UNIT 3

Market Structure

Market: Ordinarily, the term “market” refers to a particular place where goods are purchased and sold. But,
in economics, market is used in a wide perspective. In economics, the term “market” does not mean a
particular place but the whole area where the buyers and sellers of a product are spread.

Characteristics of Market: The essential features of a market are:

(1) An Area: In economics, a market does not mean a particular place but the whole region where sellers and
buyers of a product ate spread. Modem modes of communication and transport have made the market area
for a product very wide.

(2) One Commodity: In economics, a market is not related to a place but to a particular product. Hence,
there are separate markets for various commodities. For example, there are separate markets for clothes,
grains, jewellery, etc.

(3) Buyers and Sellers: The presence of buyers and sellers is necessary for the sale and purchase of a
product in the market. In the modem age, the presence of buyers and sellers is not necessary in the market
because they can do transactions of goods through letters, telephones, business representatives, internet, etc.

(4) Free Competition: There should be free competition among buyers and sellers in the market. This
competition is in relation to the price determination of a product among buyers and sellers.

(5) One Price: The price of a product is the same in the market because of free competition among buyers
and sellers.

The Four Types of Market Structures: The four basic types of market structures are perfect competition,
monopoly, oligopoly, and monopolistic competition. Each of them has their own set of characteristics and
assumptions, which in turn affect the decision making of firms and the profits they can make.

1. Perfect Competition

Perfect competition describes a market structure, where a large number of small firms compete against each
other. In this scenario, a single firm does not have any significant market power. As a result, the industry as
a whole produces the socially optimal level of output, because none of the firms have the ability to influence
market prices. The idea of perfect competition builds on a number of assumptions: (1) all firms maximize
profits (2) there is free entry and exit to the market, (3) all firms sell completely identical (i.e. homogenous)
goods, (4) there are no consumer preferences. By looking at those assumptions it becomes quite obvious,
that we will hardly ever find perfect competition in reality. This is an important aspect, because it is the only
market structure that can (theoretically) result in a socially optimal level of output.

2. Features of Perfectly Competitive Market

1) A large number of buyers and sellers

There exist a large number of buyers and sellers in a perfectly competitive market. The number of sellers is
so large that no individual firm owns the control over the market price of a commodity.
Due to the large number of sellers in the market, there exists a perfect and free competition. A firm acts as a
price taker while the price is determined by the ‘invisible hands of market’, i.e. by ‘demand for’ and ‘supply
of’ goods. Thus, we can conclude that under perfectly competitive market, an individual firm is a price taker
and not a price maker.

2) Homogeneous products

All the firms in a perfectly competitive market produce homogeneous products. This implies that the output
of each firm is perfect substitute to others’ output in terms of quantity, quality, colour, size, features, etc.
This indicates that the buyers are indifferent to the output of different firms. Due to the homogeneous nature
of products, existence of uniform price is guaranteed.

3) Free exit and entry of firms

In the long run there is free entry and exit of firms. However, in the short run some fixed factors obstruct the
free entry and exit of firms. This ensures that all the firms in the long-run earn normal profit or zero
economic profit that measures the opportunity cost of the firms either to continue production or to shut down.
If there are abnormal profits, new firms will enter the market and if there are abnormal losses, a few existing
firms will exit the market.

4) Perfect knowledge among buyers and sellers

Both buyers and sellers are fully aware of the market conditions, such as price of a product at different
places. The sellers are also aware of the prices at which the buyers are willing to buy the product. The
implication of this feature is that if any individual firm is charging higher (or lower) price for a
homogeneous product, the buyers will shift their purchase to other firms (or shift their purchase from the
firm to other firms selling at lower price).

5) No transport costs

This feature means that all the firms have equal access to the market. The goods are produced and sold
locally. Therefore, there is no cost of transporting the product from one part of the market to other.

6) Perfect mobility of factors of production

There exists geographically and occupationally perfect mobility of factors of production. This implies that
the factors of production can move from one place to other and can move from one job to another.

7) No promotional and selling costs

There are no advertisements and promotional costs incurred by the firms. The selling costs under perfectly
competitive market are zero.

Monopoly

The word monopoly has been derived from the combination of two words i.e., ‘Mono’ and ‘Poly’. Mono
refers to a single and poly to control. In this way, monopoly refers to a market situation in which there is
only one seller of a commodity. There are no close substitutes for the commodity it produces and there are
barriers to entry. The single producer may be in the form of individual owner or a single partnership or a
joint stock company. Monopolist has full control over the supply of commodity. Having control over the
supply of the commodity he possesses the market power to set the price. Thus, as a single seller, monopolist
may be a king without a crown.

Examples of monopoly include: Local telephone service, Water service, Cable television, Postal Service

Features:

1. One Seller and Large Number of Buyers: The monopolist’s firm is the only firm; it is an industry. But
the number of buyers is assumed to be large.

2. No Close Substitutes: There shall not be any close substitutes for the product sold by the monopolist.
The cross elasticity of demand between the product of the monopolist and others must be negligible or zero.

3. Difficulty of Entry of New Firms: There are either natural or artificial restrictions on the entry of firms
into the industry, even when the firm is making abnormal profits.

4. Monopoly is also an Industry: Under monopoly there is only one firm which constitutes the industry.
Difference between firm and industry comes to an end.

5. Price Maker: Under monopoly, monopolist has full control over the supply of the commodity. But due to
large number of buyers, demand of any one buyer constitutes an infinitely small part of the total demand.
Therefore, buyers have to pay the price fixed by the monopolist.

The Oligopoly Market:

The term oligopoly is derived from two Greek words: ‘oligi’ means few and ‘polein’ means to sell.
Oligopoly is a market structure in which there are only a few sellers (but more than two) of the
homogeneous or differentiated products. So, oligopoly lies in between monopolistic competition and
monopoly. Oligopoly refers to a market situation in which there are a few firms selling homogeneous or
differentiated products. Oligopoly is, sometimes, also known as ‘competition among the few’ as there are
few sellers in the market and every seller influences and is influenced by the behaviour of other firms.

Example of Oligopoly: Markets for automobiles, cement, steel, aluminium, etc.

DUOPOLY is a special case of oligopoly, in which there are exactly two sellers. Under duopoly, it is
assumed that the product sold by the two firms is homogeneous and there is no substitute for it. Examples
where two companies control a large proportion of a market are: (i) Pepsi and Coca-Cola in the soft drink
market; (ii) Airbus and Boeing in the commercial large jet aircraft market; (iii) Intel and AMD in the
consumer desktop computer microprocessor market.

Types of Oligopoly:

1. Collusive Oligopoly: If the firms cooperate with each other in determining price or output or both, it is
called collusive oligopoly or cooperative oligopoly.
2. Non-collusive Oligopoly: If firms in an oligopoly market compete with each other, it is called a
non-collusive or non-cooperative oligopoly.

Features of Oligopoly:

Few firms:

Under oligopoly, there are few large firms. The exact number of firms is not defined. Each firm produces a
significant portion of the total output. There exists severe competition among different firms and each firm
try to manipulate both prices and volume of production to outsmart each other. For example, the market for
automobiles in India is an oligopolist structure as there are only few producers of automobiles.

Interdependence:

Firms under oligopoly are interdependent. Interdependence means that actions of one firm affect the actions
of other firms. A firm considers the action and reaction of the rival firms while determining its price and
output levels. A change in output or price by one firm evokes reaction from other firms operating in the
market.

For example, market for cars in India is dominated by few firms (Maruti, Tata, Hyundai, Ford, Honda, etc.).
A change by any one firm (say, Tata) in any of its vehicle (say, Indica) will induce other firms (say, Maruti,
Hyundai, etc.) to make changes in their respective vehicles.

Non-Price Competition:

Under oligopoly, firms are in a position to influence the prices. However, they try to avoid price competition
for the fear of price war. They follow the policy of price rigidity. Price rigidity refers to a situation in which
price tends to stay fixed irrespective of changes in demand and supply conditions. Firms use other methods
like advertising, better services to customers, etc. to compete with each other. If a firm tries to reduce the
price, the rivals will also react by reducing their prices. However, if it tries to raise the price, other firms
might not do so. It will lead to loss of customers for the firm, which intended to raise the price. So, firms
prefer non- price competition instead of price competition.

4. Barriers to Entry of Firms:

The main reason for few firms under oligopoly is the barriers, which prevent entry of new firms into the
industry. Patents, requirement of large capital, control over crucial raw materials, etc, are some of the
reasons, which prevent new firms from entering into industry. Only those firms enter into the industry which
are able to cross these barriers. As a result, firms can earn abnormal profits in long run.

5. Role of Selling Costs: Due to severe competition ‘and interdependence of the firms, various sales
promotion techniques are used to promote sales of the product. Advertisement is in full swing under
oligopoly, and many a times advertisement can become a matter of life-and-death. A firm under oligopoly
relies more on non-price competition.

6. Group Behaviour: Under oligopoly, there is complete interdependence among different firms. So, price
and output decisions of a particular firm directly influence the competing firms. Instead of independent price
and output strategy, oligopoly firms prefer group decisions that will protect the interest of all the firms.
Group Behaviour means that firms tend to behave as if they were a single firm even though individually they
retain their independence.
7. Nature of the Product: The firms under oligopoly may produce homogeneous or differentiated product.

i. If the firms produce a homogeneous product, like cement or steel, the industry is called a pure or perfect
oligopoly.

ii. If the firms produce a differentiated product, like automobiles, the industry is called differentiated or
imperfect oligopoly.

8. Indeterminate Demand Curve: Under oligopoly, the exact behaviour pattern of a producer cannot be
determined with certainty. So, demand curve faced by an oligopolist is indeterminate (uncertain). As firms
are inter-dependent, a firm cannot ignore the reaction of the rival firms. Any change in price by one firm
may lead to change in prices by the competing firms. So, demand curve keeps on shifting and it is not
definite, rather it is indeterminate.

4. Monopolistic competition

Monopolistic competition is a type of imperfect competition such that many producers sell products that are
differentiated from one another (e.g. by branding or quality) and hence are not perfect substitutes.

Examples: The restaurant business, Hotels and pubs, soaps, toothpastes, coffee shoppe, Salons

Features of Monopolistic Competition

1. Large Number of Buyers and Sellers:

There are large number of firms but not as large as under perfect competition. That means each firm can
control its price-output policy to some extent. It is assumed that any price-output policy of a firm will not get
reaction from other firms that means each firm follows the independent price policy. If a firm reduces its
price, the gains in sales will be slightly spread over many of its rivals so that the extent to which each of the
rival firms suffers will be very small. Thus these rival firms will have no reason to react.

2. Free Entry and Exit of Firms:

Like perfect competition, under monopolistic competition also, the firms can enter or exit freely. The firms
will enter when the existing firms are making super-normal profits. With the entry of new firms, the supply
would increase which would reduce the price and hence the existing firms will be left only with normal
profits.

3. Product Differentiation:

Another feature of the monopolistic competition is the product differentiation. Product differentiation refers
to a situation when the buyers of the product differentiate the product with other. Basically, the products of
different firms are not altogether different; they are slightly different from others. Although each firm
producing differentiated product has the monopoly of its own product, yet he has to face the competition.
This product differentiation may be real or imaginary. Real differences are like design, material used, skill
etc. whereas imaginary differences are through advertising, trade mark and so on.

4. Selling Cost:
Another feature of the monopolistic competition is that every firm tries to promote its product by different
types of expenditures. Advertisement is the most important constituent of the selling cost which affects
demand as well as cost of the product. The main purpose of the monopolist is to earn maximum profits;
therefore, he adjusts this type of expenditure accordingly.

5. Lack of Perfect Knowledge:

The buyers and sellers do not have perfect knowledge of market. There are innumerable products each being
a close substitute of the other. Buyers do not know about these products, their qualities and prices.

6. Less Mobility: Under monopolistic competition both the factors of production as well as goods and
services are not perfectly mobile.

7. More Elastic Demand: Under monopolistic competition, demand curve is more elastic. In order to sell
more, the firms must reduce its price.

Overall comparison among the four market competitions

Basis Perfect Monopoly Oligopoly Monopolistic

competition competition
1. Number of Very large number single few large number
sellers
2. Nature of Homogeneous No close substitute Mostly Closely related but
product heterogeneous differentiated
products
3. Entry and exit of Freedom of entry Entry and exit is Difficulty in entry Freedom of entry
firms and exit restricted and exit and exit
4. Demand curve Perfectly elastic Downward sloping Indeterminate (Not Downward sloping
demand demand curve but fixed) demand demand curve but
less elastic curve more less elastic
5. Price Uniform price Price maker Price rigidity due Partial control over
to fear of price war price due to
product
differentiation
6. Selling cost No selling cost Only informative Very high selling High selling costs
(advertisement) selling cost is there costs
7. Level of Perfect knowledge Imperfect Imperfect less Imperfect
knowledge among knowledge knowledge knowledge
buyers and sellers
Examples Vegetable market Indian Rails, local Automobile firms, Restaurants,
water supply cold drinks, coaching classes,
electronic gadgets salons
 Inflation

Inflation means, a rise in general level of prices of goods and services in a economy over a period of time. When the general

price level rises, each unit of currency buys fewer goods and services. Thus, inflation results in loss of value of money. Also

inflation means "too much money chasing too few goods". Inflation occurs due to an imbalance between demand and supply of

money, changes in production and distribution cost or increase in taxes on products. When economy experiences inflation, i.e.

when the price level of goods and services rises, the value of currency reduces.

Types of inflation : Broadly speaking inflation is divided into two categories i.e.

(a) DEMAND - PULL INFLATION: In this type of inflation prices increase results from an excess of demand over supply

for the economy as a whole. Demand inflation occurs when supply cannot expand any more to meet demand; that is, when critical

production factors are being fully utilized, also called Demand inflation.

(b) COST - PUSH INFLATION: This type of inflation occurs when general price levels rise owing to rising input costs. In

general, there are three factors that could contribute to Cost-Push inflation: rising wages, increases in corporate taxes, and

imported inflation.

Major Causes leading to Inflation in India

1. Increase in money supply:

Over the last few years the rate of increase in money supply has varied between 15 and 18 per cent, whereas the national output

has increased at an annual average rate of only 4 per cent. Hence the rate of increase in output has not been sufficient to absorb the

rising quantity of money in the economy. Inflation is the obvious result.

2. Deficit financing:

When the government is unable to raise adequate revenue for its expenditure, it resorts to deficit financing. During the sixth and

seventh Plans, massive doses of deficit financing had been resorted to. It was Rs. 15,684 crores in the sixth Plan and Rs. 36,000

crores in the seventh Plan.

3. Increase in government expenditure:

Government expenditure in India during the recent years has been rising very fast. Proportion of non-development expenditure

increased rapidly, being about 40 per cent of total government expenditure. Non-development expenditure does not create real

goods; it only creates purchasing power and hence leads to inflation.

4. Inadequate agricultural and industrial growth:

Agricultural and industrial growth in our country has been much below what we had targeted for. Over the four decades period,

food grains output has increased and-.i.e. of 3.2 per cent per annum. But there are years of crop failure due to droughts. In the

years of scarcity of food grains not only the prices of food articles increased, the general price level also rose. Failure of crops

always encouraged big wholesale dealers to indulge in hoarding which pushes up the price level.

5. Rise in administered prices:

In our economy a large part of the market is regulated by government action. There are a number of important commodities, both

agricultural and industrial, for which the price level is administered by the government. The government keeps on raising prices

from time to time in order to cover up losses in the public sector. This policy leads to cost-push inflation. The upward revision of

administered prices of coal, iron and steel, electricity and fertilisers were made at regular intervals.

6. Rising import prices:

Inflation has been a global phenomenon. International inflation gets imported into the country through major imports like

fertilisers, edible oil, steel, cement, chemicals, and machinery. Increase in the import price of petroleum has been most spectacular

and its contribution to domestic price rise is very high.

7. Rising taxes:

To raise additional financial resources, government is depending more and more on indirect taxes such as excise duties and sales

tax. These taxes invariably raise the price level.

Effects of Inflation

Inflation affects different people differently. This is because of the fall in the value of money. When price rises or the value of
money falls, some groups of the society gain, some lose and some stand in-between. Broadly speaking, there are two economic

groups in every society, the fixed income group and the flexible income group.

People belonging to the first group lose and those belonging to the second group gain.

1. Effects on Redistribution of Income and Wealth:

Inflation brings about shifts in the distribution of real income from those whose money incomes are relatively inflexible to those

whose money incomes are relatively flexible.

The poor and middle classes suffer because their wages and salaries are more or less fixed but the prices of commodities continue

to rise. They become more impoverished. On the other hand, businessmen, industrialists, traders, real estate holders, speculators,

and others with variable incomes gain during rising prices.

The effects of inflation on different groups of society are discussed below:

(1) Debtors and Creditors: During inflation, debtors gain and creditors lose. When prices rise, the value of money falls.
Though debtors return the same amount of money, but they pay less in terms of goods and services. This is because the value of

money is less than when they borrowed the money. Thus the burden of the debt is reduced and debtors gain.

On the other hand, creditors lose. Although they get back the same amount of money which they lent, they receive less in real

terms because the value of money falls.

(2) Salaried Persons: Salaried workers such as clerks, teachers, and other white collar persons lose due to inflation. The
reason is that their salaries are slow to adjust when prices are rising.

(3) Wage Earners: Wage earners may gain or lose depending upon the speed with which their wages adjust to rising prices. If
their unions are strong, they may get their wages linked to the cost of living index. In this way, they may be able to protect

themselves from the bad effects of inflation.

(4) Fixed Income Group: The recipients of transfer payments such as pensions, unemployment insurance, social security,
etc. and recipients of interest and rent live on fixed incomes. Pensioners get fixed pensions. Similarly the rentier class consisting

of interest and rent receivers get fixed payments. All such persons lose because they receive fixed payments, while the value of

money continues to fall with rising prices.

(5) Equity Holders or Investors: Persons who hold shares or stocks of companies gain during inflation. When prices are
rising, business activities expand increasing profits of companies. As profits increase, dividends on equities also increase at a

faster rate than prices. But those who invest in debentures, securities, bonds, etc. which carry a fixed interest rate lose during

inflation because they receive a fixed sum while the purchasing power is falling.

(6) Businessmen: Businessmen of all types, such as producers, traders and real estate holders gain during periods of rising
prices. When prices are rising, the value of their inventories (goods in stock) rise in the same proportion. So they profit more when

they sell their stored commodities.

(7) Agriculturists: Agriculturists are of three types, landlords, peasant proprietors, and landless agricultural workers.
Landlords lose during rising prices because they get fixed rents. But peasant proprietors who own and cultivate their farms gain.

Prices of farm products increase more than the cost of production. On the other hand, the landless agricultural workers are hit hard

by rising prices. Their wages are not raised by the farm owners, because trade unionism is absent among them. But the prices of

consumer goods rise rapidly. So landless agricultural workers are losers.

(8) Government: The government as a debtor gains at the expense of households who are its principal creditors. This is
because interest rates on government bonds are fixed and are not raised to offset expected rise in prices. The government, in turn,

levies less taxes to service and retire its debt.

As creditors, the real value of their assets decline and as tax-payers, the real value of their liabilities also declines during inflation.

The extent to which they will be gainers or losers on the whole is a very complicated calculation.

2. Effects on Production: When prices start rising production is encouraged. Producers earn wind-fall profits in the future.
They invest more in anticipation of higher profits in the future. This tends to increase employment, production and income. But

this is only possible up to the full employment level. The adverse effects of inflation on production are as below:

(1) Misallocation of Resources: Inflation causes misallocation of resources when producers divert resources from the
production of essential to non-essential goods from which they expect higher profits.

(2) Reduction in Production: Inflation adversely affects the volume of production because the expectation of rising prices
along-with rising costs of inputs bring uncertainty. This reduces production.

(3) Fall in Quality: Continuous rise in prices creates a seller’s market. In such a situation, producers produce and sell
sub-standard commodities in order to earn higher profits. They also indulge in adulteration of commodities.

(4) Hoarding and Black marketing: To profit more from rising prices, producers hoard stocks of their commodities.
Consequently, an artificial scarcity of commodities is created in the market. The producers sell their products in black market

which increases inflationary pressures.

(4) Reduction in Saving: When prices rise rapidly, the propensity to save declines because more money is needed to buy
goods and services than before. Reduced saving adversely affects investment and capital formation. As a result, production is

hindered.

(6) Hinders Foreign Capital: Inflation hinders the inflow of foreign capital because the rising costs of materials and other
inputs make foreign investment less profitable.

3. Other Effects:
(1) Collapse of the Monetary System: If hyperinflation persists and the value of money continues to fall many times in a
day, it ultimately leads to the collapse of the monetary system, as happened in Germany after World War I.

(2) Social: Inflation is socially harmful. By widening the gulf between the rich and the poor, rising prices create discontentment
among the masses. Pressed by the rising cost of living, workers resort to strikes which lead to loss in production. Lured by profits,

people resort to hoarding, black marketing, adulteration, manufacture of substandard commodities, speculation, etc. Corruption

spreads in every walk of life.

(3) Political: Rising prices also encourage agitations and protests by political parties opposed to the government. And if they
gather momentum and become unhandy they may bring the downfall of the government.
Measures to Control Inflation: Inflation can be brought under control using following methods
A) Monetary and Fiscal Measures
B) Investment Control Measures
C) Other measures

A) Monetary and Fiscal Measures:

Monetary Measures: The most important and commonly used method to control inflation is monetary policy of the Central
Bank. Most central banks use high interest rates as the traditional way to fight or prevent inflation. Monetary measures used to
control inflation include:
(i) bank rate policy
(ii) cash reserve ratio and
(iii) open market operations.

(i) Bank rate policy: It is used as the main instrument of monetary control during the period of inflation. When the central
bank raises the bank rate, it is said to have adopted a dear money policy. The increase in bank rate increases the cost of borrowing
which reduces commercial banks borrowing from the central bank. Consequently, the flow of money from the commercial banks
to the public gets reduced. Therefore, inflation is controlled to the extent it is caused by the bank credit.
(ii)
(iii) (ii) Cash Reserve Ratio (CRR) : To control inflation, the central bank raises the CRR which reduces the lending
capacity of the commercial banks. Consequently, flow of money from commercial banks to public decreases. In the process, it
halts the rise in prices to the extent it is caused by banks credits to the public.

(iii) Open Market Operations: Open market operations refer to sale and purchase of government securities and bonds by the
central bank. To control inflation, central bank sells the government securities to the public through the banks. This results in
transfer of a part of bank deposits to central bank account and reduces credit creation capacity of the commercial banks.

II). Fiscal Measures: Fiscal measures to control inflation include taxation, government expenditure and public borrowings.
The government can also take some protectionist measures (such as banning the export of essential items such as pulses, cereals
and oils to support the domestic consumption, encourage imports by lowering duties on import items etc.).

B) Investment Control Measures:

i) Resources of society should be invested in projects which will not increase inflation.
ii) The project selected should have low gestation period i.e. Low capital output ratio
iii) Investment should be in real good not in share and security.
Other Measures:
i) Short term measures:
Inflation can be controlled by providing basic necessity of food through ration cards
Inflation can be controlled by restricting interstate transfer of goods

ii) Long term measures:

To control inflation, long term measure is to accelerate economic growth.
By restricting present consumption of goods which will help in saving and thus finally in controlling inflation
Suitable technological change may help in inflation control
Change in income policy by government can also play an important role in inflation control.

What is Deflation ? :
Deflation is the opposite of inflation. Deflation refers to situation, where there is decline in general price
levels. Thus, deflation occurs when the inflation rate falls below 0%. Deflation increases the real value of
money and allows one to buy more goods with the same amount of money over time. Deflation can occur
owing to reduction in the supply of money or credit. Deflation increases unemployment in an economy.
Deflation allows one to buy more goods and services than before with the same amount of money. Deflation
is an indication that economic conditions are deteriorating. Deflation is usually associated with significant
unemployment.

Causes of Deflation
1. Increased Productivity: Innovative solutions and new processes help increase efficiency, which
ultimately leads to lower prices. Although some innovations only affect the productivity of certain industries,
others may have a profound effect on the entire economy. For example, after the Soviet Union collapsed in
1991, many of the countries that formed as a result struggled to get back on track. In order to make a living,
many citizens were willing to work for very low prices.

2. Decrease in Currency Supply: As the currency supply decreases, prices will decrease so that people can
afford goods. Through central banking systems currency supplies decrease.
3. Reduction in government expenditure: Deflation can be the result of decreased governmental, business,
or consumer spending, which means government spending cuts can lead to periods of significant deflation.
4. Deflationary Spiral: Once deflation has shown its ugly head, it can be very difficult to get the economy
under control for a number of reasons. First of all, when consumers start cutting spending, business profits
decrease. Unfortunately, this means that businesses have to reduce wages and cut their own purchases. In
turn, this short-circuits spending in other sectors, as other businesses and wage-earners have less money to
spend. It continues to get worse and the cycle is very difficult to break.

Effects of Deflation: Deflation can be compared to a terrible winter: The damage can be intense and be
experienced for many years. Unfortunately, some nations never fully recover from the damage caused by
deflation. Hong Kong, for example, never recovered from the deflationary effects that gripped the Asian
economy in 2002. Deflation may have any of the following impacts on an economy:

1. Reduced Business Revenues: Businesses must significantly reduce the prices of their products in order to
stay competitive. Obviously, as they reduce their prices, their revenues start to drop. Business revenues
frequently fall and recover, but deflationary cycles tend to repeat themselves multiple times.
2. Wage Cutbacks and unemployment: When revenues start to drop, companies need to find ways to
reduce their expenses to meet their bottom line. They can make these cuts by reducing wages and cutting
positions. If businesses face more loss, they remove the employees and this leads to unemployment.
3. Changes in Customer Spending: When the economy undergoes a period of deflation, customers often
take advantage of the substantially lower prices. Initially, consumer spending may increase greatly; however,
once businesses start looking for ways to meet their supply, consumers who have lost their jobs or taken pay
cuts must start reducing their spending as well. Of course, when they reduce their spending, the cycle of
deflation worsens.
4. Reduced Stake in Investments: When the economy goes through a series of deflation, investors tend to
view cash as one of their best possible investments. Investors will watch their money grow simply by
holding onto it. Additionally, the interest rates investors earn often decrease significantly as central banks
attempt to fight deflation by reducing interest rates, which in turn reduces the amount of money they have
available for spending.
5. Reduced Credit: When deflation rears its head, financial lenders quickly start to pull the plugs on many
of their lending operations. As assets such as houses decline in value, customers cannot back their debt with
the same value.

Measures to Control Deflation: Deflation can be controlled by adopting monetary and fiscal measures
in just the opposite manner to control inflation.

1. Monetary Policy: To control deflation, the central bank can increase the reserves of commercial banks
through a cheap money policy. They can do so by buying securities and reducing the interest rate. As a
result, their ability to extend credit facilities to borrowers increases. Since business activity is almost at a
standstill, businessmen do not have any inclination to borrow to build up inventories even when the rate of
interest is very low. Rather, they want to reduce their inventories by repaying loans already drawn from the
banks. Thus all that the banks can do is to make credit available but they cannot force businessmen and
consumers to accept it. In the 1930s, very low interest rates and the piling up of unused reserves with the
banks did not have any significant impact on the depressed economies of the world. Thus the success of
monetary policy in controlling deflation is severely limited.

2. Fiscal Policy:

Government through increase in public expenditure and reduction in taxes tends to raise national income,
employment, output, and prices. An increase in public expenditure during deflation increases the aggregate
demand for goods and services and leads to a large increase in income while a reduction in taxes has the
effect of raising income thereby increasing consumption and investment expenditures of the people. The
government should increase its expenditure on such public works as roads, canals, dams, parks, schools,
hospitals and other buildings, etc. and on such relief measures as unemployment insurance, pensions, etc.
Expenditure on public works creates demand for the products. Reduction in taxes as corporate profits tax,
income tax, and excise taxes tends to leave more income for spending and investment.
 'Depreciation'
Depreciation means decrease in an asset's value caused due to its use and with the passage of time. It is a
method of allocating the cost of a tangible asset over its useful life. Businesses depreciate long-term assets for
both tax and accounting purposes. Depreciation occurs due to wear and tear, passage of time, obsolescence,
exhaustion or accident. Depreciation is used in accounting to try to match the expense of an asset to the income
that the asset helps the company earn. For example, if a company buys a piece of equipment for $1 million and
expects it to have a useful life of 10 years, it will be depreciated over 10 years. Every accounting year, the
company will expense $100,000 (assuming straight-line depreciation), which will be matched with the money
that the equipment helps to make each year.

1. Straight-Line Method: Depreciation offers businesses a way to recover the cost of an eligible asset by
writing off the expense over the course of the useful life of the asset. The most commonly used method for
calculating depreciation under generally accepted accounting principles, or GAAP, is the straight line
method. This method is the simplest to calculate, results in fewer errors, stays the most consistent and
transitions well from company-prepared statements to tax returns.

Depreciation using the straight line method reflects the consumption of the asset over time and is calculated by
subtracting the salvage value from the purchase price of the asset, and then dividing that amount by the
projected useful life of the asset. For instance, say a catering company purchases a delivery van for $35,000.
The expected salvage value is $10,000 and the company expects to use the van for five years. By using the
formula for the straight line method, the annual depreciation is calculated as (35,000 - 10,000) / 5 = 5,000. The
van depreciates at a rate of $5,000 per year for the next five years.

2. Double-Declining Methods: Under the generally accepted accounting principles (GAAP) for public
companies, expenses are recorded in the same period as the revenue that is earned as a result of those
expenses. Thus, when a company purchases an expensive asset that will be used for many years, it doesn’t
deduct the entire purchase price as a business expense in the year of purchase, but instead deducts a portion
of the price in each of several years.

For example, if a business purchased a delivery truck for $30,000 that it expected to last for 10 years, after
which it would be worth $3,000 (its salvage value), the company would deduct the remaining $27,000 as
$2,700 per year for 10 years under straight-line depreciation. Using the double-declining balance method,
however, it would deduct 20% (double 10%) of $27,000 in year 1 ($5,400), 20% of $21,600 ($27,000 minus
$5,400) in year 2 ($4,320), and so on.

3. Annuity Method: A method of depreciation centered around cost recovery and a constant rate of return
upon any asset that is being depreciated. This method requires the determination of the internal rate of return
(IRR) on the cash inflows and outflows of the asset. The IRR is then multiplied by the initial book value of
the asset, and the result is subtracted from the cash flow for the period in order to find the actual amount of
depreciation that can be taken.
The annuity method of depreciation is also commonly referred to as the compound interest method of
depreciation. If the cash flow of the asset being depreciated is constant over the life of the asset, then this
method is called the annuity method. Annuity method is particularly applicable to those assets whose cost is
 heavy and life is long and fixed, e.g. leasehold property, land and building etc. Depreciation through this
method is calculated as follows.
4. Annual depreciation = (C-Cr)/n
5. Where C- total cost, Cr- interest rate, n-number of active years
6. A firm purchased a 5 years' lease for Rs.40,000 with interest rate of 5% per annum.
7. Cr=40,000*5/100 = 2,000Rs.
8. Annual Depreciation = (40,000-2,000)/5= 8,400Rs.

Sum of the year digit Method: Sum of the years' digits method of depreciation is one of the accelerated
depreciation techniques which are based on the assumption that assets are generally more productive when
they are new and their productivity decreases as they become old. The formula to calculate depreciation under
SYD method is:

9. Remaining Useful Life

Depreciable Base ×
10. Sum of the Years' Digits

Suppose original cost= 45,000Rs., Salvage value= 5,000Rs. Useful life in years= 4

Annual Depreciation= 45,000*4/1+2+3+4=45,000*4/10= 18,000Rs.

Sinking fund method: Sinking fund method is a method of calculating depreciation for an asset in which
apart from calculating depreciation, it also keeps aside a fund for replacing the asset at the end of its useful life.
This method is used when the assets that need to be replaced are of high cost. To avoid paying for the
replacement of assets at a time, companies maintain a sinking fund that will help them recover the cost of the
asset while also accounting for its depreciation. Sinking fund method is put into use by large scale industries
such as utility industries that have a requirement for expensive long-term assets to function.

Under the sinking fund method, the depreciation that is charged for the asset is transferred to a sinking fund
account. The same amount is then invested in securities issued by the government, interest that is earned on
such securities are reinvested. The interest that is earned on the amount invested as depreciation will also be
invested and will be invested to the extent of the useful life of the asset. When the asset needs replacement, the
investment which is done in the form of securities are sold, and the asset will be purchased from the amount
thus obtained.

Sinking Fund Formula

Annual depreciation (A) = [ (FC -SV) (i) ] / [ (1 + i)^(n) -1 ]

where A = Annual depreciation

FC= First cost(initial cost) of acquiring the asset

SV= Salvage value (value of a property at the end of a property's life)

i= rate of interest

n= number of active years

Assume a machine costs Rs. 300,000 with a salvage value of Rs. 50,000 at the end of its life of 10 years. If
money is worth 6% annually, using Sinking Fund Method, depreciation cost at the 6th year will be

A = [ (300,000 - 50,000) (0.06) ] / [ (1 + 0.06)^10 -1 ]

A = Rs. 18966.99

Direct and Indirect Tax

DIRECT TAXES

Introduction :

Direct taxes are those taxes which are paid by the persons on whom they are levied. The burden of
such taxes cannot be shifted to anybody else. These taxes are levied generally on income or wealth of the
person. Such as, Income tax, wealth tax, gift tax .
Advantages of direct taxes :
(1) Equitable :
Direct taxes are base on the-principle of equity since they are charged according to the level of
income of persons which determines the ability to pay of the persons. The richer a person, the greater is the
burden of direct tax on him.

(2) Economical:
No strenuous expenditure is required in collecting the direct taxes. In this sense they are economical.
A direct tax like income tax is collected at source in case of salaried persons.
(3) Certainty :
The Govt. & the tax payer both know fairly definitely what amounts are to be collected & paid. The tax
payers can make provision to pay the taxes in advance.
Civic consciousness :
The person who pays it, is very much conscious to know how the funds provided by direct taxes are
being utilized by the Government. He immediately becomes conscious about his rights.
Elastic :
Direct taxes are elastic in the sense that slight adjustment in rates the revenue to be collected may be
increased or decreased to a great extent. The rates of taxes are adjusted.
Disadvantages of Direct Taxes :
Inconvenient to tax-payers :
Direct taxes are inconvenient some to tax-payers. Nobody pays tax happily. They are irksome partly
because numerous accounting & other formalities are to be observed & partly because large lumpsum
payments have to be made, Every increase in direct taxes hurts the feelings of the tax payers. .
(2) Uneconomical :
Direct faxes are uneconomical in the sense that the tax authorities have to contact each & every tax
payer. For this purpose, a large organization is required. The cost of collecting these taxes is much more &
the net revenue income is too little. .
Possibility of tax evasion :
These taxes encourage tax evasion. Dishonest persons generally file false return of their income &
wealth. Businessmen in India generally manipulate their accounts to evade tax liability.
(4) Narrowness of scope :
Direct taxes are levied only on certain groups of persons. A large number of citizens are not covered
under the tax net. Due to this narrowness of their scope they do not raise the civic sense in all the groups.

(5) Arbitrary :
Another objection against direct taxes is that they are invariably levied arbitrarily by the Government. No
well defined principles are considered while fixing the rates of taxes. This is against the spirit of social
justice.
(6) Unpopular :
These taxes are unpopular, partly because the tax payers are not going to be directly benefited by
these taxes & partly because they irk the tax payer.

INDIRECT TAXES

Introduction :
Indirect taxes, may be defined as those taxes which are levied on commodities either on their production
or sales. The incidence of such taxes can be shifted to other persons & therefore, these taxes are ultimately
not paid by persons on whom they are levied.
Advantages :
(1) Convenient :
Indirect taxes are convenient to pay. Such taxes are generally levied on commodities. & are
included in the price of the commodities. The consumer pay them along with the price without experiencing
any feeling of its pinch. They are paid only when a commodity is purchased.
(2) No possibility of evasion :
The possibility of tax evasion is quite remote because they are collected in the form of higher prices of
goods. If a person purchases the goods, he has to pay tax also.
(3) Equitable :
Indirect taxes are based on the principle of equity because they are paid by all the sections of the
society when they purchase the goods. Certain essential commodities are taxed at a very low rate pr are
made tax-free. As against this, certain commodities which are used by the rich, are taxed at a higher rate. In
this way, they also follow the principle of ability to pay.
(4) Socially desirable :
lndirect taxes are socially desirable since the Government Imposes heavy taxes on commodities
the use of which is undesirable in the society such as wine etc. As heavy taxes increases the price of such
commodities their use is discouraged. On the other hand, the Government may encourage the use of certain
commodities by making them tax-free on taxing them at a lower rate.
(5) Productive & elastic :
Indirect taxes are more productive & elastic as compared to direct taxes. They are productive in the
sense that they bring more revenue to the Government. Such taxes are elastic because the revenue may be
increased or contracted by making slight changes in the rate schedule making it more justifiable. .
Disadvantages of Indirect Taxes :
(1) Inequitable :
The indirect taxes are levied on consumer goods & are paid as a part of the price of the commodities.
All persons rich or poor have to pay the same amount of tax on the purchase which cannot be said to be
equitable or just because the incident of tax falls more heavily on the poor.
(2) Promote economic inequality :
Indirect taxes are heavily imposed on necessities. Since a poor person spends a major part of his
income on necessities of life, he bears a greater burden of indirect taxes that the rich person. Consequently
the social in equality increases. Besides indirect taxes are levied at a fix rate, the incidence of tax rate, the
incidence of tax is heavier on poor people.
(2) Uneconomical :
Indirect taxes are uneconomical. The collection of these taxes involve money stages & thus the cost of
collecting such taxes at different stages becomes greater.
(3) Uncertainly :
The amount of indirect taxes to be collected cannot be estimated with certainly, because an increase
in the tax will increase the price of the commodity in then market which may result in the fall of demand for
the commodity. It therefore , cannot be estimated correctly upon the increase in tax. Hence, there is always
an uncertainty about the amount of tax accruing from indirect tax .
(4) Fail to create civic consciousness :
Indirect taxes do not create civic consciousness . Since the customers do not feel that they are
paying , a tax at the time of purchasing a commodity because tax forms the part of the price of the
commodity & therefore, payment of these taxes does not create civic consciousness among the tax payers.
(6) Encourage dishonesty :
Indirect taxes encourage dishonesty among retailers & consumers in the following ways;.
(1) Levy of a small amount of indirect tax on a commodity gives an opportunity to retailers to increase
the price of, a particular commodity more than the impact of tax.
(2) The old stock which was not taxes, is also sold at price including tax.
(3) The shopkeepers generally do not provide & the Consumers do not ask for the cash memo / bill for the
purchase but the shop keeperscharge tax on such sale.
(4) Sometimes the seller & the purchaser reach an understanding not to issue cash memo or invoice &
therefore not to pay tax. Thus, it deprives the Government of taxes.
(5) The businessmen submit false account books & documents before tax authorities & thus avoid-taxes.

Difference between Direct and Indirect Taxes

Parameter Direct Tax Indirect Tax

This tax on taxpayers for the
This tax is directly on the
Tax Imposition goods and services availed or
taxpayer’s income.
purchased.
This tax is indirectly paid to the
This tax is directly paid to the
Payment course government through an
government.
intermediary.
These taxes are paid by These taxes are paid by
Paying Entity
individuals and businesses. end-consumers.
The rate of tax is decided by the
Tax rates are the same for
Rate of Payment government based on profit and
everyone.
income.
This type of tax is
Transferability of tax This type of tax is transferable.
non-transferrable.
Nature of Tax This is a progressive type of tax. This is a regressive type of tax,
 This tax rate increases with an which means the tax rate is not
individual’s profit and income. affected by the individual's
income.
Income tax, wealth tax, corporate Sales tax, service tax, value added
Types of tax
tax, etc. tax, etc.
Collecting this type of tax is
Tax Collection Tax collection is relatively easier.
difficult.

GST as Indirect Tax

With the implementation of GST, the various taxes that were mandatory earlier are now obsolete. GST is
making sure the slogan “One Nation, One Tax, One Market” becomes the reality of our country and not
just a dream. With the dawning of the ‘Goods & Services Tax (GST), the biggest relief so far is clearly the
elimination of the ‘cascading effect of tax’ or the ‘tax on tax’ quandary.

Cascading effect of tax is a situation wherein the end-consumer of any goods or service has to bear the
burden of the tax to be paid on the previously calculated tax and as a result would suffer an increased or
inflated price. Under the GST regime, however, the customer is exempted from the tax they would
otherwise pay as a result of the cascading effect.