a federation for achieving what
Professor Buchanan calls ‘inter-personal equity’. Inter-personal equity means equal treatment to equals. A transfer of
resources is necessary to achieve ‘horizontal equity’. If the same amount of expenditure were made in all states, it would
mean that the rich state would be subject to less tax than his equal income counter-part in the poor state.
The principles of federal finance are listed below:

1. No discrimination in levying taxes among the states. It implies uniformity of taxation.

2. Independence of federal finance to impose taxes and spend.
3. Central government and the federal units have no dependency on each other and should carry their functions normally
4. Resources should be capable of expansion as the requirements increase.
5. Efficient economy, i.e., minimum tax evasion, effective tax collecting system, minimum cost of tax collection,
minimised adverse effects on trade and industry, etc.
6. Provision for grants-in-aid to meet resource deficits.
 Fiscal Policy
What is Fiscal Policy?
Fiscal policy is the process of shaping government taxation and government spending so as to achieve certain
objectives. According to Prof. Samuelson, by a positive fiscal policy we mean the process of shaping public taxation and public
expenditure in order to:
(i) To help dampen down the swings of a business cycle, and
(ii) To contribute towards the maintenance of a growing high employment economy free from excessive inflation or
deflation.
Classical View vs. Keynesian View:
There are two views regarding the policies adopted by the government in order to operate the economy – Classical View and
Keynesian View.
1. Classical View: Classical economics, the prevailing economic theory prior to the Great Depression, hypothesizes that market
economies are inherently stable. In particular, actual GDP automatically adjusts to the economy's productive capacity, called
potential GDP. Economic capacity is determined by the quantity and quality of resources available (e.g., labour, capital and
natural resources). If resource prices are flexible, they will adjust until resources are fully employed and the economy is
operating at economic capacity. If resources are under-employed, their prices will fall. Production becomes more profitable as
resource prices fall, encouraging firms to expand output. GDP expands until under-employment is eliminated. Conversely,
prices will increase for over-employed resources, reducing profits, decreasing production and eliminating over-employment.
With sufficient resource price flexibility, the economy will adjust to full employment relatively quickly. In this case, counter-
cyclical fiscal policy is unnecessary in the short run and counterproductive in the long run. If resource price flexibility stabilizes
the economy relatively quickly, fiscal policy is unnecessary in the short run. Furthermore, the economy cannot accommodate the
increased aggregate demand after returning to full employment, assuming potential GDP is unaffected by expansionary fiscal
policy. Thus, expansionary fiscal policy increases prices in the long run, rather than GDP. As a result, Classical economists
believe that the Federal Government should maintain a balanced budget; flexible resource prices stabilize the economy at full
employment.
2. Keynesian View: John Maynard Keynes formalized a theory linking fiscal policy and economic performance in his book
‘General Theory of Employment, Interest, and Money’ in 1036. He believed that Classical economic theory was inconsistent with
the Great Depression that the U.S. and world economies experienced in the 1930s. Even though the U.S. unemployment rate
reached 25% in 1933, flexible resource prices failed to restore full employment.
Keynes offered two explanations for the Great Depression: sticky prices and pessimistic expectations. Keynes hypothesized
that resource and product prices are sticky rather than flexible, particularly with respect to price decreases (i.e., a horizontal AS
curve, at least in the short run). Sticky prices are slow to decrease as unemployment increases. Furthermore, if producers and
consumers have pessimistic expectations, price decreases might not stimulate increased production. Lower resource prices will
only increase output if producers expect to sell the extra output. If consumers are pessimistic about future economic conditions,
they will not consume more as prices fall; accordingly, business will not increase output. Thus, falling prices might not stimulate
business investment and production.
Keynes believed that prices were sticky and expectations pessimistic during the Great Depression. Under these conditions, the
economy can experience prolonged high unemployment rates. Keynes advocated counter-cyclical fiscal policy to supplement
private spending and stabilize the economy. He felt that the potentially prolonged unemployment during an economic
contraction imposes unacceptable social and personal costs. He supported counter-cyclical fiscal policy to minimize these short
run costs.
Keynes was among the first to advocate that federal budget deficits are appropriate in the short run when the economy is
operating below full employment.

Objectives of Fiscal Policy

Professor Lind Holm in his book ‘Introduction to Fiscal Policy’, laid down the following four main objectives of fiscal policy
(i) The achievement of desirable prices,
(ii) The achievement of desirable consumption level,
(iii) The achievement of desirable employment level, and
(iv) The achievement of desirable income distribution.
The objectives of fiscal policy differ in different countries according to their economic conditions and needs. That is why, the
fiscal policy is known as the process of shaping taxation and public spending with a view to achieve certain specific
objectives. In advanced countries, the objectives of fiscal policy is to increase aggregate demand by stimulating consumption
function, whereas in underdeveloped countries, the consumption of luxurious items has to be discouraged in order to encourage
saving for increasing the rate of economic development. In economically advanced countries, the goal of fiscal policy may be to
reduce the inequality of income in order to check under consumption; whereas in a backward economy, unequal distribution of
wealth may be allowed rather encouraged for promoting capital formation. Though the objectives are controversial but they are
grouped into three:
1. To achieve full employment without much inflation,
2. To dampen the swings of business cycle and promote moderate price stability in the economy,
3. To increase the potential rate of growth with consistency if possible without interfering with attainment of other
objectives of society.
1. Full-Employment: An economy can attain the potential rate of growth when the full-employment rate of capital formation, rate
of technological change, the improvement in levels of skill and education, and increased availability of other factor units are
achieved. Total spending (C + I + G) must at all times keep pace with rising national income (Y), or otherwise the unemployment
will develop.
2. Price Level Stability: The maintenance of a reasonably stable general price level is also regarded as a major objective of
fiscal policy. A decline in the general price level is incompatible with the maintenance of full employment and would generate
bitter labour strife, as well as injuring debtors. Inflation – a rising price level – does offer the limited advantage of aiding
investment. However, a continued inflation of any magnitude produces is undesirable.
Stability in the price level does not require stability of prices of all individual commodities. Commodities experiencing more than
average increases in productivity will decline in price; and those with little change in productivity will rise as money wages rise to
reflect the higher productivity in the other fields. If money wages keep pace with productivity in manufacturing, the general price
level will rise slowly.
As full employment is approached unions may tend to push money wages up faster than productivity and prices will rise. Some
trade off between the two objectives may be necessary, that is, society may have to accept some unemployment in order to
avoid inflation. One study concludes that 4% unemployment is necessary if the increase in the general price level is to be held
to 1½ percent; with 3 percent unemployment the price level increase will be 2½ percent or more.
3. Sustained Economic Growth: The third goal of fiscal policy is to increase the potential rate of economic growth. A higher
rate of economic growth requires a higher rate of capital formation and a higher S/Y ratio at full employment. But additional
saving requires reduction in consumption. It is a choice between present and future consumption.

Tools of Fiscal Policy / Types of Fiscal Policy

The government uses various fiscal weapons in order to achieve a growing high employment economy free from excessive
inflation or deflation. They are as follows:
1. Built-in Stabilisers / Automatic Fiscal Policy: The automatic or built-in stabilisers are as follows:
(a) Taxes: Our present tax system automatically operates to eliminate the cyclical fluctuation in the economy. When a wave of
optimistic sentiments prevails in the business circles and there is a rise in prices, rise in profits and the need is to contract the
inflationary pressure, the progressive tax system comes to rescue and contracts the surplus purchasing power from the
economy. When a country is faced with falling income and expenditure, the burden of tax automatically lessens. The state has
not to make any conscious effort to counteract deflationary potential. As the graduated rates apply on income, the burden of the
tax is reduced. The consumers are thus left with more purchasing power to spend on consumption as well as on producer
goods. We, thus, conclude that the progressive tax system contains automatic stabilising properties.
(b) Unemployment Compensation: In advanced countries of the world, people receive unemployment compensation and
other welfare payments when they are out of job. As soon as they get employment, these payments are stopped. When
national income is increasing, the unemployment fund grows due to two main reasons:
(i) Government receives greater amount of payroll taxes from the employees, and
(ii) The unemployment compensation decreases.
Thus, during boom period, the unemployment compensation reserve funds help in moderating the inflationary pressure by
curtailing income and consumption. When the economy is contracting, unemployment compensation and other welfare
payments augment the income stream and they prove a powerful factor increasing income, output and employment in the
country.
 (c) Farm Aid Programme: Farm aid programmes also stabilise against the wave like cyclical fluctuation. When the prices of
the agricultural products are falling and the economy is threatened with depression, government purchases the surplus products
of the farmers. The income and total spending of the agriculturists thus remain stabilised and the contraction phase is warded
off to some extent.
When the economy is expanding, the government sells these stocks and absorbs the surplus purchasing power. It thus reduces
inflationary potential by increasing the supply of goods and contracting the pressure of too great spending.
(d) Corporate Savings and Family Savings: The credit of having automatic or built-in stabiliser does not go to the state
alone. The corporations and companies and wise family members too play an important part to contract cyclical
fluctuations. For instance, the corporations pay a fixed amount every year to the shareholders and withhold part of the dividends
of the boom years to pay in the depression years. Thus holding back some earnings of good years contracts the purchasing
power and releasing of money in poorer years, expands the purchasing power of the people. Similarly, wise persons also try to
save something during the prosperous days in order to spend the savings in the rainy days.
2. Discretionary Fiscal Policy: By discretionary fiscal policy is meant the deliberate changing of taxes and government
spending by the control authority for the purpose of offsetting cyclical fluctuations in output and employment. The discretionary
fiscal policy has short-run as well as long-run objectives:
(a) Short-Run Counter-Cyclical Fiscal Policy: The main weapons or stabilisers of short-run discretionary fiscal policy are:
(i) Persuasion,
(ii) Changes in tax rates,
(iii) Varying public works expenditure,
(iv) Credit aids, and
(v) Transfer payments.
(i) Persuasion: In a capitalistic society, the entrepreneurs are not aware of each other’s investment plans. They, therefore, in
competition with one another over-invest capital in a particular industry or industries and thus cause overproduction and
unemployment in the economy. Similarly, in depression period, there is no agency to guide them. If government publishes the
total investment plans and marginal efficiency of capital in various industries, much of the investment can proceed at a moderate
speed and there can be stability to some extent in income, output and employment.
(ii) Changes in tax rates: It is an important weapon of fiscal policy for eliminating the swings of the business cycle. When the
government finds that planned investment is exceeding planned savings and the economy is likely to be threatened with
inflationary gap. It increases the rates of taxes. The higher taxes, other things remaining the same, reduce the disposable
income of the people who then are forced to cut down their expenditure. The economy is thus, saved from inflationary situation.
If, on the other hand, planned saving is in excess of planned investment and the economy is likely to be faced with deflationary
gap, the taxes are lowered considerably so that people are left with more disposable income. When purchasing power of the
people increases, the rate of spending on consumption and investment increases. The economy is thus saved from deflationary
situation.
(iii) Varying public works expenditure: Another important factor, which influences economic activity, is public expenditure. In
times of depression, the government can contribute direct to the income stream by initiating public works programmes and in
boom period it can withdraw funds from the income stream by curtailing them.
(iv) Credit aids: The government can also avert depression by offering long-term credit aids to the needy industrialists of starting
or expanding the business. It can also give financial help to insurance companies and bankers to prevent their failures.
(v) Transfer Payments: Variation in transfer expenditure programmes can also help in moderating the business cycle. When
the business is brisk, the government can refrain from giving bonuses to the workers and thus can lessen the pressure of too
great spending to some extent. When the economy is in recession, these payments can be released and more bonuses can be
given to stimulate aggregate effective demand.
(b) Long-Run Fiscal Policy: The objectives of long-run fiscal policy / full fiscal policy are as below:
(i) High level of employment
(ii) Stabilisation of price level
(iii) Reduction in inequality of income
Phases of Long-Run or Full Fiscal Policy: The long-run fiscal policy has two phases:
(i) Secular Exhilaration, and
(ii) Secular Stagnation
In the above diagram, the cyclical fluctuation around the income level (along Y axis) on line 1, can be eliminated by an effective
short-run fiscal policy.
At trend line 2, the economy is in a state of secular exhilaration, i.e., it is having a perpetual inflationary gap. It is obvious that
the condition of chronic inflation is not desirable and so is to be remedied. The built-in stabilisers and discretionary stabilisers
can only offset the cyclical fluctuations but cannot bring down the level of income to full employment level. So we have to adopt
long-term fiscal measures. The economists recommend that government should (i) create surplus financing, and (ii) public debt
over a long period of years.
The trend line 3 indicates a state of chronic depression which Professor Hansen calls secular stagnation. When the economy is
having a deflationary gap over decades, the anti-cyclical fiscal measures alone cannot lift the economy from secular
stagnation. The following long-term fiscal measures are recommended to overcome the situation:

1. Secular increase in public debt utilised for productive purposes,

2. A greater equality in income brought about by progressive taxation, abolition of monopolies, provision of better facilities to
the low paid workers, etc., and
3. Compensatory spending is another long-run method for lifting economy out of the morass of severe
depression. Government should increase its investment spending by raising funds on taxing hoards and borrowing at low
 rate of interest from the commercial banks. The compensatory spending by the government fills up the gap between
actual spending and the full employment spending.

Role of Fiscal Policy (Demand Side Effects)

Governments can use fiscal policy as a counter-cyclical tool, because changes in government outlays and taxes affect aggregate
demand and aggregate supply. Using fiscal policy as a counter-cyclical tool to promote full employment and price stability with
little or no regard for its effect on the national debt is known as functional finance. According to Keynes, market economies had
a proclivity to fall into depression when consumer and business spending declined. Instead of waiting for self-correcting market
mechanisms to work, Keynes advocated deliberate deficit spending by the government to stimulate aggregate demand. This
would immediately create jobs and incomes for otherwise unemployed workers.
The role of fiscal policy is to remove the inflationary or deflationary gap from the economy. The government can apply three
main fiscal tools, i.e., tax, government spending, and transfer payments:
1. Expansionary Fiscal Policy / During Deflation: During deflation the government has three choices:
(a) Increase government spending, i.e., government purchases multiplier
(b) Decrease taxes, i.e., tax multiplier
(c) Increase transfer payments
(a) Increase government spending: An increase in government spending for public goods and services:
(i) initiates a multiplier effect which results in a cumulative increase in total spending that is greater than the
initial change in government spending
(ii) is always undertaken when the public wants more government services.
(iii) should always be accompanied by an equal increase in taxes, so that the budget remains in balance,
i.e., balanced budget multiplier.
(iv) is an effective policy tool when the economy is in Stagflation.
(v) is impossible if the budget is already in deficit and the economy is in Depression.
In the above diagram, the economy is operating at equilibrium point E1, which is less than the full employment level of E2, or in
other words, the economy is facing deflationary gap. At point E1, the aggregate demand curve AD1intersects the aggregate
supply curve AS. When government spending is increased, the aggregate demand increases from AD1 to AD2. Now the new
aggregate demand curve AD2 intersects the aggregate supply curve AS at a new point of equilibrium, i.e., E2. At this new
equilibrium point E2, the national output is higher than before and the economy is operating under full employment level.
(b) Decrease taxes: Generally speaking, the tax multiplier for a decrease in taxes is weaker than the government spending
multiplier, because:
(i) paying taxes is voluntary.
(ii) the underground economy avoids paying taxes through tax loopholes.
(iii) income taxes can be passed on to somebody else.
(iv) part of a tax cut will be saved.
(v) politically, it's not as easy to cut taxes as it is to cut government spending.
In the above diagram, the economy is operating at equilibrium point E1, which is less than the full employment level of E2, or in
other words, the economy is facing deflationary gap. At point E1, the aggregate demand curve AD1intersects the aggregate
supply curve AS. When government decreases taxes to give a boost in consumption and investment expenditure, the aggregate
demand increases from AD1 to AD2. Now the new aggregate demand curve AD2 intersects the aggregate supply curve AS at a
new point of equilibrium, i.e., E2. At this new equilibrium point E2, the national output is higher than before and the economy is
operating under full employment level.
(c) Increase transfer payments: During deflation, when transfer payments (pensions, unemployment compensation,
allowances, etc.) are increased, the multiplier effect is of minor magnitude. However, it can help in:
(i) removing deflationary gap from the economy,
(ii) increasing purchasing power of the people, and
(iii) bringing full employment level in the economy (to some extent)
2. Contractionary Fiscal Policy / During Inflation: During inflation the government has three choices:
(a) Decrease government spending, i.e., government purchasing multiplier
(b) Increase taxes, i.e., tax multiplier
 (c) Decrease transfer payments
(a) Decrease government spending: During inflation, a decrease in government spending:
(i) will cause a decrease in aggregate demand more than the change in government spending through multiplier
effect
(ii) is always undertaken when there is a severe inflationary gap in the economy
(iii) is an effective fiscal measure when the economy is in hyper inflation
(iv) a decrease in government spending should always be followed by an decrease in taxes, so that the budget
remains in balance, i.e., balanced budget multiplier

In the above diagram, the economy is operating at the equilibrium point E1, which is higher than the full-employment level of EO,
or in other words, the economy is facing an inflationary gap. At point E1, the aggregate demand curve AD1 intersects the
aggregate supply curve AS. When the government reduces its spending, the aggregate demand curve shifts from AD 1 to
ADO. Now the new aggregate demand curve ADO intersects the aggregate supply curve AS at a new point of equilibrium, i.e.,
EO. At this new equilibrium point EO, the national output is less than before and the economy is operating under full employment
level.
 (b) Increase taxes: If the economy is operating at a level above full employment level, the government can remove this
inflationary gap through excessive taxation. The removal of inflationary gap will depend on the multiplier effect of increase in tax
or tax multiplier. These fiscal measures will bring the following changes in the economy:
(i) decrease in aggregate demand
(ii) decrease in consumption and investment expenditures, and
(iii) finally a decrease in national output cutting the extra inflationary pressure in the economy

In the above diagram, the economy is operating at the equilibrium point E1, which is higher than the full-employment level of EO,
or in other words, the economy is facing an inflationary gap. At point E1, the aggregate demand curve AD1 intersects the
aggregate supply curve AS. When the government increases taxes, the aggregate demand curve shifts from AD1 to ADO. Now
the new aggregate demand curve ADO intersects the aggregate supply curve AS at a new point of equilibrium, i.e., EO. At this
new equilibrium point EO, the national output is less than before and the economy is operating under full employment level.
(c) Decrease transfer payments: Decrease in transfer payments can improve the inflationary situation in the economy, but
decreases in pensions, unemployment compensations, allowances, can be very controversial and socially apathetic. However, a
decrease in transfer payments can remove the inflationary gap from the economy.

Fiscal Policy with Reference to Under-Developed Countries

The role of fiscal policy in less-developed countries differs from that in developed countries. In developed countries, the role of
fiscal policy is to promote full employment without inflation through its spending and taxing powers. Whereas the position of
developing nations is entirely different. The LDCs or economically backward countries are caught up in vicious circle of
poverty. The vicious circle of low income, low consumption, low savings, low rate of capital formation and low income has to be
broken by suitable fiscal measures. Fiscal policy in developing countries is thus used to achieve which are different from
advanced countries. The principle objectives of fiscal policy in a developing economy are as under:

1. To mobilise resources for financing development

2. To promote economic growth in the private sector
3. To control inflationary pressure in the economy
4. To promote economic stability with employment opportunities
5. To ensure equitable distribution of income and wealth

1. Resource mobilisation: Resource mobilisation for financing the development programmes in the public sector can be
attained through:
(a) Taxation: Taxation is an important instrument for fiscal policy. It is widely used to mobilise the available resources for
capital formation in the economy. The moping up of surplus resources through taxation is an effective mean of raising resources
for capital formation. There are two types of taxes which are levied to transfer funds from private to public use:
(i) Direct taxes: are levied on the income, profits and wealth of the people who have potential economic surplus.
(ii) Indirect taxes: are the taxes such as excise duty, sales tax, etc, imposed mostly on good which have higher income
elasticity of demand.
(b) Tax on farm income: Agriculture sector is another important source of revenue which can be tapped for capital
formation. Agriculture is the largest sector of under-developed countries and should be subject to progressive taxation. The
government can raise a substantial amount of tax revenue from agriculture sector.
2. Promoting development in the private sector: In a mixed economy, private sector constitutes an important part of the
economy. While framing fiscal policy, the interests of the private sector should also be prioritised. The private sector of any
economy makes significant contribution to the development of the economy. The fiscal methods for stimulating private
investment in developing countries are:
 (a) Income from government saving schemes be exempted from taxation, in order to boost up private saving,
(b) Rates of return on voluntary contribution to provident fund, insurance premium, etc., be raised for incentive to save,
(c) Retained profits of the public companies should be taxed at preferential rates or exempted from taxation, in order to
boost private investment, and
(d) Rebates and liberal depreciation allowances can also be granted to encourage investment in the private sector.
3. Restraining inflationary pressure: One of the important objectives of fiscal policy is to use taxation as an instrument for
dealing with inflationary or deflationary pressure. In developing countries, there is a tendency of the general prices to go up due
to expenditure on development projects, pressure of wages on prices, long gestation period between investment expenditure
and production, etc. Fiscal measures are used to counter act the inflationary pressure. Tax structure is devised in such a
manner that it mops up a major proportion of the rise in income. Government also tries to reduce its own spending and achieve
budgetary surplus. It helps reducing inflationary pressure in the economy.
4. Securing equitable distribution of income and wealth: A wider measure of equality in income and wealth is an integral part
of economic development and social advance. The fiscal operations, if carefully worked out can bring about a redistribution of
income in favour of the poorer sections of the society. The government can reduce the high bracket incomes by imposing
progressive direct taxes. For raising the income of the poor above the poverty line and narrowing the gap between rich and
poor, the government can take direct investment on economic and social overheads.
5. Promoting economic stability: The ultimate objective of fiscal measures is to promote economic stability with increased
employment opportunities and higher living standards.
Possible Offsets / Limitations / Critical Evaluation of Fiscal Policy
1. Crowding-out effect: mostly emphasized by monetarists stating that when expansionary fiscal policy is adopted, the
government has to borrow. Thus government, for purpose will compete to private sector as a result rate of interest will go up
because of increase in money demand. The increase in rate of interest will result in reduction in the volume of private
investment and a fall in national income. Such decrease in national income will offset that effect of increase in national income
which became possible due to adoption of expansionary fiscal policy. There are two types of crowding out effects:
(a) Indirect crowding out: is the tendency of expansionary fiscal policy through deficit spending increases interest rate which
in turn reduces investment and consumption. The interest rate declines because government finances budget deficit by
government borrowing and this will compete with the private sector in terms of borrowing money. Because of this, aggregate
demand increases by less than the amount of the increase in government spending.
(b) Direct Crowding out: refers to the situation when expenditure offsets directly. Actions taken by the private sector will offset
government spending actions. That is the way private sector will spend their money cancel out government actions.
2. Open economy effect: When interest rate increases as a result of government deficit spending through borrowing, then
foreigners will demand more rupees. As a result rupee appreciates which means that the value of rupee will increase relative to
other currencies. Therefore, exports will decrease and imports will increase and aggregate demand will decrease by the amount
of export decrease.
3. Time lags:
(a) Recognition time lag: the time lag required to get information about the economy (recession or inflation)
(b) Administrative time lag or action time lag: the time required between recognizing the economic problem and applying
fiscal policy into effective. It is too short for both monetary and fiscal policy.
(c) Operational lag or effect time lag: the time that elapses between the onset of the policy and the results of that policy.
4. Supply side economics: Both traditional fiscal policy and Supply Side economists suggest tax cuts to stimulate GDP. Fiscal
policy emphasizes the short run effects of tax cuts on aggregate demand. Supply side economics emphasizes the long run
effects of tax cuts on economic capacity. In the supply side model, economic capacity is largely determined by the quantity of
available resources. Reducing marginal tax rates can increase the supply of resources and expand productive capacity (e.g., by
reducing taxes on personal income, corporate profits, capital gains, savings and capital investment).
This introduces an apparent contradiction: the same policies are recommended to support two different goals. In actuality, both
viewpoints may be correct. Fiscal policy focuses on fiscal policy's short run effects. In the short run, lower taxes can increase
household consumption and business investment. This increases GDP. Supply side economics doesn't address short run
economic fluctuations. It takes time to translate changes in marginal tax rates into increases in productive capacity. Supply side
economics focuses on the long run impacts of tax rate changes.
Fiscal Policy vs. Monetary Policy
Keynes and the early Keynesian economists believed that counter-cyclical fiscal policy was more effective than monetary policy
for stabilizing the economy. This belief considers the mechanisms through which monetary policy affects macroeconomics
performance and experience during the Great Depression. Specifically, an increase in the money supply stimulates the
economy both directly and indirectly. (See Monetary Policy.) As the money supply increases, and supply exceeds demand,
individuals will reduce their money holdings by increasing both consumption and savings. Increases in consumption increase
aggregate demand. Increases in savings reduce interest rates. As interest rates fall, investment demand increases and
consumption demand increases further (as savings rates fall). Thus, expansionary monetary policy stimulates GDP in the short
run through a direct increase in consumption demand and indirectly through a decrease in interest rates. As with expansionary
fiscal policy, expansionary monetary policy is inflationary in the long run, after prices adjust to restore full employment.
Keynesians felt that pessimistic expectations during a recession would negate the short run effects of expansionary monetary
policy. In particular, as the money supply increases, pessimistic individuals won't use the excess money supply to increase
consumption. Thus, there is no direct effect on GDP. Furthermore, investment and consumption demand will not increase as
interest rates fall. Pessimistic individuals won't increase consumption as interest rates fall and pessimistic firms will not
invest. Thus, there is no indirect effect on GDP. Pessimism renders monetary policy ineffective in the Keynesian
model. Keynes referred to this situation as a "liquidity trap." Therefore, early Keynesians relied on counter-cyclical fiscal policy
to stabilize GDP.
Most modern Keynesian economists recognize that monetary policy has a short run impact on GDP (Keynes’ liquidity trap is no
longer relevant). Furthermore, the policy implementation lags are significantly shorter for monetary policy than they are for
discretionary fiscal policy. Discretionary fiscal policy requires parliamentary approval; monetary policy can be implemented
autonomously by the central bank. Thus, Keynesians increasingly support automatic fiscal stabilizers and monetary policy;
discretionary fiscal policy plays a smaller role.
Monetary Policy
Monetary policy changes the nation's money supply to influence macroeconomics performance, including unemployment,
inflation and economic growth. Monetary policy is conducted by the nation's central bank, the Federal Reserve System in the
United States. Changes in the money supply relative to its demand affect financial markets, including interest and exchange
rates. These changes alter investment, consumption and net exports, which in turn influence macroeconomics performance.
Increasing the money supply relative to its demand creates an excess supply of money. Individuals will spend some of this
money on consumption goods and save the rest in either savings accounts or by investing in stocks, bonds and other interest
bearing assets. An increase in savings reduces interest rates. Capital market competition and arbitrage spreads the lower
interest rates across all short run financial markets. As interest rates fall, investment demand and consumer durable purchases
increase. Finally, lower interest rates affect exchange rates. As domestic interest rates fall relative to international interest rates,
domestic investment shifts to foreign markets; foreign investment in domestic capital markets also decreases. This increases the
supply of rupees relative to demand in the international currency markets, lowering the price of a rupee. Lower exchange rates
stimulate exports and reduce imports. Thus, increasing the money supply increases aggregate demand for consumption,
investment and net exports.
Monetary policy, like fiscal policy, is a demand side macroeconomics policy. In particular, monetary policy indirectly affects
aggregate demand and macroeconomics performance through the financial markets. Fiscal policy, which involves changes in
government expenditures and taxes, directly affects aggregate demand. Government expenditures influence government
demand; tax policy influences both consumption and investment demand.
Demand side macroeconomics policies are often used to offset business cycles and stabilize economic performance, particularly
prices and unemployment. If the economy is operating below full employment, monetary and fiscal policies can be used to
increase aggregate demand. Presumably, businesses will increase output to satisfy the increase in aggregate demand. If there
are unemployed resources, including human, capital and natural resources, output can increase without significantly increasing
prices. As the economy approaches full employment, and there are few slack resources, increases in aggregate demand
primarily affect wages and prices. Businesses must compete against one another for the limited supply of resources; product
prices increase with wages and input prices. Given these responses, expansionary monetary and fiscal policy can stimulate
employment during an economic downturn; contractionary monetary and fiscal policy can alleviate inflationary pressures when
the economy is over heated.
Macroeconomic stabilization is generally considered a short run policy. In the long run, market prices for capital, labour and
other inputs adjust to full employment. The economy automatically converges to full employment in the long run. In contrast,
supply side economics addresses long run economic performance. Supply side economics emphasizes aggregate
supply. Supply side economics hypothesizes that long run economic growth requires expanding productive capacity. In the
supply side model, reducing marginal tax rates increases productive capacity by increasing the labour supply and capital
investment. Increasing economic capacity enables the economy to accommodate growth while reducing inflationary pressures.
Fiscal Policy in Pakistan
Government Receipts
The Government receipts consist of the following four sources:

1. Revenue Receipts (Net of Provincial Shares): In Pakistan, the heavy dependence is upon revenue receipts, about 65-
70% of the revenue is estimated to be drawn from revenue receipts. It includes tax revenue, non-tax revenue, and
surcharges.

(a) Tax Revenue: In taxes we have direct taxes such as income tax, and wealth tax. Indirect taxes such as
central excise, sales tax, and custom duty. Direct tax comprises about 70% of Pakistan’s total tax revenue.
(b) Non-Tax Revenue: It includes income from government property and enterprises and receipts from Civil
Administration and other functions.
(c) Surcharges: Surcharges on natural gas and petroleum fall under this category.

2. Capital Receipts: Capital receipts include external borrowing and internal non-bank borrowings consisting of unfunded
debt, public debt, treasury and deposit receipts besides the revenue account surplus and the surplus generated by
public sector, etc.

3. External Resources: External resources are loans and grants which come from various sources. These sources include
consortium, non-consortium and Islamic sources of aid:

(a) Consortium: Consortium provides aid at both bilateral and multilateral levels:
(i) Sources of consortium bilateral aid are Belgium, Canada, France, Germany, Italy,
Japan, Netherlands, Norway, Sweden, United Kingdom and United States.
(ii) Consortium multilateral aid comes from Asian Development Bank (ADB), International
Bank for Reconstruction and Development (IBRD), Int. Development Association (IDA), Int. Finance
Corporation (IFC), and Int. Fund for Agricultural Development (IFAD).
 (b) Non-Consortium: Non-consortium sources of loans and grants mostly provide bilateral aid. These include
Australia, China, Czech Republic, Denmark, Finland, Rumania, Switzerland, Russia and Yugoslavia.
(c) Islamic Aid: Bilateral aid from Islamic countries come from Saudi Arabia, Kuwait, Qatar, United Arab Emirates,
Turkey, Lebanon, Libya and Iran. While multilateral Islamic sources of aid are OPEC Fund, and IDB.
Loans and grants received by Pakistan can be classified into ‘project’ and ‘non-project aid’. Non-project aid can be further
decomposed into food, non-food, BOP and Relief aid.

4. Self-Financing by Autonomous Bodies: This is actually the surplus left after meeting all the expenses of these
bodies. This surplus is available to government for revenue and development expenditures.

Government Expenditure
Government expenditure is classified into current expenditure and development expenditure:

1. Current Expenditure: It comprises mainly debt servicing, defence, general administration, social services, law and
order, subsidies, community services, economic services, grants to Azad Jammu and Kashmir, Railway and others.
2. Development Expenditure: Public Sector Development Program (PSDP) is another name given to Government’s
development expenditure. The priority areas are transport and communication, power and water. These three sectors
combined cover about 50% of total allocation of PSDP.

The share of current expenditure is always remain substantial, it constituted around 70-80% of total Government
expenditure. Non-development expenditure is generally regarded as being excessive and therefore subjected to
persistent public criticism. With sharp increase in population, constant threat from the enemies and increasing cost of
corruption, non-development expenditure is subjected to a rising trend which could only be controlled by rapid
economic development. On the other hand, negligence of non-development expenditure may result into ill-equipped
and under-staffed hospitals, dispensaries and educational institutes, and arrears in maintenance of roads, dams,
bridges, electricity and forests. Non-development expenditure should be economically managed in order to ensure the
economic development of Pakistan.
There are six major heads of current expenditure of Federal Government of Pakistan:
1. Defence,
 2. Debt servicing,
3. Subsidies and grants,
4. General administrative,
5. Social services, and
6. Others.
Tax Structure of Pakistan

1. The narrow base enigma has been a base in Pakistan’s tax structure from the beginning.
2. In 1987 when population of the country was more than a hundred million, the total number of taxpayer was just over a
million.
3. The main base taxes imposed are direct and indirect taxes.
1. Direct tax of the Federal Government comprises of income tax, wealth tax and corporate tax
2. Indirect tax, on the other hand, consists of custom duty, excise duty, sales tax, import duty and all others.
4. Indirect tax contributes the predominant share to the total tax collection. Direct taxes have persistently dropped their
share in total tax revenue.
5. Indirect tax, on the other hand, contributes more than 70% of the total tax revenue. Indirect tax is regressive. It may
cause the inflation to rise and its incidence is fall on poor class of the economy.

Deficit Financing in Pakistan

Following are the sources of deficit financing in Pakistan:

1. Printing new currency notes

2. Public borrowings
3. Foreign loans, aid and grants
4. Using previous balances, and
5. Borrowings from banks including from the central bank.

Dr. Mahboobul Haq defines deficit financing in the following words:

 (i) Net borrowings by the government from the banking system which includes the State Bank of Pakistan (SBP)
and commercial banks but excludes non-banking institutions and individuals, and
(ii) Net borrowings by the Government from the SBP only.
But the public debt does not only constitute the above sources, it also includes money lent to Government out of the balances
of the banks which would have been held if the Government had not borrowed them.
Deficit financing is a sound and necessary instrument of the Government finance and its role, its desirability and limitations of
its use in mobilising revenue, must be properly analysed in the context of its broad implications on the economy and
compared to the adequacy of other techniques of resource mobilisation.
It was planned in Third Five-Year Plan that there will be no deficit financing during the said plan but the government had to
revise the plan. In the Fourth Five-Year Plan there were annual plans and major upsets in the economy. In the Fifth and
Sixth Five-Year Plans, though there were very large amounts of foreign remittances but there was not remarkable reduction in
deficit financing.
A well-managed deficit financing could be a key to greater economic achievements especially for a less developed country. A
wise finance minister has to keep an eye on all the factors of the economic development and spent the public fund in the
manner that is most beneficial to the nation.
Economic Planning
 Economic Planning
Planning is defined as conceiving, initiating, regulating and controlling economic activity by the state according to set priorities
with a view to achieving well-defined objectives within a given time.

According to Professor Dickinson, economic planning is the making of major economic decisions by a determinate authority on
the basis of a comprehensive survey of the economy as a whole. Such decisions include what and how much to produce; how,
when and where it is to be produced; and to whom it is to be allocated.

With reference to underdeveloped countries, Subrata Ghatak defines economic planning as a conscious effort on the part of any
government to follow a definite pattern of economic development in order to promote rapid and fundamental change in the
economy and society.

Essentials of Economic Planning

According to Arthur Lewis, a development plan may consist of the following parts:

1. Survey of current economic conditions

2. List of proposed public expenditures
3. Discussion of likely development in private sector
4. Macro economic projections of the economy
5. Review of government policies

1. Survey of current economic conditions: The economic survey shows the changes in respect of population, NI, taxation, government
expenditures and BOP, etc. It also tells us the changes needed or expected to occur in these economic variables. The economic survey
is usually for one year.

2. List of proposed public expenditures: The proposals and suggestions for incurring public expenditures on development projects are
invited from various government departments and agencies. After a thorough scrutiny of these recommendations, an order of priority is
determined deciding what is to be included, what is to be postponed or rejected as the financial resources are less than required.

3. Discussion of likely development in private sector: It is said that both public and private sectors are inter-related and rate of economic
development depends more on the working of the private sector than expenditures in public sector. The government reviews the
performance of major industries in economic planning, and sets quantitative targets for the plan period. All this involves a brief in-depth
analysis of the working and implications of market structure.
 4. Macro economic projections of the economy: It refers to the preparation of aggregate models which are applied to the economy as a
whole. These models deal with production and consumption as single aggregates. Aggregate models are used to determine the possible
growth rates in NI, the division of national product among consumption, investment and exports, the required volume of domestic savings,
imports and foreign assistance needed to carry out a given development programme. This involves massive calculations and paper
works.

5. Review of government policies: The government through development policy can influence the decisions indirectly in the private sector.

Importance / Objectives of Economic Planning w.r.t. Mixed Economy & Under-Developed Countries
In the following section we will discuss the economic planning with reference to mixed economies and under-developed
countries:

1. Efficient utilization of resources: The most essential function of economic planning is to ensure the best use of given resources within
the country. Maximum social benefits can only be ensured when the available resources are allocated and utilized in the most efficient
manner. Unused or slack utilization of resources will adversely affect the employment and productivity level of the economy. The
government has to do some arrangements in order to bring equality between demand and supply. In the market economy, there are
wasteful expenditures in the form of selling costs. Sometimes, few producers established their cartels in order to control the market. All
this can be undone by the government through effective planning.

2. Market imperfections and price distortions: In market economies, there are certain market imperfections and price distortions both in
commodity market and factor market. These distortions rise because of institutional arrangements. As the wage rate in some sectors of
the economy exceeds the opportunity cost of the labour. This may be due to trade unions’ influence. Moreover, the goods whose
demand is less elastic their producers may pursue monopolistic behaviour. There may be dualistic approach in the money market. In the
organized money market the rate of interest is kept artificially low or inexpensive credit facilities are provided. While on the other hand, in
less organized money market or in agriculture market, the ROI is extraordinary high. This situation also creates price distortion. These
market imperfections can only be corrected by efficient economic planning.

3. Greater opportunities: The most common benefit that any democratic country enjoys is that the greater market opportunities are and
should be provided to the producer and consumers. But this can be handicapped because of two reasons:

(a) Limited life span of an individual

(b) Limited resources at the disposal of an individual

4. Because of these common problems, the individuals undertake those projects which require small amount of resources and the profit can
be earned within a short period of time. In this way, the individuals would hardly be prepared to launch big projects like construction of
highways, power-stations, land-reclamation, anti water logging and salinity schemes, rail-roads, sea ports, telecommunication, etc. It is
 the duty of the modern government to provide greater resources at the disposal of individuals. At the same time the government has to
reduce excessive-consumption or the disposal of resources in few hands. This can only be ensured under efficient economic planning.

5. Maximisation of National Income and Raising Living Standard: It is the responsibility of modern state to maximise the national income
and raise the standard of living. It can only be ensured when the government correctly addresses the economic needs of the country and
takes desired actions in economic planning.

6. Full Employment: In economically advanced countries, the government’s aim is to provide full employment. All modern governments
have, in fact, underwritten employment. If they cannot provide work, they have to give doles. Unemployment is the biggest by product of
any capitalist society. The government can redistribute labour and create more work opportunities for both private and public sector.

7. Equitable distribution of income: Economic planning is the most powerful tool of equitable distribution of income. The price-mechanism
rewards people according to the resources they possess but contains in itself no mechanism for equalization of the distribution of those
resources. Therefore, there is a wide gap between haves and have-nots. Shocking economic inequalities are a marked feature of an
unplanned economy. Reduction of economic inequalities is now the avowed aim of a modern welfare state and is impossible without the
instrument of economic planning.

8. Public oriented goals: In market economy, only those goods are produced whose demands are backed by money offers. As a result the
production of public goods / services, including health, research and education, old-age benefits, poor houses, orphan houses, clean
water, sewerage and drainage, free entertainment, art and culture, historical assets, wildlife, forests, security, and defence, are altogether
ignored or very less attention is paid. It is planning which distributes the resources between present consumption and future consumption,
social development and economic development, etc. As a result the goals of planned economies are more welfare and public oriented.

9. Price Stability: The purpose of economic planning is to reduce the price instability created by business fluctuations. During the period of
increasing demand, the price hikes are inevitable due to supply shortages. In under-developed countries, because of low productive
capacity, low savings and investment, and traditional set up, the price starts rising very sharply, and its impact on the developing society is
very deep. In order to eliminate the adverse effects of price instability and business fluctuations, the government comes forward and play
a vital role in creating a favourable economic condition. This can only be done through wise economic planning.

10. Larger savings and investment: The ultimate task of any finance ministry is to boost up the savings and investment, esp. foreign
investment. In UDCs on one hand there is a vicious circle of poverty, while on the other, there is an operation of international
demonstration effect. In UDCs, there is a general tendency of demonstration effect within the people, and the whole economy’s growth is
hampered by dualism. Savings remain at the lowest level. The boost in investment, domestic or foreign, depends on the level and
duration of economic stability. More stable and viable economic growth planning may motivate the investors in investing and thus
increasing the level of employment in the economy.
 11. Provision of Social Services: In UDCs, the provision of social services forms an important objective of planning. In the fifth five year
plan, two important objectives were:

(a) Development of rural areas through various programmes and policies alongwith widespread extension of social
services such as schooling, health and clean water facilities.
(b) Easing of urban problems like water supply, sewerage and drainage, electricity, gas supply, housing and
transportation facilities, etc.

12. Aid to victims of catastrophe: The granting of assistance and the organisation of relief to victims of natural catastrophes, such as flood,
earthquakes, tsunamis, tropical storms, drought, etc. are the main the responsibilities of any government.

Limitations of Economic Planning

The following obstacles come in the way of economic planning:

1. Measurement of labour force: In economic planning, the identification and enumeration of gainfully employed population is a difficult
task, esp. in agriculture, where the employment is of part-time or seasonal nature. The important contributions to economic activities by
women and children raise further complications. In backward economies, it is very difficult to distinguish between voluntary and
involuntary unemployment.

2. Statistical data: The biggest problem with economic planning is that the planner has to work with a limited statistical data
provided. Moreover, the planner has to work with these data, collected through different surveys, consensus, polls, etc., without much
questioning about their reliability and accuracy.

3. Unused natural resources: The UDCs are identified of their unused natural resources like land, mines, rivers, forests, livestock, sea,
etc. A resource such as land, a mineral deposit, a forest or a rive may not be used in production because it is economically
inaccessible. A natural resource is valueless when its cost of extraction is greater than the price the product can command in the
market. Therefore, the fullest possible use of natural resources is not a sensible aim of an economic planning, and the extent of the use of
land or other natural resources is not a measure of economic efficiency. There are four types of resource idleness:

(a) Idleness reflecting the inability of the resource to contribute to profitable production,
(b) Withholding of the resources in the interests of monopolistic exploitation of the market,
(c) Employment of resources for commercial or private use, and
(d) Withholding of a natural resource from current production because the owner believes that it will make a more
valuable contribution to production at a later date.
4. Population and real income: The biggest problem regarding human resources is that in UDCs, the population is growing at a very high
rate. Moreover, most of the UDCs population heavily rely on agricultural income. The present rate of population growth in India and
Pakistan is not significantly greater than in the United States. But the significant point of contrast is that in the South Asia and Central
Asia, there is a heavy reliance on comparatively backward agriculture. Real income is vitally affected by the quality of the population.

5. Economic repercussions of social institutions: Certain social institutions, such as extended family system or joint family system, which
are appropriate to a subsistence economy may impede economic growth directly by reducing the rewards of individuals who take
advantage of the opportunities presented by wider markets. Subsistence economy is the economy in which people strive for the minimum
necessities to support life. The extended family system acts as a serious obstacle to economic progress. A man is much less likely to be
willing and able to save and invest, when he knows that he would have to maintain a large number of distance relatives. It minimises the
inducement for people to improve their own position. It obstructs the spreading of banking habit since people are unwilling to have
banking accounts as there is no willingness to save. However, the economic planner can overcome this situation by introducing private or
public insurance or other arrangements to replace the traditional methods for the relief of personal distress or disability.

6. Implications of restrictive tendencies: Social, political and administrative restrictive measures are directed against foreigners on the
basis of racial, national or tribal differences. Such restrictive measures are often directed also against the members of local population. It
may put restrictions on the movement of people or on the acquisition and exercise of goods or services. It may also be connected
with‘xenophobia’, esp. in the tribal areas and villages. This problem is common in Pakistan and hampers the economic development in
rural and tribal areas.

7. Wage rates and unemployment: In UDCs, the wage rate is relatively low and there is a high unemployment rate in the
economy. Limited employment opportunities may create a pool of urban unemployed. These urban members do not enjoy the security of
the extended family system, nor are they related to agricultural sector. They therefore are apt to constitute a more serious social and
political problem then the rural unemployed.

8. Monopsony in the labour market: It is a common situation in UDCs in which there are very few employers and they exercise their
monopsony powers in the labour market. Labour is more exploited when the wage rate is below the equilibrium point indicating the
unsatisfied demands of labour. Whereas in advanced countries, the supply of labour is elastic and there is little scope for monopsonistic
exploitation. The planner must address the labour issues like wage rates, overtime, bonus, allowances, perquisites, working hours, safety
measures, health and medical facilities, life insurance, transportation, children education, pension and benevolent funds, old age benefits,
income tax on salaries, etc.

9. Uneven distribution of entrepreneurial faculties: The material progress of a society is likely to be assisted greatly when there are
dynamic entrepreneurial abilities. In economically backward countries, there are difficulties in the way of developing and utilising the
entrepreneurial qualities. The government can support small and medium enterprises to come forward and develop new economic
opportunities. The government must encourage, both on private and public level, new agricultural or industrial techniques, adoption or
adaptation of new improved methods, innovative activities, internship, on-the-job training, etc. in order to raise the level of economy.
 10. Low level of capital in UDCs: The biggest problem of less developed countries is that there is a dearth of capital, whether it is physical or
financial. The low level of capital is also indicated by statistics of consumption of energy for purposes of production. In developed
countries, there is a high consumption of energy, whereas in UDCs, the energy consumption is considerably low. The general implication
of low level of capital is a low level of output and a low level of consumption per head. In such economies, there is no assurance of a
continuity in supply of goods. Transport costs are very high and limited availability of perishable or bulky goods. Because of low level of
working capital and storage facilities, there is a danger of acute shortage of food crops.

11. Methods of production: The methods of production, farming, marketing and domestic operation are not usually the same in all the
countries. What is an economic use of resources in one country may be uneconomic in another in which relative factor prices are
comparatively different. It follows that the economic efficiency of methods of production and economic organisation in UDCs cannot be
judged simply by comparing them with those familiar in advanced countries. The planner has to jot out all the possible opportunities and
focus on major weaknesses, and must plan within the available resources.

12. International demonstration effect: In UDCs, there is a strong desire to enjoy as much of attractive way of living in the advanced
countries as incomes permit. There is an international demonstration effect. Moreover, the under developed economy is divided into two
extreme sections – traditional section and modern section. There are old and new production methods, educated and illiterate population,
rich and poor, modern and backward, capitalistic and socialistic, donkey carts and motor cars existing side by side. This situation creates
great atmosphere of conflict and contradiction, as a result the economic development is hampered.

13. Political instability: Most of UDCs, especially Asian and African countries, are known of their political instability, bureaucratic
malfunctioning, corruption on administrative level, and nepotism, like India, Pakistan, Sri Lanka, Bangladesh, Afghanistan, Vietnam,
Cambodia, Myanmar, Nigeria, Zimbabwe, Uganda, Somalia, Kenya, etc. Perhaps the biggest challenge for any economic planner is the
political and administrative malfunctioning in his way of economic planning.

Elements of Economic Development

The economic development in advanced or under-developed countries depends on four elements:

1. Human resources: In poor countries GDP rises but at the same time the population also grows. Several developing
countries are facing high birth rates with stagnant national income per head. It is hard for poor countries to overcome
poverty with birth rates so high. In under-developed countries, the economic planners emphasise the following specific
programmes:

(a) Control disease and improve health and nutrition,

(b) Improve education, reduce illiteracy and train workers, and
 (c) Ensure that the labour force is well-equipped with necessary and competing skills.

2. Natural resources: Many poor countries have enormous amount of natural resources, but they are failed to explore
them. The reason is that the government has not provided necessary incentives to the farmers and landowners to invest in
capital and technologies that will increase their land’s yield.

3. Capital formation: Capital formation or inducement to invest depends on the propensity to save. In less-developed
countries, there is a very low saving tendency because of low income. Developed countries managed to save 20% of their
output in capital formation. Whereas only 5% of the national income is saved in UDCs. Much of the savings goes to
housing and basic needs and, therefore, a very small amount is left over for development.

Capital formation is the basic tool for economic development. It may take decades to invest in building up a country’s
infrastructure, information technologies, power-generating plants, and other capital goods industries. Developing countries
must have to build up their infrastructure, or social overhead capital in order to set path for economic glory.

If there are so many obstacles in finding domestic savings for capital formation, then the country depends on foreign
sources of funds. Less-developed countries have to welcomed the flow of foreign capital or foreign borrowings. As long
as the exports of these countries grew at the same rate as borrowings, it is a favourable condition. But several poor
countries needed all their earnings simply to pay interest on their foreign debts. This is an adverse situation. Such
countries need to boost up their production in order to cope with their current indebtedness.

4. Technological change and innovations: The developing countries have a potential advantage in the economic
development – i.e., they can be benefited from up-to-date technologies developed by advanced countries. They can
climbed up to industrialisation more rapidly than those advanced countries who struggled for more than 500 years.

Vicious Cycle of Poverty

Many developing countries are caught up in vicious cycle of poverty. Low level of income prevents savings, retards capital
growth, hinders productivity growth, and keeps income low. Successful development may require taking steps to break up the
chain at many points. Other points in poverty are also self-reinforcing. Poverty is accompanied by low levels of education,
literacy and skill; these in turn prevent the adaptation to new and improved technologies and lead to rapid population
growth. The vicious cycle of poverty is depicted as below:
Overcoming the barriers of poverty often requires a concentrated effort on many fronts and a ‘big-push’ is required to break the
‘vicious cycle’ into ‘virtuous circle’. If the country has stepped to invest more, improve health and education, develop labour
skills, and curb population growth, she can break vicious cycle of poverty and stimulate a virtuous circle of rapid economic
growth.

Stages of Economic Development

W.W. Rustow has defined and analysed in his book ‘The Stages of Economic Growth’ the five stages of economic development:

1. Traditional society,
2. Pre-conditions for take-off,
3. Take-off stage,
4. Drive to maturity, and
5. Stage of mass production and mass consumption.

1. Traditional society: In the traditional long-lived social and economic system, the output per head is low and tends not to rise. Economic
activities are static and national income is very low. The examples are Somalia, Bangladesh, Afghanistan, etc.

2. Pre-conditions for take-off: The second stage is ‘Pre-take-off’. It is a period of transition in which the traditional systems are overcome,
and the economy is capable of exploiting the fruits of modern science and technology. Pakistan, India, Sri Lanka, etc. are operating at this
stage.
 3. Take-off: Take-off represents the point at which the resistances to steady growth are finally overcome and the growth is normally
inevitable. The economy generates its own investment and technological improvement at sufficiently high rates so as to make growth
virtually self-sustaining. South Africa, UAE, etc. are the examples.

4. Drive to maturity: The fourth stage is the drive to maturity. It is the stage of increasing sophistication of the economy. Against the
background of steady growth new industries are developed, there is less reliance on imports and more exporting activity. The economy
demonstrate its capacity to move beyond the original industries which powered its take off, and to absorb and to apply efficiently the most
advanced fruits of modern technology. China, South Korea, Malaysia, etc. are the examples.

5. Stage of mass production and mass consumption: The fourth stage ends in the attainment of fifth stage, which is the age of mass
production. It is the stage in which there is an affluent population, and durable and sophisticated consumer goods. There are huge capital
and technological intensive industries in such an economy. People are more quality conscious and comfort lovers. Wage rates are
high. Health and safety issues are addressed by the government. The whole economy is dynamic. USA, UK, France, Germany, Japan,
Canada, Italy, Netherlands, Denmark, etc. are the examples.

Approaches to Economic Development

The following approaches are developed in recent years to explain the economic development and answer the question how
countries break out of the vicious cycle of poverty to virtuous circle of economic development:

1. The Take-off Approach: Take-off is one of the stages of economic growth. Different economies have been benefited from ‘take-off’
approach in different periods, including England at the beginning of eighteenth century, the United States at the mid of nineteenth century,
and Japan in early twentieth century. The take-off is impelled by leading sectors such as a rapid growing export market or an industry
displaying large economies of scale. Once these leading sectors begin to flourish, a process of self-sustained growth (i.e. take-off)
occurs. Growth leads to profits, profit are reinvested, capital, productivity and per capita income spur ahead. The virtuous cycle of
economic development is under way.

2. The Backwardness Hypothesis and Convergence: The second approach emphasises the global context of economic
development. Poor countries have important advantages that the pioneers of industrialisation had not. Developing nations can draw upon
the capital, skills and technologies of advanced countries. Developing countries can buy modern textile machinery, efficient pumps,
miracle seeds, chemical fertilisers and medical supplies. Because they can lean on the technologies of advanced countries. Today’s
developing nations can grow more rapidly than Great Britain, Western European Countries and United States in past. By drawing upon
more productive technologies of the leaders, the developing countries would expect to see convergence towards the technological frontier.

3. Balanced Growth: Some writers suggest that growth is a balanced process with countries progressing steadily ahead. In their view,
economic development resembles the tortoise making continual progress, rather than the hare, who runs in spurts and then rats when
 exhausted. Simon Kuznets examined the history of thirteen advanced countries and conceived that the balanced growth model is most
consistent with the countries he studied. He noticed no significant rise or fall in economic growth as development progressed.

Note one further important difference between these approaches. The ‘take-off’ theory suggests that there will be increasing
divergence among countries (some flying rapidly, while others are unable to leave the ground). The ‘backward’ hypothesis
suggests ‘convergence’, while the ‘balanced-growth’ model suggests roughly ‘constant’ differentials. In the following diagrams,
advanced countries are represented by curve A, middle income countries by curve B and low-income countries by curve C. The
curves show per capita income:
Issues in Economic Development
Following are the important issues in under developed countries:

1. Industrialisation vs. Agriculture: In most countries, incomes in urban areas are almost more than double in rural areas. Many nations
jump to the conclusion that industrialisation is the cause rather than effect of affluence. To accelerate industrialisation at the expense of
agriculture has led many analysis to rethink the role of farming. Industrialisation tends to be capital intensive, attract workers into crowded
cities, and often produces high level of unemployment. Rising productivity on farms may require less capital, while providing productive
for surplus labour.

2. Inward vs. Outward Orientation: This is a fundamental issue of economic development towards international trade. Should the
developing countries be self-sufficient? If yes, the country has to replace imported goods and services with domestic production. This
strategy is known as ‘import substitution’ or ‘inward orientation’.

If the country decides to pay for imports it needs by improving efficiency and competitiveness, developing foreign markets,
and giving incentives for exporters. This is called ‘outward orientation’ strategy. It is generally observed that by
subsidising import substitution, competition is limited, innovation is dampened, productivity growth is slow down and
country’s real income falls to a lower level. Whereas, the outward orientation sets up a system of incentives that stimulates
exports. This approach maintains a competitive FOREX rate, encourages exports, and minimises unnecessary
government regulation of businesses esp. small and medium sized firms.

3. State vs. Market: The cultures of many developing countries are hostile to the operation of markets. Often competition among firms or
profit seeking behaviour is contrary to traditional practices, religious beliefs, or vested interest. Yet decades of experience suggest that
extensive reliance on markets provides the most effective way of managing an economy and promoting rapid economic growth.

The government has a vital role in establishing and maintaining a healthy economic environment. It must ensure law and
order, enforce contracts, and orient its regulations towards competition and innovation. The government plays a leading
role in investment in human capital through education, health and transportation, but the government should minimise its
intervention or control in sectors where it has no comparative advantage. Government, should focus its efforts on areas
where there are clear signs of market failure
 Types of Economic Planning
Planning by Inducements
Planning by inducement is often referred to as ‘indicative planning’ or ‘market incentives’. In such type of planning, the market is
manipulated through incentives and inducements. Accordingly, in this system there is persuasion rather than compulsion or
deliberate enforcement of orders. Here the consumers are free to consume whatsoever they like, producers are free to produce
whatsoever they wish. But such freedom of consumption and production are subject to certain controls and regulations. The
consumers, producers and other factors of production are induced with the help of various fiscal and monetary devices. For
example, if the planning authority wishes to boost the production of corn oil in Pakistan it will provide subsidies, tax holidays and
loans to the firms involved in production of corn oil. To encourage savings and investment and discourage consumption a
suitable package of fiscal and monetary policies can be introduced in the market. Therefore, the desirable results can be
attained with the help of incentives and without the imposition of orders and instructions. Moreover, in such planning there is
less sacrifice and less loss of liberty – economic as well as non-economic.

Merits of Planning by Inducements:

(a) Consumers’ sovereignty remain intact. Planning by inducements is more democratic as compare to planning by
directions.
(b) There is a freedom of choice of profession.
(c) In planning by inducements, there is freedom of enterprise. Produces are free to produce whatever they like but
within in the capacity of given rights.
(d) Planning by inducements is smooth and flexible. It is more popular because it enables to incorporate the changes in
resources, technology and taste etc. even after the finalisation and implementation of plan.
(e) Under this sort of planning, the inertia attached with standardisation can be put to an end and producers are free to
produce in accordance with the desire of consumers. Therefore, there is a variety of goods and services in the market.
(f) There are less administrative costs involved in planning by inducements.
(g) The problem of shortages and surpluses is solved as there is an existence of automated market system. The
demand and supply is automatically adjusted and remain in balance under market economy.

Demerits of Planning by Inducements:

(a) It also fails to achieve 100% targets of economic planning.
(b) Under planning by inducements, there are profit motives more than welfare of public. Private entrepreneurs care for
those products which yield high profits. Products or services with less profit or no profit do not attract private
entrepreneurs. Such products or services include education, health, defence, security, etc.
 (c) The producers may find the government policies regarding economic affairs not attractive enough to
follow. There may be disputes among entrepreneurs and the government regarding tax rates, investment policies, interest
rates, etc.
(d) The mechanism of market economy may cause the prices to inflate esp. with reference to under-developed countries
or in case of oligopoly where there is a shortage of certain products like petroleum and gas.
(e) There may be disharmony between labour and producer, and there may be serious industrial disputes.

Planning by Directions
This type of planning is practised in socialist countries like China, Former USSR, Cuba, North Korea, etc. Under planning by
direction, there is one central authority which plans, directs and orders the execution of the plan in accordance with the pre-
determined targets and priorities. It determines the production figures, delivery schedules, quotas regarding the production of
the goods, price controls, use of foreign exchange and allocation of resources like labour, etc. amongst different competing
uses. Thus, such planning is comprehensive and encompasses the whole economy. Planning by directions is similar to military
or defence plans which are carried through orders and instructions. Thus the strategy of planning through directions coincides
with the military strategy. Alongwith the disintegration of former Soviet Union, the methodology of planning by directions has
received certain serious setbacks. Now most of the UDCs are tend to adopt market economic system.

Demerits of Planning by Directions:

(a) Planning by direction is undemocratic since the people are ignored all along.
(b) It is bureaucratic and totalitarian. Under bureaucratic system, the individual’s sovereignty is completely
abolished. Corruption, red tapism, VIP system, tyranny and austerity are the by products of bureaucracy.
(c) Rationing and control result in black marketing.
(d) There are shortages of some goods and as well as surpluses of other goods. That is, there is an imbalance in
production output.
(e) This sort of planning is inflexible. Once the plan is prepared, there is no room for alterations in later phases of
planning. A part of the plan cannot be changed without simultaneous changes in many interconnected activities. Planning
by direction is so complex that it is impossible to change even a part of it as it will involve in altering the whole plan.
(f) The fulfilment of plan cannot be guaranteed, as the planning by direction is hampered by black marketing and
corruption.
(g) Planning by direction also leads to excessive standardisation which impinges on consumer sovereignty. In other
words, under planning by direction the goods produced are standardised lacking the variety. As in case of USSR, the
produced TV, Fridges and Automobiles were identical having no differentiation.
 (h) It also involves huge administrative costs, as the planning by direction involves in elaborate census, numerous forms
and army of clerks.

Physical and Financial Planning

Physical planning is concerned with physical allocation of resources on the one side, while with the product yields on the other
side. Its aim is to bring physical balance in between investment and output. Accordingly, investment coefficients are
computed. These coefficients show how much amount of investment will be required for a given amount of output. Moreover, in
such planning it is also analysed that what will be the composition of investment to obtain an increase in output. As, how much
iron, how much coal, oil and electricity will be required to produce some specific amount of steel. While making physical
planning, an overall assessment is made regarding the real resources of the economy like raw material and manpower.

In financial planning, equilibrium is established between demand and supply to avoid inflation and bring economic stability. The
difference between physical planning and financial planning is that the physical planning tells us the size of investment in terms
of real resources, whereas the financial planning tells us the size of investment in terms of money. In financial planning, the
planner determines how much money will have to be invested in order to achieve the pre-determined objectives. Total outlay is
fixed in terms of money on the basis of growth rate to be achieved, the various targets of production, estimates of the required
quantity of consumer goods and the various social services, expenditure on the necessary infra structure, etc. as well as revenue
from taxations, borrowings and savings.

Centralised Planning and Decentralised Planning

Under centralised planning, all the economic decisions are taken by the central authority or the government. It is the government
which formulates economic plans, determines objectives, sets targets and priorities. Every member has simply to carry out the
instructions without questioning about its viability. There are more chances of failure as the individuals are not allowed to
carryout the plans in accordance to their needs and preferences. It is the government who takes responsibility of the success or
failure of the plan. It is the government who takes all the decisions of consumption, production, wages and prices. What amount
of investment is to be made?, What should be the price?, What should be the output?, How the products are to be distributed?,
How much amount of loans is to be granted?, What should be the rate of interest?, etc. Centralised planning is mostly executed
in socialist or communist countries.

Decentralised planning is connected with the capitalistic economies. The decentralised planning is implemented through market
mechanism. Decentralised planning empowers the individuals or small groups to carryout their plans for achievement of a
common goal. Under decentralised planning, the operation is from bottom to top. The planning authority formulates the plan by
having made consultation with different administrative units of the economy. The plans regarding different industries are
designed by the representatives of these industries. In such type of planning, the planning authority issues the instructions to
central and local bodies regarding incentives given over to private sectors.

Structural and Functional Planning

The planning which is aimed at bringing changes in socioeconomic set-up of a country is termed as structural planning. This
type of planning is attributed to the planning which was made in USSR in 1929 when the existing land-lord-system was
abolished, collective farming was introduced, trade, industries and transport system was nationalised.

While functional planning is a type of planning where hardly any big change is brought about in the existing socio-economic set-
up of the country. It means when planning is made in the presence of existing institutions is termed as functional planning. In
France, Germany, UK, etc planning is being made in the existing framework of capitalism.

Indicative and Imperative Planning

Indicative or planning by inducements has already been discussed in a previous section. In the following section we will discuss
the three components or approaches regarding indicative planning:

(a) Forecasting Approach: Under forecasting approach, the individuals are provided with the information, through making
certain forecasts. Such forecasting serve as a guide to their decision making. The forecasting not only indicate about the
feasible future, but they also specify a desirable future in terms of growth rate of the economy.

(b) Policy Approach: The second component of the indicative planning is concerned with policy approach. Through policy
approach, the inconsistent policies of government departments are co-ordinated within a coherent model framework keeping
in view the set objectives. Moreover, when once the policies are co-ordinated, they will provide guidelines to the people,
consumers and producers.

(c) Corporate Approach: The third way to demonstrate indicative planning is through corporative approach. This approach
is practised in France. Here the co-ordination function of indicative planning envisages at two level. In the first place, it
requires co-ordination of the behaviour of economic groups like business enterprises and trade unions, etc. which hold power
in the market. In the second place, it co-ordinates the relation between private and public activities.

Imperative planning is the planning where the formulation and implementation of the plan is made by the central planning
authority. It is also known as ‘directive planning’. Under imperative planning, it is the duty of the state to provide necessary
supplies like raw material, machines, manpower and entrepreneurs as all such resources are owned by the state. Under
socialist economies, where the imperative planning is in practice the planners always prefer future consumption over present
consumption. Thus under imperative planning the priorities laid down by the planners always supersede those of
masses. There is no consumer sovereignty under imperative planning.

Democratic and Totalitarian Planning

Under democratic planning, the philosophy of democracy is followed. Since formulation to the execution of the plan, the people
are taken into confidence. Whenever the plan is prepared, the ruling party makes a dialogue with the public firms and even with
opposition party. The purpose of such arrangements is to satisfy different segments of the economy regarding growth and
welfare programmes. After the formulation of the plan, an open discussion is make in the parliament. Under democratic
planning, whole of the economic activities are performed through price mechanism. The government influences the private
sector through fiscal and monetary policies. Moreover, the government passes anti-monopoly laws to protect the consumer’s
sovereignty.

In totalitarian planning, there is a central control, and all economic activities are governed by the central authority. In totalitarian
planning, all of consumption, production, distribution and exchange like activities are controlled by the central planning
authority. Totalitarian allows no consumer sovereignty and democratic freedom.

Fixed Plan and Rolling Plan

Fixed Plan
In a fixed plan, the contents of the plan are fixed in relation to a fixed time period. These contents consisting of targets, priorities,
strategies and resources, etc. will not be changed during the particular time period for which the plan has been prepared except
for severe unforeseen events.

Merits of Fixed Planning:

(a) There is a boldness in planning. This is the essence of planning that the planners and implementing machinery will not
bow down before the obstacles.
(b) There is effective implementation of plan.
(c) The targets of fixed plan are certain and this certainty in objectives brings stability to the economy.
(d) Fixed plans ensure discipline for the planning process.

Demerits of Fixed Planning:

(a) Fixed plans are inflexible plan. They cannot be altered in later phases.
(b) There is no revision of economic objectives and targets as there is no alteration allowed under fixed planning.
 (c) If the state is an under-developed country, the fixed plan would give the economy a hard time to achieve the basic
objectives like employment, industrialisation, education, health, etc.
(d) Fixed plans, if not properly formulated and implemented, lead to wastage of resources.

Rolling Plan
Rolling planning refers to the rolling of a plan at intervals usually one year, so that it continues to be a plan of certain number of
years. It is usually the medium term plan.

Merits of Rolling Plan:

(a) Rolling plans are flexible and can be altered in later phases.
(b) The rolling plan allows for revisions and adjustments. In rolling plan, review of the plan is a continuous exercise.
(c) Rolling plans enable the planners to keep the time horizon moving, alongwith making revisions and adjustments so as
to prepare a new plan every year in accordance with the changing circumstances.

Demerits of Rolling Plan:

(a) Rolling plan is furnished with uncertainty, as there is no fixation of economic objectives.
(b) In rolling plans, the planners are always reluctant in taking difficult decisions or taking courageous decisions.
(c) Under rolling plan, there is a lack of commitment. As there is no fixity attached with the plans, the enthusiasm on the
part of planning and administrative machinery will hardly be found.

Short-term, Medium and Long-term Planning

Short-term plans are also known as ‘controlling plans’. They encompasses the period of one year, therefore, they are also
known as ‘annual plans’. In annual plans or budgets the financial aspects of the plan, i.e., financial sources and applications are
shown. In the annual developmental plans the items pertaining to capital budgets, i.e., the capital revenue and expenditure are
listed. The main objectives of short-term planning is to raise the revenue, attain the short-term economic targets, bring price
stability, and remove deficit in BOP.

The medium-term plans last for the period of 3 to 7 years. But normally, the medium term plan is made for the period of five
years. The medium-term planning is not only related to allocation of financial resources but also physical resources. The main
objectives of medium-term economic planning are to raise per capita income, raise the level of employment, create self-
sufficiency in the economy, reduce dependence over foreign aid and raise revenues through domestic sources, and to remove
regional and intra-regional disparities.
Long-term plans last for the period of 10 to 30 years. They are also known as ‘perspective plans’. The origin of long-term
planning goes back to USSR where Goelro Plan 1920-35 was first formulated and implemented in 1920. The basic purpose of
that plan was to electrify the rural areas. The basic philosophy behind long-term planning is to bring structural changes in the
economy. Under long-term planning, there is greater freedom of choice and there is a wide scope of planning.

Corrective and Developmental Planning

The planning consisting of fiscal and monetary measures with the aim of removing the imbalances of the economy is known
as ‘corrective planning’. As to control inflation, if the government follows a very strict fiscal and monetary package; controls
aggregate demand by checking consumption, investment and government expenditure – this will be the case of corrective
planning.

On the other hand, the planning which is aimed at developing the whole economy is known as developmental
planning. Development planning involves the application of a rational system of choices among feasible courses of investment
and other development actions.

Capitalist and Socialist Planning

Capitalistic economy is also known as ‘free-enterprise economy’. Under capitalism, there was no authority governing the
planning activity. All the economic activities were controlled by the private sector. The state function was limited to tax collection
and defence. There was no public welfare measures, no developmental planning and no labour rights. But with the capacity of
time esp. after the great depression of 1930s and development of economic, social and political economic thoughts, the capitalist
economies adopt the modern functions like:

(a) formulating and implementing monetary, fiscal and trade policies,

(b) promulgating anti-monopoly and anti-cartel laws,
(c) working for the sake of community’s benefits,
(d) formulating and implementing development plans
(e) providing basic facilities of health, education, transportation, communication, and recreation, etc.

In socialism, the central planning board formulates the plan which covers the whole economy. The central planning board has
unlimited powers regarding allocation of resources and production of goods and services. The central planning authority
determines the goals and priorities regarding distribution of national income, employment, economic needs, capital accumulation
and economic growth. Under socialism all factories, resources, financial institutions, shops, stores, ware houses, foreign and
domestic trades, means of communication and transportation are under government control.
Planning under Mixed Economy
Most economists suggest the operation of mixed economy because both extreme capitalistic and socialistic system are not
suitable. Capitalistic or free enterprise economy are characterised by lot of problems including misallocation of resources,
market imperfections, monopolies, oligopolies, labour exploitation, widening gap between haves and have-nots, and consumer’s
exploitation. On the other hand, socialistic form of economy may create the problems like State’s monopoly and supremacy,
bureaucratic hold, corruption, red tapism, VIP-system, loss of consumer’s sovereignty, standardisation of products, poor quality
of products, less foreign trade, etc.

While in case of mixed economy, consumer’s sovereignty, private property ownership and operation of price mechanism are
ensured. The public sector also works parallel to private sector. The public sector in a mixed economy consists of those
projects which require heavy funds like railways, air transportation, roads, bridges, fly-overs, underpasses, power generation,
irrigation, telecommunication, research, etc. The government also addresses people’s basic needs like employment, health, and
education. In under-developed countries, the government also provides housing facilities to poor families. To avoid labour
exploitation and consumer’s exploitation, the government promulgates anti-monopoly and anti-cartel laws. In mixed economies,
the government even adopts safety measures against pollution and unhealthy working conditions in factories, offices, etc. In
case of agricultural sector, the government provides short term loans to farmers, and imports farm machines.
 Economic Development

Economic development is fundamentally about enhancing a nation’s factors of productive capacity, i.e., land, labour, capital, and technology, etc.
By using its resources and powers to reduce the risks and costs, which could prohibit investment, the public sector often has been responsible for
setting the stage for employment-generating investment by the private sector. The public sector generally seeks to increase incomes, the number
of jobs, and the productivity of resources in regions, states, counties, cities, towns, and neighbourhoods. Its tools and strategies have often been
effective in enhancing a community's:
 labour force (workforce preparation, accessibility, cost)
 infrastructure (accessibility, capacity, and service of basic utilities, as well as transportation and telecommunications)
 business and community facilities (access, capacity, and service to business incubators, industrial/technology/science parks,
schools/community colleges/universities, sports/tourist facilities)
 environment (physical, psychological, cultural, and entrepreneurial)
 economic structure (composition)
 Institutional capacity (leadership, knowledge, skills) to support economic development and growth.
However, there can be trade-offs between economic development's goals of job creation and wealth generation. Increasing productivity, for
instance, may eliminate some types of jobs in the short-run. Economic development encompasses a broad and expansive set of activities and
tools that assist communities in growth and prosperity. The best economic development practitioners strive to bring quality jobs, new businesses
and increased services (along with numerous other benefits) to communities through innovative approaches and outcome driven strategies.
Technology development has added a new dimension to the role of economic development professionals. The quest for increased technology
can be confusing and challenging from many perspectives. Communities must judge to what extent they should strive to recruit and support the
technology industry, how to determine the proper role of advanced technology on the organization’s everyday activities and design ways to help
local businesses tap into technology opportunities. Many communities have been able to incorporate technology into both their practices and
programs while others have struggled to understand the capabilities of this industry. As the information age and technology sector maintain
steady growth, the need for more advanced economic development activity is expanding as well. Technology development encompasses
increased infrastructure capabilities, advanced financing options, innovative marketing processes and start-up business assistance.

Economic Development vs. Economic Growth

 Development is a qualitative change, which entails changes in the structure of the economy, including innovations in
institutions, behaviour, and technology
 Growth is a quantitative change in the scale of the economy - in terms of investment, output, consumption, and income.
According to this view, economic development and economic growth are not necessarily the same thing. First, development is both a prerequisite
to and a result of growth. Development, moreover, is prior to growth in the sense that growth cannot continue long without the sort of innovations
and structural changes noted above. But growth, in turn, will drive new changes in the economy, causing new products and firms to be created as
well as countless small incremental innovations. Together, these advances allow an economy to increase its productivity, thereby enabling the
production of more outputs with fewer inputs over the long haul. Environmental critics and sustainable development advocates, furthermore, often
point out that development does not have to imply some types of growth. An economy, for instance, can be developing, but not growing by certain
indicators. Indeed, the measure of productivity should not be solely monetary; it should also address the issues like how effectively scarce natural
resources are being used? How well pollution is being reduced or prevented? Etc.

Stages of Economic Development

Professor W.W. Rustow has defined and analysed in his book ‘The stages of economic growth’, the five stages of economic development:
1. The traditional society: In the traditional long-lived social and economic system, the output per head is very low and tends not to rise. There
are still few examples of traditional societies in this 21st century, that is, Afghanistan, Somalia, Ethiopia, etc.
2. The pre-conditions for take-off: sometimes also referred to ‘preparatory period’. It covers a long period of a century or more during which
the preconditions for take-off are established. These conditions mainly comprise fundamental changes in the social, political and economic fields;
for example, (i) a change in society’s attitudes towards science, risk-taking and profit-earning, (ii) the adaptability of the labour force; (iii) political
sovereignty; (iv) development of a centralised tax system and financial institutions; and (v) the construction of certain economic and social
overheads like rail roads and educational institutions.
3. The take-off stage: This is the crucial stage which covers a relatively brief period of two or three decades in which the economy transforms
itself in such a way that economic growth subsequently takes place more or less automatically. The take-off is defined as the interval during which
the rate of investment increases in such a way that real output per capita rises and this initial increase carries with it radical changes in the
techniques of production and the disposition of income flows which perpetuate the new scale of investment and perpetuate thereby the rising trend
in per capita output.
4. The drive to maturity: It is the stage of increasing sophistication of the economy. Against the background of steady growth, new industries
are developed, there is less reliance on imports and more exporting activity. The economy demonstrate its capacity to move beyond the original
industries which powered its takeoff, and to absorb and to apply efficiently the most advanced fruits of modern technology.
5. The stage of mass production and mass consumption: The fourth stage ends in the attainment of fifth stage, which is the period of mass
production and consumption. The economy is characterised by affluent population, availability of durable and sophisticated consumer goods, hi-
tech industries, and production of diversified goods and services. USA, UK, Canada, France, Germany, Japan, Spain, Italy, etc are the examples.

Characteristics of Developing Economies

A developing country is one with real per capita income that is low relative to that in industrialised countries like US, Japan and those in Western
Europe. Developing countries typically have population with poor health, low levels of literacy, inadequate dwellings, and meagre diets. Life
expectancy is low and there is a low level of investment in human capital.
1. Deficiency of capital: One indication of the capital deficiency is the low amount of capital per head of population. Shortage of capital is
reflected in the very low capital-labour ratio. Not only is the capital stock extremely small, but the current rate of capital formation is also very
low, which is due to low inducement to invest and to the low propensity to save. Thus low level of per capita income limits the market size.
2. Excessive dependence on agriculture: Most of the less-developed countries are agrarians. In Pakistan, most of the people are engaged in
agriculture. Whereas in developed countries 15% of the population is engaged in agriculture. The excessive dependence on agriculture in less
developed countries is due to the fact that non-agricultural occupations have not grown in proportion with the growth in population. Hence, the
surplus labour is to be absorbed in agriculture.
3. Inequalities in the distribution of income and wealth: In under-developed countries, there is a concentration of income in a few hands. In
other terms, the income is insufficient to meet the requirements of the whole economy. Such income is diverted to non-productive investments
such as jewellery and real-estates, and unproductive social expenditure.
4. Dualistic economy: Dualistic economy refers to the existence of two extreme classes in an economy, particularly less-developed
economy. There are old and new production methods, educated and illiterate population, rich and poor, modern and backward, capitalists and
socialists, donkey carts and motor cars existing side by side. This situation creates an atmosphere of great conflict and contradiction, and
hampers the economic development in the long-run.
5. Lack of dynamic entrepreneurial abilities and highly skilled labour
6. Inadequate infrastructure: like airports, rail roads, highways, overheads, bridges, telecommunication facilities, sewerage and drainage,
power generation, hospitals, etc.
7. Rapid population growth and disguised unemployment
8. Under-utilisation of natural resources
9. Poor consumption pattern: In less-developed countries, most of the people’s income is spent on basic necessities of life. They are too poor
to spend on other industrial goods and services.

Determinants of Economic Growth

(Factors of Economic Development in UDCs / Reasons of Failure of Under-Developed Countries)
The process of economic development is a highly complex phenomenon and is influenced by numerous and varied factors, such as political, social
and cultural factors. The supply of natural resources and the growth of scientific and technological knowledge also have a strong bearing on the
process of economic development. From the standpoint of economic analysis, the most important factors determining the rate of economic
development are:
1. Availability of natural resources: The availability and use of natural resources within a country play a vital role in the economic
development. Many poor countries have enormous amount of natural resources, but they are failed to explore them. The reason is that the
government has not provided necessary incentives to the farmers and landowners to invest in capital and technologies that will increase their land’s
yield. In natural resources, minerals, oil and gas, forests, oceans and seas, livestock, land’s fertility, and mountains are generally included. It must
be noted here that the existence of natural resources is not a sufficient condition of economic growth. Many poor and under-developed countries
are rich with natural resources but there is a problem of availability of capital required for their extraction. Such countries include Pakistan, India,
Afghanistan, and several African and Latin American countries.
2. Rate of capital formation: The second important factor of economic development is the rate of capital formation. Keynes also ascribed the
economic development of Europe to the accumulation of capital. According to him, Europe was so organised socially and economically as to
secure the maximum accumulation of capital. The crux of the problem of economic development in any under-developed country lies in a rapid
expansion of the rate of its capital investment so that it attains a rate of growth of output which exceeds the rate of growth of population by a
significant margin. Only with such a rate of capital investment will the living standards begin to improve in a developing country.
Capital formation or inducement to invest depends on the propensity to save. In less-developed countries, there is a very low saving tendency
because of low income. Developed countries managed to save 20% of their output in capital formation. Whereas only 5% of the national income
is saved in UDCs. Much of the savings goes to housing and basic needs and, therefore, a very small amount is left over for development.
Capital formation is the basic tool for economic development. It may take decades to invest in building up a country’s infrastructure, information
technologies, power-generating plants, and other capital goods industries. Developing countries must have to build up their infrastructure, or social
overhead capital in order to set path for economic glory.
If there are so many obstacles in finding domestic savings for capital formation, then the country depends on foreign sources of funds. Less-
developed countries have to welcomed the flow of foreign capital or foreign borrowings. As long as the exports of these countries grew at the
same rate as borrowings, it is a favourable condition. But several poor countries needed all their earnings simply to pay interest on their foreign
debts. This is an adverse situation. Such countries need to boost up their production in order to cope with their current indebtedness.
3. Capital-output ratio: Apart from the ratio of capital formation to the aggregate national income, the growth of output depends upon the capital-
output ratio. The capital-output ratio may be defined as the relationship of investment in a given economy or industry for a given time period to the
output of that economy or industry for a similar time period. The productivity of capital depends on many factors such as the degree of technological
development associated with capital investment, the efficiency of handling new types of equipment, the quality of managerial and organisation skill,
the existence and the extent of the utilisation of economic overheads and the pattern and rate of investment. For instance, the higher the proportion
of investment devoted to the production of direct commodities, the lower the capital-output ratio, and higher the proportion of investment devoted
to public utilities, i.e., economic and social overheads, the higher shall be the capital-output ratio, and vice versa. Higher the investment devoted
to heavy industry, the higher will be the capital-output ratio, and vice versa. Higher the rate of investment and greater the technological progress,
the lower will be the capital-output ratio. The capital-output ratio also varies with the prices of inputs.
4. Technological progress: The key to economic development for any country is the technological progress. Greater the technological
progress, the higher will be the economic progress. The great importance of technological progress in the economic progress of Western European
countries was recognised by Karl Marx himself. The technological progress of a country includes development in research and development,
means of transportation, telecommunication, energy-generation, oil and gas exploration, information technologies, integrated circuits
manufacturing, etc. Again, without capital formation, the technological progress is impossible, because building huge hi-tech industries requires a
huge investment and a favourable economic condition.
5. Dynamic entrepreneurship: The modern economists recognise the dynamic role of entrepreneurs in promoting the economic growth of the
country. The efficient utilisation of entrepreneurial skills can only be ensured when there is presence of considerable profit motive. The
entrepreneur maximises his profit by making innovations, i.e., by bringing out a new product, new technologies, new product lines, new market,
new sources of raw materials and by adopting an optimum combination of factors of production. Thus he is making the most significant contribution
in the national income and in the technological progress.
The private enterprises in UDCs like India and Pakistan, has not taken them any far on the road of economic development. There is a lacking of
entrepreneurial skills in under-developed countries. There is a lack of innovation. Entrepreneurs are more attracted by commerce than by
industries. So it becomes the government’s duty to ensure the supply of required type of entrepreneurship.
6. Human Resources: Besides efficient entrepreneurs, the economic development of a country depends on the supply of skilled and semi-skilled
labour, and requires government’s greatest contribution to the development of human resources. The development of human resources depends
on the availability of hygienic food; quantity and quality of education centres and health centres; clean water; means of transportation and
communication; entertainment; counselling services; loan facilities; scholarship; job security and old age benefits; etc.
In poor countries GDP rises but at the same time the population also grows. Several developing countries are facing high birth rates with stagnant
national income per head. It is hard for poor countries to overcome poverty with birth rates so high. In under-developed countries, the economic
planners emphasise the following specific programmes:
(a) Control disease and improve health and nutrition,
(b) Improve education, reduce illiteracy and train workers, and
(c) Ensure that the labour force is well-equipped with necessary and competing skills.
7. Rate of growth of population: The size and rate of population growth has an important bearing on the economic development of a country. A
rapidly growing population aggravates the food problem, worsens the unemployment situation, adds to the number of unproductive consumers,
keeps down per capita income and labour efficiency, and militates against capital formation. A rapid rate of population growth acts like a drag on
economic development and slows down the pace of economic growth.
8. Price Mechanism: In under-developed economies, a very little emphasis is placed on price mechanism. The disequilibrium of prices has
severe consequences on the efficiency of the economy. The resource utilisation becomes lack of optimality. The productive machinery of the
community is hampered. There is no guarantee as regard to the quantity and quality of the production.
In order to speed up the economic development, price mechanism must go or confined to unimportant sectors of the economy like the purchase
and sale of consumer goods.
9. Non-economic factors: Non-economic factors include social factors, demographical factors, institutional factors and political factors. The
economic development depends on the political sovereignty, the complexion and competence of government, quality of administration, and political
ideology of government.
Vicious Cycle of Poverty
Many developing countries are caught up in vicious cycle of poverty. Low level of income prevents savings, retards capital growth, hinders
productivity growth, and keeps income low. Successful development may require taking steps to break up the chain at many points. Other points
in poverty are also self-reinforcing. Poverty is accompanied by low levels of education, literacy and skill; these in turn prevent the adaptation to
new and improved technologies and lead to rapid population growth. The vicious cycle of poverty is depicted as below:

Overcoming the barriers of poverty often requires a concentrated effort on many fronts and a ‘big-push’ is required to break the ‘vicious cycle’ into
‘virtuous circle’. If the country has stepped to invest more, improve health and education, develop labour skills, and curb population growth, she
can break vicious cycle of poverty and stimulate a virtuous circle of rapid economic growth.

Approaches to Economic Development

The following approaches are developed in recent years to explain the economic development and answer the question how countries break out
of the vicious cycle of poverty to virtuous circle of economic development:
1. The Take-off Approach: Take-off is one of the stages of economic growth. Different economies have been benefited from ‘take-off’ approach
in different periods, including England at the beginning of eighteenth century, the United States at the mid of nineteenth century, and Japan in early
twentieth century. The take-off is impelled by leading sectors such as a rapid growing export market or an industry displaying large economies of
scale. Once these leading sectors begin to flourish, a process of self-sustained growth (i.e. take-off) occurs. Growth leads to profits, profit are
reinvested, capital, productivity and per capita income spur ahead. The virtuous cycle of economic development is under way.
2. The Backwardness Hypothesis and Convergence: The second approach emphasises the global context of economic development. Poor
countries have important advantages that the pioneers of industrialisation had not. Developing nations can draw upon the capital, skills and
technologies of advanced countries. Developing countries can buy modern textile machinery, efficient pumps, miracle seeds, chemical fertilisers
and medical supplies. Because they can lean on the technologies of advanced countries. Today’s developing nations can grow more rapidly than
Great Britain, Western European Countries and United States in past. By drawing upon more productive technologies of the leaders, the
developing countries would expect to see convergence towards the technological frontier.
3. Balanced Growth: Some writers suggest that growth is a balanced process with countries progressing steadily ahead. In their view, economic
development resembles the tortoise making continual progress, rather than the hare, who runs in spurts and then rats when exhausted. Simon
Kuznets examined the history of thirteen advanced countries and conceived that the balanced growth model is most consistent with the countries
he studied. He noticed no significant rise or fall in economic growth as development progressed.
Note one further important difference between these approaches. The ‘take-off’ theory suggests that there will be increasing divergence among
countries (some flying rapidly, while others are unable to leave the ground). The ‘backward’ hypothesis suggests ‘convergence’, while the
‘balanced-growth’ model suggests roughly ‘constant’ differentials. In the following diagrams, advanced countries are represented by curve A,
middle income countries by curve B and low-income countries by curve C. The curves show per capita income:
Strategies of Economic Development
Following are the strategies commonly applied in economic planning:

1. Balanced vs. Unbalanced Growth: Currently there are two major schools of thoughts regarding the process of growth, i.e., balanced growth
strategy and unbalanced growth strategy:
(a) Balanced Growth Strategy: Economists like Ragnar Nurkse and Rosenstsein-Rodan strongly advocate balanced growth
strategy. According to them, the pattern of investment should be so designed as to ensure a balanced development of the various sectors
of the economy. They advocate simultaneous investment in a number of industries so that there is a balanced growth of different
industries.
(b) Unbalanced Growth Strategy: Economists like H.W. Singer and A.O. Hirschman, on the other side, believe that rapid economic
growth follows ‘concentration’ of investment in certain strategic industries rather than an even distribution of investment among the
various industries. In the view of these economists, unbalanced growth is more conducive in economic development than a balanced
one.
2. Big-Push Strategy: The big-push strategy is associated with the name of Rosenstein-Roden and Harvey Leibenstein. It is contended that a
big-push is needed to overcome the initial inertia of a stranger economy. Rosenstein-Roden observes that there is a minimum level of resources
that must be devoted to a development programme if it is to have any chance of success. Launching a country into self-sustaining growth is like
getting an airplane off the ground. There is critical ground speed which must be passed before the craft can become airborne.
3. Balanced, Unbalanced and Big-Push (BUB) Strategy: The advocates of this strategy suggest that no single strategy will take us to the goal
of economic development. Not only has the strategy to be changed from time to time as the situation may require, but it may be necessary
sometimes to strike a balance between the alternative strategies. In the initial stage, which is characterised by unbalances, counter-unbalance
strategy is to be adopted. But once an appropriate balance is attained by a fair dose of big-push, the strategy of balanced growth may be applied
to further planning.
Issues in Economic Development
Following are the important issues in under developed countries:
1. Industrialisation vs. Agriculture: In most countries, incomes in urban areas are almost more than double in rural areas. Many nations jump
to the conclusion that industrialisation is the cause rather than effect of affluence. To accelerate industrialisation at the expense of agriculture has
led many analysis to rethink the role of farming. Industrialisation tends to be capital intensive, attract workers into crowded cities, and often
produces high level of unemployment. Rising productivity on farms may require less capital, while providing productive for surplus labour.
2. Inward vs. Outward Orientation: This is a fundamental issue of economic development towards international trade. Should the developing
countries be self-sufficient? If yes, the country has to replace imported goods and services with domestic production. This strategy is known
as ‘import substitution’ or ‘inward orientation’.
If the country decides to pay for imports it needs by improving efficiency and competitiveness, developing foreign markets, and giving incentives
for exporters. This is called ‘outward orientation’ strategy. It is generally observed that by subsidising import substitution, competition is limited,
innovation is dampened, productivity growth is slow down and country’s real income falls to a lower level. Whereas, the outward orientation sets
up a system of incentives that stimulates exports. This approach maintains a competitive FOREX rate, encourages exports, and minimises
unnecessary government regulation of businesses esp. small and medium sized firms.
3. State vs. Market: The cultures of many developing countries are hostile to the operation of markets. Often competition among firms or profit
seeking behaviour is contrary to traditional practices, religious beliefs, or vested interest. Yet decades of experience suggest that extensive reliance
on markets provides the most effective way of managing an economy and promoting rapid economic growth.
The government has a vital role in establishing and maintaining a healthy economic environment. It must ensure law and order, enforce contracts,
and orient its regulations towards competition and innovation. The government plays a leading role in investment in human capital through
education, health and transportation, but the government should minimise its intervention or control in sectors where it has no comparative
advantage. Government, should focus its efforts on areas where there are clear signs of market failure.
 Models of Economic Growth
Classical Model of Economic Growth

Every nation strives after development. Economic progress is an essential component, but it is not the only
component. Economic development is not purely an economic phenomenon. In an ultimate sense, it must encompass more
than the material and financial side of people’s lives. Economic development should therefore be perceived as a
multidimensional process involving the reorganization and reorientation of entire economic and social systems. In addition to
improvements in incomes and output, it typically involves radical changes in institutional, social, and administrative
structures. Finally, although development is usually defined in a national context, its widespread realization may necessitate
fundamental modification of the international economic and social system as well.

The classical theories of economic development consist of following four schools of thought:

1. Linear-stages-of-growth model: Theorists of the 1950s and 1960s viewed the process of development as a series of
successive stages of economic growth through which all countries must pass. It was primarily an economic theory of
development in which the right quantity and mixture of saving, investment, and foreign aid were all that was necessary to enable
developing nations to proceed along an economic growth path that historically had been followed by the more developed
countries. Development thus became synonymous with rapid, aggregate economic growth.

This linear-stages approach was largely replaced in the 1970s by two competing economic schools of thought – theories of
structural changeand international-dependence theories.

2. Theories and patterns of structural change: Theories and patterns of structural change uses modern economic theory and
statistical analysis in an attempt to portray the internal process of structural change that a “typical ”developing country must
undergo if it is to succeed in generating and sustaining a process of rapid economic growth.

Structural-change theory focuses on the mechanism by which under-developed economies transform their domestic economic
structures from a heavy emphasis on traditional subsistence agriculture to a more modern, more urbanised, and more industrially
diverse manufacturing and service economy. It employs the tools of neo-classical price and resource allocation theory and
modern econometrics to describe how this transformation process takes place. Two well-known representative examples of the
structural-change approach are the ‘two-sector surplus labour’ theoretical model of Sir W. Arthur Lewis, and the ‘patterns of
development’ empirical analysis of Hollis B. Chenery and his co-authors.
3. International-dependence revolution: The international-dependence revolution was more radical and political in
orientation. It viewed underdevelopment in terms of international and domestic power relationships, institutional and structural
economic rigidities, and the resulting proliferation of dual economies and dual societies both within and among the nations of the
world. Dependence theories tended to emphasize external and internal institutional and political constraints on economic
development. Emphasis was placed on the need for major new policies to eradicate poverty, to provide more diversified
employment opportunities, and to reduce income inequalities.

International-dependence models view developing countries as troubled by institutional, political, and economic rigidities, both
domestic and international, and caught up in a dependence and dominance relationship with rich countries. Within this general
approach there are three major streams of thought – the neo-colonial dependence model, the false-paradigm model, and the
dualistic-development thesis.

4. Neoclassical or free-market counterrevolution: This theory is also known as neo-liberal theory. Throughout of the 1980s
and 1990s, the neoclassical or free-market counterrevolution approach prevailed. It emphasizes the beneficial role of free
markets, open economies, and the privatisation of inefficient public enterprises. Failure to develop, according to this theory, is
not due to exploitive internal and external forces as expounded by dependence theorists. Rather, it is primarily the result of too
much government intervention and regulation of the economy.

In the 1980s, the political ascendancy of conservative governments in the United States, Canada, Britain, and West Germany
brought aneoclassical counterrevolution in economic theory and policy. In developed nations, this counterrevolution favoured
supply-side macroeconomic policies, rational expectations theories, and the privatisation of public corporations. In developing
countries it called for freer markets and the dismantling of public ownership, central planning, and government regulation of
economic activities. Neo-classicists obtained controlling votes on the boards of the world’s two most powerful international
financial agencies — the World Bank and the International Monetary Fund. In conjunction and with the simultaneous erosion of
influence of organizations such as the International Labour Organization (ILO), the United Nations Development Program
(UNDP), and the United Nations Conference on Trade and Development (UNCTAD), which more fully represent the views of
LDC delegates.

The neo-classical approach states that underdevelopment arises from:

 Poor resource allocation due to incorrect price policies, and

 Government’s intervention in the economic activities.

Neo-classical or neo-liberal approach states that economic growth can be put to spur by:
  Permitting competitive free markets to flourish,
 Privatising state-owned enterprises,
 Promoting free trade and export expansions,
 Welcoming investors from developed economies, and
 Eliminating the plethora of government regulations and price distortions in factor, product and market.

1. Linear-stages-of-growth model:

Following are the growth models studied under linear-stages:

(a) Rostow’s Stages of Growth: The stages-of-growth model of development is taken by most of the newly independent
countries. According to Walt W. Rostow doctrine, the transition from underdevelopment to development can be described
in terms of a series of steps or stages through which all countries must proceed. According to Rostow, it is possible to
identify all societies, in their economic dimensions, as lying within one of five categories:

 The traditional society,

 The pre-conditions to take-off into self-sustaining growth,
 The take-off,
 The drive to maturity, and
 The age of high mass-consumption.

Rostow also clarified that these stages are not merely a way of generalising certain factual observations about the
sequence of development of modern societies. He argued that the advanced countries had all passed the stage of take-off
into self-sustaining growth and the under-developed countries that were still in either the traditional society or the pre-
conditions stage. One of the principal strategies of development necessary for any take-off was the mobilisation of
domestic and foreign saving in order to generate sufficient investment to accelerate economic growth.

(b) Harrod-Domar Model: This model, developed independently by RF Harrod and ED Domar in the l930s, suggests
savings provide the funds which are borrowed for investment purposes.

The model suggests that the economy's rate of growth depends on:

 the level of saving

 the productivity of investment i.e. the capital output ratio
 For example, if $10 worth of capital equipment produces each $1 of annual output, a capital-output ratio of 10 to 1 exists. A
3 to 1 capital-output ratio indicates that only $3 of capital is required to produce each $1 of output annually.

The Harrod-Domar model was developed to help analyse the business cycle. However, it was later adapted to 'explain'
economic growth.

2. Structural-change theory:

Following economic growth model represents the structural-change theory:

(a) Lewis Theory of Development: It is one of the best-known early theoretical models of economic development that
focused on the structural transformation of a primarily subsistence economy was that formulated by Noble-prize winner Sir
W. Arthur Lewis in the mid 1950s. His theory was later modified by his followers. The Lewis two-sector economy model
became the general theory of the development process in surplus-labour Third-World nations during most of the 1960s
and 1970s. In the Lewis model, the underdeveloped economy consists of two sectors:

 A traditional, overpopulated rural subsistence sector characterised by zero-marginal labour productivity. Lewis
classify this as ‘surplus-labour’ in the sense that it can be withdrawn from the agricultural sector without any loss of
output, and
 A high, productivity modern urban industrial sector into which labour from the subsistence sector is gradually
transferred.

The primary focus of the model is on both the process of labour transfer and the growth of output and employment in the
modern sector. Both labour transfer and modern-sector employment growth are brought about by output expansion in that
sector.

(b) Patterns of Development: The patterns of development analysis of structural change focuses on the sequential
process through which the economic, industrial and institutional structure of an underdeveloped economy is transformed
over time to permit new industries to replace traditional agriculture as the engine of economic growth.

In addition to the accumulation of capital both physical and human, a set of interrelated changes in the economic structure
of a country are required for the transition from a traditional economic system to a modern one.
 These structural changes involve virtually all economic functions, including the transformation of production and changes
in the composition of consumer demand, international trade and resource use as well as changes in socio-economic
factors such as urbanisation, and the growth and distribution of a country’s population.

3. International-dependence revolution:

Within this general approach, there are three major streams of thought:

(a) Neo-Colonial Dependence Model: It is an indirect outgrowth of Marxist thinking. It refers to the existence and
continuance of underdevelopment in a highly unequal international capitalist system. The international system is
dominated by unequal power relationships between the centre (the developed nations) and the periphery (the less
developed countries). The poor nations attempt to become self-reliant and independent but this system makes it difficult
and sometimes even impossible.

According to this theory, certain groups in the developing countries (including landlords, entrepreneurs, military rulers,
merchants, salaried public officials, and trade union leaders) who enjoy high incomes, social status, and political power
constitute a small elite ruling class whose principal interests are in perpetuation of the international capitalist system of
inequality. Directly and indirectly, they serve (are dominated by)and are rewarded by (are dependent on) international
special-interest power groups including multinational corporations, national bilateral-aid agencies, and multilateral
assistance organizations like the World Bank or the International Monetary Fund (IMF). Therefore, a major restructuring of
the world capitalist system is required to free dependent developing nations from the direct and indirect economic control
of their developed-world and domestic oppressors.

Curiously, a very similar but obviously non-Marxist perspective statement was expounded by Pope John Paul II in his
widely quoted 1988 encyclical letter:

“One must denounce the existence of economic, financial, and social mechanisms which, although they are manipulated
by people, often function almost automatically, thus accentuating the situation of wealth for some and poverty for the
rest. These mechanisms, which are manoeuvred directly or indirectly by the more developed countries, by their very
functioning, favour the interests of the people manipulating them. But in the end they suffocate or condition the economies
of the less developed countries.”

(b) False-Paradigm Model: The second and less radical international-dependence approach to development, the false-
paradigm model, attributes underdevelopment to faulty and inappropriate advice provided by well-meaning but often
 uninformed, biased, and ethnocentric international ‘expert’ advisers from developed-country assistance agencies and
multinational donor organizations. These experts offer sophisticated concepts, elegant theoretical structures, and complex
econometric models of development that often lead to inappropriate or incorrect policies. Because of institutional factors
such as the central and remarkably resilient role of traditional social structures (i.e., tribe, caste, class, etc.), the highly
unequal ownership of land and other property rights, the disproportionate control by local elites over domestic and
international financial assets, and the very unequal access to credit, these policies, based as they often are on
mainstream, Lewis-type surplus labour or Chenery-type structural-change models, in many cases merely serve the vested
interests of existing power groups, both domestic and international.

(c) Dualistic Development Thesis: Dualism is a concept widely discussed in development economics. It represents the
existence and persistence of increasing divergences between rich and poor nations and rich and poor peoples on various
levels. One of the elements of dualism is that there is a coexistence of wealthy, highly educated elites with masses of
illiterate poor people within the same country or city. According to this theory, there is a coexistence of powerful and
wealthy industrialized nations with weak, impoverished peasant societies in the international economy.

This coexistence is chronic and not merely transitional. It is not due to a temporary phenomenon, in which with the capacity
of time, the discrepancy between superior and inferior elements would be eliminated.

4. Neo-classical counterrevolution:

This approach can be implemented through the following three models:

(a) Free-Market Analysis: Free-market analysis argues that markets alone are efficient if:

 Product markets provide the best signals for investments in new activities,
 Labour markets respond to these new industries in appropriate ways,
 Producers know best what to produce and how to produce it efficiently, and
 Product and factor prices reflect accurate scarcity values of goods and resources.

Under free-market, competition is effective not necessarily perfect. Technology is freely available and nearly costless to
absorb. Information is correct and nearly costless to obtain.

(b) Public-Choice Theory: Public-choice theory, also known as ‘new political economy approach’, goes even further to
argue that government can do nothing right. This is because that politicians, bureaucrats, citizens and states act solely
 from a self-interested perspective, using their powers and the authority of government for their own selfish needs. Citizens
use political influence to obtain special benefits (sometimes also referred to as ‘rent’) from government policies, for
example, import licenses, or rationed forex. Politicians use government resources to consolidate and maintain positions of
power and authority. Bureaucrats use their positions to extract bribes from rent-seeking citizens and to operate protected
business on the side. And finally state uses its power to confiscate private property from individuals. The net result is not
only a misallocation of resources but also a general reduction in individual freedoms. The conclusion, therefore, is that
minimal government is the best government.

(c) Market-Friendly Approach: The third approach is market-friendly approach, which is the most recent variant on the
neoclassical counterrevolution. It is associated principally with the writings of the World Bank and its economists, many of
whom were more in the free-market and public-choice camps during the 1980s. This approach recognizes that there are
many imperfections in LDC product and factor markets and that governments do have a key role to play in facilitating the
operation of markets through ‘non-selective’ (market-friendly) interventions — for example, by investing in physical and
social infrastructure, health care facilities, and educational institutions and by providing a suitable climate for private
enterprise.

Karl Marx’s Model

Czarist Russia grew rapidly from 1880 to 1914; it was considerably less developed than industrialised countries like US and
Great Britain. World War I brought great hardship to Russia and allowed the communists to seize power. From 1917 to 1933,
the Soviet Union experimented with different socialist models before settling on central planning. Most economists believed until
recently that the Soviet Union grew rapidly from 1928 until the mid 1960s. After the mid 1960s, growth in Soviet Union stagnated
and output actually began to decline. In the late 1980s and early 1990s, open inflation erupted. Prices were well below market-
clearing levels and acute shortages arose in what is called ‘repressed inflation’. The repressive political system was
unacceptable to the people in Soviet Union and some countries in Eastern Europe and was universally rejected in 1989.

The father of this repressive political system – Communism is Karl Marx (1818 – 1883). The centrepiece of Marx’s work is an
incisive analysis of the strengths and weaknesses of capitalism. He argued that it is the only labour power that gives value to a
commodity. By imputing all the value of output to labour, Marx hoped to show that profits, which is the part of output that is
produced by workers but received by capitalists, amount to ‘unearned income’. According to Marx, this unearned income is
unjustly received by capitalists. This injustice can be eliminated by transferring the ownership of factories and other means of
production from capitalists to workers.
Marx saw capitalism as inevitably leading to Socialism. In Marx’s world, technology enables capitalists to replace workers with
machinery as a means of earning greater profits. As a result unemployment increases with the increased use of technological
advances. This increasing accumulation of capital will reduce the rate of profit and investment opportunities, and therefore, the
ruling capitalists will become imperialists. Karl Marx believed that the capitalist system could not continue this unbalanced
growth. Marx predicted increasing inequality under capitalism. Business cycles would become ever more violent as mass
poverty resulted in macro-economic under-consumption. Finally, a cataclysmic depression would sound the death knell of
capitalism. The economic interpretation of history is one of Marx’s lasting contributions to Western thought. Marx argued that
economic interests lie behind and determine our values. His arguments against capitalism suggested communism would arise in
the most highly developed industrial countries. Instead, it was backward, feudal Russia that adopted the Marxist vision.

Features of Karl Marx’s Socialist Model:

1. Government ownership of productive resources,

2. Planning is centralised,
3. Equal distribution of income,
4. Peaceful and democratic evolution,
5. Labour theory of value – value of a product represents the human labour used in production, and
6. Theory of surplus value.

Theory of Surplus Value:

Marx propounded his theory of surplus value on the basis of his theory of value. He said that in order to enable labour to carry
on the work of production, he should have some instruments of production and other facilities but he lacks these
facilities. Hence, he has to sell his labour to the capitalist. It is, however, not necessary for the capitalist to pay labour the full
value of the product produced by him. Here Karl Marx supported his theory on the basis of a classical theory, viz., the
subsistence theory of value, according to which the level of wages is determined by the subsistence of the worker. The work of
labour force is not merely to produce value equal to its price but much more. This surplus value is the difference between the
market value of the commodity and the cost of the factors used in the production of commodity. Karl Marx says that the
manufacturer gets for his commodity more than what he has spent on labour and other costs. The excess of market value over
the costs is the surplus value. This surplus is created because labour is paid much less than is due to it. He characterises the
appropriation of the surplus value by the capitalist as robbery and exploitation. The capitalist class goes on becoming richer and
richer through exploitation of the working class.
 Harrod Domar Growth Model
As we know that one of the principal strategies of development is mobilisation of domestic and foreign saving in order to
generate sufficient investment to accelerate economic growth. The economic mechanism by which more investment leads to
more growth can be described in terms of Harrod-Domar growth model, often referred to as the AK model.

Every economy must save a certain proportion of the national income, if only to replace worn-out or impaired capital goods
(buildings, equipment, and materials). However, in order to grow, new investments representing net additions to the capital stock
are necessary. If we assume that there is some direct economic relationship between the size of the total capital stock, K, and
total GNP, Y – for example, if $3 of capital is always necessary to produce a $1 stream of GNP – it follows that any net additions
to the capital stock in the forms of new investment will bring about corresponding increases in the follow of national output,
GNP. This relationship is known as ‘capital-output ratio’ and is represented as ‘k’. in the above case ‘k’ is roughly 3:1.

If we further assume that the national savings ratio ‘S’ is a fixed proportion of national output (e.g. 6%) and that total new
investment is determined by the level of total savings. We can construct the following simple model of economic growth:

· Saving (S) is some proportion, s, of national income (Y) such that we have the simple equation:

S = s .Y ---------------------------- (i)

· Net investment (I) is defined as the change in the capital stock, K, and can be represented by ΔK such that:

I = ΔK ----------------------------- (ii)

But because the total capital stock, K, bears a direct relationship to total national income or output, Y, as expressed by the
capital-output ratio,k, it follows that:

K = k

Or

ΔK = k
 ΔY

Or

ΔK = k.ΔY ------------------------------- (iii)

· Finally, because net national savings, S, must equal net investment, I, we can write this equality as:

S = I ------------------------------- (iv)

But from equations (i), (ii) and (iii), we finally get the following equation:

I = ΔK = k. ΔY

Therefore, we can rewrite the equation (iv) as follows:

S = s.Y = k.ΔY = ΔK = I --------------- (v)

Or simply

s.Y = k.ΔY -----------------------------------(vi)

Dividing both the sides of equation (vi) first Y and then by k, we obtain the following expression:

ΔY = s -------------------------------------- (vii)

Y k

Note that the left-hand side of the equation i.e., ΔY / Y represents the rate of change or rate of growth in GNP (i.e., the
percentage change in GNP).

The Harrod Domar Model, more specifically says that in the absence of government, the growth rate of national income will
directly or positively related to the savings ratio (i.e., the more an economy is able to save and invest out of a given GNP, the
greater the growth of that GNP will be. Harrod Domar Model further states that the growth rate of national income will be
inversely or negatively related to the economic capital-output ratio (i.e., the higher k is, the lower the rate of GNP growth will be).

The additional output can be obtained from an additional unit of investment and it can be measured by the inverse of the capital-
output ratio, k, because this inverse, 1 / k, is simply the output-capital or output-investment ratio. It follows that multiplying the
rate of new investment, s = I / Y, by its productivity, 1 / k, will give the rate by which national income or GNP will increase.

For example, the national capital-output ratio in an under-developed country is, let say, 3 and the aggregate saving ratio (s) is
6% of GNP, it follows that this country can grow at a rate of 2% (i.e., 6% / 3 or s / k or ΔY / Y). Now suppose that the national
saving rate increased from 6% to 15% through increased taxes, foreign aids, and / or general consumption sacrifices – GNP
growth can be transferred from 2% to 5% (15% / 3).

According to Rostow and other theorists, the countries that were able to save 15% to 20% of GNP could grow at a much faster
rate than those that saved less. Moreover, this growth would then be self-sustained. The mechanisms of economic growth and
development, therefore, are simply a matter of increasing national savings and investment.

The main obstacle or constraint on development, according to this theory, was the relatively low level of new capital formation in
most poor countries. But if a country wanted to grow at, let say, a rate of 7% per annum and if it could not generate savings and
investment at a rate of 21% (i.e., 7% × 3) of national income but could not only manage to save 15%, it could seek to fill this
saving gap of 6% through either foreign aid or private foreign investment.

Limitations of the model:

1. Economic growth and economic development are not the same. Economic growth is a necessary but not sufficient
condition for development

2. Harrod Domar model was formulated primarily to protect the developed countries from chronic unemployment, and
was not meant for developing countries.

3. Practically it is difficult to stimulate the level of domestic savings particularly in the case of LDCs where incomes are
low.
 4. It fails to address the nature of unemployment exists in different countries. In developed countries, the unemployment is
‘cyclical unemployment’, which is due to insufficient effective demand; whereas in developing countries, there is ‘disguised
unemployment’.

5. Borrowing from overseas to fill the gap caused by insufficient savings causes debt repayment problems later.

6. The law of diminishing returns would suggest that as investment increases the productivity of the capital will diminish
and the capital to output ratio rise.

The Harrod-Domar model of economic growth cannot be rejected on the ground of above limitations. With slight modifications
and reinterpretations, it can be made to furnish suitable guidelines even for the developing economies.
 Schumpeter’s Model of Economic Growth
Joseph Schumpeter was a famous Austro-Hungarian economist, but never followed Austrian school of thought. His famous
book was theTheory of Economic Development (1912), in which he first outlined his famous ‘theory of entrepreneurship’. He
argued that only daring entrepreneurs can create technical and financial innovations in the face of competition and falling profits,
and that it was these spurts of activity which generated economic growth. After the World War I, Schumpeter joined the German
Socialization Committee in Berlin - which then was composed of several Marxian scholars, and the Kiel School economists.

In 1919, Schumpeter became the Austrian Minister of Finance - unfortunately, presiding over the hyperinflation of the period, and
thus was dismissed later that year. Schumpeter migrated in 1921 to the private sector and became the president of a small
Viennese banking house. Ill luck dogged him: his bank collapsed in 1924. He drifted once again back into academia - taking up a
teaching position at Bonn in 1925. In 1932, Schumpeter took up a position at Harvard, succeeding the Marshallian F.W.
Taussig. Schumpeter ruled Harvard during the period of the ‘depression generation’ of the 1930s and 1940s - when Samuelson,
Tobin, Heilbroner, and Bergson were his students. His famous publications include Theory of Economic
Development (1912), Business Cycles (1939), Capitalism, Socialism and Democracy (1942) and History of Economic
Analysis (1954). He presented the theory of entrepreneurship, theory of business cycles, and theory of evolutionary economics.

In order to understand the Schumpeter’s theory of economic development, it is necessary to understand the theory of
evolutionary economics. The concept of evolution is an offspring of late 18th and early 19th century debates within philosophy
and the social sciences. The theory of evolutionary economics is much more inspired by the Darwinian theory of natural
selection. The general definition of evolution is the self-transformation process over time of a system. Such a system may be a
population of living organisms, a collection of interacting individuals as in an economy or some of its parts, or even the set of
ideas produced by the human mind. Therefore, an evolutionary theory is:

 Dynamic — such that the dynamics of the processes, or some of their parts, can be represented;
 Historical — in that it deals with historical processes which are irrevocable and path-dependent;
 Self-transformation — in that it includes hypotheses relating to the source and driving force of the self-transformation of the
system.

Schumpeter’s theory of economic development is considered as a radical theory. It is considered radical in the context that it
described the capitalist system as an evolutionary system. According to Schumpeter, capitalism is the system that internally
generates changes and technological progresses. According to him, the process of economic development is inherently
dynamic, as opposite to static nature of the theory of equilibrium. This does not mean that Schumpeter is against the theory of
equilibrium. On the contrary it is the underlying base for his own capitalist dynamic model.

Schumpeter’s model of economic development is not a substitute for the theory of equilibrium but rather a necessary
complement. Without it, it is impossible to understand the functioning of an economic system. Schumpeter started through the
‘circular flow’ as an essential block for building dynamic model. Schumpeter describes the circular flow with the following
assumptions:

 somewhere in the economic system a demand is ready awaiting every supply, and
 nowhere in the system are there commodities without complements.

Under these conditions, all goods find a market, and the circular flow of economic life is closed. In a steady state, costs in this
closed system are the price totals of the services of the production factors. Prices obtained for the products must equal these
price totals. The ultimate logical consequence of this ideal model of the clearing market is that production must flow on
essentially profitless – profit is a symptom of imperfection.

Schumpeter defines production as the combinations of materials and forces that are within our reach. The producer is not an
inventor. All components that he needs for his product or service, whether physical or immaterial, already exist and are in most
cases also readily available. The basic driving force behind structural economic growth is the introduction of new combinations of
materials and forces, not the creation of new possibilities.

Development in the Schumpeterian sense is defined by the carrying out of new combinations. This concept covers the following
five cases:

(i) The introduction of a new good – that is one with which consumers are not yet familiar – or a new quality of a
good.

(ii) The introduction of a new method of production – that is one not yet tested.

(iii) The opening of a new market – that is a market into which the country in question has not previously entered.

(iv) The conquest of a new source of supply of raw materials or half-manufactured goods.

(v) The carrying out of the new organisation of any industry, like the breaking up of a monopoly position.
The basic structure from Schumpeter’s model of economic development has two distinctive spheres. On the one hand is the
semi-closed system of the circular flow that is either in equilibrium or striving for it. And, on the other hand, is the symbiotic pair
of the entrepreneur and the sponsor that is always looking for ways to induce change in the peaceful yet boring routine-life of the
circular flow. Both spheres function within an endless reservoir of new combinations, for example, scientific knowledge and
technological inventions, but it is only the entrepreneur – backed by the capitalist – who is able to introduce new combinations
and new routines in the circular flow.

According to Schumpeter, entrepreneur who initiates the process of innovation is the central of the process of economic
development. Entrepreneurs are neither capitalists nor inventors; they see the potential of inventions and assume risk in
innovating. Schumpeter regarded the entrepreneur as something of a social deviant and noted that migrants or aliens in any
society have great potential to behave entrepreneurially. Schumpeter noted that increases of taxes, public policies favouring
labour organisations, price controls, and licensing requirements that increase the costs of doing business are the greatest
impediments to entrepreneurship. Under oppressive conditions, for example, the former Soviet Union, China, and present day
Islamic societies, very few people innovate.

The creation of something new usually requires that something old be eliminated, for example, changes in the structure of
demand or production result in structural unemployment. Economic growth cannot proceed without structural changes, i.e.,
economic development. Most technological progress is a result of activity specifically undertaken to develop new products,
reduce costs, improve quality, or develop new markets.

Economic evolution is based on cyclical disruptions and breaks of economic structures, an endogenous transformation that
results from the ‘process of creative destruction’ as an essential feature of modern capitalism. This points at the internal logic of
the cyclical restructuring of modern capitalism for evolutionary change.

Business cycle refers to regular fluctuations in economic activity. In the 19th century, business cycles were not thought of as
cycles at all but rather as spells of "crises" interrupting the smooth development of the economy. In later years, economists and
non- economists alike began believing in the regularity of such crises, analysing how they were spaced apart and associated
with changing economic structures. Schumpeter divided a business cycle into four process – boom, recession, depression and
recovery. He also classified the business cycles in the following classes:

(a) Seasonal cycles – for a year

(b) Kitchin cycles – covering a period of 3 years

(c) Juglar cycles – covering a period of 10 years

(d) Kuznets cycles – covering a period of 15 to 20 years

(e) Kondratiev cycles – covering a period of 48 to 60 years, for example, Industrial Revolution (1787 – 1842), Bourgeois
Kondratiev (1843 – 1897), and Neo-Mercantilist Kondratiev (1898 – 1950) with the expansion of electric power and the
automobile industry.
 Planning Techniques
Methodology of Planning:

The planner is gone through the following steps in economic planning:

(a) Collecting information: The most important aspect of economic planning is the collection of economic data. The data are
not only comprised of economical data, but they also cover the demographical, geographical, and political data. The planner
also considers non-quantitative data for economic planning. The planner or the team of planners must have an enough
knowledge regarding the fields like sociology, religion, politics and ethics in addition to economics.

(b) Deciding nature and duration of the plan: Once the planning authority gets the knowledge in respect of the economy on
the basis of necessary statistics, the next step is to determine the nature and size of the plan. In this connection, the planner has
to decide between the planning on micro-basis and planning on macro-basis, functional or structural, centralised or
decentralised, etc. Again it is to be decided that whether the planning will be on short-term basis, medium term, or long term. In
most of the countries, the medium term plans are advocated. The medium term plan which mostly lasts for the period of 5 years
is neither too short nor too long. In the period of five years the ruling party is in a position to implement upon its programmes,
policies and manifesto.

(c) Setting the objectives: After the nature and the duration of plan, the next issue is of setting the objectives. In other
worlds, it is an important task before the planner to decide regarding the social and economic objectives which will have to be
attained in the specified period of the plan. Most of the objectives or goals of the plan are concerned with the attainment of
higher growth rate of GNP, reduction of unemployment, removal of regional disparities, removal of illiteracy, development of
agriculture and industrial sectors, etc. After identifying such objectives, planner arranges these objectives in order of their
importance to the society and the economy as a whole.

(d) Determination of growth rate: This is the most important decision which the planner has to make while formulating the
plan. It is about to determine the growth rate during the plan period, i.e., at what rate the economy will grow during this
period. The economists agree that the growth rate of the economy should be one which could at least maintain the per capita
income of the country. This would be possible if the growth rate of the economy or growth rate of GNP and growth rate of the
population are equal. But this growth rate is least recommended. Rather, the planner will opt for that growth rate which is greater
than the population rate. For example, if Pakistan wants to maintain its existing per capita income while population is growing at
the rate of 3% p.a., then the required GNP growth rate should not be less than 3%. If we want to grow GNP by 3%, NI should
grow @ 6%. If the capital output ratio (COR) is 1:3, then we will have to invest 18% of GNP. While determining the growth rate,
the planner must keep in view the growth rate of other neighbouring or developing countries like India, China, Sri Lanka,
Indonesia, Bangladesh, etc.

(e) Financial resources of the plan: The economic planner is aimed at utilising the resources of the country in such a way
that the pre-determined objectives are attained. The real resources of a country consist of manpower, natural resources,
technological advancement, infra-structure, good governance, entrepreneurial skills, etc. The planner also has to consider the
various optional external resources in case the internal resources are short to fulfil the planning requirements. Such external
resources consist of foreign aid and assistance, foreign grants, foreign direct investment, and foreign borrowings from various
IFIs and rich countries.

(f) Sectoral allocation or determination of priorities: The resources at the disposal of a country are always short of the
requirements. Therefore, a plan is aimed at utilising the resources in such a way that the maximum social benefit could be
attained. Accordingly, the planner has to decide which project be taken-up and which project be postponed. In this way, the
planner has to prepare a schedule on the basis of relative importance of projects. Then a choice has to be made regarding
allocation of resources amongst different uses. Normally the planner has to decide between industrial sector development or
agricultural sector development, private sector or public sector, labour-intensive technology or capital-intensive technology,
etc. To settle the issue of ‘choice of priorities’ amongst different alternatives, the planners have given the concept of ‘investment
criteria’.

(g) Role of the government: In most of the countries, the purpose of planning authority is to prepare the draft of the plan
consisting of lot of proposals, schemes and projects. When once the plan is chalked out the proposals are sent to operating
agencies, ministries and other government departments which are to implement the plan. The government agencies are
inquired of their recommendations regarding the economic feasibility of different schemes and projects of the plan keeping in
view the sectoral allocation and size of the plan. The operating agency, i.e. the government has to consider the role to be played
by private sector and public sector. The government has to inform the planning agency regarding the prospective bottlenecks in
the way of effective planning. These recommendations will be helpful in finalising the draft of the plan.

(h) Formulation of economic policies: The role of planners in planning methodology is not just confined to preparation of
schemes and projects, they also have to devise economic policies which could provide a favourable atmosphere for the
operation of the plan. Accordingly, economic policies play an important role in economic planning, they provide fuel to the
engine of economic development.
 (i) Plan execution: The last step is plan execution. For effective implementation of plan, following conditions are the pre-
requisites:

(i) the government should be stable, honest, sincere and constructive,

(ii) the administrative system must be efficient, i.e. free of favouritism, corruption, bribery, red tapism, etc.

(iii) maintenance of law and order situation,

(iv) equal participation of private and public sectors in economic development,

(v) readily availability and computerised maintenance of government records, financial statements and cost
statements,

(vi) vigilant and constructive opposition, etc.

Types of Economic Policies:

Following are types of economic policies considered in the economic policy formulation:

(a) Budgetary Policy: The planner would suggest to devise such a budgetary policy which could transfer the revenue
surplus from revenue budget to capital budget. Moreover, the balanced budget would provide a guarantee for price stability.

(b) Tax Policy: The tax policy be stipulated in such a way that more revenues could be raised from taxes for the sake of
public expenditures. Moreover, the tax policy should aim at removing income disparities and wasteful expenditures on luxurious
consumption. Thus the taxes be imposed in accordance with the ability to pay.

(c) Credit Policy: The credit policy be formulated in such a way that short-term, medium-term and long-term credit could be
made available to the different sectors of the economy. When the funds are obtained by the needy sectors of the economy, the
pace of development will be accelerated and the plan targets will be realised.

(d) Foreign Trade and Foreign Exchange Policy: According to this policy a plan should seek to earn the sufficient amount
of foreign exchange by boosting the exports and reducing the imports. When the foreign exchange resources of a country
increase, the problem of debt repayment will also be alleviated.
 (e) Tariff Policy: An economic plan should devise such a tariff policy that the unnecessary and luxurious imports could be
checked. However, it should encourage the imports of essential consumer goods, capital goods, raw stuff and machinery which
would be helpful in accelerating the pace of development. Moreover, tariff policy should aim at protecting the infant industries.

(f) Price Policy: The price stability provides guarantee to the success of a plan. Therefore, such a policy should be devised
by the planners that monopolies could not grow, the limits be imposed on profit margins, government expenditures be controlled
and competitive forces be restored in the economy.

(g) Wage Policy: An economic plan should aim at protecting the rights of the labour. They must be having job security,
minimum wage laws and constitute labour unions. Civil and government servants should be given reasonable emoluments to
attract personnel to public services. Exploitation of labour by producers should be discouraged.

(h) Manpower Policy: Manpower policy is an economic policy pursuing the regularisation of skilled, semi-skilled and
unskilled persons to bring a balance between the demand and supply of labour. This will lead to maximum utilisation of
manpower.

(i) Immigration Policy: Restrictions should be imposed on internal mobility of labour in horizontal, vertical and geographical
forms. Brain drain should be checked in the early stages of development.

(j) Nationalisation Policy: As a result of severe market imperfections, the planner may pursue nationalisation policy in
economic planning. The sector or the sectors that are causing market imperfections may be nationalised or taken into
government control.

(k) Privatisation and Deregulation Policy: The purpose of this policy is to reduce the burden of governmental expenditures
and the operational inefficiencies caused by state-owned enterprises. To improve investment conditions and to promote healthy
competition, such state-owned enterprises are given under the control of private hands.

Planning Techniques:

There are several planning techniques used in different stages of planning. Some of them are discussed below:

(a) Capital-Output Ratio (COR): The Capital-Output Ratio (COR) is used during the planning stage of determination of
growth rate. COR defines the relationship between capital and output. This concept shows that how much of capital is required
for how much of output. Broadly speaking, it tells us that how much of investment is required to produce a certain level of
consumption goods. We also found its traces in Harrod-Domar Model of economic growth. According to COR, the sustained
growth rate can be represented by the following equation:

Where Gw = sustained growth rate;

s = saving ratio;

v = capital-output ratio (COR).

The above equation shows that if a developed country wishes to attain a sustained equilibrium growth rate the national income
must grow at the proportion of saving ratio (s) to capital-output ratio (v).

In planning, the planner is concerned with additional amount of capital required for additional output, then the concept of
marginal capital-output ratio (MCOR) or incremental capital-output ratio (ICOR) is used. Its equation is shown as below:

Where w = marginal capital-output ratio (MCOR) or incremental capital-output ratio (ICOR);

∆K = change in capital stock;

∆Y = change in output;

∆I = change in investment.

For example, if the ratio is 3:1, then it shows that to produce the goods worth Re. 1 will require to make the net investment worth
Rs. 3. In other words, if the economy wants to increase the output by Rs. 1 billion with the COR 3, then the required addition to
the capital stock to be provided by new investment will be Rs. 3 billion.
The economists and planners also use the concept of average capital-output ratio (ACOR). This concept shows the ratio of
existing stock of capital and the level of output which results from such capital. In other words, if we divide the value of total
capital stock by the total annual income, we will get ACOR. It is represented as follows:

Where K = existing capital stock;

Y = existing level of output.

For example, the existing capital stock of the economy is Rs. 6 billion, while the output of the economy is Rs. 1.5 billion, then the
value of ACOR will be equal to 4.

More is the value of ICOR, less will be the growth rate and vice versa. For example, if the COR is 3, saving ratio is 18%, then
the growth rate of the economy will be:

For COR 4 and 2, the growth rates at the same saving ratio will be 4.5% and 9% respectively.

COR Saving Growth Rate

Ratio
4 18% 4.5%
3 18 6
2 18 9

(b) Plan Consistency and Tabulation: A good plan must be having the elements of realism and consistency in numbers. It
means that it should not only represent true picture of the economy, but it should have a balance in context with different sectors
of the economy regarding numbers. Therefore, to attain such arithmetic target it becomes necessary the resources be analysed
arithmetically. For this purpose ‘ex-ante’ (expected) tabulation of balances between demands and supplies is made. All the
estimations and projections are entered in interlocking tables in such a way that they are linked with one another. The
interlocking tables show different items along with their statistics and importance. Following are the specimen of interlocking
tables:
1. Projected Sector Growth

Sectors Growth in Zero Period Growth during 5 years

Agriculture
Industry
Services
GDP

2. Resources and their Uses

Resources In In 5 years Uses In In 5 years

zero period zero period
GDP Capital
Surplus of FT sector Govt. expenditure
Private consumption
Total Total

3. Capital Account

In In 5 years In In 5 years
zero period zero period
Fixed investment Capital
Stocks Corporate saving
Private saving
Govt. saving
Foreign saving
Total Total

4. Government Current Account

Revenues In In 5 years Expenditures In In 5 years

zero period zero period
Taxes Govt. expenditures
Other revenues Transfer payments
Saving
Total Total

(c) Input-Output Analysis: The purpose of Input Output (IO) Analysis is to provide a balance between input, output and final
demand. It is also connected with plan consistency. Efficient planning requires that how much an industry produces must be
equal to the demand for that particular commodity. On the same lines, each industry wishes to have an assurance of the inputs
necessary for its output. It may happen that output of one industry may be an input of another industry. Thus, the purpose of IO
Analysis is to observe such input output relationships. In other words, IO Analysis encompasses the inter-industry
transactions. This technique was invented by Professor Leontief in 1951. It is also known as ‘inter-industry analysis’.

The planner constructs input-output tables where the relevant transactions are recorded. Then with the help of transaction data,
the input-output co-efficients are derived. Finally, the ‘Leontief Matrix’ is inverted to obtain a general solution. IO Table shows
the values of the flows of goods and services between different productive sectors especially inter-industry flows. In the
following IO Table, we have a 3-sector economy where there are two inter-industry sectors, i.e. agriculture and industry, and one
final demand sector:
Purchasing Sectors
(All figures in million rupees)
Sectors (1) (2) (3) (4)
Inputs to Inputs to Final demand Total Output
Agriculture Industry (Household) or Total Revenue
Selling Agriculture 500 1500 1000 3000
Sectors Industry 1000 2500 1500 5000
Value added 1500 1000 0 2500
(Payment to factors)
Total Inputs 3000 5000 2500 10500
or Total Cost

(d) Linear Programming: In economic planning, the planners wish to include in plans those methods, techniques and
programmes which would ensure the optimal use of resources. Thus the programming that is used for the best or optimum use
of resources is known as ‘linear programming’. It is programming because it has been formulated in mathematical mould and its
results are shown in terms of linear relationship. It is also known as ‘activity analysis’. It helps the planner to allocate resources
optimally among alternative uses within the specific constraints. It also helps to tackle the problems of investment
planning. Linear programming can be applied in case of number of economic problems concerning with maximisation or
minimisation subject to constraints. Through linear programming the profit function can be formulated. For e.g., for a firm
producing bicycles and motor cycles, the profit maximisation function is construction as below:
Where = maximum profit

x1 = bicycles (profit of $45 per bicycle)

x2 = motor cycles (profit of $55 per motor cycle)

Following are the given constraints:

While x1,x2≥0 (non-negativity condition)

If x1=0, then x2=30; and if x2=0then x1=20

This linear relationship can be built into a graph:

(e) Project Appraisal: Project appraisal is widely used both in the developed as well as in under-developed countries both
independently as well as an integrated scheme of national planning. The government formulate and evaluate investment
projects in such a way as to be able to compare and evaluate alternative projects in terms of their contribution to the objectives
of the nation. The team preparing project report consists of engineers and economists specialised in investment analysis and
the relevant fields. The sociologists and natural environmentalists must also be included. There are different techniques of
project evaluation, such as cost-benefit analysis, LM method, and UNIDO guideline:

(i) Cost-Benefit Analysis: This technique is also known as ‘social cost benefit analysis’. In this technique, the costs of
projects are evaluated. For the purpose of analysis the cost is disintegrated into various categories, viz., project costs,
associated costs, real and nominal costs, primary or direct costs, secondary or indirect costs, etc. The benefits are also
classified as real benefits, direct and indirect benefits, etc. The next step is to find the present value of costs and benefits
applying a certain rate of interest. Then a comparison is made between the discounted benefits with the costs of projects to
get the ratio of costs and benefits. If this ratio is one or more than one, the project is acceptable, otherwise rejected. This
technique is known as ‘net present value (NPV) method’. For this we need to calculate the present value (PV), which can be
calculated as below:

Where C = annuity amount

i = interest rate or discount rate

The decision rule for a project under NPV method is to accept the project if the NPV is positive and reject if it is
negative. Zero NPV implies that the government is indifferent between accepting or rejecting the project. This method can
also be used to make a choice between two or more than two mutually exclusive projects. On the basis of NPV method, the
various proposals would be ranked in order of NPV. The project with highest NPV would be preferable to the project with
lowest NPV.

Suppose the government has two proposed projects, i.e. project A and project B.

Project A Project B
Initial investment 60,000 59,000
 Cash inflow / profit:
2005 14,000 11,000
2006 15,000 14,000
2007 16,000 17,000
2008 18,000 18,000
2009 19,000 20,500
PV Factor 10% 10%

The NPV of both projects is calculated as below:

Net Present Value

Years Project A Project B

Cash PV factor PV Cash PV factor PV
Inflow @ 10% Inflow @ 10%
2005 14,000 0.909 12,726 11,000 0.909 9,999
2006 15,000 0.826 12,390 14,000 0.826 11,564
2007 16,000 0.751 12,016 17,000 0.751 12,767
2008 18,000 0.683 12,294 18,000 0.683 12,294
2009 19,000 0.621 11,799 20,500 0.621 12,731
PV of Cash inflows 61,225 59,355
Less: Initial investment 60,000 59,000
Net Present Value 1225 355

In the above case, the planners will opt for project A, because the NPV of the project is positive and is greater than the
NPV of project B. The economy will benefit more from project A than from project B.

(ii) The Little and Mirrless (LM) Method of Project Evaluation: There are two main features of LM method:

 Foreign exchange used as a ‘measuring rod’. Rather domestic prices, foreign exchange measures the true
costs and benefits of commodities produced. Therefore, the net value of all the goods produced should be
converted into its foreign exchange equivalents.
 The amount of savings in LDCs is less than the socially optimal level. Hence, one additional unit of investment
is more valuable than an extra unit of consumption at the margin.
 (iii) UNIDO Guideline: LM method tries to convert all the benefits and costs to an index of government income, UNIDO
translates such all benefits and costs to an index of present consumption. Thus the UNIDO method tries to find out the NPV
of all consumption flows because of an additional unit of investment.

(f) Investment Criteria for Allocation of Resources: The 'investment criteria' is a useful planning technique used in sectoral
allocation. Investment criteria refers to pattern of investment, choice of investment, choice of projects in various sectors, and
choice of technique for a particular project.

(i) Capital Turn-Over Criterion: The H-D model hints out the values of different variables which would guarantee the
UDCs to maximise their growth. According to it, the growth rate is represented as follows:

Where g = growth rate of output

S = saving income ratio

C = capital-output ratio (COR)

This equation states that to raise the growth, we are required to raise S or to lower the value of C. Professor Polak and
Buchnan argued that given the scarcity of capital in LDCs the C should be minimised. This is called ‘capital turn-over
criterion’. According to Polak and Buchnan those investment projects should be chosen which have low C, i.e. high rate of
capital turn over.

(ii) Social Marginal Productivity (SMP) Criterion: This criterion has been presented by Kahn and Chenery. They are of
the view that it is necessary to consider the total net contribution of marginal unit of investment to national output, and not
merely that portion of contribution which is gotten by private investors.

Efficient allocation consists of maximisation of national product and the principle to obtain this objective is to equate SMP
of capital in different uses. SMP criterion is represented as:
 Where V = annual value of total output

C = total annual cost of amortisation

K = total investment

VB = variations in income because of changes in 1 unit of BOP.

(iii) Maximisation of the Rate of Creation of Investible Surplus (MRIS) Principle: The objective of MRIS criterion is to
maximise per capita real income at a future point of time. Thus to achieve a higher rate of growth, it is stressed upon role of
capital accumulation. According to MRIS criterion, those projects should be selected which involve higher capital intensity. In
other words, those projects should be select which have higher COR.

(iv) Reinvestible Surplus (RS) Criterion: This criterion was suggested by Dobb and Sen. In Sen’s model the economy is
divided into two sectors, i.e. backward and modern. The modern sector is again sub-divided into two, i.e. (A) producing
machinery with labour only, and (B) producing corn with labour and machines. In the backward economy the corn is
produced by labour alone. Sen assumes that wages in the modern sector are determined by corn output by sector B. But
since it takes sometime to set-up the modern sector, wages in the modern sector would have to be paid of with the surplus in
backward sector. Sen describes how a conflict can arise between current output maximisation principle and criterion to
maximise the rate of growth of output.
 World Trade Organisation
History

At the United Nations conference held at Geneva in 1947, twenty three countries including United States of America
signed General Agreement on Tariffs and Trade (GATT). During the same year, a charter was put on the table for setting up,
within the United Nations Organisation, of a new agency to be called International Trade Organisation (ITO). Fifty nations
signed the charter in Havana the following year, but it was never subsequently ratified by the required number of countries. The
purpose of the agreement was to promote international trade free of barriers in the aftermath of World War II, and to draw up
proposals for the implementation of policies based on those principles set in the agreement. It covered all the issues like tariffs,
quotas, taxes, international commodity agreements and whatever was considered to have a bearing on the development of
international trade, and was based on policies of non-discrimination and tariff reductions.

GATT has been expanded and updated through a series of multi-year conferences. The most famous have been the Kennedy
Round (1963-1967), the Tokyo Round (1973-1979), and the Uruguay Round (1986-1994). The Uruguay Round ended with the
decision to dissolve GATT and establish the more powerful and more institutionalised World Trade Organization (WTO) in
1995. The WTO replaced GATT as an international organization, but the General Agreement still exists as the WTO’s umbrella
treaty for trade in goods. Trade lawyers distinguish between the GATT 1994, the updated agreement, and the GATT 1947, the
original agreement which is still the heart of GATT 1994.

Introduction

The WTO has nearly 150 members, accounting for over 97% of world trade. Around 30 others are negotiating membership. By
definition, the World Trade Organization (WTO) deals with the rules of trade between nations at a global or near-global level. But
there is more to it than that. There are a number of ways of looking at the WTO. It’s an organization for liberalizing trade. It’s a
forum for governments to negotiate trade agreements. It’s a place for them to settle trade disputes. It operates a system of trade
rules. (But it is not a Superman, just in case anyone thought it could solve — or cause — all the world’s problems!). The WTO is
like a table. People sit round the table and negotiate, and resolve trade disputes.

Essentially, the WTO is a place where member governments try to sort out the trade problems they face with each
other. Therefore, the first step is to talk. The WTO was born out of negotiations, and everything the WTO does is the result of
negotiations. Where countries have faced trade barriers and wanted them lowered, the negotiations have helped to liberalize
trade. But the WTO is not just about liberalizing trade, and in some circumstances its rules support maintaining trade barriers —
for example to protect consumers or prevent the spread of disease.

WTO also ensures that individuals, companies and governments know what the trade rules are around the world, and gives
them the confidence that there will be no sudden changes of policy. In other words, the rules have to be “transparent” and
predictable.

Principles / Characteristics of WTO Trading System

The World Trade Organisation is based on the following core-principles or characteristics:

1. Trade without discrimination:

The main principle in the charter of the World Trade Organisation is to promote international trade without any
discrimination. This principle is further elaborated into two – MFN and national treatment:

(a) Most-favoured-nation (MFN) – treating other people equally: Under the WTO agreements, countries cannot
normally discriminate between their trading partners. If a member country grants a special favour (such as a lower
customs duty) to another member country, she has to do the same for all other WTO members.

This principle is also known as most-favoured-nation (MFN) treatment. It is so important that it is the first article of the
GATT, which governs trade in goods. MFN is also a priority in the General Agreement on Trade in Services (GATS) and
the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS).

However, some exceptions are allowed. For example, countries can set up a free trade agreement that applies only to
goods traded within the group —discriminating against goods from outside. Or they can give developing countries special
access to their markets. Or a country can raise barriers against products that are considered to be traded unfairly from
specific countries. In general, MFN means that every time a country lowers a trade barrier or opens up a market, it has to
do so for the same goods or services from all its trading partners — whether rich or poor, weak or strong.

(b) National treatment – Treating foreigners and locals equally: Imported and locally-produced goods should be
treated equally — at least after the foreign goods have entered the market. The same should apply to foreign and domestic
services, and to foreign and local trademarks, copyrights and patents.
 National treatment only applies once a product, service or item of intellectual property has entered the market. Therefore,
charging customs duty on an import is not a violation of national treatment even if locally-produced products are not
charged an equivalent tax.

2. Freer trade:

First of all it should be noted here that the WTO is not for free trade at any cost. It is all about lowering trade barriers between
trading countries. The barriers concerned include customs duties (or tariffs) and measures such as import bans or quotas that
restrict quantities selectively. From time to time other issues such as red tape and exchange rate policies have also been
discussed.

Opening markets can be beneficial, but it also requires adjustment. The WTO agreements allow countries to introduce changes
gradually, through ‘progressive liberalization’. Developing countries are usually given longer to fulfil their obligations.

3. Predictability:

Sometimes, promising not to raise a trade barrier can be as important as lowering one, because the promise gives businesses a
clearer view of their future opportunities. With stability and predictability, investment is encouraged, jobs are created and
consumers can fully enjoy the benefits of competition — choice and lower prices. The multilateral trading system is an attempt by
governments to make the business environment stable and predictable.

One way of making investment stable and predictable is to ‘bind’ the member countries to their commitments. For example,
ceilings on customs tariff rates, etc. However, a country can change its bindings, but only after negotiating and compensating its
trading partners.

There are other ways as well to improve predictability and stability. One way is to discourage the use of quotas and other
measures used to set limits on quantities of imports. Another way is to make countries’ trade rules as clear and transparent as
possible. Many WTO agreements require governments to disclose their policies and practices publicly within the country or by
notifying the WTO. The regular surveillance of national trade policies through the Trade Policy Review Mechanism provides a
further means of encouraging transparency both domestically and at the multilateral level.

4. Promoting fair competition:

WTO is a system of rules dedicated to open, fair and undistorted competition. The rules on non-discrimination — MFN and
national treatment — are designed to secure fair conditions of trade. So these rules also apply on dumping and
subsidies. Many of the other WTO agreements aim to support fair competition, for example, in agriculture, intellectual property,
services, etc.

5. Encouraging development and economic reform:

The WTO system contributes to development. On the other hand, developing countries need flexibility in the time they take to
implement the system’s agreements. Over 3/4th of WTO members are developing countries and countries in transition to market
economies. During the seven and a half years of the Uruguay Round, over 60 of these countries implemented trade liberalization
programmes autonomously. At the end of the Uruguay Round, developing countries were prepared to take on most of the
obligations that are required of developed countries. But the agreements did give them transition periods to adjust to the more
unfamiliar and, perhaps, difficult WTO provisions — particularly for the poorest or ‘least-developed’ countries such as
Bangladesh, Cambodia, Djibouti, Central African Republic, Guinea, Madagascar, Myanmar, Nepal, Uganda, etc. A ministerial
decision adopted at the end of the round says better-off countries should accelerate implementing market access commitments
on goods exported by the least-developed countries, and it seeks increased technical assistance for them. More recently,
developed countries have started to allow duty-free and quota-free imports for almost all products from least-developed
countries.

Benefits of World Trade Organisation

The following common benefits of the WTO’s trading system doesn’t claim that everything is perfect, otherwise there would be no
need for further negotiations and for the system to evolve and reform continually:

1. The system helps promote peace. Peace is partly an outcome of two of the most fundamental principles of the trading
system:

 helping trade to flow smoothly, and

 providing countries with a constructive and fair outlet for dealing with disputes over trade issues.

It is also an outcome of the international confidence and cooperation that the system creates and reinforces.
2. Disputes are handled constructively. As trade expands in volume, in the number of products traded, and in the
numbers of countries and companies trading, there is a greater chance that disputes will arise. The WTO system helps
resolve these disputes peacefully and constructively.

Around 300 disputes have been brought to the WTO since it was set up in 1995. Without a means of tackling these
constructively and harmoniously, some could have led to more serious political conflict.

3. A system makes life easier for all. Decisions in the WTO are made by consensus. The WTO agreements were
negotiated by all members, were approved by consensus and were ratified in all members’ parliaments. The agreements
apply to everyone. This makes life easier for all, in several different ways. Smaller countries can enjoy some increased
bargaining power. Without a multilateral regime such as the WTO’s system, the more powerful countries would be freer to
impose their will unilaterally on their smaller trading partners. Smaller countries would have to deal with each of the major
economic powers individually, and would be much less able to resist unwanted pressure.

In addition, smaller countries can perform more effectively if they make use of the opportunities to form alliances and to
pool resources. Several are already doing this.

4. Freer trade cuts the costs of living. Protectionism is expensive as it raises prices through imposition of import duties and
quotas. The WTO’s global system lowers trade barriers through negotiation and applies the principle of non-discrimination.
The result is reduced costs of production (because imports used in production are cheaper) and reduced prices of finished
goods and services, and ultimately a lower cost of living.

5. It provides more choice of products and qualities. This expands the range of final products and services that are made
by domestic producers, and it increases the range of technologies they can use. When mobile telephone equipment
became available, services sprang up even in the countries that did not make the equipment. Sometimes, the success of
an imported product or service on the domestic market can also encourage new local producers to compete, increasing the
choice of brands available to consumers as well as increasing the range of goods and services produced locally.

6. Trade raises incomes. Lowering trade barriers allows trade to increase, which adds to incomes — national incomes and
personal incomes. But some adjustment is necessary. Trade also poses challenges as domestic producers face
competition from imports. But the fact that there is additional income means that resources are available for governments
to redistribute the benefits from those who gain the most — for example to help companies and workers adapt by
becoming more productive and competitive in what they were already doing, or by switching to new activities.
7. Trade stimulates economic growth. This is a difficult subject to tackle in simple terms. There is strong evidence that
trade boosts economic growth, and that economic growth means more jobs. It is also true that some jobs are lost even
when trade is expanding. But the picture is complicated by a number of factors. Nevertheless, the alternative –
protectionism – is not the way to tackle employment problems. In fact, the protectionism hurts the employment in the long
run. For example, the US car industry, when the US Government designed trade barriers to protect the jobs by restricting
imports of Japanese Cars, the American cars became more expensive, fewer cars were sold and there were major job
cuts.

8. The basic principles make life more efficient. One of the most important features of WTO is that it provides efficiency in
the international trade mechanism. It helps to cut costs because of important principles enshrined in the system. Such
principles include non-discriminatory trade, transparency, increased certainty in trade conditions, simplification and
standardisation of customs procedures, removal of red tapism, removal of bureaucracy, centralised databases of
information, and such other measures that come under the head ‘trade facilitation’.

9. Governments are shielded from lobbying. One of the lessons of the protectionism that dominated the early decades of
the 20th Century was the damage that can be caused if narrow sectoral interests gain an unbalanced share of political
influence. The result was increasingly restrictive policy which turned into a trade war.

Superficially, restricting imports looks like an effective way of supporting an economic sector. But it biases the economy
against other sectors which shouldn’t be penalized — if you protect your clothing industry, everyone else has to pay for
more expensive clothes, which puts pressure on wages in all sectors.

Governments need to be armed against pressure from narrow interest groups, and the WTO system can help. The GATT-
WTO system covers a wide range of sectors. So, if during a GATT-WTO trade negotiation one pressure group lobbies its
government to be considered as a special case in need of protection, the government can reject the protectionist pressure
by arguing that it needs a broad-ranging agreement that will benefit all sectors of the economy.

10. The system encourages good government. Under WTO rules, once a commitment has been made to liberalize a sector
of trade, it is difficult to reverse. The rules also discourage a range of unwise policies. For businesses, that means greater
certainty and clarity about trading conditions. For governments it can often mean good discipline.

The WTO agreements help in reducing corruption and bad government. But, quite often, governments use the WTO as a
welcome external constraint on their policies. This cannot be done because it would violate the WTO agreements.
Criticism on World Trade Organisation

Criticisms of the WTO are often based on fundamental misunderstandings of the way the WTO works. Following are most
common misunderstandings or criticisms on WTO:

1. The WTO dictates policy. According to critics, the WTO dictates the trade policy on its member countries. But that is not
the case; in fact, it’s the governments who dictate to the WTO. WTO is a member-driven organisation. The rules of WTO
are based on agreements resulting from negotiations among member governments. These rules are ratified by members’
parliaments. And all the decisions taken in the WTO are virtually made by consensus among all members.

2. The WTO is for free trade. There is another criticism on the World Trade Organisation is that it promotes free
trade. According to critics, free trade could hamper the domestic production and serves the interests of giant global
companies. Small domestic companies are unable to compete with such multinational companies and would not be able
to survive. As a result, unemployment increases and national income decreases. It is true that it is one of the principles of
WTO system that the member countries should lower their trade barriers and allow trade to flow more freely. But how low
those barriers should go depends on the bargaining of member countries.

Moreover, the rules written into the agreements allow barriers to be lowered gradually so that domestic producers can
adjust.

3. According to critics, the commercial interests take priority over development. Whereas, the WTO agreements are full
of provisions taking the interests of development into account. Freer trade boosts economic growth and supports
development. In that sense, commerce and development are good for each other.

4. Environmental issues. In WTO system, commercial interests do not take priority over environmental
protection. Whereas, many provisions of WTO take environmental concerns specifically into account. For example, the
preamble of the Marrakesh (Morocco) Agreement establishing the World Trade Organization includes among its
objectives, optimal use of the world’s resources, sustainable development and environmental protection.

5. Health and safety issues. Key clauses in the agreements (such as GATT Art. 20) specifically allow governments to take
actions to protect human, animal or plant life or health. But these actions are disciplined, for example to prevent them
being used as an excuse for protecting domestic producers — protectionism in disguise.
6. The WTO destroys jobs and worsens poverty. Another accusation on WTO is that WTO system destroys jobs and
widens the gap between rich and poor. In other words, it promotes economic inequalities internationally. The accusation
is inaccurate and simplistic. Trade can be a powerful force for creating jobs and reducing poverty. Sometimes adjustments
are necessary to deal with job losses, and here the picture is complicated. In any case, the alternative of protectionism is
not the solution. It should be borne in mind that the biggest beneficiary is the country that lowers its own trade barriers.

7. Small countries are powerless in the WTO. But small countries are not powerless in WTO. In fact, they would be
weaker without WTO. The WTO increases their bargaining power. In recent years, developing countries have become
considerably more active in WTO negotiations, submitting an unprecedented number of trade proposals. They expressed
satisfaction with the process leading to the Doha declarations. All of this bears testimony to their confidence in the system.

8. The WTO is the tool of powerful lobbies. This is a common misunderstanding that the system of the World Trade
Organisation supports the powerful countries such as US, EU, Japan, etc. Giant corporations get undue protection from
the WTO. The answer is that the WTO is a common platform for all the governments. The WTO treats all the countries
equally. Therefore, WTO is not the tool of powerful lobbies; in fact, it offers governments a means to reduce the influence
of narrow vested interests. The most common feature of the WTO is the negotiations that took place between the
governments. These negotiations create a balance of interests. Governments can find it easier to reject pressure from
particular lobbying groups by arguing that it had to accept the overall package in the interests of the country as a whole.

The WTO does not support the giant multinational companies. The WTO is an organisation of governments. The private
sector, non-governmental organizations and other lobbying groups do not participate in WTO activities except in special
events such as seminars and symposiums.

9. Weaker countries are forced to join the WTO. Another criticism about the WTO is that the weaker or developing
countries or poor countries are influenced by developed countries or by the WTO itself to join the WTO. In fact, weaker
countries do have a choice to join the WTO or not. However, they are convinced to join the WTO, because they can enjoy
the benefits that all WTO members grant to each other. They have the opportunity to trade, negotiate, and settle their
disputes with advanced countries within the WTO. Whereas, outside the WTO, i.e., under bilateral agreements, smaller
countries are weaker and cannot increase their bargaining power esp. with advanced countries.

10. The WTO is undemocratic. Some theorists claim that the system of the WTO is undemocratic. Whereas, decisions in the
WTO are generally by consensus. In principle, that’s even more democratic than majority rule because no decision is taken
until everyone agrees.
 WTO and the Developing Countries
In the World Trade Organisation, there are around 146 members from developing countries, i.e., about 2/3 rd majority of the
WTO. They play an increasingly important and active role in the WTO because of their numbers, because they are becoming
more important in the global economy, and because they increasingly look to trade as a vital tool in their development efforts.
Developing countries are a highly diverse group often with very different views and concerns. The WTO deals with the special
needs of developing countries in three ways:

 the WTO agreements contain special provisions on developing countries

 the Committee on Trade and Development is the main body focusing on work in this area in the WTO, with some others
dealing with specific topics such as trade and debt, and technology transfer
 the WTO Secretariat provides technical assistance (mainly training of various kinds) for developing countries.

The WTO agreements include numerous provisions giving developing and least-developed countries special rights or extra
leniency — ‘special and differential treatment’. Among these are provisions that allow developed countries to treat developing
countries more favourably than other WTO members.

The least-developed countries receive extra attention in the WTO. All the WTO agreements recognize that they must benefit
from the greatest possible flexibility, and better-off members must make extra efforts to lower import barriers on least-developed
countries’ exports.

The specific work on developing countries within the WTO can be divided into two broad areas:

1. the work of the WTO committees, and

2. the training for government officials and others.

1. WTO Committees:

The WTO consists of the following committees:

(a) Trade and Development Committee: The WTO Committee on Trade and Development has a wide-ranging
mandate. It has the following priorities regarding the developing countries:
 · implementation of provisions favouring developing countries,

· guidelines for technical cooperation,

· increased participation of developing countries in the trading system, and

· the position of least-developed countries.

Member-countries also have to inform the WTO about special programmes involving trade concessions for products from
developing countries, and about regional arrangements among developing countries.

(b) Sub-Committee on Least-Developed Countries: The Subcommittee on Least-Developed Countries reports to the
Trade and Development Committee, but it is an important body in its own right. Its work focuses on two related issues:

· ways of integrating least-developed countries into the multilateral trading system

· technical cooperation.

The subcommittee also examines periodically how special provisions favouring least-developed countries in the WTO
agreements are being implemented. The following are the WTO member countries categorized as least-developed
countries by the UN:

Angola, Bangladesh, Burundi, Cambodia, Central African Republic, Chad, Congo, Djibouti, Gambia, Guinea, Guinea
Bissau, Haiti, Madagascar, Malawi, Maldives, Mali, Mauritania, Mozambique, Myanmar, Nepal, Niger, Rwanda, Senegal,
Solomon Islands, Tanzania, Uganda, Zambia, etc.

Some additional least-developed countries are in the process of accession to the WTO. They are: Bhutan, Ethiopia, Laos,
Sudan, and Yemen.

2. WTO Technical Cooperation:

The second area of working on developing countries within the WTO is associated with the technical cooperation or the training
of government officials and businessmen from developing countries. It is devoted entirely in helping developing countries and
countries in transition from centrally-planned economies to operate successfully in the multilateral trading system. The objective
is to help build the necessary institutions and to train officials. The subjects covered deal both with trade policies and with
effective negotiation.

The WTO holds regular training sessions on trade policy in Geneva. In addition, it organizes about 400 technical cooperation
activities annually, including seminars and workshops in various countries and courses in Geneva.

Targeted are developing countries and countries in transition from former socialist or communist systems, with a special
emphasis on African countries. Seminars have also been organized in Asia, Latin America, the Caribbean, Middle East and
Pacific.

Funding for technical cooperation and training comes from three sources: the WTO’s regular budget, voluntary contributions from
WTO members, and cost-sharing either by countries involved in an event or by international organizations.

Challenges to the Developing World

The developing countries under the new WTO regime are faced with a considerable increase in their obligations particularly in
respect of government procurements, subsidies, anti-dumping, customs valuation and import licensing procedures. Again, the
new obligations that they have accepted in the area of services and intellectual property rights could have adverse economic
impact on their development.

The developing world, which consists of two-third majority of the total WTO membership, has not reaped plausible benefits under
WTO regime. They also have a strong feeling that their voice is not being heard, and the issues raised by them are not being
addressed. However, some noticeable change of strategy at the WTO seems to have taken place in recent years.

Major share of the world trade is controlled by the developed world. According to a survey only 17 countries control 72% of the
world trade. A major dilemma faced by the developing countries in the trade liberalisation process is that a country may be able
to control the speed of trade liberalisation, but cannot determine by itself how fast its exports should grow. Exports performance
depends on quality, price and competitiveness of exportable commodities. Also, to become competitive, investment is required
in developing the infrastructure, technology, human resources, and enterprise capacity for new exports, which is a long-term
process and not easily achieved. The interesting phenomenon is that the developed world continues to insist on free trade and
services and bringing down the tariffs in order to ensure fair competition between local and imported products. While, on the
other hand, the developed world itself continues to follow protectionist policies in the case of agriculture to safeguard its costly
products against cheaper foodstuff from the developing world.
Suggestions to the Developing Countries:

The developing world has tried to raise its voice on various forums but without much success. Apart from raising hue and cry for
better treatment by the WTO and the developed world it should have its own strategy for economic development. Following are
the suggestions for the developing countries:

 Identification of core strengths and competitive edge,

 Concentrate mainly on industries which use local raw material,
 Improve efficiencies, lower costs and upgrade quality of products in order to be able to make them export oriented to earn
valuable foreign exchange,
 Develop small and medium enterprises,
 Continue to improve productivity in agriculture / fishing in order to remain self reliant in food production and earn good
value for their exports,
 Develop human resource through education, training, healthcare and social justice, and
 The Government should reduce its role in running business.

But, unfortunately, most of the developing countries to-day is plagued by inefficiency, corruption, dishonesty, low productivity and
a lack of will and desire on the part of elected representatives to improve the status quo. The developing countries cannot
prosper on the prescriptions laid down by the World Bank, IMF or regular dole from rich nations. South Asian economies,
especially Malaysia, Singapore, South Korea and China are a glaring example of what can be achieved through following a
pragmatic path. Even the Indian economy has grown rapidly over the past decade with real GDP growth averaging some 6%
annually, in part due to continued structural reform, including trade liberalisation. In recent years, though, Pakistan has also
shown a remarkable performance in real GDP growth rate: 8.4% during the fiscal year 2004-05, 6.4% during 2003-04 and 5.1%
during 2002-03, but yet there are many reforms to be made especially in manufacturing and service sectors.

The developing countries have a tough task ahead. If they do not take corrective measures they will be rendered producers of
raw materials and operating locally produced agro-based industries only. They will, obviously, miss the opportunity to benefit
from global trade. According to a research report by David Dollar of the World Bank, the growth rate of the developing countries
during 1990s has been 5% (3.5% excluding China against 2% of the rich countries. He believes that there is solid evidence
available to prove that this has happened due to participation in the free trade and globalisation process.

According to WTO Annual Report 2002, poor countries need to grow their way out of poverty and trade can serve as a key
engine of that growth. But currently products of developing countries face many obstacles in entering the markets of rich
countries. Rich counties need to do more to reduce trade-distorting subsidies and dismantle their existing barriers on
competitive exports from developing countries.

Challenges faced by Pakistan

Two schools of thought prevail in Pakistan in regard to impact of WTO regime on the economy. One group favours WTO Trade
Agreements completely as it believes that free trade will have a strong positive effect in enabling conditions for poverty reduction
through employment opportunities, social welfare services, and infrastructure that can potentially benefit the poor. On the other
hand, the second school of thought believes that everything going wrong in the developing world is the result of the WTO
regime. They feel that the WTO has been formed to further the interests of the developed world only. The fact of the matter is
that we lack any empirical study and the different opinions are based on assumptions only.

Major challenges faced by Pakistan are as follows:

 Lowering of tariffs leading to cheaper imports would pose serious threat to the local industry, which, in spite of
inefficiencies, has thrived to-date owing to protectionist policies,
 An end to the quota system in textiles in early 2005 poses a serious challenge to our key foreign exchange driver,
 Due to lowering of tariffs the taxes earned by the Government on imports are constantly showing a marked reduction as a
percentage to total taxes collected,
 Lack of a clear and transparent policy by the Government towards WTO regime – and lack of understanding of implications
of Trade Agreements on our economic life.

Considering the challenges, the Government has identified the following industries with core strengths that need most attention
for development:

 Oil, gas and energy,

 Chemical, fertiliser and pharmaceuticals,
 Textile and allied industries,
 Light engineering,
 Information technology,
 Small and medium enterprises.

Other industries, which have been identified for improvements, are sports, surgical, cement, sugar, automobile, etc. These
industries will cater both for local and export markets. Needless to mention that a number of industries will be at the risk of
partial or complete closure, as they will not be able to compete with the onslaught of cheaper imports. The local electronics
industry, where product replacements are extremely rapid, faces the risk of being phased out.

The industry, which needs our utmost attention, is textiles, as it contributes almost 60% to our exports. With the start of new
open trade policy from January 2005, Pakistan is facing a serious problem of tough competition from China, India, Bangladesh
and a number of other countries. Our machinery is old, productivity is low, costs are higher and the manpower is not well-
trained. We need to invest at least US $ 6 to 7 billion in order to overcome these problems, and remain competitive in the world
market through exporting value added products.

It is heartening to note that the Government is well aware of this problem, and constant efforts are being made to produce
contamination free cotton, and modernise the present outdated machinery and infrastructure. However, both the Government
and the industry will have to move much faster in order to meet the foreign demands. If we are competitive with better quality of
products and acceptable prices, we may be able to gain a greater share of the textile trade in the world market.

Conclusion

In the present scenario of the global trade, both developing and developed worlds have their roles to play. The WTO and the
developed world must make further concessions for the developing countries, which are in majority and have a very small portion
of the total world trade, and are not in a position to compete with the advanced industrialised nations. On the other hand, the
developing world has its own responsibilities to share. They cannot continue to live on grant-in-aids and consider others
responsible for all their ills, while squandering their own resources. They have to put in serious efforts for overall improvement in
the quality of life of their impoverished masses, through sustained economic growth. This would help them achieve their due
share in the global trade, rather than see it marginalized further.
Economic Planning in Pakistan

History of Economic Planning in Pakistan

The history of national economic planning in Pakistan is divided in the following periods:

1. Period of economic coordination (1947-53)

2. Period of planning board (1953-58)
3. Period of Planning Commission (1958-68)
4. Period of decline of Planning Commission (1968-77)
5. Period of revival of Planning Commission (1978-88)
6. Period of (1988-98)
7. Period of restructuring of economy (1999-2008)

1. Period of economic coordination (1947 – 1953): Pakistan’s first planning board was established in 1950 with main emphasis on
agriculture. Unfortunately, that plan was not well implemented on time. There were no targets fixed for the plan and the planning
machinery was so weak to tackle with implementation. Therefore, the economic planning efforts during this period was a complete failure.

2. Period of planning board (1953 – 1958): The planning board of Pakistan was renamed as Planning Commission in 1953. The planning
commission was facing the following serious problems:

 Shortage of trained staff,

 Non-availability of accurate and reliable data,
 Uncertain conditions in the planning machinery
 It was regarded as a rivalry between Ministry of Finance and the State Bank of Pakistan
 Political instability
 Annual economic planning was never seriously followed
 Most of the economic advices were rejected by implementing authorities
 Economic priorities were not given due importance
 Budget decisions were also distorted

During this period, the First Five-Year Plan was made. Its implementation suffered due to rapid changes in government
and a lack of political support.
3. Period of planning commission (1958 – 1968): The third period of the planning process began in October 1958 with the assumption of
power by the military government of Ayub Khan. The new regime chooses to make economic development through a marked economy
and reliance of the private sector as its primary objective. The new government gave proper attention to achieve the following targets:

 Rapid industrialisation in the country,

 Removal of food shortage,
 Removal of political instability, and
 To overcome the problem of deficit of balance of payment.

The status of the Planning Commission was raised to a Division in the President’s secretariat. The President himself
assumed the chairmanship of the Planning Commission and Deputy Chairman, with the ex-officio status of a minister, was
made the operational head of the Commission. Provincial planning department was organised. The Planning Commission
was also provided the secretariat for National Economic Council (NEC) which looked after the day-to-day work of NEC and
was also responsible for final approval for annual development.

During this period the Second Five-Year Plan (1960-65) was made. It was so successful that Pakistan led to an example
for hunger nations of the world. But unfortunately Pakistan had to fight war against India in 1965. Then there was a hue
and cry against Ayub government and another government got the power.

4. Period of decline of planning commission (1968 – 1977): This is the period of decline of Planning Commission as an important
decision-making body coincided with the fall of Ayub Khan’s government. During the Yahya Khan period (1969 – 1971), the serious
planning on national level was completely ignored. The Third Five-Year Plan (1965 – 1970) was virtually abandoned by the Yahya Khan’s
government. In 1970, the Fourth Five-Year Plan (1970 – 1975) was made and it was also a big failure because of the worst political
conditions and instable government policies. In 1972, the newly elected government of Z. A. Bhutto decided to run the economy through
annual planning, rather than through a comprehensive five-year plan. During the same year, the Planning Commission was placed
directly under the control of Ministry of Finance as a Division. During the period from 1972 to 1977, the Planning Commission, with very
less powers, have very few favourable economic decisions. In other words, the Planning Commission was powerless and ineffective.

5. Period of revival of planning commission (1978 – 1988): After taking charge of the government, the Zia-ul-Haq’s regime emphasised
on the needs of five-year plans. In early 1980s, the Zia government took steps to revive the Planning Commission as an effective and
authoritative economic decision-making body.

During this period, two Five-Year Plans were formulated, i.e., Fifth and Sixth. In 1978, the Fifth Five-Year Plan to cover the
period of 1978 – 1983 was published. But the Government failed to pursue the plan mainly because of uncertain political
as well as economic conditions at that time. The Sixth Five-Year Plan was formulated in 1983 to cover the period 1983 –
 1988. At that time, Dr. Mahbub-ul-Haq was the Finance Minister. He formulated the plan and because of his great efforts,
this plan was a success. During his tenure, the Planning Commission has played a vital role in effectively formulating and
implementing the economic planning. Not only the Sixth Five-Year Plan, but also the annual plans were formulated by the
Planning Commission.

6. The period of (1988 – 1999): The period of 1988 to 1999 the period of political and economic instability. During this period, four elected
governments were dismissed by the President on the charges of corruption. The role of Planning Commission was over-shadowed by
political decisions. Its role was just limited to the preparation and submission of reports. It has nothing to do with the implementation of
planning.

The Seventh Five-Year Plan was formulated during the Zia-ul-Haq period. But after his death, in 1988, the newly elected
government of Benazir Bhutto took over the charge and so the Seventh Five-Year Plan has never been
implemented. After the fall of Benazir’s government in 1990, Nawaz Sharif’s government came into power. During his
tenure, he introduced privatisation, deregulation, and economic reform aimed at reducing structural impediments to sound
economic development. His top priority was to denationalise some 115 public industrial enterprises, abolishing the
government's monopoly in the financial sector, and selling utilities to private interests. Although the Nawaz Sharif
government made considerable progress in liberalising the economy, but it failed to address the problem of a growing
budget deficit, which in turn led to a loss of confidence in the government on the part of foreign aid donors. In 1993, the
Nawaz Sharif government was dismissed by the President on the charges of corruption. In the parliamentary elections of
1993, Benazir Bhutto, once again, became the Prime Minister of Pakistan. Meanwhile, the so-called Seventh Five-Year
Plan period came to an end. In 1994, the Planning Commission publish the Eighth Five-Year Plan to cover the period
1993 – 1998. In November 1996, once again, the PPP government was dismissed by the President on corruption
charges. The parliamentary election was held in 1997 and, once again, Mian Nawaz Sharif elected as the Prime Minister
of Pakistan. The targets of Eighth Five-Year Plan were also not well achieved. For example, the target of wheat was set
at 18.3 million tons which could not be achieved by 1996-97 when its actual production was 16.6 million tons. It was
achieved in the last year of the plan but it again slipped down to 17.8 million tons in the following year. Similarly the target
of non-traditional oilseeds, grape and mustard was set at 0.4 million tons which was far below the national
requirements. Likewise, the projected plan period target of agricultural credit of Rs 80.5 billion could not be achieved as the
maximum credit given during the plan period was Rs 37.7 billion and most of which went to the influential feudal lords and
politicians rather than to the common farmers. The Ninth Five-Year Plan was formulated by Nawaz Sharif government to
cover the period 1998-2003. Following were the priorities of Ninth Five-Year Plan:

(a) Maintenance of fiscal deficit at a sustainable level,

(b) Maintenance of GDP growth at 7% p.a.
 (c) Investment in physical infrastructure,
(d) Export-led industrialisation,
(e) End of agriculture-water dichotomy,
(f) Developing a civil society, etc.

7. Period of restructuring of economy (1999 – 2008): In October 1999, the Nawaz Sharif government was dismissed with the military coup
by Chief of Army Staff, General Pervez Musharraf. The entire country was in a state of jeopardy. Before that, the businessmen have
already lost their confidence due to economic instability with the Nuclear Test, freezing of foreign currency accounts, devaluation of rupee,
and the Kargil War in 1998. Therefore, the targets of Ninth Five-Year Plan were never been well implemented.

The era of General Pervez Musharraf is known as the era of economic and political restructuring. During this era, the
economy grew at an average growth rate of 5.1% (started from 2.6% in 2000-01 to 8.4% in 2004-05). President General
Pervez Musharraf invited Mr. Shaukat Aziz to take charge of the Ministry of Finance in November 1999. He very quickly
assembled a team of highly trained economists and extremely talented civil servants. To address the issue of the severe
macroeconomic crisis and place the economy on a path of sustained higher growth, financial stability, and improved
external balance of payments, the economic team launched a comprehensive set of economic stabilization and structural
reform measures. The government believed that macroeconomic stability was vital for achieving higher and sustained
economic growth, creating employment opportunities and preventing people from falling below the poverty line. It is with
this view that a series of structural reform measures were initiated in such areas as privatisation and deregulation, trade
liberalization, banking sector reform, capital market reform, tax system and tax administration reform, agriculture sector
reform etc. As a result, Pakistan’s economy started showing signs of improvement by 2000-01 well before
9/11. Manufacturing sector grew 11% in 2000-01 against 3.6% in 1998-99, revenue collection increased to Rs. 396 billion
against Rs. 308 billion, debt servicing declined from 64% to 57% of total revenue, export increased from $ 7.8 billion to $
9.2 billion. These are undeniable facts and well documented in official publications. These improvements had taken place
much before 9/11.

The present economic team under the stewardship of Shaukat Aziz has not only salvaged a near bankrupt economy but
has put it on a path of sustained high growth with financial stability and considerably improved external balance of
payments. Much has been done in the past five years. The country has witnessed a decline in poverty to 24% in 2008 and
other improvements in social indicators. The up-gradation of Pakistan in the Human Development Index of the UNDP of
2005 was a vindication of the policies pursued by the government during this period.

In 2005, the Government authorised the Planning Commission to issue the Tenth Five-Year Plan namely ‘Medium Term
Development Framework 2005-10’. The Medium Term Development Framework (MTDF) 2005-10 had been conceived
in the light of recent socio-economic performance of the country, continuing supportive public policies and challenges and
opportunities emerging from the global economy. Wide-ranging economic and financial reforms have made the economy
open, liberalised and market friendly. As a result, private sector has begun to play an active role in shaping structural
changes in the economy. The principal objective of the MTDF was to attain high growth of 8.2 percent by the terminal year
2009-10 with a sustained annual average growth of 7.6 percent during the five-year period without compromising
macroeconomic stability. The second key objective was to achieve higher level of investment to meet the targeted growth
and to effectively address the perennial issues of poverty reduction, employment generation, better access to basic
necessities of life including quality education and skill development for up grading the human resources, better health and
environment for the common man. The third crucial objective was to attract foreign investment to a level required to
become a fast growing economy like Malaysia. Last but not the least, the MTDF would focus on growth which is just and
equitable.

The plan had also anticipated the share of manufacturing sector in GDP to increase from 18.3% in 2004-05 to 21.9% in
2009-10. It was also anticipated that the production base would be expanded through the development of engineering
goods, electronics, chemicals and other hi-tech industries. The Government was also anticipating fastest growth of
IT/Telecom sector. Pakistan had seen an explosive growth in IT/Telecom sector in the last few years. The number of
mobile phones achieved their 2007 targets two years earlier, and the recent deregulation of LDI, WLL and other sections
had served to provide faster, better and wider coverage, all at lower cost. Nearly 60,000 IT professionals were operating in
the country with an annual turnover of Rs. 12 billion of which 15% was exported. The plan had also estimated that major
exports (gross) would increase from Rs. 14.05 billion in 2004-05 to Rs. 28.12 billion in 2009-10.

The MTDF projected a rising growth rate for the agriculture sector from 4.8% in 2005-06 to 5.6% in the last year of the
plan, i.e., 2009-10. The production of meat (beef, mutton, poultry meat) was anticipated to increase from 2,275 thousand
tonnes in 2004-05 to 3,124 thousand tonnes in 2009-10, and milk production from 29,472 thousand tonnes in 2004-05 to
43,304 thousand tonnes in 2009-10. The production of fisheries was projected at an average annual growth rate of 4.8 per
cent. The fish production increase was projected from 574 thousand tonnes in 2004-05 to 725 thousand tonnes in 2009-
10.

With the fall of Musharraf's Government in August 2008, the MTDF 2005-10 failed to attract the new Government's
attention, and never been prioritized by the Government, therefore, most of its targets were failed to achieve.

The chapter of Short-Term Economic Planning in Pakistan closed with the last MTDF 2005-10.
Planning Machinery in Pakistan
Following are the planning agencies in Pakistan:

National Economic Council (NEC):

The planning machinery in Pakistan is headed by the NEC as the supreme policy making body in the economic sphere. It has
the President as the Chairman and all Federal Ministers, incharge of development ministries and provincial governors as
members. In addition, a number of other persons are invited to attend the meetings of the NEC as and when the agenda relates
to matters concerning them.

Functions of NEC:
(a) To review the overall economic situation in the country
(b) To formulate plans with respect to financial, commercial and economic policies and economic development
(c) To approve the Five-Year Plans (MTDF), the Annual Development Plans (ADP), provincial development schemes in the
public sector above a certain financial limit and all non-profit projects.

It may appoint committees or bodies of experts as may be necessary to assist the council in the performance of its
functions. NEC discusses different cases and makes decisions. To ensure implementation of the decisions, the secretary of
each Ministry is expected to keep a record of all the decisions conveyed to him and to watch the progress of action until it is
completed. The Cabinet Secretary is also expected to watch the implementation of the council decisions.

Executive Committee of NEC (ECNEC):

The body directly below the NEC is the ECNEC. It is headed by the Federal Minister for Finance, Planning and
Development. Its members include all Federal Ministers incharge of development ministries, provincial governors or their
nominees and provincial ministers, incharge of planning and development departments.

Functions:
(a) To set up development schemes (both in the public and private sectors) pending their submission to the NEC.
(b) To allow moderate changes in the plan and sectoral adjustments within the overall plan allocation.
(c) To supervise the implementation of economic policies laid down by the Cabinet and the NEC.

Annual Plan Coordination Committee (APCC):

Another body concerned with economic policy is the APCC which is a purely advisory body responsible for advising the Cabinet
and the NEC regarding the coordination of policies. It is headed by the Secretary General, Finance, Planning and Economic
Coordination. All federal secretaries of development ministries, heads of provincial planning and development departments and
heads of the State Bank, the Board of Industrial Management and PIDC are its members.

Central Development Working Party (CDWP):

Below ECNEC is the CDWP which is responsible for the scrutiny and sanction of development projects. The Secretary, Planning
Division, is the president of CDWP. Its members include federal secretaries of the concerned departments, federal finance
secretary and chairman of the provincial planning and development departments.

The development schemes of federal ministers costing over Rs. 10 million and of the provincial governments costing over Rs. 50
million are submitted to CDWP for approval.

The responsibility for the overall economic evaluation of Annual Plans remains with the Planning Division which places a report
each year before the NEC evaluating economic achievements and failures. Mid-Plan reviews outlining the progress of the Five
Year Plan are also published by the Planning Commission.

A Critical Appraisal of Planning Machinery in Pakistan

Following are main hindrances in the way of effective planning in Pakistan:

(a) Administrative obstacles of planning: One major obstacle which has stood in the way of establishing a sound, efficient
and independent planning authority is the lack of an effective administrative machinery as this has greatly limited the tasks of
development policy and planning. Some of the factors which still continue to be major hindrances and act as administrative
obstacles and bottlenecks to planning are discussed below:

(i) Lack of competent personnel: One of the major obstacles in the way of an effective planning machinery is the lack
of competent personnel. Good and highly qualified economists, technicians, planners, etc. do not join government
service because of lack salaries and facilities.

(ii) Dilatory procedures: In Pakistan, documents and files must follow a prescribed series of steps through
administrative layers. It has been pointed out that often there seems to be a disposition to shift the file and documents
from one office to another, or from one ministry to another. The resultant delays are sometimes unbelievably long.
 (iii) Lack of coordination: In many cases, the coordination of development activities has been extremely difficult
because responsibility for different aspects of a project or programme are divided among many ministries and
agencies. So it becomes, sometimes, very difficult to carry on programme according to policy.

(b) Inadequate preparatory work on projects: When a potentially desirable project has to be identified, a feasibility study
has to be made to determine whether it is practicable and justified. A feasibility study involves a detailed examination of the
economic, technical, financial, commercial and organisational aspects of a project.

According to Planning Commission of Pakistan, preparatory work on public projects in the country was frequently lacking. So
due to inadequate preparatory work on projects, our plans have been failed in achieving their targets.

(c) Lack of implementation of plans: A major reason for the lack of implementation of the country’s various five year plans
has been the widespread failure of the governments of the day to maintain discipline, implicit in their plan. What is planned
and what is done in many cases bears little relationship to each other. At times it almost appears that plans are prepared by
a planning agency in one corner of a government and policy is made by various bodies in other corners.

(d) Lack of evaluation of plan progress and project implementation: Flexibility is an essential element of development
planning because in many cases changes in economic conditions make deviations from original plan unavoidable. A central
planning agency must, therefore, constantly review and assess progress in relation to events.

Unfortunately, whenever evaluation has been prepared by the country’s planning authorities, they have been issued long after
the end of the period to which they refer. In many cases the mid-term reviews of five year plans have been published almost
near the end of the plan period and the final reviews of the plan have come long after the new plan have been launched and,
therefore, been of little use to formulating targets and policies for the new plan. The need for a good reporting system on plan
and project implementation is, therefore, an essential prerequisite for a good evaluation system.

An Operational Approach to Plan/Project Appraisal

A development plan is essentially a forward looking policy framework which envisages a concrete and prioritised but somewhat
flexible programme of action to be launched in a dynamic situation to attain specified economic and social objectives. A plan or
a programme / project is ultimately as good as its implementation since it is the actual achievement of the results in line with the
targets and not merely the targets set or the resources allocated that determine the degree of success or failure of the plan /
programme as well as its impact on the socio-economic life of the people. Thus, it is clear that only the technically, financially
and economically sound and viable projects, if properly executed in a coordinated manner, can provide a strong edifice for the
successful implementation of the plan.

Most of the developing countries still need to further evolve their development planning processes by redefining their national
objectives and searching for alternative strategies, programmes and projects because it has been realised by most of them by
now that the development planning adopted so far could not achieve the desired results especially in the areas of social
development and income distribution. Recent international experience also shows conclusively that the formulation of technically
sound, economically viable and administratively feasible programmes / projects, their proper appraisal, implementation and
management are amongst the palpably weaker areas of development planning. In numerous instances, projects included in the
development plans have either not been optimally implemented or even if implemented, have failed to yield the expected results
on time. Similarly, such other factors like deliberate under-estimating of costs and over-pitching of targets at the approval stage,
coupled with recent increase in input prices, have adversely affected the overall plan implementation in most of the LDCs.

In recent years, increasing attention is being devoted to more systematic processes of planning and decision making as a means
of addressing the concerns of developing countries about the pace and pattern of economic growth, the failure to achieve
planned objectives, and the continuing financial and economic crises. This approach has reinforced the case for greater depth in
and a more systematic and inter-related approach to the monitoring, evaluation and follow-up of all public policy actions. This
renewed urge is shared both by national as well as international agencies in order to up-grade the developing countries’ status.

The United Nations International Development Strategy (UNIDS), therefore, emphasises that, to provide increasing opportunities
to all people for a better life, it is essential in the development planning to bring about more equitable distribution of income and
wealth for promoting both social justice and efficiency of production, to raise substantially the level of employment, to achieve a
greater degree of income security, to expand and improve facilities for education, health, nutrition, housing and social welfare,
and to safeguard the environment. The International Development Strategy emphasises the importance of national evaluation
system. According to UNIDS, every developing country is needed to establish a reliable and independent evaluation machinery
or strengthening the existing one, in order to ensure the implementation of development programmes.

Plan Preparation and Implementation Cycle:

The process of development appraisal and performance evaluation is an intrinsic component of planning. The standard plan
preparation and plan implementation cycle includes:

(a) Establishment of goals, objectives and targets;

(b) Formulation of strategies;
(c) Formulation of operating plans composed of policies and specific measures necessary to achieve the real targets;
(d) Implementation of policies and measures to the plan;
(e) Monitoring and evaluation of performance (both financial and physical) against targets;
(f) Adjustment of targets and/or plans as may be indicated by actual accomplishments and related developments.
It can thus be summed up that the success of the whole process of planning, implementation, monitoring and evaluation rests
upon the very first step of ‘identifying and specifying clearly the real objectives and targets’.

Home Page
 Privatisation and Deregulation

Privatisation is a supply side approach to bringing about increases in economic growth. Supply side economics is the application
of microeconomic policies intended to increase the overall supply of goods and services. By increasing the efficiency of the
factor inputs in the production process output should increase. This should have the effect of shifting aggregate supply to the
right and increasing the potential level of output as shown in the diagram below.

Arguments in favour of Privatisation:

Economists offer several arguments in favour of transferring government run firms to the private sector:

 Opening up production and consumption to market forces increase competition, economic efficiency and consumer
choice.
 Breaking down monopolies into more competitive industries introduces competition into the goods markets.
 Enables the privatised firms to compete for finance on the private capital markets both home and abroad.
 Ensures that firms become accountable to their shareholders and their desire for profit.
  Ensures that businesses are run on commercial rather than political grounds.
 Reduces the burden on the government's finances to support nationalised industries.

Arguments against Privatisation:

The process of privatisation and deregulation is intended to increase the level of competition. However, this may not happen for
a number of reasons:

 Privatisation may simply create private sector monopolies with high barriers to new firms entering the industry. There
are a number of reasons why these might exist:

o The existing firm has significant economies of scale that new firms cannot compete as in the case of natural
monopolies
o The start up costs for new firms are prohibitive

 Privatised firms make decisions based on commercial profit maximising grounds. Nationalised firms make decisions
in the public interest. If the government wants to focus on poverty reduction and development then production can be
organised appropriately. Privatisation may enable increased capital investment and reduction in the firm's long run average
costs. However, it is argued that such a goal of productive efficiency through expanding the use of capital is not
appropriate for some LDCs. Some of the problems associated with this might be:

o More sophisticated technology may need more maintenance

o Imported capital may worsen the countries balance of trade
o Lack of trained maintenance staff may prevent the capital being used effectively

 Privatising strategic industries such as the copper industry means that government revenue will diminish as profits from
copper sales are directed to the shareholders, many of whom, in the case of multinationals live abroad. Lower government
revenue may mean lower government spending on education and health.

Privatisation Process in Pakistan

History and evolution of privatisation in Pakistan:

The concept of privatisation is not new to the policy makers of this country. It may be traced as back as in 50s, when Pakistan
Industrial Development Corporation (PIDC) was established in 1952 to boost up the industrial development in the country. This
premier Corporation established over 50 industrial undertakings in the length and breadth of the country and after their
successful operation and management, these units were transferred from the public to the private sector. The tide of
nationalisation, which swept the whole economy in the first half of 70s, was reversed in 1977. The privatisation of State Owned
Enterprises (SOE) became an important instrument of economic policy of the government in late 80s. However, it was in 1991
that privatisation process in Pakistan became effective.

In this topic, we will limit our discussion only to the privatisation process post-1991. In 1990-91, the new government declared
privatisation as its primary economic policy objective. The agenda of privatisation announced by the Government covered a
wide spectrum of fields like industries, banks, development finance institutions, telecommunications and infrastructure
facilities. The government announced the creation of a Privatisation Commission on 22nd January, 1991 to implement the
disinvestment programme within the shortest possible time. The birth of Privatisation Commission institutionalised privatisation
efforts in Pakistan.

While providing a legal cover to the privatisation process, the government at the same time also moved to protect the interests of
the stakeholders, of which labour was given primary importance. A separate Inter-Ministerial Committee was constituted to deal
with the labour employed in the SOEs and safeguard their rights. The Committee negotiated a package of incentives for labour
employed in these enterprises with the representatives of workers. The agreement with labour was executed on October 15,
1991. The agreement has provided the basic parameters to safeguard the interests of labour and include minimum one year
service guarantee after privatisation, reservation of 10% shares for the labour, opportunity to the employees to purchase the unit
by putting competitive bid and several other concessions to the workers. It also provided a scheme of Golden Hand Shake
(GHS) and Voluntary Separation Scheme (VSS) for the workers and officers of the public sector undertakings.

Overall results of the privatisation process in Pakistan are mixed. In certain sectors like power generation, financial institutions,
cement and automobile the performance of the privatised units is satisfactory and the new management have succeeded in
improving the quality of product and service as well as financial health of the units. The workers have also benefited in terms of
higher salaries and better working conditions. In other sectors like edible oil and roti plants privatisation has not been very
successful.

During January 1991 to June 2003 the Commission completed 132 transactions for Rs 101 billion. During the financial year
2003-2004, the Commission has successfully completed privatisation of 8 transactions including privatisation of Habib Bank
Limited, AC Cement Rohri, Thatta Cement Limited, Kohinoor Oil Mills, and Capital Market Transactions (OGDCL, SSGC, POL,
ARL, DG Khan Cement and NBP). The total sale proceeds realized during the year amounted to Rs.33.3 billion. Out of the sale
proceeds received during the year, the Commission has remitted Rs.11.2 billion to the Government of Pakistan for debt
retirement and poverty alleviation program. The Commission during period from July 2004 to April 25, 2005 has realized Rs.
33.8 billion from sale of GOP shares in PIA, PPL, KAPCO, Falleti’s Hotel and 10% additional shares of Kohat Cement, Dandot
Cement Ltd. By 25th April 2005, the Government of Pakistan had completed or approved 147 transactions at gross proceeds of
Rs 168 billion. Some of the major transactions recently completed are:

 Sale of 51% of GOP stake in Habib Bank Limited for Rs. 22.4 billion
 51% shares of United Bank Limited sold in October, 2002. Payment of Rs.1.85 billion received.
 75% shares of MCB Bank (formerly Muslim Commercial Bank) were sold in April, 1991 for Rs.2.42 billion. Remaining
shares were divested during the years 2001 and 2002 for proceeds of Rs.1.29 billion.
 Divestment of approx. 23% shares of National Bank of Pakistan through IPO/POs during the years 2001 to 2003.
 70% shares of Bank Al-Falah (formerly Habib Credit & Exchange Bank) were sold in July, 1997 for Rs.1.63 billion. 2%
shares were meant for the HCEBL employees 28% shares sold in block for Rs.1.2 billion.
 Allied Bank Limited was privatised in 1991 with 51% shares being sold to the ABL employees.
 Banker’s Equity Limited was privatised in June, 1996 with 26% shares for proceeds of Rs.618.7 million.
 Sale of 5% ordinary shares of Oil & Gas Development Company Limited (OGDCL) through Capital Market for Rs. 6.8
billion.
 Sale of Thatta Cement for Rs. 794 million
 Sale of 10% shares of Sui Southern Gas Limited (SSGCL) for Rs. 1.7 billion through Capital Market
 Sale of shares of Kohinoor Oil Mills Limited for Rs. 81 million
 Sale of 6% shares of Pakistan International Airlines (PIA) for Rs. 1.3 billion through Capital Market
 Sale of 15% shares of Pakistan Petroleum Limited (PPL) through Capital Market for Rs. 5.7 billion
 Sale of 20% shares of Kot Addu Power Company (KAPCO) through Capital Market for Rs. 5.3 billion
Number of privatised transactions

(1991 – April 25, 2005)

 Sector No. of Amount

Transactions (Rs. In
million)
Banking 7 41,023

Capital Market 17 31,700

Transaction
Energy 13 41,144

Telecom 2 30,558

Automobile 7 1,102

Cement 14 8,681

Chemical / Fertilizer 18 10,204

Engineering 7 183

Ghee Mills 22 837

Rice / Roti Plants 23 326

Textile 2
87
Newspapers 5 270

Tourism 4 1,805

Others 6 160

Total 147 168,080

Some Major Forthcoming Transactions:

 Karachi Electric Supply Corporation (KESC) is a Government owned enterprise. KESC was incorporated on
13th September 1913 under the Indian Companies Act, 1882. The Government of Pakistan took control of KESC by
 acquiring majority share holdings in 1952. KESC is being controlled by the Ministry of Water and Power. Before privatising
the KESC, the financial health of KESC had to be improved in order to attract potential investors. During the FYs 2001
and 2002, Rs. 83 billion of debt was swapped for equity by the Government. Additionally, a capital reduction of Rs 57
billion was made to offset the accumulated losses. As a result the debt and interest burden on the Company were
significantly reduced and the deficit on the reserves was eliminated.

Privatisation Commission had invited Expressions of Interest (EOIs) from qualified utility operators and strategic and
financial investors in September 2003 for sale of up to 73% shares of KESC, with management control. Four parties
submitted EOIs and were evaluated by the Commission. Three parties were pre-qualified and invited to sign the
Confidentiality Agreement and undertake due diligence prior to bidding. The bidding for KESC was held on February 4,
2005. Two Parties i.e. Hasan Associate Consortium and Kanooz al Watan (Saudi Arabia) participated in the bid. Kanwooz
Al Watan submitted the highest bid of Rs. 20.24 billion.

 Oil and Gas Development Company Limited (OGDCL) is the largest exploration and production (E&P) company in
Pakistan currently 100% owned and controlled by the Government of Pakistan. A strategic sale of 51% of the total
shareholding along with transfer of management control is envisaged by the Government. Merrill Lynch International and
KASB Securities are the financial advisor for this transaction. Expressions of Interest (EOI) for sale of 51% shares in
OGDCL were invited in July 2002 and various oil companies submitting EOIs were invited for pre-qualification. The pre-
qualification process has not been closed and fresh interest by new prospective/potential investors will be entertained by
the Government. The pre-qualified parties that satisfy the necessary financial and technical standards will be invited to sign
a confidentiality agreement further to which they will be provided with a copy of the Information Memorandum and allowed
access to Data Room to undertake a comprehensive assessment of OGDCL.

 Pakistan Petroleum Limited (PPL) was incorporated in 1950 whereby the company inherited the assets and liabilities of
the Burmah Oil Company Limited and commenced operations from 1 July 1952. In July 2004, the Government
successfully concluded a 15% offer for sale and IPO of the company on the domestic stock exchanges at Rs. 55 per share.
The current shareholders of PPL are the Government of Pakistan (78.3%), International Finance Corporation (6.1%) and
institutional and individual investors (15.6%). The Privatisation Commission plans to proceed with a strategic sale of 51%
shareholding in PPL along with transfer of management control. Merrill Lynch International and KASB Securities are the
financial advisors for the strategic sale. The privatisation of PPL is still under process.

Expected Transactions during the Year 2005

 Name of SOEs / transactions Type of sale envisaged

Oil and Gas:

Pakistan State Oil (PSO) 51% shares alongwith management control

Banking and Finance:

National Investment Trust (NIT) Sale of management rights

Investment Corp. of Pakistan (ICP) Strategic sale

Power:

Faisalabad Electric Supply Co (FESCO) 56% shares alongwith management control

Genco 1 (Jamshoro) 51% shares alongwith management control

Industry and Real Estate:

Javedan Cement Company Ltd. 96.34% shares alongwith management control

Mustehkum Cement Ltd. 85.29% shares alongwith management control

Bolan Textile Mills Machinery sale

Lasbella Textile Mills Machinery sale

Malam Jabba Not yet determined

Pak-American Fertilizer Ltd. 94.3% shares alongwith management control

National Construction Ltd. (NCL) Not yet determined

Morafco Industries Faisalabad Not yet determined

Republic Motors Ltd. Not yet determined

Lyallpur Chemical Not yet determined

Hazara Phosphate Not yet determined

Tomato Paste Plant Asset sale

Printing Corporation of Pakistan Pvt. Ltd. Not yet determined

Karachi Shipyard and Engineering Works Ltd.  Strategic sale with transfer of management control.
 % of shares being sold not yet determined.

Pakistan Steel Mills Corporation Not yet determined

Need for Privatisation in Pakistan:

Dr. Ishrat Husain, the Governor of State Bank of Pakistan, in his speech at the Overseas Universities Alumni Club and the
21st Century Business & Economics Club on August 12th 2005, gives the exact answer to the questions arising about the
rationale for privatisation in Pakistan. According to him, two decades later, after the nationalization of 1970s, it turned out that
nationalization was not only unrealistic and flawed but the consequences were exactly opposite to what the intentions were. The
collapse of the Soviet Union and the bankruptcy of the socialist model eroded the ideological underpinning of this strategy and
the actual results on the ground in Pakistan and almost all the developing countries shattered the ideal and utopian dreams of
the proponents of this philosophy. Pakistan’s public enterprises including banks became a drain on the country’s finances
through continuous haemorrhaging and leakages and a drag on the economic growth impulses. The poor instead of benefiting
were actually worse off as almost Rs.100 billion a year were spent out of the budget annually on plugging the losses of these
corporations, banks and other enterprises. These public enterprises became the conduit for employing thousands of supporters
of political parties that assumed power in the country in rapid succession and a source of patronage, perks and privileges for the
ministers and the favoured bureaucrats appointed to manage these enterprises. These employees and managers had neither
the managerial expertise nor technical competence to carry out the job. Instead of providing goods & services to the common
citizens at competitive prices efficiently, the public enterprises turned into avenues for loot and plunder, inefficient provision of
services and production of shoddy goods.
In the past, private entrepreneurs in Pakistan did not make ‘profits’ in the real economic sense by earning a return on their
investment in a competitive world. On the contrary, they earned ‘rents’ through the maze of permits, licences, preferred credit by
the banks, subsidies, privileges, concessions and specific SROs granted to few favoured firms. Naturally when one sees people
becoming rich not through the dint of their hard work and enterprise but by manipulation, or bypassing the established rules and
laws, we should not be surprised to see the venom against the so called ‘private profits’.

The policy reforms introduced in Pakistan in 1991 has three key essentials – (i) Liberalisation, (ii) Deregulation, and (iii)
Privatisation. But unfortunately, Pakistan could not follow through these reforms in a continuous and consistent manner despite
the fact that both Benazir and Nawaz Sharif governments were fully committed to these reforms. For example, 12% shares of
PTCL were first sold to the general public in 1993-94 and it has been on the privatisation agenda of every successive
government since then.

According to a popular view in Pakistan it is okay to sell the loss making enterprises but retain the profit making entities such as
PTCL and PSO in the public sector. The main economic logic behind this divestiture is that it will promote efficient allocation of
scarce resources, optimal utilization of resources, making sound, timely and market responsive investment choices, winning and
retaining customer’s loyalty through better service standards and lower product prices or user charges and contributing to the
expansion of the economy through taxes, dividends etc. The basic reason for privatising these enterprises is that the
government should not be in the business of running businesses but regulating businesses. The role of the government should
be that of a neutral umpire, who lays down the ground rules for businesses to operate and compete, to monitor and enforce
these rules, to penalize those found guilty of contraventions and to adjudicate disputes between the competing business firms. If
the government owned firm itself, there is a strong conflict of interest and the other competitors lose confidence in the neutrality
of the umpire. Under these circumstances, the market becomes chaotic, disorderly and unruly as there is no neutral ‘person’ to
monitor and enforce the rules. The economy thus pays a heavy price for this loss of the market mechanism in the production,
sale and distribution of goods and services. The present controversy between the PIA and private airlines is a manifestation of
this tendency. The same argument can be applied in case of PTCL. If the Government had continued to own and manage
PTCL, the private sector competing firms would have felt that they would always remain at a disadvantage in relation to the
PTCL. The constant fear that the government’s coercive powers and full force of policy making ability would always be used to
safeguard and enhance the interests of PTCL. This would have kept the private firms away from investment in the fixed
telephone or wireless loop segments.

The fears about employment losses in the industry as a result of privatisation are also, by and large, unfounded. The example of
the banking industry privatisation controverts those who claim that privatisation means jobs are lost. In 1997 when the
restructuring, down-sizing and privatisation of the nationalized commercial banks picked up speed there were 105,000
employees working in the financial sector. After privatisation was completed, the banking industry has expanded and the work
force has expanded to 114,000. It is true that the pattern of employment has changed and more productive and skilled workers
have been taken in at the expense of low skilled or unskilled.

Telecom sector has already generated, after deregulation, hundreds of thousands of new jobs through public call offices, calling
cards and pre-paid card companies, Internet Service Providers, mobile phone companies, broad band services, and other value
added services under the private sector. As the penetration ratios in Pakistan are still quite low, there is going to be a large
expansion in the telecom sector. Industry estimates that 100,000 new jobs will be added during next 3 – 5 years.

Conclusion:

Privatisation contributes to economic growth through productivity gains, efficient utilization of resources, better governance and
expansion in output and employment. Profit making enterprises under the public sector may be making profits due to the unique
market structure such as monopoly or other privileges or concessions conferred upon them by the government but it does so at
the expense of the consumer who has to pay higher than market price for the product or the services. The ordinary consumer
gets a benefit only through competition among private sector firms in form of lower prices and better services as has been
demonstrated in the cases of banking, telecommunications and, more recently, air travel.

In a deregulated market environment, public ownership becomes a serious constraint as the rule – bound procedures and the
rigidity in the structure do not allow public sector companies the flexibility to respond promptly to dynamic market conditions.
Furthermore, the government’s role as a regulator and neutral umpire becomes questionable once it is itself a participant in the
game through its own company. This stifles competition and subverts expansion and growth by the private sector companies.
 Sixth Five Year Plan (1983-88)
Before the end of Fifth Five Year Plan preparation for Sixth Five Year Plan was made. NEC approved the Plan well in time and
implemented according to its schedule.

Size of the Plan:

The plan aimed at a financial outlay of Rs. 495 billion which was more than double the amount of Fifth Five Year Plan. Rs. 295
billion were decided to spend in the public sector and Rs. 200 billion were decided to spend in private sector. As regard to the
proposed resources to finance the Plan two points were important:

(a) The share of net external resources in the gross investment would fall from 24% to 16% in the Sixth Five Year Plan.
(b) The compensating efforts in the domestic front were expected in the private sector, almost quadrupling the total private
savings with little change in the size of the public savings.

Objectives:
(a) To make production sector of the economy powerful and stable.
(b) To accelerate the rate of economic development so that the standard of living of the people may be raised.
(c) To increase the agriculture production by using more fertilizers, better seeds and modern technology.
(d) To make the country self-sufficient in oil.
(e) To develop steel based engineering goods, modernisation of textiles, expansion of agro-based industries, etc.
(f) To provide maximum social services to increase the rate of literacy and to provide drinking water facilities, draining
water facilities, etc.
(g) To create harmony among different sectors of the economy.

Targets:
(a) To increase GDP by 6.5% p.a.
(b) To increase family income by Rs. 900 p.a.
(c) To increase agriculture production by 5% p.a.
 (d) To increase industrial production by 9% p.a.
(e) To provide jobs to 4 million people during the Plan period.
(f) To provide facilities of electricity to 88% of the village population.
(g) To increase exports from $ 2.43 billion to $ 4.91 billion by the end of the Plan.
(h) To construct 15000 km new roads from villages to cities.
(i) To lower dependence on foreign aid from 20 to 19% by the end of the Plan.
(j) To increase the efficiency of private sector, certain effective measures would be taken so that private sector may play
its role effectively in the development of the economy.
(k) To enable 3 million acres of land for cultivation which had been destroyed by water logging and salinity.

It was decided to allocate 18.1% of the total expenditure to agriculture and water sector, 20% to power, 18.1% to transportation,
15.6% to industry 12.2% to minerals and 11.5% to social institutions. See the table below:

Sector-wise Division of Expenditure

(Rupees in billions)
Sectors Total Percentage
Expenditure of
Total
Agriculture and Water 89.72 18.1
Sources of Power 100.00 20.0
Transportation 89.62 18.1
Industry 76.91 15.6
Minerals 6.05 1.2
Social Institutions 59.91 11.5
(health, education,
etc.)
Other Sectors 75.79 15.3
Total 498.00 100.0

Strategy:
 (a) High Growth Momentum: High rates of growth of GDP and other related macro economic variables are to be
maintained:
(i) Emphasis on increased efficiency in agriculture, particularly self sufficiency in oil seeds, expanding the exports of
rice, cotton and fruits, etc.
(ii) Balanced development of service industries, especially public services for basic human needs.
(iii) Balanced development of service industries, especially of private services for government servants and private
people.

(b) Rural Transformation: Increased opportunities for small farmers and provision of infrastructure.
(c) Employment and Income Policies: Creation of about 4 million new jobs for emphasis on small scale production in
agriculture and industry, rural works programme, vocational training with combination, income policy which related wages
to productivity, indicated salaries from fixed income growth.
(d) Decentralisation: To increase share of provincial governments in development programme of public sector and also
encouraging to local bodies to participate in investment plans.
(e) Backward Regions: Recognition of the tribal and Balochistan as economically backward regions and provision of
special funds for specific development programmes in these regions.
(f) Self Reliance: Continuing import substitution and export promotion policies and reducing dependence on foreign aid.

Performance of the Plan (Failure and Achievements):

During the Plan period, GDP was expected to increase by 6.5% p.a. It was based on the performance of agriculture and
manufacturing sectors. Because these sectors could not play their role effectively so the plan seemed helpless in achieving the
targets and objectives.

Further aggregate growth rate of GNP and GDP were related to expected increase in the rate of savings and investment during
the Plan period. The savings were expected to increase from 13% to 25% in Plan period and investment rate from 6.5% to 7.5%
p.a. But unfortunately these targets could not be achieved in the Sixth Five Year Plan.

Rate of net borrowing and net real foreign saving was expected to decline (because of the decline in foreign remittances). It was
decided to increase domestic savings because the Plan did not present any argument or evidence how the saving rate would
increase and how much to be saved by the private sector. Basic problem with the plea was shortfall in remittances. Minor crops
grew by only 3.6% p.a. as against a growth rate of 7% p.a. envisaged in the Plan.
The Sixth Five Year Plan was a mixed success. It was described as a qualified success by Planning and Development
Division. It fulfilled most of the targets, though there were some failures. On the whole, it was a good plan.
 Seventh Five Year Plan (1988-93)
Objectives:
(a) During the plan the jobs will be provided to 6 million people and educational unemployment will be removed.
(b) People will be provided better facilities regarding food, housing, education, transport and other public utilities.
(c) Human resources will be developed by giving more emphasis on education and training.
(d) The self-sufficiency will be attained in every field of economic activity. The dependence on foreign assistance will be
reduced. The local technology will be employed in place of foreign technology and skill.
(e) The role of private sector will be increased. Most of nationalised industries will be given back to their owners so that
dependence on government budget could reduce.
(f) A balance will be brought in government budget, i.e., the gap between government expenditures and revenues will be
narrowed. The autonomous bodies will be engaged in self-financing.
(g) To remove deficit in BOP and enhance exports the effective steps will be taken. A balance will be restored in exports
and imports through industrial, commercial and exchange rate policies.
(h) A restrained monetary policy will be pursued to ensure persistent price stability.

Strategy:
(a) To introduce such high yielding variety (HYV) seeds having the resistance against the heat, salinity and drought.
(b) To increase yields per hectare through more efficient use of fertilisers, water management and development of
appropriate farm technology.
(c) To get self-sufficiency in the production of sugar.
(d) To develop improved varieties of fruits and vegetables in size, seasonality and longevity of exports.

Targets:
(a) The GNP growth rate will be 6.5%.
(b) The agriculture growth rate is projected at 4.7%. The major crops growth rate will be 4%, while the minor crops growth
rate will be 5.5%.
 (c) The industrial growth rate will be 8.1%. The large scale industries will grow @ 8%, while the small scale industries will
grow @ 8.4% during the Plan period.
(d) Means of transportation and communication will grow @ 6.7%.
(e) The literacy rate will move to 40%.
(f) The production of oil per day will move to 49000 barrel.

Priorities:
(a) The first priority will be given to energy sector. Accordingly, there will be a 56% increase in resources for energy
development during the plan period.
(b) The second priority will be given to education. The expenditures on education will be doubled. More emphasis will be
given on primary education.
(c) The third priority will be given to population planning. In this respect, there will be a 76% increase in resources for
population planning.

Performance:
The Seventh Five Year Plan was prepared within a broad-based socioeconomic framework of a fifteen years perspective (1988-
2003), emphasizing efficient growth in output on one hand and improving the quality of life on the other. Of the Perspective Plan
total incremental targets, about 23.6% of GDP, 22% of investment, 23.8% of exports, 26.2% of imports and 21% of revenue,
were envisaged to be attained during the Seventh Plan. It attempted to address the deficiencies in social sectors, education,
health, women development, etc. as well as economic problems like fiscal and current account deficits, inflation and
unemployment. Many policy reforms were launched during the Plan period and a new economic edifice on free enterprise, open
market, privatisation and deregulation and liberalisation has been raised.

The tempo of growth was affected by unforeseen events on domestic and international fronts including economic contraction of
Eastern Europe and the former Soviet Union, recession in Pakistan’s export markets, the Gulf War, the delay in the settlement of
the Afghan issue, the political uncertainties on the domestic front, frequent changes of government, civil disturbances in 1989-90
and floods of 1988-89 and 1992-93. However, the overall performance has been satisfactory.
 Eighth Five Year Plan (1993-98)
The Eighth Five Year Plan was approved by the National Economic Council (NEC) on May 31, 1994. the primary aim of the plan
is to attain a sustained economic growth in an environment of macroeconomic stability, equity and justice. The Eighth Plan aims
to achieve the following five basic balances:

(a) Balance between planning for the public and private sectors.
(b) Inter and intra-sectoral balances,
(c) Balance between new investment and use of existing capital stock,
(d) Balance between project preparation and implementation,
(e) Balance between committed and available resources.

Objectives:
(a) To attain 7% p.a. growth in GDP (including 4.9% in agriculture and 9.9% in manufacturing sector) by mobilising
domestic and foreign resources and efficient use of existing resources;
(b) To encourage participation of all people in the development process and a more equitable sharing of the benefits;
(c) To generate additional employment opportunities by expanding productive avenues through private initiative as well as
Government policies and programmes;
(d) To alleviate poverty through an integrated approach of income generation, well dispersed access to social and
community services, human resource development, extension of physical infrastructure, population welfare and special
programmes for targeted groups and areas;
(e) To ensure greater self-reliance, particularly in food, energy, public finance and external balance;
(f) To conserve natural resources and ensuring protection of environment;
(g) To promote good governance; and
(h) To ensure macroeconomic stability and discipline.

Size:
On 1992-93 prices, the size of the plan was Rs. 1701 billion while its size goes to Rs. 2092 billion on 1993-94 prices.

Strategy:
(a) The development strategy of the Eighth Five Year Plan will focus on ensuring and strengthening individual initiative,
private enterprise and market mechanism;
(b) Efficiency will be the criterion on all investments;
 (c) Employment will be promoted by expanding productive revenues;
(d) Poverty alleviation and income distribution will be addressed through equitable and well-dispersed access to social and
community services and dispersal of income generating activities;
(e) Public sector will also support and protect the poor and other vulnerable groups;
(f) Fiscal discipline and monetary stability will be ensured to encourage higher levels of saving and investment;
(g) Self-reliance will be promoted through expanding exports and foreign exchange earnings, attaining self-sufficiency in
the production of food grains, and exploitation of indigenous source of energy and fuels. Import substitution would not be
dismissed out of hand. Efforts would be made to bridge the gap between actual and potential capacity in selected sectors;
and
(h) Local technologies development would be encouraged.

Targets:
(a) To attain 7% p.a. growth in GDP.
(b) The agriculture growth rate is projected at 4.9%. Wheat production to grow by 22%, cotton production to grow by 61%
and rice production to grow by 31%.
(c) The industrial growth rate is projected at 9.9%. Fertilizers production to grow by 60%, cement production to grow by
54%, sugar to grow by 54%, petroleum products to grow by 50% and steel billets to grow by 124%.
(d) Population planning coverage to increase from 20% to 80%. Population growth rate to decline from 2.9% to 2.7%.
(e) Coverage of rural water supply to increase from 47% to 71%. Rural sanitation to go up from 14% to 32%.
(f) Gas production to grow by 38%, refining capacity to grow by 183%, Ghazi Barotha Hydel Power Project to construct,
ongoing Hub Power Project to complete with the cooperation of private sector, thermal plants of WAPDA to privatise, and
electrification of 19700 villages.
(g) Indus Highway to complete, Lahore-Islamabad Motorway to complete, Makran Coastal Highway to complete, to
construct deep sea port at Gwadar with the collaboration of private sector, to increase telephone connections by 125%.

Performance:
The formal approval of the Eighth Plan is one year late. The economic growth in the first year of the Plan 1993-98 was only
4%. Due to consecutive damage to the cotton crop and decreased wheat production, and the worst political conditions in the
country, the achievement of 7% GDP growth in the next four years becomes difficult. See the following table:

GDP Growth Rate during the Eighth Five Year Plan

Year GDP Growth Rate (%)
1993-94 4.4
1994-95 5.1
1995-96 6.6
1996-97 1.7
1997-98 3.5
 Medium Term Development Framework (MTDF) 2005-10

The National Economic Council at its meeting held on May 27, 2005 approved the Annual Plan 2005-
06 and authorized the Planning Commission to release it at the time of presentation of the Federal Budget. The Plan
covers the 1st Year of Medium Term Development Framework (MTDF) 2005-10. It comprises Growth, Saving and
Investment, Balance of Payments, Fiscal and Monetary Development, Poverty
Reduction and Human Development and main features of PSDP and Sectoral
Programmes. It is in line with the Government’s agenda, priority and programmes highlighted in the MTDF. This agenda
marks a paradigm shift towards the knowledge economy through an integrated approach. Financial and physical review of
Annual Plan 2004-05 and projections and prospects for the year 2005-06 are given as follows:

Growth, Saving and Investment:

The Medium Term Development Framework (MTDF) 2005-10 has been conceived in the light of recent socio-
economic performance of the country, continuing supportive public policies and challenges and opportunities emerging from
the global economy. The targets of the year 2004-05 have been surpassed. The low growth trend experienced during 1990s
has been reversed. Wide-ranging economic and financial reforms have made the economy open, liberalized and market friendly.
As a result, private sector has begun to play an active role in shaping structural changes in the economy.

The principal objective of the MTDF is to attain high growth of 8.2 percent by the terminal year 2009-10 with a
sustained annual average growth of 7.6 percent during the five-year
period without compromising macroeconomic stability. The second key objective is to achieve higher level of investment
to meet the targeted growth and to effectively address the
perennial issues of poverty reduction, employment generation, better access to basic
necessities of life including quality education and skill development for upgrading the
human resources, better health and environment for the common man. The third crucial
objective is to attract foreign investment to a level required to become a fast growing economy like Malaysia. Last but
not the least, the MTDF will focus on growth which is just and equitable.

Growth Strategy:

The key elements of the MTDF strategy are as under:

 (a) In agriculture, not only crops but livestock and fisheries will also be
developed where a substantial improvements in yields, product quality
and market efficiency are required to meet the growing demand for domestic consumption and exports.

(b) In manufacturing , the production base would be expanded through the development of engineering goods,
electronics, chemicals and other high technology-based and value added industries. Its share in GDP will be increased
from 18.3 percent in 2004-05 to 21.9 percent in 2009-10.

(c) The social and physical infrastructure would be expanded by investing

more in water, energy, education and health and encouraging private sector to move into these sectors.

(d) Adequate infrastructure and supply of trained and skilled manpower would be ensured to meet the requirements of a
fast growing economy.

(e) To generate employment and to reduce poverty, investment will be encouraged in agriculture and livestock, SMEs,
housing and construction sectors.

(f) In the export sector, efforts will be made to increase the role of technology and improve comparative export
sophistication.

(g) To encourage higher investment and savings, efforts would be made to

provide the enabling environment to foster local and foreign investment and enhance both public and private savings.

Sectoral Growth:

With an average growth rate of 7.6 percent of real GDP targeted for the five-year period of MTDF, it is envisaged that it
would be gradually rising from 7.0 percent in 2005-06 to 8.2 percent in the terminal year 2009-
10. The agriculture sector is projected to attain a
growth rate of 5.6 percent by the terminal year and on an average would grow at a rate of 5.2 percent per annum
during the MTDF period. The manufacturing sector is projected to row at the average
rate of 11.6 percent per annum. To achieve this growth target, the government would have
to make all out efforts to further boost production in various sub-
sectors like textiles, food and beverages, electronics, automobiles, chemicals (including fertilizers) and engineering
goods. The services sector which consists of transport and communication, trade, banking and insurance, ownership of
dwellings, public administration and defence and personal and
community services is projected to row from 6.8 percent in 2005-06 to 7.9 percent in 2009-10, giving an average growth
rate of 7.3 percent per annum for the MTDF period.

GDP and Sectoral Growth Rates

(Percentage)

Sectors 2004-05 2005-06 2009-10 Average

(Projections) (Projections) 2005-10

GDP 8.4 7.0 8.2 7.6
Agriculture 7.5 4.8 5.6 5.2
Manufacturing 12.5 11.0 12.2 11.6
Services 7.9 6.8 7.9 7.3

Investment and Savings:

The growth rate of GDP depends on the level of investment, addition to the labour
force, HRD and technological change. Traditionally, in projecting the growth rate of GDP, investment is considered to be the
binding constraint. Depending upon the targeted growth
rate, the level of investment is determined through the parameter of incremental capital output ratio (ICOR). The MTDF
projections keep this in view, but are essentially the result of the Planning Commission’s macro model.

The ICOR for Pakistan on the average has been estimated at 3.9 from 1980-81 to 2002-
03. The ICOR during the 1980s has been 3.5; the growth rate
during the 1980s was 6.5 percent and the total factor productivity increased by 2.6
percentage points per annum. Over the last couple of years, growth rate has increased sharply. The ICOR declined to 2.5 in
the 2003-04. In the past, under-utilised capacity existed
in the power, cement, automobiles, consumer durables and textiles industries and only
recently high growth rate has been achieved due to better capacity utilization in these industries. Current
y in power and automotive sectors, capacity has been fu y utilized,
whereas in the cement industry very little idle capacity exists. Nevertheless, there may still exist under-utilised capacity in
textiles and construction related input industries.

The ICOR can be brought down if the future growth is concentrated in the sectors with lower capital-output ratios and
through factor productivity improvement. The capital output ratios are lower in agriculture, small-scale manufacturing
, construction, wholesale and retail trade and services sectors. They are higher in mining and quarrying , electricity
and as, transport and large-scale manufacturing sectors. Since Pakistan is deficient in
infrastructure and energy demand is expected to rise rapidly, the ICOR would tend to rise.

Services Sector:

The services sector is projected to attain growth rates from 6.6 percent in 2005-06 to 7.4 percent in 2009-10, with an
average growth rate of 6.9 percent during the period 2005-10. Within the services sector, its various sub-
sectors, like transport, storage and communications would grow from 6.4 percent in 2005-06 to 6.8 percent in 2009-10
with an average growth of 6.4 percent during 2005-10. Similarly, the other sub-sectors including
wholesale and retail trade, finance and insurance, ownership of dwellings, public
administration defence, and community and social services on the average during 2005-10
are expected to grow by 8.6 percent, 5.4 percent, 4.6 percent, 6.3 percent and 5.1 percent respectively.

The services sector plays a vital role in sustaining the growth rate of Pakistan’s economy. With a share of over 50
percent in GDP, it makes substantial contribution towards
poverty alleviation and improvement of the living conditions of the common man. The
MTDF broadly aims at achieving the following objectives for the development of services sector:
 (a) To sustain an average growth rate of 7.3 percent per annum in the combined output of services.

(b) To reduce the gap between receipts and payments of services in the balance of payments.

(c) To diversify the existing structure of output of services by inducing

domestic and private investment in business, finance, information technology (IT) and foreign trade related services.

(d) To encourage private sector participation (exclusively or through public-

private partnership) in areas still dominated by the public sector e.g. ports,
roads, highways, mass transit, civil aviation, telecommunication, broadcasting, telecasting , health and education
services.

(e) To encourage and assist private sector in setting up specialized research

establishments and training institutions to cater to the state of the art services both for domestic as well as foreign
markets.

(f) To improve regulatory framework by encouraging individuals to form professional bodies/associations in areas of their
interest.

(g) Standardization, recognition and accreditation of services institutions and facilities with international standards and
bodies.

Balance of Payments:

For MTDF, exports (gross) are projected to increase from US$ 14,050 million in 2004-
05 to US$ 28,125 million in 2009-10 at an annual compound growth rate of 14.9 percent. Imports (c&f) are projected
to increase from $ 19,291 million in 2004-05 to $ 36,491 million in 2009-10 at an annual compound growth rate of 13.6%. The
deficit trade balance is projected to increase from $ 3,555 million in 2004-05 to $ 5,211 million in 2009-10.

Investment Requirements in Pakistan:

To sustain a average GDP growth of 7.4 percent per annum during 2005-10, the investment level will have to be raised
from 19.7 percent in 2004-05 to 25.6 percent of GDP in 2009-10. To support higher levels of investment, the ratio of fixed
investment to GDP would have to rise from 18.1 percent in 2004-05 to 24.2 percent in 2009-10. For this purpose the level of
investment in private sector would be raised from 13.5 percent of GDP in 2004-05 to 16.5 percent during 2009-
10. The public sector investment would increase from 4.6 percent of GDP in 2004-05 to 7.7 percent in 2009-10. The
investment requirements for the plan period are summarized in Table I:

Investment Requirements

(As percent of GDP)

2005-06 2009-10

Targets Projections
Total investment 21.5 26.0
Fixed investment 19.4 24.3
Public 5.9 6.8
Private 13.5 17.5

Public Sector Development Programme:

Public spending on major infrastructure and goals will be as follows:

Public Sector Development Programme

(All figures in Rs. billion)

Sector 2005- 2009-10

06
Water resources 48.9 47.7
Transport & communications 47.9 79.5
Power 20.5 183.2
Fuel 0.6 1.0
Education & vocational training 16.3 33.8
Higher education 12.2 29.5
Information technology 4.6 6.3
Science & technology 3.9 17.6
Health & nutrition 14.4 21.6
Environment 4.3 7.1
 Culture, sports, tourism and youth 1.3 2.1
Khushal Pakistan Programme I 4.4 4.4
Khushal Pakistan Programme II 7.5 3.6
Local / District Government 7.4 17.4
Federal and provincial spending on agriculture & livestock 4.4 15.0

Agriculture Development:

Following are the targets for production of different crops:

Agriculture Production (2005-10)

(All figures in 000’ tonnes)

Items Targets
2005-06 2009-10
Grains:
Wheat 22139 25436
Rice 5000 6371
Maize 2905 3457
Other Cereals 621 713
Cash Crops:
Cotton (Lint) 2560 2892
Sugarcane 50095 56716
Tobacco 90 90
Pulses:
Gram 833 1067
Others 314 494
Oilseeds:
Cottonseed 5120 5783
Rape & Mustard & Canola 240 503
Sunflower 575 1006
Others 159 201
Vegetables:
Potato 2001 2527
Onion 1943 2361
Other Vegetables 3559 5116
 Fruits 6570 9445

Export Development:

Following are the targets for export during the MTDF 2005-10:

Export Projections for 2005-10

(All figures in US$ million)

Commodities Targets
2005- 2006- 2007- 2008- 2009-10
06 07 08 09
Textile & Garments:
Raw cotton 55 50 45 40 35
Yarn 1323 1389 1459 1532 1608
Fabrics 2103 2270 2450 2644 2853
Garments 2819 3095 3400 3735 4104
Madeups 517 569 626 688 757
Bed wear 1809 2080 2392 2751 3164
Towels 528 634 760 912 1095
Tents & canvas 84 88 93 97 102
Arts silk & syn. tex 556 595 637 682 729
Other textiles 80 80 80 80 80
Other Core Categories:
Rice 701 739 780 824 870
Leather goods 878 975 1085 1208 1347
Sports goods 362 387 414 443 474
Wool raw / Carpets 252 262 272 283 294
Surgical instruments 159 169 179 189 201
Petroleum products 362 417 479 551 634
Molasses 51 55 57 59 60
Developmental
Categories:
Fish & fish preparations 193 212 233 256 282
Fruits & vegetables 163 179 197 217 238
Chemicals (incl. Pharma) 390 507 659 857 1114
Engineering goods 231 324 457 647 920
Marble & granite 22 24 27 29 32
Gems & jewellery 41 48 57 67 79
I.T. Services 50 63 78 98 122
Meat & meat preparations 23 26 30 35 40
Poultry 9 12 15 20 26
Others:
Guar & guar products 26 28 29 30 32
Cement 48 56 64 73 84
Sugar 42 42 42 42 42
Oil seeds 18 22 26 31 37
Handicrafts 22 24 27 29 32
Tobacco 22 24 27 29 32
Spices 27 29 31 33 35
Other categories 1697 2338 3311 4673 6525
 Industrialisation
The modern era of human civilisation is known as the era of massive industrialisation, engineering and mining. The countries
like US, UK, France, Germany, Japan, Netherlands, Canada, Italy, etc., have dethroned poverty and unemployment through
industrialisation on massive scale. The newly emerging countries like China, South Korea, Malaysia, Taiwan, Mexico, etc. have
also shown a remarkable progress in raising their nation’s standard of living through industrialisation. But the countries like
India, Pakistan, Bangladesh, Sri Lanka, Nepal, Bhutan, etc. have failed to eradicate poverty and unemployment through
agriculture and so called industrial development. These less developed countries (LDCs) are caught up in a vicious poverty
circle, in which the productivity is very low, leading to a low level of income and purchasing power. The size of market is limited
by low purchasing power, and, hence, investment is discouraged. Since, there is less inducement to invest, the rate of capital
formation is low and the capital equipment available to each worker is small. Since the capital availability per worker is small,
productivity per worker is also very low. In this way, the vicious circle of poverty is completed on the demand side.
This vicious cycle of poverty can only be broken through production on massive basis. In other words, through industrialisation
on massive basis the living standard can be climbed up to a desirable level. We have success stories of UK, France, West
Germany and Japan, which were almost ruined after Second World War, they managed to re-industrialise their economies and
climbed up to a benchmark position. Therefore, it is obvious that the industrial development is very essential for any developing
country, either agricultural or non-agricultural, for the following reasons:

1. Increase in employment opportunities: Mostly LDCs are agrarian economies furnished with disguised unemployment,
that is, there is a surplus of labour with zero marginal productivity. Therefore, it is the industrial sector that can cope with
such heavy unemployment. Massive industrialisation provides employment opportunities on massive basis. Massive
industrialisation means establishment of more infrastructure facilities, which will in turn lead to more employment. It will
also lead to research facilities and innovation of new products. Industrialists will employ more capital equipment and labour
for the manufacture of new products.

2. Increase in living standard: Higher employment level, higher income level and greater variety of products mean higher
living standard. With optimum utilisation of natural and human resources of the country, through industrialisation, the
national income and the per capita income will rise. More industrialisation will provide greater stimulus to outputs and
stability to the economy.

3. Increase in productivity: With increased industrialisation, the industries are furnished with more capital equipment, new
production techniques, and skilled labour to enhance the productivity, improve quality, and reduce cost per unit. This will,
in turn, reap internal and external economies.

4. Attainment of internal and external economies: Heavy industrialisation enjoys the economies of scale. The term
'Internal Economies' refers to the situation, in which the individual firm gains along with technological and non-
technological factors, the larger the production, the lower the cost per unit. The external economies arise because the
development of an industry can lead to the development of ancillary services of benefit to all firms; a labour force skilled in
the crafts of the industry; a components industry equipment to supply precisely the right parts; or a trade magazine in
which all firms can advertise cheaply.

5. Reduction of BOP deficit: Increased productivity will have a positive effect on balance of payment. Higher the output
level, higher the export. All the leading industrialised countries of the world are the major players of globalisation, for
example, US, UK, France, Germany, Japan, China, South Korea, Malaysia, EU, etc. Thus, the balance of payment deficit
can be reduced through a substantial increase in export of industrially produced goods.
6. Increased savings and investments: With increased level of incomes, an industrialised economy enjoys increased
savings and investments. Foreign investors are encouraged to directly invest in the production, service and trade. Local
investors have confidence in the economy. Capital market becomes strong and stable. More employment opportunities
are available, in fact, labour become acute.

7. Increased government revenues: With increased level of income, the government revenues are increased. Therefore,
the government is able to provide more public facilities, like health care, research and education, infra structure, old age
benefits, unemployment allowance, cost of living allowance, civil defence, etc.
 Industrial Development in Pakistan
At the time of independence, Pakistan has inherited only 34 industrial units out of 921 industrial units in subcontinent. They were cotton textile,
cigarettes, sugar, rice husking, cotton ginning and flour milling industries; and together they contributed only 7% of GDP and employed a little over
26,000 employees.

Industrial development or history of industries in Pakistan can be divided into six phases:

Phase 1 (1947-1957):

1. This phase started from 1947 ended to 1958. During this period, the country was newly born and politically immature. During this 11-years
period, 8 prime ministers came into power. Not a single prime minister was strong enough to pursue the industrial policy well.

2. During this period, the policy emphasis was on import substitution.

3. Government had established a committee to formulate industrial policy.

4. This committee emphasized on manufacturing industries, reduction of imports, and net social and economic advantages to the country.

5. Pakistan Industrial Finance Corporation (PIFC) and Pakistan Industrial Credit and Investment Corporation (PICIC) were established in
1948.

6. To create skilled labour, a Swedish-Pak Institute of Technology was established in 1955.

7. Pakistan Industrial Technical Assistance Centre (PITAC) was established in 1956.

Phase 2 (1958-1969):

1. In 1958, a military government of Ayub came into power in Pakistan and announces a new industrial policy in 1959. This phase witnessed the
massive industrial growth in the country.

2. This industrial policy emphasis on private sector and the development of agro-based industries.

3. During this period, the government gave emphasis on intermediate and capital goods, i.e., electrical, chemical, machine tools, etc.

4. Various types of funds were established to promote the industrial development in the country.

Phase 3 (1973-1977):

1. During this period, a new democratic government of Bhutto came into power and adopted the principles of mixed economy.
2. Government ruthlessly nationalized 34 industrial units belonging to the following basic units:

(a) Vegetable ghee and oil industries (26 industrial units)

(b) Shipping industry

(c) Iron and steel industries

(d) Basic metal industries

(e) Heavy engineering industries

(f) Assembly and manufacture of motor vehicles

(g) Tractor plants

(h) Heavy and basic chemicals

(i) Petro-chemical industries

(j) Cement industries

(k) Public utilities including electric generations, gas and oil industries.

3. The nationalized industries were put under the management of Board of Industrial Management (BIM).

4. Pakistan Industrial Development Corporation (PIDC) was established.

5. Other reforms were taken by the government were:

(a) Labour reforms

(b) Abolition of bonus voucher system

(c) Reduction of sales tax on imported items

(d) Revision of import policy

(e) Establishment of industrial units in less developed / rural areas.

Phase 4 (1977-1988):

1. A new martial law government by Zia came into power in 1977. The new military government in 1977 announced the reversal of previous
government’s nationalization policy and introduced a new industrial policy.

2. The federal government offered for the transfer of shares of nationalized industries to their former owners, under Economic Reforms Order
1978, and thus the new open way for denationalization of industries.

3. Government announced tax holidays and revised import policy.

4. To boost private industrial development, following measures were taken:

(a) Reduction in interest charges by banks to 12.5% on all fixed investments.

(b) Removal of taxes on issuance of bonus shares.

(c) Fixing standard rebates of excise duty on additional 17 items.

Phase 5 (1988-2008):

1. During the first half of this phase, i.e., 1988 to 1999 the country had faced worst political conditions in the history of Pakistan.

2. Two governments had come into power for twice, i.e., Benazir’s Government and Nawaz’s Government, and not even governed for more than three
years. Therefore, the industrial policy was never the top priority of those two governments.

3. Nawaz Sharif, however, lightly emphasized on infrastructural development in Pakistan, but interrupted by the bloodless coup d’etat by Musharraf in
1999. Although Nawaz had adopted considerable economic policies, i.e., deletion policy, deregulation policy and privatization policy, which were also
pursued by succeeding governments. Much of these policies were influenced by IMF.

4. During the second half of this phase (i.e., 2000-2008), industries of Pakistan faced greater influence of cheaper goods imported under WTO
agreements.

5. The highlights of industrial policy of this phase are as below:

(a) Deletion Policy: Although this policy was announced during Phase 4 in 1987 but also pursued by the governments in later
phase. The objective of deletion policy was to obtain self-reliance in engineering sector.

(b) Deregulation Policy: Almost the whole industrial sector was exempted from the requirement of government sanctions except:

(i) Arms and ammunitions

 (ii) Security printing, currency and mint

(iii) High explosives

(iv) Radioactive substances

(c) Privatization Policy: To reduce the financial burden imposed on government and to reduce slack utilization of resources,
privatization policy was adopted and is still continued. The main objectives of privatization were to improve the overall performance of
state-owned industries and to promote healthy competition.
 Resource Mobilisation
There are two types of resource channels:
(a) Revenue Receipts: Revenue receipts can be bifurcated into:
(i) Tax Revenues, and
(ii) Non-Tax Revenues.
(b) Capital Receipts: Capital receipts can be classified into:
(i) External Borrowings, and
(ii) Internal Non-Bank Borrowings.
There are two ways through which resources can be mobilised. They are:
(a) Internal Resources: Resources can be mobilised internally by two methods. They are:
(i) Voluntary Savings: The task of voluntary savings is a crucial one. This can be done through moral suasion
and active government participation. The government should provide necessary incentives to increase the savings
through various policies programmes. The government should develop its financial sector so that it can act as an
efficient instrument for mobilising resources.
(ii) Involuntary Savings: Involuntary savings refer to the system of mobilising resources through tax revenues
and non-tax revenues:
 Tax Revenues: Taxation system occupies the most important place in the socio-economic aspect of a country to
mobilise the internal resources. The resources so obtained are then channelised for development purposes by
the government. Pakistan has imposed various types of direct and indirect taxes for raising revenues. These
include custom duties, excise duties, estate duty, income tax, corporate tax, taxes on sales and purchases,
terminal taxes and surcharges, etc. Tax revenues are ‘revenue receipts’.
 Non-Tax Revenues: Non-tax sources of revenues for the Federal Government are state trading profits,
earnings of commercial departments like post office, telegraph and telephone, interest charges on loans to
 provincial governments, local bodies, etc., whereas for the provincial governments, they include irrigation charges
and forests, etc.
(b) External Resources: The external resources include grants, loans and foreign aid of various types. Since the internal
resources are inadequate to meet the government expenditures, we have to rely heavily on foreign assistance. For this
purpose, we have been taking loans from IMF, IBRD, ADB and various developed countries.
How to Increase the Rate of Capital Formation:
A country can increase its capital formation through its own domestic saving and by inflows of capital from abroad. Following are
the ways to increase net capital formation as a percentage of national income:
(a) Capital Imports: We can increase the capital formation with the pain of reducing current consumption, by capital
inflows from abroad or exploitation of idle resources.
(b) Moral Suasion: The government should convince the people to save more. Sound national economic management,
coupled with a social security system, might make people less insecure about economic emergencies, so that they may
invest more in productive activity.
(c) Improvement to the Tax System: Saving is unconsumed current production. Taxation is one form of
saving. Improving the tax system increases saving. There should be emphasis on direct taxes, taxes on luxuries and
sales taxes.
(d) Increasing Investment Opportunities: Government subsidies, tariffs, loans, training facilities, technical and
managerial help and construction of infrastructure may increase saving because prospective entrepreneurs perceive
higher investment returns.
(e) Redistribution of Income: The government can encourage particular sectors and economic groups by its tax, subsidy
and industrial policies. It can redistribute income to persons with a high propensity to save or stimulate output in sectors
with the most growth potential and in which saving and taxation are high.
(f) Local Financing of Social Investment: Local government can levy taxes, that Federal Government cannot if the funds
are used to finance schools, roads or other social overhead projects that clearly benefit local residents.
(g) Inflationary Financing: The banking system can provide credit and the treasury can print money to loan to those with
high rates of saving and productive investment. Creating new money, although inflationary, increases the proportion of
resources available to high savers, so that real capital formation rises.
(h) Foreign Inflow of Capital: The foreign investors from developed countries are also invited to invest in the
country. Moreover, the foreign aid and assistance are also obtained from developed countries and international financial
institutions such as IMF, World Bank, ADB, Islamic Bank, Paris Club, EU, etc.
 Foreign Aid and Its Role in Economic Development
Definition of Foreign Aid:

Foreign Aid occurs when the recipient country receives additional resources in foreign currency over and above the capacity to
import generated by exports. In simple words, foreign aid means those additional resources which are used to raise the
performance of the recipient country above the existing level. It can be defined as the debt which is given by a country to
another country on the concessional rates. The concessional elements may be:

(a) Lower rates of interest than the prevailing rate of interest in the international commercial money market.

(b) Longer period for repayments.

(c) Grants which does not entail the payment of other principal or interest, i.e., a free gift.

A country which gives loan is called donor and the country which receives the loan is called recipient country.

Types of Foreign Aid:

There are two types of foreign aid, according to their source:

(a) Bilateral Aid: Bilateral aid is the aid which is given from the government of the donor country to the recipient
country. It depends upon political and economic relationships of various countries and it also depends on the will of donor
country.

(b) Multilateral Aid: Multilateral aid is the aid given by certain financial institutions, agencies or organisations to the
government of developing country. It is distributed in a fair manner in order to raise the pace of economic
development. So it is better than bilateral aid which is given on the basis of political considerations and the fear of the
domination of a donor country is also removed in the case of multilateral aid which may be helpful in raising the pace of
economic development.

Forms of Foreign Aid:

Following are the forms of foreign aid:

(a) Financial Aid: The simplest form of capital inflow is the provision of convertible foreign exchange, but very little foreign
capital indeed comes to the underdeveloped world so conveniently. Financial aid is further divided into various sub-forms,
i.e.:

(i) Tied Aid: Tied aid is of two types:

 Nation Tied Aid: is given to the recipient country on the condition that she will spend it in the donor
country to solve the BOP problems of that country and to stimulate exports, i.e., if Pakistan is given aid by US
and is asked to import raw materials or machinery from US only then it is ‘nation tied aid’ or ‘resource tied aid’.

 Project Tied Aid: is given only for specific projects and the recipient country cannot shift it to other projects.

(ii) Untied Aid: Untied aid is the aid which is not tied to any project or nation. It is, in all respects, better than the tied
aid because it offers more efficient use of foreign resources. It is much desired because in the case of untied aid the
recipient country is not bound to spend the foreign resources on specific projects or in the donor country which may
charge higher prices than international market.

(iii) Grants: A grant is that form of foreign aid which does not entail either the payment of principal or interest. It is a
free gift from one government to another or from an institution to a government. It is much desired because it increases
the internal expenditures and generates income. It is given on the basis of humanitarianism, especially in days of
emergencies, earth quakes, floods, wars, etc.

(iv) Loans: It is the borrowing of foreign exchange by the poor country from the rich country to finance short-term or
long-term projects. They are further sub-divided into two types:

 Hard Loans: Hard loans are also called short-term loans. In order to finance industrial imports they are given
usually for a period less than five years, and they are paid in the currency borrowed. It contains no concessional
element but interest rate is usually lower than the prevailing rate of interest in the international market.
 Soft Loans: Soft loans are also known as long-term loans. Soft loans are made for 10-20 years and it is
repaid in the currency of recipient country. Interest on these loans is lesser than hard loans and often these
loans invoice grace period. Concessional elements are comparatively greater.

(b) Commodity Aid: Commodity aid, in fact, is another type of tied aid, which relates to agriculture products, raw materials
and consumer goods. Under commodity aid, the donor country has much political influence on the recipient country, for
example, in 1960s, US gave wheat to Pakistan under PL-480 and had much influence on the development policy of
Pakistan. Commodity aid may be received in cash form or in the form of food grains:

(i) In Cash Form: If it is received in cash form it may be more helpful because then a country may buy more
commodities from cheaper sources.

(ii) In Food Grain Form: It is a special type of commodity aid, which is given in the form of food grains only, for
example, US gives food grains to the poor country under Public Law (PL-480) and funds obtained from it are used
on American companies and agencies operating in the recipient countries. The rest of the aid is granted.

(c) Food Aid: There is more than enough food produced each year to feed adequately everyone on earth. However, food
is so unevenly distributed that malnutrition and hunger exist in the same country or region where food is abundant.

During 1960s, the United States sold a sizable fraction of its agricultural exports under a concessionary Public Law 480,
where LDC recipients could pay for the exports in inconvertible currency over a long period. During late 1970s, about
three-quarters of the food aid went to low-income countries. It was about one-third of their cereal imports. Projections
indicate that food deficits are likely to increase in the 1980s and 1990s. In the early 1980s, the United States, which
provides the bulk of total food aid, reduced its food assistance.

Critics of food aid argue that it increases dependence, promotes waste, does not reach the most needy and dampens local
food production. Nevertheless, the food aid has frequently been highly effective. It plays a vital role in saving human lives
during famine or crisis, and if distributed selectively, reduces malnutrition. Unfortunately, poor transport, storage,
administrative services, distribution networks and overall economic complex hinder the success of food aid programmes,
but the concept itself is not at fault.

(d) Technical Aid: Technical aid is another form of tied aid and is much useful for the recipient country to increase the
pace of economic development by using the modern technology or skill in some specific sectors of the economy. Under
this aid programme, training facilities are provided by the donor country’s government and it bears all the expenditures
involved in the training of advisory technocrats. Technical assistance from the donor’s point of view takes two main forms:

(i) Through Recruitment: Technical assistance may be given through recruitment. Selected people of recipient
country are recruited in the donor country for service overseas, partly, often largely, at the expense of the donor
government.
 (ii) Through Scholarships & Training Facilities: The second form of technical assistance is scholarship and
training facilities in donor country for foreign students (from recipient country).

(e) Foreign Direct Investment (FDI): It is also included in the category of foreign aid. In Pakistan, the examples of FDI
are Lever Brothers, Reckitt and Colman, Bata, Philips, etc. It is often argued that FDI should be run under strict control,
like licensing, annual auditing, compulsory treatment of foreign capital as domestic capital, etc.

(f) Double Tied Aid: It is also known as ‘procurement tied aid’. It is the aid which is tied both for projects as well as for
resources.

Types of Foreign Aid to Pakistan:

The foreign aid received by Pakistan can be categorised as follows:

(a) Project Assistance: The large bulk of foreign aid received by Pakistan has been in the form of project assistance
which is tied in most cases, to both source and utilisation. Project aid is a type of aid allocated for particular development
ventures like irrigation projects or large industrial and communication networks which require a substantial imported
component.

Besides the imported component, there is also a local finance component of a particular project which has to be covered
by raising the necessary resources domestically. Once the domestic component of the project has been raised, the
government has to open a special account for the project and withdrawals from the account are possible only after the
approval of Aid Mission of the donor countries or agencies.

(b) Commodity Assistance: Commodity assistance, the second largest component amongst the different types of aid
received by Pakistan, has allowed some degree of flexibility to the country by not being tied to utilisation although in most
cases it is tied to sources. It is for this reason that Pakistan has preferred commodity over project assistance. However,
commodity assistance as a ratio of total aid decreased from 34% in 1960-65 to 23% in 1979-80.

(c) Food Aid under PL 480: The third largest component of aid received by Pakistan is commodity assistance under PL
480 provided by USA through the sale of surplus agricultural commodities. These commodities, ranging from wheat to
edible oil, have been purchased by Pakistan Government from US Government and were paid for Pakistani rupee till 1967
and in rupee and dollars after 1967. The funds generated by the sale of these surplus agricultural commodities are then
 deposited in a special counterpart fund controlled by US Government through its Aid Mission to Pakistan. The allocation of
these funds, termed as aid, between different activities has been prerogative of the US Government.

(d) Technical Assistance: This type of foreign aid is of great significance to Pakistan, because in Pakistan, there is a
shortage of technical knowledge, entrepreneurial skill and skilled labour. This type of foreign aid helps in increasing the
intangible value of our skill and semi-skill labour in particular projects, for example, construction of sea ports, dams and
other water projects, fly-overs, highways, motorways, underground railway system, high rise buildings, etc.

However, as these foreign experts are paid much higher salaries than what a local person of the same qualification can
expect to receive, the real value of technical assistance can be reduced with obvious resentment amongst local experts.

Need of Foreign Aid:

The principal economic arguments advanced in support of foreign aid are as follows:

(a) Foreign Exchange Constraints: External finance (both loans and grants) can play a critical role in supplementing
domestic resources in order to relieve savings or foreign-exchange bottlenecks. This is the familiar ‘two-gap’ analysis of
foreign assistance, which will be briefly discussed later in this chapter.

(b) Growth and Savings: External assistance also is assumed to facilitate and accelerate the process of development by
generating additional domestic savings as a result of the higher growth rates that it is presumed to induce. Eventually, it is
hoped, the need for concessional aid will disappear as local resources become sufficient to give the development process
a self-sustaining character.

(c) Technical Assistance: Financial assistance needs to be supplemented by ‘technical assistance’ in the form of high-
level manpower transfers to assure that aid funds are most efficiently utilised to generate economic growth. This
manpower gap filling process is thus analogous to the financial gap filling process.

(d) Absorptive Capacity: Finally, the amount of aid is determined by the recipient country’s absorptive
capacity. Typically, the donor countries decide which LDCs are to receive aid, how much, in what form (i.e. loans or
grants, financial or technical assistance), for what purpose and what conditions on the basis of their assessment of LDCs
absorptive capacity.

Criticism on Foreign Aid:

The following criticism has been forwarded on foreign aid:

(a) According to critics, foreign aid does not promote faster growth but may in fact retard it by substituting for, rather
than supplementing, domestic savings and investment and by exacerbating LDCs balance of payments deficits as a result
of rising debt repayment obligations and the linking of aid to donor country exports.

(b) The foreign aid is generally focused on and stimulates the growth of modern sector, thereby increasing the gap in
living standards between the rich and the poor in Third World countries. Rather then relieving economic bottlenecks and
filling gaps, aid, and for that matter private foreign investment, not only widens existing savings and foreign exchange
resource gaps but may even create new ones (e.g. urban rural or modern traditional sectors gaps).

(c) If the aid given is concerned with unproductive fields or obsolete technology, it will have the effect of increasing the
inflation in the country.

(d) The biggest objection which is imposed on foreign aid is that donor countries make interference in the economic and
political activities of the recipient country. The recipient country has to devise its economic policies in accordance with
the wishes of donor countries or international financial institutions.

Two-Gap Model:

The two-gap model was presented by Hollis Chenery and A. Strout as an approach to economic development. According to
them, most of the developing countries faced either:

 a shortage of domestic savings to match investment opportunities (i.e. the saving gap or constraint), or
 a shortage of foreign exchange to finance needed imports of capital and intermediate goods (i.e. foreign exchange
gap or constraint).

They also further assume that the savings and foreign exchange gaps are ‘unequal’ in magnitude and that they are
mutually ‘independent’. In other words, there is no substitutability between savings and foreign exchange, which is an unreal
assumption.

In an economy where the demand of investment cannot be met entirely by domestically generated savings nor through imports
financed by the country’s own export earnings, resources are transferred from abroad in the form of either loans, credits, grants,
remittances, or direct private foreign investment. This is the traditional ‘two-gap’ or dual approach to the analysis of the role of
foreign aid in economic development where foreign resources are assumed to fill both a saving-investment gap as well as a
foreign exchange gap in the recipient country. According to the assumptions of the two gap model, foreign aid, given an MPS,
raises the level of domestic savings by raising the level of income and exports with the result that at some terminal date, foreign
inflows are reduced to zero.

According to this model, a country passes through three stages on its way to self-sustained growth:

(a) In the first stage, the dominant constraint is that of absorptive capacity, i.e. the economy is so primitive and backward
that it cannot invest beneficially the minimum amount, i.e. 15% or so, necessary to achieve the required rate of growth let
say 5 to 6%. The purpose of foreign aid at this stage is to increase the absorptive capacity of the country by providing
technical assistance, training, education, managerial ability, entrepreneurial talent and so on. Once the absorptive
capacity of the economy has increase sufficiently, the constraint on growth is that of domestic savings.

(b) The second stage is the stage where there is a saving constraint on the economy. A country, like Pakistan, with a
low level of income and a large proportion of its population at subsistence level can hardly be expected to save 15-20% of
its national income. The suggested way out is that foreign aid may be used to supplement domestic savings and fill the
gap between domestic savings and the investment required for a reasonable level of growth. During this stage, the saving
gap will be greater than trade gap, and there may be some deficit BOP and high inflation as well.

(c) The third stage is the stage of trade constraint. As the economy grows, more and more inputs are required in the
form of capital goods, industrial raw materials, etc. Exports cannot keep pace with increasing imports and the resultant
difference between the two becomes larger and larger until it exceeds the difference between domestic savings and the
required savings. Therefore, at this stage, the trade gap is said to be dominant and the foreign aid is now required to
bridge this gap. However, at this stage, there is less need of foreign aid and assistance, because as the economy
develops further rising levels of income result in an increase in savings as a proportion of national income until the required
level is attained and the saving gap is closed. Also as development proceeds, first import substitution of consumer goods,
then their export and import substitution of capital goods takes place with the result that exports grow faster than the
imports and ultimately catch up with them and hence the trade gap is also filled. With the filling of this gap, the need for
foreign aid and assistance is now closed.

Foreign Aid to Pakistan:

Before discussing the foreign capital inflow in Pakistan, it is important to distinguish between pledges, commitments,
disbursement and utilisation of aid. These terms are frequently used to describe the various stages through which foreign aid
passes before being utilised in the recipient country. A pledge is a promise by the donor country to advance a specified amount
of foreign aid, commitment implies the allocation of foreign aid by the donor for specific projects or programmes, disbursement of
aid means the transfer of resources from donor to the recipient, and utilisation implies the actual implementation of foreign aid
financed projects.

Pakistan, like many other developing countries, has been relying on foreign assistance to supplement national saving to finance
investment. In order to bridge the resource gap, it started foreign borrowing as early as 1950s.

Over the years, there has been a continuous decline in the aid inflows to Pakistan. Net transfer which constituted about 90% of
the gross disbursements in 1964-65 dropped to 56% in 1977-78 and 50% in 1979-80.

In the early periods greater proportion of aid was received as grant or grant like aid or assistance. This type of assistance was
gradually reduced and its place was taken by hard terms foreign loans and credits repayable in foreign exchange with strict
terms and conditions such as tied aid and other conditionalities.

The share of grants and grants like assistance in total commitments was 80% during the first plan which was reduced to 46%
during the second plan, 31% during third plan and came to as low as 12% during non-plan period. Moreover, its share increased
slightly to above 20% during the fifth and sixth five year plan periods mainly due to relief assistance for Afghan refugees.

Pakistan’s Debt Servicing:

By subtracting the annual debt servicing (repayment of principal and interest) from gross aid, we deduce the net foreign aid
which is available to the recipient country for financing its imports and gross investment.

The annual debt servicing charges shown in official statistics are net of relief provided in the form of a moratorium. A moratorium
on debt means the postponement of the annual debt servicing obligations till some later time which no doubt provides temporary
relief to a foreign exchange crisis-ridden country. But since the debt has to eventually be repaid, a moratorium only delays, by
increasing its foreign exchange earnings, would at some later stage be in a position to fulfil its debt servicing obligations.

Pakistan's debt situation reached unsustainable level by 1999 because of persistence of large fiscal and current account deficits
during the last two decades. The ‘twin deficits’ resulted in an explosive accumulation of both domestic and external debt.
Domestic debt grew at an average annual rate of almost 28 % during the first half of the 80's; 22 % during the second half and
16 % during the first nine years of the 90's. In other words; Pakistan's total external debt and foreign exchange liabilities which
stood at $ 9 billion in 1980-81, reached almost $ 22 billion by the end of the 80's and by 97-98 touched a high figure of $ 42.7
billion.

The stock of public debt stood at Rs 155 billion by end of the 1970's and by end of the 80's another Rs 646 billion was added
which caused public debt to rise at Rs 801 billion. But by end of the 90's, another Rs 2430 billion was added to the public debt,
which stood at Rs 3231 billion. The absolute number of public debt is not much of interest. What is more damaging is the burden
of the public debt, which means as percentage of GDP or total revenue. At the end of 70's, the public debt was 56 % of GDP or
317 % of total revenue. It rose to 92 % of GDP or 505 % of the revenue by the end of the 80's. It was over 100 % of GDP and
630 % of the revenues by the end of the 90's. By any standard, this was horrifying number for any country. It was horrifying
because almost two-third of the revenues were consumed for debt servicing alone which forced the government to cut Public
Sector Development Programme (PSDP).

The various composition of expenditure also continued to change over the years. The share of defence in total expenditure was
24 % in 1980-81 while interest payment accounted for only 9 % and development budget was 41 % of total expenditure. By the
end of 1980's, defence spending increased marginally to 26 % from 24 % in beginning of 80's. The share of interest payments
more than doubled during this period from 9 % to 21 %. Development spending continued to shrink from 41 % to 25 %. In other
words, interest payment was taking over development expenditure in the country. As Pakistan entered the decade of the 90's the
composition of expenditure continued to deteriorate. Interest payments increased further to 33 % of total expenditure by the end
of the 90's, while development spending decline to 13 % and defence spending also shrank to 20 % .The onslaught of rising
interest payments continued to crowd out not only development spending but defence spending as well.

With President’s Musharraf’s policies, Pakistan has rescued the worst economic situation, but still there are lot of improvements
needed in the economy, especially in manufacturing sector and energy sector. The economy is now more stable. Interest
payment has started declining, it was as high as Rs 240 billion in 1999-2000 and declined to Rs 210 billion in 2003-04. Interest
payments were drastically reduced to 22.4 % from 33 % in the past. Most importantly public debt as percentage of GDP, which
was over 100 % a few years back, has declined to 91 %. Similarly public debt has percentage of total revenue which was as high
as 633 % has come down to 516 %. Most importantly, the external debt and foreign exchange liabilities have declined from $38
billion to $35 billion. Pakistan's external debt and liabilities to foreign exchange reserves ratio was 22 times in 1998-99 but with
the decline in debts and increase in foreign exchange reserves, the ratio declined sharply to 2.8 times in six years.

External Debt

(All figures in billion rupees)

 Particulars 2000-01 2001- 2002-03
02
External Debt 2059.5 2005.6 1927.7
Total Debt Servicing 340.3 431.2 304.7
Total Debt as % of GDP 113.5 104.3 95.1
External Debt as % of GDP 60.2 55.3 48.0
Ratio of External Debt Servicing to:
 Export Earnings 38.0 44.8 28.8

 Foreign Exchange Earnings 23.7 26.5 16.0

Ratio of Total Debt Servicing to:

 Tax Revenues 77.1 90.2 55.1

 Total Revenues 61.5 69.1 43.2

 Total Expenditure 47.4 52.2 34.1

 Current Expenditure 52.7 61.6 41.8

Pakistan’s Earthquake Disaster and the Role of Foreign Aid

An earthquake of 7.6 magnitude struck Pakistan, India, and Afghanistan, on October 8, 2005. The epicentre of the earthquake was located near
Muzaffarabad in Pakistani-administered Kashmir, and approximately 60 miles north-northeast of Islamabad. The most affected areas are the
NWFP and Azad Kashmir. More than 80,000 were killed, thousands of people injured and more than 3 million people were homeless in
Pakistan. According to United Nations, the loss and damages in October 8’s South Asia Earthquake are more than that of Tsunami struck Sri
Lanka, Indonesia and India in December 2004.

On call for aid on humanitarian basis from Pakistan, several countries come forward and generously announced aid and assistance for
earthquake victims. Initially US and Turkey announced $256 million and $250 million respectively. On 19th November the World Donor
Conference 2005 was held in Islamabad, in order to collect donations for the reconstruction and rehabilitation of earthquake affected victims
and areas. Among bilateral aid pledges United States was again on top. USA promises to provide $510 million in the Conference. About $5.9
billion were pledged on the same day and about $7 billion have been pledged so far. Most of these pledges include interest-free soft-loans
repayable within 40 years.
The USAID initially pledged $156 million to Pakistan for earthquake disaster relief, which includes $100 million for humanitarian relief and
reconstruction, and $56 million to support the Defence Department’s relief operations. The aid was further increased to $510 million pledged in
the Donor Conference 2005. Around 1000 American emergency management personnel are working in Pakistan to assist with relief efforts and
140 US military and civilian cargo airlifts have delivered thousands of tons of medical supplies, food, shelter material, blankets and rescue
equipment to the people of affected areas. Six US military ships have delivered 115 pieces of heavy equipment and 158 tons of humanitarian
assistance supplies through the port of Karachi.

In addition, American charitable organizations have raised $21.6 million for the relief effort and US companies have committed $47.9 million in
cash and in-kind contributions.

Turkey pledged aid worth $150 million to Pakistan out of which $100 million would be extended as financial assistance and $50 million in the
shape of relief goods and technical assistance. Apart from the contributions of US$150 million the Turkish Government has also committed
another US $ 3 million at the Geneva Donors Conference. Moreover, the Turkish Prime Minister Tayyip Erdogan became the first foreign
leader to visit Pakistan after the earthquake, and assured his country’s aid and assistance for relief efforts to Pakistan on long-term
basis. Turkey has also sent her medical and rescue teams to Pakistan. Turkey is also providing 1 million blankets and tents, 50000 tonnes of
flour and 25000 tonnes of sugar and cooking oil.

Star TV of Turkey organized a live telethon for donations. Turkish Prime Minister, Cabinet members and members of business community
participated with a target of is US$ 15 million. Turk Samanyolu TV, another channel collected US$ 3.7 million.

Several other countries and international organisations announced aid packages and assistance for Pakistan (before Donor Conference
2005):

 Saudi Arabia is on third rank with its financial support of US $133 for the quake victims. Saudi 1 TV Channel has also organised a live
telethon for donations and collected millions of dollars for earthquake victims in Pakistan.
 UAE announced $100 million aid package for Pakistan.
 Kuwait pledged $100 million to help the victims of the earthquake, half in immediate relief and half to finance infrastructure repairs under
the supervision of the Kuwait Fund for Arab Economic Development (a government organisation).
 Italy converts debts of US $70 million into relief, while another of 15 million US dollars will also be converted to be used for the
reconstruction and rehabilitation of the earthquake affected people. The Italian government has also offered training for Pakistani
officials in Disaster Management and preparedness.
 United Kingdom (UK) sent three Chinook Helicopters to Pakistan to take part in relief operations in Azad Kashmir and NWFP. UK has
also announced additional ₤20 million in aid.
 India announced Rs. 1 billion aid.
 China announced US $6.2 million aid for quake victims and also sent an emergency-response team. The Chinese government sent a
49-member international rescue team.
  Australia announced Australian $5.5 million (US $4.18 million) in aid, which include Australian $500,000 for immediate medical and
relief assistance. The funds will be channelled through Red Cross and Red Crescent.
 Ireland will provide one million euros to the relief effort in Pakistan.
 Afghanistan has announced US $500,000 financial help, four helicopters, 30 tonnes of dry fruit and 35-member rescue and relief
team. Afghanistan also observed a three-day mourning on the loss of lives due to the earthquake.
 Japan had sent a 50-strong emergency relief team. The team, formed by disaster rescue experts from fire fighting, police and coast
guard organizations, included police, disaster management and coast guard specialists. They are engaged in search and rescue
operations as well as information gathering.
 A military plane has been sent from Spain with emergency doctors, fire-fighters and medical supplies to help deal with the aftermath of
the South-Asian earthquake.
 The Swedish Rescue Services Agency was sending tents and blankets and the Czech government said it was ready to send rescue
teams with dogs.
 France sent sniffer dogs and cutting gear.
 Malaysian Red Crescent Society sent a 12-member team including four doctors and eight relief workers to Pakistan.
 Red Cross and Crescent workers from other Southeast Asian nations, including Indonesia, the Philippines and Singapore will also join
the relief efforts in Pakistan.

 European Union (EU) has proposed giving at least €80 million (US $96 million) in aid for reconstruction and relief activities for the
survivors of earthquake in Pakistan. This is in addition to the 13.6 million euros emergency humanitarian aid already released, bringing
the total proposed aid for 2005-06 to 93.6 million euros (US $111.7 million).
 World Bank offered US $20 million to Pakistan to help deal with the tragedy unleashed by the South Asia earthquake.
 Asian Development Bank (ADB) announced reallocation of $10 million for immediate emergency assistance in the worst-affected areas
of Pakistan.
 World Health Organization (WHO) has provided Pakistan with two emergency health kits, which will provide essential medical supplies
to care for a total of 20,000 people for three months. It has also announced five more kits as well as packages to cover 1000 surgical
operations in coming days.
 United Nations (UN) has sent its emergency coordination team to join relief efforts after the earthquake.
 NATO is planning to send engineers teams to open blocked roads and setting up hospitals in the quake ravaged areas.

According to the Government of Pakistan, Rs. 5.15 billion donations have been received in President’s Earthquake Relief Fund, while Rs. 5.35
billion donations have been pledged. And some US $ 2.05 billion foreign aid has been announced including US $1.93 billion aid pledges from
15-20 countries. It has been estimated that the time for reconstruction of earthquake devastated areas will take atleast three to five years. The
Government will need billions of dollars in the reconstruction and rehabilitation process, which could only be provided through foreign aid.
 World Donor Conference 2005

On 19th November, 2005, the World Donor Conference was held in Islamabad. The purpose of this Conference was to collect the fund necessary for the reconstruction and
rehabilitation of earthquake affected victims and areas. More than 56 countries attend the Conference, including the countries like India, Cuba, Russia, etc. President
Musharraf and Prime Minister Shaukat Aziz outlined the earthquake relief plan and the strategy to cope with the aftermath of earthquake, and the rehabilitation programme
necessary for the affected victims to survive such a mental and physical trauma. The Conference was a success. Government of Pakistan had requested the initial pledge
of $5.2 billion from the world community and received the pledge of $5.9 billion on the same day. About $7 billion have been pledged so far by the world community
including the big contributors World Bank and ADB with the pledges of $1 billion each. Most of these pledges included interest-free soft-loans repayable in 40 years. A
break-up of the aid pledges is given as below:

(all the figures in US$ million)

Countries and Multilateral Agencies Pledges
USA 510
China 300
Turkey 250
Saudi Arabia 233
Iran 200
Kuwait 150
Germany 130
UK 120
Japan 110
UAE 100
France 94
Italy 85
Australia 50
Switzerland 40
Norway 35
Sweden 20
Finland 11
Bangladesh 2
Malaysia 1
Indonesia 1
Afghanistan 0.5

World Bank 1000

ADB 1000
IMF 350
Islamic Bank 250
 EU 120
Pak-Turkish Education Foundation 36

Ireland € 1 million
India Rs. 1
billion

Besides above Canada, Russia, Singapore, Philippines, Spain, Cuba and many others have also promised to contribute in the relief efforts.
 Private Investment
Importance of Foreign Private Investment:

There is no doubt that the inflow of foreign capital accelerates the economic growth of under-developed countries in number of
ways:

(a) Foreign investment supplement domestic savings and harnesses them to secure a rapid rate of growth. It serves as
a stimulant to additional domestic investment in the recipient country. By increasing the rate of capital formation in the
country, it goes a long way in removing the capital deficiency which is the main hurdle in the economic growth.

(b) Foreign investment generally brings along with it technical know how. By providing technical expertise it helps in
building modern industrial structure in the receiving countries. In this way, it adds to their aggregate national product
and per capita income which not only works towards removing their poverty but increases the rate of savings which in turn
accelerates the process of their growth. In course of time, the vicious circle of poverty is broken and the beneficial circle of
prosperity is set in motion.

(c) Foreign investment provides valuable foreign exchange which is the desperate need of the developing
economies. It is generally observed that, in the early years of development, the import bill of such countries goes on
mounting because they have to import food grains, machinery and capital and essential industrial raw materials but their
exports lag woefully behind. This creates balance of payment difficulties in the solution of which foreign capital proves a
god send.

(d) Benefits also accrue from foreign investment to domestic labour in the form of higher real wages, to consumers in the
form of greater supply of consumer goods, larger in quantity, better in quality and greater in variety and to the
government in the form of higher tax revenues. The economy benefits through the realisation of external
economies. Since foreign capital helps in building up economic infra-structure in the form of means of transport and
communications, railways, roads, hydro-electric projects supplying irrigation and power, it undoubtedly results in
acceleration of the rate of growth.

Determinants of Private Investment:

The private investment rates in developing countries have varied significantly over time. In Pakistan, the private investment rate
fall sharply during 1990s. Instead of rapid economic growth, Pakistan witnessed slowing down of economic growth during
1990s. Investment rate decelerate from an average of over 19% of GDP to 15.6% by 1999. There are number of factors that
help explain these variations:

(a) Real Per Capita Growth Rate: There is general agreement among economists that a country’s growth rate would
have a positive impact on private investment. A higher growth rate would increase private investment activity if the
relationship between the level of real output and the desired capital stock is relatively fixed.

(b) Real Interest Rate: There are competing views about the effect of real interest rates on private investment. A high
level of real interest rates raises the real cost of capital, and therefore dampens the level of private investment. But there
is another side. Poorly developed financial markets in these countries and inadequate access to foreign financing for most
private projects implies that private investment is constrained largely by domestic savings.

(c) Level of Per Capita Income: Economists have argued that per capita income levels should be positively related to
private investment activity, because higher income countries are better able to devote resources to saving.

(d) Public Investment Rate: As with the real interest rate, the impact of the public investment rate (i.e., the ratio of public
investment expenditure to GDP) on private investment activity is uncertain.

(e) Domestic Inflation Rate: High rates of inflation adversely affect private investment activity by increasing the riskiness
of longer-term investment projects, reducing the average maturity of commercial loans, and distorting the information
conveyed by prices in the economy. In addition, high inflation rates are often considered a sign of macroeconomic
instability and the inability of government to control macro-economic policy, both of which contribute to an adverse
investment climate.

(f) External Debt Burden: Measured by its debt-service payments ratio and the ratio of external debt to GDP, the
external debt burden can have a powerful negative effect on a country’s private investment rate. A higher debt-service
payments ratio means that fewer resources are available for domestic use, including private investment, and hence should
have a direct adverse impact on private investment rates. A high ratio of external debt to GDP, which indicates that the
country has a large debt ‘overhang’, may also discourage private investment.

(g) Non Economic Factors: Besides the above economic variables, there are also other non-economic factors, such as
political stability and investor confidence, that play an important role in investment behaviour. Another factor is a country’s
tax and regulatory environment which also plays a vital role in establishing investor’s confidence in the administrative
structure of the country.
Investment Policy and the Current Situation in Pakistan:

According to Pakistan’s Board of Investment, our country’s investment policy is based on liberalisation policy. The main features
of Pakistan’s investment policy are outlined as below:

(a) All economic sectors open to Foreign Direct Investment.

(b) Equal treatment to local and foreign investors.

(c) 100 % foreign equity allowed.

(d) No Government sanction required.

(e) Attractive tax / tariff incentives package.

(f) Remittance of Royalty, Technical & Franchise Fee, Capital, Profits, Dividends allowed.

By October 2004, total foreign direct investment (FDI) stood at $950 million as against $472 million in October 1999. During the
year 2004-05, total investment provisionally estimated at 16.9%, slightly lower than last year 17.3%. Fixed investment as
percentage of GDP is estimated at 15.3% for the year 2004-05 as against 15.6% last year. Public Sector investment declined
from 4.8% in 2003-04 to 4.4% in 2004-05. During the year 2004-05 private sector investment rose marginally to 10.9%.

Net Inflow of Foreign Private Investment

(Direct + Portfolio)
(All figures in US$ million)
Country 2001-02 2002-03 2003-04 2004-05
USA 324.7 226.6 259.8 373.0
UK -2.1 184.8 41.9 199.1
UAE 17.3 120.4 146.5 417.3
Germany 11.2 3.8 4.0 15.2
France -6.6 2.6 -5.6 -3.5
Hong Kong 23.4 5.2 5.0 61.2
Italy 0.1 0.4 - 0.4
Japan 6.6 14.1 11.6 41.7
Saudi Arabia 1.4 43.6 5.3 18.2
Canada 6.2 0.5 0.5 2.0
Others 92.4 218.1 452.7 552.0
Total 474.6 820.1 921.7 1676.6
Source: State Bank of Pakistan
 Importance of Foreign Trade
Theory of Gains from Foreign Trade:

The gains from foreign trade can be broadly classified into:

(a) Static Gains: Static gains arise from optimum use of the country’s factor endowments or resources in men, money and
material, so that the national output is maximised resulting in increase in social welfare. Static gains result from the operation of
the theory of comparative cost in the field of foreign trade. Acting on this principle, the participating countries are able to make
optimum use of their resources or factor endowments so that the national output is greater than it otherwise would be. This
raises the level of social welfare in the country. Utility or welfare can be measured by indifference curves. Utility or welfare can
be measured by indifference curve. As a result of introduction or extension of foreign trade, the people can move to a higher
indifference curve. This has been shown in the following figure. Take two countries A and B both producing wheat and
cotton. Production possibility curve and indifference curves are shown as below:

In the above figure, it can be seen that, before the commencement of foreign trade, country A would be in equilibrium at the point
E where the price line PP’ is tangent to both production possibility curve AB and indifference curve IC1. The slope of the price
line shows the price ratio or cost ratio of the two commodities in the country A; TT’ is the terms of trade line showing the price
ratio at which goods can be exchanged between these two countries, TT’ line is tangent to A’s production possibility curve
AB. At point F, country A will produce more of cotton in which it has comparative advantage and less of wheat at F than at
E. Taking the pattern of demand in the country A, we have the indifference curves IC1 and IC2 representing the demand for the
two commodities. Now TT’ is tangent to IC2 at G which shows the quantities of wheat and cotton consumed by the country A. It
can be seen that as a result of introduction of foreign trade, the country A has moved from E on the indifference curve IC1 to G
on the difference IC2, which represents a higher level of social welfare in terms of larger consumption of the two trade
goods. This is called ‘static gain’ resulting from specialisation brought about by the introduction of foreign trade. It can also be
seen that the quantities of the two goods consumed and different from the quantities produced. The quantities produced are
shown at F and quantities consumed at G. The difference is accounted for by exports and imports. The country A will be
exporting KF quantity of cotton importing KG quantity of wheat.

The gain to country B can be similarly explained. Production possibility curve of B between wheat and cotton is shown by the
curve CD in the following diagram. It is clear that given the factor endowments, it is more profitable for B to produce wheat. The
country B fixes her production and consumption at point E before the introduction of foreign trade. At this point, price ratio line
PP’ and indifference curve IC1 are tangent to production possibility curve CD. The country B would gain from trade if it can sell
at a price ratio different from PP’. Given the terms of trade line TT’, the country B will produce at F on the production possibility
curve CD:
From the above diagram, it would be evident that the country B will produce more of wheat in which it has comparative
advantage and less of cotton in which it has comparative disadvantage. But given the price ratio as represented by terms of
trade line TT’, B will consume the quantities of two goods as shown by the point G where the terms of trade line TT’ is tangent to
the indifference curve IC2. It is clear that specialisation resulting from the introduction of foreign trade has enabled the country B
to move to the higher indifference curve IC2 and thus consume more of the two goods. This is her gain from international
trade. The country will now export KF amount of wheat and import KG amount of cotton. It may be borne in mind that in the
case of constant opportunity cost, each country resorts to complete specialisation i.e. producing only one of the two goods. On
the other hand, in case of increasing opportunity cost, specialisation is not complete so that a country produces relatively larger
quantity of the commodity in which it has comparative advantage.

(b) Dynamic Gains: Dynamic gains, on the other hand, refer to those benefits which promote economic growth of the
participating countries. International trade also brings to the participating countries that are known as dynamic gains. They
relate to economic growth and development which results from the introduction of international trade. According to the theory of
comparative cost, specialisation by different countries in producing commodities for which they are best fitted, results in a larger
volume of production and improves productivity. This obviously promotes economic development. There is no doubt that
extension of international trade has accelerated economic growth in the participating countries, like China, Malaysia, Indonesia,
Turkey, India, Pakistan, Sri Lanka, etc.
Role of Foreign Trade in Economic Development:

International trade increases national income and facilitates saving and opens out new channels of investment. Increase in
saving and investment is bound to promote economic growth. Exports earn foreign exchange which can be utilised in buying
capital and equipment and know-how from abroad which can serve as instruments of economic growth. The larger the national
income and output, the higher will be rate of growth. The higher level of output enables a country to avoid the vicious circle of
poverty and put the country in the ‘take-off’ or self-sustaining growth. Production possibilities and cost of production in different
countries differ so widely that foreign trade brings to the participating countries tremendous gains in terms of national output and
income.

Foreign trade promotes economic development in the following different ways:

(a) Acquisition of Capital Goods from Developed Countries: The under-developed countries (UDCs) are enabled by
foreign trade to obtain in exchange for their goods capital equipment and heavy engineering machines to foster their
countries’ economic development. For example, Pakistan exports rice, cotton and cotton textiles, leather and leather
goods, and sports goods and in exchange she imports heavy engineering machines and tools, trucks, and other capital
equipment from the developed countries.

(b) Import of Technical Know-how or Skills: An under-developed country (UDC) is short of all kinds of professionals like
engineers, architects, doctors, managers, accountants, economists, and other technical personnel. To cover this shortage
and to learn more, a UDC can allow the inflow of technical brains from developed countries.

(c) International Market: The foreign trade can extend the scope of the business to the international market. The
domestic market is limited, the foreign trade sector opens new vistas, new marketing channels and new markets. When
the markets are extended, the economies of scale are reaped, the efficiency and productivity will increase. Accordingly,
the forces of development will set themselves in motion.

(d) Foreign Investment: The foreign trade is also helpful in attracting foreign investment. The foreign investors are
attracted towards active trading countries and invest in the form of capital goods and technical expertise. In this way, the
assembling plants, the manufacturing plants and the latest technology will come into the country. As our recent investment
agreements with China, USA, UK, South Korea, Sweden, Hong Kong, Saudi Arabia and UAE will be helpful in promoting
trade and industries in the country.
 (e) Source of Public Revenue: When there is imports and exports of goods and services, the government can earn the
revenue in form of tariffs, custom duty, import licence fees, etc.

(f) Foreign Exchange Earnings: Moreover, the external sector also opens the employment opportunities for the country-
men in the foreign countries. Hundreds of thousands of Pakistanis are working abroad. Pakistan is earning billions of
dollars through foreign exchange remittances. Pakistan has earned $ 2.4 billion on account of workers’ remittances
working abroad during the year 2001-02, which increased to $ 4.2 billion during 2002-03. Therefore, such remittances are
proved to be a major source of foreign exchange earnings.

Import Substitution vs. Export Promotion:

There are two types of economic strategies – import substitution and export promotion, which are helpful in removing the deficit
in BOP and accelerating the process of industrialisation and economic development:

(a) Import Substitution: The import substitution strategy or ‘import-led’ or ‘inward-looking strategy’ aims at producing the import
substitutes in the country. The import substitution (IS) strategy will reduce the dependence of a country on foreign goods. It will
enable a country to produce the plants, machinery, electronic goods, consumer durables and a variety of goods. In this way, not
only the domestic production will increase, but the domestic employment will also be boosted up. This strategy provides self-
sufficiency in the economy. But at the same time the country has to rely on heavy foreign loans and assistance in order to
complete expensive projects.

The import substitution strategy fosters the process of industrialisation and economic development. It helps in protecting and
developing small and medium sized industries. It protects the local manufacturers and labour by protecting them from foreign
competitors.

During 1950s and 1960s, the major stress was laid upon initiating the IS strategy in Pakistan. As a result of such strategy the
manufacturing sector has had its foundations. The growth rate of manufacturing sector, during this period is estimated at 16%
p.a. Some economists accorded that Pakistan, on the basis of such IS strategy, has entered in the stage of ‘take-off’. The
import substitution strategy pursued in Pakistan was given the name of ‘Easy-Import Substitution Strategy’, which was mostly
confined to the establishment of consumer goods like textile and sugar industry. But inspite of import-substitution in the country,
we remained depending upon imports of capital goods, machinery, automobiles, chemicals, petro-chemicals and medicines, thus
increasing BOP deficits. Moreover, the industrial sector, which was came into being as a result of IS strategy, was extremely
inefficient. There was a misallocation of resources. The goods were produced at the prices higher than the international
prices. The investors engaged in import-substitution not only reaped abnormal profits, but they were also exempted from direct
taxes. They did not have to face competitors, trade-unions and even the anti-monopoly authority. Moreover, during this
period,‘multiple exchange rate system’ was prevailed in the country. Due to this system, the price of rupee had fallen to a
greater degree, which led to income disparity and unemployment. Moreover, during this era, Government’s major focus was on
industrial policies and she ignored altogether the development of agriculture sector.

(b) Export Promotion: Export promotion strategy is also known as ‘export-led’ or ‘forward-looking strategy’. Export promotion
strategy is aimed at boosting the exports of semi-manufactured and manufactured goods in place of traditional commodities and
improving the standard of exports. Export growth is equivalent to the economic growth. Because of comparative advantage
when a country specialises in a product, the export-led strategy enables her to make the product available to the world
community at cheaper prices. Thus, the international markets are extended for an exporting country. The income and
employment levels are expanded. Consequently, the process of economic development is facilitated.

The export promotion strategy will also attract the foreign capital. The countries which are well endowed with natural resources
like oil, gas, iron, rubber, tin and other mineral deposits and which are having potential and prospective comparative advantage
in these products would be able to attract the foreign investors. The foreign capital, foreign technology and foreign skill will open
new vistas. The output and employment will increase, and finally the export will go up.

In export promotion strategy, the subsidies and incentives are given to all the sectors of the economy, rather to a particular
sector of the economy (as in the case of import substitution strategy). When exports are boosted enough foreign exchange
could be earned which would be utilised in respect of importation. With the help of industrial imports, purchased with the foreign
exchange earned through exports, a country may also launch the process of industrial development.

The emphasis of Pakistan’s industrial policy has been more on import substitution than on export promotion. The position of
domestic industries results in higher prices for the consumer. Industries are become inefficient because of absence of foreign
competition, there is no incentive to reduce their production costs. The export industries of Pakistan have to be very efficient in
order to compete in the global market.

Pakistan’s Foreign Trade Sector:

Pakistan’s foreign trade balance has always been negative throughout its economic history except for the years 1947-48, 1950-
51 and 1972-73. In the first year after independence the country faced huge economic problems and as a result no attention
could be paid to industrial sector development. Import bill was less than one hundred million dollars and the trade balance, even
will small magnitude of exports, was positive. In the second year of independence, i.e. 1949-50, the trade balance was
negative. In 1950-51, because of Korean War boom, our exports increased by 140% as compared to the preceding year. This
huge increase in exports resulted in second ever positive trade balance. In 1972-73, Pakistan, once again, had a surplus
balance of trade after 21 successive yearly deficits. The success achieved in 1972-73was the result of deliberate policy actions
including devaluation and export promotion measures. This surplus partly as a result of a sharp increase in the volume and
value of exports and partly due to slower increase in imports. Besides the said financial years of surplus, Pakistan has never
achieved positive trade balance.

Pakistan’s Exports, Imports and Trade Balance

(All figures in US$ million)
Years Exports Imports Balance
1947-48 138 96 42
1950-51 406 353 53
1960-61 114 457 -343
1972-73 817 797 20
1980-81 2958 5409 -2451
1990-91 6131 7619 -1488
1998-99 7779 9432 -1653
1999-00 8569 10309 -1740
2000-01 9202 10729 -1527
2001-02 9135 10340 -1205
2002-03 11160 12220 -1060
2003-04 12313 15592 -3279
2004-05 14391 20592 -6201
 (a) Composition of Exports and Imports: Structure and composition of Pakistan exports and imports have changed over
time:

Composition of Pakistan’s Exports and Imports

(In Percentage)
Year Exports Imports
Primary Semi- Manufactured Capital Industrial Raw Consumer
Goods Manufactures Goods Goods Material Goods
Capital Consumer
Goods Goods
1969-70 33 23 44 50 11 29 10
1979-80 42 15 43 36 6 42 16
1989-90 20 24 56 33 7 41 19
1993-94 10 24 66 38 6 43 13
2000-01 13 15 72 25 6 55 14
2001-02 11 14 75 28 6 55 11
2002-03 11 11 78 31 6 53 10
2003-04 10 12 78 35 7 49 9
2004-05 11 10 79 36 8 46 10
In 1969-70 the primary commodities comprised a huge share of 33% of total exports, while of the shares of semi-manufactured
and manufactured goods were limited to 23% and 44% respectively. During the fiscal year 2004-05, the shares of primary, semi-
manufactured and manufactured commodities are 11%, 10% and 79%. The significant rise in manufactured commodities, i.e.
from 33% in 1969-70 to 79% in 2004-05, is a positive sign, but still Pakistan is lack of semi-manufactured goods. Pakistan has
to reduce the export of her primary commodities and increase that of semi-manufactured goods. This is due to the fact that our
primary commodities are short of international standards. Moreover, the prices of primary commodities are prone to severe price
shocks. Whereas, the market for manufactured goods is huge and stable.

The change in composition of imports has not been very conducive to long-term growth requirements. In the above table and
graph, it is indicated that the percentage share of ‘industrial raw materials for consumer goods industries’ has a significant rise
from 29% in 1969-70 to 46% in 2004-05. Whereas the percentage share of industrial raw material imports for capital good
industries has declined from 11% to 8%. The percentage share of imports of manufactured capital goods has decreased from
50% to 36%. This situation indicates that our consumer good imports (including industrial raw materials) have increased at a
rapid pace as compared with capital good imports which are prerequisite for long-term self-sustained economic growth. It is very
import to note that we are talking in terms of percentage share and not in terms of absolute values.
 (b) Terms of Trade: The TOT of the country has been deteriorating since long, which states that the prices of our exports are
decreasing while those of our imports are increasing. This is also one of the major shocks to our exports. Pakistan’s annual
terms of trade, and unit value indices of exports and imports are tabulated below:

Pakistan’s Annual Terms of Trade

and
Unit Value Indices of Exports & Imports
(Base Year: 1990-91)
Year Terms of Unit Value Unit Value
Trade Indices Indices
of Exports of Imports
2000-01 90.96 271.47 298.44
2001-02 90.83 271.18 298.56
2002-03 82.07 254.02 309.52
2003-04 78.68 279.65 355.43
2004-05* 73.60 288.84 392.45
* The figures of FY 2004-05 include the provisional figures of 4th Quarter (Apr-Jun).

(c) Workers’ Remittances: Workers’ Remittances are a major source of foreign exchange earnings and occupy a significant
place in financing the import bill of the country. Pakistan has shown a remarkable progress in workers’ remittances from
abroad. In 1972-73 the workers’ remittances stood at $136 million. In the year 1999-00, the workers remittances stood at
$983.73 million. It increases four-fold to $4236.85 million in 2002-03 within the period of two years. Such amount of workers’
remittances from abroad has never been achieved before in the economic history of Pakistan. This sharp increase shows the
confidence of expatriate Pakistanis in the transparency of economic and foreign policies:

Workers Remittances from Abroad

(All figures in $US Million)
Year Remittances
1998-99 1060.19
1999-00 983.73
2000-01 1086.57
2001-02 2389.05
2002-03 4236.85
2003-04 3871.58
 (d) Foreign Exchange Reserves: On November 12, 1998, the foreign exchange reserves of Pakistan were at a ridiculous
level of $415 million, hardly sufficient to finance two weeks of imports. The main reasons for such a low foreign exchange
reserves were huge budgetary deficit, uncontrollable debt servicing, low foreign investment, heavy government expenditures,
poor governance, and worst political conditions. Musharraf’s Government’s recent economic policies have survived the shortage
of foreign exchange reserves. With vigorous and transparent policies of the Government, Pakistan’s FOREX reserves stood at
$12.6 billion on June 30, 2005:

Pakistan’s FOREX Reserves

(All figures in US$ Billion)
Year End (June Total Liquid
30) Reserves
1992-93 0.46
1998-99 2.28
1999-00 1.97
2000-01 3.22
2001-02 6.43
2002-03 10.72
2003-04 12.33
2004-05 12.62
 (e) Exchange Rate: During the decade of 1990s, Pakistan has suffered a lot from huge fluctuations in foreign exchange
rates. During the year 1990-91, the rupee-dollar exchange rates averaged at Rs. 22.42 per dollar. With further devaluation of
rupee, the exchange rate climbed up to the level of Rs. 30 during the FY 1993-94 and Rs. 43 during the FY 1997-98. After the
nuclear test in May 1998 all the transactions through foreign currency accounts operating in Pakistani banks were
frozen. Different exchange rates prevail in the economy. The official exchange rate was around Rs. 46, whereas the
commercial banks announced their own exchange rates. During September 1998, the exchange rate in the open market was
averaged at Rs. 65. In June 2000, State Bank of Pakistan finally made adjustment in the exchange rate and as a result it
managed to pull down to Rs. 55.30 in the open market.

During the past four years, with the massive inflow of remittances, the foreign exchange reserves have been built up which, in
turn, has provided stability in the exchange rate.

Strategy to Promote Exports:

Pakistan is in emergent need to promote and foster her exports. During the past 50 years, Pakistan has shown a poor
performance in her export growth when compared to other Asian countries, like South Korea, India, Malaysia, etc. During 1980s,
it took 10 years to add an amount of just $ 2 billion in our exports, and during 1990s, it took 9 years to add an amount of just $
1.5 billion. However, Pakistan has shown a considerable achievement during the past 5 years adding $5 billion in total
exports. But still we need more than 100% increase in our exports. Pakistan’s exports to GDP ratio stands at a very low
percentage of just 13% when comparing to Sri Lanka with 27%, Indonesia 32%, Philippines 44%, Thailand 56%, Korea 39%
and Malaysia 96%. This simply suggests that Pakistan has to catch up with others. Following are few suggestions to promote
our exports in international market:

(a) Role of Private Sector: The following things needed to be done in enhancing the role of private sector:

 The first thing that the private sector must do is to improve their competitiveness by employing state of the art machinery;
through better management; through cost effectiveness; and by improving their working environment. They have a
comparative advantage in terms of relatively cheap labour, relatively low cost of capital, a strong macroeconomic
environment represented by a stable exchange rate, relatively low inflation and strong growth.

 The second most important task that private sector must undertake is to look for new markets and new products. Today
our exports are highly concentrated in few items and into few markets. More than 75% of our exports originate from four
items, namely cotton, rice, leather and sports goods. Similarly more than one-half of our exports go to 7 countries. This
state of affairs will not take us at higher export path. Diversification of exports, both in terms of commodity and regions will
be needed. For new markets we need to look at China, Japan, Latin America and ASEAN Region.

(b) Role of the Government:

 The first and foremost duty of the government is to provide a strong macroeconomic environment – an environment where
exchange rate is stable; a comfortable foreign exchange reserves; low cost of capital; low inflation, low budget deficit and
no debt crisis and consistent and transparent macroeconomic policies.

 The second most important duty of the government is to provide strong infrastructure – transport and communication,
roads and highways, power, well-functioning ports etc.

 The third most important duty of the government is to enter into active Trade Diplomacy. We have to explore the
possibilities in joining various Preferential Trading Arrangements (PTAs), and have to enter into bilateral negotiation at all
levels for Free Trade Arrangements (FTA).

(c) Value Addition: Pursue enhancement of manufacturing and marketing capabilities and efficiencies with a view to achieve
value addition and increased competitive strength for our core product categories.
(d) Women Entrepreneurship: To energize the women entrepreneurship in support of developing and realizing Pakistan's
export capabilities and potential, and enhance overall economic value addition.

(e) Marketing Support: Majority of our exporters are presently weak in the marketing management abilities and the financial
/human resources required for aggressive market share enhancement and product and geographical diversification. Due need of
upfront investment of funds, SME exporters are shy to invest. It is essential that professional and financial help be provided by
the government in partnership with the exporters, for aggressive international promotions, distributors and gaining access to new
customers and markets.

(f) Pakistan's Business Image: It is recognized that all countries have their strengths and weaknesses. Success depends upon
efficient capitalization of Strengths and management of Weaknesses to provide an honest and positive business image. It is also
recognized that image management has to be professionally achieved for best results.

(g) Human Resources and Skill/Technology Support: In alignment with the strategic product, geographic needs and
international trading regulations, the skills, training /technical facilities be enhanced amongst all stakeholders especially the
exporters, Pakistan's Missions and the Export Promotion Bureau, financial institutions and SMEDA.

(h) Quality, Social and Environment Management: Culture of 'TQM' (Total Quality Management) and 'CI' (Continuous
Improvement) needs to be inculcated and embedded in support of Quality, Social progressively and meet international standards
and specifications as a minimum. Appropriate regulatory framework, quality and social management processes such as ISO/SA
certifications and a transparent efficient judicial process needs to be in support.

(i) Foreign Direct Investment and Finance: Foreign Direct Investment needs to be strongly encouraged to strengthen our
exporters management expertise, technological and infrastructural support, competitive edge and market access.

Transparent access to finance will be vital for the desired significant increase in exports. Sufficient access at internationally
competitive mark ups would need to be ensured, especially for the value adding and Developmental Product Categories.

(j) Small & Medium Enterprise Development: On a medium term basis, the success of Pakistan's exports must heavily rely on
the strength of our Small and Medium size exporters. EPB in alignment with the supply chain management efforts of SMEDA,
must help enhance the exporting and marketing capacity of the SME's inclusive of adequate finance through the relevant
financial institution i.e. State Bank, SBFC, RDFC and other DFI's.
 Balance of Payment
When a payment is received from a foreign country, it is a credit transaction while a payment to a foreign country is a debit
transaction. The principal items shown on the credit side are exports of goods and services, unrequited or transfer receipts in
the form of gift etc. from foreigners, borrowings from abroad, foreign direct investment and official sale of reserve assets
including gold to foreign countries and international agencies.

The principal items on the debit side include imports of goods and services, transfer payments to foreigners, tending to foreign
countries, investments by residents in foreign countries and official purchase of reserve assets or gold from foreign countries and
internal agencies.

The credit and debit items are shown vertically in the BOP account of a country. Horizontally, they are divided into three
categories, i.e.

(a) The current account,

(b) The capital account, and

(c) The official settlements account or official reserve assets account.

(a) The Current Account: It includes all international trade transactions of goods and services, international service
transactions (i.e. tourism, transportation and royalty fees), and international unilateral transfers (i.e. gifts and foreign aid).

(b) The Capital Account: Financial transactions consisting of direct investment and purchases of interest-bearing financial
instruments, non-interest bearing demand deposits and gold comprise the capital account.

(c) The Official Reserve Assets Account: Official reserve transactions consist of movements of international reserves by
governments and official agencies to accommodate imbalances arising from the current and capital accounts.

In other words, it measures the change in nation's liquid and non-liquid liabilities to foreign official holders and the change
in a nation's official reserve assets during the year. The official reserve assets of a country include its gold stock, holdings
of its convertible foreign currencies and SDRs and its net position in the IMF.

BOP Account Chart:

1. CURRENT ACCOUNT:
(a) Merchandise:

 Exports (+) (i.e. added)

 Imports (–) (i.e. deducted)

(b) Services:

 Services rendered (+)

 Services received (–)

(c) Transfer Payments:

 Transfer payments received (+)

 Transfer payments rendered (–)

(d) Current Account Balance

2. CAPITAL ACCOUNT:
(a) Financial Transactions:

 Borrowing from foreign countries (+)

 Lending to foreign countries (–)
 Direct investment by foreign countries (+)
 Direct investment to foreign countries (–)
 (b) Capital Account Balance

3. OFFICIAL ACCOUNT:
(a) Reserves:

 Increase in foreign official assets in the country (+)

 Decrease in official reserves of gold and foreign currency (i.e. official reserve
assets) (–)

(b) Official Account Balance

Pakistan’s balance of payment for the last three years is as follows:

Balance of Payment
(All figures in US$ Million)

Details 2001-02 2002-03 2003-04

1. Trade Balance: -294 -444 -1212
Exports (fob) 9140 10889 12395
Imports (fob)
9434 11333 13607
2. Services (Net): -2617 -2128 -3585

Shipment -740 -868 -1159

Other transportation 103 237 161

Travel -147 -402 -1035

Investment income -2319 -2211 -2206

Interest payment -1469 -1107 -870

Profits and dividends and purchase of crude oil -852 -1104 -1337

Other goods, services and income 486 1116 654

3. Current Transfers (Net): 5744 6775 6684

Private transfers – net 4249 5737 6110

Workers’ remittances 2390 4237 3871

FCA (residents) 285 -12 367

Outright purchases 1376 0 0

Export of currencies 0 429 0

Official transfers 1495 1038 574

of which: Saudi Oil Facility 579 637 302

4. Current Account Balance (1+2+3) 2833 4203 1887
5. Capital Account (Net) -1107 -136 -1247
6. Errors and Omissions 928 522 247
7. Overall Balance 2654 4589 887
 8. Financing -2654 -4589 -887

Changes in reserves -2792 -5209 -832

Assets -3082 -5261 -404

SDRs -4 -233 12

FOREX (SBP) -2713 -5678 -439

FOREX (Commercial banks) -365 650 23

Liabilities 290 52 -428

Use of fund credit 290 52 -428

Repurchases -194 469 -673

Purchases / Drawings 484 469 245

Exceptional financing 138 620 -55

SBP reserves 4337 9529 10564

Source: State Bank of Pakistan

Difference between BOT and BOP:

Balance of trade refers only to the merchandise balance or balance on ‘visible transactions’ alone. Visible items refer to the
commodity exports and imports entering the balance of trade. They are visible because they are recorded at the customs
barriers of the country.

On the other hand, the balance of payments refers to the sum of both the balance on ‘visible transactions’ as well as ‘invisible
items’. It also includes capital and financial accounts. Invisible items refer to the imports and exports of services. Such services
may be of various kinds for which payments have to be made or received, for example, transport charges, shipping freight,
passenger fares, harbour and canal dues, commercial services (fees and commissions), financial services (brokers’ fees) and
services connected with the tourist traffic and payment of interest on external debt. As against the commodity or merchandise
transactions, which are visible, these services are called invisible items of the balance of payments as they are not recorded at
the customs barriers.

Balance of Payment Equilibrium:

Equilibrium is that state of balance of payment over the relevant time period which makes it possible to sustain an open economy
without severe unemployment on a continuing basis.

In BOP equilibrium, we have to make certain assumptions for the simplicity of our analysis. These assumptions are:

(a) A given supply curve,

(b) No change in price expectations,

(c) Internal capital flows depend on the level of the interest rate at home and abroad,

(d) No accumulation of real capital.

It is evident that the balance of payments depends on both the level of domestic economic activity and the level of domestic
interest rate.

FE curve is the set of all transactions of income and interest rate levels for which the overall payments balance is in equilibrium,
i.e. neither in surplus nor in deficit (as shown in the following figure).
In the above figure, FE curve showing equilibrium in BOP. All the points above FE curve show surpluses in BOP and all the
points below FE show deficits. B is the target point of policy at which the nation has achieved both internal balance (full
employment without excessive inflation) and external balance.

Types of BOP Equilibrium:

There are two types of BOP equilibrium, i.e., static equilibrium and dynamic equilibrium:

(a) Static Equilibrium: The distinction between static and dynamic equilibrium depends upon the time period. In static
equilibrium, exports equal imports including exports and imports of services as well as goods and the other items on the
BOPs – short term capital, long term capital and monetary gold are on balance, zero. Not only should the BOPs be in
equilibrium, but also national money incomes should be in equilibrium vis-à-vis money incomes abroad. The foreign
exchange rate must also be in equilibrium.

(b) Dynamic Equilibrium: The condition of dynamic equilibrium for short periods of time is that exports and imports differ
by the amount of short-term capital movements and gold (net) and there are no large destabilising short-term capital
movements.
 The condition for dynamic equilibrium in the long run is that exports and imports differ by the amount of long term
autonomous capital movements made in a normal direction, i.e. from the low-interest rate country to those with high
rates. When the BOP of a country is in equilibrium, the demand for domestic currency is equal to its supply. The demand
and supply situation is thus neither favourable nor unfavourable. If the BOP moves against a country, adjustments must
be made by encouraging exports of goods, services or other forms of exports or by discouraging imports of all kinds. No
country can have a permanently unfavourable BOP, though it is possible – and is quite common for some countries – to
have a permanently unfavourable balance of trade. Total liabilities and total assets of nations, as of individuals, must
balance in the long-run.

Types and Causes of BOP Disequilibrium:

There are three main types of BOP Disequilibrium which are discussed below:

(a) Cyclical disequilibrium,

(b) Secular disequilibrium, and

(c) Structural Disequilibrium.

(a) Cyclical Disequilibrium: Cyclical disequilibrium occurs because of two reasons. First, two countries may be passing
through different paths of business cycle. Second, the countries may be following the same path but the income
elasticities of demand or price elasticities of demand are different. If prices rise in prosperity and decline in depression, a
country with a price elasticity for imports greater than unity will experience a tendency for decline in the value of imports in
prosperity; while those for which import price elasticity is less than one will experience a tendency for increase. These
tendencies may be overshadowed by the effects of income changes, of course. Conversely, as prices decline in
depression, the elastic demand will bring about an increase in imports, the inelastic demand a decrease.

(b) Secular Disequilibrium: The secular or long-run disequilibrium in BOP occur because of long-run and deep seated
changes in an economy as it advances from one stage of growth to another. The current account follows a varying pattern
from one state to another. In the initial stages of development, domestic investment exceeds domestic savings and
imports exceed exports.

Disequilibrium arises owing to lack of sufficient funds available to finance the import surplus, or the import surplus is not
covered by available capital from abroad. Then comes a stage when domestic savings tend to exceed domestic
 investment and exports outrun imports. Disequilibrium may result, because the long-term capital outflow falls short of the
surplus savings or because surplus savings exceed the amount of investment opportunities abroad. At a still later stage,
domestic savings tend to equal domestic investment and long term capital movements are on balance, zero.

(c) Structural Disequilibrium: Structural disequilibrium can be further bifurcated into:

(i) Structural Disequilibrium at Goods Level: Structural disequilibrium at goods level occurs when a change
in demand or supply of exports or imports alters a previously existing equilibrium, or when a change occurs in the
basic circumstances under which income is earned or spent abroad, in both cases without the requisite parallel
changes elsewhere in the economy. Suppose the demand for Pakistani handicrafts falls off. The resources
engaged in the production of these handicrafts must shift to some other line or the country must restrict imports,
otherwise the country will experience a structural disequilibrium.

A deficit arising from a structural change can be filled by increased production or decreased expenditure, which in
turn affect international transactions in increased exports or decreased imports. Actually it is not so easy,
because the resources are relatively immobile and expenditure not readily compressible. Disinflation or
depreciation may be called for to correct a serious disequilibrium.

(ii) Structural Disequilibrium at Factors Level: Structural disequilibrium at the factor level results from factor
prices which fall to reflect accurately factor endowments, i.e., when factor prices are out of line with factor
endowments, distort the structure of production from the allocation of resources which appropriate factor prices
would have indicated. If, for instance, the price of labour is too high, it will be used more sparingly and the
country will import goods with a higher labour content. This will lead to unemployment, upsetting the balance in
the economy.

General Measures to Correct BOP Disequilibrium:

To correct the different types of disequilibrium in BOP the following general measures are used:

(a) Exchange depreciation (price effect) or devaluation (by government),

(b) Deflate the currency,

(c) Tariffs,
(d) Import quotas, and

(e) Export duties.

(a) Exchange Depreciation (Price Effect) or Devaluation (by Government): Exchange depreciation means a reduction
in the value of a currency in terms of gold or other currencies under ‘free market’ conditions and coming about through a
decline in the demand for that currency in relation to the supply. This is usually applied to ‘floating exchange rates’. The
purpose of this method is to depreciate the external exchange value of the home currency, thus cheapening the domestic
goods for the foreigner. Whereas, under ‘fixed-parity system’ or ‘fixed exchange rate’, the reduction of currency value in
against the gold or other currencies is official and not market based. This official reduction of exchange rate is
called ‘devaluation’. The purpose of both ‘depreciation’ and ‘devaluation’ is to cheapen the domestic goods and boost up
the exports. But the governments regarded devaluation as a means of correcting a balance of payments deficit only as a
measure of last resort. They predominantly relied on deflation of the home market and international
borrowing. Devaluation or depreciation of the exchange rate can correct a balance of payment deficit because it lowers the
price of exports in terms of foreign currencies and raises the price of imports on the home market. This does not
necessarily succeed in its purpose. The immediate effect is similar to an unfavourable change in the TOT. For the
resources devoted to the production of exports, less foreign exchange is earned with which to pay for imports. If the level
of imports remained the same, more output would have to be diverted to exports and away from home consumption and
investment simply to maintain the status quo. Devaluation or depreciation could lead to a loss of real income without any
benefit to the balance of payments.

Pakistan has always faced negative BOT except for three years, i.e. 1947-48, 1950-51 and 1972-73. The newly born
Pakistan had a quite high exports and a handsome balance of trade (US $ 42 million). With the Korean War boom in
1950-51, once again Pakistan gained a surplus in BOT (US $ 53 million). However, the reason for 1972-73’s positive BOT
($ 20 million) was the massive currency devaluation in 1972 when the rupee was devalued from Rs. 4.76 to 2.3 times
higher level of Rs. 11 per US dollar. The exports increased significantly and the share of exports in GDP rose to 14.9%.

(b) Deflate the Currency: According to this method, the currency is deflated. As the currency contracts, prices will fall,
which will stimulate exports and check imports. But the method of deflation is also full of dangers. If prices are forced
down while costs, which are proverbially rigid (especially as regards wages in countries where trade unions are well
organised), do not follow suit, the country may face a serious depression and unemployment. Correcting the balance of
payments, therefore, once a disequilibrium has arisen is not an easy matter.
(c) Tariffs: Tariff is a tax levied on imports. It is synonymous with import duties or custom duties. Tariffs are used for two
different purposes; for revenue and for protection. ‘Revenue Tariffs’ are a source of government revenue and ‘Protective
Tariffs’ are meant to maintain and encourage those branches of home industry protected by the duties.

Tariff duties are of four types:

(i) Ad Valorem Tariff: It is levied as a percentage of the total value of the imported commodity.

(ii) Specific Duties: These are levied per unit of the imported commodity.

(iii) Compound Duties: These are a mixture of above two.

(iv) Sliding Scale Duties: These vary with the prices of commodities imported.

(d) Import Quotas: As a protective device, import quotas are alternative to tariffs. Under an import quota, fixed amount of
a commodity in volume or value is allowed to be imported into the country during a specified period of time. The major
objectives of import quotas are:

(i) to avoid foreign competition,

(ii) to provide greater administrative flexibility,

(iii) to solve the problem of BOP and BOT.

Import quotas are of the following five types:

(i) Tariff quota,

(ii) Unilateral quota,

(iii) Mixing quota,

(iv) Bilateral quota, and

(v) Import licensing.

 (e) Export Duties: When world prices are higher than domestic prices, there is an incentive to export. In such a situation,
a government may levy export duties. Export duties are used to prevent exports. The reason may be that exported
commodities are required domestically.

Causes of Disequilibrium in BOP with Reference to Pakistan:

Following are the main causes of disequilibrium in BOP with reference to Pakistan:

(a) Revenue oriented tariffs: The import and export tariffs of Pakistan are by and large revenue oriented. The balance of
payment reasons are no doubt taken into account in the determination of import and export duties. However, there are
numerous anomalies in these tariffs. There are cases where the raw materials for a finished article are taxed at such a high
rate that it is cheaper to import the finished articles rather than import the raw materials and produce the finished articles
locally. In cases like this, there can be no possibility for producing such articles for export.

The import and export tariffs need a thorough revision from the point of view of minimising the tax element in the cost of
production. The approach should be to tax consumption but not production.

(b) Adverse terms of trade: The TOT has a tendency to move against us. This is because of this fact that prices of our
exports decreasing the world market while the prices of our imports are constantly rising. The prices of our exports fall
because we export raw materials and semi-manufactured goods which cannot be stored for a long time. Our cotton and
leather are facing the competition of artificial and synthetic fibre from China, Malaysia, Korea, etc. On the other hand, the
prices of our import commodities are rising because they are finished and final products and can be disposed in the market
very quickly. In such state of affairs, our international receipts go on falling while our payments go on
increasing. Accordingly, the deficit is sure to occur.

(c) Import substitution policy of Pakistan: The emphasis of Pakistan’s industrial policy has been more on import
substitution than on export promotion. The position of domestic industries results in higher prices for the consumer. But
what is worse is that industries having a sheltered domestic market tend to become inefficient, because, in the absence of
foreign competition, there is no incentive to reduce their production costs. The export industries, on the other hand, have
to be very efficient in order to be able to compete in the world market, for they don’t have the luxury of a sheltered market
at home, in which they can thrive at the cost of the consumer. Besides, some of the export industries are much more
labour intensive than the import substitution industries.
(d) Export of primary commodities: The main factor for the disturbing export performances is the adverse trend in the
terms of trade. But the vulnerability to the TOT shock is the result of heavy dependence of the country’s export earnings
on primary commodities like cotton, rice, and semi-manufactured goods, which are subject to frequent price fluctuations in
the world market. To import stability to the country’s export trade, it has been suggested times and again that the export of
manufactured goods, for example, textiles, automobiles, heavy engineering goods, etc., should be increased.

(e) Capital account problem: The deficit in Current Account of BOP may be washed out by a surplus in capital
account. But this is not the case with Pakistan. We have to face the following problems relating to capital account:

(i) The foreign official loans are specific and tied in nature and are attached with political interference and
heavy rates of interest.

(ii) A lot of amount is spent on repayment of loans and debt servicing.

(iii) The private investors are still hesitant in making investment in our country because of several reasons, like
political instability, lack of proper infra-structure, lack of energy generation plants, involvement of official
procedures, and the element of stubbornness in the country.

(f) Trade restrictions of developed countries: The trade barriers raised by developed countries against the import of
manufactures especially on agricultural products by the developing countries is one of the important factors preventing
greater production and export by some industries in Pakistan, particularly the cotton textile industry. The dismantling of
these barriers through negotiations can go a long way in increasing Pakistan’s exports of manufactured goods.

(g) Inflation: Inflationary conditions are a serious obstacle to the promotion of exports. Inflation results in a rise in the
domestic cost of production so that the goods produced cannot compete in the world market, if the rate of exchange is not
suitably adjusted. So the control of inflation is essential for keeping Pakistani goods competitive and for promoting
exports. It has not been possible to control inflation in Pakistan even in recent years.

(h) Ever-increasing demand for imports: Our socio-economic set-up is import and ultra import biased. People have
craze to purchase imported goods. Accordingly, the demand for imported vehicles, consumer durables, electronics, etc. is
increasing day by day. Moreover, the increased population, urbanisation and demonstration effect has necessitated the
increase in demand for imported goods.
 (i) Political instability: The development of the economy depends on the political circumstances of that
country. Pakistan has been chronically suffered from different political shocks since her independence. Our exports and
BOP are the clear reflection of these political instabilities. For example, during 1988-89, exports were affected by the
political uncertainty and disturbances during the greater part of the year. The events starting from the dissolution of
National Assembly on 29th May 1988 made a deep imprint on the psychology of business communities.

Measures to Correct Disequilibrium in BOP:

The following steps should be taken in order to remove the deficit or disequilibrium in balance of payment of Pakistan:

(a) Exports: The enhancing of exports will result in increasing the supply of foreign exchange in the country. In order to
promote exports following steps should be taken:

(i) The proportion of manufactured goods be increased and that of primary and semi-manufactured goods be
decreased.

(ii) In addition to manufactured exports, the non-traditional exports like food processing, dairy farming,
vegetables and fruit canning, and dry fruits be promoted.

(iii) More and more delegates be sent abroad so that new markets could be explored. The export exhibitions
and fairs be arranged in the big trading centres of the world. The establishment of Expo Centres in Karachi and
Lahore is a good step. Such expo centres should also be established in Rawalpindi-Islamabad, Faisalabad,
Peshawar and the future city of Gwadar.

(iv) The quality and cost of the export goods be improved. Management philosophies like Continuous
Improvement, TQM, Kaizen, and 3Es be adopted.

(v) The exporters be provided with compensatory and concessionary finance along with rebates, tax holidays
and bonuses, etc. Export processing zones be increased and expanded in all the major cities.

(b) Imports: Our imports need proper check. Imports of only those goods should be allowed duty-free that are used in the
production of export goods. Following steps should be taken:
 (i) The imports of luxurious items should be restricted. The Government can impose heavy tariffs on foreign
goods or even ban the imports of certain foreign goods that are deteriorating the BOP situation.

(ii) The imports of capital goods and engineering goods should be allowed, which are necessary for the
economic development. Moreover, the Government should also allow the imports of those goods duty-free that are
used in the production of export goods.

(c) Increase in Invisible Receipts and Decrease in Invisible Payments: The efforts be made to reduce the invisible
expenditures. In this respect, the expenditures faced in respect of foreign embassies and foreign tours be decreased. The
facilities of higher education regarding science and technology, medicine and surgery, business and economics,
performing arts, etc. be provided for foreign students, especially from India, Afghanistan, Iran, Sri Lanka, Saudi Arabia,
Bangladesh, independent Muslim states of Russia and UAE. In this way we can earn a lot of foreign exchange and
remove the deficit in balance of payment. Moreover, the domestic airlines, shipping services, locomotives, recreational
places including resorts, historical places, shopping places, etc should be made attractive for foreign tourists. Most of the
countries are earning through their tourism and cultural sector, for example, Sri Lanka, Maldives, Malaysia, Indonesia,
Singapore, Thailand, UAE, Egypt, Turkey, etc.

(d) Industrialisation and engineering: Reduction of BOP depends on our rapid industrial production and the quality of
our products. We need to fully utilise the existing capacity of our industries, and to promote the process of industrialisation
and development of engineering sector. The Government can establish more technical and engineering institutes and
allow foreign faculties. The Government can also reduce sales tax or even allow tax exemptions on production and sale of
machineries and heavy engineering goods including electric generators.

(e) Explore new vistas: The disequilibrium in BOP can also be corrected by exploring new vistas and diverting the
resources to the production and sale of such new exportable goods and services. For example, the Government can find
handsome export earnings in the new fields of genetic engineering, IT, anti-terrorism technology, computer gaming (like in
South Korea), computer-based surgery, or even in the field of fashion designing, art and culture including sports.
National Income Accounting
 Micro and Macro Economics
The terms ‘micro-‘ and ‘macro-‘ economics were first coined and used by Ragnar Fiscer in 1933. Micro-economics studies the
economic actions and behaviour of individual units and small groups of individual units. In micro-economics, we are chiefly
concerned with the economic study of an individual household, individual consumer, individual producer, individual firm,
individual industry, particular commodity, etc. Whereas, when we are analysing the problems of the economy as a whole, it is a
macro-economic study. In macro-economics, we do not study an individual producer or consumer, but we study all the
producers or consumers in a particular economy.

Micro-Economics or Price Theory:

The term ‘micro-economics’ is derived from the Greek prefix ‘micro’, which means small or a millionth part. Micro-economic
theory is also known as ‘price theory’. It is an analysis of the behaviour of any small decision-making unit, such as a firm, or an
industry, or a consumer, etc. For micro-economics, in contrast to macro economic theory, the statistics of total economic activity
are valueless as far as providing clues to policy decisions. It does not give an idea of the functioning of the economy as a
whole. An individual industry may be flourishing, whereas the economy as a whole may be suffering.

In respect of employment, micro-economics studies only the employment in a firm or in an industry and does not concern to the
aggregate employment in the whole economy. In the circular flow of economic activity in the community, micro-economics
studies the flow of economic resources or factors of production from the resource owners to business firms and the flow of goods
and services from the business firms to households. It studies the composition of such flows and how the prices of goods and
services in the flow are determined.

A noteworthy feature of micro-approach is that, while conducting economic analysis on a micro basis, generally an assumption
of ‘full employment’ in the economy as a whole is made. On that assumption, the economic problem is mainly that of resource
allocation or of theory of price.

Importance of Micro-Economics: Micro-economics occupies a very important place in the study of economic theory.

1. Functioning of free enterprise economy: It explains the functioning of a free enterprise economy. It tells us how
millions of consumers and producers in an economy take decisions about the allocation of productive resources
among millions of goods and services.
 2. Distribution of goods and services: It also explains how through market mechanism goods and services produced
in the economy are distributed.
3. Determination of prices: It also explains the determination of the relative prices of various products and productive
services.
4. Efficiency in consumption and production: It explains the conditions of efficiency both in consumption and
production and departure from the optimum.
5. Formulation of economic policies: It helps in the formulation of economic policies calculated to promote efficiency
in production and the welfare of the masses.

Thus the role of micro-economics is both positive and normative. It not only tells us how the economy operates but also how it
should be operated to promote general welfare. It is also applicable to various branches of economics such as public finance,
international trade, etc.

Limitations of Micro-Economics: Micro-economic analysis suffers from certain limitations:

1. It does not give an idea of the functioning of the economy as a whole. It fails to analyse the aggregate employment
level of the economy, aggregate demand, inflation, gross domestic product, etc.
2. It assumes the existence of ‘full employment’ in the whole economy, which is practically impossible.

Macro-Economics or Theory of Income and Employment:

The term ‘macro-economics’ is derived from the Greek prefix ‘macro’, which means a large part. Macro-economics is an
analysis of aggregates and averages of the entire (large) economy, such as national income, gross domestic product, total
employment, total output, total consumption, aggregate demand, aggregate supply, etc. Macro-economics is the economic
theory which looks to the statistics of a nation's total economic activity and holds that policy change designed to alter these total
statistical aggregates is the way to determine economic policy and promote economic progress. Individual is ignored
altogether. Sometimes, national saving is increased at the expense of individual welfare.

It analysis the chief determinants of economic development, and the various stages and processes of economic
growth. Different macro-economic models of economic growth have been suggested, one of which most famous is Harrod-
Domar Model. It can be applied to both developed and under-developed economies.

Importance of Macro-Economics:
 1. It is helpful in understanding the functioning of a complicated economic system. It also studies the functioning of
global economy. With growth of globalisation and WTO regime, the study of macro-economics has become more
important.
2. It is very important in the formulation of useful economic policies for the nation to remove the problems of
unemployment, inflation, rising prices and poverty.
3. Through macro-economics, the national income can be estimated and regulated. The per capita income and the
people’s living standard are also estimated through macro-economic study. It explains the fluctuations in national income,
per capita income, output and employment.

Limitations of Macro-Economics:

1. Individual is ignored altogether. For example, in macro-economics national saving is increased through increasing tax
on consumption, which directly affects the consumer welfare.
2. The macro-economic analysis overlooks individual differences. For instance, the general price level may be stable, but
the prices of food grains may have gone spelling ruin to the poor. A steep rise in manufactured articles may conceal a
calamitous fall in agricultural prices, while the average prices were steady. The agriculturists may be ruined. While
speaking of the aggregates, it is also essential to remember the nature, composition and structure of the components.
 Statics, Dynamics and Comparative Statics
The economic theory is divided into two main branches, viz., economic statics and economic dynamics. These terms were first
introduced by August Comte in social sciences. Stuart Mill made use of these concepts in economics. These concepts were
further explained by Ragnar Frisch.
Economic Statics:
Literally the word ‘static’ implies causing to stand or unchanged. Static position is a position of rest or unchanged
position. However, economic statics does not imply absence of movement, rather it denotes a state in which there is a continuous,
regular, certain and constant movement without change.
According to Clark, static state is the absence of five kinds of change: the size of population, the supply of capital, the methods of
production, the forms of business organisation and the wants of the people.
Harrod is of the view that static analysis is concerned with a state of rest. State of rest does not signify a state of idleness but
simply lack of investment with the result that the economy repeats itself over time. Unlikely other predecessor economists, he
does not confine the concept of statics to a rigidly defined state of affairs. He also includes in it the once-for-all change whereby
the economy shifts from one state of rest to another.
Professor Hicks has a somewhat different notion of statics. According to him, economic statics studies stationary situations which
are devoid of any change and which do not require any relation to the past or the future. Thus, the static economic of his vision is
a timeless economy in which the various phenomena and their effects are analysed without reference to time. For instance, when
we say that if price is lowered by 5% demand rises by 3%, we are in the field of static analysis.
According to Frisch, in economic statics we do not study anything about the connection between conditions at various points of
time, e.g., sequences, lags, etc. The ordinary theory of demand and supply is an illustration of the static analysis. It builds up a
relationship between demand and supply as they are supposed to be at any moment of time.
The economic statics is based on the concept of a stationary state where everything churns steadily like a gramophone repeating
itself endlessly. It is an economic process which goes on at an even rate or which merely reproduces itself. The tastes, resources
and technology, etc, are not supposed to change over time. The factors which control production, distribution, exchange and
consumption are assumed to be constant, yet there is movement, though at a uniform rate.
Economic Dynamics:
The word ‘dynamics’ means causing to move. In economics, the term ‘dynamics’ refers to the study of economic change. It aims
to trace and study the behaviour of variables through time, and determine whether these variables tend to move towards
equilibrium.
According to Harrod, economic dynamics is chiefly concerned with continuing change, and therefore, necessitates the study of an
economy wherein the rate of change of income (output) is itself changing. The continuing acceleration and deceleration is the
essence of Harrodian Dynamics. His point can be further illustrated with the help of following diagram:

Let us assume that OF is the level of full of employment. Starting with the income level at A for the time interval at Ot1, the rate of
growth is zero. The study of the economy from point A to B, according to Harrod, is static. With the push up of the economy, the
income level rises from B to C at the time interval Ot2. According to Harrod, the dotted path between B and C is the subject matter
of economic dynamics because, during this interval, the rate of change of income is itself undergoing a change. The rate of growth
again becomes zero and analysis of the economy becomes static when moving from point C to D.
Ragnar Frisch has broadened the vistas of economic dynamics. According to him, economic dynamics is the process of change,
and should embody functional relationships of variables with different dates appended to them. Frish’s definition of economic
dynamics takes care of the past values of the several variables, their lags, sequences, rates of change and cumulative
magnitudes, etc.
Sameulson’s definition of economic dynamics states that the essence of dynamics that economic variables at different points of
time are functionally related including velocities, acceleration, or higher derivatives. His definition of economic dynamics includes
the phenomena of cyclical growth, cyclical fluctuations, speculation, cob-web theorems of price determinations, stagnation
thesis, perspective planning, etc.
Comparative Statics:
Comparative statics is a cross of statics and dynamics. In comparative statics, we study the change from one equilibrium
position to another as a result of changes in parameters. It helps us to know the direction and magnitude of changes in the
variable when certain date change, so as to cause a movement to a new equilibrium position. Professor J.M. Keynes based his
technique of shifting equilibrium on comparative statics. The Keynesian model predicts that an upward shift in the investment
function with cause a rise in the level of income, a rise in the level of saving, and a rise in the rate of interest. At original level of
income, investment exceeds saving. Equilibrium is restored by the rise in saving resulting from the rise of income, and by the fall
in investment resulting from the rise in interest rates. Similarly, the Keynesian theory predicts that a fall in the transactions
demand for cash will cause a rise in income, a fall in interest rates and a rise in saving and investment. Also, a downward
revision in expectations about the future interest rates will lower the rate, rise income and raise saving and investment. Such are
the shifts that Keynes studies with the aid of comparative statics.
 Some Concepts of NIA
Closed and Open Economy:
Closed Economy: A closed economy is the economy in which there is no economic dealings and social interaction with outside
the world. A closed economy is said to be a self-sustained, self-contained, self-sufficient and 100% sovereign economy. A
closed economy is a hypothetical economy. In the real world, it is impossible for a country, even for a socialist or communist
country, to not interact with its fellow countries. The existence of a closed economy is only assumed for economic study.
The closed economy is consist of three activities:
(a) Production activities,
(b) Consumption, and
(c) Accumulation or capital transactions.
The flow diagram of a closed economy is as follows:

Open Economy: Open economy is an economy having economic and social dealings with other countries of the world. In the
real world, all the economies are entered into extensive economic relationship with other economic systems. No country in this
world is 100% self-sufficient, self-contained and sovereign. Every economy to a certain degree is dependent on other economy,
esp., in the 21st century’s global village.
The activities of an open economy can be divided into:
(a) Production activities,
(b) Consumption,
(c) Accumulation or capital transactions, and
(d) Interaction with ‘rest of the world’.
The flow diagram of an open economy is as follows:

Stock and Flow Distinction:

There are two kinds of quantities:
(a) Stock, and
(b) Flow.
A stock is any quantity that is measured at a single instant in time. A flow is any quantity that must be measured over a period of
time. For example, the amount of orange juice a person drinks in a month is a ‘flow’. The amount of orange juice he has in his
refrigerator is a ‘stock’. The number of sheets of ¾ inch plywood in the warehouse is a stock. The number it sells in a typical
week is a flow.
Income is a flow, whether for an individual, or will all the individuals added up to get national income. everything that is done
with income is flow, for example, paying taxes, saving, consumption, etc.
The amount of money in existence is a stock quantity, not a flow quantity. When we talk about saving, we mean new saving
during a given period, not the total stock of a household’s wealth. Therefore, saving is flow and wealth is stock.
 National Income Accounts
What is National Income Accounting?
National income accounting is a term which is applied to the description of the various types of economic activities that are taking
place in the community in a certain institutional framework. In national income accounting, we are concerned with statistical
classification of the economic activity so that we are able to understand easily and clearly the operation of the economy as a
whole. In national income accounting the following distinctions are drawn between:
(a) forms of economic activity, namely, production, consumption, and accumulation of wealth;
(b) sectors or institutional division of the economy; and
(c) types of transactions, such as sales and purchases of goods and services, gifts, taxes, and other current transfers.
In national income accounting, a transactor is supposed to keep a set of three accounts in which transactions are recorded:
(i) In the first account, incomes and outgoings relating a productive activity of the transactor are brought
together. The difference between the two shows the profit or gain.
(ii) The second account seeks to show how this profit and any other income that accrues to the transactor are
allocated to different uses. The excess of income over outlay is saving.
(iii) The third account shows how this saving and any other capital funds are used to finance the capital expenditure
or to give loans to other transactors.
Since in an economy, there are numerous transactors, therefore, they are grouped into sectors. In a sector, accounts of a same
type are consolidated. The ‘sector accounts’ form the units in a system of national income accounting.
Comparison of National Income Accounting and Individual Income Accounting:
(a) Double entry book-keeping: Both national income accounting system and individual income accounting system are
based on the method of double-entry book-keeping. For example, under individual income accounting, a cash sale is
recorded as a debit in Cash Account and as a credit in Sales Account. Whereas, in national income accounting, the cash
transactions are not separately presented. Cash balances are recorded in the capital transaction account. The difference is
that the national income accounting does not record the second entry in detail.
(b) Individual vs. collective individuals: Individual income accounts or private accounts relate to an individual
businessman or a corporate firm. Whereas, the national income accounts are closely related to all the businessmen or
corporate firms in the community.
(c) Profit and loss account: Individual income accounts are usually presented in the form of a Profit and Loss Account or
Income Statement which shows the flow of income and its allocation during a year. The Balance Sheet shows the stock of
assets and liabilities at the end of the year. The Profit and Loss Account of a private businessman resembles in national
income accounting to what is called the Appropriation Account. The only difference is that in private accounting, the profit
often includes some elements of costs such as depreciation on plant and machinery and fees paid to the directors of the
company. On the other hand, in national income accounting, these incomes are shown net. There is no counterpart at all
of a Balance Sheet in national income accounting since there is a great difficulty in collecting such a huge bank of data
accurately and completely especially on uniform basis.
Income Statement of a Typical Firm
For the year ended on December 31, 2005
Debits Rs. Credits Rs.

To Sales Account By Cost of Sales:

(50,000 units @ Rs. 25)
1,250,000 Wages 750,000
Rent 150,000
Interest 150,000
Profit (residual) 200,000

Total 1,250,000 Total 1,250,000

National Product Account 2004-05

(Millions of rupees)
Flow of Product Rs. Flow of Earning Rs.
 Costs or Earnings:
Final Output
(500 million units @ Rs. 25) 12,500 Wages 7,500
Rent 1,500
Interest 1,500
Profit 2,000
Total 12,500 Total 12,500

Uses of National Income Accounting:

(a) Clear picture of the economy: The national income accounts or social accounts give a clear picture of the economy
regarding the GDP, national income, per capita income, saving ratio, production, consumption, disposable income, capital
expenditure, etc. It gives a clear view of the health of the economy and the way in which it functions. It also gives a view on
the living standard of the people.
(b) Promotion of efficiency and stability of the economy: To foster the economic growth, any government has to see
what she has achieved in the past and what has to be done in the future. For this purpose, the preparation of national
income accounts is quite inevitable for the promotion of economic efficiency and stability. It helps the government to set the
national priorities, such as education, inflation, unemployment, defence, social development, and industrialisation, etc., in
long-term and medium-term planning. It also helps the planner to set the economic objectives to be achieved in the near
future. Thus it serves the purpose of planning and controlling tool for public administrators.
(c) Measurement of economic welfare: Measurement of economic welfare is another purpose of the preparation of social
accounts. Through social accounting, we can know at a glace to what extent the masses are better off than at the time when
planning started.
(d) Interrelationship of different sectors of the economy: Through the study of national income accounts, the reader is
in a position to inter-relate different sectors of the economy. For example, through the study of national income accounts,
we can know that Pakistan’s industrial sector is largely dependant on agriculture sector, because most of the raw materials
like cotton, silk, leather, sugarcane, milk, poultry, etc. are supplied from agriculture.
(e) Monetary, fiscal and trade policies: The national income accounts are very essential for the statesmen, governments,
and politicians, because they help them to efficiently formulate different economic policies, including monetary policy, fiscal
policy and trade policy. In the absence of national income accounts, the economic planning would be disastrous.
Gross National Product (GNP):
GNP is the basic national income accounting measure of the total output or aggregate supply of goods and services. It has been
defined as the total value of all final goods and services produced in a country during a year. GNP is a ‘flow’ variable, which
measures the quantity of final goods and services produced during a year. For calculating GNP accurately, all goods and
services produced in any given year must be counted once, but not more than once.
Approaches of Measuring GNP/GDP:
The primary purpose of national accounts is to provide a coherent and comprehensive picture of the economy. To be concise,
these estimates tend to answer questions such as:
(a) What is the output of the economy, its size its composition, and its uses? And
(b) What is the economic process by which this output is produced and distributed? These questions are addressed below
in relation to estimation of GDP/GNP and final uses of the GNP.
The gross national product (GNP) is the market value of all final goods and services, produced in the economy during a year.
GNP is measured in Rupee terms rather than in physical units of output. Gross domestic product (GDP) is a better idea to
visualize domestic production in the economy. GDP may be derived in three ways or in combination of them.
(i) Production Approach: It measures the contribution to output made by each producer. It is obtained by deducting from
the total value of its output the value of goods and services it has purchased from other producers and used up in
producing its own output, i.e.:
VA = value of output – value of intermediate consumption.
Total value added by all producers equals GDP.
(ii) Income/Cost Approach: In this approach, consideration is given to the costs incurred by the producer within his own
operation, the income paid out to employees, indirect taxes, consumption of fixed capital, and the operating surplus. All
these add up to value added.
(iii) Expenditure Approach: This approach looks at the final uses of the output for private consumption, government
consumption, capital formation and net of imports & exports. According this approach, GDP is the sum of following four
major components:
  Personal consumption expenditure on goods and services,
 Gross private domestic investment,
 Government expenditure on goods and services, and
 Net export to the rest of the world.
The concepts of expenditure approach and cost approach have been illustrated in the following diagram of circular flow of a
simplified two-sector economy:

In the above diagram, the upper loop represents the ‘expenditure’ side of the economy. Through this loop, all the products flow
from business sector to household sector. Each year the nation consumes a wide variety of final goods and services: goods
such as bread, apples, computers, automobiles, etc.; and services such as haircuts, health, taxis, airlines, etc. But we include
only the value of those products that are bought and consumed by the consumers. In our ‘two-sector economy’ illustration, we
have excluded the investment expenditure, government expenditure and taxes from GDP calculation.
The lower loop represents the ‘cost or revenue’ side of the economy. Through this loop, all the costs of doing business
flow. These costs include wages paid to labour, rent paid to land, profits paid to capital, and so forth. But these business costs
are revenues that are received by households in exchange of supplying factors of production to the business sector.
Precautions in Measuring GNP/GDP / Problems in National Income Measurement / Dangers of National Income
Accounts:
The federal statisticians and economists have to be very careful in measuring GDP or preparing national income accounts. The
following precautionary measures should be taken:
(a) Reliable source of data: All the data for national accounts are collected from different sources, including surveys,
income tax returns, retail sales statistics, and employment data. Inaccurate or incomplete data can severely damage the
integrity of the national accounts. The economists have to be very careful in collection and selection of national income
accounting data.
(b) Difficulties of Measuring Some Services in Money Terms: National Income of a country is always measured in money
terms, but there are some goods and services, which cannot be measured, in monetary terms. Such goods include, the
services of the housewife, housemaid and the singing as a hobby by an individual. Exclusion of these services from the
national income, underestimate the national income account.
(c) Illegal Activities in the Economy/The Growth of “Black Economy”: The “Black Economy” refers to that part of
economic activity, which is undeclared and therefore unrecorded for tax purposes and is therefore deemed to be
‘illegal’. Many illegal activities in the economy generally escape both the law and measurement in the national income. Such
illegal activities include, smuggling, drug trafficking and all parallel market transactions. Since such activities are outlawed,
income earned, through them are not captured in the national income, thus, under estimating the national income account.
(d) Danger of double counting: While measuring GDP, we have to distinguish between the three forms of goods:
(i) Final product: A final product is one that is produced and sold for consumption or investment.
(ii) Intermediate good: Intermediate goods are semi-finished goods or goods-in-process.
(iii) Raw material: Raw materials are unfinished and unprocessed goods.
To avoid double or multiple counting, it is necessary to add the value of only those goods which have reached their final stage of
production, i.e., final goods, and to not add the value of intermediate goods and raw materials, which are already included in the
value of final goods. GDP, therefore, includes bread but not wheat, cars but not steal.
(e) Problem of Including All Inventory Change in GNP: Firms generally record inventories at their original cost rather
than at replacement costs. When prices rise, there are gains in the book value of inventories but when prices fall, there are
losses. So, the book value of inventories overstates or understates the actual inventories. Thus, for correct computation of
GNP, inventory evaluation is required. This is achieved when a negative valuation of inventory is made for inventory gains
and a positive valuation is made for losses.
(f) Problem of Price Instability: Since national income is measured in money terms, fluctuation in the general price level
will render unstable the measuring rod of money for national income. When prices are rising, the national income figures
are rising even though production might have gone down. On the other hand, when prices are falling, GNP is declining even
though the production might have gone up. To solve this problem, economist and statisticians have introduced the concept
of real income.
(g) Exclusion of Capital Gain or Losses from GNP: Capital gain or losses accruing to property owners by increase or
decrease in the market value of their asset are not included in GNP computation because such changes do not result from
current economic activities. Such exclusions underestimate or overestimate the GNP.
(h) Value added: ‘Value added’ is the difference between a firm’s sales and its purchases of materials and services from
other firms. In calculating GDP earnings or value added to a firm, the statistician includes all costs that go to factors other
than businesses and excludes all payments made to other businesses. Hence business costs in the form of wages, salaries,
interest payments, and dividends are included in value added, but purchases of wheat or steel or electricity are excluded
from value added. The following table illustrates the concept of value addition in GDP:

Table 1
Bread Receipts, Costs, and Value Added

Rupees Per Loaf

Stages of (1) (2) (3)

Production
Sales Cost of Value
Receipts Intermediate Added
Materials (wages,
profit, etc.)
(1 – 2)
Wheat 2.00 0 2.00

Flour 5.50 2.00 3.50

 Baked dough 7.25 5.50 1.75

Delivered bread 10.00 7.25 2.75

Total 24.75 14.75 10.00

(i) Non-productive transactions are excluded from GDP: The non-productive transactions are excluded from GDP
measurement. There are two types of non-productive transactions:
(i) Purely financial transactions: Purely financial transactions are:
 All public transfer payments, which do not add to the current flow of goods such as social security payments,
relief payments, etc.
 All private financial transactions, such as receipt of money by a student from his father, etc.
 Buying and selling of marketable securities, which make no contribution to current production.
(ii) Sale proceeds of second-hand goods.
Difference between GDP and GNP:
GDP is the most widely used measure of national output in Pakistan. Another concept is widely cited, i.e., GNP. GNP is the
total output produced with labour or capital owned by Pakistani residents, while GDP is the output produced with labour and
capital located inside Pakistan. For example, some of Pakistani GDP is produced in Honda plants that are owned by Japanese
corporations. The profits from these plants are included in Pakistani GDP but not in Pakistani GNP. Similarly, when a Pakistani
university lecturer flies to Japan to give a paid lecture on ‘economies of under-developed countries’, that lecturer’s salary would
be included in Japanese GDP and in Pakistani GNP.
Net National Product (NNP):
Net national product (NNP) or national income at market price can be obtained by deducting depreciation from GNP. NNP is a
sounder measure of a nation’s output than GNP, but most of the economists work with GNP. This is so because depreciation is
not easier to estimate. Whereas the gross investment can be estimated fairly-accurately.
NNP equals the total final output produced within a nation during a year, where output includes net investment or gross
investment less depreciation. Therefore, NNP is equals to:
NNP = GNP – Depreciation
It is the net market value of all the final goods and services produced in a country during a year. It is obtained by subtracting the
amount of depreciation of existing capital from the market value of all the final goods and services. For a continuous flow of
money payments it is necessary that a certain amount of money should be set aside from the GNP for meeting the necessary
expenditure of wear and tear, deterioration and obsolescence of the capital and ‘it should remain intact’.
In the above definition, the phrase ‘maintaining capital intact’ is meant to make good the physical deterioration which has taken
place in the capital equipment while creating income during a given period. This can only be made by setting aside a certain
amount of money every year from the annual gross income so that when the income creating equipment becomes obsolete, a
new capital equipment may be created out. If the depreciation allowance is not set aside every year, the flow of income would
not remain intact. It will decline gradually and the whole country will become poor.
National Income or National Income at Factor Cost:
National income (NI) or national income at factor cost is the aggregate earnings of all the factors of production (i.e., land, labour,
capital, & organisation), which arise from the current production of goods and services by the nation’s economy. The major
components of national income are:
(i) Compensation of employees (i.e., wages, salaries, commission, bonus, etc.);
(ii) Proprietors income (profits of sole proprietorship, partnership, and joint stock companies);
(iii) Net income from rentals and royalties; and
(iv) Net interest (excess of interest payments of the domestic business system over its interest receipts and net
interest received from abroad).
National income can be calculated as follows:
National Income = NNP – Indirect Taxes + Subsidies
Personal Income:
Personal Income is the total income which is actually received by all individuals or households during a given year in a
country. Personal income is always less than NI because NI is the sum total of all incomes earned, whereas, the personal
income is the current income received by persons from all sources. It should be noted here that all the income items which are
included in NI are not paid to individuals or households as income. For instance, the earnings of corporation include dividends,
undistributed profits and corporate taxes. The individuals only receive dividends. Corporate taxes are paid to government, and
the undistributed profits are retained by firms. There are certain income items paid to individuals, but not included in the national
income, commonly known as ‘transfer payments’. Transfer payments include old age benefits, pension, unemployment
allowance, interest on national debt, relief payments, etc. Personal income can be measured as follows:
Personal Income = NI at Factor Cost – Contributions to Social Insurance – Corporate Income Taxes – Retained
Corporate Earnings + Transfer Payments
Disposable Income:
Disposable income is that income which is left with the individuals after paying taxes to the government. The individuals can
spend this amount as they please. However, they can spend in categorically two ways, i.e., either they can spend on
consumption goods, or they can save. Therefore, the disposable personal income is equal to:
Disposable Income = Personal Income – Personal Taxes
or
Disposable Income = Consumption + Saving
Details of National Income Accounts:
It is very important to take a brief tour of major components or particulars of national accounts or product accounts. In this way,
we can thoroughly understand the concept of GDP/GNP:
(a) GDP Deflator: The problem of changing prices is one of the problems economists have to solve when they use
money as their measuring rod. Clearly, we want a measure of the nation’s output and income that uses an invariant
yardstick. This problem can be solved by using ‘price index’, which is a measure of the average price of a bundle of
goods. The price index is used to remove inflation from GDP or to deflate the GDP, that is why, it is also called ‘GDP
deflator’. The function of GDP deflator is to convert the ‘nominal GDP’ or the ‘GDP at current prices’ to ‘real GDP’. The
formula of real GDP is as follows:
Real GDP = Nominal GDP
GDP Deflator
or
Q = PQ
P
Nominal GDP or PQ represents the total money value of final goods and services produced in a given year, where
the values in terms of the market prices of each year. Real GDP or Q removes price changes from nominal GDP
and calculate GDP in constant prices. And the GDP deflator or P is defined as the price of GDP.
Example:
A country produces 100,000 litres of coconut oil during the year 2005 at a price of Rs. 25
per litre. During the year 2006, she produces 110,000 litres of coconut oil at a price of
Rs. 27 per litre. Calculate nominal GDP, GDP deflator and real GDP (using 2005 as
base year).
Solution:
Nominal GDP:
Year Price Quantity Price × Quantity
P Q PQ
Nominal GDP
2005 25 100,000 2,500,000
2006 27 110,000 2,970,000

Hence, during 2006, the nominal GDP grew by 18.8%.

GDP Deflator:
P1 = Current year price ÷ Base year price = Rs. 25 ÷ Rs. 25 = 1
P2 = Current year price ÷ Base year price = Rs. 27 ÷ Rs. 25 = 1.08
Real GDP:
 Year Nominal GDP GDP Deflator Real GDP
PQ P (PQ/P)
Q
2005 2,500,000 1 2,500,000
2006 2,970,000 1.08 2,750,000
Hence, during 2006, the real GDP grew by 10%.

(b) Investment and Capital Formation: Investment consists of the additions to the nation’s capital stock of buildings,
equipment, and inventories during a year. Investment involves sacrifice of current consumption to increase future
consumption. Instead of eating more pizzas now, people build new pizza ovens to make it possible to produce more
pizza for future consumption.
To economists, investment means production of durable capital goods. In common usage, investment often denotes
using money to buy shares from stock exchange or to open a saving account in a bank. In economic terms,
purchasing shares or government bonds or opening bank accounts is not an investment. The real investment is that
only when production of physical capital goods takes place.
Investment can be further categorised as:
(i) Gross investment: Gross investment includes all the machines, factories, and houses built during a year –
even though some were bought to replace some old capital goods. Gross investment is not adjusted for
depreciation, which measures the amount of capital that has been used up in a year.
(ii) Net investment: Gross investment does not adjust the deaths of capital goods; it only takes care of the births
of capital. However, the net investment takes into account the births as well as deaths of capital goods. In other
words, net investment is adjusted for depreciation. Therefore, the net investment plays a vital role in estimating
national income:
Net Investment = Gross Investment – Depreciation
(c) Government Expenditure: Government expenditures include buying goods like from roads to missiles, and
paying wages like those of marine colonels and street sweepers. In fact, it is the third great category of flow of
products. It involves all the expenditures incurred on running the state. However, it does not mean that GDP includes
all the government expenditures including ‘government transfer payments’. The government transfer payments, which
include payments to individuals that are not made in exchange for goods and services supplied, are excluded from
GDP measurement. Such transfers payments include expenditures on pensions, old-age benefits, unemployment
allowances, veterans’ benefits, and disability payments. One peculiar government transfer payment is ‘interest on
national debts’. This is a return on debt incurred to pay for past wars or government programmes and is not a payment
for current government goods and services. Therefore, the interests are excluded from GDP calculations.
(d) Net Exports: ‘Net exports’ is the difference between exports and imports of goods and services. Pakistan is facing
negative net export situation since her birth, except for few years. The biggest reason is that Pakistan is a developing
nation and consistently importing capital goods and final consumption goods from developed countries at much higher
prices. Whereas, we export raw materials and intermediate goods at lower prices, which have less demand due to
their poor quality or because of availability of much cheaper substitute goods in the market.
 Circular Flow of Income
The amount of income generated in a given economy within a period of time (national income) can be viewed from three
perspectives. These are:

 Income,
 Product, and
 Expenditure.

The above assertion implies that we can view national income as either the total sum of all income received within a particular
period (income); the total good and services produced within a particular period (product) or total expenditure on goods and
services within a given period (expenditure). Whichever approach is used, the value we get is the same.

The circular flow of income and product is used to show diagrammatically, the equivalence between the income approach and
the product approach in measuring gross national product (GNP).

In analysing the circular flow of income, there are three scenarios:

1. A simple and closed economy with no government and external transactions, i.e., two-sector economy;

2. A mixed and open economy with savings, investment and government activity, i.e., three-sector economy; and

3. A mixed and open economy with savings, investment, government activity and external trade, i.e., four-sector
economy.

1. Circular Flow of Income in a Two-Sector Economy:

According to circular flow of income in a two-sector economy, there are only two sectors of the economy, i.e., household sector
and business sector. Government does not exist at all, therefore, there is no public expenditure, no taxes, no subsidies, no social
security contribution, etc. The economy is a closed one, having no international trade relations. Now we will discuss each of the
two sectors:

(i) Household Sector: The household sector is the sole buyer of goods and services, and the sole supplier of factors of
production, i.e., land, labour, capital and organisation. It spends its entire income on the purchase of goods and services
produced by the business sector. Since the household sector spends the whole income on the purchase of goods and
services, therefore, there are no savings and investments. The household sector receives income from business sector by
providing the factors of production owned by it.

(ii) Business Sector: The business sector is the sole producer and supplier of goods and services. The business sector
generates its revenue by selling goods and services to the household sector. It hires the factors of production, i.e., land,
labour, capital and organisation, owned by the household sector. The business sector sells the entire output to
households. Therefore, there is no existence of inventories. In a two-sector economy, production and sales are thus
equal. So long as the household sector continues spending the entire income in purchasing the goods and services from
the business sector, there will be a circular flow of income and production. The circular flow of income and production
operates at the same level and tends to perpetuate itself. The basic identities of the two-sector economy are as under:

Y=C

Where Y is Income

C is Consumption
Circular Flow of Income in a Two-Sector Economy (Saving Economy):

In a two-sector macro-economy, if there is saving by the household sector out of its income, the goods of the business sector will
remain unsold by the amount of savings. Production will be reduced and so the income of the households will fall. In case the
savings of the households is loaned to the business sector for capital expansion, then the gap created in income flow will be filled
by investment. Through investment, the equilibrium level between income and output is maintained at the original level. It is
illustrated in the following figure:
The equilibrium condition for two-sector economy with saving is as follows:

Y=C+S or Y=C+I or C+S=C+I

or

S=I

Where Y is Income

C is Consumption
 S is Saving

I is Investment

When saving and investment are added to the circular flow, there are two paths by which funds can travel on their way from
households to product markets. One path is direct, via consumption expenditures. The other is indirect, via saving, financial
markets, and investment.

Savings: On the average, households spend less each year than they receive in income. The portion of household income that is not used to
buy goods and services or to pay taxes is termed ‘Saving’. Since there is no government in a two-sector economy, therefore, there are no taxes
in this economy.

The most familiar form of saving is the use of part of a household’s income to make deposits in bank accounts or to buy stocks,
bonds, or other financial instruments, rather than to buy goods and services. However, economists take a broader view of
saving. They also consider households to be saving when they repay debts. Debt repayments are a form of saving because
they, too, are income that is not devoted to consumption or taxes.

Investment: Whereas households, on the average, spend less each year than they receive in income, business firms, on the average, spend
more each year than they receive from the sale of their products. They do so because, in addition to paying for the productive resources they
need to carry out production at its current level, they desire to undertake investment. Investment includes all spending that is directed
toward increasing the economy’s stock of capital.

Financial Market: As we have seen, households tend to spend less each year than they receive in income, whereas firms tend to
spend more than they receive from the sale of their products. The economy contains a special set of institutions whose function is
to channel the flow of funds from households, as savers, to firms, as borrowers. These are known as ‘financial markets’. Financial
markets are pictured in the center of the circular-flow diagram in the above figure.

Banks are among the most familiar and important institutions found in financial markets. Banks, together with insurance
companies, pension funds, mutual funds, and certain other institutions, are termed ‘financial intermediaries’, because their role is
to gather funds from savers and channel them to borrowers in the form of loans.

2. Circular Flow of Income in a Three-Sector Economy:

We have so far discussed the two-sector economy consisting of household sector and business sectors. Under three-sector
economy, the additional sector is the government. Two-sector economy is a hypothetical economy, whereas the three-sector
economy is much more realistic. The inclusion of the government sector is very essential in measuring national income. The
government levies taxes on households and on business sector, purchases goods and services from business sector, and attain
factors of production from household sector. The following figure illustrates three-sector economy:

In the above diagram, in one direction, the household sector is supplying factors of production to the factor market. Business
sector demands the factors of production from factor market. Inputs are used by the business sector, which produces goods and
services that are purchased back by the households and the government. Personal income after tax or disposable income that
is received by households from business sector and government sector is used to purchase goods and services and makes up
consumption expenditure (or C). The money spent in the product market is the market value of final goods and services (or
GDP). That money goes to business sector that pays it back in the form of wages, rent, profits and interests.

Total spending on goods and services is known as ‘aggregate demand’. The total market value of output produced and sold is
also known as‘aggregate supply’. To measure aggregate demand in a closed economy, we simply add consumption spending
(C), investment spending (I) and government spending (G). Therefore:

Y=C+I+G

Where Y is Income,

C is Consumption,

I is Investment, and

G is Government Spending.

Note that government spending (G) includes its buying of labour from factor market, buying of goods and services from product
market, and transfer payments to the household sector. Transfer payments are payments the government makes in return for no
service, for example, welfare payments, unemployment compensation, pension, etc. The government collects its money in the
form of tax, which makes up most of the government revenue. But the government does not always balance their budgets. The
government always tends to spend more than it takes in as taxes. The federal government almost always runs a deficit. The
government deficit must be financed by borrowing in financial markets. Usually this borrowing takes the form of sales of government
bonds and other securities to the public or to financial intermediaries. Over time, repeated government borrowing adds to the
domestic debt. The ‘debt’ is a stock that reflects the accumulation of annual ‘deficits’, which are flows. When the public sector as a whole
runs a budget surplus, the direction of the arrow is reversed. Governments pay off old borrowing at a faster rate than the rate at which new
borrowing occurs, thereby creating a net flow of funds into financial markets.

3. Circular Flow of Income in a Four-Sector Economy:

Two-sector economy and three-sector economy are briefly discussed in previous sections. These are hypothetical
economies. In real life, only four-sector economy exists. The four-sector economy is composed of following sectors, i.e.:
 (i) Household sector,

(ii) Business sector,

(iii) The government, and

(iv) Transaction with ‘rest of the world’ or foreign sector or external sector.

The household sector, business sector and the government sector have already been defined in the previous sections. The
foreign sector includes everyone and everything (households, businesses, and governments) beyond the boundaries of the
domestic economy. It buys exports produced by the domestic economy and produces imports purchased by the domestic
economy, which are commonly combined into net exports (exports minus imports). The inclusion of fourth sector, i.e., foreign
sector or transaction with ‘rest of the world’ makes the national income accounting more purposeful and realistic. With the
inclusion of this sector, the economy becomes an open economy. The transaction with ‘rest of the world’ involves import and
export of goods and services, and new foreign investment. It is illustrated in the following figure.
In four-sector economy, goods and services available for the economy’s purchase include those that are produced domestically
(Y) and those that are imported (M). Thus, goods and services available for domestic purchase is Y+M. Expenditure for the
entire economy include domestic expenditure (C+I+G) and foreign made goods (Export) = X. Thus:

Y+M=C+I+G+X

Y = C + I + G + (X – M)

Where, C = Consumption expenditure

I = Investment spending

G = Government spending

X = Total Exports

M = Total Imports

X – M = Net Exports

Economy Leakages and Injections:

Leakages: When households engage in savings and purchase of goods and services from abroad, we experience temporary
withdrawal of funds from circulation. Therefore, leakages in the circular flow are savings, taxes and imports

Injection: On the other hand, when we sell abroad (export) we receive income. More so when foreigners invest in our country
the level of income will also increase. These two activities are injection into the income stream. Therefore, injections are
investment, government spending and exports.

Total Leakages = Total Injections

C + I + G + (X-M) = C + S + Net Taxes

S + Net Taxes + Imports = I + G + Exports

 S = I + (G – NT) + (X – M)

One way of thinking about the circular flow of income is to imagine a water tank. Investment, government spending and
spending by foreigners is injected into the tank, and savings, taxes and spending on imports leak out. The injections and the
withdrawals are equal to each other so the level in the tank is stable, or as economists like to say in equilibrium.

If injections are greater than withdrawals or leakages then the level in the tank will rise. If withdrawals are greater than injections
then the level in the tank falls. If planned (I+G) is equal to planned (S+T), so that injections is equal to leakages and total
spending is equal to total income and total demand is equal to total supply. Then we have a ‘stable economy’. If leakages are
higher than injections i.e., planned savings plus taxes are greater than planned investment plus government spending (S+T >
I+G), economy contracts resulting in inventory accumulation, too little spending and drop in prices. If injections are higher than
leakages, i.e., planned investment plus government spending are greater than planned saving plus taxes (I+G > S+T), economy
expands resulting in more goods and services produced, and higher prices.
 Theory of Employment
TYPES OF UNEMPLOYMENT:

(a) Structural Unemployment: It is also known as Marxian unemployment or long-term unemployment. It is due to
slower growth of capital stock in the country. The entire labour force cannot be absorbed in productive employment,
because there are not enough instruments of production to employ them.

(b) Seasonal Unemployment: Seasonal unemployment arises because of the seasonal character of a particular
productive activity so that people become unemployed during the slack season. Occupations relating to agriculture, sugar
mills, rice mills, ice factories and tourism are seasonal.

(c) Frictional Unemployment: It arises when the labour force is temporarily out of work because of perfect mobility on
the part of the labour. In a growing and dynamic economy, in which some industries are declining and others are rising
and in which people are free to work wherever they wish, some volume of frictional unemployment is bound to exist. This
is so because it takes some time for the unemployed labour to learn new trades or to shift to new places, where there is a
demand for labour. Thus, frictional unemployment exists when there is unsatisfied demand for labour, but the unemployed
workers are either not fit for the jobs in question or not in the right place to meet this demand.

(d) Cyclical Unemployment: It is also known as Keynesian unemployment. It is due to deficiency of aggregate effective
demand. It occurs when business depression occurs. During the times of depression, business activity is at low ebb and
unemployment increases. Some people are thrown out of employment altogether and others are only partially
employed. This type of unemployment is due to the fact that the total effective demand of the community is not sufficient to
absorb the entire productive of goods that can be produced with the available stock of capital. When the businessmen
cannot sell their goods and services, their profit expectations are not fulfilled. So the entrepreneurs reduce their output
and some factors of production become unemployed.

(e) Disguised Unemployment: Disguised unemployment is the most widespread type of unemployment in under-
developed countries. In under-developed countries, the stock of capital does not grow fast. The capital stock has not
been growing at a rate fast enough to keep pace with the growth of population, the country’s capacity to offer productive
employment to the new entrants to the labour market has been severely limited. This manifests itself generally in two
ways:
 (i) the prevalence of large-scale unemployment in the urban areas; and

(ii) in the form of growing numbers engaged in agriculture, resulting in ‘disguised unemployment’.

In disguised unemployment, there is an existence of a very backward agricultural economy. People are engaged in
production with an extremely low or zero marginal productivity. Since the employment opportunities in non-agricultural
sector are not sufficient, therefore, most of the workers are bound to work in agricultural sector. This gives rise to the
concept of ‘disguised unemployment’, in which people are unwillingly engaged in occupations, where their marginal
productivity is very low.

THEORIES OF EMPLOYMENT:

The theories of employment are broadly classified into two:

(a) Classical theory of employment

(b) Keynesian theory of employment.

The classical theory assumed the prevalence of full employment. The ‘Great Depression’ of 1929 to 1934, engulfing the entire
world in widespread unemployment, low output and low national income, for about five years, upset the classical theorists. This
gives rise to Keynesian theory of employment.

Classical Theory of Employment:

The term ‘classical economists’ was firstly used by Karl Marx to describe economic thought of Ricardo and his predecessors
including Adam Smith. However, by ‘classical economists’, Keynes meant the followers of David Ricardo including John Stuart
Mill, Alfred Marshal and Pigou. According to Keynes, the term ‘classical economics’ refers to the traditional or orthodox principles
of economics, which had come to be accepted, by and large, by the well known economists by then. Being the follower of
Marshal, Keynes had himself accepted and taught these classical principles. But he repudiated the doctrine of laissez-faire. The
two broad features of classical theory of employment were:

(a) The assumption of full employment of labour and other productive resources, and

(b) The flexibility of prices and wages to bring about the full employment
(a) Full employment:

According to classical economists, the labour and the other resources are always fully employed. Moreover, the general over-
production and general unemployment are assumed to be impossible. If there is any unemployment in the country, it is assumed
to be temporary or abnormal. According to classical views of employment, the unemployment cannot be persisted for a long
time, and there is always a tendency of full employment in the country. According to classical economists, the reasons for
unemployment are:

(i) Intervention by the government or private monopoly,

(ii) Wrong calculation by entrepreneurs and inaccurate decisions, and

(iii) Artificial resistance.

The economy is assumed to be self-adjusting and perfectly competitive economy. It is the economy in which the relative values
of goods and services are determined by the general relations of demand and supply. The pricing system serves as the
planning mechanism.

(b) Flexibility of prices and wages:

The second assumption of full employment theory is the flexibility of prices and wages. It is the flexibility of prices and wages
which automatically brings about full employment. If there is general over-production resulting in depression and unemployment,
prices would fall as a result of which demand would increase, prices would rise and productive activity will be stimulated and
unemployment would tend to disappear. Similarly, the unemployment could be cured by cutting down wages which would
increase the demand for labour and would stimulate activity. Thus, if the prices and wages are allowed to move freely,
unemployment would disappear and full employment level would be restored. Further, the classical economists treated money
as mere exchange medium. They ignored its role in affecting income, output and employment.

Say’s Law:

1. Say’s Law is the foundation of classical economics. Assumption of full employment as a normal condition of a free market
economy is justified by classical economists by a law known as ‘Say’s Law of Markets’.
 2. It was the theory on the basis of which classical economists thought that general over-production and general
unemployment are not possible.

3. According to the French economist J. B. Say, supply creates its own demand. According to him, it is production which
creates market for goods. More of production, more of creating demand for other goods. There can be no problem of
over-production.

4. Say denies the possibility of the deficiency of aggregate demand.

5. The conceived Say’s Law describes an important fact about the working of free-exchange of economy that the main
source of demand is the sum of incomes earned by the various productive factors from the process of production itself. A
new productive process, by paying out income to its employed factors, generates demand at the same time that it adds to
supply. It is thus production which creates market for goods, or supply creates its own demand not only at the same time
but also to an equal extent.

6. According to Say, the aggregate supply of commodities in the economy would be exactly equal to aggregate demand. If
there is any deficiency in the demand, it would be temporary and it would be ultimately equal to aggregate
supply. Therefore, the employment of more resources will always be profitable and will take to the point of full
employment.

7. According to Say’s Law, there will always be a sufficient rate of total spending so as to keep all resources fully
employed. Most of the income is spent on consumer goods and a par of it is saved.

8. The classical economists are of the view that all the savings are spent automatically on investment goods. Savings and
investments are interchangeable words and are equal to each other.

9. Since saving is another form of spending, according to classical theory, all income is spent partly for consumption and
partly for investment.

10. If there is any gap between saving and investment, the rate of interest brings about equality between the two.

Basic Assumptions of Say’s Law:

(a) Perfectly competitive market and free exchange economy.

 (b) Free flow of money incomes. All the savings must be immediately invested and all the income must be immediately
spent.

(c) Savings are equal to investment and equality must bring about by flexible interest rate.

(d) No intervention of government in market operations, i.e., a laissez faire economy, and there is no government
expenditure, taxation and subsidies.

(e) Market size is limited by the volume of production and aggregate demand is equal to aggregate supply.

(f) It is a closed economy.

Pigou’s Theory:

1. According to Professor Pigou, the unemployment which exists at any time is because of the fact that changes in
demand conditions are continually taking place and that frictional resistances prevent the appropriate wage adjustment
from being made instantaneously.

2. Thus, according to classical theory, there could be small amounts of ‘frictional unemployment’ attendant on changing from
one job to another but there could not be ‘involuntary unemployment’ for a long period.

3. According to Professor Pigou, if people were unemployed, wages would fall until all seeking employment were in fact
employed.

4. Involuntary unemployment which was found at times of depression was because of the fact that wages were kept too high
by the actions of labour unions and governments. Therefore, Professor Pigou advocated that a general cut in money
wages at a time of depression would increase employment.

5. According to Pigou, perfectly elastic wage policy would abolish fluctuations of employment and would ensure full
employment.

6. The of the economy as described by the classical theory is depicted as follows:

Suppose the consumer saves 10% of his income. The result will be firm’s receipts fall by the same proportion. Profit will fall and
the firm will tend to react by reducing the output and hence reducing the employment and income. Therefore, to avoid this
problem the savings are channelled to firms through banking.

Criticism of Classical Theory:

 1. Supply may not create its own demand when a part of the income is saved. Aggregate demand is not always equal to
aggregate supply.

2. Employment in a country cannot be increased by cutting general wages.

3. There is no direct relationship between wages and employment.

4. Interest rate adjustments cannot solve savings-investment problem.

5. Classical economists have made the economy completely self-adjusting and self-reliant. An economy is not so self-
adjusting and government intervention is unobvious.

6. Classical economists have made the wages and prices so much flexible. In practical, wages and prices are not so
flexible. It will create chaos in the economy.

7. Money is not a mere medium of exchange. It has an essential role in the economy.

8. The classical theory has failed to explain the occurrence of trade cycles.

Keynesian Theory of Employment:

Keynes has strongly criticised the classical theory in his book ‘General Theory of Employment, Interest and Money’. His theory
of employment is widely accepted by modern economists. Keynesian economics is also known as ‘new economics’
and ‘economic revolution’. Keynes has invented new tools and techniques of economic analysis such as consumption function,
multiplier, marginal efficiency of capital, liquidity preference, effective demand, etc. In the short run, it is assumed by Keynes that
capital equipment, population, technical knowledge, and labour efficiency remain constant. That is why, according to Keynesian
theory, volume of employment depends on the level of national income and output. Increase in national income would mean
increase in employment. The larger the national income the larger the employment level and vice versa. That is why, the theory
of Keynes is known as ‘theory of employment’ and ‘theory of income’.

Theory of Effective Demand:

According to Keynes, the level of employment in the short run depends on aggregate effective demand for goods in the
country. Greater the aggregate effective demand, the greater will be the volume of employment and vice versa. According to
Keynes, the unemployment is the result of deficiency of effective demand. Effective demand represents the total money spent
on consumption and investment. The equation is:
Effective demand = National Income (Y) = National Output (O)

The deficiency of effective demand is due to the gap between income and consumption. The gap can be filled up by increasing
investment and hence effective demand, in order to maintain employment at a high level.

According to Keynes, the level of employment in effective demand depends on two factors:

(a) Aggregate supply function, and

(b) Aggregate demand function.

(a) Aggregate supply function:

1. According to Dillard, the minimum price or proceeds which will induce employment on a given scale, is called
the ‘aggregate supply price’ of that amount of employment.

2. If the output does not fetch sufficient price so as to cover the cost, the entrepreneurs will employ less number of
workers.

3. Therefore, different numbers of workers will be employed at different supply prices.

4. Thus, the aggregate supply price is a schedule of the minimum amount of proceeds required to induce varying
quantities of employment.

5. We can have a corresponding aggregate supply price curve or aggregate supply function, which slopes upward to
right.

(b) Aggregate demand function:

1. The essence of aggregate demand function is that the greater the number of workers employed, the larger the
output. That is, the aggregate demand price increases as the amount of employment increases, and vice versa.
 2. The aggregate demand is different from the demand for a product. The aggregate demand price represents the
expected receipts when a given volume of employment is offered to workers.

3. The aggregate demand curve or aggregate demand function represents a schedule of the proceeds of the output
produced by different methods of employment.

Determination of Equilibrium Level of Employment:

1. In the above diagram, AS curve shows the different total amounts which all the entrepreneurs, taken together, must
receive to induce them to employ a certain number of men. If the entrepreneurs are convinced to receive OC amount of
money, they will employ ON1number of labour.

2. The AD curve shows the different total amounts which all the entrepreneurs, taken together, expect to receive at
different levels of employment. If they employed ON1 level of employment, they expect to receive ON amount of proceeds
from the total output.
3. At ON1 level of employment, the economy is not in equilibrium. Because the total expected amount is greater than the
total amount paid:

OH > OC

4. The equilibrium level of employment is ON2, as at this point the AD curve intersects the AS curve or the AD is just
equal to AS. The amount of proceeds, i.e., OM which entrepreneurs expect to receive from providing ON2 number of jobs
is just equal to the amount i.e. OM which they must receive if the employment of that number of workers is to be
worthwhile for the entrepreneurs.

5. If the situation is such that the total amount of money expected to be received from the sale of output exceeds the
amount that is considered necessary to receive, there will be competition among the entrepreneurs to offer more
employment and thus, the employment will increase. On the left of N2, AD is greater than AS, i.e., the amount expected to
be received is greater than the amount considered necessary, there will be competition amount entrepreneurs to employ
more labour.

6. Beyond the N2, the AD curve lies below AS curve, which means that the amount expected by the entrepreneurs is less
that the amount they considered necessary to receive. Therefore, the number of persons employed will be reduced in the
economy.

7. The slope of AS curve, at first rises slowly and then after a point it rises sharply. It means that at beginning as more
and more men are employed, the cost of output rises slowly. But as the amount received by the entrepreneurs increases
they employ more and more men. As soon as the entrepreneurs start getting OT amount, they will be prepared to employ
all of the workers.

8. The AD curve, in the beginning, rises sharply, but it flattens towards the end. This shows that in the beginning as more
men are employed, the entrepreneurs expect to get sharply increasing amounts of money from the sale of the output. But
after employment has sufficiently increased, the expected receipts do not rise sharply.

9. Effective demand is that aggregate demand price which becomes ‘effective’ because it is equal to aggregate supply
price and thus represents a position of short-run equilibrium.
10. Effective demand also represents the value of national output because the value of national output is equal to the total
amount of money received by the entrepreneurs from the sale of goods and services. The money received by the
entrepreneurs from the sale of goods is equal to the money spent by the people on these goods. Hence the equation is:

Effective demand = National income

= Value of national output

= National expenditure

= Expenditure on consumption goods + Expenditure on investment goods

11. It is not necessary that the equilibrium level of employment is always at full employment level. Equality between AD
and AS does not necessarily indicate the full employment level. It can be in equilibrium at less that full employment or an
under-employment equilibrium.

12. Actually there is always some unemployment in the economy, even in economically advanced countries.

13. According to Keynes, full employment is the level of employment beyond which further increases in effective demand
do not increase output and employment.

14. At the point of intersection of AS and AD, the entrepreneurs are maximising their profits. The profit will be reduced if
volume of employment is more or less that this point. Even if the point does not represent full employment.

15. AD and AS will be equal at full employment only if the investment demand is sufficient to cover the gap between the
AS price and consumption expenditure. The typical investment falls short of this gap. Hence the AD curve and AS curve
will intersect at a point less than full employment, unless there is some external change.
 16. In the above diagram, in this situation of aggregate supply (AS), ON’ number of men were seeking employment,
whereas only ON number of men could secure employment.

17. In this situation, the economy has not yet reached the full employment level, and there are still NN’ number of workers
unemployed in the economy.

18. If the favourable circumstances push the economy and the AD increases so much that the entrepreneurs now find it
worthwhile to employ ON’ men at the equilibrium point E’, where the economy is in full employment level.

19. The situation in which the economy is in equilibrium at the level of full employment is called the ‘optimum situation’.

20. The root cause of the under-employment equilibrium is the deficiency of AD. This deficiency is due to the fact that
there is a gap between income and consumption. As income increases consumption increases but not proportionately. If
the investment is increased sufficiently to cover this gap, there can be full employment. Hence the gap between income
and consumption and insufficiency of investment to this gap are responsible for under-employment equilibrium.

Comparison between Classical and Keynes’ Theories:

(a) Equilibrium at full employment:

 (i) According to classical theory, the economy can only be in a state of equilibrium at full employment
level. Any deviation from full employment would be of short period.

(ii) Keynes’ theory is of the viewpoint that an economy can be in equilibrium even at less than full
employment level. There is a small possibility of full employment in a country.

(b) Macro vs. Micro:

(i) The classical economic theory dealt with individual aspects of the economy, and relates to
microeconomics.

(ii) Keynes’ theory relates to macroeconomics which studies the economy as a whole.

(c) Aggregates vs. Innumerable decisions:

(i) The classical economic theory studies the economic system in terms of innumerable decision making
units, for example, producers’ equilibrium and consumers’ equilibrium.

(ii) Whereas, the Keynes’ theory deals with aggregates, for example, aggregate supply and aggregate
demand.

(d) Wages and employment:

(i) Classical economists believed that a state of full employment could be brought about through cuts in
money wages.

(ii) According Keynes, lowering wages will reduce the aggregate income and so effective demand which in
turn reduce the level of employment in an economy.

(e) Interest:

(i) According to classical theorists, interest is the reward for ‘waiting’ or for time preference.

(ii) According to Keynes, interest is a reward for parting with liquidity.

(f) Rate of interest:

(i) According to classical theory, the rate of interest is determined by the interaction of savings and
investment.

(ii) According to Keynesian theory, the rate of interest is determined at different levels of income.

(g) Statics vs. Dynamics:

(i) The classical theory is based on the conception of static economy.

(ii) The Keynesian theory is based on the conception of dynamic economy.

(h) Full employment theory vs. General theory:

(i) The classical theory relates only to full employment.

(ii) The Keynesian approach is a general theory which has a very wide application at all situations, i.e.,
unemployment, partial employment and near full-employment.

(i) Theory of money and prices:

(i) The classical economists had segregated the theory of money from the theory of value and output, and
dealt with them as if they are unrelated to one another which is actually not the case.

(ii) Keynes’ theory is more realistic. He has integrated the theory of money and prices with the theory of
income and employment in the country.

(j) Budgeting:

(i) Classical economists believed in orthodox finance and balanced budgets.

(ii) According to Keynes’ a country’s budget should reflect the financial situation, and should vary in
accordance with the requirements. Keynes has not emphasised on balanced budget, because there are several
developing countries with deficit budgets dictated by their economic conditions and requirements.
 (k) Supply of money:

(i) According to classical economists, increase in money supply would bring about inflation and should be
controlled in order to avoid the employment less than full employment.

(ii) Whereas, the Keynes’ theory states that an appropriate increase in money supply would increase
employment and output and does not necessarily bring inflation.

(l) General price level vs. Individual commodity prices.

(m) Level of employment in a community vs. Employment of a particular class of labour.

Significance of Keynesian Theory:

1. Keynes has given a new approach, i.e., Macro-approach to the field of economics. His theory has several names:
theory of income and employment, demand-side theory, consumption theory, and macro-economic theory. In fact, he has
brought about a revolution in economic analysis, often known as ‘Keynesian Revolution’.

2. Keynes’ theory has completely demolished the idea of full-employment and forwards the idea of under-
employment equilibrium. He states that employment level in the economy can only be increased by increasing investment.

3. The new economic tools and techniques developed by Keynes have enabled the today’s economists to draw correct
conclusions on the economic situation of a country. Such tools are consumption function, multiplier, investment function,
liquidity preference, etc.

4. Keynes has integrated the theory of money with the theory of value and output.

5. Keynes has first time introduced a dynamic economic theory, in order to depict more realistic situation of the
economy.

6. He also states the reasons of excess or deficiency of aggregate demand through inflationary and deflationary gap
analysis.

7. Keynes’ theory is a general theory and therefore, can be applied to all types of economic systems.
 8. Keynes influenced on practical policies and criticised the policy of surplus budget. He advocated deficit financing, if
that sited the economic situation in the country.

9. Keynes has emphasised on suitable fiscal policy as an instrument for checking inflation and for increasing
aggregate demand in a country. He advocated extensive public work programmes as an integral part of government
programmes in all countries for expanding employment.

10. He advised several monetary controls for the central bank, which in turn will act as the instrument of controlling
cyclical fluctuations.

11. Keynesian theory has played a vital role in the economic development of less-developed countries.

12. He rejected the theory of wage-cut as a means of promoting full-employment.

13. Keynes’ theory has given rise to the importance of social accounting or national income accounting.

Criticism on Keynes’ Theory:

1. According to Schumpeter, the Keynes theory is a depression theory, which has limited applications.

2. Some socialist or communist economists had said that Keynes’ theory is dead if communism comes. However, even the
socialist countries have strived to raise their national income by using Keynesian theory.

3. Keynesian theory is not as much dynamic and it may more properly be called comparative statics.

4. Keynesian theory has ignored microanalysis and is not helpful in the solution of the problems of individual firms and
consumers.

5. Keynes has not given any place to the accelerator principle.

6. It pays excessive attention to money in economic analysis.

Relevance of Keynes’ Theory to Less-Developed Countries (LDCs) (Extended Criticism):

1. The Keynesian theory is primarily for fighting depression. The assumptions on which Keynesian theory is based are:
 (a) The multiplier, and

(b) Short-term analysis.

2. In the short-term analysis, Keynes assumes that capital equipment, technology, organisation, labour and their
efficiency remains constant. He thinks that the problems relating to employment in developed countries arises only on
account of the deficiency of demand.

3. But the problem in case of LDCs is to increase capital equipment, to improve technology and labour efficiency. Solving
this problem will take a long process; it cannot be solved in short-run.

4. The developing countries like Pakistan and India, the basic cause of unemployment is low rate of savings and
investment.

5. Most of the LDCs are agriculturists and the Keynesian approach is industry-oriented. Therefore, increase in national
income by deficit spending will lead to increase in demand for food. This will raise the prices of food grains. Therefore,
heavy reliance on Keynesian approach could mislead the economists, and can plunge the economy into inflationary spiral.

6. The principle of multiplier does not much work in LDCs. Suppose new investments are made in the country,
increased investment will lead to the establishment of new factories, workers will get employed, income will increase,
demand will increase, but it does not guarantee the increase in the supply of goods because there is no excess capacity,
and the supply of productive factors is not elastic. Increased income will be absorbed in high prices.
 Determination of National Income
1. In the short run, the level of national income is determined by aggregate demand and aggregate supply. The supply of
goods and services in a country depends on the production capacity of the community. But during the short period the
productive capacity does not change.

2. If AD increases, output will also increase and the level of national output (i.e., national income) will rise. On the other
hand, if AD decreases, the national output or national income will also decrease. It follows that the equilibrium level of NI
is determined by AD since the aggregate capacity remains more or less the same during the short run.

3. Thus, there are two components of effective demand:

(a) Consumption demand, and

(b) Investment demand.

4. Aggregate Demand = Consumption + Investment

i.e., AD = C + I

5. The consumption demand depends on propensity to consume and income. At a given propensity to consume, as income
increases, the consumption demand will also increase.
6. In the above diagram the 45o line represents aggregate supply line and it is also called ‘income line’. This income line
shows two things:

(a) Total output or aggregate supply (C + I), and

(b) National income.

7. In the above diagram, the curve C rises upward to the right which means that as income increases consumption also
increases. The distance between income line and consumption line represents saving. Thus, NI = C + S or Y = C + S.

8. One noteworthy thing about propensity to consume is that it remains stable or constant during the short period. Because
the propensity to consume depends on the tastes and needs of the people and these do not change in the short run.

9. Since consumption is more or less stable and cannot be varied, therefore, variation in NI depends on variation in
investment.

10. Investment is the second component of AD. Investment depends on two things:

(a) Marginal efficiency of capital, and

 (b) The rate of interest

11. The rate of interest is more or less stable, hence, change in investment depends on the marginal efficiency of capital
(MEC).

12. The MEC means expectations of profit from investment. In other words, the expected rate of profit is called MEC.

13. The MEC depends on two factors:

(a) Replacement cost of capital goods, and

(b) Profit expectations of investors.

14. If we join the investment demand with the curve C of propensity to consume, we get AD curve C + I in which C represents
consumption and I investment. The distance between propensity to consume curve C and AD curve C + I is equal to
investment.

15. The level of NI will be determined at point at which the AD and AS curves intersect each other. At this point AD and AS
are in equilibrium.

16. In the above diagram, the equilibrium level of income is OY. At this point the AD curve and AS curve intersect each other.

17. If the income is more than OY, than total output or AS is greater than AD (C + I), and the entire output cannot be sold out.

18. If the income is less than OY, then total output or AS is less than AD (C + I), and the entire output will be sold out. In such
a situation there is a shortage of supply, but the output will be increased in order to cover the shortage and the NI will also
increase.

19. OY is the equilibrium level of income which is less than full employment level, i.e., OYF. Whereas, the HF corresponds the
saving.

20. The economy will be in full employment level only when investment demand increases so as to cover this saving. But
there is no guarantee that investment demand will exactly be equal to savings.

Equality of Saving and Investment:

1. There is another way of determining the equilibrium level of NI, i.e., through equality of savings and investment.

2. Take the same diagram of AD and AS. At point E, the savings and investment are equal to GE. At above the point the
saving is more than investment, and for income less than this point, the investment is more than saving. Saving and
investment are only equal at the equilibrium level of income, and when they are not equal, the NI is not in equilibrium.

3. When at a certain level of NI intended investment by the entrepreneurs is more than intended savings by the people, this
would mean that AD is greater than total output or AS, i.e.,

I > S or AD > AS

This would induce the firms to increase production raising the level of income and employment.

4. Hence, when at any level of NI, investment is greater than savings, there will be a tendency for the NI to increase.

5. On contrary, when at any level of NI, the investment demand is less than saving, it means that AD is less than AS. As a
result of a decline in national output, the national income will also reduce.

6. Saving is withdrawal of some money from the income stream. On the other hand, investment is the injection of money into
the income stream. If the intended investment is more than intended saving, it means that more money has been injected
in the economy. This would increase the national income.

7. But when investment is just equal to saving, it would mean that as much money has been put into income stream as has
been taken out of it. The result would be that the NI will neither increase nor decrease, i.e., it would be in equilibrium. The
determination of NI by investment and saving is illustrated in the following diagram:
 8. In the above diagram, the investment line (II curve) has been drawn parallel to the X-axis. This is done on the assumption
that in any year, the entrepreneurs intend to invest a certain amount of money. That is, we assume that investment does
not change with income.

9. The saving line (SS curve) shows intended saving at different levels of income.

10. The saving line and investment line intersect each other at the equilibrium point E, where the intended saving and the
intended investment are equal at OY level of income. Hence OY is the equilibrium level of NI.

11. In the above diagram, there is no tendency for income to increase or decrease.

12. If the income level is greater than OY, the amount of intended investment is less than saving, as a result, the income will
finally decrease.

13. If the income level is less than OY, the amount of intended investment is greater than intended saving, as a result, the
income will continue to increase to the equilibrium level.

Inflationary Gap:
Inflationary gap arises when consumption and investment spending together are greater than the full employment GNP
level. This means that people are demanding more goods and services than can be produced. In other words, the implication of
inflationary gap is that national income, output and employment cannot rise further. The only consequence of increased demand
is that the price level will increase. Or we may say that there will be an inflationary gap if scheduled investment tends to be
greater than full employment saving. In a situation like this, more goods will be demanded than the economic system can
produce. The result will be that price will begin to rise and an inflationary situation will emerge. Thus, if full employment saving
falls short of scheduled investment at full employment (which means that peoples’ propensity to spend is higher than the
propensity to save), there will be an inflationary gap.

In the above diagram, C + I + G (consumption, investment and government spending) line shows the total expenditure on
demand in the economy. At this level, Y is the real output, as shown by the intersection, point D, with the 45o line. YF represents
a full employment level on real output. Real income of the economy, obviously cannot reach Y. At YF, total demand (C + I + G)
exceeds total output, leaving a gap AB, which is the inflationary gap in the Keynesian sense.

Deflationary Gap:

The deflationary or recessionary gap is the amount by which the aggregate expenditure falls short of the full employment level of
national income. It causes a multiple decline in real NI.
In the above diagram, Y is the total output at full employment level. Let us assume that the total demand is (C + I + G)’ which
cuts the 45o line at B, with real output Y’, AB then is the deflationary gap.
 Consumption Function
Propensity to consume is also called consumption function. In the Keynesian theory, we are concerned not with the
consumption of an individual consumer but with the sum total of consumption spending by all the individuals. However, in
generalizing the consumption behaviour of the whole economy, we have to draw some useful conclusions from the study of the
behaviour of a normal consumer, which may be valid for all consumers’ behaviour of the economy. Aggregate consumption
depends on consumption function or propensity to consume.
The economic term ‘consumption’ means the amount spent on consumption at a given level of income. ‘Consumption
function’ or ‘propensity to consume’ means the whole of the schedule showing consumption expenditure at various levels of
income. It tells us how consumption expenditure increases as income increases. The consumption function or propensity to
consume, therefore, indicates a functional relationship between the aggregates, viz., total consumption expenditure and the
gross national income. It is a schedule that expresses relationship between consumption and disposable income.
According to Keynesian theory, following are the factors that influence consumption:
(a) The real income of the individual,
(b) The past savings, and
(c) Rate of interest.
Average and Marginal Propensities to Consume:
The average propensity to consume (apc) is a relationship between total consumption and total income in a given period of
time. In other words, apc is the ratio of consumption to income. Thus:
apc = C
Y
Where C : Consumption
Y : Income
apc : Average propensity to consume
While, the marginal propensity to consume (mpc) measures the incremental change in consumption as a result of a given
increment in income. In other words, mpc is the ratio of change in consumption to the change in income.
mpc = ΔC
ΔY
Where ΔC : Incremental change in consumption
ΔY : Incremental change in income
mpc : Marginal propensity to consume
the normal relationship between income and consumption is that when income increases, consumption also increases, but by
less than the increase in income. In other words, in normal circumstances, mpc is less than one. It is drawn as a straight-line
with a slope of less than one. This slope indicates the percentage of additional disposable income that will be spent. It is
assumed that the whole additional income is not spent, i.e., a certain amount is spent and the remainder is saved. This can be
further explained with the help of following table and diagram:
Income Consumption Saving

100 75 25
120 90 30
140 105 35
180 135 45
220 165 55
In the above diagram, OL is the income line and OP is income consumption curve. The income consumption line OP lies below
the income line OL. The mpc will be measured by the tangent of the angle that income consumption curve makes with X-axis.

The curve as we have drawn turns out to be straight line rising from the origin, which means that mpc is constant
throughout. This, however, need not be so and the curve may well become flatter as income rises, for as more and more
consumption needs have been satisfied, a greater share of an increase in income than before may be saved. The dotted curve
OM represents such a relationship showing that as income rises, mpc becomes smaller and smaller.
There is a level of disposable income (DI) at which the entire income is spent and nothing is saved. This point is often known
as ‘point of zero savings’. Below this level of DI, the consumption expenditure will exceed the DI. There may be cases in which
the consumer has no income at all. In such cases, the income consumption curve may not rise from the origin but from farther
left showing that when income is zero, consumption is not zero and that the individual is living on his past savings.
Propensity to Save:
In the above diagram, ON represents the saving-income curve. Savings at a given level of income can also be read off from the
distance between a point on income-consumption curve and corresponding point on income curve (See the figure of income-
consumption relationship). The marginal propensity to save (mps) can be measured by the slope of income-saving curve
ON. Marginal propensity to save (mps) is the increment in savings caused by a given increment in income. The mps is always
equal to one minus mpc:

Keynes’ Law of Consumption:

Keynes propounded a law based on the analysis of consumption function. This law is known as ‘Fundamental Law of
Consumption’ or‘Psychological Law of Consumption’. It states that aggregate consumption is a function of aggregate disposable
income.
Propositions of the Law:
This law consists of three propositions:
(a) When aggregate income increases, consumption expenditure will also increase but by a somewhat smaller amount.
(b) When income increases, the increment of income will be divided in same proportion between saving and
consumption. Consumption and saving go side by side. What is not consumed is saved. Savings is, thus, the
complement of consumption.
(c) As income increases, both consumption spending and saving go up. An increment in income is unlikely to lead either
to less spending or less savings than before. It will seldom happen that a person may decrease his consumption or his
savings when he has got more income.
Assumptions:
(a) Habits of people regarding spending do not change or that the propensity to consume remains the same or stable.
(b) The economic conditions remain normal. There is no hyper-inflation or war or other abnormal conditions.
(c) The economy is a free-market economy. There is no government intervention.
(d) The important characteristic of the slope of consumption function is that the marginal propensity to consume (mpc)
will be less than unity. This results in low-consumption and high-saving economy.
Implications:
According to Keynesian theory, the mpc is less than unity, which brings out the following implications:
(a) Since consumption largely depends on income and consumption function is more or less stable, it is necessary to
increase investment fill the gap of declining consumption as income increases. If this is not done, the increased output will
not be profitable.
 (b) When the income increases, and the consumption are not increased, there is a danger of over-production. The
government will have to step in to remedy the situation. Therefore, the policy of laissez-faire will not work here.
(c) If the consumption is not increased, the marginal efficiency of capital (MEC) will diminish. The demand for
capital will also diminish, and all the economic progress will come to a standstill.
(d) Keynes’ Law explains the turning points in the business cycle. When the trade cycle has reached the highest point
of prosperity, income has gone up. But since consumption does not correspondingly go up, the downward cycle starts, for
demand has lagged behind. In the same manner, when the business cycle has touched the lowest point, the cycle starts
upwards, because consumption cannot be diminished beyond a certain point. This is due to the stability of mpc.
(e) Since the mpc is less than unity, this law explains the over-saving gap. As income goes on increasing, consumption
does not increase as much. Hence saving process proceeds cumulatively and there arises a danger of over-saving.
(f) This law also explains the unique nature of income generation. If money is injected into the economic system, it will
increase consumption but to a smaller extent than increase in income. This again is due to the fact that consumption does
not increase along with increase in income.
Factors Influencing Consumption Function:
There are certain factors affecting the propensity to consume in the long-run:
1. Objective Factors:
(a) Distribution of income: It is generally observed that the average and marginal propensities to consume of the poor
are greater than those of the rich. This is because the poor has a lot of unsatisfied wants and he is likely to seize every
opportunity that comes his way to satisfy them. On the other hand, the rich have already a high standard of living and
relatively less urgent wants remain to be satisfied, so that in their case, an addition to their incomes is more likely to be
saved than spent on consumption.
(b) Fiscal policy: Fiscal policy of the government will also influence the consumption behaviour of an economy. A
reduction in taxation will leave more post-tax incomes with the people and this will stimulate higher expenditure on
consumptions. Similarly, an increase in taxes will depress consumption.
(c) Changes in business expectations: Business expectations by affecting the incomes of certain classes of people
affect consumption function.
 (d) Windfall gains and losses: The windfall losses and gains arising out of changes in capital values affect the ‘saving
brackets’ mostly and not the spending sections. Hence, their influence on consumption function is not so well marked.
(e) Liquidity preferences: Another factor is the people’s liquidity preferences. If people prefer to keep their income in
liquid ford, consumption is reduced correspondingly.
(f) Substantial changes in the rate of interest.
2. Subjective Factors:
(a) Individual motives to save:
(i) Building of reserves for unforeseen contingencies as illness or unemployment,
(ii) To provide for anticipated future needs such as daughter’s wedding, son’s education, etc.
(iii) To enjoy an enlarged future income by investing funds out of current income, etc.
(b) Business motives:
(i) The desire to expand business,
(ii) The desire to face emergencies successfully,
(iii) The desire to have successful management,
(iv) The desire to ensure sufficient financial provision against depreciation and obsolescence.
Measures for Raising Consumption:
1. Redistribution of income in favour of poor where propensity to consume is greater.
2. Comprehensive social security measures like unemployment doles, old-age pension, sickness insurance, etc.
3. Liberal wage policy, and
4. Credit facilities for middle and poor classes for purchasing more consumer goods.
Importance of Consumption Function:
1. Important tool of macro-economic analysis.
 2. Value of the multiplier gives us a link between changes in investment and changes in income.
3. Consumption function invalidates the Say’s Law, which states that supply creates its own demand, because this theory
does not hold accurate in the real world.
4. It shows the crucial importance of investment.
5. It explains the reasons of declining MEC.
6. It explains the turning points of business cycle.
Post-Keynesian Developments Regarding Consumption Function:
(a) The Ratchet Effect:
(i) Professor Duesenberry says that in matter of consumption, an individual is not merely influenced by current
income, but also by standard of living in the past.
(ii) The consumers are not easily reconciled to fall in their income. They try hard to maintain their previous
standard of living. This is to maintain their position among their relatives, friends and neighbours.
(iii) Consumption as a proportion of income goes up as income increases and does not fall in the same proportion
as the income falls. In other words, consumption is not reversible. This is known as ‘Ratchet Effect’.
(b) Demonstration Effect:
(i) The Duesenberry Hypothesis suggests that the consumer expenditure depends on relative and not on absolute
incomes. The consumption function is linear rather than curved because it is the income of a family relative to that of
other families.
(ii) The ‘Demonstration Effect’ determines how much a consumer spent and how much he saves. Middle-class and
poor people imitate the life style of rich people. People in under-developed countries try to follow the consumption
pattern of affluent nations. This is called the ‘Demonstration Effect’, and it is dangerous as it retards the economic
growth.
(c) Pigou Effect:
 (i) When prices fall as a result of a cut in money wages, the purchasing power of money with a consumer
increases, or there is an increase in the real value of money. People feel that they are now better off and they increase
their consumption expenditure. This leads to expansion in GNP and has been referred to as ‘Pigou Effect’.
(ii) Keynes seems to be agreed that theoretically it is possible to bring about full employment by sufficiently
lowering the money wages. But the process would be so slow that it could be ignored as a practical possibility. It would
be more realistic to assume that wages are not so flexible (as assumed by Pigou) as to permit the working of Pigou
effect to bring about full employment.
(d) Government Consumption:
(i) Another factor which affects consumption and the level of economic activity is the government expenditure.
(ii) It differs from country to country and in the same country it differs over time.
(iii) Government may have a vital role in creating employment, influencing consumption and adjusting saving
through fiscal and other policies.
Theories of Consumption Function:
There are three different economic theories explaining consumption-income relationship:
(a) Absolute Income Theory: According to Keynes, on average, men increase their consumption as their income
increases but not by as much as the increase in income. In other words, the average propensity to consume goes down
as the absolute level of income goes up. Hence, according to this theory, the level of consumption expenditure depends
upon the absolute level of income and the relationship between the two variables is non-proportionate. However, it is
pointed out that although this relationship is one of non-proportionality, yet there is illusion of proportionality caused by
factors other than income, viz., accumulated wealth, migration to urban areas, new consumer goods, etc. Owing to such
factors as these, the consumers spend more and the relationship appears to be proportional.
(b) Relative Income Hypothesis: The Relative Income Hypothesis was first introduced by Dorothy Brady and Ross
Friedman. It states that the consumption expenditure does not depend on the absolute level of income but instead the
relative level of income.
According to Dussenberry, there is a strong tendency for the people to emulate and imitate the consumption pattern of
their neighbours. This is the ‘demonstration effect’. The relative income hypothesis also tells us that the level of
consumption spending is determined by the households’ level of current income relative to the highest level of income
earned previously. People are then reluctant to revert to the previous low level of consumption. This is ‘ratchet effect’.
The relative income theory states that if current and peak incomes grow together changes in consumption are always
proportional to change in income. That is, when the current income rises proportionally with peak income, the apc remains
constant.
This proportionality relationship can be illustrated by the following diagram:

Income and consumption lines (Y and C) show proportional relationship, when income grows steadily. Similarly, if income
grows in spurts and dips, the response of the consumption is same. Thus Y’ and C’ lines show proportional relationship.
(c) Permanent Income Hypothesis: Friedman draws a distinction between permanent consumption and transitory
consumption. Permanent consumption stands for that part of consumer expenditure which the consumer regards as
permanent and the rest is transitory. Distinction can also be made between durable and non-durable consumer
goods. Durable consumption is concerned with purchasing capital assets and in the case of non-durable goods the act of
consumption destroys the good. Ordinary consumer expenditure relates to non-durable consumption, i.e., consumption of
goods which are quickly used in consumption. These are the ‘flow’items since a flow of them is being continuously
consumed. On the other hand, durable consumption, which relates to the purchase of capital assets, is an act of
investment. These are ‘stock’ items.
According to Friedman, permanent consumption (Cp) is a function of:
(i) Rate of interest,
(ii) Rates of consumer’s income from property and his personal effort, i.e., human and non-human wealth, and
(iii) Consumer’s preference for immediate consumption multiplied by permanent income (Yp).
The permanent income theory really emphasises the important role of capital assets or wealth in determining the size of
consumption. It shows how both income and consumption are closely linked with the consumer’s wealth. It is capital and
wealth, which affects the level of consumption rather than consumer’s income.
(d) Life Cycle Hypothesis: According to Life Cycle Hypothesis, the consumption function is affected more by consumer’s
whole life income rather than his current income. This view has been put forward by Modigliani, Brumberg and Ando. The
permanent income hypothesis focuses attention on the income of the consumer earned in recent past as well as expected
future earnings (and wealth). But the life cycle hypothesis states the consumption function depends upon consumer’s
whole life income. In childhood, the consumer earns nothing but spends all the same (his parents spend on him); in the
middle age, when he comes to have a family, he earns and spends. But he will be earning more than he spends. He tries
to save enough to maintain himself in his old age when he will not be able to earn or earn much. Over his life span, the
consumer tries to maintain a certain uniform standard and with that end in view he organises whole life’s uneven income
flows of cash receipts. In other words, he will arrange his income and expenditure in such a manner as to maintain a
certain standard of living which he desires.
The ‘Life Cycle Hypothesis’ seems to be quite realistic and plausible. It may be noted, however, that this hypothesis
emphasises income as derived from wealth more than cash receipts. It also draws our attention to the fact that the
consumers have to make a choice between immediate consumption and accumulating of assets for future use.
 Investment
Investment, in the theory of income and employment, means, an addition to the nation’s stock of capital like the building of new
factories, new machines as well as any addition to the stock of finished goods or the goods in the pipelines of
production. Investment includes addition to inventories as well as to fixed capital. Thus, investment does not mean purchase of
existing securities or titles, i.e., bonds, debentures, shares, etc. Such transactions do not add to the existing capital but merely
mean change in ownership of the assets already in existence. They do not create income and employment. Real investment
means the purchase of new factories, plants and machineries, because only newly constructed or created assets create
employment or generate income.

Types of Investment:

1. Gross and Net Investment: Net investment means gross investment minus depreciation. In the theory of income and
employment, investment means net investment.

2. Ex-ante and Ex-poste Investment: Ex-ante investment is planned or anticipated investment. Ex-post investment is
actually realised investment, or the investment which is not merely planned but which is actually invested or implemented.

3. Private and Public Investment: Private investment is on private account and public investment is by the State or local
authorities. The private investment is influenced by marginal efficiency of capital (MEC) i.e., profit expectations and the
rate of interest. Therefore, the private investment is profit-elastic. In public investment, the profit motives do not enter into
consideration. It is undertaken for social good and not for private gain.

4. Autonomous and Induced Investment: Autonomous investment is independent of income level, and depends on
population growth and technical progress. Such investment does not vary with the level of income. In other words, it is
income-inelastic. The influence of change in income is not altogether ruled out. The examples of autonomous investment
are ‘long range’ investments in houses, roads, public buildings and other forms of public investment. Such investment is
generally done by the State as necessitated by the growth of population and facilitated by technical progress and not as a
result of change in NI. These investments are independent of changes in income and are not governed by profit
motive. They are generally made by governments and local authorities for promoting general welfare.
 Induced investment varies with NI. Changes in NI bring about changes in aggregate demand which in turn affects the
volume of investment. When NI increases, AD too increases, and investment has to be undertaken to meet this increased
demand. Thus induced investment is income-elastic.

Investment is made by the people as a result of changes in income level or consumption. It is also influenced by price
changes, interest changes, etc., which affect profit possibilities. It is undertaken for the sake of profit or income and it
changes with a change in income. Thus, induced investment is governed by profit motive.

Factors Affecting Investment:

1. Marginal Efficiency of Capital (MEC) or expected rate of profit: MEC or expected rate of profit the most important
factor affecting private investment. If the business expectations are good or if the MEC is high, more investment will be
made. On the contrary, if there is an economic depression in the country or there are bleak prospects of profits,
investment will be discouraged. Thus, the fluctuations in investment are mainly caused by the fluctuations in the MEC.

2. Rate of interest: The second important factor affecting investment is rate of interest. The rate of interest does not quickly
change; it is more or less sticky or constant. Hence, the inducement to invest, by and large, depends on the MEC. For a
suitable investment condition, the rate of return or profit must at least equal to rate of interest. So long as the expected
rate of return exceeds the rate of interest, investment will continue to be made. In other words, the MEC must never fall
below the current rate of interest, if investment is to be worthwhile.

3. Excess capacity: There are some other factors that affect investment. Excess capacity is one of them. If a firm has
already ‘excess capacity’ and can easily handle increased future demand, it will not go in for further investment in capital
equipment.

4. Technological progress: Technological progress also affects current level of investment. For instance, a new invention
may render the present capital stock of a firm obsolete and adversely affect its ability to compete. In this case, further
investment will be called for.

5. Political and security conditions: This factor has become one of the major important factors that affect the investment,
esp. with reference to under-developed countries including Pakistan. Political instability, poor security arrangements and
society’s negative attitude towards investment companies can badly damage the investment environment, and the country
can be suffered from poverty and unemployment due to lack of investment. Countries like Kenya, Zimbabwe, Sudan, etc.
are the worst victims.
Marginal Efficiency of Capital (MEC):

MEC is the highest rate of return expected from an additional unit of a capital asset over its cost. It is the expected rate of
profitability of a new capital asset. J.M. Keynes has defined MEC as being equal to the rate of discount which would make the
present value of the series of annuities given by the returns expected from the capital assets during its life just equal to the
supply price. Symbolically it is expressed as:

Where Sp denotes supply price or replace cost of the asset, R1, R2,…..Rn are the prospective annual returns or yield from the
capital asset in the year 1, 2, and n respectively. i is the rate of discount which makes the capital asset exactly equal to the
present value of the expected yield from it.

Investment-Demand Curve:

The investment-demand schedule is also known as MEC schedule. The MEC schedule shows a functional relationship between
MEC and the amount of investment in a given type of capital asset at a particular period of time for the whole economy.

Investment MEC /
(In Million Rate of Interest
US $) (In %)
200 10
250 9
400 7
750 5
1000 3
In the above diagram, the marginal efficiency of capital is represented by MEC curve. It slopes downward from left to right which
means that as investment increased its marginal efficiency goes down.

Investment at any time depends on the rate of interest prevailing at that time. If the rate of interest is 5%, the investment is US
$750 million, because, at this level, MEC is equal to the rate of interest. The MEC represents the investor’s return and the rate of
interest is his cost. Obviously, the return on capital must at least be equal to the rate of interest, which is its cost. Suppose the
rate of interest goes down to 3%, then it will become worthwhile to invest US $1,000 million. Thus, the MEC and the rate of
interest move together.

Position and Shape of MEC Curve: The elasticity of MEC determines the extent to which the volume of investment would change
consequent upon changes in the rate of interest. If MEC is relatively interest-elastic, a little fall in the rate of interest will result in
a considerable expansion in the volume of investment. On the other hand, if the MEC is relatively interest-inelastic, then a
considerable fall in the rate of interest may not lead to any increase in the volume of investment.
Shifts in MEC: As the expectations regarding the prospective yields change, the MEC will change too and the MEC curve will
shift upwards or downwards. It is illustrated in the following diagram:

Suppose a war breaks out or demand for goods increases on account of some other reason. As a result, entrepreneurs’
expectations of profit will rise high and the investment demand curve or the MEC curve will shift upwards to MEC’. This means
that at a given rate of interest, investment will be greater than before. From the above diagram, it will be seen that whereas the
rate of interest i, investment was OM before, it now becomes OM’. Similarly, if for some reason demand for goods has
decreased bringing down the MEC to MEC” at the same rate of interesti, investment will only be OM” as compared with OM
before.

Influence of Rate of Interest: The rate of interest along with the MEC determines the volume of investment. If the rate of
interest is higher than the MEC, it will not be profitable to create a new physical asset. This is because we assume that the aim
of individual investor is to maximise the money profits. Two courses of action are open to invest, either he can use his money to
crease additional physical assets, i.e., he can invest in the Keynesian sense of the term, or else he can lend his money to others
at a certain rate of interest. Now, if MEC is lower than the current rate of interest, it is more profitable to lend money rather than
use it for creating new assets. On the other hand, if MEC is higher than the rate of interest, it is better to invest more. At the
point, where MEC equals the current rate of interest, we have the equilibrium level of investment.

Factors of MEC:

The marginal efficiency of capital depends upon psychological and objective factors:

1. Psychological Factors: Whenever a firm undertakes an investment, it estimates its MEC in the light of the experience of
the past, existing conditions and guesses about the future conditions. If the businessmen are optimistic about the future,
they will estimate the MEC higher and if they are pessimistic about the further business condition, naturally the MEC will be
estimated low.

2. Objective Factors:

(a) MEC and the Market: If the market of a particular commodity is wide and is expected to grow further, the
investment in that project will be favourable and the MEC high. On the other hand, if the demand of a particular
commodity is limited and is expected to decline in the future, the investment will be discouraged in that project and
the MEC will be low.

(b) Rate of Growth of Population: MEC is also influenced by the rate of growth of population. If population is
growing at a rapid speed, it is usually believed that the demand of various classes of goods will increase. So a rapid
rise in the growth of population will increase the MEC and a slowing down in its rate of growth will discourage
investment and thus reduce MEC.

(c) Technological Development: If inventions and technological development take place in the industry, the
prospect of increase in the net yield brightens up. For example, the development of automobiles in the 20th century
has greatly stimulated the rubber industry, the steel and oil industry, etc. So we can say that inventions and
technological developments encourage investment in various projects and increase MEC.

(d) Existed Capital Goods: If the quantity of any particular type of goods is available in abundance in the market
and the consumers can partially or fully meet demand, then it will not be advantageous to invest money in that
particular project. So in such cases, the MEC will be low.

(e) Current Rate of Investment: Another influence on the MEC is the rate of investment currently going on in a
particular industry. If in a relevant field, much investment has already taken place and the rate of investment
currently going on in that industry is also very large, then new investors will hesitate to invest their money in that
direction. As the anticipated net yield from that project will be very small, so they can invest money in such project
only if they expect extremely favourable demand conditions.

(f) Rate of Taxes: MEC is directly influenced by the rate of taxes levied by the government on various
commodities. When taxes are levied, the cost of commodities is increased and the revenue is lowered. When
profits are reduced, MEC will naturally be affected. It will be low, if taxes are very high and high if taxes are low.
 Multiplier and Accelerator
(Determination of National Income Continued)
THE MULTIPLIER:
Keynes’ Multiplier Theory gives great importance to increase in public investment and government spending for raising the level
of income and employment. Both consumption and investment create employment. But both have complementary relationship
with one another. When investment increases, consumption increases too and helps in creating employment. It is only when
the level of full employment has been reached that investment and consumption become competitive instead of being
complementary; then increase in one will reduce the other, one will be at the expense of the other.
Kahn’s Employment Multiplier:
Kahn’s Multiplier is known as Employment Multiplier, and Keynes’ Multiplier is known as Investment Multiplier. According to
Kahn’s Employment Multiplier, when government undertakes public works like roads, railways, irrigation works then people get
employment. This is initial or primary employment. These people then spend their income on consumption goods. As a result,
demand for consumption goods increases, which leads to increase in the output of concerned industries which provides further
employment to more people. But the process does not end here. The entrepreneurs and workers in such industries, in which
investment has been made, also spend their newly obtained income which results in increasing output and employment
opportunities. In this way, we see that the total employment so generated is many times more than the primary employment.
Suppose the government employs 300,000 persons on public works and, as a result of increase in consumer goods, 600,000
more persons get employment in the concerned industries. In this way, 900,000 persons have been able to get employment,
that is, three times more people are now employed. In other words, Kahn’s employment multiplier means that by the government
undertaking public works many more times total employment is provided as compared with initial employment.
Keynes’ Income or Investment Multiplier:
Keynes’ income multiplier tells us that a given increase in investment ultimately creates total income which is many times the
initial increases in income resulting from that investment. That is why it is called income multiplier or investment
multiplier. Income multiplier indicates how many times the total income increases by a given initial investment.
Suppose Rs. 100 million are invested in public works and as a result there is an increase of Rs. 300 million in income. In this
case, income has been increased 3 times, i.e., the multiplier is 3. If ΔI represents increase in investment, ΔY indicates increase
in income and K is the multiplier, then the equation of multiplier is as follows:

----------------------------------- (i)

The multiplier is the numerical co-efficient showing how large an increase in income will result from each increase in
investment. The multiplier is the number by which the change in investment must be multiplied in order to get the resulting
change in income. It is the ratio of change in income to the change in investment. If an investment of Rs. 50 million increases
income by Rs. 150 million, the income multiplier is 3 and if Rs. 200 million, the multiplier is 4 and so on.
In the following multiplier equation, the relationship between income and investment is determined through marginal propensity
to consume:

------------------------------------(ii)

Where:

(mps: Marginal Propensity to Save)

Therefore, the third multiplier equation is:

--------------------------------------(iii)
It should be noted that the size of multiplier varies directly with the size of mpc. When the mpc is high, the multiplier is high and
when the mpc is low, the multiplier is also low.
The multiplier works not only in money terms but also in real terms. In other words, the increase in income takes place not only
in the form of money but in the form of goods and services.
Example 1:

mpc is ¾

Initial investment is Rs. 1,000 million

Required:

(a) Multiplier,

(b) Marginal propensity to save,

(c) Increase in the level of national income, and

(d) Conclusion.

Solution:
(a) Multiplier (K):

(b) Marginal Propensity to Save (mps):

 (c) Increase in the level of NI:

(d) Conclusion:
From the above example, we can see that with an initial primary investment of Rs.
1,000 million, with an mpc at ¾ and multiplier at 4, gives rise to an increase of Rs.
4,000 million in the level of national income.

Example 2:

Calculate mpc, mps and multiplier (K):

mpc mps K

4/6 ? ?
½ ? ?
? ¼ 4
? 1/7 ?
1 ? ?
0 ? ?

Solution:
*
If the mpc is 1, the mps will be zero and the multiplier will be infinity; and a given dose of
investment (let say, Rs. 1,000 million) will automatically create full employment.
**
If the mpc is 0, the mps will be 1 and the multiplier will be 1 so that total increase in income
will just equal the increase in primary investment.
Keynes multiplier theory is also very helpful in the determination of national income. In his book, ‘General Theory of
Employment, Interest and Money’, he has contradicted the viewpoint of the classical economists. He is of the opinion that if an
economy operates at a level of equilibrium it is not necessary that there should be a high level of employment in a country. It is
just possible that there may be millions of people unemployed. So according to Keynes, if any country wishes to achieve level of
employment, it can only do so through the changes in the magnitude of investment.
According to Keynes’ theory, there are two main methods of measuring the equilibrium level of NI, i.e.:
(a) The AD-AS Approach, and
(b) The Saving Investment Approach
(a) AD-AS Approach: For explaining the determination of level of income in a two-sector economy, we assume an
economy in which there is no international trade, no government role and in which corporations retain no earnings. In this
simplest model of economy, the level of income is determined at a point where the AD intersects the AS. It is depicted as
below:

In the above diagram, the national income is determined at the point where AD curve (C+I) cuts the AS curve (C+S), i.e., at
E. The multiplier effect is also shown in this diagram. The curve C represents the mpc which is assumed to be ½. That is
why the slope of curve C is 0.5. Since the AD curve (C + I) cuts the 45o angle line at E, OY1 is the level of income
determined. If now investment is increased to EH (ΔI) we can find out the increase in income (ΔY). As a result of
investment EH, the AD curve shifts upwards to C + I’. This new AD curve cuts the AS curve (45o angle line) at F, so that
OY2 income is determined. Thus, income increases by Y1Y2 as a result of investment increase of EH, which (Y1Y2) is
double of EH.
It is clear, therefore, that the multiplier is 2. It is also calculated as below:

(a) Saving-Investment Approach: In order to simplify the analysis of income determination we imagine an economy (1)
where there are no taxes levied by the government, (2) the corporations retain no earnings, and (3) there are no changes
in the level of prices. The equilibrium level of NI is determined at a point where planned or intended saving is equal to
planned or intended investment, or in other words, where the saving intersect the investment. It is further explained with
the help of following diagram:
 The above diagram shows the multiplier effect of an increase in investment on the equilibrium level of income. SS is the
supply curve and II is the investment curve showing the total level of investment of OI. These two curves intersect each
other at the equilibrium point E where is income is OY1. If now there is a change in investment from OI to OI’, i.e., an
increase of II’, then the II curve will shift to the position of I’I’ and the two curves I’I’ and SS intersect each other at the new
equilibrium point E’, where the income is OY2. Now it is clear that when mps is ½, an increase in investment by II’ (let say
Rs. 10 million) has led to the increase in income by Y1Y2 (let say Rs. 30 million). Obviously the value of the multiplier is
equal to 3.
Limitations of Multiplier:
(a) Efficiency of production: If the production system of the country cannot cope with increased demand for consumption
goods and make them readily available, the incomes generated will not be spent as visualised. As a result, the mpc may
decline.
(b) Regular investment: The value of the multiplier will also depend on regularly repeated investments. A steadily
increasing investment is essential to maintain the tempo of economic activity.
(c) Multiplier period: Successive doses of investment must be injected at suitable intervals if the multiplier effect is not to
be lost.
 (d) Full employment ceiling: As soon as full employment of the idle resources is achieved, further beneficial effect of the
multiplier will practically cease.
Leakages of Income Stream and Their Effect on the Multiplier:
As we know that as income increases, consumption does not increase to the same extent or proportionately, because a part of
the income is saved. The part of the income that is saved is as if a leakage from the flow of income stream. These leakages
obstruct the growth of national income. In the absence of these leakages, mpc would have been unity. The consumption
expenditure would have increased 100 per cent of the increase in income and there would have been full employment. The
following are the principal leakages:
(a) Paying off debts: It generally happens that a person has to pay a debt to a bank or to another person. A part of his
income goes out in repaying such debts and is not utilised either in consumption or in productive activity. Income used to
pay off debts disappears from the income stream. If, however, the creditor uses this amount in buying consumer goods or
in some productive activity, then this sum will generate some income, otherwise not.
(b) Idle cash balances: It is well known that people keep with them ready cash which is neither used productively nor in
purchasing consumer goods. Keynes has mentioned three motives for holding ready cash for liquidity preference, viz.,
transactions motive, precautionary motive and speculative motive. This means that the re-spent part of income goes on
decreasing. In this way, a part of the initial expenditure leaks out of the income stream.
(c) Imports: The part of the money spent by country for importing goods also leaks out of the country’s income stream. It
does not encourage or support any business or industry in the country. This is specially so if the imports do not help the
trade and industry of the country or if they are not used for export promotion. The net import is a leakage.
(d) Purchase of existing securities: Some people purchase securities (saving certificates) from others and the seller of
securities can hoard this money. This money also leaks out of the income stream. This may also be valid in case of
purchase of shares, debentures, bonds, insurance policy, or some other financial investment. If this invested money is not
used in productive areas, there will be a leakage in the income stream.
(e) Price inflation: Inflationary situation is also responsible for leakage. In such a situation, investment does not help in
generating employment or increasing income. If there is already full employment in the country, increase in investment, far
from increasing demand for consumer goods, it decreases it as a result of which employment in the consumer goods
 industries contracts and demand for capital goods decreases. Whatever increase in income there is, it is spent in high
prices and it does not help in creating income and employment.
As a result of leakages of income from the main income stream of the country, the multiplier effect of the primary or initial
investment in increasing income is reduced. If somehow these leakages are plugged, the multiplier effect of investment in
generating income and employment would increase. If they cannot be plugged altogether, they should be reduced or the
propensity to consume should be increased or propensity to save should be reduced, otherwise the new investment will not have
full effect in increasing income and employment.
Importance of Multiplier:
Keynes’ principle of multiplier has a great role in removing the Great Depression of 1929-34. These days governments are
actively interfere in the economic affairs of the community through multiplier. Its importance is further explained as below:
1. The multiplier principle focuses on the importance of public investment, which is the key to remove unemployment
during the days of depression. An investment of Rs. 1 million can create income and employment worth many times, and
can help the government to remove unemployment from the country.
2. During the days of depression, the private entrepreneurs are discouraged to invest in the economy. Therefore, to fill
this gap, the government comes forward and undertakes the investment in her own hands. Hence, the demand for
consumer goods increases and also the level of NI and employment increases on account of the working of the multiplier.
3. When the demand for goods increases and incomes rise owing to government investment, the profit expectations of
the entrepreneurs go up and as a result the MEC rises.
4. When the government makes investment in public works to fight depression and unemployment, private investment
is encouraged on account of the operation of the multiplier. The confidence of private investors is restored, and hence
helps in further removing the economic depression of the country.
Assumptions of Multiplier:
The following certain essential conditions / assumptions for the operation of multiplier:

1. The supply curve of output should be elastic. In other words, when demand for certain goods or services increases, its
supply can be increased without much difficulty.
 2. There is excess productive capacity in consumer goods industries, so that the supply of goods can be easily
increased when demand increases.

3. The supply of raw materials and working capital should also be elastic.

4. There should be ‘involuntary unemployment’. That is, there are people who want work at the prevailing wage rate, but
are not getting it.

Criticism on Keynes’ Multiplier Theory:

Many economists including the classical economists and the economists from third world countries have strongly criticise the
Keynes’ Multiplier Theory. It is explained in brief as below:

1. Keynes’ multiplier theory assumes that the supply of output, raw materials and working capital is elastic, i.e., it can be
increased whenever required. But, according to critics, this condition cannot be fulfilled in an under-developed country
(UDC), where there is a continuous vicious cycle of poverty. The whole economy is based on agriculture, and there is a
dearth of capital equipment, skill labour and technology. The existing industries cannot fulfill the increased
demand. Moreover, the government is so poor to invest in public works.

2. According to Keynes’ multiplier theory, there is excess productive capacity in consumer goods industries. But according to
critics, there is a little excess productive capacity in poor countries; therefore, this theory cannot be applied to UDCs.

3. Another condition of Keynes’ theory is that there should be ‘involuntary unemployment’. That is, there are people who
want work at the prevailing wage rate, but are not getting it. Whereas, in UDCs, there is ‘disguised unemployment’,
and most of the workers are self-employed, therefore, this condition cannot be fulfilled in such countries.

4. According to critics, this theory can only be applied to economically advanced and highly industrialised countries,
and cannot be applied to under-developed countries, which are pre-dominantly agricultural countries. In UDCs, the
heavy plant and machineries, and skilled labour are not easily available and the supply cannot be increased quickly.

THE ACCELERATOR:
The multiplier describes the relationship between investment and income, i.e., the effect of investment on income. The multiplier
concept is concerned with original investment as a stimulus to consumption and thereby to income and employment. But in this
concept, we are not concerned about the effect of income on investment. This effect is covered by the ‘accelerator’. The
term ‘accelerator’ should not be confused with the accelerator in cars. It does not make the investment to grow faster and faster.
The term ‘accelerator’ is associated with the name of J.M. Clark in the year 1914. it has been proved a powerful tool of
economic analysis since then. Keynes, astonishingly, has altogether ignored this concept. That is why, the concept of
accelerator is not considered the part of Keynesian theory.
According the principle of accelerator, when income increases, people’s spending power increases; their consumption increases
and consequently the demand for consumer goods increases. In order to meet this enhanced demand, investment must
increase to raise the productive capacity of the community. Initially, however, the increased demand will be met by over-working
the existing plants and machinery. All this leads to increase in profits which will induce entrepreneurs to expand their plants by
increasing their investments. Thus a rise in income leads to a further induced investment. The accelerator is the numerical
value of the relation between an increase in income and the resulting increase in investment.
(Figures in Rs. ‘000)
Years Demand Required Replacement Net Gross
Stock of Cost Investment Investment
Capital
2007 500 5 machines 1 machine 0 machine 300
1500 300
2008 500 5 machines 1 machine 0 machine 300
1500 300
2009 800 8 machines 1 machine 3 machines 1200
2400 300 900
2010 1000 10 machines 1 machine 2 machines 900
3000 300 600
2011 1000 10 machines 1 machine 0 machine 300
3000 300
2012 800 8 machines 1 machine – 2 machines – 300
2400 300 600
Cost per machine: Rs. 300,000 per machine

In the above example, suppose we are living in a world, where the only commodity produced is cloth. Further suppose that to
produce cloth Rs. 100,000, we require one machine worth Rs. 300,000, which means that the value of the accelerator is 3 (i.e.,
the capital-output ratio is 1:3). That is, if demand rises by Rs. 100,000, additional investment worth Rs. 300,000 takes place. If
the existing level of demand for cloth remains constant, let us say, at Rs. 500,000, then to produce this much cloth we need five
machines worth Rs. 1.5 million. At the end of one year, let us suppose, that one machine becomes useless as a result of wear
and tear, so that at the end of one year, a gross investment of Rs. 300,000 must take place to replace the old machine in order
that the stock of capital is capable of producing output worth Rs. 500,000.
In the third period, i.e., the year 2009, demand rises to Rs. 800,000. To produce output worth Rs. 800,000, we need 8
machines. But our previous stock consisted of only 5 machines. Thus if we are to produce output worth Rs. 800,000, we must
install 3 new machines, worth Rs. 900,000. The net investment for the year 2009 will be Rs. 900,000 and with the replacement
cost of one machine Rs. 300,000, our gross investment jumps from Rs. 300,000 in the year 2008 to Rs. 1.2 million in the year
2009. A 60 per cent increase in demand led to a 400 per cent increase in gross investment. Here we have a glimpse of the
powerful destabilising role of accelerator.
Assumptions of the Accelerator:

1. Under the principle of accelerator, it is assumed that there is no excess capacity existing in the consumer goods
industries. No machines are lying idle and shift working is not possible.

2. In capital goods industries, it has been assumed that there is an existence of surplus capacity. If there is no
excess capacity in capital goods industries, increased demand for machines could not lead to increase in the supply of
machines.

3. Output is flexible. The machine-making industry or capital goods industry can increase its output whenever desired.

4. The size of the accelerator does not remain constant over time. It value will be affected by the businessmen’s
calculations regarding the profitability of installing new plants to make more machines on the basis of their probable
working life.

5. The demand for machines will remain stable in the future, although the increase in demand has suddenly cropped up.
 Trade Cycles
Trade cycles refer to regular fluctuations in the level of national income. It is a well-observed economic phenomenon, though it
often occurs on a generally upward growth path and has a variable time span, typically of three years.
In trade cycles, there are upward swings and then downward swings in business. The periods of business prosperity alternate
with periods of adversity. Every boom is followed by a slump, and vice versa. Thus, the trade cycle simply means the whole
course of trade or business activity which passes through all phases of prosperity and adversity.
Several suggestions have been put forward as to the cause of cycles. The most well known are developed by Samuelson,
Hicks, Goodwin, Phillips and Kalecki in the 1940s and 1950s, combine the multiplier with the accelerator theory of
investment. More recently, attention has been paid to the effects of shocks to the economy from technology and taste changes.
Phases of Trade Cycles:
Typically economists divide business cycles into two main phases – depression and recovery. Boom and slump mark the turning
points of the cycles:
(a) Depression: In this phase, the whole economy is in depression and the business is at the lowest ebb. The general
purchasing power of the community is very low. The productive activity, both in the production of consumer goods and the
production of capital goods, is at a very low level. Business settles down at a new equilibrium point with a low level of
prices, costs and profits. It may last for a number of years. Following are the characteristics of depression:
(i) The volume of production and trade shrinks,
(ii) Unemployment increases,
(iii) Overall prices fall,
(iv) Profits and wages fall, thus, the income of the community falls to a very low level,
(v) Aggregate expenditure and the effective demand come down,
(vi) There is a general contraction of credit and little opportunity to invest,
(vii) Stock markets show that prices of all shares and securities have fallen to a very low level,
 (viii) Interest rates decline all round,
(ix) Practically, all construction activity – whether in buildings or machinery, comes to an end.
(b) Recovery: This phase is also known as ‘expansion’. The depression period of trade cycle ends in the recovery
period. The economic situation has now become favourable. Money is cheap and so are the other materials and the
factors of production. Productive activity has been increased. The entrepreneurs have now sufficient financial
backing. Constructional and allied industries are receiving orders and employing more workers, thus creating more income
and employment. This stimulates further investment and production. The whole economy is moving faster towards the
boom.
(c) Boom: Boom or peak is the turning point of the trade cycle. It is the highest point of economic recovery. The typical
features of boom are as follows:
(i) A large number of production and trade,
(ii) A high level of employment and job opportunities in sufficient amount to permit a good deal of labour mobility,
(iii) Overall rising prices,
(iv) A rising structure of interest rates, so that a bullish tendency rules stock exchanges,
(v) A large expansion of credit and borrowing,
(vi) High level of investment, i.e., manufacturing or machinery
(vii) A rise in wages and profits so that the community’s income rises, and
(viii) Operation of the economy at optimum capacity.
(d) Recession: It is a sharp slow down in economic activity, but it is different from depression or slump which is more
severe and prolonged downturn.
Just as depression created the conditions of recovery, similarly, the boom conditions generate their own checks. All idle
factors have been employed and further demand must raise their prices, but the quality is inferior. Less efficient workers
have to be taken on higher wages.
 Rate of interest rises and so also of the necessary materials. The costs have after all started the upward swing. They
overtake prices ultimately and the profit margins are first narrowed and then begin to disappear. The boom conditions are
almost at an end.
Then starts the downward course. Fearing that the era of profits has come to a close, businessmen stop ordering further
equipment and materials. The prudent businessmen want to get out altogether and cuts down his establishment
ruthlessly. The government applies the axe mercilessly. The bankers insist on repayment. The bottlenecks appear,
stocks accumulate. Desire for liquidity all round. This accentuates the depression.
The trade cycle is depicted in the following diagram:

Theories of Trade Cycle:

(a) Climatic Theory: It is said that there are cycles of climate. For some years the climate is favourable and then comes
an unfavourable turn. Changes in climate bring about changes in agricultural production. The cycle of agricultural
production results in a cycle of industrial activity, for industry is deeply affected by the state of agricultural production.
One of the famous climatic theories is ‘Jevons’ Sunspot Theory’. According to Stanley Jevon, spots appear on the face of
the sun at regular intervals. These spots affect the emission of heat from the sun, which, in turn, conditions the degree of
rainfall. The rain affects agriculture, which, in turn, affects trade and industry. That is how trade cycles are caused.
(b) Psychological Theory: According to psychological theory of trade cycle, there are moods of optimism alternating the
moods of pessimism in the economy, without any tangible basis. At some stage, people just think that trade is good and
that it is going to remain good. Business activity is intensified and becomes feverish. Then, all of a sudden, people start
thinking that the period of prosperity has lasted long enough and adversity is round the corner. Thus, although there was
no valid reason for depression to come about, but it is brought about by the people themselves. It is all psychological.
(c) Under-Consumption Theory: According to under-consumption theory, there is too much of saving during a boom and
further additions to saving reduce the level of consumption. A reduction in the level of consumption, in the face of
increasing productive capacity, must sooner or later lead to the collapse of the boom. This theory is associated with the
names of J. A. Hobson and Major Douglas.
(d) Monetary Theory: R.G. Hawtrey was a firm believer in monetary theory. According to him, variations in flows of
money are the sole and sufficient determinants of business activity and account for alternating phases of prosperity and
depression. When the business prospects are good, the banks freely extent credit facilities. The businessmen go on
expanding their business, entering into further and further commitments with the banks. A huge superstructure of credit is
built up and this superstructure can be maintained by cheap money conditions. But a point reached, when banks think that
they have gone a bit too far in the matter of advances. Probably their reserve ratio fallen dangerously low. In self-defence,
they apply the brake, curb further expansion of credit, and begin to recall advances. This sudden suspension of credit
facilities proves a bombshell in the business community. Businessmen have to sell their stocks in order to repay. This
general desire for liquidity depresses the market, and may even led to bankruptcy for certain firms.
(e) Over-Investment Theory: According to over-investment theory, fluctuations in the rate of investment are the main
causes of trade cycles. Investment becomes excessive during the boom. That investment during the boom is borne out
by the fact that investment goods industries expand faster than consumption goods industries during the upward phase of
the cycle. During the depression, investment goods industries suffer more than consumption goods industries.
(f) Keynes’ Theory: According to Keynes, the business cycle is a rhythmic fluctuation in the overall level of income,
output and employment. According to him, fluctuations in economic activity are caused by fluctuations in the rate of
investment. And fluctuations in the rate of investment are caused mainly by fluctuations in the marginal efficiency of
capital. The rate of interest, which is the other determinant of investment, is more or less stable and does not play a
significant role in cyclical fluctuations in investment.
Fluctuations in MEC or the expected rate of profit on new investment are due to:
(i) changes in the prospective yields, and
(ii) changes in the cost or supply price of the capital goods.
Towards the end of the boom, the decline in the prospective yields on capital is due, in first instance, to the growing
abundance of capital goods which lowers the MEC. The turning point from expansion to contraction is, thus, explained by
the collapse of MEC. As investment falls, because of the decline in MEC, income also falls. The multiplier works in
reverse direction.
Just as the collapse of MEC is the main cause of the upper turning point in the trade cycle, similarly the lower turning point,
i.e., change from recession to recovery, is due to the revival of MEC. The interval, between the upper turning point and the
start of recovery, is conditioned by two factors:
(i) the time necessary for wearing out of durable capital assets, and
(ii) the time required to absorb the excess stocks of goods left over from the boom.

(g) Theory of Interaction Between Multiplier and Accelerator:Theory of Interaction Between Multiplier and
Accelerator: The Keynes theory has ignored the acceleration effect on trade cycle. According to this theory, trade cycle is
result of the interaction between multiplier and accelerator. An autonomous increase in the level of fixed investment raises
income by a marginal amount according to the value of the multiplier. This increase in total income will induce further
increase in investment through acceleration effect. When this happens, the chain of causation is linked round in a ‘loop’;
investment affects income, which in turn affects investment. Take a look of the following table:
(All figures in billion Rs.)
Period Autonomous Induced ΔC Induced Total
Investment Consumption Investment Deviation of
(Deviation C = Y × mpc I = ΔC × Accelerator Income from
from
Base Period)
Base Period
 Y=C+I
(1) (2) (3) (4) (5) (6)

Rs. Rs. Rs. Rs. Rs.

0 0 0 0 0 0
1 10 0 0 0 10
2 10 6.7 6.7 13.4 30.1
3 10 20.0 13.3 26.6 56.6
4 10 37.8 17.8 35.6 83.4
5 10 55.6 17.8 35.6 101.2
6 10 67.5 11.9 23.8 101.3
7 10 67.6 0.1 0.2 77.8
8 10 51.8 -5.0 -10.0 51.8
9 10 34.6 -5.0 -10.0 34.6
10 10 23.0 -5.0 -10.0 23.0
11 10 15.4 -5.0 -10.0 15.4
12 10 10.2 -5.0 -10.0 10.2
13 10 6.8 -3.4 -6.8 10.0
14 10 6.6 0.1 0.2 16.8

In the above table, the mpc is assumed to be 2/3, accelerator to be 2 and there is one-period lag. One-period lag means that an
increase in income in one period induces an increase in consumption in the succeeding period. In the above table, an
autonomous investment of Rs.10 billion is added up each period. In the first period, an autonomous increase in investment of
Rs.10 billion gives rise to an increase in income of only Rs. 10 billion. It does not induce increase in consumption in period 1, as
we have assumed a lag of one period.
Now with mpc of 2/3, the increase in income of Rs. 10 billion in period 1 induces an increase in consumption of Rs. 6.7 billion (10
× 2/3) in period 2. With the value of accelerator as 2, there will be induced investment of Rs. 13.4 billion (6.7 × 2) in the period
2. Now the total increase in income in period 2 over the base period will be equal to the autonomous investment of Rs. 10 billion
which is maintained in the second period plus induced consumption of Rs. 6.7 billion plus induced investment of Rs. 13.4 billion
(total increase in income in period 2 = Rs. 30.1 billion). Now in the third period, the consumption would be 30.1 × 2/3 = Rs. 20
billion. The formula for income for this purpose is follows:

Income = Autonomous Investment + Induced Investment + Induced Consumption

The increase in consumption (ΔC) in period 3 is Rs. 13.3 billion (i.e., Rs. 20 billion – Rs. 6.7 billion). This increase in
consumption of Rs. 13.3 billion will induce investment of the value of Rs. 26.6 billion in period 3. Thus, the total increase in
the income in period 3 over the base period is equal to Rs. 56.6 billion. Under the combined effect of multiplier and
accelerator, the income increases up to the 6thperiod, but, beyond the 6th period, it begins to decrease. 1st to 6th is the
stage of expansion or upswing. The 6th one is a turning point and from 6th onward is the phase of contraction or down
swing.
In the above table, it has been assumed that there is no limitation of productive resources. In other words, there is no full
employment ceiling. The above table conveys the idea about interaction between the multiplier and accelerator and its impact
on national income.
As there is a limit to the increase in NI set by the full employment ceilings, Professor Hicks explains the different phases of trade
cycle with the help of following diagram:

In the above diagram, AA is the line representing autonomous investment. The multiplier and autonomous investment together
determine the equilibrium level of income shown by the line LL. This line is also known as ‘floor line’. The national income grows
from one year to the next along with this floor line. The line EE shows the equilibrium time path of national income determined
by autonomous investment and the combined effect of multiplier and accelerator. FF is the full employment ceiling. It is the line
that shows the maximum national output at any period of time.
Starting from point E, the economy will be in equilibrium moving along the path EE determined by the combined effect of
multiplier and accelerator and the growing level of autonomous investment. When the economy reaches P0 along the path
EE, suppose there is an external shock. There is an outburst of investment due to certain innovations or jump in
government investment. When the economy experiences such an outburst of autonomous investment, it pushes the
economy above the equilibrium path EE after point P0. The rise in autonomous investment due to external shock causes
NI to increase at a greater rate than shown by the slope of EE. This increase in NI will cause further increase in induced
investment through acceleration effect. The increase in induced investment causes NI to increase by a magnified amount
through multiplier.
Thus, under the combined effect of multiplier and accelerator, NI or output will rapidly expand along the path from P0 to
P1. But this expansion must stop at P1, because this is the full employment ceiling. The limited human and material
resources of the economy do not permit a greater expansion of NI. Therefore, when point P1 is reached, the rapid growth
of NI must come to an end. It is assumed that the full employment ceiling grows at the same rate as autonomous
investment. Therefore, FF slopes gently unlike the greater slope of the line from P0 to P1. When point P1 is reached, the
economy must grow at the same rate as the usual growth in the autonomous investment.
For a short time, the economy may crawl along the full employment ceiling FF. But because NI has ceased to increase at
the rapid rate, the induced investment via accelerator falls off to the level consistent with the modest rate of growth. But
the economy cannot crawl along its full employment ceiling for a long time. The decline in induced investment, when NI,
and hence consumption, ceases to increase rapidly, initiates a contraction in the level of income and business
activity. Thus, there is a slackening off at P2 and the level of NI moves towards EE. Investment falls off rapidly and
multiplier works in the reverse direction.
The fall in NI and output resulting from the sharp fall in induced investment will not stop on touching the level EE but will go
further down. The economy must consequently move all the way down from point P2 to point Q1. But at point Q1, the floor
has been reached. NI will not fall further, because this is the equilibrium level given by the working of ordinary multiplier
and autonomous investment free from simultaneous operation of the accelerator. The economy may crawl along the floor
through the path Q1 to Q2. In doing so, there is a growth in the level of NI. This rate of growth as before induces
investment and both the multiplier and accelerator come into operation, and the economy will move towards Q3 and the full
employment ceiling FF. This is how interaction between multiplier and accelerator causes economic fluctuations as
explained by Professor Hicks.
(h) Kaldor’s Contribution to Modern Trade Cycle Theory: Kaldor has also used a modified and more realistic form of
accelerator and investment function in trade cycle theory. According to the conventional concept of accelerator, the
investment or demand for capital depends upon the rate of change of the level of economic activity (i.e., the level of
income and employment). Whereas, according to Kaldor’s point of view, the demand for investment or capital goods
depends upon the level of activity rather than the rate of change of that level. It should be remembered that in Kaldor’s
analysis the level of activity means the level of national output, income and employment. In Kaldor's model of trade cycle,
the capital accumulation by raising the productive capacity affects the investment decisions of the entrepreneurs. The
effect of the capital accumulation on the investment decision of the entrepreneurs makes the investment function non-
linear in the real world (that is, investment-incomes or investment-employment curve is not a straight line). Through this
non-linear investment function, Kaldor has explained the conditions of stability and instability of an economy, which are
described as below:
In his theory, Kaldor has used ex-ante concepts of saving and investment, i.e., ex-ante saving and ex-ante
investment. Ex-ante investment means planned net addition to the stock of fixed capital and inventories of goods. This
ex-ante investment differs from the realised, actual or ex-post investment by the amount of unintended accumulations or
dis-accumulations of inventories of goods which arise due to difference between the planned and realised sales
goods. Ex-ante saving means the savings planned by the people for a period if they had accurately forecast their
incomes. Therefore, unexpected changes in the level of income will make the realised or ex-post saving different from the
planned or ex-ante saving.
When ex-ante investment exceeds the ex-ante saving, the level of activity or income and employment will rise and vice
versa. The equilibrium level of activity (income and employment) is determined at which ex-ante investment is equal to ex-
ante saving.
(i) Linear Saving and Investment Functions: Let us now see how Kaldor explains the stability and instability of the level
of economic activity and the course of trade cycle. Kaldor takes first the cases of linear (straight line) saving and
investment functions.
In the above diagram, linear investment and saving function is shown. The investment curve II is steepier than saving
curve SS. The two functions intersect each other at the equilibrium point C, at which the income is determined to be
Y0. But this equilibrium between ex-ante saving and ex-ante investment is unstable, because, if once this equilibrium is
disturbed, the economy will move either towards hyper-inflation or towards collapse.
Now consider the following diagram for a stable condition:
In the above diagram, the investment curve II is less steeply inclined than the saving curve SS. In this case any
disturbance, which sends the economy on either side of the equilibrium level, will not reinforce itself and the economy will
tend to come back to its equilibrium level Y0. But such a stability is also not realistic because economic system in the real
world shows great instability. Both the cases of linear ex-ante saving and ex-ante investment functions are quite
unrealistic and therefore Kaldor has ruled them out. According to him, in the real world, both the saving and investment
functions are non-linear, that is, they are not straight lines. The trade cycles or the fluctuations in the economy are
explained by non-linear saving and investment functions.
(ii) Non-Linear Saving and Investment Functions: The following figure describes the non-linear saving and investment
functions:
In the above diagram, the shapes of the investment curve II and the saving curve SS are not straight. They are cyclical
and fluctuating. Both the functions intersect each other at three different points, i.e., A, B and C. Equilibrium at point B is
quiet unstable. Above point B, investment exceeds saving and, therefore, once as a result of some disturbing investment
exceeds saving, the income (i.e., the level of activity) will go on moving upward till point C is reached, and below point B
saving exceeds investment and any disturbance which moves the system below point B, the level of activity or income will
go on moving downward till point A is reached. Above point C, saving exceeds investment and, therefore, if the system
does above point C, it will come back to it. Therefore, the system is stable upward. On the other hand, below point C,
investment exceeds saving and, therefore, any disturbance which sends the system below point C, it will be corrected by
the return to the point C. Thus, the level of activity or income at point C is also stable downward. It, therefore, follows that
the level of activity or income is in stable equilibrium at point C.
Point A also represents a stable equilibrium. Above point A, saving exceeds investment and below point A, investment
exceeds saving, which means that the level of activity will tend to return to point A if any disturbance, causing movement
either upward or downward, occurs. It, therefore, follows that both the extreme points C representing boom period and A
representing depression, are stable equilibrium points. This means that economy should tend to be in stable equilibrium at
either a very high or a very low level of activity. This is, however, a quiet unlikely and improbable result since in the real
world the economy is not found to be stable at these extreme levels of activity. This trade cycle is also known as ‘self-
generating trade cycle’.
Kaldor has explained this ‘self-generating trade cycle’ through the shifts or changes in the investment function and saving
function. According to Kaldor, when the level of investment is very high, production of consumer goods increases and as a
result both consumption and saving increase. This means that saving function SS will shift upward when the high level of
activity is reached. Besides, with a high level of investment the opportunities for further investment may become
temporarily restricted and as a result of this investment function curve II tends to shift downward. Thus, when the economy
is at a high level of activity, i.e., at point C, the saving function curve SS tends to move upward and the investment function
curve II tends to move downward and consequently the point C tends to move down and point B tends to move up as in
the following figure (a), until they meet each other at the combined point BC as in figure (b). at the combined point BC, the
economy is in unstable downward position. The contraction in the level of activity will continue further until point A is
reached.

The economy will not go below point A, because, saving and investment are in stable equilibrium at this point. But
according to Kaldor, reversal movement of the cycle will start because the investment function curve will shift
downward. Given the level of activity at A, investment in machines or equipment may not be sufficient to cover the
depreciation. This creates opportunities for more investment, which causes the investment function curve to move
upward. With the level of activity A, as the investment function curve II moves upward relative to the saving function curve
SS, the point B will separate from point C and tend to move towards A as in the following figure 7 (a). The investment
function curve II will go on shifting upward till combined point AB is reached in figure 7(b).
 But the combined point AB is unstable upward, for above combined point AB, investment exceeds saving. As a result, the
expansion in the level of activity will not stop at point AB but will continue until once again point C is reached. Now, with
the point C representing again the situation of boom having been reached, the investment opportunities once again will
become restricted and as a result the movement of contraction in the level of activity will start once again and the whole
process of contraction and then expansion will be repeated again. This is how Kaldor shows that the occurrence of trade
cycles in a free market economy is self-generating.
Policy for Trade Cycle:
(a) Monetary Policy: A country must always formulate and follow an appropriate monetary policy so as to avoid the
occurrence of booms and slumps. Monetary policy embraces banking and credit policy relating to loans and interest rates
as well as the monetary standard and public debt and its management. It influences the volume of credit base and,
through it the volume of bank credit and thus the general level of prices and of economic activity. When boom conditions
are developing, bank rate is raised and thus credit is contracted with the consequent brake upon the undue expansion of
business activity. In a depression, a policy of cheap money may be adopted to stimulate business investment and thus
assist recovery.
The bank credit policy involves two types of controls, i.e., the qualitative and the quantitative. The quantitative control is aimed at
general tightening or easing of the credit system as the situation may demand. It is exercised by influencing the reserves of the
banks. The qualitative or selective control seeks to regulate particular type of credit. Its object is to stimulate, restrict or stabilise
bank advances for specific business schemes.
 But there are limitations of monetary policy relating to bank rate and open market operations. Its success will depend on
how far certain assumptions are true. For example, how far the various member of the banking system are prepared to
accept the lead given by the central bank; how far the banks can make their borrowers use their credits for purposes for
which such credits have actually been created; further, how far monetary causes are responsible for the economic
fluctuations; and still further, and most important, whether the business community will adjust their investment exactly in
accordance with the altered rates of interest.
(b) Fiscal Policy: Since public expenditure in all modern states constitutes a fairly respectable proportion of the total national
income, fiscal policy is bound to affect the level of prices, production and employment, irrespective of the fact whether this policy
is deliberately aimed at this or not. Fiscal policy consists of two elements, i.e., public spending or the policy of public works, and
appropriate taxation.
In a year of depression, that is, when private investment is at a low ebb, the deficiency in investment will have to be made up by
large capital outlay by the state, and conversely, during the upward swing of the cycle, the state will have considerably to cut
down its spending programme. Thus, during the depression years, the state must be ready to spend beyond its current
revenues. In other words, the state should be prepared to have deficit budgets during depression. Conversely, there should be
surplus budgets during the years of prosperity. To put it another way, instead of having balanced budgets every year, the state
should aim at budget-balancing over a series of years.
On the revenue side, rates and taxes should be lowered during depression, while they should be raised during boom years. To
stimulate business investment during depression, not only the rates of taxes should be lowered but also more liberal allowances
for depreciation and obsolescence, etc., should be granted.
Thus, fiscal policy, which is also known as the contra-cyclical management of public finance, may be operated both through
public revenues and public expenditure.
(c) International Measures: So far we have discussed individual national efforts at economic stabilisation. But trade cycle
is an international phenomenon and no country is hermetically scaled from the rest of the world. In fact, this international
aspect creates complications and makes crisis control all the more difficult.
The measures which are suggested to be adopted on an international scale are: International Production Control, International
Buffer Stocks and International Investment Control. International Production Control envisages control of production and prices
of the importance primary products. The difficulties of such control are indeed formidable, notably because agriculture in
countries like India and Pakistan is usually carried on a small scale and more as a mode of living than business, so that even
though it ceases to be profitable, it will be continued. But production control, as far as possible, combined with buffer stocks to
counteract sudden changes in supply and demand, will go a long way in preventing rise or fall in their prices, which give rise
further to serious fluctuations in the entire economy.
An international investment control for developing backward regions would help in raising the standards of living of their people
and thus reduce the inequalities in the standard of living of different peoples. Such reduction in those inequalities is bound to
strengthen the forces of stabilisation.
 National Income Accounting in Pakistan
A system of national accounts consists of a coherent, consistent and interrelated set of economic accounts for sectors or sub-sectors o
economy as a whole. It provides a set of concepts, definitions and classifications within a broad accounting framework. It is designed f
of economic analysis and policy-making, including the formulation and monitoring of economic programmes and development planning
scientific, technological or social nature can be systematically related to economic data within the framework of an overall system of ac

In Pakistan, the national accounts are prepared as per guidelines provided by the United Nations System of National Accounts (UNSN
United Nations System of National Accounts (SNA) was published in 1953. The UN recommended countries to compile their econom
within the SNA framework to achieve consistency and facilitate international economic comparison. SNA has been revised several ti
account of these wider concerns. The latest version of the system was completed in 1993 and provides measures of producti
consumption, savings, capital formation and their financing for individual sectors and for the economy as a whole. SNA is a powerful
tool to provide the detailed economic information required to meet analytical and policy needs.

The first estimates of national accounts of Pakistan were prepared by the Economic Advisor’s Office in 1949. On the setting up of the
Statistical Office (CSO) in 1950, the job was transferred to CSO, now Federal Bureau of Statistics (FBS). Since then the FBS has been
different series of national accounts at current and constant prices.

For improvement of national accounts, several groups and committees were set up from time to time, the prominent being the Nationa
Commission-1963 and IBRD Statistical Mission-1969. As a result the national accounts of Pakistan have undergone modifications and
improvements at various stages with respect to timeliness, data availability, coverage and statistical techniques involved in their compu
1972-73, FBS undertook an exercise for switching over the base from 1959-60 to 1969-70. These estimates were presented before the
Accounts Committee but could not be adopted due to inconsistencies in the estimates of manufacturing sector. The Committee directe
to prepare estimates with 1975-76 base. The estimates with base 1975-76, on improved data availability, concepts and methodology w
prepared for the year 1975-76 through 1983-84 and presented before the Committee but could not be adopted by it due to persistent
inconsistencies. Despite successive efforts for the improvement of national accounting in Pakistan, the desired results have not been
particular the revised UN System of National Accounts–1968 could not be implemented even though nearly two decades have elapsed
adoption. During the year 1984-85, the NEC decided to shift the base to 1980-81. Accordingly a Committee on National Accounts wa
constituted to review the present methodology for preparation of National Accounts and to propose improvements considered necessa
Committee. The result was the 1980-81 base completed in 1988.
Efforts were made from time to time to shift the base from 1980-81 but due to one reason or the other, the work was postponed. Final
the NAC decided to shift the base year from 1980-81 to 1999-2000.

Sectoral Estimation of GNP/GDP:

GDP in Pakistan is estimated as per guidelines provided by the SNA. For the purpose of GDP estimation by sectoral activities (current
prices), product, income and expenditure approaches are applied. The economy is divided into the following sectors.

(a) Production Sectors

(i) Agriculture

 Major Crops
 Minor Crops
 Livestock
 Fishing
 Forestry

(ii) Industry

 Mining & Quarrying

 Manufacturing
o Large-Scale
o Small-Scale
o Slaughtering
 Construction
 Electricity, Gas and Water Supply

(b) Service Sectors

 Transport, Storage & Communications

 Wholesale & Retail Trade
 Finance and Insurance
  Ownership of Dwellings
 Public Administration & Defence
 Community, Social & Private Services

GDP is computed by a combination of product, income and expenditure methods. Product method is applied to compute value added in agriculture
quarrying, manufacturing, electricity & gas distribution, wholesale & retail trade and ownership of dwellings whereas income method is used to wor
accruing from transport, storage & communication, finance and insurance, public administration & defence and services sectors. Expenditure meth
estimate value added in construction on the basis of investment made and the co-efficient of value added relating to investment.

GNP/GDP Sectors
Approaches
Product method Agriculture, mining and quarrying;
manufacturing; electricity and gas distribution;
wholesale and retail trade; and ownership of
dwellings.
Income method Transport; storage and communication; finance
and insurance; public administration and
defence; and service sector.
Expenditure method Used to estimate value added in construction
on basis of investment made and the co-
efficient of value added relating to investment.

Gross Fixed Capital Formation (GFCF):

As per system of national Accounts SNA 1993 the gross fixed capital formation is measured by the total value of a producer’s acquisiti
disposals of fixed assets during the accounting period plus certain additions to the value of non-produced assets realized by the produ
of institutional units. Fixed assets are tangible or intangible assets produced as outputs from processes of production that are themselv
repeatedly or continuously in other processes of production for more than one year.

The estimates of GFCF in Pakistan are primarily constructed separately for private and public sectors by economic activity as well as b
assets. It comprises expenditure incurred on the acquisition of fixed assets, replacement, additions and major improvements of fixed c
land improvement, buildings, civil and engineering works, machinery, transport equipment and furniture and fixture. The methodology u
estimate GFCF in private and public sectors including general government is given in the succeeding paragraphs:
Private Sector: Estimates of private sector are computed by a combination of approaches i.e. commodity flow approach, expenditu
(Survey Method) and financial approach. Commodity flow approach that uses the net availability of capital goods in value terms fro
production and imports and exports, duly adjusted for various margins, is applied to the following three sectors.

(i) Agriculture

(ii) Construction

(iii) Transport

Expenditure approach (Survey Method) is applied to the following sectors:

(i) Mining & Quarrying

(ii) Large Scale Manufacturing (In-Production)

(iii) Small & Household Manufacturing Industries

(iv) Wholesale & Retail Trade

(v) Financial Corporate Sector

(vi) Ownership of Dwellings

(vii) Services

Financial approach is used to estimate GFCF in under-construction large scale manufacturing establishments, livestock farming, pou
and fishing supplemented by survey method.

Public Sector: The estimates of gross fixed capital formation in the public sector are compiled on the basis of data received from all the a
institutions by sub-sectors of the economy.
 Flow of Funds Accounts of Pakistan
In Pakistan, the Flow of Funds Accounts is prepared by the Statistics Department of State Bank of Pakistan since 1987. The flow
of funds accounts analysis was initiated in 1982 by SBP in collaboration with Federal Bureau of Statistics and Planning Commission
of Pakistan. Flow of funds accounts analysis includes sector classification, transaction categories and compilation procedure on
the basis of guidelines of SNA 1968[1], which is approved by the Standing Committee comprising of representatives from SBP,
PC[2], Ministry of Finance and Ministry of Production.
Flow of funds accounts provides a full picture of the financial interrelations among all economic sectors by linking their
transaction accounts and balance sheet accounts. It shows all the transactions that take place in an economy whether involving
purchases or sales of goods and services or exchanges of assets and liabilities. These transactions generate flows of funds from
one agent to another and from one sector to another. National flow of funds accounts, provide a record of these flows for the
whole economy. The flow of funds accounts mainly consist of two parts viz., non-financial flows, and financial flows:
(a) Non-Financial Flows: Non-financial flows relate to the flow of current income and expenditure, saving and investment.
As per SNA 1968, income and outlay account of a sector relates to the incoming of factor incomes and outgoing of
consumption expenditure. Saving is transferred from the income and outlay account to the capital finance account and is
used for investment purposes. The surplus/deficit in the non-financial flows represents the saving-investment gap.
(b) Financial Flows: The financial flows account is an extension of capital finance account, and describes lending and
borrowing operations of the different sectors in the economy. Sectors borrow by issuing claims on themselves or lend to
others by accepting claims on them. A sector may carry out both of these activities in varying degrees. A sector is classified
as a ‘deficit sector’ when the claims issued are more than the claims accepted, and a ‘surplus sector’ for vice versa. The
borrowing transactions take the form of increase in liabilities, sale of financial assets or reduction of money balances. The
lending operations comprise acquisition of financial assets, increase in money balances or repayment of past debts.
Sectoral Classification:
A very significant element in the preparation of flow of funds accounts is the appropriate grouping of commonly identifiable
economic units into sectors. A sector refers to a subdivision of the economy, in particular to a group of decision-making units
within the economy that are more or less homogeneous in certain respects. Pakistan’s economy is divided into following
economic sectors:
 (i) Federal Government: This sector includes all departments, offices, establishments and other bodies, which are
instruments of the Federal Government (other than financial institutions and non-financial public enterprises).
(ii) Provincial and Local Governments: This sector includes all departments, offices, establishments and bodies,
which are instruments of provincial governments and local governments’ institutions.
(iii) Public Enterprises (Non-Financial): This sector covers enterprises principally engaged in non-financial activities
and owned or controlled by public authorities, e.g., Pakistan Railways, Pakistan Post Office and the publicly owned non-
financial units which are financially integrated with the Federal Government.
(iv) Other Public Institutions: This sector includes non-profit institutions, which primarily serve households or
business enterprises and are wholly or mainly financed and controlled by public authorities and bodies.
(v) State Bank of Pakistan: This sector covers the transactions carried out by the Issue and Banking Departments
of the State Bank of Pakistan.
(vi) Scheduled and Co-operative Banks: This sector comprises scheduled banks and co-operative banks. In other
words, this sector includes all institutions licensed as banks and carrying out regular banking business.
(vii) Non-Bank Financial Institutions (NBFIs): All entities other than those which are primarily engaged in financial
transactions in the market, consisting of both incurring liabilities and acquiring financial claims on others. These comprise
development finance institutions (DFIs) except those which are scheduled bank, leasing companies, investment banks,
modarabas, housing finance companies, discount houses etc.
(viii) Insurance: This sector includes insurance companies (both private and public) consisting of organizations
providing life, accident, sickness, fire, casualty or other forms of insurance.
(ix) Private Corporate Business: This sector includes privately owned and/or controlled enterprises primarily
engaged in non-financial activities.
(x) Non-Corporate and Households: This sector purports to cover the transactions of persons, private
unincorporated enterprises (not included in other sectors) in agriculture, trade and industry and private non-profit making
trusts serving households. In essence, it comprises all domestic units not covered in other sectors.
(xi) Rest of the World: This sector covers Pakistan’s transactions with the rest of the world.
Classification of Transactions:
The various items of liabilities and assets have been classified into the following non-financial/financial instruments for the
compilation of Flow of Funds accounts:
(a) Non-Financial Transactions:
(i) Gross Fixed Capital: It includes the outlays (purchases and own account production) of industries, producers of
government services and private non-profit services to households, in additions to their stock of fixed assets less the net
scrapped goods.
(ii) Inventories: It represents the stock of raw materials, finished goods, and work-in-process. It also includes stores
and spares.
(iii) Gross Savings: Savings are the balancing item on the income and outlay account of domestic sectors
considering all current receipts and disbursements.
(b) Financial Transactions:
(i) Currency: Currency includes notes and coins in circulation excluding holdings of the State Bank of Pakistan and
the Federal government.
(ii) Deposits: Deposits include amounts held in bank accounts as demand, time, savings, or call deposits. It also
includes deposits with post offices, deposits held with NBFIs, deposits with insurance companies, deposits held abroad
by the SBP and authorized dealers in FOREX.
(iii) Bonds and Debentures: A bond is a security that gives the holder the unconditional right to a fixed money
income. With the exception of perpetual bonds, a bond also gives the holder an unconditional right to a capital payment
on a specified date or dates. Both short-term and long-term bonds and government bonds including Prize Bonds are
included in this category.
(iv) Treasury Bills: This covers treasury bills issued by the Federal Government including government treasury
deposit receipts.
(v) Small Savings: This comprises national savings schemes launched by the Federal Government, e.g., Defence
Savings certificates, Special Savings certificates, and Savings Accounts etc.
(vi) Stocks and Shares: Corporate equity securities include capital participation. These are instruments and records
acknowledging claims to the residual value and residual income of incorporated enterprises after claims of all creditors
 have been met. Equity securities do not provide the right to a predetermined income or to a fixed sum on dissolution of
the incorporated enterprises. Ownership of equity is usually evidenced by shares, stocks, participation, or similar
documents. Preference stocks or shares and certificates are also included here. NIT units and mutual fund certificates
also form part of it.
(vii) Loans and Advances: This transaction includes commercial bills, mortgage loans, bank overdrafts and other
bank loans, government loans and foreign loans, both guaranteed and non-guaranteed.
(viii) Life Fund: This covers reserves held against life assurance policies by life insurance business.
(ix) Provident Fund: This includes the assets of employees, provident funds in both public and private sectors.
(x) Monetary Gold: It covers changes in monetary gold held by SBP, which is a part of a country’s international
reserves.
(xi) Other Receivables and Payables: Financial items other than those described above are grouped under this
head.
Aggregate Balance Sheet:
The aggregate balance sheet of a particular sector, which depicts a complete picture of its liabilities and assets, is the
fundamental basis for compilation of the flow of funds accounts. The assets appearing therein are divided into physical and
financial assets while liabilities are classified as net worth and other financial liabilities. Increase in physical and financial assets
of the balance sheet represents investment and lending on the uses side of the flow of funds accounts; whereas increase in
reserves and liabilities appear as saving and borrowing on the resources side. As total assets are equal to total liabilities in the
balance sheet, the resources match with the uses in the flow of funds accounts. That is, the sum of investment and lending is
equal to the sum of saving and borrowing. It may, however, be mentioned that though saving-investment gap exists at the sector
level, saving equals investment at the aggregate level for the economy as a whole. Similarly, total financial resources equal total
financial uses for the aggregate economy. The following are the balance sheet items:
(a) Fixed Assets at Cost: Fixed assets consist of items which are not readily convertible into cash during the course of
normal operations of an institution...They are of a fairly permanent nature and are not normally liquidated or intended to be
turned into cash except in the form of depreciation which is add to the cost of goods sold. The following items are included
in fixed assets:
 (i) Real estate (e.g., freehold & lease hold land, factory and office building, residential buildings and capital projects in
progress at cost);
(ii) Plants and machinery and rolling stock;
(iii) Furniture, Fixture, Fitting and allied equipments etc.
(b) Stock in Trade: Stock in trade is the stock of finish, unfinished goods, and raw materials.
(c) Stores and Repairs: Consist raw material other than stock in trade; loose tools etc are taken from company’s annual
balance sheet.
(d) Cash in Hand: Cash in hand includes local currency in hands. Cheques, bank drafts etc are not included in the category.
(e) Federal Government Securities: Comprises investment in Federal government loans, income tax bonds, Federal
investment bonds, Pakistan investment bonds etc.
(f) Provincial Government Securities: Consist investments in various loans floated by the provincial governments and
bonds issued by local and provincial governments.
(g) Coins: These are the rupee and subsidiary coins issued by the Federal Government with various quantity of currency,
apprehended with State Bank of Pakistan.
(h) Deposits held Abroad: Deposit accounts and other placements with central banks of other countries are the total of
cash components of the balances sheet items of State Bank of Pakistan captioned approved foreign exchange and balances
held outside Pakistan.
(i) Foreign Securities: Are the aggregate balance sheet items of State Bank of Pakistan, scheduled and co-operative
banks & Insurance sectors, comprises investment of these sectors in foreign securities and shares.
(j) Other Securities: This item appeared in the aggregate balance sheet of scheduled and co-operative banks, comprises
debentures and participation term certificates (PTCs) an interest free instrument for meeting the term finance needs of the
corporate sector. Also included are other investments not specified elsewhere.
(k) Bill Purchased and Discounted: Advances extended through discounting or purchasing of trade bills – import/export
or inland bills, presented in the balance sheets of scheduled and co-operative banks.
(l) Other Assets: Other assets are the balance sheet items not covered elsewhere such as sundry debtors, accounts
receivable, prepayments, suspense accounts, dead accounts etc.
(m) Surplus: Arrives at by aggregating all types of reserves excepting depreciation reserve and reserve for bad & doubtful
debts plus the balance of profit & loss account and staff gratuity and subtracting there from intangible or fictitious assets e.g.
goodwill, preliminary expenses, patents, trade marks, prospecting expenditure, other deferred costs, adverse balance of
profit & loss account etc. Surplus also includes balance of amount received from consumers as contributions towards the
cost of supplying and laying service lines and mains, deferred interest on debentures and other deferred liabilities.
(n) Depreciation: Is the reduction in the currant market value of machinery, equipment or a fixed asset over a defined period
of time through usage or obsolescence; it is the amount allocated to cover the depreciable cost of an asset over the
accounting period during the asset’s useful life.
(o) Paid-up Capital: Paid-up capital (share capital) is amount rose through sale of stocks. It includes shares fully paid in
cash, issued as bonus shares and shares issued for consideration other than cash. Preferred stocks or shares, which also
provide for participation in the distribution of the residual value on dissolution of an incorporated enterprise (preferred in
distribution over ordinary shareholders), are included.
(p) Special Drawing Rights (SDRs): The instruments for financing international trade after Second World War were
predominantly reserve currencies, such as dollar, sterling and gold. J.M. Keynes had put forward the idea of an international
currency, to be called ‘Bancor’, regulated by a central institution. This idea was turned down then for fear that the creation
of liquidity would generate inflation. In 1969, the ‘group of ten’ agreed to establish SDRs, which are similar in principle to
Keynes’ original idea, and their agreement was ratified by the IMF. The SDR was linked to gold and equivalent to US $1 at
the gold rate of exchange of $35 per oz. Since then the SDR has slowly become more acceptable, and now commercial
banks accept SDR. It is a composite currency based on a standard basket of currencies, used by the IMF in determining
country quotas, purchase and repurchases, standby facilities, and other assistance facilities available to the member country.
Amount owed by Pakistan is recorded in the annual account of State Bank of Pakistan.
(q) Notes in Circulation: These are promissory notes issued by the State Bank of Pakistan with the promise to pay the said
quantity (face value) in Rupee when called for payment. These are issued with the guarantee of the Government of Pakistan.
(r) Head Office Accounts: Represents the foreign insurers’ balances with their branch offices in Pakistan as recorded in
the balance sheets of insurance sector.
 (s) Other Liabilities: Other liabilities are the balance sheet items not covered elsewhere such as sundry creditors, worker
profit participation funds, provision for taxation, unpaid dividend, other accounts payable, contingencies funds, and consumer
securities deposits etc.
Pakistan: Flow of Funds Account 2003-04
(Million Rs.)

Transactions / Sectors OverallDomesticSectors General Private Banking Rest of

Government Sector the World
Gross national disposable 5,578,625 564,872 5,013,753
income (GNDI)

Final consumption 4,515,363 462,462 4,052,901

Gross investment 864,701 267,110 597,591

Change in stock 94,294 94,294

Export of goods and non- -869,547

factor services

Import of goods and non- 1,018,953

factor services

Net factor income and -224,253

private transfers

Official transfers -29,421

Non-financial balances (S 104,267 -164,780 268,967 0 -104,267

– I) = CAB

Foreign financing 28,800 -88,102 -43,526 102,828

Non-monetary -59,302 28,800 -88,102 59,302

Direct investment (FDI) 54,753 54,753 -54,753

Net foreign borrowing -114,055 28,800 -142,855 114,055

Monetary -43,526 -43,526 43,526

 Change in net foreign -43,526 -43,526 43,526
assets

Of which: Valuation -3,649 3,649

changes

Domestic financing 135,900 -172,817 36,917

Monetary 63,700 -100,617 36,917

Domestic credit 63,700 307,234 -370,934

Broad money -407,851 407,851

Non-monetary 72,200 -72,200

Non-bank 72,200 -72,200

Net error and omissions -1,440 -8,049 6,609 1,440

Source: SBP Annual Report, Pakistan Economic Survey and Balance of Payments statement.

[1] SNA 1968 – System of National Accounts 1968

[2] PC – Planning Commission

Introduction to Statistics
 Introduction to Statistics
History of Statistics:

1. The word ‘statistics’ has been derived from the origin Latin word ‘status’ or the Italian word ‘statista’.
2. In 1749, Gottfried Achenwall during one of his lectures at a German university, used the word ‘statistik’ to mean the
political science of several countries.
3. Baron J.F. von Bielfeld defined statistics as the science that teaches what is the political arrangement of all the modern
states of the known world.
4. In 1839-39, the Journal of the Royal Statistical Society in an issue defined statistics as the ascertaining and bringing
together those facts which are calculated to illustrate the conditions and prospects of the society.
5. The subject matter of statistics has its origin in ancient times.
6. Moses and David numbered their people and made fairly accurate counts of population.
7. A census of population was held in Egypt as early as 3050 B.C. in connection with the construction of pyramid.
8. A land survey was conducted by Rameses II at about 1400 B.C. to redistribute the land among the inhabitants of Egypt.
9. Similar census of population and wealth were conducted by Chinese, Roman, Greek and Arab rulers.
10. Famous statisticians and mathematicians in the history are John Graunt, Casper Neuman, James G. Cardano (1501-36),
Jacob Bernoulli (1654-1705), Thomas Bayes, Pascal, Fermat, De Moivre, Laplace (1749-1827), Gauss (1777-1855), Karl
Pearson, William S. Gosset (1876-1937), R.A. Fisher (1890-1962), J. Neyman (1894-1983) and E.S. Pearson (1895-1981).

Famous Statisticians and Their Contributions:

Statisticians Contributions
John Graunt (1661) Vital Statistics

James G. Cardano (1501- Theory of Probability

1536)
Jacob Bernoulli (1654-1705) Theory of Probability
 Thomas Bayes (1763) Theory of Probability

De Moivre (1733) Normal Curve Equation

Adolf Quetlet (1796-1874) Applied Statistical Tools in

Education and Sociology
Francis Galton Applied Statistical Tools in Heredity,
Eugenics and Psychology
Karl Pearson Chi-Square Distribution

William S. Gosset (1876- Probable Error of Mean

1937)
R.A. Fisher (1890-1962) Developed Small Sample Theory

J.Neyman (1894-1983) and Theory of Hypothesis Testing

E.S. Pearson (1895-1981)

A. Wald (1902-1950) Statistical Decision Theory

Descriptive and Inferential Statistics:

1. Descriptive statistics deals with collection of data, its presentation in various forms, such as tables, graphs and diagrams,
and finding averages and other measures which would describe the data.
2. Inferential or inductive statistics deals with techniques used for analysis of data, making the estimates and drawing
conclusions from limited information taken on sample base and testing the reliability of estimates.

Characteristics of Statistics:

1. Statistics are aggregates of facts,

2. Statistics are affected to a great extent by the multiplicity of causes,
3. Statistics are numerically expressed,
4. Statistics are enumerated or estimated according to reasonable standards of accuracy,
5. Statistics are collected in a systematic manner,
 6. Statistics are collected with a definite object in view, and
7. Statistics are capable of being placed in relation to each other.

Functions or Uses of Statistics:

1. Statistics simplifies complexities,

2. Statistics presents facts in a definite form,
3. Statistics simplifies comparison of data,
4. Statistics studies relationship among different facts,
5. Statistics studies changes in the level of a given phenomenon,
6. Statistics aids forecasting,
7. Statistics guides the formation of policies, and
8. Statistics tests the laws of other sciences.

Limitations of Statistics:

1. Statistical results are true only on the average or in the long run,
2. Statistics does not deal with facts which cannot be numerically measured,
3. Statistical results may be sometimes, due to poor collection of data, fallacious and misleading,
4. Only experts can handle the statistical data efficiently, and
5. Statistics provides only the tools for analysis. It cannot however change the nature of the causes affecting statistical data.

Collection of Data:

There are two sources of collecting data:

(a) Primary Sources: The data published or used by an organisation which originally collects them are called ‘primary
data’. The data in the Population Census reports are primary because they are collected, compiled and published by the
Population Census Commission.
 (b) Secondary Sources: The data published or used by an organisation other than the one which originally collected
them are known as ‘secondary data’. For example, the data in Economic Survey of Pakistan.

Methods of Collection of Primary Data:

(a) Direct Personal Observation, i.e., through individual interviews.

(b) Indirect Oral Investigation, i.e., on evidence of persons or parties suppose to know the facts directly or indirectly.
(c) Registration is the most popular method of collecting data.
(d) Estimates Through Local Correspondents is not a formal collection of data. This method is generally used in crop
or land estimates.
(e) Investigation Through Enumerators to get the forms of inquiry filled in from the informants.
(f) Mailed Questionnaire Method.

Methods of Collecting Secondary Data:

(a) Official Sources, i.e., publications of Federal Bureau of Statistics; Ministries of Finance, Trade and Industry,
Telecommunication, Education, etc.
(b) Semi-Official Sources, i.e., publications of State Bank of Pakistan, SECP, District Councils, Municipal Committees,
etc.
(c) Private Sources, i.e., publication of trade associations, Chamber of Commerce and Industry, etc.
(d) Technical and Trade Journals.
(e) Research Organisations, i.e., universities, Institute of Education and Research, Institute of Development Economics,
etc.

Variable and Constant:

1. A measurable quantity which can vary from one individual to another is called a ‘variable’. Examples are heights and
weights of students in a class, prices of commodities, number of children in a family, etc. It is denoted by the last letters of
alphabets, i.e., x, y, and z.
 2. ‘Constant’ is a quantity which can assume only one value. Examples are p = 3.14159, e = 2.71828, etc. It is usually
denoted by the first letters of alphabets, i.e., a, b, c, d, …

Continuous or Discrete Variables:

1. A variable which can assume any value within a given range is called a continuous variable. For example, the heights
and weights of students, temperature, speed, etc. the height of a student can be 62”, 62.5” or 62.45”.
2. A variable which can assume only some specific values within a given range is called a discontinuous or discrete
variable. For example, the number of houses in a town, number of children in a family, number of students in a class,
etc. a discrete variable takes on values which are integers or whole numbers like 0,1,2,3,4,5, … but cannot be 2.5, 3.3,
3.91, 14.235, etc. There cannot be 4.5 houses in a town or 10.15 number of students in a class, etc.

Quantitative and Qualitative Data:

1. Quantitative variables are heights, weights, temperature, speed, etc.

2. Qualitative data are described by qualitative variables, such as marital status, religion, colour, race, etc.

Errors of Measurement:

The difference between the measured value and true value is called the error of measurement. These errors are of two types:

(a) Compensating Errors: are the errors which tend to balance or cancel out in the long run are called ‘compensating
errors’ or ‘chance errors’ or ‘random errors’.
(b) Biased Errors: are the errors which tend to occur in the same direction and have cumulative in effect, are called
‘biased errors’ or ‘cumulative errors’. Such errors are arised from faulty instruments or personal intentions.

Classification of Data:

The process of arranging data into classes or categories according to some common characteristics present in the data is
called‘classification’.

Data can be classified by many characteristics, but there are four main bases of data classifications, there are:
 (a) Qualitative, i.e., sex, religion, marital status, race, etc.
(b) Quantitative, i.e., height, weight, income, etc.
(c) Geographical, i.e., continents, states, cities, etc.
(d) Chronological, i.e., arrangement of data by their time occurrence, e.g., date of birth, date of joining, etc.

Types of Data Classifications:

Data can be classified by one, two or more characteristics at a time:

(a) Quantitative:

(i) One-way: when data are classified by one characteristic.

(ii) Two-way: when data are classified by two characteristics.
(iii) Three-way: when data are classified by three characteristics.
(iv) Many-way: when data are classified by many characteristics.

(b) Qualitative:

(i) Two-fold or dichotomy: we may divide a characteristic into two sub-classes one possessing the
characteristic and the other not possessing it. For example, the literacy and illiteracy of a country.
(ii) Three-fold or trichotomy: when data are classified into three sub classes.
(iii) Manifold: when data are classified into many sub-divisions.

Frequency Distribution:

(a) Frequency Distribution of Discrete Data: There are no class boundaries because discrete data are not in
fractions. If class interval size is one we usually take single values.
No. of children in a Number of
family families
0 7
1 3
 2 25
3 16
4 9
5 4
6 1
Total 65

(b) Frequency Distribution of Continuous Data: Class boundaries are formed for continuous data because the
continuous data are in fractions:

Heights of students in a class Number of

(inches) students
55.5-58.0 1
58.0-60.5 6
60.5-63.0 17
63.0-65.5 18
65.5-68.0 18
68.0-70.5 4
70.5-73.0 1
Total (S f) 65

(c) Cumulative Frequency Distribution: is the table showing cumulative frequencies:

Heights No. of Heights No. of

(inches) students (inches) students
Less than Greater than
Cumulative Cumulative
Frequency Frequency
Less than 55.5 0 55.5 and more 65
Less than 58.0 1 58.0 and more 64
Less than 60.5 7 60.5 and more 58
Less than 63.0 24 63.0 and more 41
Less than 65.5 42 65.5 and more 23
Less than 68.0 60 68.0 and more 5
Less than 70.5 64 70.5 and more 1
Less than 73.0 65 73.0 and more 0
 (d) Relative Frequency Distribution: is expressed in percentage of frequency to total frequency:

Heights Frequency Relative

(No. of frequency
students) (%)
55.5-58.0 1 1 / 65 × 100 = 1.54
58.0-60.5 6 6 / 65 × 100 = 9.23
60.5-63.0 17 26.15
63.0-65.5 18 27.69
65.5-68.0 18 27.69
68.0-70.5 4 6.16
70.5-73.0 1 1.54
65 100

(e) Relative Cumulative Frequency Distribution:

Heights No. of Relative Heights No. of Relative
(Inches) students Frequency (Inches) students Frequency
Less than Greater than
Cumulative Cumulative
Frequency Frequency
Less than 55.5 0 0 55.5 and more 65 100
Less than 58.0 1 1 / 65 × 100 = 1.54 58.0 and more 64 98.46
Less than 60.5 7 7 / 65 × 100 = 10.77 60.5 and more 58 89.23
Less than 63.0 24 36.92 63.0 and more 41 63.08
Less than 65.5 42 64.61 65.5 and more 23 35.38
Less than 68.0 60 92.31 68.0 and more 5 7.69
Less than 70.5 64 98.46 70.5 and more 1 1.54
Less than 73.0 65 100 73.0 and more 0 0

(f) Bivariate Frequency Distribution: involves constructing frequency distribution of two variables:
Weights Heights (inches)
(pounds) 57-59 60-62 63-65 66-68 69-71 72-74 Total
100-104 3 7 - - - - 10
105-109 - 5 10 2 1 - 18
110-114 1 1 4 6 4 0 14
115-119 - - 1 1 4 2 8
Total 3 12 15 9 9 2 50
 Graphical Presentation I
Types of Graphs:

(a) Histogram
(b) Frequency Polygon
(c) Relative Frequency Histogram and Polygon
(d) Cumulative Frequency Polygon or Ogive
(e) Frequency Curves and Smoothed Ogive

(a) Histogram:

1. A histogram consists of a set of adjacent rectangles having bases along x-axis (marked off by class boundaries) and
areas proportional to class frequencies.
2. To adjust the heights of rectangles in a frequency distribution with unequal class interval sizes, each class frequency
is divided by its class interval size.
Class Frequency
boundaries
109.5-119.5 1
119.5-129.5 4
129.5-139.5 17
139.5-149.5 28
149.5-159.5 25
159.5-169.5 18
169.5-179.5 13
179.5-189.5 6
189.5-199.5 5
199.5-209.5 2
209.5-219.5 1
Sf 120
 Class f Class Size Adjusted
Interval Boundaries Frequency
10-11 4 9.5-11.5 2 4/2=2
12-14 12 11.5-14.5 3 12 / 3 = 4
15-19 25 14.5-19.5 5 25 / 5 = 5
20-29 60 19.5-29.5 10 6
30-34 25 29.5-34.5 5 5
35-39 15 34.5-39.5 5 3
40-42 6 39.5-42.5 3 2
147
(b) Frequency Polygon:

1. It is constructed by plotting the class frequencies against their corresponding class marks (mid-points) and then
joining the resulting points by means of straight lines.
 2. The ends of the graph so drawn do not meet the ends of x-axis. A polygon is a many sided closed figure. Therefore,
extra classes are to be added at both ends of the frequency distribution with zero frequencies.
3. The frequency polygon can also be obtained by joining the mid-points of the tops of rectangles of histogram.

(c) Relative Frequency Histogram and Polygon: Same as described above.

(d) Cumulative Frequency Polygon or Ogive:

1. The graph showing the cumulative frequencies plotted against the upper class boundaries is called a ‘cumulative
frequency polygon’ or ‘ogive’.
2. The graph corresponding to a less than or a more than cumulative frequency distributions are called ‘less-than’ and
‘more-than ogives’ respectively.
Class Frequency Less than More than
Boundaries Cumulative Cumulative
 Frequency Frequency
109.5-119.5 1 1 119
119.5-129.5 4 5 115
129.5-139.5 17 22 98
139.5-149.5 28 50 70
149.5-159.5 25 75 45
159.5-169.5 18 93 27
169.5-179.5 13 106 14
179.5-189.5 6 112 8
189.5-199.5 5 117 3
199.5-209.5 2 119 1
209.5-219.5 1 120 0
Sf 120

(e) Frequency Curves and Smoothed Ogives:

Types of Frequency Distribution and Curves:

(a) Symmetrical Distribution,

(b) Moderately Skewed or Asymmetrical Distribution,
(c) Extremely Skewed or J-Shaped Distribution,
(d) U-Shaped Distribution, and
(e) Multi-Modal Distribution.

(a) Symmetrical Distribution: A frequency distribution is said to be symmetrical if the frequencies equidistant from the
maximum are equal.

Class 0-9 10-19 20-29 30-39 40-49 50-59 60-69

interval
Frequency 2 5 9 12 9 5 2
(b) Moderately Skewed or Asymmetrical Distribution: A frequency distribution is said to be skewed when it departs
from symmetry, i.e., when the frequencies tend to pile up in one end or the other end of a distribution.

Asymmetrical distributions are of two types, i.e.:

(i) Positively skewed, and

(ii) Negatively skewed.

(i) Positively Skewed:

Class 0-9 10-19 20-29 30-39 40-49 50-59 60-69

interval
Frequency 2 5 12 9 7 4 1

(ii) Negatively Skewed:

 Class 0-9 10-19 20-29 30-39 40-49 50-59 60-69
interval
Frequency 1 4 7 9 12 5 2

(c) Extremely Skewed or J-Shaped Distribution:

Income 0-1999 2000- 4000- 6000- 8000- 10000- 12000-

3999 5999 7999 9999 11999 13999
No. of 4000 3000 2500 1500 500 350 150
persons
(d) U-Shaped Distribution: In such a distribution, the maximum frequencies occur at both ends and a minimum in the
centre.
 Class 1-5 6-10 11-15 16-20 21-25 26-30
interval
Frequency 45 30 18 12 24 40

(e) Multi-Modal Distribution:

1. Frequency distributions with more than one maximum are called ‘multi-modal distribution’.
2. A distribution with two maxima is called a ‘bimodal distribution’.
Types of Charts:

(a) Simple Bar Chart,

(b) Multiple Bar Chart,
(c) Component Bar Chart,
(d) Percentage Component Bar Chart, and
(e) Pie Chart.

(a) Simple Bar Chart:

1. Simple bar chart consists of vertical or horizontal bars of equal width.

2. The length of the bars is taken proportionately to the magnitude of the values represented. The width of the bars
has no significance.
3. Vertical bars are used to represent quantitative data or chronological data. Whereas, the horizontal bars are
represented for qualitative data or geographical data.
4. If the data do not relate to time, then they should be arranged in ascending or descending order of magnitude.
 Exports of Pakistan (in US $ million)

Year Exports
1948 138
1951 406
1961 378
1971 683
1981 2958
1991 6168
2001 9202
2005 14410

(b) Multiple Bar Chart:

1. Multiple bar chart is an extension of simple bar chart.

2. Grouped bars are used to represent related sets of data. For example, imports and exports of a country together are
shown in multiple bar chart.
3. Each bar in a group is shaded or coloured differently for the sake of distinction.
Years Imports Exports
Rs. (billion) Rs. (billion)
 1982-83 68.15 34.44
1983-84 76.71 37.33
1984-85 89.78 37.98
1985-86 90.95 49.59
1986-87 92.43 63.35
1987-88 111.38 78.44

(c) Component Bar Chart:

1. This chart consists of bars which are sub-divided into two or more parts.
2. The length of the bars is proportional to the totals.
3. The component bars are shaded or coloured differently.

Current and Development Expenditure – Pakistan (All figures in Rs. Billion)

Years Current Development Total

Expenditure Expenditure Expenditure
1988-89 153 48 201
1989-90 166 56 222
1990-91 196 65 261
 1991-92 230 91 321
1992-93 272 76 348
1993-94 294 71 365
1994-95 346 82 428

(d) Percentage Component Bar Chart:

1. Component bar charts may also be drawn on percentage basis by expressing the components as percentages of
their respective totals.
2. All the bars are of equal length showing the 100%. These bars are sub-divided into component bars in proportion to
the percentages of their components.
Areas Under Crop Production (1985-90)
(‘000 hectors)
Year Wheat Rice Others Total
1985-86 7403 1863 1926 11192
 1986-87 7706 2066 1906 11678
1987-88 7308 1963 1612 10883
1988-89 7730 2042 1966 11738
1989-90 7759 2107 1970 11836

Percentage Areas Under Production

Year Wheat Rice Others Total

1985-86 66.2% 16.6% 17.2% 100%
1986-87 66.0 17.7 16.3 100
1987-88 67.2 18.0 14.8 100
1988-89 65.9 17.4 16.7 100
1989-90 65.6 17.8 16.6 100

(e) Pie Chart:

1. Pie chart is used to compare the relation between the whole and its components.
2. The difference between the component bar chart and pie chart is that in case of component bar chart the length of
the bars are used while in case of a pie chart the area of the sector of a circle is used.
3. In pie chart, the circle is drawn with radii proportional to the square root of the quantities to be represented because
the area of a circle is given by 2pr2.
4. The sectors are coloured and shaded differently.
5. To construct a pie chart, we draw a circle with some suitable radius (square root of the total). The angles are
calculated for each sector as follows:
Angles for each sector = Component Part × 360o
Total
 Graphical Presentation II
Exercises:

1.

Height 59 58 57 56 55 54 53 52 51 50 49 48 47
(in inches)
No. of 1 3 7 8 25 30 55 50 40 38 30 9 4
boys

2.

Weekly 20-25 25-30 30-35 35-40 40-45 45-50 50-55 55-60

wages
No. of 2 4 7 11 14 9 5 1
persons
3.

Year 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949
Yield 5 7 9 6 10 12 8 11 12 10
per
Acre
4.

Year No. of
Student
1983 1140
1984 1300
1985 1210
1986 1299
1987 1330
5.

Year 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971
Production 1050 1200 1250 1370 1425 1500 1585 1620 1750 1820
of cars
6.

Countries Birth rate Death rate

Japan 32 19
Germany 16 10
Egypt 44 24
France 21 16
7.

Country Production of
wheat
UK 12
USA 50
Canada 108
Pakistan 55
8.

City Population in
10,000s
1981 1991 2001
A 94 126 196
B 87 95 144
C 42 54 69
D 30 42 52
9.

Year Value (In Rs. Million) Year Value (In Rs. Million)
Imports Exports Imports Exports
1980-81 53544 29280 1985-86 90460 45592
1981-82 59482 26270 1986-87 92481 63353
1982-83 68151 34442 1987-88 112551 78443
1983-84 76707 37339 1988-89 135841 90183
1984-85 89778 37979
10.

Agriculture Value Added in Pakistan

(All figures in Rs. million)
Year Major Crops Minor Crops Other Crops Total
1972-73 12350 2830 6720 21900
1973-74 15330 3780 8970 28080
1974-75 18270 4900 10470 33640
1975-76 20720 5690 12180 38590
11.

Year Wheat Barley Oats Total

1971 34 18 27 79
1972 43 14 24 81
1973 43 16 27 86
1974 45 13 34 92
12. Schedule of Production for Each Year of Each Crop as a Percentage of Annual Total (See Exercise 11.)

Year Wheat Barley Oats Total

1971 43% 23% 34% 100%
1972 53 17 30 100
1973 50 19 31 100
1974 49 14 37 100
13.
14.

Items Expenditure Angle of Cumulative

Sectors Angle
 (In Rs. (In Degrees)
Thousand)
Food 95 142o 142 o
Clothing 32 48 o 190 o
Rent 50 45 o 265 o
Medical Care 23 35 o 300 o
Others 40 60 o 360 o
Total 240 360 o
 Measures of Central Tendency I
Definition:
A value which is used in this way to represent the distribution is called an ‘average’. Since the average lies in the centre of a distribution,
they are called ‘measures of central tendency’. They are also known as ‘measures of location’.
Types of Averages:
(a) Arithmetic Mean,
(b) Geometric Mean,
(c) Harmonic Mean,
(d) Median, and
(e) Mode.

(a) Arithmetic Mean (AM):

1. AM is defined as the value obtained by dividing the sum of the values by their number.
2. It is expressed as follows for sample data:
 Measures of Central Tendency II
(d) Median:

1. Median is defined as the middle value of the data when the values are arranged in ascending or descending order.
2. If there are even number of values in the data, the average of two middle values in the array is taken as the median:
 Measures of Dispersion
Definition:

1. Two or more distributions may differ greatly in their dispersion, although their means may be the same, for e.g.:

67,67,67,67,67,67,67,67

43,43,50,55,66,90,91,97

2. By dispersion we mean the extent to which the values are spread out from the average. The measures used for computing the amount
of dispersion in a distribution is known as ‘measures of dispersion’ or ‘measures of variation’.
3. In the above distribution, the first distribution has zero dispersion, and the second distribution has a dispersion greater than the
former. The dispersion cannot be less than zero.

Types of Measures of Dispersions:

Measures of dispersion are of two types:

(i) Measures of Absolute Dispersion, and

(ii) Measures of Relative Dispersion.

(i) Measures of Absolute Dispersion: The actual variation or dispersion determined by the Measures of Absolute
Dispersion is called ‘absolute dispersion’.

(ii) Measures of Relative Dispersion: The measures of absolute dispersion cannot be used to compare the variation of two
or more series. For e.g., the SD of the height of students (in inches) cannot be compared with the SD of weights (in pounds). Even
if the units are identical, for e.g., the comparison of height of men (in inches) and length of their noses (in inches). If the SD of
heights of man is greater than the SD of their nose lengths, it does not mean that the degree of variability is greater in case of
heights.

To compare the variation of two or more series, we need a measure of relative dispersion. It is defined as:
Types of Measures of Absolute Dispersion:

(a) The Range,

(b) The Quartile Deviation,

(c) The Mean Deviation, and

(d) The Standard Deviation.

(a) The Range:

1. The range is the simplest measure of dispersion. It is defined as the difference between the largest value and the smallest
value in the data:

2. For grouped data, the range is defined as the difference between the upper class boundary (UCB) of the highest class and the
lower class boundary (LCB) of the lowest class.

(b) Quartile Deviation (QD):

1. It is also known as the Semi-Interquartile Range. The range is a poor measure of dispersion where extremely large values
are present. The quartile deviation is defined half of the difference between the third and the first quartiles:

2. The difference between third and first quartiles is called the ‘Inter-Quartile Range’.

(c) Mean Deviation (MD):

 1. The MD is defined as the average of the deviations of the values from an average:

It is also known as Mean Absolute Deviation.

2. MD from median is expressed as follows:

3. For grouped data:

(d) Standard Deviation (SD):

1. The SD is defined as the positive Square root of the mean of the squared deviations of the values from their mean.

2. Thus, the SD of population of N values, x1, x2, ….. xn is expressed as follows:

 Measures of the Shape of Distribution
The frequency distribution can be described by the following four characteristics:

1. The ‘central value’ in the distribution around which the observations tend to lie, which is described by the ‘measures of central
tendency’,
2. The ‘dispersion’ i.e., the extent to which the observations are spread out from the central value, which is described by the ‘measures of
dispersion’,
3. The manner in which the observations are distributed around the central values, i.e., whether the distributions
is ‘symmetrical’ or ‘skewed’, which is described by the ‘measures of skewness’, and
4. The ‘peakedness’ or ‘flatness’ of the distribution which is measured relative to a distribution known as ‘normal distribution’, which is
described by the‘measures of kurtosis’.

All these four characteristics can be described by what are known as ‘moments’.

Moments:

Moments are the AM of the powers to which the deviations are raised. Thus, the mean of the first power of the deviations from mean is
the ‘first moment about mean’, the mean of the second power (squares) of the deviations from mean is the ‘second moment about mean’, and
so on.

(a) Moments about Mean:

Symbolically, the first four ‘moments about mean’ (denoted by m1, m2, m3 and m4) are defined as:
 Index Numbers I
Introduction:

1. An index number is a device which shows by its variations the change in a magnitude which is not capable of accurate measurement in
itself or of direct valuation over time.
2. To measure changes in a situation we combine the prices and qualities and find a single number. This single number which shows
overall changes in a phenomenon is known as ‘Index Number’.
3. It is used to compare changes in a complex phenomenon like the cost of living, total industrial production, wages, etc.
4. It is very useful in measuring changes in prices and quantities of commodities with different measuring units, for example, wheat per
maund, cloth per yard, etc., which cannot be compared directly.

Types of Index Number:

(a) Price Index Number: It compares changes in prices, from one period to another. Wholesale price index and cost of living index
are the examples.

(b) Quantity Index Number: It measures how much the quantity of a variable changes over time. Index of industrial production and
business activity index are examples.

(c) Value Index Number: It measures changes in total monetary worth. It combines price and quantity changes to present a more
informative index. Index of GNP and index of retail sales are the examples.
Uses of Index Numbers:

1. An index number is a device for measuring changes in a variable or a group of related variables.
2. It can be used to compare changes in one or more variables in one period with those of others or in one region with those in the others.
3. The index number of industrial activity enables us to study the progress of industrialisation in the country.
4. The quantity index numbers show rise or fall in the volume of production, volume of exports and imports, etc.
5. The cost of living index numbers are, in fact, the retail price indices. They show changes in the prices of goods generally consumed by the
people. Therefore, they can help the government to formulate the suitable price policy.
6. The cost of living index number can be made a basis for regulation of wage rates and can be used by industrial and commercial organisations to
grant dearness allowance and bonus to their employees in order to meet the increased cost of living.
7. Index numbers are also used for forecasting business activity and in discovering seasonal fluctuations and business cycles.
Steps in the Construction of Index Numbers of Prices:

(i) Defining the purpose and scope of index number, i.e., the general-purpose or special purpose,

(ii) Selecting commodities to be included,

(iii) Collection of prices, i.e., (a) considering the prices to be used like average price, retail price or wholesale price, etc; and (b) the
sources of price data like from representative markets, price lists or trade journals.

(iv) Selecting base period, (a) fixed-base method, and (b) chain-base method.

(v) Choice of average to be used, i.e., AM, median or GM.

(vi) Selecting suitable weights: (a) implicit weighting, and (b) explicit weighting.

Notations:

Pn = Price in current year

Po = Price in base year
Qn = Quantity in current year
Qo = Quantity in base year
Pon = Price for the nth year to the base year
Qon = Quantity for the nth year to the base year

Construction of Price Index Numbers:

(a) Simple Relatives or Simple Index Numbers,

(b) Unweighted Index Numbers, and

(c) Weighted Index Numbers.

(a) Simple Relatives: are further classified into two categories:

(i) Price Relatives: are obtained by dividing the price in a given year by the base year price and expressed as
percentage. Thus:
 Index Numbers II
Theoretical Tests for Index Numbers:
According to Dr. Irvin Fisher, a good index number is required to satisfy the theoretical tests given below:
(a) Time Reversal Test: This test may be stated as follows:
“If the time subscripts of a price (or quantity) index number formula be interchanged, the resulting price (or quantity) index formula
should be reciprocal of the original formula”

The Fisher’s and Marshall-Edgeworth’s formulae satisfy the ‘Time Reversal Test’.
Wholesale Price Index:
The wholesale price number is designed to measure changes in the goods and services produced in different sectors of the economy and
traded in wholesale markets. These goods and services even include electricity, gas, petrol, telecommunication, etc. These indices are
constructed by weighted aggregative method with quantities produced or sold as weights.
Consumer Price Index (CPI):
1. This index is also known as the ‘Cost of Living Index’ or ‘Retail Price Index’. It is designed to measure changes in the cost of living.
2. By cost of living, the cost of goods and services of daily use purchased by a particular class of people in a city or town is
meant. These goods and services are known as ‘market basket’ consists of food, house rent, apparel, energy, education, health and
miscellaneous items.
3. CPI is essentially a weighted aggregative price index. The prices used are the coverage retail prices paid by the consumers for
purchase of goods and services. The weights are proportion of expenditure on different goods and services.
Construction of Consumer Price Index:
Following steps are involved in the construction of CPI:
(a) Scope: As the first step the scope of index number is determined, e.g., the industrial workers, middle class, salaried individuals,
low-income earners, etc. It is, therefore, necessary to specify the class of people and the locality where they reside. The class or
group of people considered should, as far as possible, be homogenous with regard to their incomes and consumption patterns.
(b) Family Budget Inquiry and Allocation of Weights: The second step is to conduct a family budget inquiry so as to ascertain the
proportions of expenditure on different items and to assign weights to various items. The information regarding the nature, quality
and quantities of commodities consumed should be analysed and weights assigned in proportion to the expenditure on different
items.
(c) Price Data: The prices used in the construction of consumer price index are the retail prices.
(d) Methods of Construction: Two methods are used for the construction of CPI. The index numbers under both methods are the
same. These methods are:
(i) Aggregative Expenditure Method: In this method, the quantities consumed in the base year are taken as weights. It
is thus the base year weighted index number given by Lespeyre’s formula:
 (ii) Family Budget Method: This method is the weighted average of relatives. The amounts of expenditure incurred by
families on various items in the base period are used as weights. This method is known as ‘Family Budget Method’ because the
amounts of money spent by the families are obtained from a family inquiry:

Example:
Commodity Qty. Unit of Price Price
Consumed
2001 2005

Wheat 250 kgs Rs. per 10 kgs bag 120 150

Rice 100 kgs Rs. per 40 800 1120

kgs bori (bag)

Sugar 18 kgs Rs. per 40 440 1200

kgs bori (bag)

Milk 57 kgs Rs. per kg 18 32

Tea 14 kgs Rs. per 100 kgs bag 17800 18000

Salt 1 kg Rs. per kg 1 5

Compute consumer price index number for the year 2005 taking 2001 as base year using:
(a) Aggregative Expenditure Method, and
 (b) Family Budget Method.
Solution:
(a) Aggregative Expenditure Method:
Quantity Qo Prices Aggregate
Consumed Expenditure
Po Pn PoQo PnQo

Wheat 250 kgs 25 bags 120 150 3000 3750

Rice 100 kgs 2.5 boris(bags) 800 1120 2000 2800

Sugar 18 kgs 0.45 bori(bag) 440 1200 198 540

Milk 57 kgs 57 kgs 18 32 1026 1824

Tea 14 kgs 0.14 bag 17800 18000 2492 2520

Salt 1 kg 1 kg 1 5 1 5

8717 11439

(b) Family Budget Method:

Uses of Consumer Price Index:
(a) Purchasing Power of Money: The purchasing power of a rupee is the reciprocal of CPI. It expresses the purchasing power of
rupee in a current time period relative to the base period:

(b) Deflation of Per Capita Income: The effect of changing prices on per capita income may be removed by deflating the income
expressed in current money by CPI to produce a measure expressed in terms of deflated (real) money. This relationship is:
 The deflated (or real) per capital income is expressed in terms of the price level at the time of the base period of CPI.
Example:
For the following CPI, calculate the purchasing power of rupee for each year:
Year CPI

2000 100

2001 103.54

2002 106.75

2003 111.63

2004 121.98

Solution:

Year CPI Purchasing Power of Rupee

2000 100 1.0000

2001 103.54 0.9658

2002 106.75 0.9368

2003 111.63 0.8958

2004 121.98 0.8198

Example:
Deflate the Per Capita Income (PCI) by the consumer price index given in the following table, with base year 2000:
Year CPI PCI
(In US$)
2000 100 526
 2001 103.54 501

2002 106.75 503

2003 111.63 579

2004 121.98 657

Solution:
Deflated Per Capita Income:

Construction of Wholesale and Consumer Price Indices in Pakistan:

Three price indices are prepared in Pakistan by Federal Bureau of Statistics:
(a) Wholesale Price Index,
 (b) Consumer Price Index, and
(c) Sensitive Price Indicator.
(a) Wholesale Price Index: This index is based on 91 commodities comprising 690 specifications. Lespeyre’s method is used and the
average wholesale prices for the current year are used.
(b) Consumer Price Index (CPI): This index is based on around 500 items of daily use grouped in 9 groups. Prices are collected from
25 major cities of the country. Number of markets varied from 1 to around 15 depending upon the size of the town. The average
prices collected from the markets of a town represent the average retail price of that town. Lespeyre’s method is used for
construction of CPI.
(c) Sensitive Price Indicator: This index measures changes in the retail prices of around 50 essential items of daily use of low-income
earners’ group.
Splicing Index Numbers:
1. A series of index numbers may be discontinued because of obsolete commodities included in it or because of change in weights of
these commodities.
2. If a new series of index numbers is constructed with changed commodities or changed weights, the two series (old and new) are
not comparable. The old and new series must therefore be adjusted so that the two series are comparable.
3. To adjust the new series, new index numbers are multiplied by the ratio of the old to the new index in the period of
discontinuation:

4. Likewise, to adjust the old series, old index numbers are multiplied by the ratio of the new to old index:

The above procedures are known as ‘Splicing Index Numbers’.

Example:
In the data given below, 2001 is the year of discontinuation of the old series. Construct a continuous series by splicing:
(a) Old series, and
(b) New series.
Year Index Index
(Old Series) (New Series)
1995 99.8

1996 96.7

1997 95.3

1998 111.9

1999 134.6

2000 159.8

2001 173.2 96.7

2002 100.0

2003 100.9

2004 109.1

2005 111.0

Solution:

(a) Old Series: To splice the old series, multiply old indices by 0.5583, i.e., .

(b) New Series: To splice the new series, multiply new indices by 1.7911, i.e., .
Year Index Index Spliced Spliced
(Old) (New) Index Index
(Old) (New)
1995 99.8 55.7 99.8

1996 96.7 54.0 96.7

1997 95.3 53.2 95.3

1998 111.9 62.5 111.9

1999 134.6 75.1 134.6

2000 159.8 89.2 159.8

2001 173.2 96.7 96.7 173.2

2002 100.0 100.0 179.1

2003 100.9 100.9 180.7

2004 109.1 109.1 195.4

2005 111.0 111.0 198.8

 Probability
Definition:
An experiment is any well-defined operation or procedure that results in one of two or more possible outcomes. An outcome is particular
result of an experiment.
Counting Techniques:
(a) Tree Diagram,
(b) Multiplication Rule,
(c) Permutation, and
(d) Combination.
(a) Tree Diagram: Counting the number of possible outcomes of an experiment plays a major role in probability theory. These
possible outcomes can be shown by the branches of a tree-like diagram called ‘Tree-Diagram’ or ‘Branch Diagram’.
(b) Multiplication Rule: If an operation of an experiment can be performed in n1 ways and if for each of these ways another
operation can be performed in n2ways, then the two operations can be performed together in n1 × n2 ways, and the kth in nk ways,
then all the k operations can be performed together in n1 × n2 × n3 × …….. × nk ways.
For example, a coin and a die tossed together, the possible outcomes will be:
n1 = 2 (coin: two sides)
n2 = 6 (die: 6 sides)
The two operations can result in (n1 × n2) 12 ways.
(c) Permutations: A permutation is a group of items with a certain ordered arrangement. For example: ABC, ACB, CAB, CBA and BCA
are different permutations. The rules of permutation are different under each of the following four situations:
Situation I:
 (i) All the items are distinct,
(ii) Each item can occur only once in an arrangement, i.e., repetition not allowed or without replacement, and
(iii) Each item can occupy any place in an arrangement.
Basic Concepts of Probability Theory:
(a) Possibility Space,
(b) Event,
(c) Complementary Event,
(d) Mutually Exclusive Events,
 (e) Composite Events, and
(f) Joint Events.
(a) Possibility Space: Also known as ‘sample space’ or ‘outcome space’. A possibility space is a set of all possible outcomes of an
experiment and is denoted by S.
If an experiment consists of a toss of a fair die and the numbers are of interest, the possibility space would be:
S = {1, 2, 3, 4, 5, 6}
If the interest is whether the number is even or odd, the possibility space would be:
S = {even, odd}
A possibility space may be represented by a rectangle. The number of outcomes in the possibility space is denoted by n(S).
(b) Event: A subset of a possibility space is called an event and is usually denoted by first few capital letters A, B, C, ……… For
example, a coin is tossed, the sample space is S = {H, T} and the subset A = {H} is the event when a head occurs.
Take another example, two coins are tossed. The sample space is S = {HH, HT, TH, TT} and the subset B = {HH, HT, TH} is the event
that at least one head appears when two coins are tossed.
An event may be represented by a circle inside the rectangle of the possibility space.
An event is further divided into the following:
(i) Simple Event: is the subset if it contains only one outcome of the possibility space.
(ii) Compound Event: is the subset if it contains more than one outcomes of the possibility space.
(iii) Null Event: is a subset containing no outcomes. It is also called ‘impossible event’.
(iv) Sure Event: It is also called ‘certain event’. It is a subset containing all outcomes of the possibility space.
Number of possible events = 2n
Example:
Two coins are tossed. List all the possible events or subsets of the possibility space.
Solution:
S = {HH, HT, TH, TT}
n(S) = 4
Number of possible events = 2n = 24 = 16 events
Possible Events of two tossed coins:
 Random Variable and
Its Probability Distribution
Random Numbers:

1. In our every day life, we base many of our decisions on random outcomes, i.e., change occurrence. For e.g., captains of two cricket
teams toss a coin to decide as to which team will play first, or lotteries are drawn by spinning wheal, etc.
2. Random numbers are the numbers obtained by some random process (manually or mechanically).
3. These numbers are assumed to be randomly and uniformly (equally) distributed. The basic random numbers are the 10 one-digit
numbers, i.e., 0, 1, 2, ………. 9. Each of these numbers has an equal change 1/10 of being selected.
4. Random numbers can be generated manually as well as mechanically. Random numbers can be generated manually by drawing cards
from playing cards or rotating spinning wheel, etc. Mechanically generated random numbers are from calculators and computers.
5. The most common use of random numbers is for selection of samples.

Random Variables:

1. Experiments in which outcomes vary from trial to trial are called ‘Random Experiments’.
2. A variable whose values are determined by the outcomes of a random experiment is called a random variable.
3. In other words, random variable is a rule which assigns numbers to the outcomes of the possibility space and is denoted by X.
4. For example, throwing of a die is a random experiment and its outcomes, i.e., the occurrence of 1, 2, 3, 3, 4, 5 and 6 is a random
variable.
5. A random variable is also called a ‘chance variable’, ‘stochastic variable’ or simply a ‘variable’. Capital letters of X or Y are used to
denote a variable and lower case letters x or y are used to denote its values.
6. Many random variables may be defined for one and the same possibility space.
7. When any characteristics of the individuals of a population (or a sample) are measured or counted, the characteristic itself is a random
variable.
8. The random variables are further bifurcated into:

(a) Discrete Random Variable, and

(b) Continuous Random Variable.

 (a) Discrete Random Variable: A random variable which can assume only a finite number of values or a sequence of whole
numbers is called a discrete random variable. For example, the number of spots on a die is a discrete random variable, number of
persons enrolled for CSS examinations, number of students passed in 1 st division in a particular class, number of defective items in
a lot, etc. are discrete random variables, which could assume any of the possible values, i.e., 1, 2, 3…….

(b) Continuous Random Variable: A random variable which can assume all possible values on a continuous scale in a given
interval is called a continuous random variable. For example, height, weight, temperature, distance, life periods, speed, etc. are
continuous random variables.

Example:

A coin is tossed three times. Find the possibility space and define two random variables for this possibility space.

Solution:

S = {HHH, HHT, HTH, THH, HTT, TTH, THT, TTT}

(i) Let a random variable (X) the number of heads:

X = no. of heads.

Note: The same value may be assigned to different outcomes of the possibility space.

(ii) Let a random variable (X) head as +1 and tail as –1:

Probability Distribution:

1. An arrangement of all possible values of a random variable along with their respective probabilities is called a ‘probability
distribution’ or a ‘probability function’.
2. Probability distribution can be further bifurcated into:

(a) Discrete Probability Distribution, and

(b) Continuous Probability Distribution.

(a) Discrete Probability Distribution: Let a discrete random variable X assume values x1, x2, x3, ……….., xn with respective
probabilities P(x1), P(x2), P(x3), …………, P(xn). Since the random variable takes a discrete set of values, it is also called a discrete
probability distribution. A discrete probability distribution may take the form of a table, a graph or a mathematical equation.

A probability distribution is similar to a relative frequency distribution with probabilities replacing relative frequencies.

A discrete probability distribution must possess the following two properties:

(i) 0 ≤ P(xi) ≤ 1

(ii) ∑P(xi) = 1, which means that the sum of probabilities is equal to one.

Example:

A coin is tossed three times. Find the probability distribution of the random variable number of heads.

Solution:

S = {HHH, HHT, HTH, THH, HTT, THT, TTH, TTT}

No. of Heads Probability of X

X P(X)
1
0 /8
3
1 /8
3
2 /8
 1
3 /8
Total 1

Example:

Determine whether the function for X = 1, 2, 3 and 4 can be a probability distribution.

Solution:

X P(X)
2
1 /14
3
2 /14
4
3 /14
5
4 /14
Total 1

(b) Continuous Probability Distribution: As we known that a random variable which can assume all possible values within a given
interval is called a continuous random variable. Within a given interval, there are an infinite number of values. For example, there
may be an infinite number of weights between 69.5 kgs and 70.5 kgs. In case of a continuous random variable, therefore, we compute
probabilities for various intervals of continuous random variable, such as P(a ≤ X ≤ b) or P(X ≥ c).

The probability distribution of a continuous random variable cannot be presented in tabular form. It can be represented by means of a
formula or through a graph. The formula is necessarily in the form of a function of the numerical values of the continuous random
variable X. For e.g., a continuous random variable can assume values between X = 2 and X = 4 and the function is given by:

The continuous probability distribution is further discussed in detail later.

Mean and Variance of a Random Variable:

In a probability distribution of a random variable X, the mean, also referred to as ‘Mathematical Expectation’ or ‘Expected Value’, and the
variance are defined as:
 μ = E(X) = Σ X · P(X)

and σ2 = V(X) = Σ X2 · P(X) – [E(X)]2

Distribution Function:

A function showing probabilities that a random variable X has a value less than or equal to x is called the ‘cumulative distribution
function’ or ‘distribution function of x’.

Symbolically, the cumulative distribution function, denoted by f(x) is defined as:

The cumulative distribution function has the following properties:

(i) f(– ∞) = 0 and f(∞) = 1, which means that f(x) is an increasing function ranging from 0 to 1.

(ii) If a < b then f(a) < f(b) for any real numbers a and b.

For a discrete random variable, distribution function is obtained by cumulating probabilities just as we obtained cumulative distribution.

The distribution function for the probability distribution of the previous two examples is as below:

x f(x)
x<0 0
0≤x<1 1
/8
1≤x<2 4
/8
2≤x<3 7
/8
x≥3 1
x f(x)
x<1 0
1≤x<2 2
/14
2≤x<3 5
/14
3≤x<4 9
/14
x≥4 1
Example:

Calculate the mean and variance for the following probability distribution:

X 0 1 2 3 4 5 6 7
P(X) 0.11 0.23 0.34 0.16 0.10 0.06 0.04 0.01

Solution:

X P(X) XּP(X) X2ּP(X)

0 0.11 0 0
1 0.23 0.23 0.23
2 0.34 0.68 1.36
3 0.16 0.48 1.44
4 0.10 0.40 1.60
5 0.06 0.30 1.50
6 0.04 0.24 1.44
7 0.01 0.07 0.49
Total 1 2.4 8.06

μ = E(X) = Σ X · P(X) = 2.4

σ2 = V(X) = Σ X2 · P(X) – [E(X)]2 = 8.06 – (2.4)2 = 2.3

Binomial Probability Distribution:

1. Binomial probability is a mathematical formula to determine probabilities of the discrete values of a random variable called ‘Binomial
Random Variable’.
2. The following are the conditions of Binomial Probability:

(i) If an experiment contains only two possible outcomes, i.e., success or failure.

(ii) The probability of ‘success’ is denoted by ‘p’ and the probability of ‘failure’ is denoted by ‘q’ where q = 1
– p or p + q = 1.

(iii) Such an experiment is repeated n times independently. In independent repetitions, the probability p remains
constant.

3. The number of success in n experiments is the Binomial Random Variable and is denoted by X. The possible values of X are 0, 1, 2, 3,
4, ….., n. The probabilities of the values of X are calculated by the following formula:

Where x = 1, 2, 3, 4, ………, n

The above formula is ‘Binomial Probability Distribution’. The two constant quantities p and n are called the parameters of a Binomial
Distribution. The quantity q is not a separate parameter because q = 1 – p.

Mean and Variance of a Binomial Distribution:

The mean and variance of a binomial distribution are directly evaluated in terms of its parameters p and n.
Example:

A coin is tossed 3 times. ‘Number of heads’ in 3 tosses is the random variable X. Calculate probabilities of all possible values of X. Also
calculate mean and variance.

Solution:

Experiment: A coin is tossed for 3 times.

Success: Head

p = P(success) = P(head) = ½

n = number of times the coin is tossed = 3

x = 0, 1, 2, 3.

Now applying the Binomial Formula:

Mean and Variance:

X P(X) X.P(X) X2.P(X)

0 0.125 0 0
1 0.375 0.375 0.375
2 0.375 0.75 1.5
3 0.125 0.375 1.125
Total 1 1.5 3

Hyper Geometric Probability Distribution:

1. It is a formula to determine the probabilities of the values for a random variable called ‘Hyper Geometric Random Variable’.
2. Following are the conditions of hyper geometric random variable:

(i) There are N items of which K are of first kind and the remaining (N – K) are of second kind,

(ii) A sample of n items is randomly drawn without replacement from the N items.

Number of items of first kind in the sample is the random variable X:

Possible values of X are 0, 1, 2, ………, k when n ≥ K and

0, 1, 2, ……….., n when n < K

3. The probabilities of these values are calculated by the formula:

 Where x = 0, 1, 2, 3, …….., k when n ≥ k

And x = 0, 1, 2, 3, ………, n when n< k

The above formula is called ‘Hyper Geometric Probability Distribution’. A schematic explanation of this formula may be given as:

Example:

A committee of 3 persons is to be formed from among 3 men and 2 women. If the selection of the committee members is random, construct
the probability distribution of the random variable ‘Number of women in the committee’.

Solution:
The Hyper Geometric Probability Distribution of RV ‘No. of Women in the Committee’ is as follows:

X P(X)
0 0.1
1 0.6
2 0.3
Total 1

Poisson Probability Distribution:

 1. A random variable created by counting the number of items or events in a unit of either time or space is called a ‘Poisson Random
Variable’.
2. Examples of Poisson random variable are the number of accidents per day on a highway, number of cars arriving at petrol pump in a
five minute period of time, number of typing mistakes per page and number of defects in a painted surface, etc.
3. A Poisson probability distribution formula assigns probabilities to the values of the ‘Poisson Random Variable’:

Where x = 0, 1, 2, 3, ……..

4. Where λ (lambda) is the only parameter of the distribution and e is the mathematical constant 2.71828………..:

(i) The number of events per unit of time or space remains stable for a long period of time. This is the parameter of the
distribution denoted by λ.

(ii) The number of events in one time period is independent of the number of events in another time period.

Example:

In an industry, the average number of damaged output units per week is 10. What is the probability that there will be (i) no damaged unit in
the next week, (ii) 5 damaged units in the next week, and (iii) 15 damaged units in the next week.

Solution:

(i) no damaged unit in the week:

X = number of damaged output units next week = 0

λ = average number of damaged units per week = 10

 (ii) 5 damaged units in the next week:

X = number of damaged output units next week = 5

λ = average number of damaged units per week = 10

(iii) 15 damaged units in the next week:

X = number of damaged output units next week = 15

λ = average number of damaged units per week = 10

Poisson Approximation to Binomial Distribution:

The computations involved in the binomial distributions become quite tedious when n is large. In such cases the binomial distribution can be
approximated to a Poisson distribution with λ = n p under the following conditions:

(i) n is very large,

(ii) p is very small, and

(iii) n p is finite.

A frequently used rule of thumb is that the approximation is appropriate when p ≤ 0.05 and n ≥ 20. However, the Poisson distribution
sometimes provides close approximations even in cases where n is not large nor p is very small.

Example:
In a village, the local government approximated that 2% of the population are infected with seasonal flu due to absence of proper
medication. What is the probability that the number of infected persons in a random sample of 50 will be 4?

Solution:

Using binomial distribution with:

n = 50, p = 0.02 and x = 4

Using Poisson approximation to the binomial with:

λ = n p = 50 × 0.02 = 1

The Poisson probability is close to the binomial probability.

Mean and Variance of Poisson Distribution:

The mean of a Poisson Random Variable is the parameter of the Poisson distribution λ, that is:

E(X) = λ

The variance is also the parameter λ:

V(X) = λ

Thus mean and variance of Poisson distribution are equal to λ.

Continuous Probability Distribution (In Detail):

 1. The concept of probability for continuous random variable is somewhat different with that of a discrete random variable.
2. The function or the formula of continuous probability distribution is generated and its curve is drawn on a graph paper such that:

(i) the function is non-negative for all possible values of the random variable, and

(ii) the total area under the curve of the function is one.

This function is called ‘probability density function’ and its curve a ‘probability curve’.

3. The probability of an interval from a to b is defined as the area under the probability curve between the two vertical lines erected on the
x-axis at the points aand b.
4. The probability of an individual value under the continuous probability distribution is considered zero.
5. Probabilities of continuous random variable are represented by areas under the probability curve.

Normal Probability Distribution:

1. The most important and widely used probability density function is the ‘Normal Distribution’ where probability curve is a bell shaped
symmetrical curve:

2. The most mathematical form of Normal Probability Density Function is:

 Where – ∞ ≤ x ≤ ∞

3. A normal probability distribution or its probability curve characterised by two quantities μ and σ called the parameters of the
distribution.
4. Two normal curves with different means μ and equal standard deviations σ are as below:

5. The normal curves with different standard deviations σ and equal means μ:

6. Two normal curves with different means μ and different standard deviations σ:
Area under Normal Curve:

1. The area between two limits of an interval under a normal probability curve cannot be determined analytically.
2. Tables of areas evaluated numerically could have been constructed but it would be impossible for an infinite number of normal curves
for all values of μ and σ.
3. This problem is overcome by ‘Standard Normal Probability Distribution’ whose mean is zero (μ = 0) and standard deviation is one
(σ = 1). The standard normal variable is denoted by ‘x’:

4. The table of areas under the standard normal curve is used to find area under normal probability curve:
5. Following steps are involved in determining the area or probability of a particular interval of a normal distribution with μ and σ:

(i) Determine the z-values for each limit of interval,

(ii) From the normal area table, determine the area for each z-value,

(iii) Subtract the smaller area from the larger one.

6. Precisely, a value of random variable ‘x’ can be converted to value ‘z’ by:
 Where μ and σ are the mean and standard deviation of the random variable z.

7. Conversely, the z-value can be converted into random variable x by:

x=μ+σ·z

8. ‘z’ is the number of standard deviations from or to the mean. All intervals containing the same number of standard deviations from
mean will contain the same area under the curve for any normal distribution.
9. ‘Normal Area Table’ gives an idea under the curve to the left of a z-value. For example, for z = 1.51, the Area under Normal Curve (as
shown in the Table) is 0.9345; for z = – 2.69, the Area under Normal Curve (from the Table) is 0.0036.
10. Some of the rules should be remembered:

Example:

A normal random variable x has mean µ = 24 and standard deviation σ = 1.8. Determine z values for x = 14, 15.9, 29.2 and 33. Also show
these values on normal curve.

Solution:
Example:

A normal random variable x has mean μ = 36 and standard deviation 2.05, determine the values of x for z = – 3.36, – 1.8, 0.95 and 2.75.

Solution:
x=μ+σ·z

For z = – 3.36; x = 36 + 2.05 × (– 3.36) = 29.112 ≈ 29.11

For z = – 1.8; x = 36 + 2.05 × (– 1.8) = 32.31

For z = 0.95; x = 36 + 2.05 × 0.95 = 37.9475 ≈ 37.95

For z = 2.75; x = 36 + 2.05 × 2.75 = 41.6375 ≈ 41.64

Example:

The mean and SD of a normal random variable are 34.5 and 5.8 respectively. Find the following areas:

(i) to the left of 19.5

(ii) to the right of 40

(iii) between 19.5 and 40

Solution:

(i) to the left of 19.5, i.e., P(x ≤ 19.5):

P(– ∞ ≤ x ≤ 19.5) = P(– ∞ ≤ z ≤ –2.59) = 0.0048

Where
 (ii) to the right of 40, i.e., P (x ≥ 40):

P(40 ≤ x ≤ ∞) = P(0.95 ≤ z ≤ ∞) = 0.8289

Where

(ii) between 19.5 and 40, i.e., P(19.5 ≤ x ≤ 40):

P(19.5 ≤ x ≤ 40) = P(– 2.59 ≤ z ≤ 0.95) = 0.8289 – 0.0048 = 0.8241

Continuity Correction:

1. A population with unknown mean and standard deviation can be assumed a normal population of the frequency distribution of a sample
is symmetrical. The sample mean and sample standard deviation are used as estimates of population mean and population standard
deviation respectively.
2. Observations or data are always discrete, recorded up to a certain degree of accuracy irrespective of whether the variable itself is
discrete or continuous.
3. When the symmetrical distribution of any data is assumed to be normal, a continuity correction is applied to the observed values to
make the data continuous.
4. If the data are recorded in whole numbers, data values are considered as mid-points of the intervals x ± 0.5, if the data are recorded up
to one decimal place, data values are considered as mid points of the intervals x ± 0.05 and so on. It should be cleared that the 0.5 and
0.05 should be subtracted from lower limit and added to upper limit or at most limit.

Normal Approximation to Binomial Distribution:

A Binomial Distribution with large n and moderate p can be approximated to a Normal Distribution with mean μ = np and :

μ = np

Example:

A pair of dice is rolled for 800 times. What is the probability that a total of 6 occur:

(i) at least 100 times, and

 (ii) between 150 to 300 times.

Solution:

(i) Probability of at least 100 times, i.e., P(100 ≤ x ≤ 800) or P(99.5 ≤ x ≤ 800.5):

P(–1.19 ≤ z ≤ 70.49)
From ‘Normal Area Table’ the Normal Area corresponding to – 1.19 is 0.1170

= 1 – 0.1170 = 0.8830

(ii) Probability of between 150 and 300 times, i.e., P(130 ≤ x ≤ 300) or P(149.5 ≤ x ≤ 300.5):
P(1.88 ≤ z ≤ 19.37)
From ‘Normal Area Table’ the Normal Area corresponding to 1.88 is 0.9699

= 1 – 0.9699 = 0.0301
 Sampling Distribution Theory I
Population and Sample:

1. A ‘population’ is a well-defined group of individuals whose characteristics are to be studied. Populations may be finite or infinite.

(a) Finite Population: A population is said to be finite, if it consists of finite or fixed number of elements (i.e., items, objects,
measurements or observations). For example, all the university students in Pakistan, the heights of all the students enrolled in
Karachi University, etc.

(b) Infinite Population: A population is said to be infinite, if there is no limit to the number elements it can contain. For
example, the role of two dice, all the heights between 2 and 3 meters, etc.

2. A ‘sample’ is a part of the whole selected with the object that it will represent the characteristics of the whole or population or
universe. The individuals or objects of a population or a sample may be concrete things like the motor cars produced in a company,
wheat produced in a farm, or abstract things like the opinion of students about the examination system. Thus all the students in
schools, colleges and universities form population of students. The process of selecting the sample from a population is
called ‘sampling’. A sample may be taken with replacement or without replacement:

(a) Sampling with Replacement: If the sample is taken with replacement from a population finite or infinite, the element
drawn is returned to the population before drawing the next element.

(b) Sampling without Replacement: If the sample is taken without replacement from a finite population, the element selected
is not returned to the population.

Probability Samples and Non-Probability Samples:

1. ‘Probability samples’ are those in which every element has a known probability of being included in the sample. Following are the
probability sampling designs:

(a) Simple Random Sampling: refers to a method of selecting a sample of a given size from a given population in such a way that
all possible samples of this size which could be formed from this population have equal probabilities of selection. It is a method in
 which a sample of n is selected from the population of N units such that each one of the NCn distinct samples has an equal chance of
being drawn. This method sometimes also refers to ‘lottery method’.

(b) Stratified Random Sampling: consists of the following two steps:

(i) The material or area to be sampled is divided into groups or classes called ‘strata’. Items within each stratum are
homogenous.

(ii) From each stratum, a simple random sample is taken and the overall sample is obtained by combining the samples for
all strata.

(c) Systematic Sampling: is another form of sample design in which the samples are equally spaced throughout the area or
population to be sampled. For e.g., in house-to-house sampling every 10th or 20th house may be taken. More specifically a
systematic sample is obtained by taking every kth unit in the population after the units in population have been numbered or
arranged in some way.

(d) Cluster Sampling: One of the main difficulties in large scale surveys is the extensive area that may have to be covered in
getting a random or stratified random sample. It may be very expensive and lengthy task to cover the whole population in order to
obtain a representative sample. It is not possible to take a simple random or systematic sample of persons from the entire country or
from within strata, since there is no such list in which all the individuals are numbered from 1 to N. Even if such a list existed, it
would be too expensive to base the enquiry on a simple random sample of persons. Under these circumstances, it is economical to
select groups called ‘clusters’ of elements from the population. This is called ‘cluster sampling’. The difference between a cluster
and a stratum is that a stratum is expected to be homogenous and a cluster must be heterogeneous as possible. Clusters are also
known as the primary sampling units. Cluster sampling may be consisted of:

(i) Single-stage Cluster Sampling,

(ii) Sub-sampling or Two-stage Sampling, and

(iii) Multi-stage Sampling.

2. ‘Non-probability sampling’ designs consist of:

 (a) Judgement or Purposive Sampling: There are many situations where investigators use judgement samples to gain needed
information. For example, it may be convenient to select a random sample from a cart-load of melons. The melons selected may be
very large or very small. The observer may use his own judgement. This method is very useful when the sample to be drawn is
small.

(b) Quota Sampling: is widely used in opinions, market surveys, etc. In such surveys, the interviewers are simply given quotas to
be filled in from different strata, with practically no restrictions on how they are to be filled in.

Parameters and Statistic:

1. A numerical value such as mean, median or standard deviation calculated from the population is called a ‘population parameter’ or
simply a ‘parameter’. On the other hand, a numerical value such as mean, median or SD calculated from the sample is called a ‘sample
statistic’ or simply a ‘statistic’.
2. Parameters are fixed numbers, i.e., they are constants. Statistics very from sample to sample from the same population.
3. In general, corresponding to each population parameter there will be a statistic to be computed from the sample.
4. The purpose of sampling is to gather information that will be used as a basis for making generalisation about the unknown population
parameters.
5. A parameter is usually denoted by a Greek letter and a statistic is usually denoted by a Roman letter. For e.g., the population mean is
denoted by μ while the sample mean is denoted by . Similarly, the SD of a population is denoted by σ while the sample SD is
denoted by S.

Sampling and Non-Sampling Errors:

(a) Sampling Errors:

1. The sample data deals with only a portion of the population under consideration rather than the whole population. Because of this
partial information about the population, there is always a chance of ‘errors’ or ‘discrepancies’ to exist. This discrepancy or error is
simply known as ‘sampling error’. It is also known as ‘sampling variations’ and ‘chance variations’.
2. Sampling error is present whenever a sample is drawn. Mathematically, the sampling error is defined as the difference between the
sample statistic and population parameter. The conventional procedure consists of subtracting the value of parameter, θ, from that of
the statistic t; that is, the sampling error, E, is:

E=t–θ
 3. The sampling errors are negative if the parameter is under estimated, and positive if it is over-estimated.
4. The chance of sampling error can be reduced by increasing the size of the sample.

(b) Non-Sampling Errors:

1. Such errors enter into any kind of investigation whether it is a sample or a complete census.
2. Non-sampling errors arise from the following reasons:

o Faulty interviews and questionnaires,

o Incomplete and inaccurate responses,
o Mistakes in recording or coding the data,
o Errors made in processing the results, etc.

3. These errors can be controlled if the volume of data processed is small.

4. Non-sampling errors are less significant in a sample.

Bias:

1. It is refer to the overall or long-run tendency of the sample results to differ from the parameter in the particular way.
2. Bias should be not be confused with sampling errors. Mathematically, it is defined as below:

B=m–μ

Where μ is the true population value and m is the mean of the sample statistics of an infinity of samples.

3. The bias may be positive or negative according to as m is greater or less than μ.

Precision and Accuracy:

1. ‘Accuracy’ refers to the size of deviations from the true mean μ, whereas, the ‘precision’ refers to the size of deviation from the overall
mean m obtained by repeated application of the sampling procedure.
2. Precision is a measure of the closeness of the sample estimates to the census count taken under identical conditions and is judged in
sampling theory by the variance of the estimates concerned.
Sampling Distribution:

1. The value of a statistic varies from one sample to another even if the samples are selected from the same population. Thus, statistic is a
random variable.
2. The distribution or probability distribution of a statistic is called a sampling distribution. For e.g., the distribution of sample mean is a
sampling distribution of mean and the distribution of the sample proportion is a sampling distribution of proportion. The SD of the
sampling distribution of a statistic is called the‘standard error’ of the statistic.
Example:

Take the data of previous example and assume sampling ‘without replacement’, and compute:

(a) Population mean,

(b) Population standard deviation,

(c) Mean of each sample,

(d) Sampling distribution table of sample mean w/o replacement, and

(e) Mean and standard deviation of sampling distribution.

Solution:

(a) and (b) Population mean and SD:

As calculated above.

(c) Mean of each sample:

No. of possible samples = NCn = 4C2 = 6 samples

Samples (without replacement):

(1,2) (1,3) (1,4) (2,3) (2,4) (3,4)

Mean:

1.5 2 2.5 2.5 3 3.5

(d) Sampling Distribution:

 Sampling Distribution Theory II
Sampling Distribution of Proportion:

1. The sampling distribution of proportion is defined as:

Example:

A coordination team consists of seven members. The education of each member as follows: (G = Graduate, PG = Post Graduate)

Members 1 2 3 4 5 6 7
Education G PG PG PG PG G G

(i) Determine the proportion of post-graduates in the population.

(ii) Select all possible samples of two members from the population without replacement, and compute the proportion of post-
graduate members in each sample.

(iii) Compute the mean (μp) and the SD (σp) of the sample proportion computed in (ii).

Solution:

(i) Proportion of PG in the population:

N=7

No. of PG = 4

π = 4/7 = 0.57

(ii) No. of possible samples (without replacement) = NCn = 7C2 = 21 samples.

1,2 1,3 1,4 1,5 1,6 1,7

2,3 2,4 2,5 2,6 2,7
3,4 3,5 3,6 3,7
4,5 4,6 4,7
5,6 5,7
6,7

The corresponding sampling proportions are:

0.5 0.5 0.5 0.5 0 0
1 1 1 0.5 0.5
1 1 0.5 0.5
1 0.5 0.5
0.5 0.5
0
 Coefficient of Correlation
Population Correlation Coefficient:

1. The measure of joint or mutual variation in a bivariate population with two variables x and y, is called ‘covariance of x and y’:

2. In order to make comparison, the covariance must be standardised by dividing (x – μx) and (y – μy) by their
SDs σx and σy respectively. This expression is called ‘coefficient of correlation’; the ‘population coefficient of correlation’ is denoted
by ‘ρ’ (rho):

Sample Correlation Coefficient:

1. The sample covariance of x and y, Sxy, measures the tendency for x and y to increase or decrease together in the sample:

2. The ‘sample coefficient of correlation’ is denoted by ‘r’. It is also known as ‘Karl Pearson’s product moment coefficient of
correlation’. The coefficient of correlation always lies between –1 and +1 respectively, i.e., –1 ≤ r ≤ +1:
3. (a) If r = –1, all the points on the scatter diagram lie on the regression line of negative slope. It is called a ‘perfect negative
correlation’.

(b) If r = 1, all the points on the scatter diagram lie on the regression line of positive slope. It is called a ‘perfect positive correlation’.

(c) If r = 0, all the points on the scatter diagram are spread throughout the diagram indicating no correlation between x and y.

“Correlation coefficient is a measure of the closeness of linear relationship between the two variables.”
Correlation Coefficient and Regression Coefficient:

1. The two regression coefficients b and d of the two regression lines can also be stated as follows:

2. Since , therefore, Sxy = r ∙ Sx ∙ Sy.

3. The regression coefficients b and are related to correlation coefficient r by:

Properties of Coefficient of Correlation:

1. The correlation coefficient is symmetrical with respect to x and y, i.e., rxy = ryx
2. The correlation coefficient is the geometric mean of the two regression coefficients, i.e.:

.
 3. The correlation coefficient is a pure number and does not depend upon the units employed. For e.g., if the correlation coefficient
between the heights and weights of students is computed as 0.98, it will be expressed simply as 0.98 (neither as 0.98 inches nor 0.98
pounds).
4. The correlation coefficient is independent of origin and unit of measurement. By this we mean that if we take deviations
of x and y from some suitable origins or transform x and y into u and v respectively, it will not affect the correlation
coefficient. Symbolically:

rxy = ruv

5. The correlation coefficient lies between –1 and +1, i.e., it cannot be less than –1 and greater than +1:

–1 ≤ r ≤ +1

Example:

x 3 1 1 2 4 2 3 5 2 3
y 2 4 3 2 1 2 1 3 2 1

Required:

(a) Covariance of x and y,

(b) Standard deviation of x and y,

(c) Coefficient of correlation, and

(d) Scatter diagram.

Solution:

(a) Covariance of x and y:

x y x – μx x – μy (x – μx)( x – μy) (x – μx)2 (x – μy)2

3 2 0.4 –0.1 –0.04 9 4
1 4 –1.6 1.9 –3.04 1 16
 1 3 –1.6 0.9 –1.44 1 9
2 2 –0.6 –0.1 0.06 4 4
4 1 1.4 –1.1 –1.54 16 1
2 2 –0.6 –0.1 0.06 4 4
3 1 0.4 –1.1 –0.44 9 1
5 3 2.4 0.9 2.16 25 9
2 2 –0.6 –0.1 0.06 4 4
3 1 0.4 –1.1 –0.44 9 1
26 21 –4.6 82 53

(d) Scatter diagram:

Example:

Calculate:

(a) Covariance of x and y,

(b) Variances of x and y,

(c) Coefficient of correlation, and

(d) Coefficient of determination.

For the following sample data:

x 1 2 4 6 8 10 14 15 18 20
y 10 20 30 40 50 60 70 80 90 100

Solution:
Probable Error:

1. The probable error is about two-third of the standard error:

 2. Assuming ρ = 0, the sampling distribution of r has standard error:

3. In a standard normal distribution, z = ± 0.6745 will contain 50% of the area under curve, symbolically:

P(–0.6745 ≤ z ≤ 0.6745) = 0.5

4. Thus, the probable error r is:

P.E. = 0.6745 × σr

or

5. Probabilities of r can now be calculated using P.E. as a unit of deviation:

P(–P.E. ≤ r ≤ P.E.) = 0.5

P(–3P.E. ≤ r ≤ 3P.E.) = 0.9544

Rank Correlation:

1. If observations on two variables are given in the form of ranks rather than some numerical measurements, it is possible to compute a
coefficient of correlation between ranks of the two variables. This correlation coefficient is called ‘Rank Correlation Coefficient’.
2. As this formula was presented by Spearman in 1904, it is also known as ‘Spearman’s Rank Correlation Coefficient’:
 Where di = xi – yi (the difference between the rankings).

3. In order to test that there is no correlation between the two rankings, critical values of rs at α = 0.05 are given below:

Number of ranks (n) Critical value (rs)

5 1.0
6 0.89
7 0.79
8 0.74
9 0.74
10 0.65
20 0.45
25 0.40
50 0.28

Example:

Ranks of 9 students in a class in History (x) and Geography (y) are as follows:

Students I II III IV V VI VII VIII IX

x 1 9 7 4 5 3 8 2 6
y 4 5 6 3 7 2 8 1 9

Calculate Spearman’s Rank Correlation Coefficient and test its significance.

Solution:

Students x y d=x–y d2
I 1 4 –3 9
II 9 5 4 16
III 7 6 1 1
IV 4 3 1 1
V 5 7 –2 4
VI 3 2 1 1
VII 8 8 0 0
VIII 2 1 1 1
 IX 6 9 –3 9
Total 45 45 0 42

Where di = xi – yi

Critical value of rs for n = 9 and α = 0.05 is 0.74

Since 0.65 is less than the critical value of 0.74, rs is insignificant.

 Regression
1. The term ‘regression’ was used by Sir Frances Galton in connection with the studies he made on the statures fathers and sons.
2. It is a technique which determines a relationship between two variables to estimate one of the variables (dependent) for a given value
of the other variable (independent).
3. The variable whose value is to be estimated is called dependent variable (y) whereas the variable whose value is given is called
independent variable (x).
4. Examples of dependent and independent variables are:

Independent Dependent
Price Demand
Rainfall Yield
Credit sales Bad debts
Volume of production Manufacturing expenses

5. The values of the independent variable are assumed to be fixed. Hence it is not a random variable. On the other hand, the dependent
variable, whose values are determined on the basis of the independent variable, is a random variable.
6. If x is the independent variable and y is the dependent variable then the relationship between x and y, described by a straight line (y = a
+ bx), is called‘linear relationship’.

Regression Lines:

1. If we plot the paired observations (X1Y1), (X2Y2), ……….., (XnYn) on a graph, the resulting set of points is called a ‘scatter diagram’.
2. A scatter diagram indicates a relationship between the variables X and Y and the dots of the scatter diagram tend to cluster around a
curve or a line. Such a curve or line is known as ‘curve of regression’ or ‘line of regression’.
 Trend Series Analysis I
1. There are four important bases for classification of data namely qualitative, quantitative, geographical and chronological. In the
classification on chronological basis, the data are arranged by successive time periods, e.g., years, quarters, months, etc. An
arrangement of data by successive time periods is called a‘time series’.
2. A time series is a sequence of observations obtained as successive time periods.
3. Examples of time series are:

 Annual yield of a crop in a country for a number of years,

 Annual profit before tax of a firm,

 Daily temperature of a city,

 Annual rainfall of a country,

 Total monthly sales receipts in a departmental store,

 Daily closing prices of a share on the stock exchange,

 Annual balance of trade of a country,

 Weekly consumer price index number, etc.

4. Basically, there are two objectives of time series:

(a) to examine the patterns of change over time, and

(b) to use these patterns to forecast and predict future values.

Graph of a Time Series – Histogram:

A time series trend is graphically presented by plotting observed values against corresponding time points and joining these points by straight
lines. This graph is commonly known as ‘Histogram’.

Example 1:

Plot the following observed values on a graph:

Table I – Quarterly Sales (In million Rs.)

Time Sale
2003 I 219
II 357
III 645
IV 513
2004 I 549
II 640
III 701
IV 590
2005 I 657
II 394
III 543
IV 600

Solution:
Signal and Noise:

1. Time series may be considered as made up of two types of sequences, i.e., signal and noise. The sequence which follows some
regular patterns of variation and can be completely determined or specified is called the ‘systematic sequence’ or ‘signal’.
2. The sequence following random or irregular patterns of variation is called ‘noise’.
3. Let the values of time series variable Y be Y1, Y2, ………., Yn observed at equal intervals of time t1, t2, …………, tn, then the time series
may be represented by the model:

Y = f(t) + U

Where Y : time series variable,

f(t) : systematic sequence signal, and

U : random sequence noise.

Components of a Time Series:

The change or variations in the observations of a time series are due to one or more of the four factors called ‘components of the time
series’ or ‘characteristic movements of a time series’. These components are:
 (a) Secular trend (T)

(b) Seasonal variations (S)

(c) Cyclical variations (C)

(d) Random variations (R)

(a) Secular Trend (T): The word ‘secular’ is used to mean ‘long-term’ or ‘relating to long periods of time’. Thus, the secular trend
refers to the movement of a time series in one direction over a fairly long period of time. The movement is smooth, steady and regular
in nature. Such a movement characterises the general pattern of increase or decrease in an economic or social phenomenon.

(b) Seasonal Variations (S): Such movements refer to short-term variations which a time series usually follows during corresponding
months or seasons of successive years. It is refer to any variation of repeating nature, within a period of one year, caused by recurring
events. For example, increased demand for woollen clothes during winter, increased sales at a departmental store before Eid, increased
sale of candies before Christmas, etc.

(c) Cyclical Variations (C): Such movements refer to long-term oscillations or swings about the trend line or curve. Since the
movements take the form of upward and downward swings, they are also called ‘cycles’. The movements are considered cyclical only
if they recur after a period of more than one year. The term ‘cycle’ is used for ‘business cycle’, which is consist of four phases, i.e.,
prosperity recession, depression and revival.

(d) Random Variations (R): These movements refer to fluctuations of irregular nature caused by chance events such as war, flood,
storm, earthquake, accidents, strikes, etc. They are also known as ‘irregular’, ‘accidental’ or ‘erratic’ movements.

The first three components, i.e., secular trend, seasonal variations and cyclical variations, follow regular patterns of variation, therefore, fall
under signal. While the random variations follow irregular patterns of movements, therefore, it falls under noise.
Analysis of Time Series / Time Series Model:

1. An approach to represent time series data is to multiply the four components . this is called ‘Multiplicative Time Series Model’:

Y=T×C×S×I

Where Y : observed value of a time series at a particular time point

T : Trend (secular)
C : Cyclical variations
S : Seasonal variations
R or I : Irregular or random variations

2. The second approach is based on additive law, known as ‘Additive Model’:

Y=T+C+S+R

3. This analysis is often called the ‘decomposition’ of a time series into basic component movements.

Measurement of Secular Trend:

(a) Freehand curve method,

 (b) Semi-averages method,

(c) Moving-averages method, and

(d) Least-squares method.

Freehand, semi-averages and moving averages methods are used to study the pattern of change over a long period of time. They remove the
short-term changes or smooth out the series. Least squares method is used to forecast the future values.

(a) Freehand Curve Method: In this method the data are plotted on a graph measuring the time units (years, months, etc.) along the
x-axis and the values of the time series variable along the y-axis. A trend line or curve is drawn through the graph in such a way that it
shows the general tendency of the values.

Example 2:

Take the data from Example 1, and plot the observed on a graph and draw a trend line using ‘freehand curve method’.

Solution:
 (b) Semi-Averages Method: In this method, the data are divided into two parts. If the number of values is odd, either the middle
value is left out or the series is divided unevenly. The averages for each part are computed and placed against the centre of each
part. The averages are plotted and joined by line. The line is extended to cover the whole data.

Example 3:

For the following data, calculate the trend values and plot them on a graph using ‘semi-averages method’:

Table II
Pakistan’s Per Capita Income (In Rs.)
Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
PCI 15522 17393 18901 20377 25244 27227 28769 31572 35196 41008

Solution:

Year PCI Semi Semi Trend

Total Average Value
1996 15522 14180.6
1997 17393 16834.0
1998 18901 97437 19487.4 19487.4
1999 20377 22140.8
2000 25244 24794.2
2001 27227 27447.6
2002 28769 30101.0
2003 31572 163772 32754..4 32754.4
2004 35196 35407.8
2005 41008 38061.2

Note:

Difference between semi-averages: 32754.4 – 19487.4 = 13267

Average increase in income per year: 13267 ÷ 5 = 2653.4

Trend values for 1997: 19487.4 – 2653.4 = 16834

Trend values for 1999: 19487.4 + 2653.4 = 22140.8

(c) Moving-Averages Method: Moving averages method is appropriate only when the trend is linear. It is also used to eliminate
seasonal, cyclical and irregular fluctuations in the data. In this method, we find the simple average successively taking a specific
number of values at a time. For e.g., if we want to find 3-year moving average, we shall find the average of the first three values, then
drop the first value and include the fourth value. The process will be continued till all the values in the series are exhausted.

Example 4:

For the following data, calculate 3-year and 5-year moving averages and plot them on a graph using ‘moving-averages method’:

Annual GDP Growth Rate (in percent)

Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
% 6.6 1.7 3.5 4.2 3.9 1.8 3.1 4.8 6.4 8.4

Solution:

Year Values 3 year 3 year 5 year 5 year

moving moving moving moving
total average total average
 1996 6.6
1997 1.7 11.8 3.93
1998 3.5 9.4 3.13 19.9 3.98
1999 4.2 11.6 3.87 15.1 3.02
2000 3.9 9.9 3.3 16.5 3.3
2001 1.8 8.8 2.93 17.8 3.56
2002 3.1 9.7 3.23 20 4
2003 4.8 14.3 4.77 24.5 4.9
2004 6.4 19.6 6.53
2005 8.4

(d) Least Squares Method: The method of least squares states that of all the curves which can possibly be drawn to approximate the
given data, the best fitting curve is the one for which the sum of squares of deviations is the least.

Method of least squares is used to fit a linear trend given by the straight line and non-linear trend given by a second and higher degree
curves. In this method, an algebraic equation is fitted to the observed data. This equation may be linear, quadratic or exponental
depending upon the pattern of time series graph.
 Trend Series Analysis II
Measurement of Seasonal Trend:

(a) Simple Average Method,

(b) Link Relative Method,

(c) Ratio to Moving Average Method, and

(d) Ratio to Trend Method.

*
previous example
As calculated in the
** As calculated in Example
Monetary Economics
 Central Banking
Courtesy: Mohd. Ovais (the original author), Tabani School of Accountancy

1. THE CENTRAL BANKING

1.1 Acts on behalf of the government to supervise, regulate and control the country’s banking system. A nationalised corporation run
by a board of directions, governor, deputy governor, and some executive directors and part-time directors.

(a) banker to the central government and holds the ‘public deposits’. Deposit include the national loans fund, the consolidated
fund and the account of the paymaster general

(b) central note-issuing authority in Pakistan.

(c) manager of the national debt i.e. it deals with long-term and short-term borrowing by the central government

(d) the manager of the exchange equalisation account

(e) acts are agent for the government in carrying

(f) supervisor of the banking

(g) informal supervisor of other financial such as the Stock Exchange.

(h) Banker to the commercial banks.

(i) As a lender to the banking system State Bank of Pakistan will provide the money that banks need

The bank as manager of the exchange equilisation account

1.3 the deposits of a country’s gold and foreign currency reserves. Used to influence the exchange rate

The bank as supervisor of the banking system

1.4 has the responsibility under the Banking Act for

The bank as lender of last resort to the commercial banking system

1.5 State Bank of Pakistan lends money to the banking system.

(a) supply cash to the banking system, does this by buying eligible bills from the discount houses exchange for ‘cash’ bills (i.e. debt
instruments)

(b) bank will remove excess cash from does this by selling bills to the discount, discount houses obtain interest-bearing bills in place.

Process known as open market operations describes the buying and selling of eligible bills between

Open market operations and short-term interest rates

1.6 Open market operations provide a method of control over short-term interest rates.

1.7 Are traded at a discount to their face value, Interest rates on bills, have an immediate influence on other money.

1.8 If interest rates in the discount market’s open market operations went up, soon be an increase in other money market rates, and
then the banks’, lending rates on bank loans.

1.9 Open market operations are an important feature of the government’s monetary policy.

The independence of action of the bank

An adviser to the government, not an agent of the government.

2. STATE BANK OF PAKISTAN (SBP)

2.1 have an independent currency and banking system. Decided with India that the Reserve Bank of India would continue to act as
the central bank and as currency authority for Pakistan, by order called “Monetary System and Reserve Bank Order 1947”.
 (a) the sole not issuing authority in Pakistan
(b) Indian notes will remain legal tender in both Pakistan and India until 30 th September, 1948.
(c) Bank of India would transfer the assets of value equal to Pakistani notes to the Government of Pakistan after
th
30 September, 1948.
(d) Government of Pakistan would also issue coins in the country after 30 th September, 1948.
(e) Reserve Bank of India would perform the full functions

Establishment of State Bank of Pakistan

2.2 Reserve Bank of India showed reluctance in solving the banking crises. Refusing to give Rs.55 crore which Pakistan was entitled
to share

2.3 The Reserve Bank of India was relieved, the first day of July, 1948, the bank is entrusted with the duty of “regulating the issue
of bank notes and keeping of reserve with a view to seeking monetary stability in Pakistan and generally to cooperate the currency and
credit system of the country to its advantage, State Bank of Pakistan Act, 1956, “regulate the monetary and credit system of Pakistan and
to foster its growth in the best national interest with a view to securing stability fully and utilisation of the country’s productive resources.

Share capital

2.4 Original share capital, three crore of rupees divided into three lac, 51% was contributed by the Central Government and the
balance 49% subscribed by the private sector. Upto 31st December 1973, the State Bank was a government-cum-shareholders bank in
terms of its original statute. Nationalisation Ordinance, 1974, the State Bank has been a purely government-owned institution. The private
shareholders are compensated by the federal government through endowment of negotiable bonds repayable at par at any

Constitution

2.5 Not guided by profit motive in its operation. Foster its growth in the best national interest with a view to securing monetary
stability and fuller utilisation.

2.6 Consists of one governor, one more deputy governor and nine directors. Executive committee, empowered to transact business
on behalf of the central board of directions. chief executive, governor who controls and directors the affairs of the bank on behalf, has 14
departments, over 5000 persons.
 (a) Accounts Department
(b) Administration Department
(c) Agricultural Credit Department
(d) Audit Department
(e) Bank Control Department
(f) Bank Inspection Department
(g) Engineering Department
(h) Exchange Control Department
(i) Legal Division
(j) Public Relations Department
(k) Research Department
(l) Security’s Department
(m) Statistics Department, and
(n) Training Department.

The functions of the various departments of the central directorate are briefly described below.

3. FUNCTIONS OF STATE BANK OF PAKISTAN

3.1 business and functions, governed by State Bank of Pakistan Act, 1956 and Banking Company’s Ordinance, 1962, operates through
two separate departments:

(a) issue department; and

(b) banking departments.

3.2 issue department issue of notes in the country. Banking Department is concerned with the carrying on and transacting banking
business.

(a) State Bank as a bank of issue, has the sole right to issue notes except one rupees note and subsidiary coins which are issued
by the government. The hank adopted the proportional reserve system for the issue of notes. Currency backing by gold bullion,
foreign securities is now fixed at Rs.1200 million through an Ordinance in December, 1965. System of note is known as minimum
reserve system. Size of notes issue reflects the public demand for money. Assets of the Issue Department are always equal to
liabilities.

(b) Banker to the government. Acts as a banker to the government, balances of the central and provincial governments are
deposited with the State Bank does not pay interest on them. The bank administers exchange control on behalf of the government.
It carries out exchange, remittances and other banking operations including the management of public debt. Floats new loans on
behalf of the central.

(c) Custodian of the cash reserves of the commercial banks in Pakistan. All the scheduled banks are required to maintain with
the State Bank of Pakistan at least 5% balance of the replenishes the commercial banks stocks of cash when they are running low.

(d) State Bank as a clearing house. The clearing house is a place where the representatives of commercial banks meet each
day to exchange cheques drawn on each other and then settles the differences owed to each other .

(e) Advisor to government. Since, the bank is deeply involved in the money and foreign exchange, its therefore, tender advice
on financial and economic matters to the government. It also provides advice to commercial banks State Bank has a direct link
with international bodies like IMR, IBRD etc.

(f) State Bank as a lender of last resort. Commercial banks are short of cash reserves due to large debt balances in the inter-
bank. It provides cash to the commercial banks by rediscounting bills of exchange, treasury bills and other gilt edged securities.

(g) State Bank as a controller of credit. Has wide power to use the instruments of credit control for influencing the aggregate
spending, the inflation rate and the balance of payments in the country.
Uses to tools of open market operations, discount rate and the percentage reserve requirements
other minor tools such as issuing directives to restrict bank advances
regulating credit in the country.

(h) State Bank and economic growth, playing a significant role in facilitating and fostering economic development and growth
of the banking, promotional activities of the bank.

(i) The development of the capital market in the country

(ii) Under the State Bank’s Export Finance, provide finance to the exporters at the concessional
 (iii) Helped in the establishment of specialised credit institutions for meeting the medium and long-term, IDBP, ADBT,
NIT, EPF, (Equity Participation Fund) NDFC, HBFC, ICP

5. CLEARANCE HOUSE

5.1 Association of commercial banks, purpose of interchange and settlement of credit claims. National Bank of Pakistan, as a
representative, Pakistan, acts as a clearing house.

5.2 Cheque, as we know, is an effective method of making payments. When cheques are draw on one bank and the holder (payee)
deposits the same in his account at the bank of drawer, the mutual obligations are settled by the internal bank administration and there
arises no interbank debits from the use of cheques. The total assets and total liabilities of the bank remain unchanged.

5.3 In practice, the person receiving a cheque is rarely a depositor of the cheque at the same bank as the drawer. He deposits the
cheque with his bank (other than of the payer) for the collection of the amount. Now, the bank in which the cheque has been deposited
becomes a creditor of the drawer’s bank. The debtors bank will pay his amount of the cheque by transferring it from cash reserves if there
are no offsetting transactions. In the course of everyday life, there are large number of cheques drawn on a bank deposited in other banks.
The banks on which the cheques are drawn become in debt to the banks in which the cheques are deposited.

4.5 This facility of net interbank payments is provided by the clearing house.

4.6 Local commercial banks meet at a fixed time on all, meeting is held in the office of the bank which, cheques payable at other
local banks and receive the cheques drawn, A summary sheet is prepared which shows the names of the
difference between the totals represents the amount to be paid by particular bank and the amount, The net payments are made issuing a
credit voucher on

4.7 The working of clearing house is now explained with the help of an example. Let us assume there are five banks in city and at
the end of days operation, the following payments are due to the banks from each other:
Rs.
Cheques drawn on Bank A Bank B Bank C Bank D Bank E Total
Package of contents
Rs. Rs. Rs. Rs. Rs. Rs.
Bank A - 14,000 20,000 14,000 8,000 56,000
Bank B 10,000 - 12,000 10,000 16,000 48,000
 Bank C 6,000 10,000 - 6,000 4,000 26,000
Bank D 4,000 16,000 16,000 - 12,000 48,000
Bank E 8,000 12,000 8,000 18,000 - 46,000
Total 28,000 52,000 56,000 48,000 40,000 224,000

4.8 For clear understanding the table is summarised below:

Banks Cheque Cheque Debit Credit

Received Brought Balance Balance
(Debit) (Credit)
Bank A 28,000 56,000 - 28,000
Bank B 52,000 48,000 4,000 -
Bank C 56,000 26,000 30,000 -
Bank D 48,000 48,000 - -
Bank E 40,000 46,000 - 6,000
Total 224,000 224,000 34,000 34,000

4.9 From the above table it is clear that Bank B and C are to pay debit balances of Rs.4,000 and 30,000 respectively (Total: Rs.34,000).
Bank A and E are entitled to receive their credit balances of Rs.28,000 and 6,000 respectively (Rs.34,000 in total). Bank D’s credit and
debit balances are equal. Hence, cheques worth Rs.224,000 are cleared by a more payment of Rs.34,000. The clearing house thus helps
in saving a lot of cash reserves and transactions, reduces the number of entries made in the registers and eliminates the unnecessary task
of carrying the cheque packages from one bank to another bank.

Merits of clearing houses

4.10 The main advantages of clearing house are as under:-

(a) Settlement of mutual obligations of commercial banks

(b) House provides an opportunity to the commercial, off inter bank debits without making payments in cash

(c) The central bank keeping the cash reserves of the banks

(d) House provides an opportunity to promote the interest of the member banks.
uniform policy for issuing of bank
 (e) Can also prove an effective device for preventing, competition

(f) Financial stress, the member banks can assist.

5. STATE BANK OF PAKISTAN AS CONTROLLER OF CREDIT

Objectives of credit control

5.1 State Bank of Pakistan Act, 1956 gives special powers to the State Bank to regulate, credit policy pursued, State Bank aims at
channelising funds of the commercial banks to productive sectors of the country. It discourages the use of bank loans for non-productive
purposes so as to achieve prosperity, stability and the growth of domestic economy. The long term objectives of the credit policy of the
State Bank, however, is the promotion of high and stable level of employment in the country.

Instruments of credit control

5.2 main instruments of credit policy applied by the State Bank of Pakistan are now discussed in brief.

Quantitative control

Bank rate

5.3 Bank rate is also called the discount rate. Is the official rate at which the State Bank rediscounts the first class securities at its
counter. the bank rate is raised
followed by an increase in the discount rate of commercial banks.
discourage in the country and it eventually, bank rate has the opposite effect.

5.4 now charging 10% on rediscounting the first class bills of exchange.
the discount rate has not proved to be an effective instrument of credit
as the bill market is not very organized and soundly
rate weapon is now replaced by the power for the bank to fix its profit sharing ratio in respect of its own financial assistance.
 Open market operations

5.5 meant the sale and purchase of government securities in the open market by the central bank of the country. The sale of securities
leads to contraction of credit and the purchase, therefore, to the expansion of credit.

5.6 Has been using this weapon to regulate the flow of the credit in the country.

(a) money market is not responsive in Pakistan;

(b) the commercial banks are carrying excess reserves the themselves; and
(c) the marketable securities are inadequate.

Variable reserve requirements

5.7 Effective weapon of credit control of the central bank of a country.

Section 36 of the Act, requires the scheduled banks to maintain at least 5% of demand and time liabilities with it, the power to change
the minimum reserve rests with the State Bank.

5.8 The instrument of variable reserve ratio, is used for affecting the liquidity position of the banks and hence their ability to finance.
When the reserve requirements are raised by the central bank, thus restricts and expansion of credit in the country. Central bank lowers
the reserve ratio. The commercial banks are also required to maintain 25% liquidity ratio on a day to day basis against their time an
demand liabilities.

Credit rationing

5.9 Empowered to place limits on the amount available for each application of loan.

Credit target

5.10 Pakistan has set up National Credit Consultative Council (NCCC) in 1974. The functions of NCCC is to examine overall credit
situation in the country and indicate the credit limits for the public and private enterprises. The State Bank of Pakistan sets specific target
of funds to be given to agriculture business industry and low cost housing by the commercial banks. If the commercial banks fail to
achieve the ceilings, it imposes penalty on them. The defaulting commercial banks shall have to make interest free loan to the State Bank
of the amount falling short of the target.
Qualitative controls

Moral persuasion

5.11 Banks are advancing funds for speculative or non-essential, State Bank can persuade and directly appeal to them to follow.

Direct action

5.12 If the commercial banks do not act upon the credit policy of the State Bank, the State Bank is empowered to take action against
them.

5.13 Moeen Qureshi made the State Bank of Pakistan an autonomous central bank. Set and implement standards for commercial banks
lending view independently.

Prudential controls

Introduction

5.14 With a view to provide for a continued health and viability of financial system, the Prudential Regulations (PR) have been issued
in the following areas:

(a) PR issued by State Bank of Pakistan

(i) Corporate and Commercial Banking

(ii) Small and Medium Enterprises financing
(iii) Customer financing

(b) PR issued by Security and Exchange Commission of Pakistan

(i) Non banking finance companies

(ii) Modarabas.
PR for corporate and commercial banking

5.15 These regulations are divided into following categories:

(i) Risk management

(ii) Corporate Governance
(iii) Know your customer & and anti-money laundering
(iv) Operations.

5.16 A brief of the regulations dealing with credit control is as follows.

(a) Regulation R-1

Limited on exposure to a single person: any single person shall not at any point in time exceed 30% of the bank’s / DFI’s equity,
to the condition that the maximum outstanding against fund based exposure does not exceed 20% of the bank’s

(b) Regulation R-2

Limit on exposure against contingent liabilities: exceed at any point in time 10 times of its equity.

(c) Regulation R-3

Minimum conditions for taking exposure: give due weightage to the credit report relating to the borrower and his group obtained
from Credit
statements duly audited by a chartered accountant.

(d) Regulation R-4

Limit on exposure against unsecured financing facilities:
unsecured / clean financing facility in any form of a sum exceeding Rs.500,000/- (Rupees five hundred thousand only) to any one
person.

(e) Regulation R-5

Linkage between financial indicators of the borrower and total exposure from financial institutions.

(i) the total exposure (fund-based and / or non-fund based) availed by any borrower from financial institutions does
not exceed 10 times of borrower’s equity.
 (ii) the time of allowing fresh exposure / enhancement / renewal, the current assets to current liabilities ration of the
borrower shall not be lower then 1:1.

(f) Regulation R-6

Exposure against shares / tfcs and acquisition of shares

(i) (1) Exposure against shares / TFCS: Banks / DFIs shall not take exposure.

(ii) (2) Acquisition of shares: scripts in excess of 5% of their own equity own equity investment of banks in
shares should not exceed 20% of their own equity.

(g) Regulation R-7

Guarantees: All guarantees issued by the banks / DFIs shall be fully secured, except in the cases such as bid bonds, performance
bonds and guarantees.

(h) Regulation R-9

Assuming obligations on behalf of NBFCS DFIs shall not issued by guarantee or letter of comfort nor assume any obligation
whatsoever in respect of deposits, sale of investment certificates, issued of commercial papers, or borrowings of any non-banking
finance company.

(i) Regulation R-10

Facilities to private limited company: DFIs shall formulate a policy, duly approved by their Board of Directors, about obtaining
personal guarantees of directors of private limited companies.

(j) Regulation R-12

Monitoring: Statements from borrowers that contain a bank-wise.

PR for small medium enterprises financing (SMEs)

5.17 Risk management category (R). For the remaining three categories [i.e. Corporate Governance (G), Anti Money Laundering (M)
and Operations (O)]
 Prudential Regulations for SMEs Financing, SME means an entity, ideally not a public limited company, which does not employ more
than 250 persons
50 persons

(a) A trading/service concern with total assets at cost excluding land and building upto Rs.50 million.
(b) A manufacturing concern with total assets at cost excluding land an building upto Rs.100 million.
(c) Any concern (trading, service or manufacturing) with net sales not exceeding Rs.300 million as per latest financial statements.

An individual, if he or she meets the above criteria, can also be categorized as an SME.

5.18 A brief of the regulations dealing with credit control is an follows:

(a) Regulation R-1

Source and capacity of repayment and cash flow backed lending to the identified.

(b) Regulation R-2

Personal guarantees: All facilities except those secured against liquid assets, extended to SMEs shall be backed by the personal
guarantees of the owners of the SMEs.

(c) Regulations R-3

Limited on clean facilities secured solely against personal guarantees, on a SME up to Rs.3 million provided that funded exposure should
not exceed Rs.2 million.

(d) Regulation R-4

Securities: Relaxation in Regulation R-3, for facilities upto Rs.3 million, all facilities over and above this limit shall be
appropriately secured as per satisfaction of the banks/DFIs.

(e) Regulation R-5

Margin requirements: Banks/DFIs are free to determine the margin requirements on facilities provided by them to their clients taking
into account the risk profile of the borrower(s) in order to secure their interests.

(f) Regulation R-6

Per party exposure limit: The maximum exposure of a bank / DFI on a single SME shall not exceed Rs.75 million.
 (g) Regulation R-7
Aggregate exposure of a bank / DFI on SME sector shall not exceed the prescribed limits.

(h) Regulation R-8

Minimum conditions for taking exposure: DFI should give due weightage to the credit report relating to the borrower and his group.

(i) Regulation R-9

Proper utilization of loan: The loans have been properly utilized by the SMEs and for the same, acquired / obtained.

(j) Regulation R-10

Restriction on facilities to related parties: On a SME in which any of its director, major shareholder holding, any family member of these
persons is interested.

PR for Consumer Financing

5.19 Financing allowed to, personal, family or household needs.

(i) Credit Card mean cards, which allow a customer to make payments on credit. Supplementary credit cards shall be
considered part of the principal borrower. Corporate Card will not fall under this category and shall be regulated by Prudential
Regulations for credit cards shall also be applicable on charge cards, value cards and BTF (Balance Transfer Facility).

(ii) Auto loans mean the loans to purchase the vehicle for personal use.

(iii) Means loan provided to individual for the

(iv) Personal loans mean the loans to individuals for the payment
Running Finance / Revolving Credit to individuals.

That any financing facility, other than SMEs Financing, above, shall be governed by the Prudential.

5.19 These are divided into following categories.

 (a) Regulations (general concept)
(b) Regulations for credit cards
(c) Regulations for auto loans
(d) Regulations for housing finance
(e) Regulation for personal loan including loan for the purchase of consumer durables.

5.20 A brief of the regulations dealing with credit control is as under:

(a) Regulation R-1

Extended by banks/DFIs to their directors, major shareholders, employees
persons shall be at arms length basis and on normal terms.

(b) Regulation R-2

The prescribed limit on exposure against total consumer financing shall not be exceed.

(c) Regulation R-3

Total financing facilities to be commensurate with the income.

(d) Regulation R-4

General reserve against consumer finance: General reserve at least equivalent to 1.5% of the consumer portfolio which is fully
secured and 5% of the consumer portfolio which is unsecured.

(e) Regulation R-5

Bar on transfer of facilities from one category to another to avoid classification: transfer any loan or facility to be classified

(f) Regulation R-6

Margin requirements: Determine the margin requirements on consumer facilities provided by them to their clients taking

PR for non banking financing companies (NBFCs)

5.22 Non Banking Financial Institutions (NBFIs), Companies (NBFCs) and are being regulated, November 15, 2002, information,
returns and statements to SECP and Credit Information Bureau, in the same manner.
5.23 Part II of these rules applies to borrowing facilities for (a) corporate borrowers.
5.24 A brief of the conditions is as follows:
(a) Limit on NBFC’s exposure to a single person: NBFC to any single person shall not at any point in time exceed 30%,
Exceed 20% of the NBFC equity.

(b) Minimum conditions for grant of financing facilities.

(i) Fund/non-fund based facility exceeding, Information Bureau of the State Bank of Pakistan. If the credit report
indicates.
(ii) Obtain copy of accounts relating to the business of each.
(iii) Ensure that the Loan Application Form prescribed/devised by a modaraba is accompanied, ”Borrower’s Basic Fact
Sheet’.
(c) Borrower’s equity and total exposure from financial institutions: Borrower from institutions does not exceed 10 times.

(d) Financial indicators of the borrowers: Debt-equity ratio of the borrower

current liabilities ratio is not lower than 1:1.

(e) Margin against facilities: Minimum margins shall be maintained against various facilities and all guarantees will be backed
by 100% realizable securities.
(f) Facilities against Shares / TFC’s and acquisition of share: NBFC shall not take exposure against the security of shares /
TFCs issued by them.

PR for Modarabas
5.25 Part II of these rules applies to borrowing facilities for (a) corporate borrowers an (b) individual borrowers.
5.26 A brief of the conditions is as follows:
(a) Limit on modaraba’s exposure to a person: Point in time exceed 30% of the modaraba’s equity, exceed 20% of the
modaraba’s equity.
(b) Minimum conditions for grant of financing facilities
(i) To give due weightage to credit report relating to the borrower and his group obtained from Credit
Information Bureau of the State Bank of Pakistan.

(ii) While granting any facility to the customers other than individuals, modaraba shall obtain copy of accounts
relating to the business of each of its borrower for analysis and record.
(c) Linkage between a borrower’s equity and total exposure, moderabas shall ensure that the total exposure availed by
any borrower from financial institutions does not exceed 10 times of borrower’s equity as disclosed in its financial
statements.

(d) Financial indicators of the borrowers: equity ration of the borrower does not exceed 60:40 and current assets to
current liabilities ratio is not lower than 1:1
(e) Margin against facilities: Margins shall be maintained against various facilities and all guarantees will be backed
by 100% realizable securities:
(f) Facilities against Shares / TFCs and acquisition of shares: Modarabas shall not take exposure against the security
of shares /TFC issued by them.

(g) Regulations for Housing Finance for individuals

(i) The maximum per party limit in respect of housing finance by the modarabas will be Rs.7.5 million.

(ii) Modarabas are free to extend mortgage loans for housing, for a period not exceeding twenty years.
Modarabas should be mindful of their adequate asset liability matching.

(iii) The house financed by the moderabas shall be mortgated in modaraba’s favour by way of equitable or
registered mortgage.

(iv) Modarabas shall either engage professional expertise or arrange sufficient training for their concerned
officials to evaluate the property, assess the genuineness and integrity of the title document, etc.

(v) The housing finance facility shall be provided at a maximum Loan to Value ratio of 85:100 (85%)
 (vi) The housing finance facility shall be provided at a maximum of Income to installment ratio of 3:1.

6. CENTRAL BANK AS THE GOVERNMENT’S BANKER

6.1 Central bank in each country, has now been assigned the responsibility of acting as fiscal agent to the government. Previously,
this duty was performed by a large number of government treasuries spread all over the country. The services performed by treasuries
for receiving, holding and disbursing of government funds were dissatisfactory. The treasury office established at different places were
expensive to operate. The net movement of coins and paper money into and out of the treasury were also risky. It was, therefore, decided
that the central bank should be given the privilege and also the responsibility to deposit free of interest all the cash balances of the
government and in lieu therefore perform some fiscal functions for the government. These functions in brief are as under:

(a) Central Bank as government’s banker. The central bank acts as a banker to the government. It deposits free of interest all
the cash balances of the government. In return, it performs all the services which a commercial bank ordinarily does for its
customers. It receive on deposits, income taxes, customers and other internal revenues taxes. It also undertakes the work of
collection of cheques and drafts drawn on other banks and provides cash to the government. The bank pays salaries, pensions,
reliefs, public works, etc., on behalf of the government. It transfers funds from one part of the country to another or from one
account to another for the government. The central bank grants short-term loans to the government against government securities.
In time of emergencies like war or depression, it makes extraordinary advances to the government. The bank charges no
commission from the government for all these banking services rendered by it.

(b) Bank as agent of the government. The central bank acts as agent of the government. It is entrusted with the issued of new
loans and treasury bills on behalf of the government. It pays interest on the public debt and redeems maturing securities. It also
underwrites securities of the government. The central bank also acts as agent in gold and foreign exchange transactions for the
treasury. It also buys and sells foreign exchange on its own account and as agent for the treasury. It services as depository of IMF
and IBRD.

(c) Bank as a financial advisor. The central bank performs a very important function by acting as financial advisor to the
government. Though the government has its own staff for giving advice on matters of economic policy, yet it obtains advice from
the central banks also. The central bank is constantly in touch with the money, securities and foreign exchange market conditions
in the country. It, therefore, gives advice to the government in its debt management, foreign exchange transactions, deficit
financing, devaluation of the currency, trade policies, mobilisation of savings, agricultural and industrial credit, etc. The central
bank also acts as fiscal agent for various agencies and corporation established by the government.
7. ROLE OF STATE BANK OF PAKISTAN IN THE ECONOMIC DEVELOPMENT

7.1 The role of the State Bank of Pakistan is not confined now to the regulation of overall supply of credit in the country. Its aim is
to create a machinery which helps in mobilising domestic resources. These resources are directed into productive channels, helping in
the establishment of specialised financial institutions for carrying out development programmes in various sectors of the economy,
holding the price line, increasing employment and maintaining equilibrium in the balance of payments. The role of State Bank of Pakistan
is, therefore, promotional and developmental. The State Bank of Pakistan since its establishment in July, 1948 has taken the following
measures for promoting economic development in the country.

(a) Growth of banking system. At the time of partition, there were only two Muslim scheduled banks, Habib Bank Limited,
and Australia Bank operating in Pakistan. The State Bank immediately after its establishment in 1948, took up the herculean task
in building up a sound banking system in the country. The start was made with the establishment of National Bank of Pakistan in
1949. Since then the total number of domestic commercial banks and foreign banks have increased to 25 and 19 with 8326 and 74
braches respectively in operation in the country. These banks are paying a prominent role in the mobilisation of saving in rural
and urban areas an disbursing credit for promoting developing in the country.

(b) Assistance to specialised financial institutions. The State Bank of Pakistan is providing assistance to specialised financial
institutions for enabling them to extend adequate finance to different sectors of economy. The loans are given to Agricultural
Development Bank of Pakistan (ADBP) for financing seasonal agricultural operations and for development of agriculture. The
House Building Finance Corporation (HBFC), Industrial Development Bank of Pakistan (IDBP), National Development Finance
Corporation (NDFC), Investment Corporation of Pakistan (ICP) and Federal Bank of Cooperative also get financial assistance
from SBP.

(c) Monetary and credit policy. The bank is pursuing a monetary policy which aims at:

(i) checking inflationary pressure; and

(ii) ensuring adequate availability of bank finance for productive activities in general and the priority sectors in
particular.

(d) Export finance scheme. Under the State Bank Finance Scheme, the banks are providing finance to the exports at the
concessional rates. The refinance, in turn, is provided by the State Bank at low rate of interest.
(e) Credit targets for priority sectors. The State Bank gave targets to commercial banks for providing small loans in the fields
of business, industry, agriculture, housing every year. The prescribing of credit target for priority sectors have greatly helped in
raising production.

(f) Islamisation of financial system. As a part of the government policy, the State Bank of Pakistan has prepared and
implemented a programme of Islamic modes of financing, from July 1, 1985. All financing and loaning operations of the banks
conform to the Islamic system. The non-bank financial institutions like the ICP, NIT, SBFC, BEL (Banker Equity Limited) have
also converted to entire investment operations on an interest free basis.

(g) Establishment of banking publicity board. The State Bank Limited to set up Banking Publicity Board in 1959 for
developing banking habit among the people and for mobilisation of savings in the length and breadth of the country.

(h) Managed float. The SBP fixes the Pakistan’s rupee exchange parity against the basket of currencies. Pakistani rupee has
been made fully convertible on current account from July, 1994.

(i) Training scheme. The State Bank started a training scheme for imparting banking knowledge to the persons working in
the banks and to those who are to join banks as their profession. The training scheme was a success and it produced a large number
of trained bankers of financial experts for the various banking concerns.

(j) State Bank and autonomy. The State Bank now regulates 137 financial institutions in the country the breakup of which is
as follows:

Domestic Banks 25
Foreign Banks 19
Modaraba Companies 52
Leasing Companies 29
Investment Banks 12
Total 137

The SBP should have constitutional powers to dictate monetary policy. It should be an independent institutions offering expert
counsel with powers to implement them.
7.2 Those who oppose this view are of the opinion that ultimate decision-making powers for guiding and managing the economy
should rest with the democratic government of the country. It is correct that the ultimate decision making power should be government
of the country but the policies which shape the level of inflation and interest rate should lie with the central bank. If the central bank’s
autonomy is chipped away, then the demand for budgetary support to centre and provinces will continue rising leading to inflationary
pressure in the country.

Courtesy: Mohd. Ovais, Tabani School of Accountancy

 Islamic Banking in Pakistan
(Introduction, history, formation, statutory requirements, and accounting standards)

Featured Article

Introduction and History of Islamic Banking:

In the early stages of 20th century, the Islamic banking was only limited to models and modus operandi. The full-fledged system
of Islamic banking was introduced in 1960s by an Egyptian bank 'Myt Ghamr'. The earliest Islamic banks faced serious challenges
ranging from general suspicions about their viability to a common mistrust about their intentions. Since then, the Islamic banks have been
steadily growing to a remarkable level at this stage. During the last decades, financial instruments used by Islamic banks have developed
significantly, both on assets and liability sides. Many instruments have been developed to mobilize financial surpluses. A number of Islamic
banks have launched investment instruments in the form of certificates with short-term maturities or have established funds earmarked for
certain investments. Accordingly, at present, there are around 70 countries in which the Islamic financial institutions are operating
in full-fledged or in part. Recently six countries including Bahrain, Saudi Arabia, Malaysia, Indonesia, Brunei and Sudan have
signed a memorandum of understanding (MOU) for establishment of the first International Islamic Financial Market (IIFM) in co-
operation of Islamic Development Bank (IDB). IIFM is designed to provide a co-operative framework among around 200 Islamic
banks and financial institutions all over the world. A Liquidity Management Centre (LMC) is also working in Bahrain which
addresses the critical need for liquidity management by Islamic banks in line with the Shariah principles.

The Islamic Financial Institutions (IFIs) can be divided into two broad categories:

1. Islamic commercial banks; and

2. Islamic investment institutions and international holding companies

Legendary names of Islamic finance are as follows:

Banks / Financial Institutes Countries

Darul-Mal Al-Islami Switzerland
Dallah Al-Baraka Group Saudi Arabia
Bahrain Islamic Investment Bank Bahrain
Al-Rahji Banking and Investment Corporation Saudi Arabia
Al-Meezan Bank Pakistan
 Faisal Islamic Bank Egypt
Jordan Islamic Bank Jordan
Islami Bank Bangladesh
Bank Islam Malaysia Berhad Malaysia
Dubai Islamic Bank UAE
Kuwait Finance House Kuwait
Al-Baraka Islamic Investment Bank Pakistan

Islamic financial institutions are diverse and becoming increasingly innovative. Value of their assets has reportedly exceeded $200 billion with
asteady growth rate of 10-15 percent per annum. They represent a small but dynamic market, no longer confined to its original strongholds in the
Middle East and South East Asia. In USA, UK and a number of other European countries, various Islamic funds have existed for a number of
years. Some conventional financial institutions of international standing have established Islamic banking subsidiaries and windows. Many
banks, both in the Muslim world and outside, are offering Islamic financial products and take active part in capital market transactions. Liquid
instruments are emerging through Securitization by way of Islamic finance like equity/mutual funds. There is also Dow Jones Islamic Market
Index.

In Pakistan, the process of Islamic financing and banking started with the reforms in specialised financial institutions like NIT, ICP
and HBFC in conformity with the Islamic principles. From 1st July, 1985 all the commercial banking operations were made
'interest free'.

Estabilishment of Islamic Bank as per to the Requirements of State Bank of Pakistan:

Recently, State Bank of Pakistan has allowed the formation of full-fledged Islamic banks in the private sector. The existing
scheduled commercial banks were also authorised to open subsidiaries for Islamic banking operations. Such subsidiaries shall
be considered as the Islamic Banking Subsidiaries and shall have a separate body of governance. It is a statutory requirement
for the bank to appoint a Shariah Adviser / Shariah Supervisory Committee consisting of Shariah scholars of repute to advise the
Islamic bank on matters pertaining to Shariah. Shariah Adviser / Committee will be responsible to vet all agreements, and
products offered by the Islamic bank. The detailed criteria for setting up Islamic Banking Subsidiaries has been issued by the
State Bank, which are highlighted as below:

1. The proposed subsidiary shall be a Public Limited Company and shall be listed on the Stock Exchange;
2. The banking subsidiary (Islamic) are required to conduct the banking activities strictly in accordance with the Shariah
principles;
 3. To commence the business, the subsidiary shall have a minimum paid up capital of Rs. 1 billion; and
4. At least 51% of the total paid up capital shall be subscribed by the (parent) banking company, and a maximum of
49% of shares shall be offered to public.

Islamic Banking Division: The bank shall be required to set up an Islamic Banking Division (IBD) at the head office / country office
in Pakistan. The bank is also required to prepare a full detail of the organisational structure of the IBD and submit to State
Bank. The responsibilities of IBD are as follows:

(a) To manage and be responsible for the operations of Islamic Banking Branch (IBB) including policy and
procedural matters;

(b) To liaise with other departments in the bank and the Shariah Adviser / Committee to ensure smooth operations of
IBB;

(c) To ensure that all funds pooled into the Islamic Banking Fund (IBF) are channelled into Shariah complaint financing
and investment activities;

(d) To arrange training of staff on Islamic banking;

(e) To arrange for compilation and submission of such returns, as may be required to be submitted to State Bank from
time to time;

(f) To ensure that all directives and guidelines, particularly those applicable to Islamic banking, issued by State Bank are
strictly complied with;

(g) To maintain the Statutory Cash Reserve and Liquidity Requirement with State Bank as prescribed by State Bank
from time to time; and

(h) Other roles and responsibilities as determined by the bank or State Bank from time to time.

Islamic Banking Fund (IBF): The bank shall be required to maintain a minimum fund of Rs. 50 million or 8% of risk weighted
assets of IBB, whichever is higher. The funds of Islamic Banking shall be funded by the head office or its country office and
controlled by the IBD for the operations of IBB.
Shariah Compliance: Obviously, the sole purpose of the Islamic bank is to conduct banking strictly in accordance with the Shariah
principles, as outlined in Holy Quran and Sunnah. The bank is required to ensure the Shariah compliance on all the agreements,
and products and services offered and handled by the IBD and / or IBB. The responsible authority for the Shariah compliance is
the Shariah Adviser / Committee consisting of Shariah scholars having sufficient related knowledge, qualifications and
experience. The Shariah adviser or Shariah Supervisory Committee, appointed by the bank, shall advise the IBD on all of the
business matters pertaining to Shariah.

Islamic Financial Accounting Standard:

Recently the Institute of Chartered Accountants of Pakistan (ICAP) has issued the first Islamic Financial Accounting Standard
(IFAS) 1 -Murabaha. The purpose of this Standard is to provide guidance for the transactions regarding Murabaha. Murabaha is
a particular kind of sale where seller expressly mentions the cost he has incurred on the commodities to be sold and sells it to
another person by adding some profit or mark up thereon which is known to the buyer.

Thus, Murabaha is a cost plus transaction where the seller expressly mentions the cost of a commodity sold and sells it to
another person by adding mutually agreed profit thereon which can be either in lump-sum or through an agreed ratio of profit to
be charged over the cost, thus resulting in an absolute price. According to IFAS 1, Murabaha should fulfill the following
conditions:

(a) The thing or commodity is in existence;

(b) It is owned by the seller;

(c) The bank must have a good title to the commodity before it sells it to its clients; and

(d) The commodity must come into the possession of the bank, whether physically or constructive, in the sense that the
commodity must be its risk, though for a short period.

For a Murabaha transaction, the bank itself may purchase the commodity and keep it in its possession. But, as soon as the
client purchases the commodity from the bank, the ownership, as well as the risk, passes to the client. According to this
Standard, for a valid Murabaha transaction, the financing must be in accordance with Shariah principles.
Management of Economics
 Pricing Strategy

Steps in Setting Price:

Following are the steps in setting price for a product:

1. Selecting the pricing objectives;

2. Determining the consumers' demand;
3. Estimating costs;
4. Analysing the competitors' costs, prices and offers;
5. Selecting a pricing method; and
6. Selecting the final price.

1. Selecting the pricing objectives: Before selecting a suitable price for a product, the marketer is needed to review the
company's objectives. The more clearer the company's objectives, the more easier to set a price. Following are the
possible pricing objectives:

1. survival,
2. maximum current profit,
3. maximum market share,
4. maximum market skimming, and
5. product quality leadership.

The decision whether to select high price or low price depends on various factors:

1. Price susceptibility of market,

2. Number of competitors in the market, and
 3. Production cost per unit.

The price level also depends on the type of marketing strategy adopted for the product. The possible marketing strategies
are listed below:

1. Rapid Skimming: It refers to launching a new product at a high level of price with high level of sales promotion. It refers
to the product which is of high quality, but not known to the buyers. As soon as the product is known to the buyers, the
buyers are willing to purchase them even at a higher price. It may also refer to the market where there are strong
potential competitors.
2. Slow Skimming: It refers to launching a new product at a high price with low level of promotion. It also refers to the
situation where the company's brand is known to the buyers and they are willing to purchase them even at a higher
price. It may also refer to the market where there are few competitors.
3. Rapid Penetration: It refers to launching a new product at a low price with high level of promotion. This marketing
strategy is adopted where the company's brand is unknown in the market and where there are strong potential
competitors.
4. Slow Penetration: Under the slow penetration market strategy, the company launches a new product at a low level
price with low level of promotion. The brand of the company is known and there are few competitors in the market.

2. Determining the consumer's demand: The next step is determining the consumer's demand. At this stage, marketer
analyses the different level of demand at different prices. Therefore, it leads to the study of law of demand, elasticity of
demand, demand curve, etc. In normal case, the demand and price are inversely related, i.e, the higher the price, the
lower the demand, and vice versa. But some goods have 'elastic' or 'inelastic' demand. For example, demand for
automobiles, perfumes, etc. are elastic; whereas the demand for rice, flour, eggs, etc. are inelastic.
3. Estimating costs: Demand sets a ceiling on the price and the costs set the floor. The company wants to charge a suitable
price covering the cost of production, selling and distribution, and administration. Costs taken into two forms, i.e, variable
costs and fixed costs. Variable costs vary directly with the variation in production, but remain fixed per unit of production.
However, the fixed cost does not vary with the change in production units, but it does not remain fixed per unit, as the
production units varies. In other words, the fixed cost remain fixed in total and decreases in Rs. per unit with the increase
in the production units or increases in Rs. per unit with the decrease in the production units.
4. Analysing the competitors' costs, prices and offers: For a marketer, the next step in setting a price for a product is to
analyse the costs and prices of the product and after-sales services and different other services offered by the competitors
 of the company. A deep analysis may enable a marketer to discover the strengths and weaknesses of the competitor and
the tastes or the purchasing trends of buyers.
5. Selecting a pricing method: The company has to select an appropriate method for pricing its products. Following are the
suggested pricing methods:

1. Mark-up Pricing: Under mark-up pricing, the price is equal to cost plus percentage mark-up on cost. For example, the
cost of constructing one residential flat for a constructor / developer is Rs. 500,000 and the constructor / developer
charges 25% above cost, the selling price of 1 residential flat will be equal to Rs. 625,000, i.e, [500,000 + (500,000 ×
25%)]. This kind of pricing method is common among the contractors, lawyers, chartered accountants, different
practitioners and manufacturing companies for pricing job orders, custom products, etc.
2. Target Return Pricing: Under target return pricing, the price of a product is equal to cost plus required rate of return on
investment. For example, the shareholders / owners of a product-selling company is expecting a return of 20% on net
assets that amounts to, let say, Rs. 200,000, the marketer would select a price which would scratch a net profit of Rs.
200,000. This sort of pricing method is adopted in public investment companies, large-scale manufacturing companies,
etc.
3. Perceived Value Pricing: The market price of a product is calculated on the basis of customers' perceptions about a
product. It is extensively used in non-durable consumer goods manufacturing companies. Non-durable or soft goods
may be defined either as goods that are used up when used once, or that have a lifespan of less than 3 years.
Examples of non-durable goods include cosmetics, food, cleaning products, fuel, office supplies, packaging and
containers, paper and paper products, personal products, rubber, plastics, textiles, clothing and footwear, etc.
4. Value Pricing: It refers to pricing high quality products at fairly level. This sort of pricing method is extensively used in
personal computer manufacturing industry, electronic goods manufacturing industry, etc.
5. Going Rate Pricing: Under this pricing method, the price of a product is based on prices of existing products in the
market. The going rate pricing method is used in pricing paper, cement, fertilizers, steel, petrol and chemical industries.
6. Sealed Bid Pricing: It also refers to 'competitive-oriented pricing'. It is common where firms submit scaled bids for jobs
/ contracts. For example, pricing for scraps, wastages of factory, etc.

6. Selecting a final price: The final and the last step in setting prices is, of course, selecting a final price from a number of
alternative prices, which would match the company's short term and long term objectives.

Price Adaptation Strategies:

Following are the price adaptation strategies:

1. Geographical Pricing: Geographical pricing refers to the product pricing for the customers in different locations, cities and
countries. It also accounts for various tariffs, taxes and shipping costs. In foreign trade, another term is extensively used,
i.e, counter-trade. It has taken 15-25% of the total world trade and may have the following forms:

1. Barter: Exchange of goods with no money and third party.

2. Compensation deal: The seller receives partial cash payment and the rest in products by the buyer.
3. Buyback arrangement: The seller receives cash, as partial payment for the plant or machinery or any other technology
being sold. And the rest of payment is made in the products manufactured on that machinery.
4. Offset: The seller receives the full amount, but he will have to spent a part of it in the country or the location of buyer.

2. Price Discounts and Allowances: To promote the sales, the seller has to allow price discounts and allowances.
Following are the forms of price discounts and allowances:

1. Cash Discounts: Cash discounts are allowed by suppliers on early payments within the stipulated time, e.g, 2/10, net
30, 3/7 EOM, 2/15, net 40 ROG, etc. which are extensively used in trading and merchandising. 2/10, net 30 means the
buyer must pay within 30 days of the invoice date, but will receive a 2% discount if they pay within 10 days of the
invoice date.. 3/7 EOM - this means the buyer will receive a cash discount of 3% if the bill is paid within 7 days after the
end of the month indicated on the invoice date. It should be noted that if an invoice is received on or before the 25th day
of the month, payment is due on the 7th day of the next calendar month. If a proper invoice is received after the 25th
day of the month, payment is due on the 7th day of the second calendar month. 2/15 net 40 ROG - this means the
buyer must pay within 40 days of receipt of goods, but will receive a 2% discount if paid in 15 days of the receipt of
goods by the purchaser. (ROG is short for "Receipt of goods.").
2. Quantity Discounts: Quantity discounts are the price reductions generally allowed on bulk purchases, for example, 1%
on less than 1000 units, 2% on 1000 units or more than 1000 units. The rationale behind them is to obtain economies of
scale and pass some (or all) of these savings on to the customer. In some industries, buyer groups and co-ops have
formed to take advantage of these discounts. Quantity discounts are, generally, of two types, i.e, cumulative quantity
discounts and non-cumulative quantity discounts.
 1. Cumulative quantity discounts: also known as accumulation discounts. These are price reductions based on the
quantity purchased over a set period of time. The expectation is that they will impose an implied switching cost and
thereby bond the purchaser to the seller.
2. Non-cumulative quantity discounts: are price reductions based on the quantity of a single order. The expectation
is that they will encourage larger orders, thus reducing billing, order filling, shipping, and sales personal expenses.

3. Functional Discounts: Functional discounts are allowed to channel members if they perform various functions like
distribution, storing, shelf-stocking and record keeping. Also known as 'trade discounts'. Trade discounts are often
combined to include a series of functions, for example 20/12/5 could indicate a 20% discount for warehousing the
product, an additional 12% discount for shipping the product, and an additional 5% discount for keeping the shelves
stocked. Trade discounts are most frequent in industries where retailers hold the majority of the power in the distribution
channel.
4. Seasonal Discounts: Seasonal Discounts are allowed on off-seasoned buyings. For example, warm-wear in June-July,
cold drinks in December-January, etc.
5. Allowances: Allowances are extra-payments designed to gain reseller participation in special programmes, e.g, trade
allowances, promotional allowances, brokerage allowances, etc.

3. Promotional Pricing: The promotional pricing strategies are:

1. Loss-Leader Pricing: Super markets and departmental stores often drop prices on branded products to promote their
stores' sales. But it dilutes the company's brand image and may lead to complaints from other retailers who charge the
normal list price.
2. Special Event Pricing: Special event pricing are for special events, e.g, Eid sale, Christmas sale, back-to-school sale,
Eid Mela, etc.
3. Cash Rebates: Cash rebates allowed by auto manufacturers and some consumer goods manufacturers within a
specified time period.
4. Low Interest Financing: Low interest financing is provided on certain consumer goods like automobile, motorcycle,
television, refrigerators, air conditioners, etc.
5. Longer Payment Terms: Sellers, especially mortgage banks and auto companies, stretch loans to their customers
over longer periods and thus lower the monthly payments.
 6. Warranties and Service Contracts: Warranties and service contracts are provided on, especially, the consumer goods
like television, refrigerators, air conditioners, personal computers, etc.
7. Psychological Discounting: Psychological discounting involves in setting an artificially high price and then offering the
same product at substantial savings.

4. Discriminatory Pricing: Price discrimination exists when sales of identical goods or services are transacted at different
prices from the same supplier. Different prices are charged on the basis of different consumer groups, locations, product
forms, etc. Discriminatory pricing may take the following forms:

1. Consumer-Segment Pricing: Discriminatory pricing based on consumer segments, e.g, museum often charge low
admission fee for students and senior citizens.
2. Product-Form Pricing: Different versions of the same product are priced differently but not proportionately to the
increase in costs. For example, Microsoft sold different versions of its operating software Windows XP at different price
level. 'Windows Vista Home Basic Version' is sold at $200 and with some variations the same operating software
'Windows Vista Ultimate Version' is sold at $320.
3. Image Pricing: Image pricing refers to pricing the same product on the basis of different images, e.g, a perfume
manufacturer may put a perfume in a bottle, name it and give it an image and may price it at $10 per ounce; he may put
the same perfume in a different bottle, give it another name and image and may price it at $18 per ounce.
4. Location Pricing: Discriminatory pricing based on different locations, even though the cost of offerings at each location
is identical, e.g, theatre charges different prices for different audience preferences for different locations.
5. Time Pricing: Prices are varied by seasons, day or hours. Time pricing is usually applicable in public utilities like
electricity, telephone bills, hotels and airlines, and also for internet hours.

Predatory Pricing: There is another type of pricing of discriminatory pricing known as 'predatory pricing'. It refers to setting
a price of a product below its cost, just to beat the competitors in the market. This has been prohibited by law. There was a
strong legal allegation against the Microsoft that it has been perceived from its pricing tactics that it is involved in predatory
pricing. Thus, the US Government's anti-trust lawsuits against Microsoft, bring it to a big trouble. It even led the court to
think to bifurcate the company into two companies. Actually, in 1996, the company started giving away its product 'Internet
Explorer' below its cost and in some cases absolutely free. This Microsoft's pricing tactics wrest the market dominance
from Netscape Communication Corporation. Netscape constantly revised its pricing structure but failed to appeal the
 customers. This cause rivals to label Microsoft as a predator, which was further tendentious for raising prices as it gains
the lion's share of the market.

5. Product Mix Pricing: In pricing a product, the marketer must also accounts for profitability of product mix. Product mix
pricing is a difficult task because each product has different demand, cost and competition. Product mix pricing may take
several forms:

1. Product-Line Pricing: Companies normally develop product lines rather than single products and develop different
price levels, for e.g, three price levels $200, $350 and $500 for men's suits, the customers will associate low, average
and high quality with the three price levels.
2. Optional Features Pricing: It refers to the pricing of additional features with the main products, e.g, pricing of air
conditioners, personal computers, automobiles, etc.
3. Captive-Product Pricing: Fr example, manufacturers of razors and cameras often price them low and set high mark-
ups on razor blades and camera film rolls.
4. Two-Part Pricing: It consists of a fixed charge and a variable charge based on consumption, e.g, pricing in telephone
billings, electricity, etc.
5. By-Product Pricing: It refers to pricing of by-products for the consumers seeking to purchase the by-products.
6. Product-Bundling Pricing: Sellers often bundle their products and features at a set price.
 Direct Marketing
Direct Marketing is a marketing system that uses one or more advertising media to affect a measurable response and/or transaction at any
location. Direct marketing is also known as “Direct Order Marketing”. Here the “measurable response” refers to customer’s direct
order. Direct marketing has been extensively used by hotels, airlines, sports’ clubs, fans’ clubs, and internet companies. Direct marketers
occasionally send birthday cards, information materials and such other benefits to their selected customers.

Benefits:
Direct marketing has several benefits; some of them are listed below:
1. Convenient and hassle-free shopping;
2. It saves time and introduces consumers to a larger selection of merchandise;
3. Marketer has more information about customer’s preferences;
4. Strong relationship with customers;
5. Direct marketer’s offers and strategies are less visible to competitors;
6. Certain communication barriers are overcome.

Major Channels of Direct Marketing:

Direct marketers can use a number of channels for reaching the prospects and customers. These are:

1. Face to Face Selling: Face-to-face selling is the oldest and original form of direct marketing. Now the industrial and many consumer industries employs professional
sales force to locate the prospects, develop them into customers and grow the business.
2. Direct Mail: Direct mail marketing involves sending an offer, announcement, reminder, or other item to the prospect at a particular address. Now-a-days, usually
high selective customers are sent direct mails. Some companies even sent audio cassettes/CDs, video cassettes/CDs, floppies and USB memories to their
customers. Direct mail has three forms:
1. Fax mail via fax machines,
2. Email via Internet,
3. Voice recordings/mails via telephone, mobile phones and internet.
3. Catalogue Marketing: Catalogue marketing refers to the situation where companies mail one or more product catalogues to the selected addresses. Catalogues give
brief description of the product’s features, quality and price, usually printed on papers or available on CDs, tapes and Internet. Catalogues take three forms:
1. Full-line merchandise catalogues,
2. Specialty consumer catalogues,
3. Business catalogues.
4. Other Media: There are several other media involved in direct marketing, for example, newspaper, magazines, television, videotext, tele-text, etc. Now-a-days FM
Radio Channels have also become a platform for direct marketing.
5. Kiosk Marketing: Some companies have even designed their own “customer-order-placing machines”, known as “KIOSK”, used to dispense actual products to
customers at stores, airports and various other spots.
 6. Tele-Marketing: Telemarketing refers to the use of telephones in marketing a product customers can process their orders through telephones and can record their
preferences, suggestions and complaints. Telemarketing has become a major direct marketing tool. Companies advertise their products on television and receive
orders on telephones. Telemarketing is cheaper and quicker in response.
7. Online Marketing: With the Internet revolution, buyers have gained more capabilities to receive information, initiate requests, design the offerings and use the
software agents to search for offers from sellers. Therefore, a new kind of direct selling channel has been explored with the Internet revolution. Marketers have now
their own websites featuring company’s history and prospects, product’s characteristics, services, order forms, and prices. Now the customer can choose a car, a
mobile phone, home furnishings, clothes, food and various other consumer products at his home. Online marketing offers several advantages like:
1. Customer’s convenience,
2. Comparative information about company and its competitors,
3. Lower costs for marketer,
4. Strong relationship with customers,
5. Meaningful information about prospects,
6. Quicker adjustment to market conditions,
7. Lesser consumer’s hassles.
Direct marketers can plan online marketing by adopting the following steps:
a. Electronic presence by creating online links, for e.g., www.toyota.com
b. Placing ads online, for e.g., ads on Yahoo, Google and Bing.
c. Participating in forums, newsgroups, blogs, bulletin boards and various web communities, for e.g., CNN, Express Tribune,
Blog Spot, ZDNet, etc.
d. Using email and web casting, for e.g., daily emails from various companies, also notoriously known as “Junk Mails”.

Personal Selling:
Personal selling is a face-to-face interaction with one or more prospective purchasers for the purpose of making presentations, answering
questions and procuring orders. Personal selling is one of the common communication platform other being advertising, sales promotion, public
relations and direct marketing.

Major Aspects of Personal Selling:

Following are the major aspects of personal selling:
1. Professionalism
2. Negotiation
3. Relationship Marketing

1. Professionalism: Personal selling is an ancient art of selling. Now companies spent millions of rupees to train their sales people in the art of selling. There are two
approaches in training sales people:
2. Negotiation: Personal selling is much more involved in negotiation. Two parties need to reach agreement on the price and other terms of sale. Sales person has to
accept orders without hurting the profitability.
 3. Relationship Marketing: Besides sales and profit objectives, the marketer has also to seek strong customer relationship. Companies are now become more
relationship marketing oriented rather than transaction marketing oriented. As the relationship marketing is properly implemented, the organization will begin to
focus as much on managing its customers as on managing its products.

Major Steps in Personal Selling:

Following are the major steps in effective personal selling:
1. Identifying and qualifying prospects,
2. Preapproach, i.e., sales person, should study about company’s prospects and decide about how to approach or reach the customers,
3. Approach, i.e., sales person should know how to meet the buyers in a good and friendly environment,
4. Presentation and demonstration of company’s brand and product’s features and benefits,
5. Overcoming objectives through psychological resistance and logical resistance,
6. Closing, i.e., sales person should know how to close or end the speech,
7. Follow-up and maintenance, i.e., delivery time, purchase terms and other matters.
 Distribution Channel
Channel:
Marketing channels are the sets of interdependent organizations involved in the process of making a product or service available for use or
consumption.

Channel Functions:
1. It performs the work of moving goods from producers to consumers.
2. It overcomes the time, place and possession gaps between producers and consumers.
3. It gathers information about customers, competitors and other factors in the market.
4. It places orders with manufacturers.
5. It acquires funds to finance inventories.
6. It assumes risks associated with channel working.
7. It provides storage for inventories.
8. It reaches agreement with customers on prices and other terms.
9. It provides credit to customers on purchasing.

Channel Levels:
The channel levels can be bifurcated into:
1. Consumer marketing channels, and
2. Industrial marketing channels.

1. Consumer Marketing Channels:

1. Zero-level channel:
i. Manufacturer
ii. Consumer
2. One-level channel:
i. Manufacturer
ii. Retailer
iii. Consumer
3. Two-level channel:
i. Manufacturer
ii. Wholesaler
iii. Retailer
iv. Consumer
4. Three-level channel:
 i. Manufacturer
ii. Wholesaler
iii. Jobber
iv. Retailer
v. Consumer
2. Industrial Marketing Channels:
1. Zero-level channel:
i. Manufacturer
ii. Industrial customers
2. One-level channel:
i. Manufacturer
ii. Industrial distributors
iii. Industrial customers
3. Two-level & three-level channels:
i. Manufacturer
ii. Manufacturer’s representative/sales branch
iii. Industrial distributors
iv. Industrial customers.

Channel Designing:
Following are the steps taken in channel designing:
1. Analyzing customer’s needs,
2. Establishing objectives and constraints,
3. Identifying major channel alternatives, and
4. Evaluating the major channel alternatives.

1. Analyzing customer’s needs: In designing marketing channel, the marketer must understand the “service output levels” desired by target
customers. Marketing channels produce service outputs, which are as follows:
1. Lot size,
2. Waiting time,
3. Spatial convenience,
4. Product variety,
5. Service backup.
2. Establishing objectives and constraints: Channel objectives must be stated in terms of service output levels as targeted in the first phase of channel
designing. Channel objectives vary with product features. For examples, perishable products require direct marketing, heavy and bulky products require
channels to be near to the market, etc.
3. Identifying major channel alternatives: The third step is to identify the major channel alternatives. The channel alternative is described by three
elements, i.e.:
1. Types of Intermediaries: Following are the types of intermediaries:
i. Company Sales Force: refers to its own sales force in different regions and territories.
ii. Manufacturers’ Agency: refers to hired sales agents in different regions and territories.
iii. Industrial Distribution: refers to the distribution in different regions, which will buy and carry the
inventories.
2. Number of Intermediaries: There are three strategies available:
i. Exclusive Distribution: means severely limiting the number of intermediaries. It often involves in
making an agreement in which the seller agrees to not carry other competing brands. Such type of distribution requires
good relationship between seller and reseller. It is generally used in automobiles, television, refrigerators, air conditioners
and some other consumer.
ii. Selective Distribution: involves more than few but less than all of the intermediaries available. The
company does not have to dissipate its efforts over too many outlets. It enables the producer to gain adequate market
coverage with more control and less cost than intensive distribution. Nike, the world’s largest athletic shoe maker, is the
example of selective distribution.
iii. Intensive Distribution: refers to the distribution of goods and services to as many intermediaries as
possible. This strategy is generally used for daily consuming items, for e.g., soap, shampoo, shaving cream, shaving razors,
cigarettes, condoms, cooking oil, tea and coffee, milk, vegetables, etc.
3. Terms and Responsibilities of Channel Members: The terms and responsibilities of channel members, can be classified by the producer in the
following terms:
i. Price Policy, i.e., price lists, discounts and allowances schedules.
ii. Condition of Sale, i.e., payment terms and producer’s guarantees.
iii. Distributors’ territorial rights.
iv. Mutual services and responsibilities.
4. Evaluating major channel alternatives: Each channel alternative is evaluated in terms of economy, control and adaptive criteria:
1. Economic Criteria: For each alternative, the marketer needs to calculate sales (estimated) and costs (estimated) separately and must duly compare
them. The marketer conducts Cost and Benefit Analysis.
2. Control Criteria: The marketer must also evaluate his control effectiveness over the working sales agencies. Independent sales agencies have their
own profit objectives and thus may concentrate on the products which yield them high profits.
3. Adaptive Criteria: The marketer must also ensure that the channel members are adaptive to the ever-changing market environment. It involves in
evaluation of adaptability of channel members.
Channel Management:
Following are the steps in deciding about channel management:
1. Selecting channel members,
2. Training channel members,
3. Motivating channel members,
4. Evaluating channel members, and
5. Modifying channel arrangements.

1. Selecting channel members: The first step in channel management is selecting appropriate channel members for distribution of goods and services.
2. Training channel members: Company needs to plan and implement careful training programs for their distributors and dealers, because intermediaries
will be viewed as the company itself by end users. Microsoft requires third party service engineers, and for this it introduces a certification program with
training. After training, the trainee will become a Microsoft Certified Professional, and can use this designation to promote business.
3. Motivating channel members: Motivating the channel members is an essential part of channel management. It refers to providing adequate incentives
to the channel members for distributing their products or offerings to the desired locations. Therefore, the company needs to determine intermediaries’
needs and to provide them the superior value, which they deserve. In motivating and managing channel members, the producer exercises several powers
to elicit cooperating such powers are classified as below:
1. Coercive Power: used by the producer to threaten the intermediary to withdraw a resource or to terminate the relationship, if the intermediary fails
to cooperate.
2. Reward Power: exercised by the producer to reward the intermediary if it is succeeded in achieving a certain task.
3. Legitimate Power: is a legal power used by the manufacturer to behave or to act in the manner as provided by the contract. The intermediary has
the obligation on its side.
4. Expert Power: can be used only if the manufacturer has specialized knowledge in certain areas like technology. Such a power is a value for the
intermediaries. In the global market, expert power has been extensively used by Intel, Microsoft, Google, Toyota, Siemens, Sony, Philips, Nokia,
Apple Inc., etc.
5. Referent Power: are generally exercised by well-established and highly respected firms over their intermediaries. Such companies are Pepsi-Cola,
Coca-Cola, Gillette, Citibank, Lloyd (insurance), McDonalds, etc.
4. Evaluating channel members: Producers must periodically evaluate intermediaries’ performance against such standards as sales-quota attainment,
average inventory level, customer delivery time, treatment of damaged or defective goods, etc.
5. Modifying channel arrangements: A producer is also needed to periodically review, evaluate and finally modify the channel
arrangements. Modification becomes necessary in the following cases:
1. Distribution channels are not working well as planned,
2. Where the market expands,
3. Where the new competitors arrived in the market,
4. Where the product has moved into the later stage of product development life cycle, and
5. Where the distribution channels need up to date technology and latest innovations.
Channel Dynamics:
The channel dynamics can be divided into three:
1. Vertical marketing systems,
2. Horizontal marketing systems, and
3. Multi channel marketing systems.

1. Vertical Marketing Systems: The conventional marketing channel comprises of the producer, the wholesaler and retailer. All the members have their
own profit motives and work independently. No channel member has a control over the other members. Vertical Marketing System (VMS), by contrast,
comprises the producer, wholesalers and retailers acting as a unified system. One channel member must be a channel captain to lead the whole system or
to franchise the other channel members. The channel captain may be a producer, a wholesaler or a retailer. There are three types of VMS:
1. Corporate Vertical Marketing System: combines successive stages of production and distribution under single ownership. It is favoured by those
companies that desire a high level of control over their channels.
2. Administered Vertical Marketing System: combines successive stages of production and distribution through the size and power of one of the
members. Manufacturers of a dominant brand are able to secure strong cooperation and support from resellers. For example: Gillette, P&G,
Kodak, Uni Lever, etc.
3. Contractual Vertical Marketing System: consists of independent firms at different levels of production and distribution integrating their efforts
on a contractual basis. Contractual VMS are of three types:
i. Wholesaler-Sponsored Voluntary Chains,
ii. Retailer Cooperatives, and
iii. Franchise Organisations:
 Manufacturer-Sponsored Retailer Franchise, e.g., Honda, Suzuki, Toyota, etc.
 Manufacturer-Sponsored Wholesaler Franchise, e.g., Coca-Cola, Pepsi-Cola, etc.
 Service-Firm-Sponsored Retailer Franchise, e.g., McDonalds, KFC, Pizza Hut, etc.
2. Horizontal Marketing System: In Horizontal Marketing System (HMS), two or more unrelated companies are combined to exploit new marketing
opportunities. Many supermarket chains have arrangements with local banks to offer in-store banking. Companies might work with each other on a
temporary or permanent basis or create a joint venture. It is also known as “Symbolic Marketing”.
3. Multi Channel Marketing System: Multi Channel Marketing System refers to the system when a single firm uses more than one distribution channel to
reach one or more customer segments. Through this, the firm has three major benefits:
1. Increased Market Coverage, i.e., to reach unexploited customer segments.
2. Lower Channel Cost, i.e., through diversifying the selling cost among more than one channel and through direct selling to customers.
3. More Customized Selling.
 Market Oriented Strategies
Market oriented strategic planning is the managerial process of developing and maintaining a viable fit between the organisation’s objectives and
resources and the markets ever-changing opportunities and environment. And the aim of strategic planning process is to shape the company’s
businesses and products so that they yield target profits and growth.

Comments:
The company has to change with the changing market environment, even if it bears a heavy loss in case of changed technology or a changed trend. In
mid-70s, many US companies were failed due to this main reason and the market competitors, i.e., Japanese companies took advantage of it and that
companies like Sony, Toyota and Mitsubishi were appeared on the globe.

Organisational Levels of Large Companies:

Corporate and Business Strategic Planning:
It undertakes four planning activities:

1. Defining the corporate mission.

2. Establishing Strategic Business Units (SBUs)
3. Assigning resources to each SBU
4. Planning new businesses, downsizing older businesses.

1. Defining the corporate mission: Typically the corporate mission or mission statement consist of two elements:
1. Policies, i.e., dealing with customers, stakeholders, suppliers, distributors, etc.
2. Competitive scope, i.e., industrial goods or consumer goods, competition on geographical basis, the range of products and applications,
range of competition, for e.g., major electronic items, automobiles and cranes are manufactured by Mitsubishi.
2. Establishing Strategic Business Units (SBUs): A business must be viewed as a customer-satisfying process, not as a goods-producing
process. Products are translents, but basic needs and customer groups endure forever. A horse-carriage company will go out of business soon
after the automobile is invented, unless it switches to making cars. Some of the examples are enlisted below:

Company Product Definition Market Definition

Missouri Pacific We run a railroad. We are a people and goods mover.

Railroad
Standard Oil We sell gasoline. We supply energy.

Columbia Pictures We make movies. We market entertainment.

Encyclopaedia We sell We distribute information

Britannica encyclopaedias.

A business can be defined in terms of three dimensions, customer groups, customer needs and technology. An SBU has three characteristics:

1. It is a single business or collection of related businesses that can be planned separately from the rest of the company.
2. It has its own set of competitors.
3. It has a manager who is responsible for strategic planning and profit performance and who controls most of the factors affecting profit.

2. Assigning resources to each SBU: The third step is to decide about assigning resources to each SBU. The marketer has to evaluate the
profitability of each SBU. There are two best known business portfolio evaluation models:
1. The Boston Consulting Group (BCG) Approach: BCG is a leading management consultant group. It developed a ‘market growth-
share matrix’.

According to BCG model, all the business units are divided into four categories:

i. Dogs

ii. Question Marks

iii. Stars

iv. Cash Cows

 i. Dogs: The companies or business units under ‘dogs’ category have less market share as well as less
market growth rate. Therefore, the marketer or investor should consider more critically to invest in ‘dogs’ business units.

ii. Question Marks: Question marks are the businesses that operate in high growth and low market
share. Such business units have their opportunities to operate at high market share, the question mark is in the investor’s or
marketer’s mind is “Where to invest?”, and “How much to invest?”

iii. Stars: If the “Question Marks” business is successful, it becomes a star. A star is the market leader
with high market growth rate and high market share. A star does not necessarily produce positive cash flow.

iv. Cash Cows: A “Cash Cow” produces a lot of cash for the company, but the market’s growth rate is
lowered down. However, its relative market share is the highest.

The bubbles in each category represent different available business units. Each business unit has its own profitability and has its
own market share at different market growth rates. Business units no. 4, 5 and 6 are considerably healthy business units. The
figure also shows a life cycle, as the time passes, each SBU changes their position from dogs to question marks, from question
marks to stars, from stars to cash cows and from cash cows to dogs.

2. The General Electric Model: According to GE Model, each SBU is rated in terms of two major dimensions, i.e., market attractiveness
and business strength. To measure these two dimensions, strategic planners must identify the factors underlying each dimension, for
example, for the hydraulic pump manufacturing and trading business, GE considers the following factors:

Weight Rating Value

(1 – 5)

Market Attractiveness:

Overall market size 0.2 4 0.8

Annual market growth rate 0.2 5 1.0

Historical profit margin 0.15 4 0.6

Competitive intensity 0.15 2 0.3

Technological requirements 0.15 4 0.6

Inflationary vulnerability 0.05 3 0.15

Energy requirements 0.05 2 0.1

Environmental impact 0.05 3 0.15

1 3.7

Market Strength:

Market share 0.15 4 0.6

Share growth 0.15 2 0.3

Product quality 0.15 4 0.6

Brand reputation 0.05 5 0.25

Distribution network 0.05 4 0.2

Promotional effectives 0.05 3 0.15

Productive capacity 0.05 3 0.15

Productive efficiency 0.05 2 0.1

 Unit costs 0.2 3 0.6

R&D performance 0.1 3 0.3

1 3.25

4. Planning new businesses, downsizing older businesses: In planning new business, the gap between the desired sales and profit level, and the
expected level is filled with different growth strategies. There are three options available:
1. Intensive growth: There are three approaches for intensive growth strategy:

i. To encourage its own customers to purchase more of its products,

 ii. To attract competitors’ customers,

iii. To attract non-users of such products.

2. Integrative growth: Sales and profits can be increased through horizontal integration within its industry. For example, a manufacturing
company may acquire more of its suppliers, to gain more control or generate more profit. This is called ‘backward integration’. The
example of ‘forward integration’ is the situation when company acquires its wholesalers or retailers.
3. Diversification growth: Diversification occurs when good opportunities are found outside the current market and current
product. Diversification growth occurs when the other industry is highly attractive with strong business strength. Following are the
diversification strategies:

i. Concentric diversification strategy: refers to the situation when the company seeks for new product
having existing technologies and marketing factors though the new product may appeal to a different group of customers. For
example: from music systems to game stations.

ii. Horizontal diversification strategy: refers to new products with new technologies and marketing
synergies unrelated to existing product lines with current customers. For example: from desktop PCs to tablet PCs.

iii. Conglomerate diversification strategy: refers to new products, new technologies and absolutely new
market. For example: from microchips to automobiles.