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CAB - Paper 1.
UNT-1 Fundamentals of Economics,
Microeconomics and Macroeconomics and Types
of Economics
1.0 Objectives
1.1 Economics an ntroduction
1 .2 Microeconomics and
1.3 Macroeconomics Types of Economies
!.4 Market, Command, and Mixed Economies
Let Us Sum Up
This chapter will be helpful in understanding:
1. Meaning and Definition of Economics
2. Concept of Microeconomics
3. Concept of Macroeconomics
4. Problems of Economic Organization
5. Market, Command and Mixed Economies
Economics deals with the production, allocation, and use of goods and services. t is
important to study how resources can best be distributed to meet the needs of the
greatest number of people. As we are more connected globally to one another, the
study of Economics becomes extremely important.
Economics is 'the science which studies human behaviour as a relationship between
ends and scarce means which have alternative uses.' Scarcity means that available
resources are insufficient to satisfy all wants and needs. n the absence of scarcity and
alternative uses of available resources, there is no economic problem. The subject thus
defined involves the study of choices as they are affected by incentives and resources.
The essence of Economics is to acknowledge the reality of scarcity and then figure out
how to organize society in a way which produces the most efficient use of resources.
That is where Economics makes its unique contribution.
Adam Smith, the father of modern Economics, in his book entitled An Enquiry into the
Nature and Causes of the Wealth of Nations (published in 1776) defined Economics as
a study of wealth. According to him, the subject matter of Economics is the study of how
wealth is produced and consumed. Smith's definition is known as wealth definition.
This definition was too materialistic. t gave more importance to wealth than to man for
whose use wealth is produced.
1. Marshalls Definition
According to Prof. Alfred Marshall, the well-known English economist, 'Economics is a
study of mankind in the ordinary business of life. t is on the one side, the study of
wealth and on the other and more important side, a part of the study of man.' Wealth
here means any commodity, which gives man satisfaction or utility or welfare. Wealth is
the means to welfare. The ultimate purpose or objective of Economics is to promote
well-being or welfare. He viewed Economics as a science of human welfare. Hence his
definition is known as welfare definition.
!. Ro""inss Definition
According to Lionel Robbins, 'Economics is the science which studies human behaviour
as a relationship between ends and scarce means which have alternative uses.' This
definition presents Economics as a study of 'means' and 'ends'. The means or
resources are less in relation to their demand. How men use the scarce resources to
fulfill their desires is the subject matter of Economics. Robbins's definition is known as
scarcity definition. The definition of Robbins can be analyzed as follows:
(a) Man has unlimited wants: 'Ends' refer to wants. Human beings have wants, which
are unlimited. All economic activities are undertaken to satisfy human wants. Man
experiences all types of wants such as food, clothing, shelter, education, entertainment,
etc. There is no limit to man's wants. We cannot say that there will be a stage when all
the wants of a person are fully satisfied. When one want is satisfied another arises.
#"$ The means to satisfy the wants are limited: The multiplicity of wants alone will not
create an economic problem. f man has unlimited resources or means to satisfy them,
there is no economic problem. But it is not so. The resources are scarce in relation to
demand. The mere shortage of supply of a commodity does not make it scarce, if there
is no demand for it. Thus rotten eggs, though much fewer than good ones, are not
scarce in the economic sense. On the other hand there may be huge stocks of a
commodity like wheat or coal in the world, yet it is considered scarce because the
demand is even greater than the supply.
#%$ Resources are not only limited but also have alternative uses: The scarce
means can be put to alternative uses. f a commodity could be put only to one use, no
economic problem would arise in its use. n actual life, however, we find that a
commodity can be put to several alternative uses. With Rs.50 you can buy either a good
pen or you can go for a movie. A piece of land can be put under paddy, sugarcane or
wheat cultivation. Thus, the resources available to a person or to the community are not
only limited but are capable of alternative uses.
#&$ Man has to make a choice: Man has to make use of his limited resources to satisfy
his unlimited wants. He cannot satisfy all his wants with the limited resources. These
limited resources can be put to alternative uses. So every man has to decide which
wants he will satisfy now and which he would postpone. Thus Economics is also called
a science of choice.
Adam Smith is considered to be the founder of the field of Mi%roe%ono'i%s, the branch
of economics which today is concerned with the behaviour of individual entities such as
markets, firms, and households. n The Wealth of Nations (1776), Smith considered
how individual prices are set, studied the determination of prices of land, labour and
capital, and inquired into the strengths and weaknesses of the market mechanism. Most
important, he identified the remarkable efficiency properties of markets and saw that
economic benefit comes from the self-interested actions of individuals.
Mi%roe%ono'i%s is a branch of economics that studies how households and firms
make decisions to allocate limited resources, typically in markets where goods or
services are being bought and sold. Microeconomics examines how these decisions
and behaviours affect the supply and demand for goods and services, which determines
prices; and how prices, in turn, determine the supply and demand for goods and
services. Microeconomics analyses the market behaviour of individual consumers and
firms in an attempt to understand the decision-making process of firms and households.
The other major branch of economics is Ma%roe%ono'i%s, which is concerned with the
overall performance of the economy. Macroeconomics did not exist in its modern form
until 1936, when John Maynard Keynes published his revolutionary book titled General
Theory of Employment, Interest and Money. At that time, England and the United
States were still stuck in the Great Depression of the 1930s, with over one-quarter of
the American labour force unemployed. n his new theory, Keynes developed an
analysis of what causes business cycles, with alternating spells of high unemployment
and high inflation. Today, macroeconomics examines a wide variety of areas, such as
how total investment and consumption are determined, how central banks manage
money and interest rates, what causes international financial crises, and why some
nations grow rapidly while others stagnate. Although macroeconomics has progressed
far since his first insights, the issues addressed by Keynes still define the study of
macroeconomics today.
Ma%roe%ono'i%s is a branch of Economics that deals with the performance, structure
and behaviour of a national or regional economy as a whole. t is the study of the
behaviour and decision-making of entire economies. Macroeconomists study
aggregated indicators such as GDP, unemployment rates and price indices to
understand how the whole economy functions. Macroeconomists develop models that
explain the relationship among such factors as national income, output, consumption,
unemployment, inflation, savings, investment, international trade and international
finance. n contrast, Microeconomics is primarily focused on the actions of individual
agents, such as firms and consumers, and how their behaviour determines prices and
quantities in specific markets.
The two branches microeconomics and macroeconomics converge to form the core
of modern Economics.
The Three *ro"le's of an E%ono'i% Or,ani-ation.
Every human society whether it is an advanced industrial nation, a centrally planned
economy, or an isolated tribal nation must confront and resolve three fundamental
economic problems. Every society must have a way of determining what commodities
are produced, how these goods are made, and for wham they are produced.
ndeed, these three fundamental questions of an economic organization what, how
and for whom are as crucial today as they were at the dawn of human civilization. Let
us look more closely at them:
1. What commodities are produced and in what quantities? A society must
determine how much of each of the many possible goods and services it will make and
when they will be produced. Will we produce pizzas or shirts today? A few high-quality
shirts or many cheap shirts? Will we use scarce resources to produce many
consumption goods (like pizzas)? Or will we produce fewer consumption goods and
more investment goods (like pizza-making machines), which will boost production and
consumption tomorrow?
2. How are goods produced? A society must determine who will do the production, with
what resources, and what production techniques they will use. Who farms and who
teaches? s electricity generated from oil, from coal or from the sun? Will factories be
run by people or robots'?
3. For whom are goods produced'? Who gets to eat the fruit of economic activity? s the
distribution of income and wealth fair and equitable? How is the national product divided
among different households? Are many people poor and a few rich? Do high incomes
go to teachers or athletes or auto workers or venture capitalists? Will society provide
minimal consumption to the poor or must people work if they are to eat'?
What are the different ways that a society can answer the questions of what, how and
for whom? Different societies are organized through alternative economic systems and
Economics studies the various mechanisms that a society can use to allocate its scarce
We generally distinguish two fundamentally different ways of organizing an economy. At
one extreme, government makes most economic decisions, with people on top of the
hierarchy giving economic commands to those further down the ladder. At the other
extreme, decisions are made in markets, where individuals or enterprises voluntarily
agree to exchange goods and services, usually through payments of money. Let us
briefly examine each of these two forms of economic organization.
Mar2et E%ono'34Ca5italisti% E%ono'3
n the United States, and increasingly around the world, most economic questions are
settled by the market mechanism. Hence, their economic systems are called market
economies. A market economy is one in which individuals and private firms make the
major decisions about production and consumption. A system of prices, of markets, of
profits and losses, of incentives and rewards determines what, how, and for whom.
Firms produce the commodities that yield the highest profits (the what) by the
techniques of production that are least costly (the how). Consumption is determined by
individuals' decisions about how to spend the wages and property incomes, generated
by their labour and property ownership (for whom). The extreme case of a market
economy, in which the government does not interface in economic decisions, is called a
'laissez-faire' economy.
So%ialisti% E%ono'34Co''an& E%ono'3
n contrast, a command economy is one in which the government makes all important
decisions about production and distribution. n a command economy, such as the one
which operated in the Soviet Union during most of the twentieth century, the
government owns most of the means of production (land and capital); it also owns and
directs the operations of enterprises in most industries; it is the employer of most
workers and tells them how to do their jobs; and it decides how the output of the society
is to be divided among different goods and services. n short, in a command economy,
the government addresses major economic questions by virtue of its ownership of
resources and its power to enforce decisions.
Mi6e& E%ono'3
No contemporary society or economy falls completely into either of these extreme
categories. Rather, all societies are mixed economies, with elements of both market and
command economies. There has never been a 100 per cent market economy (although
nineteenth-century England came close).
Today most decisions in the United States are made in the marketplace. But the
government plays an important role in overseeing the functioning of the market;
government passes laws that regulate economic life, produce goods and services, and
control pollution. Most societies/nations today operate as mixed economies.
ndia, right from the beginning of its economic planning, has been a mixed economy
where public sector, private sector and joint sector coexist and complement each other.
Che%2 )o7r *ro,ress
Ti%2 the Corre%t Ans8er
97estion 1. A&a' S'ith &efine& E%ono'i%s as a:
The %hoi%es are:
1. Study of welfare
2. Study of 'means' and 'ends'
3. Study of Wealth
4. None of these
Ri,ht Ans8er: #($ St7&3 of ;ealth
97estion !. Ma%roe%ono'i%s &eals 8ith<
The %hoi%es are:
(1) Gross domestic product
(2) Unemployment rate
(3) Price indices
(4) All the above
Ri,ht Ans8er: #.$ All the a"o=e.
97estion (. ;ho is %onsi&ere& as the fo7n&er of the fiel& of Mi%roe%ono'i%s>
The %hoi%es are:
(1) Lionel Robbins
(2) Amartya Sen.
(3) Adam Smith
(4) Prof. Alfred Marshall
Ri,ht Ans8er: #($ A&a' S'ith
97estion .. Mi%roe%ono'i%s is %on%erne& 8ith the "eha=io7r of
The %hoi%es are:
(1) Gross domestic product
(2) ndividual entities
(3) Economy as a whole
(4) None of the above
Ri,ht Ans8er: #!$ In&i=i&7al entities.
97estion ?. En&s refer to
The %hoi%es are:
(1) Demand
(2) Resources
(3) Utility
(4) Wants
Ri,ht Ans8er: #.$ ;ants
97estion @. A 'ar2et e%ono'3 is one
The %hoi%es are:
(1) n which individuals and private firms make the major decisions about
production and consumption.
(2) n which the government makes all important decisions about production and
(3) Both (1) and (2)
(4) None of these
Ri,ht Ans8er: #1$ In 8hi%h in&i=i&7als an& 5ri=ate fir's 'a2e the 'aAor &e%isions
a"o7t 5ro&7%tion an& %ons7'5tion.
97estion B. In&ia is a
The %hoi%es are:
(1)Capitalistic Economy
(2) Socialistic Economy
(3) Mixed Economy
(4) Laissez-faire economy
Ri,ht Ans8er: #($ Mi6e& E%ono'3
97estion C. Daisse-Efaire e%ono'3 is
The %hoi%es are:
(1) The extreme case of a market Economy
(2) The extreme case of a Command Economy
#($ The e6tre'e %ase of a 'i6e& E%ono'3
(4) None of these
Ri,ht Ans8er: #1$ The e6tre'e %ase of a 'ar2et E%ono'3
97estion F. Mar2et e%ono'3 is also 2no8n as
The %hoi%es are:
(1) Mixed Economy
(2) Capitalistic Economy
(3) Command Economy
(4) Socialistic Economy
Ri,ht Ans8er: #!$ Ca5italisti% E%ono'3
97estion10. ;hi%h of the follo8in, is Ca5italisti% E%ono'3>
The %hoi%es are:
(1) England
(2) China
(3) ndia
(4) None of the above
Ri,ht Ans8er: #1$ En,lan&
Det Us S7' U5
. Economics is the science that deals with the production, allocation, and use of goods
and services.
2. Economics is 'the science which studies human behaviour as a relationship between
ends and scarce means which have alternative uses.
3. Microeconomics is concerned with the behaviour of individual entities such as
markets, firms, and households. Macroeconomics views the performance of the
economy as a whole.
4. Every society must answer three fundamental questions: what, how, and for whom'?
What kinds and quantities are produced among the wide range of all possible goods
and services? How are resources used in producing these goods? And for whom are
the goods produced (that is, what is the distribution of income and consumption among
different individuals and classes?)
5. A market economy is one in which individuals and private firms make the major
decisions about production and consumption. A system of prices, of markets, of profits
and losses, of incentives and rewards determines what, how, and for whom.
6. n command economy, the government addresses the major economic questions by
virtue of its ownership of resources and its power to enforce decisions.
7. No contemporary society/nation falls completely into either of these polar/extreme
categories. Rather, all societies are mixed economies, with elements drawn from market
and command economies.
Wealth; Welfare; Ends and means; Microeconomics; Macroeconomics; Market
Economy; Command Economy; Capitalistic Economy; Mixed Economy; laissez-faire
Unit-2 Supply and Demand
2.0 Objectives
2.1 ntroduction
2.2 The Demand Schedule
2.3 Forces behind the Demand Curve
2.4 Shifts in Demand
2.5 The Supply Schedule
2.6 Forces behind the Supply Curve
2.7 Shifts in Supply
2.8 Equilibrium of Supply and Demand
2.9 Effect of a Shift in Supply or Demand
2.10 nterpreting Changes in Price and Quantity
Let s !um p
This chapter will be helpful in understanding:
1. Concepts of Demand and Supply
2. Demand Schedule, Demand Curve, Market Demand
3. Supply Schedule, Supply Curve
4. Equilibrium of Supply and Demand
5. Price Mechanism
Like weather, markets are dynamic, subject to periods of storm and calm, and
constantly evolving. Yet, as with weather forecasting, a careful study of markets will
reveal certain forces underlying the apparently random movements. To forecast prices
and outputs in individual markets, you must first understand the concept of supply and
Economics has a powerful tool for explaining such changes in the economic
environment. t is called the theory of supply and demand. This theory shows how
consumer preferences determine consumer demand for commodities, while business
costs determine the supply of commodities. The increase in the price of petrol occurred
either because the demand for petrol had increased or because the supply of crude oil
had decreased. The same is true for every market, from food to diamonds to land:
changes in supply and demand drive changes in output and prices. f you understand
how supply and demand works, you have gone a long way toward understanding a
market economy.
This chapter introduces the notions of supply and demand and shows how they
operate in competitive markets for individual commodities. We begin with demand
curves and then discuss supply curves. Using these basic tools, we will see how the
market price is determined where these two curves intersect where the forces of
demand and supply are just in balance. t is the movement of prices the price
mechanism which brings supply and demand into balance or equilibrium. This
chapter deals with some examples of how supply-and-demand analysis can be applied.
Both common sense and careful scientific observation show that the amount of a
commodity people buy depends on its price. The higher the price of an article, other
things held constant; fewer the units consumers are willing to buy. The lower is its
market price; the more units of it are bought. There exists a definite relationship
between the market price of a good and the quantity demanded of that good, other
things held constant. This relationship that exists between price and quantity bought is
called the demand schedule, or the demand curve.
Let us look at a simple example. Table 2.1 presents a hypothetical demand
schedule for apples. At each price, we can determine the quantity of apples that
consumers purchase. For example, at Rs.500 per box, consumers will buy 9 million
boxes per year.
At a lower price, more apples are bought. Thus, at a price of Rs.400, the quantity
bought is 10 million boxes. At yet a lower price (P) equal to Rs.300, the quantity
demanded (Q) is still greater, at 12 million. and so forth. We can observe that the
quantity demanded increases with the fall in price as shown in Table 2.1.
TABDE !.1 The Demand Schedule for Apple
Price (Rupees per box) Quantity demanded
(millions of boxes per year)
A 500 9
B 400 10
C 300 12
D 200 15
E 100 20
At each market price, consumers will want to buy a certain quantity of apples. As
the price of apples falls, the quantity of apples demanded will rise.
The De'an& C7r=e
The graphical representation of the demand schedule is the demand curve. We
show the demand curve in Fig. 2. 1, which graphs the quantity of apples demanded on
the horizontal axis and the price of apples on the vertical axis. Note that quantity and
price are inversely related; that is, Q goes up when P goes down. The curve slopes
downward, going from northwest to southeast. This important property is called the law
of downward-sloping demand. t is based on common sense as well as economic theory
and has been empirically tested and verified for practically all commodities apples,
petrol, computers etc.
Law of downward-sloping demand: When the price of a commodity is raised (and
other things being constant), buyers tend to buy less of the commodity. Similarly, when
the price is lowered, other things being constant, quantity demanded increases.
Quantity demanded tends to fall as price rises for two reasons. First is the
substitution effect. For instance, when the price of a particular good rises, will
substitute other similar goods for it (as the price of mutton rises, eat more chicken).
Second is the income effect. This comes into play when a higher price reduces quantity
demanded. Because when price goes up, find myself somewhat poorer than was
before. f petrol prices double, have in effect less real income, so will naturally curb
my consumption of petrol and other goods.
Market Demand
Our discussion of demand has so far referred to 'the' demand curve. But whose
demand is it? Mine? Yours? Everybody's? The fundamental building block for demand
is individual preferences. However, in this chapter we will focus on the market demand,
which represents the sum total of all individual demands. The market demand is what is
observable in the real world.
The mar"et demand #ur$e is found %y addin& to&ether the quantities demanded %y all
indi$iduals at ea#h pri#e.
Does the market demand curve obey the law of downward - sloping demand? t
certainly does. f prices drop, for example, the lower prices attract new customers
through the substitution effect. n addition, a price reduction will induce extra purchases
of goods by existing consumers through both the income and the substitution effects.
Conversely, a rise in the price of a good will cause some of us to buy less.
What determines the market demand curve for apples or petrol or computers? A
whole array of factors influences how much will be demanded at a given price: average
levels of income, the size of the population, the prices and availability of related goods,
individual and social tastes and special influences.
1. The a$era&e in#ome of consumers is a key determinant of demand. As
people's income rises, individuals tend to buy more of almost everything, even if prices
do not change. Automobile purchases tend to rise sharply with higher levels of income.
2. The size, of the market - measured, say, by the population - clearly affects the
market demand curve. Mumbai's 21 million people tend to buy 1.5 times more apples
and cars than do Chennai's 7 million people.
3. The prices and availability of related goods influence the demand for a
commodity. A particularly important connection exists among substitute goods - ones
that tend to perform the same function, such as apples and oatmeal, pens and pencils,
small cars and large cars, or oil and natural gas. Demand for good A tends to be low if
the price of substitute product B is low.
4. n addition to these objective elements, there is a set of subjective elements
called tastes or preferen#es. Tastes represent a variety of cultural and historical
influences. They may reflect genuine psychological or physiological needs (for liquids,
love, or excitement). And they may include artificially contrived cravings (for cigarettes,
drugs, or fancy sports cars). They may also contain a large element of tradition or
religion (eating beef is popular in America but taboo in ndia, while curried jellyfish is a
delicacy in Japan but would make many Americans gag).
5. Finally, spe#ial influen#es will affect the demand for particular goods. The
demand for umbrellas is high in rainy Mumbai but low in sunny Delhi; the demand for air
conditioners will rise in hot weather. n addition, expectations about future economic
conditions, particularly prices, may have an important impact on demand.
As economic life evolves, demand changes incessantly. Demand curves sit still
only in textbooks. Why does the demand curve shift? Because influences other than the
good's price change. Let us work through an example of how a change in a non-price
variable shifts the demand curve. We know that the average income of ndians rose
sharply during the economic boom of 2006-08. Because there is a powerful income
effect on the demand for automobiles, this means that the quantity of automobiles
demanded at each price will rise. For example, if average incomes rose by 10 per cent,
the quantity demanded (of a car) at a price of Rs.2, 00,000 might rise from 10 million to
12 million units. This would be a shift in the demand curve because the increase in
quantity demanded reflects factors other than the good's own price.
The net effect of the changes in underlying influences is what we call an increase
in demand. An increase in the demand for automobiles is illustrated in Fig. 2.2 as a
rightward shift in the demand curve. Note that the shift means that more cars will be
bought at every price.
Let us now turn from demand to supply. The supply side of a market typically
involves the terms on which businesses produce and sell their products. The supply of
tomatoes tells us the quantity of tomatoes that will be sold at each tomato price. More
precisely, the supply schedule relates the quantity supplied of a good to its market price,
other things being constant. n considering supply, the other things that are held
constant include input prices, prices of related goods and government policies.
The supply schedule (or supply curve) for a commodity shows the relationship
between its market price and the amount of that commodity that producers are willing to
produce and sell, other things being constant.
The S755l3 C7r=e
Table 2.2 shows a hypothetical supply schedule for apples, and Fig. 2.3 plots the
data from the table in the form of a supply curve. These data show that at an apples'
price of Rupees 100 per box, no apples will be produced at all. At such a low price,
apple cultivators might want to devote their resources to producing other types of
products like cereals and pulses that earn them more profit than apples. As the price of
apples increases, ever more apples will be produced. At ever-higher apples prices,
cereal makers will find it profitable to add more workers and to buy more automated
apples-stuffing machines and even more apples factories. All these will increase the
output of apples at the higher market prices.
TABLE 2.2 Supply Schedule for Apples
Price (Re. per box)
Quantity suppffied
M11= of boxes per yaw)
A 500
B 400 16
C 300 12
D 200 7
E 100 0
Figure 2.3 shows the typical case of an upward-sloping supply curve for an
individual commodity. One important reason for the upward slope is 'the law of
diminishing returns'. Edible oil will illustrate this important law. f society wants more
edible oil, then additional labour will have to be added to the limited farm suitable for
producing edible oil crops. Each new worker will be adding less and of less extra
product. The price needed to coax out additional edible oil output is therefore higher. By
raising the price of edible oil, society can persuade edible oil producers to produce and
sell more edible oil; the supply curve for edible oil therefore is upward-sloping. Similar
reasoning applies to other goods as well.
i 1 1.1 1 1 1 1 1 1 1 1
1 1 1 1 1
5 10 15 20 Quantities of Apples (Millions of boxes per year)
+IIURE !.(
Supply Curve elating Quantity Supplied to Prices
n examining the forces determining the supply curve, the fundamental point to
grasp is that producers supply commodities for profit and not for fun or charity. One
major element underlying the supply curve is the #ost of produ#tion. When production
costs for a good are low relative to the market price, it is profitable for producers to
supply a great deal. When production costs are high relative to price, firms produce
little, switch over the production of other products, or may simply go out of business.
Production costs are primarily determined by the pri#es of inputs and
te#hnolo&i#al ad$an#es. The prices of inputs such as labour, energy or machinery
obviously have a very important influence on the cost of producing a given level of
output. For example, when petrol prices rose sharply in the 1970s, the increase raised
the price of energy for manufacturers, increased their production costs and lowered
their supply. By contrast, as computer prices fell over the last three decades,
businesses increasingly substituted computerized processes for other inputs, for
example, in payroll or accounting operations, this increased supply.
An equally important determinant of production costs is te#hnolo&i#al ad$an#es,
which consist of changes that lower the quantity of inputs needed to produce the same
quantity of output. Such technological advances include everything from scientific
breakthroughs to better application of existing technology or simply reorganization of the
flow of work. For example, manufacturers have become much more efficient over the
last decade or so. t takes far fewer hours of labour to produce an automobile today
than what it did just 10 years ago. This advance enables car-makers to produce more
automobiles at the same cost.
But production costs are not the only ingredient that goes into the supply curve.
Supply is also influenced by the pri#es of related &oods, particularly goods that are
alternative outputs of the production process. f the price of one production substitute
rises, the supply of another substitute will decrease. For example, auto companies
typically make several different car models in the same factory. f there is more demand
for one model, and its price rises, they will switch over more of their assembly lines to
making that model, and the supply of the other models will fall. Or if the demand and
price for trucks rise, the entire factory can be converted to making trucks and the supply
of cars will fall.
Go$ernment poli#y also has an important influence on the supply curve.
Environmental and health considerations determine what technologies can be used,
while taxes and minimum-wage laws can significantly raise input prices. n the local
electricity market, government regulations influence both the number of firms that can
compete and the prices they charge. Government trade policies have a major impact
upon supply aspects.
Finally, spe#ial fa#tors affect the supply curve. The weather exerts an important
influence on farming and on the agro- industry. The computer industry has been marked
by a keen spirit of innovation, which has led to a continuous flow of newer products.
Market structure will affect supply, and expectations about future prices often have an
important impact upon supply decisions.
Businesses are constantly changing the mix of products and services they
provide. What lies behind these changes in supply behaviour?
When changes in factors other than a good's own price affect the quantity
supplied, we call these changes as shifts in supply. Supply increases (or decreases)
when the amount supplied increases (or decreases) at each market price.
When automobile prices change, producers change their production and quantity
supplied; however, the supply and the supply curve do not shift. By contrast, when other
influences affecting supply change, supply changes and the supply curve shifts.
We can illustrate a shift in supply for the automobile market. Supply would
increase if the introduction of cost-saving computerized design and manufacturing
reduced the labour required to produce cars, if autoworkers took a pay cut, if there were
lower production costs in Japan, or if the government repealed environmental
regulations on the industry. Any of these elements would increase the supply of
automobiles in the country at each price.
FGURE 2.4 Quantity of Supplied of Automobiles (Million per year)
Till now, we have been considering demand and supply in isolation. We know the
amounts that are willingly bought and sold at each price. We have seen that consumers
demand different amounts of apples, cars and computers as a function of these goods'
prices. Similarly, producers willingly supply different amounts of these and other goods
depending on their prices. But how can we put both sides of the market together?
The answer is that supply and demand interacts to produce equilibrium price and
quantity or market equilibrium. The market equilibrium comes at that price and quantity
where the forces of supply and demand are in balance. At the equilibrium price, the
amount that buyers want to buy is just equal to the amount that sellers want to sell. The
reason we call this equilibrium is that, when the forces of supply and demand are in
balance, there is no reason for price to rise or fall, as long as other things remain
Let us work through the example of apples as given in Table 2.3 to see how
supply and demand determines market equilibrium; the numbers (figures) in this table
come from Tables 2.1 and 2.2.
To find the market price and quantity, we find a price at which the amounts
desired to be bought and sold just match. f we try a price of Rs.500 per box, will it
prevail for long? Clearly not. As row A in Table 2.3 shows, at Rs.500 producers would
like to sell 18 million boxes per year while demanders want to buy only 9. The amount
supplied at Rs.500 exceeds the amount demanded, and stocks of apples pile up in
markets. Because too few consumers are chasing too many apples, the price of apples
will tend to fall, as shown in column (5) of Table 2.3.
TABLE 2.3- How Supply and Demand Determines Market Equilibrium
Possible price
(Rupees per
(millions of
(millions of
State of
on price
1 2 3
4 5
A 500 9 18 Surplus Downward
B 400 10 16 Surplus Downward
C 300
12 12 Equilibrium Neutral
D 200 15 7 Shortage Upward
E 100
20 0 Shortage Upward
Let us try at Rs.200. Does that price clear the market? A quick look at row D
shows that at Rs.200 consumption exceeds production. Apples begin to disappear from
the stores at that price. As people scramble around to find their desired apples, they will
tend to bid up the price of apples, as shown in column (5) of Table 2.3.
We could try other prices, but we can easily see that the equilibrium price is
Rs.300, or row C in Table 2.3. At Rs.300, consumers' desired demand exactly equals
producers' production, each of which is 12 units. Only at Rs.300 will consumers and
suppliers both be making consistent decisions.
Market equilibrium comes at the price at which quantity demanded equals
quantity supplied. At that equilibrium, there is no tendency for the price to rise or fall.
The equilibrium price is also called the market-clearing price. This denotes that all
supply and demand orders are filled, the books are 'cleared' of orders and demanders
and suppliers are satisfied.
EJ7ili"ri7' 8ith S755l3 an& De'an& C7r=es
We often show the market equilibrium through a supply-and-demand diagram
like the one in Fig. 2.5. This figure combines the supply curve from Fig. 2.3 with the
demand curve from Fig. 2.1. Combining the two graphs is possible because they are
drawn with exactly the same units on each axis.
We find the market equilibrium by looking for the price at which quantity
demanded equals quantity supplied. The equilibrium price comes at the intersection of
the supply and demand curves, at point C.
How do we know that the intersection of the supply and demand curves is the
market equilibrium? Let us repeat our earlier experiment. Start with the initial high price
of Rs.500 per box, shown at the top of the price axis in Fig. 2.5. At that price, suppliers
want to sell more than demanders want to buy. The result is a surplus or excess of
quantity supplied over quantity demanded, shown in the figure by the black line labeled
'Surplus.' The arrows along the curves show the direction that price tends to move when
a market is in surplus.
At a low price of Rs.200 per box, the market shows a shortage or excess of
quantity demanded over quantity supplied, here shown by the black line labeled
'Shortage.' Under conditions of shortage, the competition among buyers for limited
goods causes the price to rise, as shown in the Fig. 2.5 by the arrows pointing upward.
We now see that the balance or equilibrium of supply and demand comes at
point C, where the supply and demand curves intersect. At point C, where the price is
Rs.300 per box and the quantity is 12 units, the quantities demanded and supplied are
equal: there are no shortages or surpluses; there is no tendency for price to rise or fall.
At point C, and only at point C, the forces of supply and demand are in balance and the
price has settled at a sustainable level.
The equilibrium price and quantity come where the amount willingly supplied
equals the amount willingly demanded. n a competitive market, this equilibrium is found
at the intersection of the supply and demand curves. There are no shortages or
surpluses at the equilibrium price.
The analysis of the supply-and-demand apparatus can do much more than tell us
about the equilibrium price and quantity. t can also be used to predict the impact of
changes in economic conditions on prices and quantities. Let us change our example to
the bread. Suppose that a spell of bad weather raises the price of wheat, a key
ingredient of bread. That shifts the supply curve for bread to the left. This is illustrated in
Fig. 2.6, where the bread supply curve has shifted from SS to S'S'. n contrast, the
demand curve has not shifted because people's sandwich demand is largely unaffected
by farming weather.
What happens in the bread market? The harvest causes bakers to produce less
bread at the old price, so quantity demanded exceeds quantity supplied. The price of
bread therefore rises, encouraging production and thereby raising quantity supplied,
while simultaneously discouraging consumption and lowering quantity demanded. The
price continues to rise until, at the new equilibrium price, the amounts demanded and
supplied are once again equal.
As Fig. 2.6 shows, the new equilibrium is found at E', the intersection of the new
supply curve S'S' and the original demand curve. Thus a bad harvest (or any leftward
shift of the supply curve) raises prices and, by the law of downward-sloping demand,
lowers quantity demanded.
We can also use our supply-and-demand apparatus to examine how changes in
demand affect the market equilibrium. Suppose that there is a sharp increase in family
incomes, so everyone wants to eat more bread. This is represented in Fig. 2.7 as a
'demand shift' in which, at every price, consumers demand a higher quantity of bread.
The demand curve thus shifts rightward from DD to D'D'.
The demand shift produces a shortage of bread at the old price. A scramble for
bread ensues, with long lines in the bakeries. Prices are bid upward until supply and
demand come back into balance at a higher price. Graphically, the increase in demand
has changed the market equilibrium from E to E' in Fig. 2.7.
For both examples of shifts a shift in supply and a shift in demand a variable
underlying the demand or supply curve has changed. n the case of supply, there might
have been a change in technology or input prices. For the demand shift, one of the
influences affecting consumer demand incomes, population, and the prices of related
goods or tastes changed and thereby shifted the demand schedule.
Let us go back to our earlier example of bread. Suppose that you go to the store
and see that the price of bread has doubled. Does the increase in price mean that the
demand for bread has risen or does it mean that bread has become more expensive to
produce? The correct answer is that without more information, you do not know it
could be either one, or even both. Let us look at another example. f fewer airline tickets
are sold, is the cause that airline fares have gone up or that demand for air travel has
gone down?
Economists deal with these sorts of questions all the time: When prices or
quantities change in a market, does the situation reflect a change on the supply side or
the demand side? Sometimes, in simple situations, looking at price and quantity
simultaneously gives you a clue about whether it is the supply curve that is shifted or
the demand curve. For example, a rise in the price of bread accompanied by a
decrease in quantity suggests that the supply curve has shifted to the left (a decrease in
supply). A rise in price accompanied by an increase in quantity indicates that the
demand curve for bread has probably shifted to the right (an increase in demand).
This point is illustrated in Fig. 2.8. n both panel (a) and panel (b), the quantity
goes up. But in (a) the price rises and in (b) the price falls. Figure 8(a) shows the case
of an increase in demand or a shift in the demand curve. As a result of the shift, the
equilibrium quantity demanded increases from 10 to 15 units. The case of a movement
along the demand curve is shown in Fig. 2.8(b). n this case, a supply shift changes the
market equilibrium from point E to point E'. As a result, the quantity demanded changes
from 10 to 15 units. But demand does not change in this case; rather, quantity
demanded increases as consumers move along their demand curve from E to E' in
response to a price change.
Che%2 )o7r *ro,ress
*i%2 the %orre%t Ans8er
97estion1. De'an& S%he&7le is the
The %hoi%es are:
(1) Relationship between demand and quantity bought
(2) Relationship between price and quantity bought
(3) Relationship between price and demand
(4) None of these
Ri,ht Ans8er: #!$ Relationshi5 "et8een 5ri%e an& J7antit3 "o7,ht
97estion !.Mar2et De'an& C7r=e o"e3s the
The %hoi%es are:
(1) Law of downward-sloping demand
(2) Law of upward-sloping demand
(3) Law of diminishing
(4) None of these
Ri,ht Ans8er: #1$ Da8 of &o8n8ar&Eslo5in, &e'an&
97estion (. +or%es "ehin& the &e'an& %7r=e
The %hoi%es are:
(1) Expectation about future economic conditions
(2) Average ncome
(3) Cost of production
(4) Both (1) and (2)
Ri,ht Ans8er: #.$ Both #1$ an& #!$
97estion .. A &o8n 8ar& Slo5in, De'an& C7r=e relates J7antit3 &e'an&e& to
The %hoi%es are:
(1) Supply
(2) ncome
(3) Price
(4) Demand
Ri,ht Ans8er: #($ *ri%e
97estion ?. Shifts in S755l3 'eans
The %hoi%es are:
(1) When changes in factors other than goods own price affect the quantity supplied.
(2) When changes in goods own price affect the quantity supplied.
(3) Both (1) and (2)
(4) None of these
Ri,ht Ans8er: #1$ ;hen %han,es in fa%tors other than ,oo&s o8n 5ri%e affe%t the
J7antit3 s755lie&.
97estion @. The EJ7ili"ri7' *ri%e is also 2no8 as
The %hoi%es are:
(1) Market price
(2) Optimum price
(3) Real price
(4) Market-clearing price
Ri,ht Ans8er: #.$ Mar2etE%learin, 5ri%e
97estion B. +or%es "ehin& the S755l3 C7r=e
The %hoi%es are:
(1) Cost of production
(2) Technological advances
(3) Government policies
(4) All of the above
Ri,ht Ans8er: #.$ All of the a"o=e
C. S755l3 %7r=e relates J7antit3 s755lie& to
The Choi%es are:
(1) Supply
(2) ncome
(3) Price
(4) Demand
Ri,ht Ans8er: #($ *ri%e
97estion F. Mar2et eJ7ili"ri7' %o'es at the 5ri%e at 8hi%h J7antit3 &e'an&e&
eJ7als to J7antit3
The %hoi%es are:
(1) Produced
(2) Supplied
(3) nventory
(4) Demand
Ri,ht Ans8er: #!$ S755lie&
Det Us S7' U5
1. There exists a definite relationship between the market price of a good and the
demanded quantity of that good, other things being constant. This relationship between
price and quantity bought is called the demand schedule, or the demand curve.
!. Law of downward-sloping demand: When the price of a commodity is raised (and
other things are held constant) buyers tend to buy less of the commodity. Similarly,
when the price is lowered, other things being constant, quantity demanded increases.
(. The market demand curve is found by adding together the quantities demanded by all
individuals at each price.
.. When there are changes in factors other than a good's own price which affect the
quantity purchased, we call these changes shifts in demand. Demand increases (or
decreases) when the quantity demanded at each price increase (or decrease).
?. The supply schedule (or supply curve) for a commodity shows the relationship
between its market, price and the amount of that commodity that producers are willing
to produce and sell, other things held constant.
@. When changes in factors other than a good's own price affect the quantity supplied,
we call these changes as shifts in supply.
B. Market equilibrium comes at the price at which quantity demanded equals quantity
supplied. At that equilibrium, there is no tendency for the price to rise or fall. The
equilibrium price is also called the market-clearing price. This denotes that all supply
and demand orders are filled, the books are `cleared' of orders, and demanders and
suppliers are satisfied.
C. The equilibrium price and quantity come where the amount willingly supplied equals
the amount willingly demanded. n a competitive market, this equilibrium is found at the
intersection of the supply and demand curves. There are no shortages or surpluses at
the equilibrium price.
F. When the elements underlying demand or supply change, this leads to shifts in
demand or supply and to changes in the market equilibrium of price and quantity.
Demand; Demand schedule; Supply schedule; Shifts in supply; Shifts in demand;
Equilibrium of Supply and Demand.
*A*ERE 1
3.0 Objectives
3.1 What is Money?
3. 2 Money Supply
3.3 nflation
3.4 Causes of nflation
3.5 Measures of nflation
Let s !um p
This chapter will be helpful in understanding:
1. Definition and measures of money concept
2. Causes and measures of inflation
Money is anything which performs the following four functions:
1. Medium of Exchange;
2. A measure of value;
3. A store of value over time,;
4. Standard for deferred payments;
Let us understand each of the above functions.
1. Me&i7' of E6%han,e: ndividual goods and services, and other physical assets, are
'priced' in terms of money and are exchanged using money.
!. A Meas7re of Val7e: Money is used to measure and record the value of goods or
(. A store of =al7e o=er ti'e: Money can be held over a period of time and used to
finance future payments.
.. Stan&ar& for Deferre& *a3'ents: Money is used as an agreed measure of future
receipts and payments in contracts.
(.! MONE) SU**D)
Money supply refers to the stock of money in circulation in the economy at a given point
of time. This is partly exogenous (decided by the government and the central bank) and
partly endogenous..
Meas7res of Mone3 S755l3
The four most common measures of money supply, which are used in ndia, are as
(a) Narrow Money (M 1) is equal to Currency with the public plus Demand deposits with
the banking system plus `Other' deposits with the RB.
(b) M2 is equal to M1 plus Savings deposits of post office savings banks
M3 is equal M plus Time deposits with the banking system
J M4 is equal M3 plus All deposits with post office savings banks (excluding National
Savings Certificates).
1. `Currency with the public' is currency in circulation less cash held by banks.
2. 'Demand deposits' include all liabilities which are payable on demand and they
include current deposits, demand liabilities portion of savings bank deposits, margins
held against letters of credit/ guarantees, balances in overdue fixed deposits, cash
certificates and cumulative/ recurring deposits, etc.
3. `Time deposits' are those which are payable otherwise than on demand and they
include fixed deposits, cash certificates, cumulative and recurring deposits, time
liabilities portion of savings bank deposits, etc.
The concept of nflation refers to a sustained rise in the general level of prices of goods
and services in an economy over a period of time.
nflation leads to fall in purchasing power. When the price level rises, each unit of
currency buys fewer goods and services; consequently, inflation is also erosion in the
purchasing power of money a loss of real value in the internal medium of exchange
and unit of account in the economy.
A chief measure of price inflation is the inflation rate, i.e. the annualized percentage
change in a general price index over time.
nflation has both positive and negative effects on an economy. Negative effects of
inflation include loss in stability in the real value of money and other monetary items
over time, uncertainty about future inflation may discourage investment and saving, and
high inflation may lead to shortages of goods if consumers begin hoarding out of
concern that prices will increase further in the future. Positive effects include a
mitigation of economic recessions and debt relief by reducing the real level of debt.
There are many factors that can trigger inflationary pressure in an economy. The most
important of these are:
De'an&E*7ll Inflation
1. t is a rise in general prices caused by increasing aggregate demand for goods and
2. ncreasing quantity of money in the hands of the people increases the aggregate
demand for goods and services, and if aggregate supply does not follow the suit, prices
(Demand exceeding supply leads to shortage and hence, an increase in price)
CostE*7sh Inflation
1. t is a type of inflation caused by substantial increases in the cost of production of
important goods or services where no suitable alternative is available.
2. For example, if prices of some key inputs like oil rise, producers will have to either
adjust output supply or translate the higher costs into higher output prices. When output
declines because of cost pressure on producers, there will be a shortage in output
markets and as a result prices will rise.
nflation denotes a rise in the general level of prices. The general price level is
measured by a price index. When newspapers tell us 'nflation is rising,' they are in fact
reporting the movement of a price index. A price index is a weighted average of the
prices of a selected basket of goods and services relative to their prices in some
designated base-year.
Cal%7latin, Inflation 8ith *ri%e In&e6es
nflation is calculated by taking the price index from the year of interest and subtracting
the base year from it, then dividing by the base year. This is then multiplied by 100 to
give the percentage (%) change in inflation.
nflation is equal to (Price ndex in Current Year minus Price ndex in Base Year
multiplied by 100 Price ndex in Base Year
The most important price indexes are:
1. Wholesale Price ndex (WP)
2. Food nflation ndex
3. Consumer Price ndex (CP)
4. GDP deflator
;holesale *ri%e In&e6 #;*I$
The WP reflects the change in the level of prices of a basket of goods at the wholesale
level. WP focuses on the price of goods traded between corporations at the wholesale
stage, rather than goods bought by consumers. WP helps to monitor price movements
that reflect supply and demand in industry, manufacturing and construction sectors. n
ndia WP (Headline nflation) is the official inflation index used for policy decisions.
+oo& Inflation In&e6
Recently, it has been decided by government that WP will be announced monthly.
However the indices for the food group and fuel group will be announced weekly.
Cons7'er *ri%e In&e6 #C*I$
The CP reflects the change in the level of prices of a basket of goods and services
purchased/consumed by the households. t measures the prices at the retail level. This
is the measure of inflation more relevant for the consumers. t is the cost of living index
popularly known as Core nflation.
We have four different index numbers of consumer prices. These are:
1. CP for industrial workers (CP-W),
2. CP for agricultural labourers (CP-AL),
3. CP for rural workers (CP-RW) and
4. CP for urban non-manual employees (CP-UNME)
CP in ndia is released by Labour Bureau, Ministry of Labour and Employment,
Government of ndia.
ID* Deflator
GDP deflator is a measure of the level of prices of all new, domestically produced, final
goods and services in an economy.
The GDP deflator is not based on a fixed basket of goods and services. The basket is
allowed to change with people's consumption and investment patterns. (Specifically, for
GDP, the 'basket' in each year is the set of all goods that were produced domestically,
weighted by the market value of the total consumption of each good.) Therefore, new
expenditure patterns are allowed to show up in the deflator as people respond to
changing prices.
Che%2 )o7r *ro,ress
Ti%2 the Corre%t Ans8er
97estion 1. Mone3 S755l3 refers to
The %hoi%es are:
(1) The amount of money in banks
(2) The amount of money with the people
(3) The amount of money in circulation in an economy
(4)None of the above.
Ri,ht Ans8er: #($ The a'o7nt of 'one3 in %ir%7lation in an e%ono'3
97estion !. Narro8 Mone3 %onsists of
The %hoi%es are:
(1) Currency with the Public Demand Deposits, 'Other 'Deposits with the RB
(2) Currency with the Public, Time Deposits, `Other' Deposits
(3) Time deposits, Demand Deposits, 'Other' Deposits with the RB
(4) Currency with the Public, Demand Deposits
Ri,ht Ans8er: #1$ C7rren%3 8ith the *7"li% De'an& De5osits0 Other De5osits
8ith the RBI
97estion (. Ti'e De5osits are
The %hoi%es are:
(1) Paid on demand
(2) Not paid on demand
(3) Relatively less liquid than cash and demand deposits
(4)Both (1) and (2)
Ri,ht Ans8er: #.$ Both #1$ an& #!$
97estion.. De'an& De5osits are
The %hoi%es are:
(1) Paid on demand
(2) Not paid on demand
(3) Relatively less liquid than cash and demand deposits
(4) Both (1) and (2)
Ri,ht Ans8er: #1$ *ai& on &e'an&
97estion ?. ;hi%h of the follo8in, state'ents is tr7e a"o7t KInflation>L
The %hoi%es are:
(1) A rise in the general level of prices
(2) Leads to fall in purchasing power
(3) Both (1) and (2)
(4) None of the above
Ri,ht Ans8er: #($ Both #1$ an& #!$
97estion @. *ri%e In&e6 7se& in In&ia to %al%7late inflation for 5oli%3 for'7lation
The %hoi%es are:
(1) Consumer price index
(2) GDP deflator
(3) Wholesale price index
(4) Retail price index
Ri,ht Ans8er: #($ ;holesale 5ri%e in&e6
97estion B. Cons7'er 5ri%e in&e6 'eas7res 5ri%es at
The %hoi%es are:
(1) Wholesale level
(2) Retail level
(3) Producer level
(4) Consumer level
Ri,ht Ans8er: #!$ Retail le=el
Det Us S7' U5
. Money performs four functions Medium of exchange, a measure of value, a store of
value over time, Standard for deferred payments.
2. Sources of Money supply analyzed by the RB, consist of the following: Net bank
credit to the government, Bank credit to the commercial sector, Net foreign exchange
assets of the banking sector, Government's Currency Liabilities to the Public, Net non-
monetary liabilities of the RB and the other banks.
3. The most common measures of money supply used in ndia are: Narrow Money (M1),
Broad Money (M3), M2 is equal to M1plus demand deposits in post office savings
accounts, M4is equal to M3 plus all deposits with post offices.
4. nflation is a sustained rise in the general level of prices of goods and services in an
economy over a period of time. A chief measure of price inflation is the inflation rate, the
annualized percentage change in a general price index over time.
5. The most important causes of inflation are: Demand-Pull nflation, Cost-Push
nflation. Demand-Pull nflation is a rise in general prices caused by increasing
aggregate demand for goods and services. Cost-Push nflation is a type of inflation
caused by substantial increases in the cost of important goods or services where no
suitable alternative is available.
6. nflation denotes a rise in the general level of prices. The general price level is
measured by a price index. The most important price indexes are: Wholesale price
index, Consumer price index and GDP deflator.
7. The WP reflects the change in the level of prices of a basket of goods at the
wholesale level. The CP reflects the change in the level of prices of a basket of goods
and services purchased/consumed by the households. GDP deflator is a measure of the
level of prices of all new, domestically produced, final goods and services in an
Money; Money Supply; Measures of Money Supply; Narrow Money; Broad Money;
Demand deposits; Time deposits; nflation; nflation Rate; Price index; Wholesale price
index; Food inflation index: Consumer price index; GDP deflator.
*A*ER 1
4.0 Objectives
4.1 ntroduction
4.2 Keynes' Liquidity Preference Theory of Rate of nterest
4.3 Money Demand Curve
4.4 Determination of Rate of nterest: Equilibrium in the Money Market
4.5 Effect of an ncrease in the Money Supply
4.6 Shifts in Money Demand or Liquidity Preference Curve
4.7 Hicks-Hansen Synthesis: S-LM Curve Model
4.8 Derivation of the S Curve
4.9 Derivation of the LM Curve from Keynes' Liquidity Preference Theory
4.10 The Slope and Position of the LM Curve
4.11 ntersection of the S and LM Curves: Simultaneous Determination
of nterest Rate and ncome
Let Us Sum Up
This chapter will be helpful in understanding:
1. Concept of nterest
2. Keynes' Liquidity Preference Theory of Rate of nterest
3. Hicks-Hansen Synthesis: S-3. LM Curve Model
4. Determination of nterest Rate and ncome
nterest is a payment made by a borrower for the use of a sum of money for a period of
time; it is one of the four types of income, the others being rent, wages, and profit.
Three elements can be distinguished in interest: (1) payment for the risk involved in
making the loan; (2) payment for the trouble involved; (3) pure interest, that is a
payment for the use of the money. At any particular time there is a prevailing rate of
interest, which many regard as a price determined like other prices in markets, by the
demand to borrow in relation to the supply of loanable funds. This is pure interest.
Differences in the rate of interest on different loans made during the same period of time
must, therefore, be due to differences in the risk or trouble involved. Thus, the rate of
interest charged by a moneylender on an unsecured loan will be higher than the rate
charged by a bank to one of its customers who can offer satisfactory collateral security.
Similarly, the government has generally to offer a higher rate of interest on a long-term
than on a short-term loan.
n his epoch-making book, The General Theory of Employment( Interest and Money,
J.M. Keynes gave a new view of interest. According to him, the rate of interest is a
purely monetary phenomenon and is determined by demand for money and supply of
money. The theory is known as Liquidity Preference Theory.
The De'an& for Mone3 in a T8oEAsset E%ono'3: n order to explain the demand
for money and interest-rate determination, Keynes assumed a simplified economy
where there are two assets which people can keep in their portfolio balance. These two
assets are: (1) money in the form of currency and current deposits in the banks which
earn no interest, (2) long-term bonds. t is important to note that rate of interest and
bond prices are inversely related. When bond prices go up, rate of interest rises and
vice versa. The demand for money by the people depends upon how they decide to
balance their portfolios between money and bonds. This decision about the portfolio
balance can be influenced by two factors.
First, the higher the level of nominal income in a two-asset economy, more the money
people would want to hold in their portfolio balance. This is because of transactions
motive according to which at the higher level of nominal income, the purchases by the
people of goods and services in their daily life will be relatively larger, which require
more money to be kept for transactions purposes.
Second, the higher the nominal rate of interest, the lower the demand for money for
speculative motive. This is firstly because a higher nominal rate of interest implies a
higher opportunity cost for holding money. At higher rate of interest, holders of money
can earn more incomes by holding bonds instead of money. Secondly, if the current rate
of interest is higher than what is expected in the future, the people would like to hold
more bonds and less money in their portfolio. On the other hand, if the current rate of
interest is low (in other words, if the bond prices are currently high), the people will be
reluctant to hold larger quantity of bonds (and instead they could hold more money in
their portfolio) because of the inherent fear that bond prices would fall in the future
causing capital losses to them.
t follows from above that quantity of money demanded increases with the fall in the rate
of interest or with the increase in level of nominal income. At a given level of nominal
income, we can draw a money demand curve showing the quantity of money demanded
at various rates of interest. As demand for money is inversely related to the rate of
interest, the money demand curve at a given level of income, say will be downward-
sloping, as is shown by the curve LP, in Fig.4. 1. When the level of money income
increases, (suppose from Yand Y) the curve of demand for money shifts upward to
the new position LP
The rate of interest, according to .M. Keynes, is determined by demand for money
(Liquidity Preference) and supply of money. The factors which determine demand for
money has been explained above. The supply of money, at a given time, is fixed by the
monetary authority of the country.
n Fig. 4.2, LP is the demand curve for money at a given level of nominal income. MS is
the money supply curve which is a vertical straight line showing that Rs.200 crone is the
money supply fixed by the monetary authority. t will be seen that quantity of money
demanded equals the given money supply at 10 per cent rate of interest. So the money
market is in equilibrium at 10 per cent rate of interest. There will be disequilibrium if rate
of interest is either higher or lower than 10 per cent. Suppose the rate of interest is 12
per cent. Supply of money exceeds the demand for money. The excess supply of
money reflects the fact that people do not want to hold as much money in their portfolio
as the monetary authority has made it available to them. The people holding assets in
the present two-asset economy would react to this excess money supply with them by
buying bonds and thus replace some of money in their portfolios with bonds. Since the
total money supply at a given moment remains fixed, it cannot be reduced by buying
bonds by individuals. Such bonds-buying spree would lead to the rise in prices of
bonds. The rise in bond prices mean the fall in the rate of interest. As will be seen from
the Figure with the fall in the interest rate from 12 per cent to 10 per cent, quantity
demand of money has increased to become once again equal to the given supply of
money, and the excess supply of money is entirely eliminated and money market is in
On the other hand, if the rate of interest is lower than the equilibrium rate of 10 per cent,
say it is 8 per cent, and then (as will be seen from Fig. 4.2) there will be excess demand
for money. As a reaction to this excess demand for money, people would like to sell
bonds in order to obtain a greater quantity of money for holding at lower rate of interest.
The stock of money remaining fixed, the attempt by the people to hold more money
balances at a rate of interest lower than the equilibrium level through sale of bonds will
only cause the bond prices to fall. The fall in bond prices implies the rise in the rate of
interest. Thus, the process that started as a reaction to the excess demand for money at
an interest rate below the equilibrium will end up with the rise in the interest rate of the
equilibrium level.
Let us now examine the effect of increase in money supply on the rate of interest. n
Fig. 4.3 LP is the money demand curve for satisfying various motives. To begin with,
ON is the quantity of money available. Rate of interest will be determined where the
demand for money is in balance or equal to the fixed supply of money ON. t is clear
from the figure that demand for money is equal to ON quantity of money at Or rate of
interest. Hence, Or is the equilibrium rate of interest. Assuming no change in
expectations and nominal income, an increase in the quantity of money (through buying
securities by the central bank of the country from the open market), will lower the rate of
interest. n Fig. 4.3, when the quantity of money increases from ON to ON', the rate of
interest falls from Or to Or' because the new quantity of money ON' is in balance with
the demand for money at Or' rate of interest. n this case, we move down on the curve.
Thus, given the money demand curve or curve of liquidity preference, an increase in the
quantity of money brings down the rate of interest.
Let us see how increase in money supply leads to the fall in the rate of interest. With
initial equilibrium at Or, when the money supply is expanded from ON to ON', there
emerges excess supply of money at the initial Or rate of interest. The people would
react to this excess quantity of money supplied by buying bonds. As a result, the bond
prices will go up which implies that the rate of interest decline. This is how the increase
in money supply leads to the fall in rate of interest.
The position of money demand curve depends upon two factors: (1) the level of nominal
income and (2) the expectations about the changes in bond prices in the future which
implies change in rate of interest in future. As has been explained above, a money
demand curve is drawn by assuming a certain level of nominal income. With the
increase in nominal income, money demand for transactions and precautionary motives
increase causing an upward shift in the money demand curve.
Shifts in 'one3 %7r=e &e'an& %7r=e (or what Keynes called liquidity preference
curve) can also be caused by changes in the expectations of the people regarding
changes in bond prices or movements in the rate of interest in future. f some changes
in events lead the people on balance to expect a higher rate of interest in the future than
they had previously supposed, the money demand or liquidity preference for speculative
motive will increase which will bring about an upward shift in the money demand curve
or liquidity preference curve and this will raise the rate of interest.
n Fig. 4.4, assuming that the quantity of money remains unchanged at ON, the rise in
the money demand or liquidity preference curve from LP to LP, the rate of interest rises
from Or to Oh because at Oh, the new speculative demand for money is in equilibrium
with the supply of money ON. t is worth noting that when the liquidity preference curve
rises from LP to LP, the amount of money held does not increase; it remains ON as
before. Only the rate of interest rises from Or to Oh to equilibrate the new liquidity
preference or money demand with the available quantity of money ON.
Renowned economists, Sir John Richard Hicks and Alvin Hansen, have brought about a
synthesis between the Classical and Keynes' theories of interest and have thereby
succeeded in propounding an adequate and determinate theory of interest through the
intersection of what are called S and LM curves. They are of the opinion that the
classical and loanable funds theories amount to the same thing. According to them, the
difference between these two theories, i.e. classical and loanable funds, lies only in the
meaning of savings. Through derivation, the S curve from the classical theory and LM
curve from Keynes' liquidity preference theory, they have brought about a synthesis
between the classical and Keynes' theories of interest to provide an adequate and
determinate theory of the rate of interest. From the classical theory they get a family of
saving curves at various income levels.
From these various saving curves at various income levels together with the given
investment demand curve, the S curve is derived. This S curve tells us what will be the
various rates of interest at different levels of income, given the investment demand
curve and a family of saving curves at different levels of income. On the other hand,
from Keynes' formulation, the LM curve is obtained from a family of liquidity preference
curves corresponding to various income levels together with the given stock of money
supply. This is because as the level of income increases, people would like to hold more
money under the transactions motive. That is, the higher the level of income, the higher
would be the liquidity preference curve. With the given supply of money, the different
levels of liquidity preference curves corresponding to various levels of income would
determine different rates of interest. This yields LM curve, which depicts the various
combinations of interest and income level, at which money market is in equilibrium.
Now, Hicks and Hansen show that with the intersection of S and LM curves, both the
interest and income are simultaneously determined. Thus the classical and Keynes'
theories taken together help us in obtaining an adequate and determinate theory of
interest. n what follows we explain how the S curve is derived from the classical
theory, and the LM curve from Keynes' theory. Further, we will explain what factors
determine the shape and the levels of S and LM curves.
n Fig. 4.5, as the income rises, the savings curve shifts to the right and the rate of
interest, which equalizes savings and investment, falls. n Fig. 4.6, we measure income
(Y) on the X-axis and plot the corresponding rates of interest determined by the equality
of savings and investment on the Y-axis. Thus, when income is Y the relevant
savings curve is SY and the corresponding rate of that equalizes equalizing savings
and investment is r. Similarly, for other levels of income rates of interest that equalize
savings and investment can be obtained and plotted. Since, as income increases, rate
of interest falls, the S curve slopes downward.
Thus, S curve relates the rates of interest with the levels of income at which intended
savings and investment are equal. n other words, the S curve depicts the various
combinations of levels of interest and income at which, intended savings equal
investment; goods-market is in equilibrium. Since with the increase in income the
savings curve shifts to the right, its intersection with the investment demand curve will
lower the rate of interest, the level of income and rate of interest are inversely related.
That is, the S curve slopes downward, as shown in Fig. 4.6. Further, the steepness of
the S curve depends upon the elasticity or sensitiveness of investment demand to the
changes in rate of interest. f the investment demand is highly elastic, that is, very
sensitive to the changes in the rate of interest, a given change in interest will produce a
large change in investment and thereby cause a large change in the level of income.
Thus when investment demand is greatly elastic or highly sensitive to the rate of
interest, the S curve will be flat (i.e. less steep). On the other hand, when investment
demand is not very sensitive to the changes in rate of interest, the S curve will be
relatively steep.
Now, what determines the position of S curve and what would cause changes in its
level. t is the level of autonomous expenditure such as government expenditure,
transfer payments, autonomous investment which determines the position of the S
curve. f the government expenditure or any other type of autonomous expenditure
increases, it will increase the equilibrium level of income at the given rate of interest.
This will cause the S curve to shift to the right. How much does the S curve shift
following an increase in expenditure depends on the size of multiplier. A reduction in
government expenditure or transfer payments will shift the S curve to the left.
The LM curve can be derived from the Keynesian liquidity preference theory of interest.
Liquidity preference or demand for money to hold depends upon transaction motive and
speculative motive. t is the money held for transactions motive which is a function of
income. The greater the level of income, the greater the amount of money held for
transactions motive and, therefore, the higher the level of liquidity preference curve.
Thus, we can draw a family of liquidity preference curves at various levels of income.
Now, the intersection of these various liquidity preference curves, corresponding to
different income levels with the supply curve of money fixed by the monetary authority,
would give us the LM curve that relates the rate of interest with the level of income as
determined by money-market equilibrium corresponding to different levels of liquidity
preference curve. The LM curve tells us what the various rates of interest will be (given
the quantity of money and the family of liquidity preference curves) at different levels of
income. But the liquidity preference curves alone cannot tell us what exactly the rate of
interest will be.
n Fig. 4.7 (a) and (b), we have derived the LM curve from a family of liquidity
preference curves. As income increases, liquidity preference curve shifts outward and
therefore the rate of interest, which equates supply of money with demand for money,
rises. n Fig. 4.7 (b) we measure income on the X-axis and plot the income levels
corresponding to the various interest rates determined at those income levels
through money-market equilibrium by the equality of demand for and supply of money in
Fig. 4.7 (a).
Figure 4.7 (b) shows that the LM curve slopes upward to the right. This is because with
higher levels of income, demand for money (that is, the liquidity preference curve) is
higher and consequently the money market equilibrium, that is, the equality of the given
money supply with liquidity preference curve occurs at a higher rate of interest. This
implies that rate of interest varies directly with income. t is important to know which
factors determine the slope of the LM curve. There are two factors on which the slope of
the LM curve depends. First, the responsiveness of demand for money (i.e. liquidity
preference) to the changes in income. As the income increases, say from Y to Y,
the liquidity preference curve shifts from LP to LP, that is, with an increase in
income, demand for money would increase for being held for transactions motive, L is
equal to f multiplied by Y. This extra demand for money would disturb the money-market
equilibrium, and in order to restore the equilibrium the rate of interest will rise to the
level where the given money supply curve intersects the new liquidity preference curve
corresponding to the higher income level. t is worth noting that in the new equilibrium
position, with the given stock of money supply, money held under the transactions
motive will increase whereas the money held for speculative motive will decline. The
greater the extent to which demand for money for transactions motive increases with
the increase in income, the greater the decline in the supply of money available for
speculative motive. Given the liquidity preference schedule for speculative motive, the
higher the rise in the rate of interest the steeper the LM curve consequently. According
to Keynes' liquidity preference theory, r is equal to f (M, L) where M 'S the stock
of money available for speculative motive and L is the money demand or liquidity
preference function for speculative motive.
The second factor which determines the slope of the LM curve is the elasticity or
responsiveness of demand for money (i.e., liquidity preference for speculative motive) to
the changes in rate of interest. The lower the elasticity of liquidity preference with
respect to the changes in interest rate, the steeper will be the LM curve. On the other
hand, if the elasticity of liquidity preference (money-demand function) to the changes in
the rate of interest is high, the LM curve will be relatively flat or less steep.
Another important thing to know about the S-LM curve model is to know what brings
about shifts in the LM curve. As seen above, an LM curve is drawn with a given stock of
money supply. Therefore, when the money supply increases, given the liquidity
preference function, it will lower the rate of interest at the given level of income. This will
cause the LM curve to shift down and to the right. On the other hand, if money supply is
reduced, given the liquidity preference (money; demand) function, it will raise the rate of
interest at the given level of income and therefore cause the LM curve to shift above
and to the left.
The other factor that causes a shift in the LM curve is the change in liquidity preference
(money demand function) for a given level of income. f the liquidity preference function
for a given level of income shifts upward, this, given the stock of money, will lead to the
rise in the rate of interest. This will bring about a shift in the LM curve above and to the
left. On the contrary, if the liquidity preference function for a given level of income
declines, it will lower the rate of interest and will shift the LM curve down and to the
The S curve and the LM curve relate to the two variables: (a) income, and (b) the rate
of interest. ncome and the rate of interest determined together at the equilibrium rate of
interest are, therefore, determined together at the point of intersection of these two
curves, i.e. E in Fig. 4.8.
The equilibrium rate of interest thus determined is Or and the level of income
determined is OY. At this point, income and the rate interest stand in relation to each
other such that (1) investment and saving are in equilibrium, and (2) the demand for
money is in equilibrium with the supply of money (i.e., the desired amount of money is
equal to the actual supply of money). t should be noted that LM curve has been drawn
by taking the supply of money as fixed.
Thus, a determinate theory of interest is based on: (1) the investment-demand function,
(2) the saving function (or, conversely, the consumption function), (3) the liquidity
preference function, and (4) the quantity of money. We see, therefore, that according to
Hicks and Hansen, both monetary and real factors, namely, productivity, thrift, and the
monetary factors, that is, the demand for money (liquidity preference) and supply of
money play a part in determining of the rate of interest. Any change in these factors will
cause shift in S or LM curve and will therefore change the equilibrium level of the rate
of interest and income.
Che%2 )o7r *ro,ress
Tick the Correct Answer
Question1. Pick odd man out:
The choices are:
(1) Rent
(2) nterest
(3) Wages
(4) Money
Right Answer: (4) Money
Question 2. According to J.M.Keynes rate of interest and bond prices are related
The Choices are:
(1) nversely
(2) Directly
(3) Parallel
Right Answer: (1) nversely
Question 3. Keynes explained interest in terms of
The choices are:
(1) Real forces
(2) Economic forces
(3) Monetary forces
(4) Social forces
Right Answer: (3) Monetary forces
Question 4. The initials LM stand for
The choices are:
(1) Liquidity Model
(2) Liquidity preference and Money supply equilibrium
(3) Liquidity and Money Model
(4) Liquidity and money
Right Answer: (2) Liquidity preference and Money supply equilibrium
Question 5. S curve is derived from
The choices are:
(1) Classical theory.
(2) Keynesian liquidity preference theory of interest
(3) Law of diminishing marginal utility
(4) Law of equimarginal utility
Results: (1) Classical theory.
Question6. LM curve is derived from
The choices are:
(1) Classical theory
(2) Keynesian liquidity preference theory of interest
(3) Law of diminishing marginal utility
(4) Law of equimarginal utility
Right Answer: (2) Keynesian liquidity preference theory of interest
Det Us S7' U5
1. nterest is one of the four types of income, the others being rent, wages, and profit.
Three elements can be distinguished in interest: (i) payment for the risk involved in
making the loan; (it) payment for the trouble involved; (iii) pure interest, that is a
payment for the use of the money.
2. Supply-and-demand analysis explains the rate of interest as a price determined by
the demand for money and the supply of loans.
3. According to Keynes, rate of interest is determined by liquidity preference or demand
for money to hold and the supply of money. The theory is known as Liquidity Preference
Theory. nterest is a reward for parting with liquidity for a specified period.
4. n two-asset economy the demand for money by the people depends upon how they
decide to balance their portfolios between money and bonds.
5. The position of money demand curve depends upon two factors: (1) the level of
nominal income, and (2) the expectations about the changes in bond prices in the future
which implies change in rate of interest in future.
6. Keynes asserted that it is not the rate of interest which equalizes saving and
investment. But this equality is brought about through changes in the level of income.
7. Hicks and Hansen have brought about a synthesis between the Classical and
Keynes' theories of interest and have thereby succeeded in propounding an adequate
and determinate theory of interest through the intersection of what are called S and LM
8. S curve tells us what will be the various rates of interest at different levels of income,
given the
investment demand curve and a family of saving curves at different levels of income.
9. The S curve and the LM curve relate the two variables: (a) income and (b) the rate of
interest. ntersection point of these two curves is the equilibrium rate of interest.
nterest; Liquidity preference; The Demand for Money in a Two-Asset Economy; Money
Demand Curve; Determination of Rate of nterest: Equilibrium in the Money Market;
Effect of an ncrease in the Money Supply; Shifts in Money Demand or Liquidity
Preference Curve; S and LM curves
*A*ER 1
UNT-5 Business Cycles
5.0 Objectives
5.1 ntroduction
5.2 Characteristics of a Business Cycle
5.3 Phases of a Business Cycle
Det Us S7' U5
This chapter will be helpful in understanding:
1. Concept and characteristics of business cycle
2. Phases of a business cycle
The term "7siness %3%le (or e%ono'i% %3%le) refers to economy-wide fluctuations in
production or economic activity over several months or years. These fluctuations occur
around a long-term growth trend, and typically involve shifts over time between periods
of relatively rapid economic growth (expansion or boom), and periods of relative
stagnation or decline (contraction or recession).
Business cycle simply means the whole course of business activity which passes
through the phases of prosperity and depression. A business cycle is not a regular,
predictable, or repetitive phenomenon like the swing of the pendulum of a clock. ts
timing is random and, to a large degree, unpredictable.
The business cycles influence business decisions. The cycles affect not only the
economy in general, but each individual business firm.
1. A "7siness %3%le is s3n%hroni%. The upward and downward movements tend to
occur at almost the same period in all industries. The wave of prosperity or depression
in one industry will soon generate a wave in other industries.
!. A "7siness %3%le sho8s a 8a=eEli2e 'o=e'ent. The period of prosperity and
depression can be alternatively seen in a cycle.
(. C3%li%al fl7%t7ations are re%7rrin, in nat7re. The various phases are repeated. A
boom is followed by depression and the depression again is followed by boom.
.. There can be no indefinite depression or eternal boom period.
?. Business cycles are pervasive in their effects.
@. The up and down movements are not symmetrical. The downward movement is more
sudden and violent than the upward movement.
A business cycle is identified as a sequence of four phases, viz., recovery, boom,
recession and depression.
During the boom phase production capacity is fully utilized and also products fetch an
above-normal price which gives higher profit. This attracts more and more investors. To
manufacture more number of products entrepreneur purchases new machines and also
employees work at higher wage rate. The increasing cost tendency of the factors of
production leads to a continuous increase in product cost. The fixed income group or
the salaried class finds it difficult to cope with this increase in prices. As their income
does not increase accordingly, they are now compelled to reduce their consumption.
The demand is now more or less stagnant or it even decreases. Thus the boom or
prosperity reaches its peak.
Once economy reaches the peak the course changes. A downward tendency in
demand is observed. But the producers who are not aware of this trend go on
producing. The supply now exceeds demand. Now the producers come to notice that
their stocks are piling up. They are compelled to give up future investment plans. The
order for new equipments and raw materials are cancelled. A businessman even cuts
down his existing business. Workers are retrenched. Bankers insist on repayment,
stocks accumulate, business failure increases, investment ceases and unemployment
expands. Unemployment leads to fall in income, expenditure, prices, profits and
industrial and trade activities. Desire for liquidity increases all around. Producers are
compelled to reduce price so that they can find money to meet their obligations.
Consumers who expect a still further decline in prices postpone their consumption.
Stocks go on piling up. Some firms are forced into bankruptcy. The failure of one firm
affects other firms with whom it has business connections. There is general distress.
This phase of the business cycle is known as the crisis. t is the utmost suffering for a
Underemployment of both men and materials is a characteristic of this phase. General
demand falls faster than production. Producers are compelled to sell their goods at a
price which will not even cover the full cost. Manufacturers of both capital goods and
consumers' goods are forced to reduce the volume of production. As a consequence,
workers are thrown out. The remaining workers are poorly paid. The demand for bank
credit is at its lowest which results in idle funds. The interest rates also decline. The
firms that cannot pay off their debts are wound up. Prices of shares and securities fall
down. Pessimism prevails in the economy. The less-confident investors are not ready to
take up new investment projects. The aggregate economic activity is at its bottom.
Depression phase does not continue indefinitely. Depression contains in itself the germs
of recovery. The idle workers now come forward to work at low wages. As the prices are
at their lowest, the consumers, who postponed their consumption expecting a still
further fall in price, now start consuming. The banks, with accumulated cash reserves,
now come forward to give loans at easier terms and lower rates. As the demand
increases, the stocks of goods become insufficient. The economic activity now starts
picking up, investment picks up, and employment and output slowly and steadily begin
to rise. ncreased income leads to increase in demand, resulting in rise in prices, profits,
further investment, employment and incomes. The wave of recovery once initiated soon
begins to feed upon itself. Stock markets become alive thus hastening the revival.
Optimism develops among the entrepreneurs. Bank loans and demand for credit start
rising. The depression phase then gives way to recovery.
Che%2 )o7r *ro,ress
Ti%2 the Corre%t Ans8er:
97estion1.B7siness C3%le is also 2no8n as
The %hoi%es are:
(1) Entrepreneur cycle
(2) Economic cycle
(3) Vicious circle
(4) None of the poverty
Ri,ht Ans8er: #!$ E%ono'i% %3%le
97estion !. *i%2 o&& 'an o7t
The %hoi%es are:
(1) Boom
(2) Depression
(3) Slowdown
(4) Recovery
Ri,ht Ans8er: #($ Slo8&o8n
97estion. ( Un&ere'5lo3'ent of "oth 'en an& 'aterials is a %hara%teristi% of
8hi%h 5hase>
The %hoi%es are:
(1) Depression
(2) Boom
(3) Recovery
(4) Recession
Ri,ht Ans8er: #1$ De5ression
97estion .. ;hi%h 5hase of the "7siness %3%le s also 2no8n as the %risis>
The %hoi%es are:
(1) Boom
(2) Depression
(3) Recovery
(4) Recession
Ri,ht Ans8er: #.$ Re%ession
Let Us Sum Up
. Business cycle refers to economy-wide fluctuations in production or economic activity
over several months or years.
2. Business cycle simply means the whole course of business activity which passes
through the phases of prosperity and depression.
3. A business cycle is identified as a sequence of four phases, viz., recovery, boom,
recession and depression.
*A*ER 1

UNT 6- ndian Economy and Various Sectors of the
6.0 Objectives
6.1 ntroduction
6.2 Various Sectors of the Economy
6.3 Structural Changes in ndian Economy
Det Us S7' U5

This chapter gives an overview of:
1. ndian Economy
!. Various Sectors of the Economy
(. Structural Changes in ndian Economy
In&ian E%ono'3: A Brief O=er=ie8
n the first five decades of the twentieth century, till we got our independence in 1947,
the per capita GDP in ndia was stagnant. The trend growth in GDP during this period
was 0.9 per cent with population growing by about 0.8 per cent.
As compared with the near stagnant growth in the first half of the twentieth century, the
annual growth, averaging at around 3.5 per cent during the period 1950 to 1980, was
comparatively better.
The average growth rate of the ndian economy over a period of 25 years since 1980-81
was about 6.0 per cent a significant improvement over the annual growth rate of the
earlier three decades.
n the new millennium, the GDP growth rate has further accelerated averaging 7.2 per
cent during the seven-year period 2000-01 to 2007-08, with the growth rate in the last
five years (2003-04 to 2007-08) averaging 8.8 per cent. Over the years, while the GDP
growth has been accelerating, the population growth rate has moderated, giving a sharp
impetus to the growth in per capita income.
The strengthening of economic activity in the recent years has been supported by a
sustained increase in the gross domestic investment rates from 22.8 per cent of GDP in
2001-02 to 35.9 per cent in 2006-07. t may also be noted that over 95 per cent of the
investment during this period was financed by domestic savings.
Since independence, the inflation rate, in terms of the wholesale price index (WP), on
average basis, was above 15 per cent in only five out of fifty years and was in single-
digit for thirty-six of these years. On most occasions, high inflation was due to food or oil
shortages. The inflation rate accelerated steadily from an annual average of 1.7 per
cent during the 1950s to 6.4 per cent during the 1960s and further to 9.0 per cent in the
1970s before easing marginally to 8.0 per cent in the 1980s. The inflation rate declined
from an average of 11.0 per cent during 1990-95 to 5.3 per cent during the second-half
of 1990s. n recent years, inflation rate has averaged around 5 per cent.
An important characteristic of the recent growth phase of over a quarter century is the
country's resilience to shocks. During this period, we have witnessed only one serious
balance of payments crisis, triggered largely by the Gulf war in the early 1990s. The
ndian economy, in the later years, could successfully avoid any adverse contagion
impact of shocks from the East Asian crisis, the Russian crisis during 1997-98,
sanction-like-situation in post-Pokhran scenario, the border conflict during May-June
1999 and Sub-prime Crisis. Viewed in this context, this robust macroeconomic
performance, in the face of recent oil as well as food shocks, demonstrates the vibrancy
and resilience of the ndian economy.
t is necessary to note that, despite the recent encouraging performance, the ndian
economy faces several severe challenges. These relate, in particular, to poverty,
education, health, environment, physical infrastructure, and fiscal issues.
Agriculture is one of the most important sectors of ndian economy. Agriculture
(including allied activities) accounted for 17 per cent of the Gross Domestic Product
(GDP-at constant prices) in 2008-09 as compared to 21.7 per cent in 2003-04.
Notwithstanding the fact that the share of this sector in GDP has been declining over
the years, its role remains critical as it accounts for about 52per cent of the employment
in the country. Apart from being the provider of food and fodder, its importance also
stems from the raw materials that it provides to industry. The prosperity of the rural
economy is also closely linked to agriculture and allied activities.
One of the biggest success stories of independent ndia is the rapid strides made in the
field of agriculture. From a nation dependent on food imports to feed its population,
today ndia is not only self-sufficient in grain production but also has substantial food
reserves. Dependence of ndia on agricultural imports and the crises of food shortage
encountered in 1960s convinced planners that ndia's growing population, as well as
concerns about national independence, security, and political stability, required self-
sufficiency in food production. This perception led to a programme of agricultural
improvement called the Green Revolution. t involved bringing additional area under
cultivation, extension of irrigation facilities, the use of improved high-yielding variety of
seeds, better techniques evolved through agricultural research, water management and
plant protection through judicious use of fertilizers, pesticides and cropping practices. All
these measures had a salutary effect and the production of wheat and rice witnessed a
quantum leap.
However, there are still a host of issues that need to be addressed regarding ndian
agriculture. ndian agriculture is heavily dependent on monsoons. The monsoons play a
critical role in determining whether the harvest will be rich, average, or poor. The
structural weaknesses of the agriculture sector are reflected in the low level of public
investment, exhaustion of the yield potential of new high yielding varieties of wheat and
rice, unbalanced fertilizer use, low seeds replacement rate, an inadequate incentive
system and post-harvest value addition.
There is an urgent need for second green revolution in ndian agriculture. Following
steps need to be taken to achieve this objective:
1. Doubling the rate of growth of irrigated area;
2. Reclaiming degraded land and focusing on soil quality;
3. mproving water management, rain water harvesting and watershed development;
4. Bridging the knowledge gap through effective extension services;
5. Diversifying into high value outputs, fruits, vegetables, flowers, herbs and spices,
medicinal plants, bamboo, bio-diesel, but with adequate measures to ensure food
6. Providing easy access to credit at affordable rates.
ndustry accounts for 19 per cent of the GDP in 2008-09. About one-third of the
industrial labour force is engaged in simple household manufacturing only.
The different industry sectors of ndia witnessed astronomical growth over the last 19
years. This growth of the different industry sectors of ndia is attributed to the
Government of ndia's liberal economic policy. Previously, the ndian economy was of
closed type and the government enterprises controlled all ndian market. The post-1990
Government of ndia economic policy endorsed a complete different economic policy
and opened its market for foreign investments. This saw a lot of FD coming to ndia. As
a result, different industry sub-sector made huge progress, both technologically and
Central Statistical Organization (CSO) classifies the industrial sector into 3 segments:
Mining and Quarrying, Manufacturing and Electricity, Gas and Water Supply.
Mi%ro an& S'all Enter5rises #MBEs$
As per the data on micro and small enterprises (MSEs) in the Annual Report of Ministry
of Micro, Small and Medium Enterprises, 2006-07, the sector accounted for around 39
per cent of total industrial production, 34 per cent of the exports in the industrial sector
and around 35 per cent of total employment among units engaged in manufacturing and
services. The sector registered a robust annual average growth in value of output,
exports and employment at 16.8 per cent, 20.0 per cent and 4.4 per cent, respectively
during the expansionary phase of 2003-07, before showing signs of slowing down in
200708 particularly in respect of employment growth to 2.9 per cent.
The problems cited by MSE borrowers in obtaining access to bank finance are
insistence on collaterals/ guarantees, limited outreach of banks, rigid approaches, high
interest and other costs, complex documentation, lack of supporting business
development services and so on. From the banker's point of view, the critical factors
affecting credit delivery to this sector are low equity base, absence of marketing tie up,
diversion of funds, poor management and book keeping, higher NPAs, mounting of
receivables due to delay in payment of bills especially during downturn.
Measures to increase flow of credit leading to almost three fold increase in the credit to
this sector from public sector banks from Rs.67,600 crore as on March 31, 2005 to
Rupees 1,90,958 crore as on March 31, 2009.
The major policies in regard to credit delivery to this sector are as follows.
1. nclusion of MSE (as per revised definition) in priority sector with sub limits for the
micro units.
2. Stipulation that collateral should not be taken for loans up to Rs.5 lakh to MSE units.
3. Providing credit guarantee for collateral free loans from the Credit Guarantee Trust
Fund administered by SDB.
Micro, Small And Medium Enterprises Development (MSMED) Act, 2006
1. The MSMED Act, 2006 classifies enterprises broadly into two categories, viz., (1)
manufacturing enterprises; and (2) service enterprises. These broad categories are
further classified into micro enterprises, small enterprises and medium enterprises,
depending upon the level of investment in plant and machinery and equipment as the
case may be.
2. The existing provisions of the nterest on Delayed Payment Act, 1998 to small scale
and ancillary industrial undertakings have been strengthened under the MSMED Act.
3. The Act also provides for constitution of a National Board for Micro, Small and
Medium Enterprises under the chairmanship of the Union Minister for MSME, with wide
representation of stakeholders.
The Service Sector now accounts for about two third of ndia's GDP: 64 per cent in
2008-09. This sector has gained at the expense of both the agricultural and industrial
sectors through the 1990s. The rise in the service sector's share in GDP marks a
structural shift in the ndian economy and takes it closer to the fundamentals of a
developed economy (in the developed economies, the industrial and service sectors
contribute a major share in GDP while agriculture accounts for a relatively lower share).
Some economists caution that if the service sector bypasses the industrial sector,
economic growth can be distorted. According to them service sector growth must be
supported by proportionate growth of the industrial sector; otherwise the service sector
grown will not be sustainable. t is true that, in ndia, the service sector's contribution in
GDP has sharply risen and that of industry has fallen.
Phenomenal growth has been noticed in selected service sector segments like T/TES,
telecom, banking, insurance and real estate, and civil aviation.
The ndian economy has registered an impressive growth in recent times with GDP
recording an average of 7.2 per cent growth rate in the current decade from an average
growth of 5.7 per cent in the 11990s. A comparison with the earlier period since the
beginning of the last century brings out the extent of economic transformation far more
clearly (Table 6.1). During the first 50 years of the nineteenth century, the average GDP
growth rate has been just 0.7 per cent, which picked up to 3.5 per cent (popularly called
as 'Hindu rate of growth') in the three decades after independence, before progressing
to higher growth path in the recent decades. Concomitantly, the per capita income grew
from a mere 0.2 per cent in 1900-1950 and 1.1 per cent in 1951-1980 to 3.2 per cent in
the 1980s and 3.6 per cent in the 1990s and further to 5.4 per cent in the current
TABLE 6.1 Structural Changes in GDP (Growth Rate in
1951-80 1980s 1990s 2000-09
Agriculture & allied activities NA 2.1 4.4 3.2 2.8
ndustry NA 5.4 6.4 5.7 6.5
Services NA 4.5 6.3 7.1 9.0
GDP 0.7* 3.5 5.6 5.7 7.2
*Angus Maddision (2007): The World Economy, OECD. NA: Not Available
TABLE 6.2 Structural change in GDP (share in GDP)New series (Base:1999-2000)
1950-51 1960-61 1970-71 1980.81 1990.91 2008-09
Agriculture & allied
55 51 44 38 31 17
ndustry 11 13 15 17 20 19
Services 34 36 41 45 49 64
Transformation of the economy is quite apparent from the noticeable changes that have
occurred in the sectoral composition of output. The share of services in the national
income has steadily increased with corresponding fall in the contributions of agriculture
and industry over the years. Services sector now accounts for nearly two-third of total
output as against less than half in the early 1980s and the 1990s. Share of industry
declined marginally to 19 per cent from 20 per cent whereas share of agriculture
registered steep decline from 55 per cent to just 17 per cent (Table 6.2).
Che%2 )o7r *ro,ress
Ti%2 the Corre%t Ans8er.
97estion 1. The a=era,e ,ro8th rate of In&ian e%ono'3 o=er a 5erio& of !? 3ears
sin%e 1FC0EC18as a"o7t
The %hoi%es are:
(1) 3 to 4 per cent
(2) 6 per cent
(3) 9 per cent
Ri,ht Ans8er: #!$ @ 5er %ent
97estion !. ;hat se%tor is %alle& as *ri'ar3 Se%tor in In&ia>
The %hoi%es are:
(1) ndustrial Sector
(2) Service Sector
(3) External Sector
(4) Agricultural Sector
Ri,ht Ans8er: #.$ A,ri%7lt7ral Se%tor
97estion (. CSO %lassifies the In&7strial Se%tor in to ho8 'an3 se,'ents>
The %hoi%es are:
(1) Three
(2) Four
(3) Six
(4) Two
Ri,ht Ans8er: #1$ Three
97estion .. MSE 'eans
The Choi%es are:
(1) Medium and Small Enterprises
(2) Micro and Small Enterprises
(3) Medium State Enterprises
(4) None of the above.
Ri,ht Ans8er: #!$ Mi%ro an& S'all Enter5rises
97estion ?. Ser=i%e Se%tor is also %alle& as
The Choi%es are:
(1)Primary Sector
(2) Secondary Sector
(3) Tertiary Sector
(4) None of the above
Ri,ht Ans8er: #($ Tertiar3 Se%tor
97estion @. The share of ser=i%es in the national in%o'e fro' the last 10 3ears is
The %hoi%es are:
(1) decreasing
(2) Constant
(3) ncreasing
Ri,ht Ans8er: #($ In%reasin,
Det Us S7' U5
1. The ndian economy has registered an impressive growth in recent times with GDP
recording an average of 7.2 per cent growth rate in the current decade from an average
growth of 5.7 per cent in the nineties.
2. From a nation dependent on food imports to feed its population, ndia today is not
only self-sufficient in grain production but also has substantial food reserves.
3. ndian agriculture is heavily dependent on monsoons.
4. The different industry sectors of ndia witnessed astronomical growth over the last 19
years. This growth of the different industry sectors of ndia is attributed to the
Government of ndia's liberal economic policy.
5. CSO classifies the industrial sector into 3 segments: Mining and quarrying,
Manufacturing and Electricity, gas and construction.
6. The service sector now accounts for two third of ndia's GDP. Phenomenal growth
has been noticed in T/TES, telecom, banking, insurance and real estate, and civil
ndian Economy; Agriculture Sector; ndustrial Sector; Service Sector; MSEs ;Hindu
Rate; Structural Change in ndian Economy.
*A*ER 1
UNT 7- Economic Reforms
7.0 Objectives
7.1 ntroduction
7.2 Transformation
7.3 Economic Transformation Real Sector
7.4 Economic Transformation Financial Sector
7.5 Economic Transformation ntegration with the Global Economy
7.6 Do We Deserve Accolades?
7.7 ssues
7.8 Way Forward
Let s !um p
This chapter will be helpful in understanding:
1. How the economic reforms brought about transformation in different sectors of the
2. Economic transformation Real Sector
3. Economic transformation Financial Sector
4. Economic Transformation ntegration with the Global Economy
5. Financial nclusion
Structural reforms, during last two decades, have unambiguously altered the economic
landscape of the country. However, there are certain questions/concerns that have
always been a source of discomfort and have acquired a new relevance as economy
moved to a higher growth trajectory in recent years. For instance, how inclusive our
growth process is? Are we moving towards affording a decent standard of life to people
at large? How the reforms brought about transformation in different sectors of the
Transformation of the economy is quite apparent from the noticeable changes that have
occurred in the sectoral composition of output. The share of services in the national
income has steadily increased with corresponding fall in the contributions of agriculture
and industry over the years Services sector now accounts for nearly two third of total
output as against less than half in the early 1980s and the 1990s. Share of industry
declined marginally to 19 per cent from 20 per cent whereas share of agriculture
registered a steep decline from 38 per cent to just 17 per cent.
This positive performance seems to be an outcome of reforms encompassing a range of
measures that led to transformation spreading over all the sectors of economy.
Transformation brought in higher degree of sophistication and efficiency in operations of
almost all the sub-segments of real as well as financial sectors. Moreover, domestic
economy has become far more integrated with rest of the world which is visible not only
in terms of growing trade volumes; financial flows from and to the outside world have
also been steadily growing. There are some experts who argue that ndia's economic
transformation needs to be attributed to change in policy orientation of 1980s rather
than the reforms undertaken during 1990s. Although they do recognize the possibility
that improvement in 1980s might have run out of steam without further reforms
undertaken in the nineties. While academic debate as to what triggered the economic
transformation might still be unresolved; there is a near consensus with regard to the
important role of liberalization process initiated in the early nineties in placing the
economy on a higher growth path.
The economic reforms that ushered in 1991 put forward some important political
questions. The first question that comes to our mind is about the timing of the reforms,
i.e. why the reforms were started only in 1991 and why not earlier? How the process of
reforms continued despite changes in ruling party at the centre? How the direction of
reforms sustained and remained irreversible despite various hurdles and hiccups? The
answers to these questions, to a large extent, lie in the transformation in political
spectrum of the ndian electoral democracy. As one avid follower of ndia's economy
puts it, the greatest change has been in the positive attitude towards reforms
Besides brewing up of twin economic imbalances, i.e. fiscal crisis and external payment
crisis, the timing of reforms may have been the outcome of international and domestic
political events. nternationally, two major events questioned the basic premise of our
earlier social consensus regarding the development strategy. First was the collapse of
erstwhile USSR and the East European socialist regimes and their march towards
market oriented economic system. Second, the spectacular success of 'socialist market
economy' of China with the aggressive opening up since 1978 and its associated
success in poverty reduction raised concerns about the efficacy of ndia's inward
orientated strategy. Domestically, the appreciable growth performance of 1980s which
was induced by hesitant liberalization efforts strengthened the hands of pro-
liberalization minority in the bureaucracy and in the Government that has been
instrumental in systemic reforms in the 1990s.
The continuation of reform process and irreversibility of its direction could be explained
with three interlinked political developments. First is the emergence of regional parties
and their increasing holds in national politics. Second is the beginning of the era of
coalition Government at the centre. Third is the growing and widespread acceptance of
the need for rapid economic growth that can be achieved by the market-oriented
reforms. Besides, competing claims of various states on benefits of economic reforms
has also helped in sustaining the momentum of reform process in ndia.
During the reform period some states have performed well while others have been
lagging. This has been the effect of policy environment and the quality of governance at
the state level. Those states, which reorganized their policies in favour of market
oriented reforms in tune with national economic policy framework and provided hassle
free investment environment to entrepreneurs, have reaped more benefits of economic
reforms in terms of high growth and per capita income.
Let us now see how the reform process has brought about transformation in each of
sub-sectors of the economy.
Real Sector Policy measures mainly focused on the manufacturing sector in the early
stages of reform process. Deregulation of industry by way of eliminating licensing
requirement, overhauling of public enterprises, enhanced role for private sector,
abolition of M R T P Act, automatic approval route for foreign investment, elimination of
quantitative import restrictions and reduction in tariff rates crated a conducive
environment to gear up the industry to face growing domestic as well as external
competition to which it was exposed by the reform process. Another area where reforms
came about at a later stage related to de-reservation of large number of items that were
earlier meant to be produced exclusively in the small scale sector. Measures were
further supplemented with liberalization of foreign direct investment not only in terms of
scope and proportion of foreign ownership but also with regard to procedural details.
ndustry responded to reforms by undertaking massive restructuring of its operations by
upgrading their technologies, expanding to more efficient scales of production, resorting
to mergers and acquisitions both within and outside the country and refocusing their
activities to the core competence.
While manufacturing became more competitive and efficient, major impact occurred
with respect to services sector. Entry of private sector and foreign direct investment that
introduced competition and state of the art technology brought a sea change in the
services sector. For instance, there was a time when telephone was a luxury and
customers had to queue up for years to get a connection. Now it is available on
demand. Mobile phones have reached to the lowest rung of the society and have played
a key role in integrating the far flung areas to the mainstream. Synergies provided by
the manufacturing sector, liberalization of financial sector with entry of private sector in
areas hitherto restricted to public sector and policy initiatives with regard to information
technology led to surge in growth of services sector.
The boom in information technology ( T) and nformation Technology and Enabled
Services ( T E S) sector essentially led to an era of 'services-led growth' as ndia
emerged as global hub for B P O/K P O services in the world. This shift in the pattern of
off-shoring services to ndia was mainly due to inherent advantages of ndian T/ T E S
sector. Advantage of the low wage structure, flexibility due to time zone differences and
access to a larger and better talent pool provide globally active companies, ndia as an
ideal place, to look for off-shoring services. n the last two decades, the ndian T/ T E
S industry has contributed significantly to ndian economic growth in terms of GDP,
foreign exchange earnings and employment generation. ndian T/ T E S sector's
contribution to the country's GDP has been steadily increasing.
Socio-economic dimension, that lends uniqueness to ndia's pattern of growth and
economic transformation, is evident in the relative surge in the growth of industrial and
services sectors vis-a-vis primary segment. ndia seems to have skipped the stage of
development that emphasizes growth in labour intensive industries with absorption of
surplus labour from the agricultural sector. As transformation of industrial as well as
services sector has overwhelmingly been based on capital intensive techniques
requiring skilled manpower, relative shift in sectoral incomes have been devoid of any
commensurate relocation of surplus labour and more than three-fifth of population
continued to draw its livelihood from the primary sector.
While foregoing has been the reason for general perception about relative isolation of
the agricultural sector from the reform process; keeping with the growing openness, a
series of policy initiatives transformed this sector as well. Measures relating to free
movement of agricultural commodities, A P M C Act permitting farmers to bypass the
mandatory requirement of sale in regulated markets and relaxation of restrictions under
Essential Commodity Act, 1955 along with introduction of future trading brought major
change in the pricing mechanism. National commodity futures markets discover price
rather manipulation by local traders. Banks in association with professionally managed
godowns extend credit to farmers against warehouse receipts. Large consumer goods
companies directly source agricultural produce from the farmers. While, these
developments have worked towards improving the terms of trade (T O T) for the
agriculture sector, this trend in T O T was also strengthened by lowering of protection
for the manufacturing sector and market determined price of foreign exchange. With
economic growth and rising disposable incomes, the consumption basket has changed
significantly. Growing demand for milk, poultry products and horticulture products, has
induced substantial diversification towards allied activities which now account for nearly
three-fifth of total primary sector output.
Financial sector reforms have been carried out in accordance with the
recommendations made by basically three committees: (a) Narasimham committee
report on financial sector reforms (1992) (b) Narasimham committee report on banking
sector reforms (1998) and (c) S. H. Khan report of the working group for harmonizing
the role and operations of Development Financial nstitutions and banks Reforms in
financial sector complemented the real sector developments. Transformation of financial
sector not only assisted in sharp pick-up in services sector growth, it helped the
manufacturing sector to progress from a high cost to internationally competitive
segment of the economy. t was a clear recognition of the role of market forces in price
discovery process. Prior to these reforms, pricing of financial resources whether it is
bank lending to corporate or borrowings by the government or the foreign exchange,
each of these was determined broadly on the basis of regulator's decision or an
administrative fiat rather than its opportunity cost. Cost of resources hardly reflected the
underlying situation of a capital scarce economy. Along with free pricing, removal of
constraints in terms of participation, type of instruments, market infrastructure and policy
environment instilled life in severely underdeveloped financial market segments. While
measures were taken to bring financial markets at par with international best practices,
it was a conscious decision to go slow on derivative products, a stand amply vindicated
by the current global crisis and relative immunity of ndia's financial sector.
Mone3 Mar2et
Reforms in money market were essentially aimed at providing avenues for the market
players to deploy or access to short-term funds and a platform to the monetary authority
to modulate liquidity in the system. Liberalization measures in money market preceded
the overall reform process as steps related to deregulation of interest rates and
introduction of new instruments were initiated in the late 1980s itself. A series of steps
over the years, viz., freeing of interest rates on call and other money market
instruments, introduction of Commercial Paper and Certificate of Deposit, exemption of
inter-bank lending from reserve requirement, introduction of screen-based trading and
rupee derivatives such as nterest Rate Swaps ( R S) and Forward Rate Agreements
(FRA), enlarging the scope of Repo market by expanding the repo-able securities and
eligible participants in the repo market and introduction of tripartite repo, i.e.
Collateralized Borrowing and Lending obligation C B L O to create pure inter-bank call
money market, led to pick up in activity and volumes across the instruments unlike in
the past when volumes remained concentrated in call money market.
With steps towards making call market a pure inter-bank market, turnover progressively
switched from call money market to repo and C B L O market as daily average volumes
in call market got almost half in 2008-09 from Rupees 23,161 crore in 1999-2000.
Volumes in case of market repo, on the other hand, rose by two-fold during the period
and in case of C B L O increase has been four-fold during 2004-05 to 2008-09. Volumes
in other market segments such as C P and C D rose as well. Besides, reforms also lent
stability to the market as volatility in call market got reduced by nearly half in the current
decade from levels prevailing in the 1990s.
Io=ern'ent Se%7rities Mar2et
Till mid-1980s or the early 1990s, government had been borrowing at sub-market rates,
a system sustained by captive market created by statutory reserve requirement. As a
part of reforms, concessionary financing was eliminated with introduction of market
auction system and phasing out of automatic monetization with Ways and Means
Advances (W M A). As yields became market related and government started
competing with the private sector in the market for funds, it had the desired impact on
G-Sec market as evident by rising secondary market activity and near emergence of
market yield curve. The annual turnover in the market has grown from about Rupees
2.8 lakh crore in 1998-99 to Rupees 56.3 lakh crore in 2007-08. Yields on G-Sec now
provide benchmark for pricing of securities in other markets.
With reforms, G-Sec is no longer a captive market. nvestment in G-Sec by the banks is
based on their commercial judgement rather than being dictated by the reserve
requirement. Since late nineties, banks' holding of G-Sec have been far in excess of the
reserve requirement with ratio going up to near 42 per cent of net demand and time
mportantly, since April 2006, Reserve Bank of ndia does not participate in the primary
segment of the G-Sec market that not only provide leeway to R B in implementing
monetary policy, the pricing of Government securities has also become far more
market-oriented. Beside these core aspects, development of the market was sustained
by up-gradation of technology and market infrastructure with regard to settlement
systems and trading systems and amendment of legislative provisions.
+orei,n E6%han,e Mar2et
Prior to reforms, foreign exchange market was virtually absent. Exchange earners were
required to surrender/purchase foreign exchange from Reserve Bank at the reference
rate. n this highly regulated system, very few transactions used to take place among
the authorized dealers and trades were required to be squared off by the close of the
day. ntroduction of market-based exchange rate regime, adoption of current account
convertibility and relaxation on capital account, inter-alia, in terms of permission to run
open positions, to hold investments abroad and to retain foreign exchange along with
introduction of hedging tools (derivatives) led to emergence of active and vibrant foreign
exchange market. Now exchange rate is flexible and market determined; and capital
account is also effectively convertible for the nonresidents. t is interesting to note that
with significant liberalization on the capital account and given that market forces play a
predominant role in determining external value of the rupee, there has not been large
volatility in this market barring few mild episodes related to turbulence in global markets.
Ca5ital Mar2et
Like other market segments, there have been far-reaching changes in both the primary
and secondary market segments of capital market. Primary market witnessed a
significant movement away from Controller of Capital ssues (C C ) regime imposing
primary issuance at sub-market rates to free pricing and book-building system along
with mandatory disclosures as prescribed by S E R . n the secondary market,
corporatization of exchanges, screen-based trading replacing open outcry system,
introduction of options and futures replacing erstwhile Badla System, rolling settlement
replacing 14-day settlement cycle, dematting of securities with depository system
created state-of-the- art infrastructure comparable to best international practice. This not
only integrated stock markets across the country, capital market became far more
efficient as could be observed in terms of various parameters.
Cre&it Mar2et
Prior to reforms, banking operations both on the assets and liabilities side were
governed by the guidelines set out by the regulator. With guidelines that ensured banks'
margin on cost-plus basis, competition was virtually absent with no incentive to cut cost,
raise efficiency or upgrade credit assessment skills. While broad approach to reforms in
this market has been to bring more competition along with higher flexibility and
operational autonomy to the banks, stability of the players at the same time was
intended to be ensured by emphasizing building up of risk management capabilities and
introduction of prudential regulation and supervision in line with best international
practices. Moreover, widening of ownership due to stock market listing and associated
disclosure requirements brought greater market discipline and transparency in the bank
management. These measures transformed the banking sector which could be
discerned in measures of efficiency and soundness. There has been steady decline in
intermediation cost of banks from 6.24 per cent in 1991-92 to 3.43 per cent in 2006-07.
Data Envelopment Analysis (D E A) based estimates of efficiency and productivity
indicates sharp improvement in operations of public sector banks and is now
comparable to their counterparts in the private sector. Growing soundness of the
banking sector is also evident in falling N P As from 7.7 per cent in 1995-96 to about 1
per cent in 2006-07.
While banks' operations became more efficient, there has been considerable progress
in terms of business volumes reflecting growing economy and reach of the banking
sector. Over the past 11 years, on an average, deposits of scheduled commercial banks
have risen at a compound growth rate of 17.7 per cent and advances grew by 21 per
cent. Growth has been higher for urban and semi-urban branches compared to rural
branches. n terms of advances to various sectors of the economy banks' portfolio has
been quite diversified. Since 1998-99, while share of advances to agriculture sector
remained around 12 per cent, there has been progressive diversification from industrial
and wholesale credit to segments such as professionals, personal loans, etc.
*a3'ent S3ste's
The rapid developments in the Payment Systems and technology have led to the
deeper penetration in terms of increase in the number of direct and indirect participants
and market players in the payment systems. Among the major developments in recent
times, the enactment of the Payment and Settlement Systems Act, 2007 empowering
the Reserve Bank to regulate and supervise payment and settlement systems, lay down
policies and providing a legal basis for multilateral netting and settlement finality, is of
great significance. Another recent development has been to make free the use of other
bank ATMs with effect from 1 April 2009 (since changed). The service charges for
'Electronic Payment Products' and outstation cheque collection have also been
rationalized. 'Speed Clearing' has been introduced to reduce the time taken for
Realisation of outstation cheques to T+1 or T+2 basis. 'Cheque Truncation System (C T
S)' has been introduced in cheque clearing since July 2008 in New Delhi. The coverage
of Electronic Clearing System (E C S) has been increased to S centers and 89 banks
with 55,225 branches are participating in National Electronic Funds Transfer (N E F T)
n terms of payment systems growth, the Real Time Gross Settlement System (R T G
S) volume has gone up from a modest 17.67 lakh in 2005-06 to 133.6 lakh in 2008-09,
and the value has gone up from Rupees 1,15,40,836 crore to Rupees 3,22,79,881 crore
in the corresponding period. The retail Electronic Clearing volume has gone up from 8.3
crore in 2005-06 to 28.06 crore in 2008-09, and the value has gone up from Rupees
1,06,598 crore to Rupees 4,16,419 crore in the corresponding period. The M C R
Cheque Clearing volume has gone up from 101.59 crore in 2005-06 to 114.04 crore in
2008-09, and the value has gone up from Rupees 54, 01,429 crore to Rupees 58,
49,642 crore in the corresponding period. The spread of A T Ms has increased from
34,789 in March 2008 to 43,651 in March 2009 and the volume of A T M transactions
has increased from 17,797 lakh in 2007-08 to 23,530 lakh. These data suggest that the
payment systems in ndia are robust, sound and have been growing at a steady pace.
Another aspect of developments in ndia's economic arena that facilitated the process of
transformation by enabling rapid growth of services sector and change in character of
manufacturing sector in terms of efficiency and sophistication with considerable outward
orientation, relates to its growing integration with rest of the world. The most common
measure of country's integration with the global economy is its openness, i.e. its
participation to international trade and capital flows. n ndia, the share of merchandise
exports to GDP increased from 5.8 per cent in 1990-91 to 15.1 per cent in 2008-09, the
share of merchandise imports as percentage to GDP, on the other hand, increased from
8.8 per cent to 25.5 per cent during the same period. On the import side, ndia's
demand for primary products, viz., raw materials and energy has increased since
1990s, which may be linked to its rapid economic growth. n 2007, ndia was the 7th
largest oil importer of the world. While, ndia's merchandise trade has grown many folds
in the current decade, during 2008, ndia ranks 26th in the world with a share of 1.1 per
cent. However, in terms of commercial services exports, ndia ranks much higher at 9th
in the world with a share of 2.7 per cent. n terms of capital flows, ndia has emerged as
one of the most favoured destinations of global investment among the developing and
emerging market economies. Net capital inflows increased from US $ 7.1 billion in
1990-91 to $45.2 billion in 2006-07, and further to $108.0 billion during 2007-08. The
gross volume of capital inflows, however, amounted to $428.7 billion in 2007-08 as
against an outflow of $320.7 billion.
This growing integration of ndian economy with rest of the world was essentially an
outcome of reform measures triggered by balance of payments crisis in 1991. Apart
from a swift transition to a market determined exchange rate regime, other important
reforms measures included dismantling trade restrictions, moving towards current
account convertibility, liberal inflows of private capital, removal of restrictions on all
inflows and related outflows, as also, gradual liberalization of certain restrictions on
Tra&e Di"erali-ation
De-licensing of virtually all intermediate inputs and capital goods, progressive reduction
in tariff rates along with permission for all current business transactions, expenses for
education and medical and foreign travel enabled ndia to accept MF Article 8
obligation thereby making rupee convertible on current account as early as in 1994.
Further liberalization with regard to import licensing for consumer goods and reduction
of tariff rate below 10 per cent (barring few exceptions, such as automobiles)
considerably enhanced the outward orientation of ndian economy.
Ca5ital A%%o7nt
Although the external payment crisis of 1991 brought to the fore the need for debt-
dominated capital account financing, the move towards full capital account liberalization
has been calibrated with extreme caution. The broad approach that characterized the
policy framework for capital inflows involved supplementing debt capital with non-debt
capital with a clear prioritization in favour of the latter.
+orei,n Dire%t In=est'ent
The major policy thrust towards attracting foreign direct investment (F D ) began in the
early 1990s by introduction of automatic approval route that empowered R B to
approve equity investment up to 51 per cent in select 34 priority industries. Currently,
unless there is specific restriction contained in F D policy, 100 per cent foreign
investment is permitted under automatic route. A very limited number of activities fall
under this category, viz., retail trading, atomic energy, lottery business, gambling and
betting. Again, the list for F D cap below 100 per cent is also quite short including
broadcasting, print media, defence, insurance, asset reconstruction, investment
companies, petroleum and air transport.
*ortfolio In=est'ent
Portfolio investment both in primary and secondary market by Foreign nstitutional
nvestor (F ) was opened up in 1992. At the same time, ndian companies were
permitted to raise equity finance through issue of G D R and A D R in Europe and
American markets. Policy with regard to F investment was progressively liberalized
with total F share in equity being raised from 24 per cent to total sectoral cap on
foreign investment. For majority of sectors this cap is 100 per cent. Besides, F are
permitted to invest in debt instruments issued by both private corporate and the
Government, and they can operate in forward market to hedge their currency risks
E6ternal Co''er%ial Borro8in,s #E C B$
Permission to access E C B further contributed to integration of ndia's financial sector
with rest of the world with corporate increasingly compared the cost of financing and
switched between E C B and the domestic bank credit. n the recent years, corporate
have increasingly accessed commercial borrowings from abroad with net inflow on
account of E C B rising from U S $5 billion in 2004-05 to more than U S $22 billion in
2007-08. However, the policies towards E C B that, inter alia, include bank loans,
buyers' credit, suppliers' credit have been guided by the overall consideration of prudent
external debt management by keeping the maturities long, cost low and priority for
projects in the infrastructure and core sectors.
O7t8ar& +lo8s
n line with liberalized regime with regard to inflows, outward capital flows were also
progressively relaxed for both individuals and the corporate sector. Firms can invest
abroad up to their net worth plus E E F C holdings and also the foreign exchange raised
through A D R/G D R. This has been a key policy feature that enabled emergence of
ndian MNCs in the recent years.
Structural transformation of almost all the segments of the economy during past two
decades has brought discernible improvement in terms of efficiency, competitiveness
and productivity. This reflects in economy moving over to higher growth trajectory with
far greater integration with the rest of the world in terms of diversification of goods and
services as well as destinations to which exports are being made. Of course, we take
pride in these achievements and we together deserve it. But, there are enough reasons
that we must not get complacent with regard to transformation process. We need to ask
ourselves a few relevant questions. How far the benefits of economic progress have
percolated down? Whether standard of living of the population has uniformly improved?
Can we say economic transformation has brought prosperity to public at large and could
we make dent in poverty?
n terms of incidence of poverty measured on the basis of consumption expenditure,
there is a definite improvement over the years, both in rural and urban areas. There is
about 7 to 8 percentage points decline in poverty ratio in 2004-05 over 1993-94 and
improvement being more predominant in the rural areas. While these numbers seem to
suggest satisfactory improvement, divergence in income distribution has worsened
further since the early nineties. Gini Coefficient, a standard measure of
income/expenditure inequality, has further deteriorated from 32.9 per cent in 1993 to
36.2 per cent in 2004. Per capita spending in absolute terms would suggest that there is
lot more to be done to fend off hunger and malnutrition. As per N S S 61st round, per
capita consumption expenditure of more than 60 per cent population was less than
Rupees 20 per day in 2004-05.
So%ioEE%ono'i% De=elo5'ent
Human Development ndex (H D ), a widely used indicator of socio-economic
conditions has placed ndia at 132 out of 179 countries in the world in the year 2006
deterioration from a relatively better ranking of 121 in the year 1990. However, in terms
of pure index, ndia's position did improve from 28 in 1990 to 61 in 2006, which implies
countries in the world have grown and improved their lot much faster than ndia. This
slip in ranking is broadly reflective of poor performance in terms of health and education
services as shown by their respective individual rankings.
Since a transition from high mortality to a state where people generally lead a long and
ailment-free life is a desirable social goal, ndia's policies have been focused on this
aspect since beginning and there has been significant improvement over the years in
terms of various demographic indicators such as life expectancy, infant and child
mortality and maternal mortality rates. However, in terms of international comparison.
ndia slipped further in terms of ranking and continues to lag behind otherwise
comparable countries in the world.
Resources devoted to health services are much lower in ndia compared to other
countries, even if both public and private sector expenditure is taken into account. Per
capita expenditure on health services in ndia in 2006 has been lowest among select
countries just half of that spent by Sri Lanka and a bit lower than that spent by
While poor infrastructure is reflective of a small share of G D P devoted to health
services, perhaps efforts need to be made in terms of public-private partnership and
appropriate supervision of these services particularly in the public sector. To quote
Report of the National Commission on Macroeconomics and Health (2005), 'The
existing system of primary health care has collapsed in several parts of the country, for
reasons other than under funding.'
ndian Constitution had set the goal of free education for all children aged up to 14
years by 1960 and recently 86'h constitutional amendment has made free and
compulsory education to all children of 6 to 14 years of age a fundamental right. Given
the enormity of task, Government envisaged to shoulder primary responsibility for
provision of elementary education. Overall there is improvement as discernible from
gross enrolment ratio, but as per one survey conducted in 2006, 8.9 per cent of children
of age 6-14 years in rural areas still remain out of school. Although in terms of public
spending on education, there has been some marginal improvement from 3.6 per cent
of G D P in 1993 to 4.1 per cent of G D P in 2002, reasons for poor outcome lies in sub-
optimum performance of Government sector. Teacher absenteeism and achievement
level (test score) are worse than low-end private schools. As per one estimate made in
2006, overall teacher absenteeism has been at 25 per cent in ndia, compared with 16
per cent in Bangladesh and 29 per cent in Uganda. Apart from these, quality of
education is another area of major concern. As revealed by a recent survey assessing
quality of education, less than 9% of student in First and Second grade could read their
respective text books. Nearly half of the 51h grade students are unable to read level 2
texts. mproving quality of education and skill formation is important, if we want to
encash demographic dividend and retain our edge in services sector.
B.C ;a3 +or8ar&
Our discussion of process of transformation, its achievements as well as failures do
throw up some issues which need to be addressed to ensure that economic progress is
sustainable and it is percolating downwards for the benefit of the masses. More thrust
on inclusive growth and redistribute justice with emphasis on the deprived society will
have to be pursued. Without proper distribution of economic wealth, economic
liberalization remains meaningless.
A,ri%7lt7ral In=est'ent
While structural transformation from agriculture to services-led growth is a positive
feature, corresponding movement in terms of population dependent on respective
sectors has not occurred. The share of agriculture in total income has dropped to 17 per
cent; still more than 60 per cent of population continues to draw its livelihood from this
sector. This workforce also accounts for sizeable proportion of poor in the country.
There is an urgent need to enhance investment in this sector not only to raise crop
productivity, but also to create employment opportunities outside the farming. There is a
need to effectively integrate rural sector with urban economy by creating needed
infrastructure, viz., roads in rural areas; electricity; major and minor irrigation projects;
and cold-storage chains to provide farm producers access to urban markets. Besides,
there is also a requirement felt for bringing legal reforms with regard to tenancy rights
that would give a boost to contract farming and higher productivity in farming activity
particularly when individual farm size is rapidly dwindling.
Da"o7r Refor's
The topic of Labour Laws Reforms in ndia has always been a matter of debate. The
issue here is not to argue whether the ndian labour laws are rigid or liberal, but to find
out whether the existing laws are helping in bringing market efficiency and productivity.
We have to analyse whether the present laws are encouraging and promoting the
growth of the entrepreneurs, creating a positive investment environment and
opportunities. There is a need to ensure relativity in the rights of management and
workers to promote healthy milieu for growth and progress. A liberal exit policy can only
coexist with generous unemployment, retraining benefits and severance pay. One may
also need to examine and rationalize some extant labour regulations and provisions.
For instance, let us see the pension laws where the workers get the right of pension
only after having devoted a minimum numbers of years in the job which in fact restrain
them from availing the best opportunities in the market.
The disparity between the organized and the unorganized sectors in terms of working
condition and protection of employees' rights also needs to be bridged. There is a need
to enhance protection of workers in the unorganized sector with provision of insurance,
pension schemes, medical facility and vocational training. n recent times, it has been
witnessed that those countries, especially the emerging market economies where the
labour laws have been rationalized and more awareness has been created in the
unorganized sectors, have achieved higher growth rate of economic development. f we
are able to address these issues successfully, we will be deriving manifold benefits of
the economic development.
De'o,ra5hi% Di=i&en&
Besides technology, a key factor that has immensely added to ndia's economic
potential is its demographic advantage popularly called as 'demographic dividend'.
Share of the working age group (15-64) in the population has been increasing since the
1980s and has been projected to be in the range of 62 to 68 per cent during first quarter
of current century. However, for these demographic changes to provide upward push to
economic growth, it needs to be accompanied by process of skill formation and
employment opportunities. This would require larger investment in human capital
formation and encouragement to entrepreneurial activities by creating conducing
environment. Current performance of the education sector particularly in terms of quality
leaves much scope for improvement.
+inan%ial In%l7sion
While financial sector has performed appreciably in the past two decades with gains in
terms of efficiency and productivity, it has grown many folds in terms of volumes and
thereby supporting overall growth in the economy. However, it is increasingly being felt
that benefits of growth have not percolated down to the underprivileged sections. While
a number of steps have been taken to achieve inclusive growth through various
Financial nclusion initiatives, these are constrained by several factors. High operating
cost in remote areas, small ticket size, lack of collaterals and illiteracy have obstructed
the steps towards financial inclusion. Today, availability of banking technology has
brought the realization that poor are bankable with good business prospects and hence
our efforts should be in the direction of using technology in such a fashion to make the
transaction cost cheaper and affordable for the poor. The recent initiatives taken by the
RB and banks to promote financial inclusion are laudable though much has to be
accomplished in the years to come.
Che%2 )o7r *ro,ress.
Ti%2 the Corre%t Ans8er.
97estion 1. Refor's 8ere starte& in
The %hoi%es are:
(1) 1981
(2) 1991
(3) 1971
(4) 1995
Ri,ht Ans8er: #!$ 1FF1
97estion !. T8in e%ono'i% i'"alan%es e6iste& &7rin, 1FF0
The %hoi%es are:
(1) Fiscal crisis and external payment crisis
(2) Fiscal and monetary crisis
(3) Monetary and external payment crisis
(4) None of the above
Ri,ht Ans8er: #1$ fis%al %risis an& e6ternal 5a3'ent %risis
97estion(. Real Se%tor *oli%3 'eans fo%7s on 6 6 6 in the earl3 sta,es of refor'
The %hoi%es are:
(1) Mining and quarrying
(2) Electricity
(3) Manufacturing sector
(4) None of the above
Ri,ht Ans8er: #($ Man7fa%t7rin, se%tor
97estion.. E65an& I T E S.
The %hoi%es are:
(1) nformation Technology and Electronic Services
(2) nformation Technology and Enabled Services
(3) nformation Technology and Efficient Services
(4) None of the above
Ri,ht Ans8er: #!$ Infor'ation Te%hnolo,3 an& Ena"le& Ser=i%es.
97estion ?. E65an& ; M A
(1) Wealth and Means Advances
(2) Wealth and Monetary Advances
(3) Ways and Monetary Advances
(4) Ways and Means Advances.
Ri,ht Ans8er: #.$ ;a3s an& Means A&=an%es.
97estion@. E1*AND N E + T.
The %hoi%es are:
(1) Nominal Electronic Funds Transfer
(2) National Electronic Funds Transfer
(3) National Electronic Funds Transformation
(4) None of the above
Ri,ht Ans8er: #!$ National Ele%troni% +7n&s Transfer
Det 7s S7' U5
To sum up, the reform process that began economic transformation since the early
1990s has been based on a broad political and intellectual consensus in the country
that explains as to why there has never been any policy reversal since then. At times we
have been accused to be slow in taking up reforms in certain sectors, but our stance
with regard to pace and timing of reforms have been vindicated by our ability to ward off
each of the crises that occurred in the global economy.
Transformation of the economy, which is discernible in the form of improved
competitiveness, efficiency and productivity across all the sectors, has led the economy
to a higher growth trajectory. Consequent shift in relative contribution of various sectors
to national income, however, brought to fore the concerns for sustainability of the
transformation process and the need for an 'inclusive growth'. This would require
greater focus towards investment in the sectors namely, agriculture and allied activities,
small and micro enterprises, and infrastructure. The use of technology to make
available 'affordable' financial and banking services to the underprivileged sections of
our society for achieving inclusive growth is also our noble but critical objective. Finally,
economic transformation is an ongoing process that needs to be pursued with
perseverance and consensus while keeping in view their aptness to the domestic
economy. Let us hope that this process continues and gains pace in the coming years.
Structural reforms; Economic transformationReal Sector; Economic Transformation
Financial Sector; Money Market; Government Securities Market; Foreign Exchange
Market; Capital Market; Credit Market; Economic Transformation - ntegration with the
Global Economy; Trade Liberalization; Capital Account; Foreign Direct nvestment;
Portfolio nvestment; ECB; Financial nclusion.
UNT 8 Monetary Policy and Fiscal Policy
8.0 Objectives
8.1 ntroduction
8.2 Tools of Monetary Policy
8.3 How did Monetary Policy in ndia Respond to the Global Financial Crisis
8.4 Fiscal Policy
8.5 F R B M Act
Let Us Sum 75
This chapter will be helpful in understanding:
1. Concept of Monetary Policy
2. Tools of Monetary Policy
3. Fiscal Policy, F R B M Act
Monetary Policy is the process by which the government, central bank or monetary
authority of a country controls: (1) the supply of money, (2) availability of money and (3)
cost of money or rate of interest, in order to attain a set of objectives oriented towards
the growth and stability of the economy. Monetary theory provides insight into how to
craft optimal monetary policy.
Monetary policy is referred to as either being an expansionary policy, or a
contractionary policy, where an expansionary policy increases the total supply of money
in the economy, and a contractionary policy decreases the total money supply.
Expansionary policy is traditionally used to combat unemployment in a recession by
lowering interest rates, while contractionary policy involves raising interest rates in order
to combat inflation. Monetary policy is contrasted with fiscal policy, which refers to
government borrowing, spending and taxation.
Ban2 Rate
Bank rate, also referred to as the discount rate, is the rate of interest which a central
bank charges on the loans and advances that it extends to commercial banks and other
financial intermediaries. Changes in the bank rate are often used by central banks to
control the money supply. However, the role of the bank rate as an instrument of
monetary policy has been very limited in ndia because of these basic factors:
(a) The structure of interest rates is administered by RB they are not automatically
linked to the bank rate;
(b) Commercial banks enjoy specific refinance facilities, and not necessarily rediscount
their eligible securities with RB at bank rate; and
(c) The bill market is under-developed and the different sub-markets of the money
market are not influenced by the bank rate.
Cash Reser=e Ratio #C R R$
The present banking system is called a "fractional reserve banking system", as the
banks are required to keep only a fraction of their deposit liabilities in the form of liquid
cash with the central bank for ensuring safety and liquidity of deposits. The Cash
Reserve Ratio refers to this liquid cash that banks have to maintain with the Reserve
Bank of ndia (R B ) as a certain percentage of their net demand and time liabilities.
For example if the C R R is 10%, then a bank with net demand and time deposits of
Rupees 1,00,000 will have to deposit Rupees 10,000 with the RB as liquid cash.
Go8 is C R R 7se& as a Tool of Cre&it Control>
CRR was introduced in 1950 primarily as a measure to ensure safety and liquidity of
bank deposits, however over the years it has become an important and effective tool for
directly regulating the lending capacity of banks and controlling the money supply in the
economy. When the RB feels that the money supply is increasing and causing an
upward pressure on inflation, the RB has the option of increasing the CRR thereby
reducing the deposits available with banks to make loans and hence reducing the
money supply and inflation.
Stat7tor3 DiJ7i&it3 Ratio #S D R$
Statutory Liquidity Ratio refers to the amount that all banks require maintaining in cash
or in the form of Gold or approved securities. Here, by approved securities we mean
dated securities, government bonds and shares of different companies.
This Statutory Liquidity Ratio is determined as percentage of total demand and time
liabilities. Time Liabilities refer to the liabilities, which the commercial banks are liable to
pay to the customers on their anytime demand. The liabilities that the banks are liable to
pay within one month's time, due to completion of maturity period, are also considered
as time liabilities.
n ndia, Reserve Bank of ndia always determines the percentage of Statutory Liquidity
Ratio. There are some statutory requirements for temporarily placing the money in
Government Bonds. Following this requirement, Reserve Bank of ndia fixes the level of
Statutory Liquidity Ratio. At present, the minimum limit of Statutory Liquidity Ratio that is
set by the Reserve Bank is 25 per cent.
There are some reasons behind introducing Statutory Liquidity Ratio. The main
objectives for maintaining the Statutory Liquidity Ratio are the following:
1. Statutory Liquidity Ratio is maintained in order to control the expansion of Bank
Credit. By changing the level of Statutory Liquidity Ratio, Reserve bank of ndia can
increase or decrease bank credit expansion.
2. Statutory Liquidity Ratio, in a way ensures, the solvency of commercial banks.
3. By determining Statutory Liquidity Ratio, Reserve Bank of ndia, in a way, compels
the commercial banks to invest in government securities like government bonds.
Mar2et Sta"ili-ation S%he'e #M S S$
To understand this we need to take a look at the year 2004 when F s (Foreign
nstitutional nvestors) started bringing in dollars to buy ndian stocks. This has resulted
in an oversupply of US dollars in the ndian market. R B bought dollars, thus creating
an equivalent amount of rupees.
As a response to the large-scale capital inflows and the consequent problems faced in
managing liquidity, the Reserve Bank introduced the Market Stabilization Scheme after
consulting the Government of ndia for mopping up liquidity of a more enduring nature in
March 2004. Under this scheme, the government would issue existing instruments, such
as, Treasury Bills and/or dated securities by way of auctions under the M S S, in
addition to the normal borrowing requirements, for absorbing liquidity from the system.
The intention of M S S is essentially to differentiate the liquidity absorption of a more
enduring nature by way of sterilization from the day-to-day normal liquidity management
operations. n order to provide transparency and stability to the financial markets, an
indicative schedule for issuance of Treasury Bills/dated securities on a quarterly basis is
being announced.
Re5o Rate
Repo (Repurchase) rate is the rate at which the R B lends shot-term money to the
banks. When the repo rate increases borrowing from RB becomes more expensive.
Therefore, we can say that in case, RB wants to make it more expensive for the banks
to borrow money, it increases the repo rate; similarly, if it wants to make it cheaper for
banks to borrow money, it reduces the repo rate. Bank lending rates are determined by
the movement of Repo Rate.
Re=erse Re5o
Reverse Repo rate is the rate at which banks park their short-term excess liquidity with
the RB. The RB uses this tool when it feels there is too much money floating in the
banking system. An increase in the reverse repo rate means that the RB will borrow
money from the banks at a higher rate of interest. As a result, banks would prefer to
keep their money with the RB.
Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected in
to the banking system by RB, whereas Reverse repo rate signifies the rate at which the
central bank absorbs excess liquidity from the banks.
O5en Mar2et O5erations #O M O$
Under the OMO, the RB buys or sells government bonds in the secondary market. By
absorbing bonds, it drives up bond yields and injects money into the market. When it
sells bonds, it does so to suck money out of the system.
As the crisis intensified, the Reserve Bank of ndia, like most central banks, took a
number of conventional and unconventional measures to augment domestic and foreign
exchange liquidity, and sharply reduced the policy rates. n a span of seven months
between October 2008 and April 2009, there was unprecedented policy activism. For
example: (1) the repo rate was reduced by 425 basis points to 4.75 per cent, (2) the
reverse repo rate was reduced by 275 basis points to 3.25 per cent, (3) the cash
reserve ratio (C R R) was reduced by a 400 basis points to 5.0 per cent, and (4) the
actual/potential provision of primary liquidity was of the order of Rupees 5.6 trillion (10.5
per cent of G D P).
There are, however, some key differences between the actions taken by the Reserve
Bank of ndia and the central banks in many advanced countries:
1. First, in the process of liquidity injection, the counter-parties involved were banks;
even liquidity measures for mutual funds, NBFCs and housing finance companies were
largely channeled through the banks.
2. Second, there was no dilution of collateral standards which were largely government
securities, unlike the mortgage securities and commercial papers in the advanced
3. Third, despite large liquidity injection, the Reserve Bank's balance sheet did not show
unusual increase, unlike global trend, because of release of earlier sterilized liquidity.
4. Fourth, availability and deployment of multiple instruments facilitated better
sequencing of monetary and liquidity measures.
5. Finally, the experience in the use of procyclical provisioning norms and counter-
cyclical regulations ahead of the global crisis helped enhance financial stability.
By synchronizing the liquidity management operations with those of exchange rate
management and non-disruptive internal debt management operations, the Reserve
Bank of ndia ensured that appropriate level of liquidity was maintained in the system,
consistent with the objective of price and financial stability. The policy stance clearly
reflected the forward-looking undertone, particularly the expectations of more prolonged
adverse external conditions in the face of no visible risks to inflation. While the
magnitude of the crisis was global in nature, the policy responses were adapted to
domestic growth, inflation and financial sector conditions.
R B IS Monetar3 *oli%3 Ai's to a%hie=e the +ollo8in, O"Ae%ti=es:
1. Monitor the 'global' and 'domestic' economic conditions and respond swiftly as
2. Ensure higher bank credit expansion to achieve higher growth but at the same time
protect the credit quality.
3. Maintain price stability and financial stability.
4. Give thrust on nterest Rate Management, nflation Management and Liquidity
n Economics, fiscal policy is the use of government spending and revenue collection to
influence the economy.
Fiscal policy can be contrasted with the other main type of economic policy, monetary
policy, which attempts to stabilize the economy by controlling interest rates and supply
of money. The two main instruments of fiscal policy are government spending and
taxation. Changes in the level and composition of taxation and government spending
can have impact on the following variables in the economy:
1. Aggregate demand and the level of economic activity;
2. The pattern of resource allocation;
3. The distribution of income.
Fiscal policy refers to the overall effect of the budget outcome on economic activity.
Governments use fiscal policy to influence the level of aggregate demand in the
economy, in an effort to achieve economic objectives of price stability, full employment,
and economic growth.
C.? + R B M ACT<
The history of the Fiscal Responsibility and Budget Management Act may be
summarised as follows. A committee headed by Dr. E. A. S. Sarnia was set up in
January 2000 to recommend draft legislation on fiscal responsibility. This report was
submitted in July 2000. The bill was introduced in Parliament in December 2000, and
enacted as law in August 2003, after a period of extensive discussion and analysis.
;hat the A%t ReJ7ires
The F R B M Act has four main requirements. First, it requires the Government to place
before Parliament three statements each year along with the Budget, covering Medium
Term Fiscal Policy, Fiscal Policy Strategy and Macroeconomic Framework. The content
is prescribed in the Act and the format in the Rules.
Second, the Act lays down fiscal management principles, making it incumbent on the
Centre to 'reduce the fiscal deficit' (no target is mentioned in the Act, but the Rules
prescribe 3 per cent of GDP) and, more categorically, to 'eliminate revenue deficit' by 31
March 2008.
t requires the government to set a ceiling on guarantees (the Rules prescribe 0.5 per
cent of G D P). The Act provides that the ceilings may be exceeded on grounds of
"national security or national calamity or such other exceptional grounds as the Central
Government may specify."
Third, in its most stringent provision, the Act prohibits the Centre from borrowing from
the Reserve Bank of ndia that is, it bans 'deficit financing' through money creation.
The R B is also barred from subscribing to primary issues of Central Government
securities. Temporary Ways and Means advances to tide over cash flow problems are
permitted. This provision will not apply till April 2006. Exceptions are also allowed
whenever the Government declares an exceptional situation, as mentioned earlier.
Fourth, the Finance Minister is required to keep Parliament informed through quarterly
reviews on the implementation, and to take corrective measures if the reviews show
deviations. The Act provides that no deviation shall be permissible 'without the approval
of Parliament'.
The main theme of F R B M Act is to reduce the dependence of the Government on
borrowings and help to reduce the fiscal deficit in a phased manner.
Che%2 )o7r *ro,ress
Ti%2 the Corre%t Ans8er
97estion 1. Ban2 rate is also referre& to as
The %hoi%es are:
(1) Discount rate
(2) Subsidy rate
(3) Marginal rate
(4) None of the above
Ri,ht Ans8er: #1$ Dis%o7nt rate
97estion !. E65an& C R R
The %hoi%es are:
(1) Credit Reference Rate
(2) Credit Reserve Ratio
(3) Cash Reserve Ratio
(4) Cash Reserve Rate
Ri,ht Ans8er: #($ Cash Reser=e Ratio
97estion(. E65an& S D R
(1) Statutory Leverage Ratio
(2) Statutory Liquidity Ratio
(3) Statutory Liquidity Rate
(4) Static Liquidity Ratio
Ri,ht Ans8er: #!$ Stat7tor3 DiJ7i&it3 Ratio
97estion.. E65an& O M O
(1) Open Market Operations
(2) Open Market Organization
(3) Open Monetary Operations
(4) None of the above
Ri,ht Ans8er: #1$ O5en Mar2et O5erations
97estion?. E65an& + R B M A%t
The %hoi%es are:
(1) Fiscal Responsibility and Business Management Act
(2) Fiscal Role and Budget Management Act
(3) Fiscal Role and Business Management Act
(4) Fiscal Responsibility and Budget Management Act
Ri,ht Ans8er: #.$ +is%al Res5onsi"ilit3 an& B7&,et Mana,e'ent A%t
97estion @. + R B M A%t ena%te& in
The %hoi%es are:
(1) 2001
(2) 2003
(3) 2004
(4) 2000
Ri,ht Ans8er: #!$ !00(
Det Us S7' U5
1. Monetary policy is the process by which the government, central bank or monetary
authority of a country controls: (i) the supply of money, (ii) availability of money and (iii)
cost of money or rate of interest, in order to attain a set of objectives oriented towards
the growth and stability of the economy.
2. Tools of Monetary Policy- Bank rate is the rate of interest which a central bank
charges on the loans and advances that it extends to commercial banks and other
financial intermediaries. Cash Reserve Ratio (C R R) refers to the liquid cash that banks
have to maintain with the Reserve Bank of ndia (R B ) as a certain percentage of their
net demand and time liabilities.
4. Statutory Liquidity Ratio or S L R refers to the amount that all banks require
maintaining in cash or in the form of Gold or approved securities.
5. Repo (Repurchase) rate is the rate at which the R B lends shot-term money to the
banks. Reverse Repo rate is the rate at which banks park their short-term excess
liquidity with the R B .
6. Under the O M O, the RB buys or sells government bonds in the secondary market.
7. n Economics, fiscal policy is the use of government spending and revenue collection
to influence the economy.
Monetary policy; Expansionary policy; Contractionary policy; Tools of Monetary Policy
Bank Rate; Cash Reserve Ratio; Statutory Liquidity Ratio; Repo (Repurchase) rate;
Reverse Repo rate; O M O; Fiscal Policy; F R B M act.
*A*ER 1
UNIT F EID* Con%e5ts
9.0 Objectives
9.1 ntroduction
9.2 Computation
9.3 Utility
Det Us S7' U5
This chapter will be helpful in understanding:
(1) GDP Concepts
(2) Methods of computing G D P
(3) Utility
I D * Con%e5ts
!ross "omestic #roduct $! " #%: t is the total market value of all the final goods and
services produced within the territorial boundary of a country, using domestic resources,
during a given period of time, usually one year.
!ross &ational 'ncome $! & '% at Market #rices is equal to G D P at market prices
plus taxes less subsidies on production and imports (Net receivable from abroad) plus
Compensation of Employees (Net receivable from abroad) plus property income ( Net
receivable from abroad)
Gross National Product (G N P) is equal to G D P plus total capital gains from overseas
investment minus income earned by foreign nationals domestically.
G N P is equal to G D P plus N R (Net income from assets abroad (Net ncome
According to the National ncome Accounting, there are three ways to compute G D P:
() *+penditure ,ise: Calculating the total expenditure of all the entities.
-) 'ncome wise: Calculating the total incomes received by factors of production minus
land, labour, capital and entrepreneur.
.) #roduct wise: Calculating the total production.
1. E65en&it7re Metho&
G D P is equal to consumption plus Gross investment plus Government spending plus
(Exports minus mports) and the formula is: G D P is equal to C plus plus G plus (X
minus M).
/onsumption: This includes personal expenditures pertaining to food, households,
medical expenses, rent, etc.
!ross 'nvestments: Business investment as capital which includes construction of a
new mine, purchase of machinery and equipment for a factory, purchase of software,
expenditure on new houses, buying goods and services, but, investments on financial
products is not included as it falls under savings.
!ross spending: t is the sum of government expenditures on final goods and services.
t includes salaries of public servants, purchase of weapons for the military, and any
investment expenditure by a government. t does not include any transfer payments,
such as social security or unemployment benefits.
*+ports: This includes all goods and services produced for overseas consumption.
'mports: This includes any goods or services imported for consumption and it should
be deducted to prevent from calculating foreign supply as domestic supply.
!. In%o'e A55roa%h
G D P from the income is the sum of the following major components:
1. Compensation of employees
2. Property income
3. Production taxes and depreciation on capital
/ompensation of *mployees: t represents wages, salaries, and other employee
#roperty income: t constitutes corporate profits, proprietor's incomes, interests, and
! " # at market prices measures the value of output at market prices, after adjusting
for the effect of indirect taxes and subsidies on the prices.
Market price is the economic price, for which goods or service is offered in the market
! " # at factor cost measures the value of output in terms of the price of factors used
in its production.
Factors of production are land, labour, capital and entrepreneur; they get remunerations
in the form of rent, wages, salaries, interest and profits respectively.
G D P at factor cost is equal to G D P at market prices minus (indirect taxes minus
(. *ro&7%t A55roa%h
n ndia, for all these years we have been getting GDP Product-wise i.e. we have 8
sectors, we calculate how much has been produced (value added that is) in each sector
and aggregate it to get G D P figure. We also get G D P based on state levels.
Real ! " # or GDP at constant price: s simply the value of today's output at yesterday
price (meaning some base year price). Real G D P is calculated by tracking the volume
or quantity of production after removing the influence of changing prices or inflation. t
reflects the real growth.
&ominal ! " # or G D P at current prices: represents the total money value of final
goods and services produced in a given year, where the values are expressed in terms
of the market prices of each year. Simply it is the value of today's output at today's
1. G D P is an `aggregate' measure. t does not speak any thing about how the GDP is
distributed among the population of the country. Per capita income, another derivative
of G D P, also does not indicate the pattern of income distribution. Thus, a country may
have high GDP but much skewed distribution of income. Such inequality in income
distribution often leads to social tensions.
2. Like the inequality of income distribution among population, there could be regional
disparity in G D P with a few developed states contributing the most to the country's G D
P and a majority of less developed state economies contributing a meagre. This is very
true of ndia where regional strife due to disproportionate distribution of income region-
wise is a common feature.
3. Higher G D P does not necessarily imply higher welfare. Welfare is a wider concept
which encompasses development in all aspects of the society, e.g., health, education,
sanitation, etc., ndia has over time grown from a low G D P nation to high G D P nation,
yet its social development indicators are not commensurately favourable. Therefore,
interpretation of G D P should always be supplemented by some kind of Human
Development ndex (H D ) as developed by the World Bank.
4. G D P does not reflect the total income of a country if the country is an export-
oriented economy like one of those South-East Asian economies. Gross National
Product (G N P) is a more accurate measure in this context, as it factors in earnings
from the external sector.
5. Concepts like G D P does not throw light on how much of the population is financially
excluded or included. Lower level of financial inclusion is today a global malady and
therefore G D P measures should be evaluated accordingly.
6. One of the newest concepts in G D P today is the 'green' G D P. A country may be
achieving high G D P but at the cost of its environmental degradation. Environmental
issues in growth are quite pertinent and sensitive matters today. Statisticians all over
the world are busy with developing models which can measure 'green' G D P.
Che%2 )o7r *ro,ress
Ti%2 the Corre%t Ans8er
97estion1.*ersonal Cons7'5tion e65en&it7re on ho7sehol&s &i=i&e& into<
The %hoi%es are:
(1) Durable goods
(2) Non-durable goods
(3) Services
(4) All of the above
Ri,ht Ans8er: #.$ All of the a"o=e
97estion !. +a%tors of *ro&7%tion are:
The %hoi%es are:
(1) Land, Labour and Capital
(2) Assets, Machineries and Money
(3) Land, Labour, Capital and Entrepreneur
(4) None of the above.
Ri,ht Ans8er: #($ Dan&0 Da"o7r0 Ca5ital an& Entre5rene7r
97estion (. Mar2et *ri%e is the 6 6 6 5ri%e for 8hi%h ,oo&s or ser=i%e is offere&
at the 'ar2et 5la%e.
The %hoi%es are:
(1) Nominal Price, (2) Economic Price
(3) Marginal Price, (4) Deficit Price.
Ri,ht Ans8er: #!$ E%ono'i% *ri%e
Det Us S7' U5
. GDP is the total market value of all the final goods and services produced within the
domestic economy, using domestic resources, during a given period of time, usually
one year.
2. G D P at market prices measures the value of output at market prices after adjusting
for the effect of indirect taxes and subsidies on the prices.
3. G D P at factor cost measures the value of output in terms of the price of factors used
in its production.
4. G D P is an 'aggregate' measure. t does not speak any thing about how the G D P is
distributed among the population of the country.
5. Higher G D P does not necessarily imply higher welfare. Welfare is a wider concept
which encompasses development in all aspects of the society, e.g. health, education,
sanitation, etc.
G D P; Consumption; Gross nvestment; Government; (Exports-imports); Measures of G
D P; 'green' G D P; Output; Aggregate demand; External Economy; Monetary
Conditions; Financial Markets; nflation Situation; Growth and nflation Outlook.
*A*ERE 1
UNT 10- Union Budget
10.0 Objectives
10.1 Receipts
10.2 Expenditure
10.3 Plan Expenditure
10.4 Deficit Concepts
Let Us Sum Up
This chapter will be helpful in understanding:
1. Revenue Concepts
2. Expenditure Concepts
3. Deficit Concepts
Re=en7e Re%ei5ts
1. Ta6 Re=en7e
Iross Ta6 Re=en7e
1. Corporation tax
2. ncome Tax
3. Other Taxes and Duties
4. Customs
5. Union Excise Duties
6. Service Tax
7. Taxes of the Union Territories.
Net Ta6 Re=en7e: Gross tax revenue (Minus) N C C D transferred to the National
Calamity Contingency Fund Minus States' Share
!. Total NonETa6 Re=en7e
. nterest Receipts
2. Dividend and Profits
3. External Grants
4. Other Non-Tax Revenue
5. Receipts of Union Territories.
Total Revenue Receipts: Net Tax Revenue plus Total Non-Tax Revenue
Capital Receipts*: Non-debt Receipts plus Debt Receipts
NonE&e"t Re%ei5ts:
1. Recoveries of Loans & Advances (excludes recoveries of short-term loans and
advances from States and loans to Government servants, etc.)
2. Miscellaneous Capital receipts
De"t Re%ei5ts.
1. Market Loans
2. Short Term Borrowings
3. External Assistance (Net)
4. Securities ssued against Small Savings
5. State Provident Funds (Net)
6. Other Receipts (Net)
The receipts are net of repayments.
Total Receipts: Total Revenue Receipts plus Capital Receipts plus Drawdown of Cash
0inancing of 0iscal "eficit: Debt Receipts + Draw-Down of Cash Balance
NonE*lan E65en&it7re
Re=en7e E65en&it7re
1. nterest Payments and Prepayment Premium
2. Defence
3. Subsidies
4. Grants to State and U.T. Governments
5. Pensions
6. Police
7. Assistance to States from National Calamity Contingency Fund
8. Economic Services (Agriculture, ndustry, Power, Transport, Communications,
Science & Technology etc.)
9. Other General Services (Organs of State, Tax Collection. External Affairs etc.)
10. Social Services (Education, Health, Broadcasting, etc)
11. Postal Deficit
12. Expenditure of Union Territories without Legislature
13. Amount met from National Calamity Contingency Fund
14. Grants to Foreign Governments
Ca5ital E65en&it7re.
1. Defence
2. Other Non- Non-plan Capital Outlay
3. Loans to Public Enterprises
4. Loans to State and U.T. Governments
5. Loans to Foreign Governments
6. Others
&on-plan *+penditure: Revenue Non-Plan Expenditure plus Capital Non-Plan
Re=en7e E65en&it7re
1. Central Plan
2. Central Assistance for State & Union Territory Plans
Ca5ital E65en&it7re
1. Central Plan
2. Central Assistance for State & Union Territory Plans
#lan *+penditure: Revenue Expenditure plus Capital Expenditure
Total *+penditure: Total Non-Plan Expenditure plus Total Plan Expenditure
1. Revenue deficit is the excess of revenue expenditure over revenue receipts.
!. !ross fiscal deficit is the excess of total expenditure including loans, net of
recoveries over revenue receipts (including external grants) and non-debt receipts.
(. &et fiscal deficit is the difference between gross fiscal deficit and net lending.
.. !ross primary deficit is the difference between the gross fiscal deficit and interest
?. &et primary deficit denotes net fiscal deficit minus net interest payments.
@. The net R B credit to the Central Government is the sum of increase in the Reserve
Bank's holding of 1) Treasury Bills, 2) Government of ndia dated securities 3) rupee
coins and 4) Loans and Advances from the Reserve Bank to centre since April 1, 1997
adjusted for changes in Center's cash balances with the Reserve Bank.
Che%2 )o7r *ro,ress
Ti%2 the Corre%t Ans8er
97estion1. E65an& N C C D
The %hoi%es are:
(1) National Council on Crime and Delinquency
(2) National council on Credit and Debentures
(3) National council on Commerce and deregulation
(4) None of the above
Ri,ht Ans8er: 1$ National Co7n%il on Cri'e an& DelinJ7en%3
97estion!. *i%2 o&& 'an o7t
The %hoi%es are:
(1) Customs
(2) Service Tax
(3) nterest Receipts
(4) ncome Tax
Ri,ht Ans8er: #($ Interest Re%ei5ts
97estion(. *i%2 o&& 'an o7t
The %hoi%es are:
(1) Securities issued against Small Savings
(2) Recoveries of Loans & Advances
(3) State Provident Funds
(4) Other Receipts
Ri,ht Ans8er: #!$ Re%o=eries of Doans M A&=an%es
97estion.. *i%2 o&& 'an o7t.
The %hoi%es are:
(1) Loans to Public Enterprises
(2) Pensions
(3) Subsidies
(4) Police
Ri,ht Ans8er: #1$ Doans to *7"li% Enter5rises
97estion ?. Net fis%al &efi%it is the &ifferen%e "et8een
The %hoi%es are:
(1) gross fiscal deficit and net interest payments
(2) gross fiscal deficit and interest payments
(3) gross fiscal deficit and net lending
(4) None of the above
Ri,ht Ans8er: #($ ,ross fis%al &efi%it an& net len&in,
Det Us S7' U5
() &et Ta+ Revenue: Gross tax revenue (Minus) N C C D transferred to the National
Calamity Contingency Fund Minus States' Share.
-) Total Revenue Receipts: Net Tax Revenue plus Total Non-Tax Revenue;
.) Total Receipts: Total Revenue Receipts plus Capital Receipts plus Draw-Down of
Cash Balance.
1) Total *+penditure: Total Non-Plan Expenditure plus Total Plan Expenditure
Growth-oriented budget; Revenue Receipts; Capital Receipts; Total Receipts; Non-plan
Expenditure; Plan Expenditure; Total Expenditure; Revenue Deficit; Fiscal Deficit;
Primary Deficit.
UNT-11 Challenges Facing ndian Economy
11.0 Objectives
11.1 ntroduction
11.2 Unique Features of the ndian Economy
11.3 Concerns
Let Us Sum Up
This chapter will be helpful in understanding:
1. Features of ndian Economy
2. Challenges facing ndian Economy
From the perspective of Emerging Market Economies (EMEs) and particularly for that of
ndia, there are five concerns. These are: first, timing of exit from the accommodative
monetary policy in the context of rising food price-led inflation but still weak growth;
second, the possibility of another surge in capital flows, especially if we turn out to be an
outlier in withdrawal of monetary stimulus; third, monetary transmission mechanism as it
is evolving from the crisis period; fourth, return to fiscal consolidation and quality of
fiscal adjustment; and finally, the implications of the efforts towards financial stability on
financial inclusion and growth.
There are a few unique features to the ndian economy.
What are the unique features of the ndian economy that distinguish it from other
EMEs? First, our growth is driven by domestic demand both consumption and
investment. Consumption and saving are well balanced. n ndia, the share of private
final consumption expenditure in GDP is around 55 per cent. Our savings rate is 37.7
per cent and investment rate is 39.1 per cent.
Second, twin deficitsfiscal as well as current account deficit. ndia was on a path of
fiscal consolidation before the crisis, but got off track because of the counter cyclical
spending necessitated by the crisis. Unlike major EMEs, which are running current
account surpluses, we have recorded deficits on the current account. Although current
account deficits have been modest, the deficit reached a high of 2.6 per cent of GDP in
2008-09 but is expected to moderate during 2009-10.
Third, given the right balance between domestic consumption and saving on the one
hand, and infrastructural bottlenecks in major areas (such as power, roads, urban
infrastructure as also social infrastructure) on the other, ndia is essentially a supply-
constrained economy. Just before the crisis, such supply concerns led to a view that
there might be overheating in the economy. Generally, weak external demand has led
to some externally induced cyclical slowdown. However, as the global economy
recovers, supply constraints are again expected to be binding.
+irst Con%ern: *+it from 2ccommodative Monetary #olicy: !rowth
vs) 'nflation
While there is broad agreement that we need to exit from the present excessively
accommodative monetary and fiscal policies, there is less agreement on when and how
we should exit. There are incipient signs of recovery. ndustrial production has picked
up in the past couple of months, but export growth remains negative. Business
confidence surveys suggest recovery from the troughs touched a year ago although the
confidence levels remain below the earlier peaks.
Even as recovery remains weak, consumer price inflation (CP) is running in double
digits on the back of high food prices. Both Headline inflation (WP) and Core inflation
(CP) are on the increase. The food inflation is a matter of concern. Higher food prices
in our case are partly a result of the structural demand-supply imbalances. At present,
cyclical factors are also at play. Monsoon in the current season, which ended on
September 30, has been the weakest since 1972. Agricultural output is expected to
suffer and this could keep upward pressure on food prices in the coming months. High
food prices are, therefore, a mix of structural and cyclical factors. While the buffer stock
of food grains and better supply management could mitigate the adverse effects to an
extent, imports are not an easy solution given the requirement.
Although inflation pressures emanating from higher food prices may limit the scope for
monetary policy action, there are implications for inflation expectations. Furthermore,
unlike the major advanced economies, growth remains positive. Real GDP growth was
6.7 per cent in 2008-09 and is expected to be 6.0 per cent (with an upward bias) as per
the Reserve Bank's growth projections. n view of the country specific features, we may
need to exit from accommodative monetary policy earlier than advanced economies.
This calls for careful management of trade-offs: growth concerns warrant a delayed exit,
but inflation concerns call for an earlier exit. An early exit on inflation concerns runs the
risk of derailing the fragile growth, while a delayed exit may engender inflation
Se%on& Con%ern: Mana,e'ent of Dar,e an& Volatile Ca5ital +lo8s
Ma3or central banks such as the US Fed, the ECB, and the BoE have flushed
their financial systems with unprecedented amount of liquidity. Till the first quarter of
2009, this liquidity was finding its way back to the central banks as excess reserves
because of risk aversion.
Risk appetite is now returning. There are signs of recovery in portfolio investments to
the EMEs. For instance, portfolio investments by Fls in the ndian equity market
amounted to US$ 13.6 billion in the period April 1 September 18, 2009 as against
outflows of US$ 5.2 billion in the corresponding period of 2008 reflecting a turnaround of
almost US$ 19 billion.
Moreover, as noted above, in view of incipient inflationary pressures, policy rates in our
case may have to be tightened ahead of those in advanced economies. The resultant
larger interest differential may attract larger capital inflows. Will capital inflows be
modest or turn into a flood as in 2007? The latter concern is particularly relevant in view
of abundant liquidity in the major advanced economies. What will the implications be for
exchange rates? n ndia, the current account is in modest deficit; hence large and
volatile capital flows can impose macroeconomic costs.
Emerging market central banks have three options in managing capital flows. The first
option is for the central bank not to intervene in the forex market and let the exchange
rate bear the burden of adjustment. Will undue exchange rate appreciation not further
widen the current account and what will the implications be for future sustainability? Will
exchange rate appreciation help to contain inflation? These are the questions to
address if this option is adopted.
Second, the central bank can intervene in the forex market, but refrain from sterilization.
Such an approach runs the risk of excessive growth in monetary and credit aggregates
which can lead to higher inflation as well as credit and investment booms and create
financial fragility.
The third option is to sterilize the interventions. rrespective of the method of
sterilization, the financial cost of sterilization in terms of national balance sheet is
obviously ultimately borne by the government even though direct costs may be borne by
separate agencies. Sterilized intervention can exacerbate fiscal pressures, but this
needs to be assessed against the benefits of macro-financial stability.
Thir& Con%ern: DeE%lo,,in, Monetar3 Trans'ission Me%hanis'
Following the collapse of Lehman Brothers, the global economic outlook deteriorated
sharply, and the ndian economy got impacted by the contagion through all the channels
the financial channel, the real channel and the confidence channel. The Reserve
Bank's crisis response included, like in the case of other central banks, both
conventional and unconventional measures.
n response to the easing of policy interest rates and abundant liquidity made available,
market rates eased significantly. Yields on 10-year central government securities fell
from 8.6 per cent at end-September 2008 to 5.3 per cent by end-December 2008. This
trend has since reversed with yields hardening since the beginning of the current
calendar year on the back of large and abrupt increase in the government borrowing
n contrast, interest rates on bank deposits and loans have exhibited stickiness. While
the Reserve Bank cut the effective policy rate by 575 basis points, banks' Benchmark
Prime Lending Rates (BPLRs) have seen a reduction of only 100-275 basis points. This
stickiness has impeded monetary transmission and blunted the intended impact of
policy actions- What is the explanation for the stickiness in the interest rate structure of
There are several factors that cause this stickiness the higher rates of interest offered
by the small savings instruments which discourage banks from reducing deposit rates,
the high cost of deposits raised by banks during earlier tighter monetary policy regime
which raised their weighted average costs, and the large government borrowing
programme which pushed up yields on government securities. These factors, which
impeded monetary transmission, were in play even before the crisis. A definite task
going forward will be to address the impediments to monetary transmission.
+o7rth Con%ern: +is%al Sti'7l7s H ;ith&ra8al an& 97alit3 of
Like in other economies, fiscal stimulus measures and weakening of economic activity
have led to substantial increase in our fiscal deficits. The Central Government's fiscal
deficit is budgeted to jump from 2.7 per cent of GDP in 2007-08 to 6.8 per cent in 2009-
10; the combined fiscal deficit of the Centre and the states is expected to increase from
4.2 per cent of GDP to 10.2 per cent over the same period. These deficits are large and
need to be rolled back. What is the scope for adjustment? What lesson does our past
experience offer?
As a result of the discipline imposed by the Fiscal Responsibility and Budget
Management (FRBM) Act, the Centre's fiscal deficit came down from 6.2 per cent of
GDP in 2001-02 to 2.7 per cent in 2007-08. Over the same period, the deficit of the
state governments declined from 4.1 per cent of GDP to 1.5 per cent. Thus, we saw a
large adjustment over a relatively small period. This past experience with fiscal
adjustment may raise hopes that we will be able to roll back the recent fiscal deficits.
Such a simplistic approach may be misleading. A large part of our fiscal deficit is
structural and not cyclical. Also, at least a part of fiscal consolidation resulted from high
growth, not the other way round. t is important to acknowledge this in order to define
the problem and assess the enormity of the challenge.
Three issues are important in this context. First, this concept of 'fiscal adjustment over a
cycle' is inadvisable for us. Adjustment over a cycle is for mature and advanced
economies. Even there it does not work the UK, for instance, was running its highest
fiscal deficit at the peak of the economic cycle. We will be safest sticking to a single
formula and tying ourselves down to annual, inflexible targets. This is a blunt but safe
way of de-linking fiscal adjustment from democratic pressures. Second, we must focus
on the quality of fiscal adjustment, not just chase a numerical target. The ratio of capital
outlay to GDP for the Central Government has stagnated between 1 and 2 per cent of
GDP since the early 1990s from around 2-3 per cent in the preceding decade. Third, we
cannot sit back and hope that tax increase will deliver fiscal consolidation on a platter.
Revenue expenditure has increased from around 12 per cent of GDP during the period
2000-08 to over 15 per cent now. We need to work seriously on expenditure
compression. This is going to be politically challenging both at the Centre and in the
States, but it needs to be done regardless.
+ifth Con%ern: +inan%ial Sta"ilit3. +inan%ial In%l7sion an& Iro8th
Given the enormity of the crisis, financial sector regulation is being tightened under the
aegis of international bodies such as the Basel Committee on Banking Supervision and
Financial Stability Board. There are proposals that would raise the reserve requirement
of banks. New regulations for liquidity requirements are also going to be in place. There
are also proposals to require banks to hold government securities. Many of these
measures are necessary. But we need to recognize that all such proposals will have the
impact of increasing the banks' funding costs which will translate into higher lending
rates. How will banks react to such higher costs? Will this lead to an erosion of banks'
social responsibility towards the poorer and other needy segments of the society? n
economies such as ndia, a large part of population remains financially excluded. We
will need to ensure that efforts at financial inclusion do not get negated by the ongoing
tightening of the regulatory regime.
n order to safeguard financial stability, we have traditionally used a variety of prudential
measures such as specifying exposure norms and pre-emptive tightening of risk
weights and provisioning requirements. But these measures are not always costless.
For instance, tightening of risk weights arguably tempers the flow of credit to certain
sectors, but excessive, premature or unnecessary tightening could blunt growth.
Similarly, exposure norms offer protection against concentration risks; however, such
limits could restrict the availability of credit for important growth sectors. This is a live
issue in our country in the context of the immense needs of infrastructure financing.
Thus, as in the case of price stability, central banks face the challenge of managing the
trade-off between financial stability and growth.
t needs to be recognized that after a crisis, with the benefit of hindsight, all conservative
policies appear justified. But excessive conservatism in order to be prepared to ride out
a potential crisis could thwart growth and financial innovation. The question is what
price are we willing to pay, in other words, what potential benefits are we willing to give
up, in order to prevent a black swan event? Experience shows that managing this
challenge, that is to determine how much to tighten and when, is more a question of
good judgment rather than analytical skill. This judgment skill is the one that central
banks, especially in developing countries such as ndia, need to hone as they
simultaneously pursue the objectives of growth and financial stability.
Che%2 )o7r *ro,ress
Ti%2 the Corre%t Ans8er
97estion 1. *i%2 o&& 'an o7t
The %hoi%es are:
(1) Brazil
(2) France
(3) ndia
(4) Russia
Ri,ht Ans8er: #!$ +ran%e
9estion!. E65an& EMEs
The %hoi%es are:
(1) External Marketing Economics
(2) Environmental Efficiency
(3) Emerging Market Economies
(4) None of the above
Ri,ht Ans8er: #($ E'er,in, Mar2et E%ono'ies
97estion (. E65an& B*DRs
The %hoi%es are:
(1) Benchmark Prime Lending Rates
(2) Benchmark Prime Loan Rates
(3) Benchmark Process Lending Rates
(4)None of the above
Ri,ht Ans8er: #1$ Ben%h'ar2 *ri'e Den&in, Rates
Det Us S7' U5
1. UniJ7e feat7res of the In&ian e%ono'3
a. Growth is driven by domestic demand
b. Twin deficits fiscal as well as current account deficit.
c. Supply-constrained economy.
!. +i=e %on%ern areas.
(a) Timing of exit from the accommodative monetary policy in the context of rising food
price-led inflation but still weak growth.
(b) The possibility of another surge in capital flows, especially if we turn out to be an
outlier in withdrawal of monetary stimulus.
(c) Monetary transmission mechanism as it is evolving from the crisis period.
(d) Return to fiscal consolidation and quality of fiscal adjustment.
(e) The implications of the efforts towards financial stability on financial inclusion and
Emerging Market Economies; Domestic demand; Twin deficits; Supply-constrained
economy; Financial, Stability; Fiscal Stimulus: De-clogging Monetary Transmission
Mechanism; Management of Large and Volatile Capital Flows.
*A*ER 1
UNT 12- Time Value of Money
12.0 Objectives
12.1 ntroduction
12.2 Common Sense Approach to Present Value
12.3 Calculation of Present Value
12.4 Relation of Risk to Present Value
12. 5 Discounting/Compounding a Cash Flow
12.6 Annuity
12.7 Growing Annuities
12.8 Perpetuity
Appendi+ , -resent .alue Ta%le
The objective is to understand the concept that money has a time value. The notion
that, a rupee today is preferable to the rupee in the future is intuitive enough for most
people to grasp. This can be grasped without the use of models and mathematics. The
concept of present value enables us to calculate exactly how much a rupee in the future
is worth today. n this chapter we shall examine the following questions:
1. What do we mean by time value of money?
2. What is the basis for present value? What factors affect the timing of cash flows and
how does this affect the time value?
The principles of present value are used in Corporate Finance by evaluating projects
and valuation of company shares and also in personal finance and investment. Present
value is a concept which shows that money has a time value. t is an intuitive and
simple concept, simple to calculate and can be applied in a wide range of situations in
corporate finance. We can use this concept in buying a house, saving for a child's
education, picking a project. That money has time value stems from the concept that the
value of money gets eroded by the concept of inflation. How often have we heard our
elders say that a kilo of rice was so cheap or that a house was so cheap? How often are
clothes cheaper, education cheaper and all the common essentials becoming dearer
year after year? n the following section you will understand the concept and learn to
apply it in real-life examples.
A cash flow in the future is worth less than a similar cash flow today because:
1. People prefer present consumption to future consumption. People would have to be
offered more in the future to give up present consumption.
2. Due to inflation, the value of money/currency depreciates or erodes over a period of
time. This happens due to inflation. The greater the inflation, the greater is the erosion
in the value of the rupee in the future.
3. Due to the uncertainty of receiving the cash flow in the future the value of the cash
flow in the future reduces further. This means there is a risk associated with receiving
the cash flow in future and this reduces the value associated with the cash flow. Higher
the risk more is the erosion in value.
The process by which future cash flows are adjusted to reflect these factors is called
discounting, and the magnitude of these factors is reflected in the dis#ount rate.
;hat is Dis%o7nt Rate>
The discount rate is a rate at which present and future cash flows are traded off. t
incorporates the following:
1. The preference for current consumption (greater preference higher discount rate).
2. Expected inflation (higher inflation higher discount rate).
3. The uncertainty in the future cash flows (higher risk higher discount rate).
A higher discount rate will lead to a lower present value for future cash flows.
Tra&e off in Cons7'5tion o=er Ti'e
Although individuals prefer present consumption to future consumption, the degree of
this preference varies across individuals/ across time, across different places. This
trade-off between present consumption (C0) and future consumption (C1) can be
explained as follows. People may get the same amount of money in each period and
they may either consume it or save it or lend it. A may choose to consume the whole
amount. B may consume more money by borrowing. C may consume less, save and
lend the remaining portion. f the preference for current consumption is strong, then we
have to offer more in terms of future consumption to give up current consumption. Thus
there is always a trade off which is reflected by the high-real rate of return or discount
rate. f the preference for current consumption is weak then a person can settle for a
lower real rate of return or discount rate. The assumption here is that any money saved
will always be lent out, because it can earn a return for the saver. The story of the
grasshopper and the ant reflects this. The grasshopper may make merry and use all of
his money whereas the ant may save to enjoy during winter. Many old couples enjoy
their retirement because they have intuitively used the concept of time value of money
properly and when their earning capacity goes down they can enjoy the fruits of their
savings and investment decisions.
The process of discounting future cash flows converts them into present cash flows.
Conversely, the process of compounding converts present cash flows into future cash
Cash flows at different points of time cannot be compared and aggregated unless they
are all brought to the same point in time before we can compare or aggregate them.
There are different types of cash flows such as simple cash flows, annuities,
perpetuities, etc.
Si'5le Cash +lo8
A simple cash flow is a single cash flow in a specified future time period. On a time line,
0 to time t, it occurs at time t.
This cash flow can be discounted back to the present, using a discount rate that reflects
the uncertainty of the cash flow. Conversely, cash flows in the present can be
compounded to arrive at an expected future cash flow.
"iscounting is the process by which a cash flow, which is expected to occur in the
future, is converted to its present value.
/ompounding is the process by which a cash flow today is converted into its expected
future value.
Cal%7latin, *resent Val7e
The present value of Rupees 100,000 a year from now must be less than Rupees
100,000 today. Thus, the present value of the future payment can be found out by
multiplying the payment amount with the discount factor which is less than 1. f the
discount factor is more than 1, a rupee today would be less worthy than a rupee
tomorrow. f C1 denotes the expected payment at period 1, one year hence then
*resent Val7e #*V$ is e4ual to Dis%o7nt fa%tor '7lti5lie& "3 C1
Let us now see as to how to work out the discount factor.
Let us say that rate of return at which present value PV will become C1 at the end of
period 1 is per cent per period.
nterest for 1 period,
NT1 is equal to PV multiplied by i divided by 100
f we denote i divided by 100 by r, then
NT1 is equal to PV multiplied by r
Cash flow at the end of period 1 will be
C1 is equal to P V plus PV multiplied by r equal to P multiplied by ( plus r)
Suppose, now we have 2 periods (say 2 quarters) at the end of which value becomes
nterest rate is i per cent for one period, and r is equal to i divided by100.
We have seen above, at the end of period 1, cash flow C1 will be
C1 is equal to PV multiplied by (1 -lus r)
Now interest at the end of second period will be
NT 2 is equal to C1 multiplied %y r
is equal to PV multiplied by, (1 plus r), multiplied %y r
And total cash flow C2 will be
C2 is equal to C1 plus NT 2
Is equal to PV multiplied %y ( plus r) plus PV multiplied %y ( plus r/ multiplied %y r
C is equal to -. multiplied %y( (1 plus r) multiplied by (1 plus r)
Is equal to PV multiplied by (1 Plus r) whole square
Similarly at the end of 'nth' period, amount Cn will work out to be
Cn is eJ7al to *V multiplied by #( plus r$ to the 5o8er of n0 8here r is eJ7al to i
&i=i&e& "3 100.
E6a'5le 1
Present value is Rs.10, 000
nterest rate is 12 per cent per annum.
nterest is compounded on quarterly basis.
What will be the cash flow at the end of first year?
Now there are 4 quarters (as compounding is quarterly) nterest rate per quarter is 3 per
C is equal to PV multiplied %y [1plus divided by 100]
is equal to 10,000 multiplied %y (1.03)
is equal to 10000 multiplied %y (1.0609)
is equal to 10000 multiplied %y (1.12550881)
is equal to 12550.88
Cash flow at the end of the first year will be Rupees 12,550.88.
Therefore, present value of Rupees. 12,550.88 due at the end of one year would be
Rupees. 10,000.
E6a'5le !
Cash flow at the end of one year is Rupees.10, 000. Discount rate is 8 per cent at
quarterly rests. What is the present value?
C is equal to PV multiplied by 1plus 2divided by 100
10,000 is equal to PV multi plied by (1 .024)
PV is equal to 10,000 di$ided %y (1.02)
Is equal to 10,000 di$ided %y 11.02/3 multiplied %y 11.02/3
Is equal to 10,000 di$ided %y 11.0404/3
Is equal to 9611.6880 divided by 1.0404
Is equal to 5267.48
E6a'5le (
You are considering investing in a house or property worth Rupees 4,00,000 today and
your real estate advisor has estimated that the cost would go up to Rupees 5,00,000 in
a year. That is not the only way you can earn money as you have various investment
options. You can invest in Public Provident Fund with an interest rate of 8 per cent p.a.
How much would you have to invest in PPF to receive Rupees 5, 00,000 after a year?
That is easy as the interest rate is 8 per cent, you would have to invest Rupees 5,
00,000 divided by 1.08, which is Rupees 462963.
Thus the building investment is a better option as you get a higher rate of return.
However you must bear in mind that the real estate investment has a higher risk in
terms of variability of return. Thus risk is related to return whereas the PPF option has a
lower risk and lower return.
To calculate present value, we discount the expected cash flow by the rate of return
offered by equivalent investment alternatives in the capital or financial markets. This
rate of return is often referred to as the discount rate, hurdle rate, or opportunity cost of
capital. t is called opportunity cost because it is the return forgone by investing in the
project rather than investing in securities.
n our example the opportunity cost was 8 per cent. Present value was obtained by
dividing Rupees 5, 00,000 by 1.08.
PV is equal to Discount factor multiplied %y C is equal to 1 di$ided %y1 (1 plus r)
multiplied by C
is equal to 5, 00,000 divided by1.08
is equal to 4, 62,963
Net *resent Val7e
When we deal with number of cash flows that could be payouts and pay ins, we work
out present value of each cash flow. Pay ins are assigned positive signs and pay outs
have negative signs. Total of all the present values with respective signs is called Net
Present Value.
For example, we have following cash flows
Today pay out of Rupees. 10,000
After one year pay in of Rupees.6, 500
After two years - pay in of Rupees. 9,000 After two years pay out of Rupees. 1,000
Now, assuming discount rate of 10 per cent and compounding is on annual basis,
present value of these 4 cash flows will be as follows:
PV is equal to Minus 10,000 as it is payout
PV is equal to 6,500 di$ided %y (1 plus10 di$ided %y 100)
is equal to Plus 5,909
PV3 is equal to Plus 9,000 di$ided 1.1
is equal to Plus 9,000 di$ided %y 1.21
is equal to Plus 7,438
PV is equal to Minus 1,000 di$ided %y1.21
is equal to Minus 729.48
Now net present value
NPV is equal to PV plus PV plus PV plus PV
Is equal to (Minus10, 000) Plus (5,909) Plus (7,438) Plus (Minus826)
is equal to 13,347 Minus 10,826
is equal to Plus 2, 521
Net Present Value or Net Present Worth is defined as algebraic total of present value
(PV) of a time series of cash flows.
t is a standard method for using the time value of money to appraise long-term project.
t is used for capital budgeting and widely used throughout economics. t measures
excess or shortfall of cash flows, in present value terms. t enables comparisons of cash
flows over different time horizons.
Dis%o7nt Rate
The rate used to discount future cash flows to their present values is a key variable in
the process. A firm's cost of capital or weighted average cost of capital is often used for
this purpose. Another approach to choosing the discount rate factor would he to take
into account return in alternative scenario, say, return on risk free investments. t is also
appropriate to use variable discount rates for cash flows at different time periods. This
would reflect yield curve premium for long-term debt. For some investoRs, they may
have targeted rate of return. This desired rate of return, if used as discount rate, would
provide direct comparison with profitability of the project.
When desired rate is used as discount rate and NPV > 0, it gives signal that the project
may be accepted. f NPV < 0, the project should be rejected. The situation of NPV is
equal to 0 indicates neutral or indifferent decision.
O55ort7nit3 Cost
t is not wise to keep money idle and not earn any return on that. Normally, a person
would keep his surplus in a bank's fixed deposit, which is considered as a risk-free
investment. Return in risk free investment such as bank's fixed deposit or government
securities is the opportunity cost. When you invest in some business project or real
estate or commodities/stock market, you forgo your return in such risk-free avenues.
Returns from such ventures, projects are expected to be more than the returns on risk-
free investments i.e. opportunity cost. Thus, opportunity cost is an important benchmark
while making any investment decision.
Opportunity cost is defined as return or income forgone in investing in a particular
project instead of investing the same in risk-free securities.
n many of our calculations, we feel that it is enough to compare the present values and
aggregates. However, we make the unrealistic assumption of assigning the same level
of risk and taking decisions based on the comparative returns of alternative means of
investments. The real estate advisor or property advisor cannot be sure about the return
in the market. f the future value of this property is risky, our calculation is wrong. Public
Provident Fund is certainly less risky, as it is akin to government security. Thus, if you
were asking someone else to invest in this property along with you, they may not agree
to give you the present value amount but something less than that. Thus, we invoke
another financial principle that a safe rupee is worth more than a risky one. Thus, we do
not use the same discount factor while comparing alternative investment avenues. The
discount rate for PPF may be 8 per cent or 0.08 but the discount rate for the building
property may be 11 per cent or 0.11. Only after the present values are calculated using
these two different discount rates, the best investment avenue or project is decided.
Most investors avoid risk when they can do so without sacrificing return. However, the
concepts of present value and the opportunity cost of capital still make sense for risky
investments. t is still proper to discount the payoff by the rate of return offered by an
equivalent investment. But we have to think of expected payoffs and the expected rates
of returns on other investments.
Effe%t of Inflation on Dis%o7nt Rate: The effect of inflation on present value is
evident. t reduces the purchasing power of future cash flows. This adjustment reduces
the value of future cash flows. These real cash flows will have to be reduced further to
reflect real returns (i.e. the tradeoffs between current and future consumption) and any
uncertainty associated with the cash flows to arrive at the present value. Thus, an
investor who expects to make Rupees 11 lakhs a year from now will have to reduce this
expected cash flow to reflect inflation rate and arrive at the present value. f the inflation
rate is 10 per cent, the present value would be Rupees 10 lakhs in this case.
The general formula for converting nominal cash flows at a future period't' to real cash
flows is Real Cash Flow is equal to (Nominal cash flow) divided by (1 + nflation rate)
Effect on Risk on Discount Rate: Although both the preference for current consumption,
and expected inflation affect the present value of all cash flows, not all cash flows are
equally predictable. Promised cash might not be delivered for a number of reasons: the
promisor might default on the payment (nterest and investment not received as
company winds up); the promisee might not be around to receive payment (might
have died) or some other contingency or happening may intervene to prevent the
promised payment or to reduce it. The greater the uncertainty associated with a cash
flow in the future, the higher the discount rate used to calculate the present value.
Resultantly, the present value of that cash flow will consequently be lower.
You have decided to invest in a construction of an office building. The project's future
value is equal to its future income discounted at the rate of return offered by say,
government securities.
We can say this in another way. Our building venture is worth undertaking because its
rate of return exceeds its cost of capital. The rate of return is simply the profit as a
proportion of the initial outlay.
Return is equal to Profit divided by investment is equal to (5, 00,000 minus 4, 30,000)
divided by4, 30,000
is equal to (70,000) - (4,30,000)
is equal to 0.163 about 16per cent
The cost of capital is the return foregone by not investing in securities. f the investment
is made in government securities, it would give return of 8 per cent p.a. Return of 16 per
cent on building far exceeds 8 per cent opportunity cost. t is therefore worthwhile to
invest in building project.
We have two equivalent decision rules for capital investment.
1. Net Present Value Rule: Accept investments that have positive net present values.
Rate of Return Rule: Accept investments that offer rates of return in excess of their
opportunity costs of capital.
Discounting a cash flow converts it into present value rupees and enables the user to do
several things. First, once cash flows are converted into present value, they can be
aggregated and compared. Second, if present values are estimated correctly the user
should be indifferent between the future cash flow and the present value of the cash
Other things remaining equal, the present value of a cash flow will decrease as the
discount rate increases. Thus present value is a decreasing function of the discount
Present value of a cash flow also decreases as the period of future flow increases. Thus
present value is also a decreasing function of the time period.
Co'5o7n&in, a Cash +lo8
Current cash flows can be moved into the future by compounding the cash flow at the
appropriate discount rate.
The future value of a simple cash flow is
FV is equal to CF multiplied %y ( + r)
Where CF0 is equal to Cash Flow Now
r is equal to Discount Rate
n is equal to number of time periods
The compounding effect increases with both the discount rate and the compounding
Co'5o7n&in, is the process by which cash flows are converted from present value to
future value.
I""otson an& SinJ7efiel&Ls St7&3
As the length of the holding period is extended, small differences in discount rates can
lead to large differences in future value. n a study of returns on stocks and bonds
between 1926 and 1992, bbotson and Sinquefield found that stocks on the average
made 12.4 per cent, Treasury Bonds made 5.2 per cent, and Treasury Bills made 3.6
per cent. Assuming that these returns continue into the future, the table below provides
the future value of USD 100 invested in each category at the end of a number of holding
periods year, 5 years, 10 years, 20 years, 30 years and 40 years.
The differences in future value from investing at these different rates of return are small
for short compounding periods (such as one year) but become larger as the
compounding period is extended. For instance, with a 40 year time horizon, the future
value of investing in stocks, at an average return of 12.4 per cent, is more than 12 times
larger than the future value of investing in Treasury bonds at an average return of 5.2
per cent and more than 25 times the future value of investing in Treasury Bills at an
average return of 3.6 per cent.
TABLE 12.1
112.40 108.20 106.90
8 1:5.40 127.78 115.64
10 621.79 199.02 142.46
20 1068.52 2:8.92 202.79
60 6664.17 48:.85 277.56
40 10:61.60 :85.97 411.82
The R7le of B!E A short%7t to esti'atin, the Co'5o7n&in, effe%t
n a pinch, the rule of 72 provides an approximate answer to the question 'How quickly
will this amount double in value? Dividing 72 by the discount or interest rate used in the
analysis. Thus, a cash flow growing at 6 per cent per annum will double in value in
approximately 12 years, while a cash flow growing at 9 per cent per annum will double
in value in approximately 8 years.
Effe%ti=e Interest fate
This is the true rate of interest, taking into account the compounding effects of more
frequent interest payments.
+reJ7en%3 of Dis%o7ntin, an& Co'5o7n&in,
Frequency of compounding affects both the future and present values of cash flows. n
the preceding examples, the cash flows were assumed to be discounted and
compounded annually that is, interest payments and income were computed at the
end of each year, based on the balance at the beginning of each year. n some cases,
however, the interest may be computed more frequently, such as on a monthly or
quarterly basis. n these cases, the present and future values may be very different from
those computed on annual basis. The stated interest rate on an annual basis can
deviate significantly from the effective or true interest rate. The effective interest rate
can be computed as follows.
Effective nterest Rate is equal to (1plus r divided n) 1
where n is equal to number of compounding periods (quarterly - 4; monthly - 12) and r is
annual rate.
For nstance, 10 per cent annual interest rate, if there is semi-annual compounding,
works out to an effective interest rate of
Effective nterest Rate is equal to (1.05 1) is equal to (1.1025 1.0) is equal to 10.25
per cent.
As compounding becomes continuous, the effective interest rate can be computed as
Effective nterest Rate is equal to e

where e is equal to exponential number
r is equal to stated annual interest rate
Table 1.2 provides the effective rates as a function of the compounding frequency.
TABLE 12.2 provides the effective rates as a function of the compounding frequency.
10 1
.10 10
Semi-Annual 10 2 (1plus10di$iidedby2)
Monthly 10 12 (1plus.10divided by12)
minus1 10.47
Daily 10 365 (1plus.10divided by365)
minus1 10.5156
Continuous 10 continuous e.
_1 10.5171
As compounding becomes more frequent, the effective rate increases, and the present
value of future cash flows decreases.
For example, a home loan may have monthly repayments and monthly compounding.
The interest rate quoted may seem to be low, but that could be deceptive. To get the
effective Annual rate, you should use the formula above and see what the actual
effective interest rate works out.
1!.@ ANNUIT)
An annuity is constant cash flow that occurs at regular intervals at fixed period of time.
Defining A to be the fixed amount payable at regular intervals, the time line for an
annuity may be drawn as follows:
0 1 2 3 4
An annuity can occur at the end of each period, as in this time line, or at the beginning
of each period.
#resent 5alue of an *nd-of-the-#eriod 2nnuity
The present value of an annuity can be calculated by taking each cash flow and
discounting it back to the present and then adding up the present values. Alternatively,
a formula can be used in the calculation. n the case of annuities that occur at the end of
each period, this formula can be written as
*V of an Ann7it3 is eJ7al to *V '7lti5lie& "3 #A0r0n$is eJ7al to A &i=i&e& "3 rN1
'in7s 1 &i=i&e& "3#1 5l7srO
Where A is equal to Annuity
r is equal to Discount Rate per period
N is equal to Number of periods
The notation used internationally for the present value of an annuity is PV (A, r, n).
Suppose you start a rent-a-car business and want to buy an automobile. You have
choice of buying the car cash down for Rupees 400,000 or paying Rupees 90,000 a
year for five years for the same car. What would you do, if the opportunity cost is 10 per
PV of Rupees 90,000 each year for the next 5 years
PV (90, 000,10,5 is equal to 90,000 multiplied %y (1.10
-1) di$ided %y 0.10 multiplied by
Is equal to 90,000 multiplied %y (1.61051-1)
Is equal to 341171
;%$iously it is %etter to ta"e the auto loan rather than pay #ash down. -erhaps( no auto
loan #ompany or %an" will #ome up with su#h a s#heme. The present values of your
installments versus cash down will always be higher. f you do not have the money right
now or you can get a higher return by using this loan then it is worthwhile taking the
loan. Thus you will also have to look into your inflows by hiring out the car/s in your rent-
a-car business.
When the present values of your installment payments exceed the cash down price, it is
better to pay cash down and acquire the asset.
Alternatively, in above example, you could have discounted each installment separately
and added up the present values for all five and arrived at the same figure. Nowadays,
spreadsheets like excel are used to calculate the values of different annuities or using
advanced program calculators. Thus using the formulas programmed in the
spreadsheet and changing the variables like amount, time and rate of interest/discount
factor, you can calculate the present value of different annuities and take financial
decisions both, personal and commercial.
0uture value of *nd6of-the-period 2nnuities
n some cases, an individual may plan to set aside a fixed annuity each period for a
number of periods and will want to know how much he or she will have at the end of the
period. The future value of an end of-the-period annuity can be calculated as follows:
+V of an Ann7it3 +V #A0r0n$ is eJ7al to A &i=i&e& "3 r '7lti5lie&
N#1 5l7s r$
H 1$O
The standard notation commonly practised for Future Value of an annuity is FV (A, r, n).
Knowing the future value formula, can you calculate the future value of Rupees 5000
tax exempted PPF you deposit every year for twenty years? Assume you start at age 25
f it is taxed, obviously you have a lower return.
Juggling the above formula, if you know the future value of what you have to repay and
you need to set aside a fixed sum every year for repayment, you can use annuity
Thus Annuity given Future Value which means you are given the future value and
are looking for the annuity A (FV, r, n), can be calculated as follows:
Annuity given the future value is equal to A (FV, r, n) is equal to FV multiplied by r
divided by [(1 plus r)
7alloon Repayment Loan: A balloon Repayment loan refers to a loan on which only in
crest is paid for the life of the loan, and the entire principal is paid at the end of the
loan's life. Companies that borrow money using balloon repayment loans like bonds or
debentures often set aside money in sinking funds during the life of the loan to ensure
they have enough at maturity to pay the principal on the loan or the face value of the
bonds. Thus any company will have to set aside a fixed amount each year till the date of
redeeming of bonds/debentures for repayment to bond holders or debenture holders.
The size of the sinking fund will vary with the change in interest rates.
Sinking 0und: A sinking fund is a fund to which firms make annual contributions in
order to have enough funds to meet a large financial liability in the future.
Annuity at the beginning of Period
.1 1
The annuities we talked about till now are end of the period cash flows. Both the present
and future values are affected if the cash flow occurs at the beginning of each period
instead of the end. To illustrate this effect, consider an annuity of Rupees 100 at the end
of each year for the next four years, with a discount rate of 10 per cent; and we also
consider similar annuity at the beginning of each year.
Rupees 100 Rupees 100 Rupees 100 Rupees 100 Er,: of 1',,r,)d
2 Begin Penn(
Rupees 100 Rupees 100 Rupees 100 Rupees 100
n case "beginning of period' (BOP) annuity , the first of cash flow occurs right now, and
the remaining cash flows take the form of an end-of-the-period annuity over three years,
the present value of this annuity can be written as follows:
PV of Rupees.100 at beginning of each year for four years is equal to 100 plus 100
divided by0.10 multiplied by [1minus1 divided by1.1

s equal to 100 plus100O multiplied by [1 minus divided by 1.331]
s equal to 100+1,000 multiplied by (1-0.7513)
s equal to 100 + 248.70
s equal to 348.70
PV of Rupees.100 at end of each year for four years is equal to 100divided by 0.10
multiplied by [1 1 divided by 1.1
s equal to 1000 multiplied by ( 0.6830)
s equal to 1000 multiplied by 0.3170
is equal to 317
Thus you would observe, present value of BOP annuity is more than PV of end of
period annuity.
Present Value of Beginning-of-Period Annuities
n general, the present value of a beginning-of-a-period annuity over n yeaRupees can
be written as follows:
PV BOP is equal to A+ Ax1, (+r')
This present value will be higher than the present value of an equivalent annuity at the
end of each period.
+7t7re Val7e of Be,innin,EofE*erio& Ann7ities
The future value of a beginning-of-a-period annuity typically can be estimated by
allowing for one additional period of compounding for each cash flow:
f annuity of Rupees A is paid at the beginning of period, for n periods, the future value
at the end of n periods can be calculated as following:
+V of BO* Ann7it3 is eJ7al to +V 'in7s BO* #A0 r0 n$ is eJ7al to A &i=i&e& "3 r
'7lti5lie& "3 #I 5l7s r$ '7lti5lie& "3 N#I 5l7s r$
This future value will be higher than the future value of an equivalent annuity at the
end of each period. Thus if you invest your annuity at the beginning of each year
instead of the end of each year, your future value will be higher.
Suppose you put Rupees 1,000 in Recurring deposit account for 3 years with annual
The first payment is made today; the last and third payment is made at the beginning of
the third year. nterest rate is 10 per cent pa and compounding is done on annual basis.
We now want to calculate the maturity value at the end of three years.
FV (A, r, n) is equal to A multiplied by ( + r) multiplied by [(+ r)' ] divided by r
FV (1,000, 0. 1. 3) is equal to 1,000 multiplied by 1. 1 multiplied by(1.1
-1) divided by0.1
s equal to 1,000 multiplied1.1multiplied by . multiplied by(1.331-1) divided by 0.1
s equal to , 000multiplied by0.33l multiplied by 1.1divided by 0.1
s equal to 331 multiplied by 11
s equal to 3641
Thus the maturity value in this case would be Rupees 3641
A growing annuity is a cash flow that grows at a constant rate for a specified period of
time. f A is the current cash flow and g is the expected growth rate, the time line for a
growing annuity is as follows:
A(1 +g)' A(1 +g)is equal to All +g)3 A(1 +g)4
0 1 2 3 4
Note that to qualify as a growing annuity; the growth rate in each period has to be the
same as the growth rate in the prior period.
Dis%o7ntin, a Iro8in, Ann7it3
The present value of a growing annuity can be estimated by using the following formula:
PV of a Growing Annuity is equal to A multiplied %y (1 plus g) di$ided %y(r minus g)
multiplied %y [1 minus (1 plus g)
di$ided %y (1 plus r)
The present value of a growing annuity can be estimated in all cases but one if the
growth rate is equal to the discount rate, the present value is equal to the nominal sums
of the annuities over the period, without the growth effect.
PV of a Growing Annuity for n years (when r is equal to g) is equal to n A
t is important to note that the expanded formulation works even when the growth rate is
greater than the discount rate.
Perpetuity is a constant cash flow paid (or received) at regular time intervals forever.
Thus a lifetime pension can be considered as a perpetuity or rentals received from
exploitation of land which is passed on from generation to generation.
The present value of perpetuity can be written as
*V of 5er5et7it3 is e4ual to 2 divided by r
A Console Bond is a bond that has no maturity and pays a fixed coupon (rate of
Assume that you have a 6 per cent coupon console bond. The original face value is
equal to Rupees 1000. The current value of this bond if the interest rate is 9 per cent is
as follows.
Current Value of Console Bond is equal to Rupees 60 divided by 0.09 is equal to
Rupees 667.
The value of a Console bond will be equal to its face value only if the coupon rate is
equal to the interest rate. n this case Rupees 1,000, i.e. 60/0.06
!rowing #erpetuities
A growing perpetuity is a cash flow that is expected to grow at a constant rate forever.
The present value of a growing perpetuity can be written as
*V of Iro8in, *er5et7it3 is eJ7al to C1 &i=i&e& "3#r 'in7s ,$
Where C, is equal to A ( plus g) i.e. payment at the end of the first period.
A growing perpetuity is a constant cash flow, growing at a constant rate, and paid at
regular time intervals forever.
Although a growing annuity and a growing perpetuity share several features, the fact
that a growing perpetuity lasts forever puts constraints on the growth rate. It has to "e
Iess than the &is%o7nt rate for the for'7la to 8or2.
&otations: Common Notations used in calculations are as follows and we have used
them throughout the Unit.:
Notation Meanin,
*V *resent Val7e
+V +7t7re Val7e
Ct Cash flo8 at the en& of 5erio& t
A Ann7it3 Constant Cash +lo8s o=er se=eral 5erio&s
r Dis%o7nt rate
F E65e%te& ,ro8th rate in %ash flo8s
n N7'"er of 5erio&s o=er 8hi%h %ash flo8s are re%ei=e& or 5ai&
Time value of money: A rupee today is more valuable than a rupee a year later.
8pportunity /ost of /apital: When money is invested, what it earns should be
compared with the earning from risk free investment. We should be able to earn at least
the same amount or more. The interest rates on bonds/ securities, etc., will be the
opportunity cost of capital.
"iscount Rate: The process of discounting is simply the inverse of compounding. The
rate at which the future cash flows are discounted is called the Discount rate.
Annuity: A series of periodic cash flows of equal amounts, e.g. Sinking Fund, Pension
Fund, nsurance premia.
#resent value of Money: The present value is calculated by discounting the future
payments at the discount rate
( a) PV of a single cash flow C, after n years at r per cent interest rate:
*V is eJ7al toC '7lti5lie& "3 N1 &i=i&e& "3 #1 5l7s r$ to the 5o8er of n
(b) PV of an Annuity: A '7lti5lie& "3 N#1 5l7s r$ to the 5o8er of n

E1O &i=i&e& "3 r
'7lti5lie& "3 #1 5l7s r$

to the 5o8er of n
'nflation *ffect: n an inflationary period, a rupee today represents greater real
purchasing power than a rupee a year hence.
0uture 5alue of Money: f you deposit your money in the bank, compound it annually
at the given interest rate, then the deposit would grow to a bigger amount.
FV of single cash flow: P (1 + r)to the power of n
FV of an annuity: equal payment made every year for n years at r per cent
A N#1 5l7s r$ to the 5o8er of n E1O &i=i&e& "3 r
0re4uency: When compounding (or discounting) is done more frequently than annually,
the effective discounting rate of interest is greater than the nominal rate of interest.
#erpetuity: Perpetuity is an annuity of infinite duration. The present value of perpetuity
is expressed as is equal to A divided by r
&et #resent 5alue $&#5%: This value is the difference between the cash outflows and
cash inflows at the base period. That is, calculate the present values of inflows and
outflows and find the difference. Only when the NPV is positive, we should go ahead
with the investments.
1. What will be future value of money invested at a given interest rate after a given
period of time?
2. What is the present value of a cash flow to be received in the future?
3. How can we calculate present and future values of streams of cash payments?
4. What is the difference between ral and nominal cash flows and real and nominal
interest rates?
5. Why does money have time value?
6. Explain the rule of 72.
7. Can we compare cash flows occurring at different times? What should we do to bring
them to a common base?
8. am 50 years old, retire at the age of 60 and expect to live 10 years more. f want to
spend Rupees 10,000 per month, how much should save by the age of 60 to support
this plan? Assume an interest rate of 8 per cent. What is the required savings if the
interest rate is only 5 per cent? Comment on the results.
9. How long will it take for Rupees 500 to grow to Rupees 2,000 at the following interest
(a) 4per cent; (b) 10per cent; (c) 12per cent
10. What is the effective annual interest rate in the following cases?
(a) 12per cent compounded monthly
(b) 8per cent compounded every 4 months
1. f invest Rupees 5,000 today and expect to sell at Rupees 10,000 in 8 years. f the
interest rate is 5 per cent, is this a good deal? What if the interest rate is 12 per cent?
12. What is Net Present Value? When there is no profit or loss in an investment, what is
the NPV?
13. How much should be deposited at the beginning of each year for 10 years, in order
to provide a sum of Rupees 5 lakhs at the end of 10 years?
14. Ravi receives an amount of Rupees 10 lakhs from the Provident Fund. He deposits
this amount in his bank and earns 10 per cent interest. f he withdraws every year
Rupees 2 lakhs; what will be the amount left in his account at the end of 5 years.
15. Ram is saving to buy a car after 5 years. The car costs Rupees 6 lakhs and he
earns 8 per cent a year on savings. He wants to save an equal amount each year.
(a) How much does he need to put aside at the end of years 1 to 5?
(b) Suppose the interest rate decreases by 2 per cent from year 3.He still wants to go
ahead with the purchase of the car, at the end of year 5. By how much should he
increase the savings?
(c) f he follows earlier pattern of savings, when will he be able to buy the car?
16. ABC company has three projects to choose from. The Finance Manager and the
Operations Manager discuss the matter. They are not able to come to a decision. Then
they meet a consultant to get advice. As a consultant, what advice you will give?
The cash flows are as follows. All amounts are in lakhs of Rupees.
*roAe%t 1: Duration 15 years
Beginning Cash Outflow is equal to Rupees 100
Cash inflows (at the end of the year)
Year 1-Ruees 30; year 2- Rupees 30; Year 3- Rupees 30; Year4-
Rupees10; Year 5- Rupees 10.
*roAe%t !: Duration 5 years
Beginning cash outflow Rupees 100
Cash inflows (at the end of the year)
Year 1- 5; year2-15; year 3-25; year4-35; year5-50
*roAe%t (: Duration 15 years
Beginning Cash Outflow Rupees 100.
Cash inflows (at the end of the year)
Year 1-Rupees 30 Year 2- Rupees 20 (for 10 continuous years)
Years 11 to 15 Rupees 10 (for the next 5 years).
f the cost of capital is 8per cent, which of the 3 projects should the ABC Company
accept? Answer the following questions
(a) f A invests Rupees 100 at 7per cent interest rate for 3 years, what will be the value
at the end of 3 years?
Ans8er: 1!!.?0
(b) My grandfather, starts giving me gifts of Rupees 1 lakh for the next 4 years. f the
interest rate is 10per cent pa, how much will get at the end of 4 years?
Ans8er: R75ees .0@.0100
(c) A quarterly repayments of a loan carry an interest rate of 8per cent per annum. What
is the effective annual interest rate?
Ans8er: C.! 5er %ent
(d) Find the interest rate. Present Value is Rupees 100. Future Value becomes 115.76
in 3 years.
Ans8er: C 5er %ent.
(e) A receives a contract for Rupees 15 lakh, providing Rupees 3 lakh for 5 years. B
receives a contract for the same work, Rupees 14 lakh, for the same 5 Yr. period, giving
him Rupees 4 lakh upfront and Rupees 2 lakh at the end of each year for 5 years. Who
is better off?
Ans8er: B
(f) f take a loan of Rupees 8,000 and repay Rupees 225 per month, for 4 years, what
is the effective annual rate on the loan?
Ans8er: 1?.?C 5er %ent.
(g) buy a property for Rupees 3 lakh, and plan to sell it in 5 years for Rupees 4 lakh;
(a) What is the PV of selling price if the interest rate is 8per cent?
(b) s the investment attractive?
Ans8er: a$ R75ees !0 B!0!((. "$ No
(h) Under the rule of 72, how long will it take for an investment to quadruple in value, if
the interest rate is 12per cent?
Ans8er: 1! 3ears
() if the interest rate changes, from 8per cent this year to 10per cent next year. What is
the Future value of Rupees 100 in 2 years? What is the Present Value of Rupees 100 to
be received after 2 years?
Ans8er: #1$ R75ees 11C.C< R75ees F..1C
Appendix Table 1
Dis%o7nt +a%tors: *resent =al7e of R75ees 1 to "e re%ei=e& after t 3ears is eJ7al
to 1 &i=i&e& "3#1 5l7s r$
.971 .962 .952.943 .935 .926 .917 .909 .901 .893 .885 .877 .870
.943 .925 .907.890 .873 .857 .842 .826 .812 .797 .783 .769 .756
.915 .889 .864.840 .816 .794 .772 .751 .731 .712 .693 .675 .658
.888 .855 .823.792 .763 .735 .708 .683 .659 .636 .613 .592 .572
5 .
.822 .784.747 .713 .681 650 .621 .593 .567 .543 .519 .497
6 .. .837 .790 .746.705 .666 .630 .596 .564 .535 .507 .480 .456 .432
7 .. .813 .760 .711.665 .623 .583 .547 .513 .482 .452 .425 .400 .376
.769 .731 .677.627 .582 .540 .502 .467 .434 .404 .376 .351 .327
.766 .703 .645.532 .544 .500 .460 .424 .391 .361 .333 .308 .284
10 .
.744 .676 .614.558 .508 .463 .422 .386 .352 .322 .295 .270 .247
11 .
.722 .650 .585.527 .475 .429 .388 .350 .317 .287 .261 .237 .215
.625 .557.497 .444 .397 .356 .319
.286 .257 .231 .208 .187
.681 .601 .530.469 .415 .368 .326 .290 .258 .229 .204 .182 .163
.661 .577 .505.442 .388 .340 .299 .263 .232 .205 .181 .160 .141
15 .
.642 .555 .481.417 .362 .315 .275 .239 .209 .183 .160 .140 .123
16 .. .623 .534 .458.394 .339 .292 .252 .218 .188 .163 .141 .123 .107
17 .
.605 .513 .436.371 .317 .270 .231 .198 .170 .146 .125 .108 .093
.587 .494 .416.350 .296 .250 .212 .180 .153 .130 .111 .095 .081
.570 .475 .396.331 .277 .232 .194 .164 .138 .116 .098 .083 .070
20 .
.554 .456 .377.312 .258 .215 .178 .149 .124 .104 .087 .073 .061
.478 .375 .295.233 .184 .146 .116 .092 .074 .059 .047 .038 .030
.412 .308 .231.174 .131
.099 .075 .057
For example, if the interest rate is 10per cent per year, the present value of Re 1
received at year 5 is Rupees 0.621.
122 1 - - tD BAN'~'
Appendix Table 2
+7t7re =al7e of Re 1 after t 3ears is eJ7al to 1'7lti5lie& "3#1P r$
1.010 1.02
1.110 1.120
2 1.020 1.04
1.232 1.254
3 1.030 1.06
1.368 1.405
4 1.041 1.08
1.518 1.574
5 1.051 1.10
1.685 1.762
6 1.062 1.12
1.870 1.974
7 1.072 1.14
2.076 2.211
8 1.083 1.17
2.305 2.476
9 1.094 1.19
2.558 2.773
10 1.105 1.21
2.839 3.106
11 1.116 1.24
3.152 3.479
12 1.127 1.26
3.498 3.896
13 1.138 1.29
3.883 4.363
4.310 4.887
15 1.161 1.34
4.785 5.474
16 1.173 1.37
5.311 6.130
17 1.184 1.40
5.895 6.866
18 1.196 1.42
6.544 7.690
19 1.208
7.263 8.613
20 1.220 1.48
8.062 9.646
25 1.282 1.64
13.59 17.00
30 1.348 1.81
22.89 29.96
For example, if the interest rate is 10per cent per year, the investment of Re 1 today will
be worth Rupees 1.611 at year 5.
Appendix Table 3
1 0.990 0.9
0.885 0.877 0
2 1.970
1.668 1.647
3 2.941
2.361 2.322
4 3.902 3.8
2.974 2.914 2
5 4.853 4.7
3.517 3.433 3
6 5.795 5.6
3.998 3.889 3
7 6.728
4.423 4.288
8 7.652
4.799 4.639
9 8.566 8.1 7.78 7.43 7.10 6.80 6.51 6.24 5.99 5.75 5.537 5.132 4.946 4
10 9.471 8.9
5.426 5.216 5
11 10.37 9.7
5.687 5.453 5
5.918 5.660
13 12.13 11.
6.122 5.842 5
14 13.00
6.302 6.002
15 13.87 12.
8.462 6.142 5
16 14.72 13.
6.604 6.265 5
17 15.56
6.729 6.373
18 16.40
6.840 6.467
19 17.23
6.938 6.550
20 18.05 16.
7.025 6.623 6
25 22.02 19.
7.330 6.783 6
30 25.81 22.
7.496 7.003 6
For example, if the interest rate is 10per cent per year, the present value of Re 1
received in each of the next 5 years is Rupees 3.791.
UNT 13 Sampling Methods
13.0 Objective
13.1 ntroduction
13.2 Random Sampling
13.3 Sampling Distributions
13.4 Sampling from Normal Populations
13.5 Sampling from Non-normal Populations
13.6 Central Limit Theorem
13.7 Finite Population Multiplies
2nne+ure- #robability Table
The objectives of this unit are as follow:
1. Learn to take a sample from an entire population and use it to describe the population
2. Make sure the samples represent the population.
3. ntroduce the concepts of sampling distributions
4. Understand the trade off between costs of larger samples and accuracy
5. ntroduce experimental design sampling procedures.
6. Estimation data analysis and interpretation of sample data
7. Testing of hypotheses one-sample data
8. Testing of hypotheses two-sample data
As you know, statistics is a tool used in business and finance. Statistics is an
appreciated as well as maligned tool depending on how it is used. n the last Lok Sabha
elections in ndia the exit polls based on statistical forecasting were proved wrong. We
need statistical methods to reduce risk, uncertainty and improve our decision making
skills. Decision making in a situation involves collecting information and then using this
data for the future strategy. Usually we cannot use the complete data because of the
sheer size or numbers involved. Therefore, we take a sample and test it. For example if
a milk plant processes 1 lakh litres of milk every day, one cannot break open each
packet and test the milk for quality. Here we take samples from each batch. f we want
to do a market survey we cannot interview each and every household, we take a
representative sample. Thus sampling becomes an integral tool of the quantitative
methods we use. We take a sample, collect data from the sample and attempt to
generalize the results for the whole data.
Tea tasters at tea auctions are very highly paid employees of tea companies. They
sample a small portion of the tea produced from the plantation before the auction. Food
products are often tasted before being sold. Before you buy Diwali sweets, you may
take a small bite, before deciding to buy it. Obviously everything cannot be opened and
tasted or tested as there would be nothing left to sell. We have to select a sample and
test that only. f you want to write a report on why many people are migrating from ndia
to Canada or Australia, contacting each and every ndian who migrated would be time
consuming and expensive. So you would choose a sample and make a report
accordingly. Thus time and size are decisive factors which make it necessary to take
business decisions on sample. f your sample is properly chosen, your report would truly
reflect reasons of the entire population for migration. Of course in any situation, the best
results would be available, if we collect data from the entire population. Such complete
enumeration or census is used in the population census carried out in our country every
ten years.
Statisticians use the word population to refer not only to people but to all items that are
to be studied. The word sa'5le is used to describe a portion chosen from the
We can describe samples and populations by using measures such as mean, median,
mode and standard deviation. When these terms describe a sample, they are called
statistic and are not from the population but estimated from the sample. When these
terms describe a population they are called parameters.
A statistic is a characteristic of a sample; a parameter is a characteristic of a population.
Conventionally, statisticians use lower case Roman letters to denote sample statistics
and Greek or Capital letters to denote population parameters.
Table 13.1 lists these symbols.
TABLE 13.1 mportant Statistics Notations and Symbol
Population Sample
Definition Collection of all items Part of the population
Characteristics Parameters Statistics
Symbols Size N Size n
Meanla Mean x
Standard Standard
Deviation a Deviation s
Types of Sampling
There are two methods of selecting samples from populations: non-random or
judgement sampling and random or probability sampling. n probability sampling all the
items in the population have a chance of being chosen in the sample. n judgement
sampling, personal knowledge or opinions are used to identify the items from the
population that are to be included in the sample. A sample selected by judgement
sampling is based on someone's experience with the population. An oil drilling company
would ask an experienced geologist to test different terrains or land beneath the sea
before deciding where to explore for oil. Sometimes a judgement sample is used as a
pilot or trial sample to decide how to take a random sample later. f we want to launch a
new city newspaper, a pilot test of the paper can be launched at a judgement sample to
see the response. But the rigorous statistical analysis which can be done with random
probability samples cannot be done with judgement samples. On the other hand, they
are more convenient and can be used successfully even if we cannot test their validity.
But if a study uses judgement sampling and loses a significant degree of representative
ness, it will have purchased convenience at a high price.
7iased samples
Suppose the Parliament is debating on the women's bill. You are asked to conduct an
opinion survey. Because women are the most affected by women's bill, you go and
interview a lot of women in different cities, towns and rural areas of ndia. Then you
report that an overwhelming 95 per cent are in favour of reservation for women in
Sometime later the government has to take up the issue of Foreign Direct nvestment
(FD) in print media. Since newspaper publishers are the most affected you contact all
of them both national and regional in ndia and report that the majority is not in favour of
FD in print media.
n both these cases you picked a biased sample by choosing people who would have
strong feelings on this issue. You have to have proper samples.
A report based on the data collected from such biased sample then would not truly
reflect public opinion. To avoid such errors, if we follow random sampling, it is possible
to statistically determine the reliability of the estimates obtained from the sample.
There are four main types of random sampling.
1. Simple Random Sampling
2. Systematic Sampling
3. Stratified Sampling
4. Cluster Sampling
1. Si'5le Ran&o' Sa'5lin,
Simple Random Sampling selects samples by methods that allow each possible sample
to have an equal probability of being picked and each item in the entire population to
have an equal chance of being included in the sample.
Suppose we have 4 teenagers participating in a talk show. We want a sample of two
teenagers at a time for participating with the chat show host.
The following table illustrates the possible combinations of samples of teenagers, the
probability of each sample being picked and the probability that each teenager will be in
a sample.
Teenagers A, B, C, D
Possible samples of two teenagers: AB, AC. AD, BC, BD, CD.
Probability of drawing these samples of two people is the same as below:
P (AB) is equal to 1 divided by 6
P (AC) is equal to 1divided by6
P (AD) is equal to 1divided by6
P (BC) is equal to 1divided by6
P (BD) is equal to 1divided by6
P (CD) is equal to 1divided by6
You would observe that any one student appears in 3 of the 6 possible samples.
Therefore, probability of a particular student in the sample is
P (A) is equal to 1divided by2
P (B) is equal to 1divided by2
P(C) is equal to 1divided by2
P (D) is equal to 1divided by2
The example illustrates a finite population of four teenagers. f we write A, B, C, D on 4
identical slips of paper, fold the papers, and randomly pick any two of them-, we get a
sample. While picking up 2 paper slips, we may pick up one, keep it away, and then
pick another from the remaining three. This type is called sampling without
There is another way of doing it. Suppose after picking the first slip, we note the name
on it and put the slip back in the lot, i.e. replace the paper slip. Then we draw the
second slip. There is a chance that we may draw the same student again. This is called
sampling with replacement)
Theoretically, it is possible to have an infinite population. For example, the population of
all prime numbers is infinite. Although many populations seem exceedingly large, no
truly infinite population of physical objects actually exists. After all, given unlimited
resources and time, one can enumerate any finite population. As a practical matter, we
will use the term infinite population when we are talking about a population that could
not be enumerated in a reasonable period of time. Thus we use a theoretical concept of
infinite population as an approximation of a large finite population.
:ow to do Random Sampling;
Suppose there are 100 employees in a company, and we wish to interview a randomly
chosen sample of 10. We write the name of each employee on a slip of paper and
deposit the slips in a box. After mixing them thoroughly, we draw 10 slips at random.
The employees whose names are on these 10 slips are our random sample.
This method of drawing a sample works well with small groups of people, but presents
problems with large populations. Also, add to this the problem of the slips of paper not
being mixed well.
We can also select a random sample by using random numbers. These numbers can
be generated either by a computer programmed to scramble numbers, or by a table of
random digits.
The table is a part like random digits. These numbers have been generated by a
completely random process. The probability that any one digit from 0 through 9 will
appear is the same for each digit, and the probability of one sequence of digits
occurring is the same as for any other sequence of the same length.
15,819 20,685 82,621 83,748 69,662
09,281 72,950 85,961 48,980 06,840
41,120 48,326 18,824 54,466 94,470
74,574 63,491 00,923 04,142 51,336
00,995 02,727 96,703 12,671 31,976
59,987 93,247 72,301 34,290 69,051
69,787 72,950 56,709 54,709 70,945
71,642 54,358 40,316 88,897 99,907
35,939 34,406 11,987 23,691 70,582
67,494 30,909 20,395 50,973 74,338
96,974 22,756 34,574 81,235 60,089
i , METHODS 1 129
20,079 07,000 50,890 37,689 39,622
45,847 76,661 55,448 14,318 74,840
38,401 64,88B 08,409 90,352 56,923
63,151 91,208 72,286 78,612 98,120
01,904 02,727 18,928 53,446 01,778
55,700 48,000 38,595 60,089 26,117
26,926 36,478 33,822 45,786 36,984
31,406 67,652 15,134 53,872 87,520
70,645 65,145 96,286 59,837 79,304
83,832 97,712 31,209 83,209 09,007
11,865 68,401 98,654 43,211 11,559
16,264 19,856 40,972 75,623 09,406
52,203 64,287 05,963 23,673 32,329
49,420 22,936 42,003 32,367 15,130
02,875 33,739 27,092 29,805 75,614
88,094 92,125 72,709 42,514 40,618
31,196 26,299 50,839 67,173 82,465
Let us see how to use this table. We assign each employee a number from 00 to 99,
consult the table above and pick a systematic method of selecting two digit numbers.
Like the first two digits. So we have 15, 09, and so on till we get our 10 numbers.
Systematic Sampling
n systematic sampling, elements are selected from the population at a uniform level
that is measured in time, order, or space. f we wanted to interview every twentieth
student on a college campus, we would choose a random starting point in the first
twenty names in the student directory and then pick every twentieth name thereafter.
Systematic sampling differs from simple random sampling in that each element has an
equal chance of being selected but each sample does not have an equal chance of
being selected. This would have been the case if, in our earlier example we had
assigned numbers between 00 and 99 to our employees and then began to choose our
sample of 10 by picking every tenth number beginning 1, 11, 21, 31, and so forth.
Employees numbered 2, 3, 4 and 5 would have no chance of being selected together.
n systematic sampling there is a probability of introducing an error into the sampling
process. The system chosen may cause a problem. f we want to check the chances of
people eating out on different days of the week and choose Friday. There is higher
likelihood of Friday as it is the beginning of the weekend and we get a higher result.
Systematic sampling has some advantages. Even though systematic sampling may be
inappropriate when the elements lie in a sequential pattern, this method may require
less time and sometimes results in lower costs than the simple random sample method.
Stratifie& Sa'5lin,
To use stratified sampling, we divide the population into relatively homogenous groups,
called strata. Then we use one of two approaches. Either we select at random from
each stratum a specified number of elements corresponding to the proportion of that
stratum in the population as a whole or we draw an equal number of elements from
each stratum and give weight to the results according to the stratum's proportion of total
population. With either approach, stratified sampling guarantees that every element in
the population has a chance of being selected.
,hen to use< Stratified Sampling;
Stratified sampling is appropriate when the population is already divided into groups of
different sizes and we wish to acknowledge this fact. Example middle class, upper
class, lower middle class, etc. or according to age, race, sex or any other stratification.
A jeans company may want to study which age group prefers to wear jeans the
maximum. Thus the age groups may be 13 to 20, 20 to 30, 30 to 40, 40 plus. The
advantages of stratified samples are that when they are properly designed, they more
accurately reflect the characteristics of the population from which they are chosen than
do other kinds of samples.
Cl7ster Sa'5lin,
n cluster sampling, we divide the population into groups or clusters and then select a
random sample of these clusters. We assume that these individual clusters are
representative of the population as a whole. f a market Research team is attempting to
determine by sampling the average number of television sets per household in a large
city, they could use a city map and divide the territory into blocks and then choose a
certain number of blocks (clusters) for interviewing. Every household in each of these
blocks would be interviewed. A well designed cluster sampling procedure can produce a
more precise sample at considerably less cost than that of simple random sampling.
/omparison of Stratified and /luster Sampling
With both stratified and cluster sampling, the population is divided into well-defined
groups- We use stratified sampling when each group has small variation within itself but
there is wide variation between the groups. We use cluster sampling in the opposite
case when there is considerable variation within each group but the groups are
essentially similar to each other.
7asis of Statistical 'nterference: Simple Random Sampling
Systematic sampling, stratified sampling and cluster sampling attempt to approximate
simple random sampling. All are methods that have been developed for their precision,
economy or physical ease. However as we do problems, we shall assume that the
entire sample we are talking about, are data based on simple random sampling. The
process of making statistical inferences is based on the principles of random sampling.
Once you understand the basics for random sampling, the same can be extended to
other types of samples with some amendments which are best left to professional
statisticians. t is important that you get a grasp of the concepts concerned.
n this section, we presume you would have learnt in your high school mathematics
concepts such as mean, mode, median, standard deviation, etc. Each sample you draw
from a population would have its own mean or measure of central tendency, and
standard deviation. Thus the statistics we compute for each sample would vary and be
different for each random sample taken.
Let us take an example:
We take a finite population of 5 young boys; A, B, C, D, E and collect data about their
heights in centimeters. The data is shown in Table 13.2.
TABLE 13.2 Sampling Distribution Table
HEGHT (cm)
160 162 164 170 156
Now, if we take samples of size 3 that is, select 3 boys in each sample, we will get 10
different samples. We list these samples, the corresponding data and their mean in
Table 13.3.
o12 4 5 6 7'
9 10
159.33 165.33 160.66 164.66
160 162 162.66 163.33
From Table 13.3, you can see that sample mean for each sample is different. This
collection of different values of sample mean for samples of size 3 forms a distribution
of sample means. This distribution has a mean. f we add all sample means in Table 2,
and divide the sum by the number of samples, i.e. 10, we get 162.397
Normally, we will be dealing with large populations. Hence the number of samples of a
particular size is also very large.
We could also have a sampling distribution of proportion. Suppose we have to
determine the proportion of sugar plants in a plantation affected by pest disease in
samples of 100 plants taken from a very large plantation. We have taken a large
number of these 100 item samples. f we plot a probability distribution of the proportions
of infested plants in all these samples, we would see a distribution of the sample
proportion. (The term proportion here refers to the proportion that is infected.)
Sa'5lin, &istri"7tion is the distribution of all possible values of a statistic from all
possible samples of a particular size drawn from the population.
Des%ri"in, Sa'5lin, Distri"7tion
Any probability distribution (and, therefore, any sampling distribution) can be partially
described by its mean and standard deviation. Table 13.4 describes how different
sampling distributions
can be
Population Sample Sample Statistic
1. Water in a River 10-one litre
of water
Mean number of
parts of mercury
per million parts
S.No. Population Sample Sample Statistic
2. All professional
Groups of 5
3. All parts
produced in
a manufacturing
50 of each part Proportion
Sampling Distribution
Sampling distribution of the mean
Sampling Distribution
Sampling distribution of the median
Sampling distribution of the proportion
Each of the above sampling distributions can be partially described by its mean and
standard deviation.
Con%e5t of Stan&ar& Error
Standard deviation of the distribution of the sample means is called the standard error
of the mean. Similarly standard error of the proportion is the standard deviation of the
distribution of the sample proportions.
The term standard error is used because it has a very specific meaning. For example,
we take the average heights of college girls in ndia across various samples. We would
calculate the mean height for each sample. Obviously, there would be some variability
in our observed mean. This variability in sampling statistics results from the sampling
error due to chance. Thus the difference between the sample and population means is
due to the choice of samples.
Thus the standard deviation of the sampling distribution of means measures the extent
to which the means vary because of a chance error in the sampling process. Thus, the
standard deviation of the distribution of a sample statistic is known as the standard error
of the statistic.
Thus a standard error indicates not only the size of the chance error but also the
accuracy we are likely to get if we use the sample statistic to estimate a population
statistic. Thus a mean with a smaller standard deviation is a better estimator than one
with a higher standard deviation.
Understanding sampling distributions allows statisticians to take samples that are both
meaningful and cost effective. Because large samples are more expensive, decision
makers should always aim for the smallest sample which will give the most reliable
Sa'5lin, Distri"7tions
Figures 13.1 (a) and (b) will help you to understand sampling distributions. There are
three parts to this illustration. Figure 13.1(a) illustrates a population distribution. Assume
that this population is all the non-performing assets of a large bank and this distribution
is the number of years the assets have been classified as nonperforming in the balance
sheet. This distribution of number of years has a mean mu and a standard deviation of
Suppose we are able to take all possible samples of 10 non-performing assets (NPA s)
from the population distribution. There would be too many so we possibly cannot take
all. Next we would calculate the mean and standard deviation for each one of these
samples, as represented in Fig. 13-1(6). As a result each sample would have its own
mean T, and its own standard deviation's'. All the individual sample means would not be
the same as the population mean. They would tend to be near the population mean, but
only rarely would they be exactly that value.
As a last step, we would produce a distribution of all the means from every sample that
could be taken. This distribution, called the sampling distribution of the mean, is
illustrated in Fig 13.1(c).
This distribution of the sample means (the sampling distribution) would have its own
mean- -x, and its own standard deviation or standard error -x.
n statistical terminology, the sampling distribution is obtained by taking all the possible
samples of a given size is the theoretical sampling distribution.
Figure 13.1(c) shows an example of such a distribution. n practice, the size and
character of most real life populations prohibit 'us from taking all the possible samples
from a population distribution. Fortunately, formulas are developed for estimating the
characteristics of these theoretical sampling distributions, making it unnecessary for
collecting large numbers of samples. n most cases decision makers take only one
sample from the population, calculate some statistics from the sample, and from those
statistics estimate something about the parameters of the entire population. We shall
show this shortly.
Now, we shall be discussing the sampling distribution of the mean in the examples that
follow. Once you understand the formulae and concepts here, the same can be applied
to other sampling distributions as well.
Let us go back to the example of taking samples of size 3 from a population of size 5.
From Table 13.4, we find mean mu of the population
'7 is eJ7al to 1@!..0
n Table 13.5, we have the sample means, x bar for the 10 samples.
The mean of these sample means mu, is equal to 162.40; which is the same as
population mean. This is not a coincidence. The mean of the sample means is the same
as the population mean, whenever we use simple random sampling.
Now from Table 13. 1, we see that the values range from 156 to 170. From Table 13.2,
we see that the sample means range from 159.33 to 165. Thus sample means have
smaller spread than the population.
Thus, if our population is normally distributed, the sampling distribution is also normal.
Further (1) the mean of the sampling distribution is same as the population mean. Mu
multiplied xbar is equal to and (2) the standard deviation of the sampling distribution is
equal to the population standard deviation divided by the square root of the sample size.
Sigma multiplied by x bar is equal to sigma divided by square root of n.
Now suppose we increase our sample size from 5 to 20. This would not change the
standard deviation of the items in the original population. But with samples of 20, we
have increased the sample means. Figure 2.3 illustrates this point. The properties are
also explained below.
Properties of Sampling Distribution of Mean, when Population is normally Distributed
Sampling Distribution has Mean equal to Population Mean. EJ7ation: '7 '7lti5lie&
"3 6 "ar is eJ7al to '7
Sampling distribution has Standard Deviation equal to Population Standard Deviation
divided by Square root of Sample size. EJ7ation: si,'a '7lti5lie& "3 6"ar is eJ7al
to si,'a &i=i&e& "3 SJ7are root of n
An example will further illustrate these properties. A bank calculates that its individual
savings accounts are normally distributed with a mean of Rupees 2,000 and a standard
deviation of Rupeess600. f the bank takes a random sample of 100 accounts, what is
the probability that the sample mean will lie between Rupees 1,900 and Rupees 2,050?
This is a question about the sampling distribution of the mean; therefore, we must first
calculate the standard error of the mean. n this case, we shall use the equation for the
standard error of the mean designed for situation in which the population is infinite
(later, we shall introduce an equation for finite populations):
Since the sampling distribution is a normal distribution, let us first see how to find the
probabilities associated with a normal distribution.
The probabilities associated with a standard normal variable, that is, a normal variable
with mean 0, and standard deviation 1, are available in the form of a Table. See
ANNEXURE at the end of this unit. We first convert a value in our sample to a standard
normal value by using the equation
Z is equal to is divided by sigma multiplied by xbar [X bar minus mu].
The ANNEXURE gives us the probability that the variable z is between 0 and the given
value. For example, if we want to know the probability that the variable z is between 0
and 1.54, we get the answer from the Table 13.4 as 0.4382.
The probability that the variable is between minus 0.96 and 0 is given as 0.3315. (Note
that we ignore the minus sign.)
The probability that the variable is between minus minus0.96 and 1.54 is then 0.4382
plus 0.3315 is equal to 0.7697
The probability that the variable is between minus 0.96 and minus 1.54 is 0.4382 minus
0.3315 is equal to 0.1067.
The probability that the variable is between 0.96 and 1.54 is also 0.4382 minus 0.3315
is equal to 0.1067.
So if the values have the same sign (plus or minus), we subtract the smaller value in the
Table from the bigger one.
On the other hand, if the values have opposite signs, we add the values obtained from
the Table.
Stan&ar& Error of the Mean for Infinite *o57lations
Standard error of the mean is equal to sigma divided by square root of n
Where is equal to population standard deviation
n is equal to sample size.
Applying this to our example, we get
Standard error of the mean is equal to 600 divided by60 is equal to 10
Using this equation z is equal to (x bar minus Mu) divided by sigma multiplied by
We get 2 z values
For x bar is equal to Rupees 1, 900, z is equal to (1900-2000) divided by 60is eual to
Minus 1.67
For xbar is equal to Rupees 2050, z is equal to (2050 minus 2000) divided by 60 is
equal to 0.85
Annexure table gives us an area or probability of 0.4525 corresponding to a z value of
1.67, and it gives probability of 0.2967 for a z value of 0.83. f we add these two
together, we get 0.7492 as the total probability that the sample mean will lie between
Rupees and Rupees 2,050.
The probabilities are also shown by the areas under the probability curve shown in Fig.
n the preceding section, we stated that when the population is normally distributed, the
sampling distribution of the mean is also normal. But we come across many populations
that are not normally distributed. How does the sampling distribution of the mean
behave when the population from which the samples are drawn is not normal? An
illustration will help us answer this question.
Consider the data in Table 13.5, concerning five motorcycle owners and the lives of
their tyres. Because only five people are involved, the population is too small to be
approximated by a normal distribution. Let us take all of the possible samples of the
owners in groups of three, compute the sample means (30 1 list them, and compute the
mean of the sampling distribution (jE). We have done this in Table 2.5. These
calculations show that even in a case in which the population is not normally distributed,
(l-LX, the mean of the sampling distribution is still equal to the population mean.
Now look at Fig. 13.3(a) which shows the population distribution of tyre lives for the five
motorcycles owners, a distribution that is anything but normal in shape. n Fig. 13.3(b)
we show the sampling distribution of the mean for a sample size of three, taking the
information from Table 13.1. Notice the difference between the probability distributions
in Figs. 13.3(a) and 13.3(b). n Figure 13.3(b), the distribution looks a little more like the
bell shape of the normal distribution.
Simulated effect of increases in the sample size on the appearance of the sampling
distributions.1see Figs. 13.3 (a-b)]. We repeat this exercise, and enlarge the population
size to 40; we could take samples of different sizes. Then plot the sampling distributions
of the mean that would occur for the different sizes. This will show quite dramatically
how quickly the sampling distribution of the mean approaches normality, regardless of
the shape of the population distribution.
The example in Table 2.2 and the probability distribution in the above graphs, tell us
many things. First, the mean of the sampling distribution of the mean will equal the
population mean regardless of the sample size, even if the population is not normal. As
the sample size increases, the sampling distribution of the mean will approach
normality, regardless of the shape of the population distribution.
This relationship between the shape of the population distribution and the shape of the
sampling distribution of the mean is called The Central Limit Theorem. The central limit
theorem is perhaps the most important theorem in all of statistical inference. t assures
us that the sampling distribution of the mean approaches normal as the sample size
1. Actually, a sample does not have to be very large for the sampling distribution of the
mean to approach normal.
2. Statisticians use the normal distribution as an approximation to the sampling
distribution whenever the sample size is at least 30, but the sampling distribution of the
mean can be nearly normal with samples of even half the size.
3. The significance of the central limit theorem is that it permits us to use sample
statistics to make inferences about population parameters without knowing anything
about the shape of the frequency distribution of that population
Let's illustrate the use of the central limit theorem. The distribution of annual earnings of
all bank tellers with five years' experience is as shown below in Fig. 13.4. This
distribution has a mean of Rupees19, 000 and a standard deviation of Rupees 2,000. f
we draw a random sample of 30 tellers, what is the probability that their earnings will
average more than Rupees19, 750 annually? n Fig. 13.4 we show the sampling
distribution of the means that would result, and highlighting the area representing
'earnings over Rupees19, 750.
Our first task is to calculate the standard error of the mean from the population standard
deviation, as follows:
Standard error of the mean sigma multiplied by xbar is equal to sigma divided by
square root of n.
s equal to 2000 divided by square root of 30
s equal to 2000 divided by 5477 is equal to Rupees 365.16
Because we are dealing with a sampling distribution, we must now use the equation for
z value and the Standard Normal Probability Distribution (App. Table z is equal to (xbar
minus mu) divided by sigma multiplied by xbar.
For xbar is equal to Rupees 19750
Z is equal to (19750 minus19000 divided by 365.16
s equal to 750 divided by 365.16
s equal to 2.05
Annexure Table gives us probability of 0.4798 for a z value of 2.05. We show the
corresponding area in Fig. 13.4 as the area between the mean and Rupees l9,750.
Since half or 0.5000 of the area under the curve lies between the mean and the right-
hand tail, the shaded area must be
0.5000 (Area between the mean and the right-hand tail)
0.4798 (Area between the mean and 19,750)
0.0202 (Area between the right-hand tail and 19,750)
Thus, we have determined that there is slightly more than a 2 per cent chance of
average earnings being more than Rupees 19,750 annually in a group of 30 tellers.
The central limit theorem is one of the most powerful concepts in statistics. What it
really says is that the distribution of sample means tends to be a normal distribution.
This is true regardless of the shape of the population distribution from which the
samples were taken.
1. n a sample of 25 observations from a normal distribution with mean 98.6 and
standard deviation 17.2
(a) What is P (92 below xbar below102)?
i b) Find the corresponding probability given a sample of 36.
(a) N is equal to25, mu is equalto98.6 and sigma is equal to 17.2
Sigma multiplied by xbar is equal to sigma divided by square root of n
s equal to 17.s divided by square root of 25 is equal to 3.44
P (92below xbar below 102) is equal to P [(92 minus98.6) divided by 3.44is below (xbar
minus mu) divided by sigma multiplied by xbar is below (100 minus98.6) divided by
s equal to P multiplied by (-19.2 is below z is below 0.99) is equal to 0.4726 plus
0.3389 is equal to0.8115.
(b) n is equal to 36
sigma multiplied by xbar is equal to sigma divided by square root of n is equal to
17.2divided by square root of 36is equal to2.87
P (92 is below xbar is below 102) is equal to P [(92 Minus 98.6) divided by2.87] below (x
bar minus mu) divided by sigma multiplied by xbar is below (100 Minus 98.6) divided
s equal to P (-2.30 below z below 1. 18) is equal to.4893 Plus 0.3 8 10 is equal to 0.
2. Kamala, an auditor for a large credit card company knows that than on average, the
monthly balance of any given customer is Rs112, and the standard deviation is Rupees
56. f Mary audits 50 randomly selected accounts, what is the probability that the
sample average monthly balance is
(a) Below Rupees 100?
(b) Between Rupees 100 and Rupees 130
The sample size of 50 is large enough to use the central limit theorem
mu is equal to 112, sigma equal to 56, n is equal to 50, and sigma xbar is equal to 56
divided by square root of 50 is equal to 7.920
(a)P( xbar below100)is equal to P multiplied by [(xbar minus mu)divided by sigma
multiplied by xbar below (100 - 112) divided by7.9201]
s equal to P(z below minus 1.52) is equal to 0.5 minus 0.4357 is equal to 0.0643
b) P(100belowxbelow130)is equal to P[(100 minus 112)divided by7.920below(xbar
minus mu)divided by sigma multiplied by xbar below(130-112)divided by,7.920]
is equal to P (Minus 1.52 below z below 2.27) is equal to 0.4357 plus 0.4884 is equal to
2n important consideration in Sampling: The Relationship between Sample Si=e
and Standard *rror
We saw earlier in this chapter that the standard error, sigma multiplied by xbar (sigma
xbar) is a measure of dispersion of the sample means around the population mean. f
the dispersion decreases (if (sigma xbar becomes smaller), then the values taken by the
sample mean tend to cluster more closely around mu. Conversely, if the dispersion
increases (if (sigma xbar becomes larger), the values taken by the sample mean tend to
cluster less closely around t. We can think of this relationship this way: As the standard
error de#reases( the $alue of any sample mean will pro%a%ly %e #loser to the $alue of
the population mean. As the standard error de#reases the pre#ision with whi#h the
sample mean #an %e used to estimate the population mean in#reases.
f we refer to Equation, we can see that as n increases, sigma xbar decreases. This
happens because in an Equation a larger denominator on the right side would produce
smaller sigma xbar on the left side. Two examples will show this relationship; both
assume the same population standard deviation sigma of 100.
When n is equal to 10, sigma xbar is equal to sigma divided by square root of n
100divided by3.162 is equal to 31.63, standard error of the mean.
And when n is equal to 100:
Standard error of the mean; sigma xbar is equal to100divided by square root of 100 is
equal to10
What have we shown? As we increased our sample size from 10 to 100 (a ten fold
increase), the standard error dropped from 31.63 to 10, which is only about one-third of
its former value. Our examples show that, because sigma xbar varies inversely with the
square root of n, there is diminishing return in sampling.
t is true that sampling more items will decrease the standard error, but this benefit may
not be worth the cost. t seldom pays to take excessively large samples. Managers
should always assess both the worth and the cost of the additional precision they will
obtain from a larger sample before they commit resources to take it.
n our discussion of sampling distributions, we have used the following equation to
calculate the standard error of the mean:
Si,'a 6"ar is eJ7al to si,'a &i=i&e& "3 sJ7are root of n
This equation is designed for situations in which the population is infinite, or in which we
sample from a finite population with replacement (that is, after each item is sampled,
it is put back into the population before the next item is chosen, so that the same item
can possibly be chosen more than once).
n fact, many of the populations studied are finite; that is, of stated or limited size.
Examples of these include the employees in a given company, the clients of a city
social-services agency, the students in a specific class, and a day's production in a
given manufacturing plant. So we need to modify the equation to deal with finite
populations. The formula designed to find the standard error of the mean when the
population is finite, and we sample without replacement, is
Stan&ar& Error of the Mean for +inite *o57lations
Si,'a 6"ar is eJ7al to si,'a &i=i&e& "3 sJ7are root of n '7lti5lie& "3 Q8hole
root of N 'in7s n &i=i&e& "3 NE1R
where N is equal to size of the population
n is equal to size of the sample
The new term on the right-hand side, which we multiply by our original standard error, is
called the finite population multiplier)
+inite *o57lation M7lti5lier
Finite population multiplier is equal to the whole root of N-1 divided by N-n
A few examples will help us become familiar with interpreting and using the above
equation. Suppose we are interested in a population of 20 textile companies of the
same size, all of which are experiencing excessive labour turnover. Our study indicates
that the standard deviation of the distribution of annual turnover is 75 employees. f we
sample five of these textile companies, without replacement, and wish to compute the
standard error of the mean, we would use the equation as follows:
Sigma xbar is equal to sigma divided by square root of n{whole root of N Minus n
divided by N minus 1
is equal to 75 divided by square root of 5 multiplied by whole root of 20 minus 5 divided
by 20 minus 1.
is equal to (33.54) multiplied by(0.888)
is equal to 29.8 Standard error of the mean of a finite population
n this example, a finite population multiplier of 0.888 reduced the standard error from
33.54 to 29.8.
n cases in which the population is very large in relation to the size of the sample, this
finite population multiplier is close to 1 and has little effect on the calculation of the
standard error. Say, that we have a population of 1.000 items and that we have taken a
sample of 20 items. f we use the Equation to calculate the finite population multiplier,
the result would be
Nn Finite population multiplier is equal to whole root of N minus n divided by N minus 1
s equal to whole root of 1000inus 20 divided by1000 Minus 1
s equal to whole root of 1980 divided by 999
Using this multiplier of 0.99 would have little effect on the calculation of the standard
error of the mean.
This last example shows that when we sample a small fraction of the entire population
(that is, when the population size N is very large relative to the sample size n), the finite
population multiplier takes on a value close to .C. Statisticians refer to the fraction n
divided by N as the sampling fraction, because it is the fraction of the population N that
is contained in the sample.
When the sampling fraction is small, the standard error of the mean for finite
populations is so close to the standard error of the mean for infinite populations that we
might as well use the same formula for both, namely,
Equation xbar is equal to sigma divided by square root of n
The generally accepted rule is: When the sampling fraction is less than >)>?< the
finite population multiplier need not be used)
When we use above equation sigma is constant, and so the measure of sampling
precision sigma xbar depends only on the sample size n and not on the proportion of
the population sampled. That is, to make sigma smaller, it is necessary only to make n
larger. Thus, it turns out that it is the absolute size of the sample that determines
sampling precision, not the fraction of the population sampled.
Although the law of diminishing return comes from economics, it has a definite place in
statistics too. t says that there is diminishing return in sampling. Although sampling
more items will decrease the standard error, (the standard deviation of the distribution of
sample means) the increased precision may not be worth the cost. Because n is in the
denominator, when we increase it (take larger samples) the standard error (5T
decreases. n our example, when we increased the sample size from 10 to 100 (a
tenfold increase) the standard error fell only from 31.63 to 10 (about a two-thirds
decrease). Maybe it wasn't smart to spend so much money increasing the sample size
to get this result. That's exactly why statisticians (and smart managers) focus on the
concept of the "right" sample size. Some finite populations are so large that they are
treated as if they were infinite. An example of this would be the number of TV
households in our country.
/e38or&s 4Ilossar3
/ensus: The measurement or examination of every element in the population.
.Sample< A portion of the elements in a population chosen for direct examination or
Strata: Groups within a population formed in such a way that each group is relatively
homogeneous, but wider variability exists among the separate groups
/lusters: Groups, in population, those are similar to each other, although the groups
themselves have wide internal variation.
Random or probability sampling: A method of selecting a sample from a
population in which all the items in the population have an equal chance of being
chosen in the sample.
Stratified Sample: A method of random sampling. The population is divided into
homogeneous groups or strata. Elements within each stratum are selected at random
according to one of two rules.
1. A specified number of elements is drawn from each stratum corresponding to the
proportion of that stratum in the population.
2. Equal numbers of elements are drawn from each stratum, and the results are
weighted according to the stratum's proportion of the total population.
Systematic sampling: A method of sampling in which elements to be sampled are
selected from the population at a uniform interval that is measured in time, order or
/luster sampling: A method of random sampling. The population is divided into
groups, or clusters of elements, and then a random sample of these clusters is selected.
@udgement Sampling: A method of selecting a sample from a population in which
personal knowledge or expertise is used to identify the items from the population
those are to be included in the sample.
Statistic: Measures describing the characteristics of a sample.
#arameters: 5alues that describe the characteristics of a population.
Statistic: Measures describing the characteristics of a sample.
Sampling distribution of the mean:: A probability distribution of all the possible means
of samples of a given size, n, from a population.
Sampling distribution of a statistic: For a given population, a probability distribution
of all the possible values a statistic may take on for a given sample size.
Sampling error: Error or variation among sample statistic. Differences between each
sample and the population, and among several samples, which are due to the elements
we happen to choose for the sample.
Standard error: The standard deviation of the sampling distribution of a statistic.
Standard error of the mean: The standard deviation of the sampling distribution of the
mean, a measurement the extent to which we expect the means from different samples
to vary from the population mean, owing to the chance error in the sampling process.
Statistical inference: The process of making inferences about populations from
information contained in samples.
/entral Limit: theorem states that the sampling distribution of the mean approaches
normality as the sample size increases, regardless of the shape of the population
distribution from which the sample is selected.
0inite population: A population having a stated or limited size.
0inite population multiplier: A factor used to correct the standard error of the mean
for studying a population of finite size that is small in relation to the size of the sample.
'nfinite population: A population in which it is theoretically impossible to observe all
the elements.
Sa'5lin, 8ith re5la%e'ent: sampling procedure in which sampled items are returned
to the population after being picked, so that some members of the population can
appear in the sample more than once.
Sampling without replacement: A sampling procedure in which sampled items are
not returned to the population after being picked, so that no members of the population
can appear in the sample more than once.
EJ7ations intro&7%e& in the Unit
EJ7ation 1 si,'a 6"ar is eJ7al to si,'a &i=i&e& "3 sJ7are root of n
Use this formula to derive the standard error of the mean when the population is infinite,
that is, when the elements of the population cannot be enumerated in a reasonable
period of time, or when we sample with replacement. This equation states that the
sampling distribution has a standard deviation, which we also call a standard error,
equal to the population standard deviation divided by the square root of the sample size.
EJ7ation ! - is eJ7al to #6 "ar Min7s '7 &i=i&e& "3 si,'a 6"ar.
A modified version of the equation allows us to determine the distance of the sample
mean x bar from the population mean mu, when we divide the difference by the
standard error of the mean sigma xbar. Once we have derived a z value, we can use
the Standard Normal Probability Distribution Table and compute the probability that the
sample mean will be that distance from the population mean. Because of the central
limit theorem, we can use this formula for non-normal distributions if the sample size is
at least 30.
EJ7ation ( si,'a 6"ar is eJ7al to si,'a &i=i&e& "3 sJ7are root of n '7lti5lie& "3
8hole root of N 'in7s n &i=i&e& "3 N 'in7s 1
where N is equal to size of the population; n is equal to size of the sample
This is the formula for finding the standard error of the mean when the population is
finite, that is, of stated or limited size, and the sampling is done without replacement.
EJ7ation . Finite population multiplier is equal to Whole root of N minus n divided by
N minus 1.
n Equation 3, the term is equal to N Minus , which we multiply by the standard error
from Equation (1), is called the finite population multiplier. When the population is small
in relation to the size of the sample, the finite population multiplier reduces the size of
the standard error. Any decrease in the standard error increases the precision with
which the sample mean can be used to estimate the population mean.
. Explain Random Numbers.
2. What is a Sampling distribution?
3. What is sample mean?
4. Explain Distribution of all sample means.
5. Define Standard Error.
6. f we have a population of 10,000 and we wish to sample 20 randomly. Use random
number table to choose the sample.
7. A population is made up of groups that have wide variations within the group and less
variation from group to group. Which is the appropriate type of sampling method?
8. Explain: Sampling allows us to be cost-effective. We have to be careful choosing
representative samples.
9. Suppose you are sampling from a population with a mean of 5.3. What sample size
will guarantee that
(a) The sample mean is 5.2?
(b) The standard error of the mean is zero?
10. n a sample of 16 observations from a normal distribution with a mean of 150 and a
variance of 256, what is
(a) P multiplied by xbar below 160)?
P multiplied by (xbar greater than 142)?
f, instead of 16 observations, 9 observations are taken, find
(c)P multiplied by(xbar below 160)
P(xbar greater than 142)
11. n a sample of 19 observations from a normal distribution with mean 18 and
standard deviation 4.8
(a) What is P(16 below xbar below 20)?-
(b) What is P multiplied by( 6 less or equal to xbar is less than or equal to 20 )?
(c) Suppose the sample size is 48. What is the new probability in part(a)?
12. n a normal distribution with mean 56 and standard deviation 21, how large a
sample must be taken so that there will be at least a 90 per cent chance that its mean is
greater than 52?
13. n a normal distribution with mean 375 and standard deviation 48, how large a
sample must be taken so that there will be at least a 0.95 that the sample mean falls
between 370 and 380?
(b) f the astronomer watches for an additional hour, will this probability rise or fall?
14. The average cost of a flat at Powai Lake is Rupees 62 lakh and the standard
deviation is Rupees 4.2 lakh. What is the probability that a flat at this location will cost at
least Rupees 65 lakh
15. State whether following statements are true or false.
(a) When the items included in a sample are based on the judgement of the individual
conducting the sample, the sample is said to be non-random. True or False
Ans8er: Tr7e
(b) A statistic is a characteristic of a population. True or False
Ans8er: +alse
(c) A sampling plan that selects members from a population at uniform intervals in time
order or space is called stratified sampling. True or False
Ans8er: Tr7e
(d) As a general rule, it is not necessary to include a finite population multiplier in a
computation for standard error of the mean when the size of the sample is greater than
50. True or False
Ans8er: +alse
(e) The probability distribution of all the possible means of samples is known as the
sample distribution of the mean. True or False
Ans8er: Tr7e
(f)The principles of simple random sampling are the theoretical foundation for statistical
inference. True or False
Ans8er: Tr7e
(g) The standard error of the mean is the standard deviation of the distribution of sample
means. True or False
Ans8er: Tr7e
(h) A sampling plan that divides the population into well-defined groups from which
random samples are drawn is known as cluster sampling. True or False
Ans8er: Tr7e
() With increasing sample size, the sampling distribution of the mean
approaches normality, regardless of the distribution of the population.
True or False
Ans8er: Tr7e
(j) The standard error of the mean decreases in direct proportion to sample size.
or False
Ans8er: Tr7e
(k) To perform a complete enumeration, one would need to examine every item in a
population. Trueor False
Ans8er: Tr7e
(l) n everyday life, we see many examples of infinite populations of physical objects.
True or False
Ans8er: +alse
(m) To obtain a theoretical sampling distribution, we consider all the samples of a given
size. TrueorFalse
Ans8er: Tr7e
(n) Large samples are always a good idea because they decrease the standard
error. TrueorFalse
Ans8er: Tr7e
(o) f the mean for a certain population were 15, it is likely that most of the samples we
could take from that population would have means of 15. True or False
Ans8er: +alse
(p) The standard error of a sample statistic is the standard deviation of its sampling
distribution. True or False
Ans8er: Tr7e
(q) Judgement sampling has the disadvantage that it may lose some representative
ness of a sample. True or False
Ans8er: Tr7e
(r) The sampling fraction compares the size of a sample to the size of the
population. True or False
Ans8er: Tr7e
(s) Any sampling distribution can be totally described by its mean and
standard deviation. TrueorFalse
Ans8er: Tr7e
(t) The precision with which the sample mean can be used to estimate the population
mean decreases as the standard error increases. TrueorFalse
Ans8er: Tr7e
1@. *lease sele%t the %orre%t ans8er fro' the %hoi%es 5ro=i&e&E
1. Which of the following is a method of selecting samples from a population?
(a) Judgement sampling (b) Random sampling
(c) Probability sampling (d) All of these (e) (a) and (b) but not (c)
Ans8er: #e$ #a$ an& #"$ "7t not #%$
2. Choose the pair of symbols that best completes this sentence: is a parameter,
whereas is a statistic.
(a) N, g (b) (y, s
(c) N, n (d) All of these (e) (b) and (c) but not (a)
Ans8er: #e$ #"$ an& #%$ "7t not #a$
3. n random sampling, we can describe mathematically how objective our estimates
are. Why is this?
(a) We always know the chance that any population element will be included in the
(b) Every sample always has an equal chance of being selected
(c) All the samples are exactly the same size and can be counted
(d)None of these
(e) (a) and (b) but not (c)
Ans8er: #e$ #a$ an& #"$ "7t not #%$
4. Suppose you are performing stratified sampling on a particular population and have
divided it into strata of different sizes. How can you now make your sample selection?
(a) Select at random an equal number of elements from each stratum
(b) Draw equal numbers of elements from each stratum and weigh the results
(c) Draw numbers of elements from each stratum proportional to their weights in the
(d) (a) and (b) only
(e) (b) and (c) only
Ans8er: #e$ #"$ an& #%$ onl3
5. n which of the following situations would (7,, is equal to (For,rn be the correct formula
to use for computing
(a) Sampling is from an infinite population
(b) Sampling is from a finite population with replacement
(c) Sampling is from a finite population without replacement
(d) (a) and (b) only
(e) (b) and (c) only
Ans8er: #&$ #a$ an& #"$ onl3
6. The dispersion among sample means is , the dispersion among the sampled items
themselves because
(a) Each sample is smaller than the population from which it is drawn
(b) Very large values are averaged down and very small values are averaged up
(c) The sampled items are all drawn from the same population
(d) None of these
(e) (b) and (c) but not (a)
Ans8er: #"$ Ver3 lar,e =al7es are a=era,e& &o8n an& =er3 s'all =al7es are
a=era,e& 75
7. Suppose that a population with N is equal to 144 has p is equal to 24. What is the
mean of the sampling distribution of the mean for samples of size 25?
(a) 24 (b) 2
(d) Cannot be determined from the information given
Ans8er: #a$ !.
8. The central limit theorem assures us that the sampling distribution of the mean
(a) s always normal
(b) s always normal for large sample sizes
(c) Approaches normality as sample size increases
(d) Appears normal only when N is greater than 1,000
Ans8er: #"$ Is al8a3s nor'al for lar,e sa'5le si-es
9. Suppose that, for a certain population, sigma xbar is calculated as 20 when samples
of size 25 are taken and as 10 when samples of size 100 are taken. A quadrupling of
sample size, then, only halved sigma xbar. We can conclude that increasing sample
size is
(a) Always cost-effective (b) Sometimes cost-effective (c) Never Cost-effective
Ans8er: #%$ Ne=er CostEeffe%ti=e
10. For the previous questions, what must be the value of (Y for this infinite population?
(a) 1,000 (b) 500
(c) 377.5 (d) 100
Ans8er: #&$ 100
11. The finite population multiplier does not have to be used when the sampling fraction
(a) Greater than 0.05 (b) Greater than 0.50
(c) , 0.50 (d) Greater than 0.90
(e) None of these
Ans8er: #e$ None of these
12. The standard error of the mean for a sample size of two or more is
(a) Always greater than the standard deviation of the population
(b) Generally greater than the standard deviation of the population
(c) Usually , the standard deviation of the population
(d) None of these
Ans8er: #%$ Us7all3 0 the stan&ar& &e=iation of the 5o57lation
13. A border patrol checkpoint that stops every passenger van is using
(a) Simple random sampling (b) Systematic sampling
(c) Stratified sampling (d) Complete enumeration
Ans8er: #&$ Co'5lete en7'eration
14. n a normally distributed population, the sampling distribution of the mean
(a) s normally distributed
(b) Has a mean equal to the population mean
(c) Has a standard deviation equal to the population standard deviation divided by the
square root of the sample size
(d) All of the above
(e) Both (a) and (b)
Ans8er: #&$ All of the a"o=e
15. The central limit theorem
(a) Requires some knowledge of the frequency distribution
(b) Permits us to use sample statistics to make inferences about population parameters
(c) Relates the shape of a sampling distribution of the mean to the man of the sample
(d) Requires a sample to contain fewer than 30 observations
Ans8er: #"$ *er'its 7s to 7se sa'5le statisti%s to 'a2e inferen%es a"o7t
5o57lation 5ara'eters
17. A portion of the elements in a population chosen for direct examination or
measurement is a ___________________
Ans8er: Sa'5le
8. The proportion of the population contained in a sample is the___________________
Ans8er: Sa'5lin, fra%tion.
19. _______________ is the process by which inferences about a population are
made from information about a sample.
Ans8er: Statisti%al inferen%e.
20._____________ sampling should be used when each group considered has small
variation within itself but there is wide variation between different groups.
Ans8er: Stratifie&.
2L A method of random sampling in which elements are selected from the population at
uniform intervals is called________________ sampling.
Ans8er: S3ste'ati%
2 2. ___________ is the degree of accuracy with which the sample mean can
estimate the population mean.
Ans8er: Stan&ar& error of the 'ean.
23. Within a population, groups that are similar to each other (although the groups
themselves have wide internal variation) are called ____________
Ans8er: Cl7ster.
24. A sampling distribution of the proportion is a probability distribution of the
Ans8er: Sa'5le 5ro5ortion.
*A*ER 1
UNT 14 Correlation and Regression
14.0 Objectives
14. 1 ntroduction
14.2 Scatter Diagrams
14.3 Correlation
14.4 Regression
14.5 Standard Error of Estimate

1. To understand relationship between two variables and its impact on decision making.
2. To draw scatter diagram from available data to visualize the relationship.
3. To use regression analysis to estimate one variable when a value of the other is
4. To learn how co-relation analysis describes the degrees to which 2 variables are
linearly related to each other
5. To recognize the limitations of the coefficient of correlation.
`A good education is essential to achieve success in life.' We often hear this. We often
say this too. But is it true? Suppose we decide to test it. We take a sample of 50
individuals and from each we collect data about two things: the number of years of
education and annual income. These two variables are taken to quantify 'a good
education' and 'success in life'. Our aim is to find if the two are %orrelate&.
Further, we would also like to see if we can predict the annual income of a person if we
know how many years' education he or she has had. This is called re,ression.
There are situations where more than two variables come into play. The study in that
case is called multiple correlation or regression. But here we shall limit ourselves to the
study of the relationship between two variables.
Visual representation of data can give us a good idea about the relationship between
two variables. Let us start with an example.
Suppose, the Principal of a college wants to find out whether there is a relationship
between the entrance examination score and the final graduation GPA score of a
student. Then, we take a random sample of students' data from college records, and
plot the graph. The Principal wants to use the score in the entrance examination to
predict final outcome. (see Fig. 14.1).
The graph in Fig. 14.1 is called a scatter diagram. n a scatter diagram we just plot the
points whose coordinates are the data pairs. n this example we have the data pairs, (6,
6), (7, 10), (10, 16), (14, 22), (14, 30), (12, 25), (13, 25). (17, 31), (10, 20), (11, 12), (15,
25). This diagram gives us a rough idea that if the entrance exam score is higher, the
GPA score also is higher. Such a relationship is called a direct relationship.
There are situations when the data indicate an inverse relationship. This is what you
expect between the time spent on exercising and weight gain in a given period. There
could be situations where there is no relationship between two variables. For example,
the marks obtained by a student in English and those in Mathematics. We now give a
few scatter diagrams to show you how easy it is to identify the relationship from them.
(See Fig. 14.2).
n Fig. 14.2(a) you see that as one variable increases, the other decreases which
indicating an inverse relationship. From Fig. 14.2(b), we can not infer anything about the
variables. From Fig. 14.2(c) we see that the relationship is inverse in the beginning but
becomes direct later on. n Figs. 14.1 and 14.2 (a), we can imagine a line drawn across
the points (see Figs. 14.3a and b).
This means there is a linear relationship between the variables. n Fig. 14.3(c) we
cannot draw a line to `fit' the data, but a curve can be drawn. Such a relationship is
called a curvilinear relationship. n this chapter we shall study only linear relationships.
Both scatter diagrams indicate a direct relationship. But the points in (a) are very close
to the line drawn across them, and those in (b) are more scattered. The line drawn
across the data points are used to predict one variable if the other one is known. From
the figure, it is clear that the line in (a) fits the data better than the line in (b). This
means, the predictions based on the data in (a) would be more accurate than those
based on (b). Comparing the scatter of the points in (a) and (b), we can say that the
variables in (a) are more strongly related than those in (b). So, the stronger the
relationship, the better will be our prediction. So how do we measure the strength of a
relationship? The measure we use is called coefficient of correlation or correlation
coefficient, and is denoted by r.
f X and Y are two variables, correlation coefficient 'r' is computed as below:
r is equal to covarient of (X,Y) divided by standard deviations of variables x and y
where covariant of (X, Y) = divided by N multiplied by sum(x minus xbar) multiplied
by(y minus y bar)
Cov (X, Y) is called the covariance between X and Y.
N is the total number of observations.
X bar Y bar are the means and sigma x, sigma y are the standard deviations of the
variables X and Y. Y x1N; Y, y1N
1(x.302 N
J(Y Y)2
Correlation Coefficient can also be calculated using the formula:
NTxy (Er) (Ty)
(VNEX2 (Y-X)2) (VNXy 2 (,Y)2 )
Calculate the correlation coefficient for the following data.
This formula is easier to use when calculations are done with the help of a calculator.
Let us take an example.
(Rupees in crores)
The value of r always lies between Minus1 and 1. A value of r = Minus 1 indicates
perfect inverse relationship between the two variables. A scatter diagram in this case
will have all points lying on a line of negative slope, i.e. sloping from left to right.
A value of r = 1, on the other hand indicates a perfect direct relationship, with all the
points in the scatter diagram lying on a line sloping up from left to right.
A value of r = 0 indicates that there is no linear relationship between the variables. t is
important to note here, that some other kind of curvilinear relationship may exist
between the variables.
Thus, the correlation coefficient is a measure of linear relationship between two
variables. A value of the coefficient near plus 1 or minus 1 indicates a strong
relationship. A value closer to zero indicates a weak relationship.
Here are some exercises for you.
Draw scatter diagrams and calculate the correlation coefficient for the following data
Once we get an idea of the kind and strength of the relationship between two variables
from the scatter diagram and the value of the correlation coefficient, we try to draw a
line which best represents the points. To fit the data, the line should pass close to all
points and should have points on both sides. This is to ensure that the difference
between the points in the scatter diagram and those on the line is minimal. The
technique of least squares is used to arrive at the following:
The equation of the line used to predict values of y, if values of x are known, is y = a
plus bx, where b is called the slope of the line. ts sign (plus or minus) tells us whether
the line slopes from left to right, or from right to left. a is called the y-intercept. t is the
point where the line crosses the y-axis. [see Fig. 14.5 (a and b)].
After calculating a and b, we write the equation ' y = a + b-v and whenever a value of x
is given, we put it in this equation to get the value of y. This is our prediction, based on
Let us take an example.
E6a'5le 1..!
Given the data in example 13. 1, estimate the value of y, when x = 70.
See if you can predict the values in the following exercise: Estimate y when x =
35, for data in exercise (i) 90, for data in exercise (ii)
We have seen how to measure the strength of a linear relationship between two
variables. We have also seen how to predict the value of one variable when that of the
other is given to us. Our prediction is based on the line of best fit. t would be useful to
know how good our prediction is. Standard error of the estimate is a measure which
tells us exactly this. For this, we calculate the difference between observed and
estimated values of y. f y denotes the estimated value of they variable, then the
standard error S, is worked out as
Se (Y V (n 2)
where n is the number of observations of each variable. y = a+ bx, and so we can also
a1y bYxy (n-2)
A small value of Se indicates that our estimates are fairly accurate. We can be
reasonably sure (65 per cent confident) that the actual value of y will lie between S, )
and (y + S,) . y Se, y + S, ) is called a 65 per cent confidence interval.).
We can be 95 per cent confident that the actual value of y lies between 2S, y + 2S,)
we shall study more about confidence intervals in Unit 5.
Di'itation of the Coeffi%ient of Correlation
When we judge the strength of a relationship between two variables by the value of the
coefficient of correlation, we must remember that it measures only linear relationships.
So even though two variables have a perfect curvilinear relationship, say all points in
the scatter diagram are on a circle, the coefficient of correlation will be zero. So
correlation analysis should be applied only to linear relationships.
Secondly the data obtained should be homogeneous. f the sample chosen is
heterogeneous, it may give rise to a high value of correlation coefficient, even when no
correlation actually exists.
Thirdly, a value of r close to 1 indicates a strong direct linear relationship. This means
that the two variables rise or fall together. t does not indicate any cause effect
relationship between the two. For example, over a period of 20 years from 1970 to
1990, the annual consumption of rice in ndia has increased. n the same period the
number of road accidents has also increased. These two variables will, therefore, show
a correlation coefficient close to 1. But it is ridiculous to say that increased rice
consumption is the cause of the increase in road accidents.
Scattered diagram: observed and predicted values. Helps to get feel of the situation.
'ndependent variable: Variable that is the basis of prediction.
"ependent variable: Variable that is predicted is called dependent variable.
Trend 2nalysis: The type of relationships straight line, curvilinear, parabola, circle,
Regression 2nalysis Fitting the line of relationship.
Standard error of the estimate: Measure which tells us how good the prediction is.
/orrelation 2nalysis: The strength of relationship is measured.
Coeffi%ient of %orrelation: Coefficient of determination; Covariance.
1. Plot the scatter diagram for the given data. Develop the estimating equation. Predict
for x = 6,13.4 and 20.5.
2. n the college, a teacher collected the data about absenteeism of students. He
wanted to find out whether there is any relationship between absence and temparature
of the day.
(a) State the dependent variable and the independent variable.
(b) Draw the scatter graph.
(c) Does the relationship between the variables appear to be linear or curvilinear?
(d) What is the type of curve?
(e) What is the logical explanation for observation?
3. (a) For the following data find the best fitting line.
(b) Compute std. error of estimate.
(c) Find an approx. prediction interval for the dependant variable y,
when x = 44 (with 95% confidence interval).
4. n new housing areas appliances sales (mixers, refrigerators. heaters, toaster etc.)
are very good. The data has been collected fora new area development.
The number of houses and appliances are in thousands.
(a) Develop an equation for the relationship between the appliances sales and house
(b) nterpret the slope of the regression line.
(c) Compute and interpret the s. error of the estimate.
(d) For the next year as high as 8.0 million houses are being predicted (may be beyond
the recorded range). Compute an approx. 90% prediction interval for appliances sales,
based on previous data and the new prediction of housing starts.
5. n a factory, a consultant was studying the relationship between the workers and
supervisors. The consultant talks about the dangers of over-supervising their workers.
A worker in an assembly line is given a series of complicated tasks to perform. During
the workers' performance, a supervisor constantly interrupts the worker to assist him.
Then at the end of the tasks, the worker is given a psychological test to measure his
hostility towards the supervisor. The score of 8 workers are given below. Note: higher
the score lower the hostility.
(a) Plot the data. Develop the equation with the best-fit. Give your comments.
(b) Predict the expected test Score, when x = 18.
(c) Calculate the sample coefficient of determination and the sample coefficient
correlation for the given data.
6. We give data for employment and output for 10 companies:
(a) Which is the dependent variable?
(b) Draw 2 linear trends, one using employment as dependent variable and other using
output as dependent variable. (Least squares method)
(c) Find coefficient of determination, covariance and coefficient of correlation.
7. The airlines company is interested in decreasing waiting time spent by customers
while buying air-tickets. So the relationship between waiting time y (in minutes), and
number of counters x operating to sell tickets has been studied.
Therefore, customers were randomly selected and data was collected.
x 2 3 5 4 2 6 1 3 4 3 3 2
y 12.8 11.3 3.2 6.4 11.6 3.2 8.7 10.5 8.2 11.3 9.4 12.8
(a) Calculate the regression equation that best fits the data.
(b) Calculate the coefficient of determination and coefficient of correlation.
(c) Give your comments on the results.
(d) f you want to reduce the waiting time to 5 minutes, what should you do.
8. What is regression analysis?
9. What is an estimating equation?
111. What is a correlation analysis?
H. Define direct and inverse relationships.
12. What types of correlation (positive, negative, or zero) should be expected from
these variables:
(a) Ability of supervisors and output of their subordinates.
(b) Number of years of education and age at first job. (Assume job is got immediately
after education)
(c) Weight and blood pressure.
(d) Student's height and his score in the H.Sc. examination.
13. Draw a plot of points, where the correlation is zero, and explain why.
14. The correlation coefficient will always lie between Minus 1 and Plus 1. True or false.
15. What is the relationship between covariance and coefficient of correlation?
/ase Study - ( $/ity Traffic #olice%
When the number of cars is increasing, accidents are also increasing. But in this city,
there are many minor traffic violations happening during weekends with parades, and
The data about weekend accidents is given below:
X Parades
20 30 10 12 15 25 34
Y Accidents 6 9 4 5 7 8 9
(a) Plot this data. Develop the equation which best fits the data.
(b) The traffic chief wants to predict the number of accidents in the next week when he
expects 33 rallies.
(c) Calculate the standard error of estimate.
,(d) What precautions can he take?
/ase Study A - $BCD 0actory$
The management has been wondering about the increase in overheads. While
production increases, overheads have been increasing but not proportionately. They
were not fixed costs.
So the C.E.O., Mr. Ramesh, wanted a formula with which he can calculate the expected
overhead. He called his cost accountants Balla and Dalbhir, and asked them to work out
the expected overhead costs, when he increases production.
Ramesh: oh do not want to face a situation when do not know the overhead costs.
have to allocate them to products and work out prices. Secondly, if the level of
overheads is too much we should take action to cut costs. He asked them to come back
with results soon.
Dalbhir and Balla collected for 10 days, the actual data of production and overheads:
Production-units 40 42 40 53 35 56 39 48 30 37
Overheads 191 170 178 272 155 280 173 234 116 153
"albhir: am not able to find out anything.
7alla: think we should take the help of Statistics Dept. have heard of something
about best-fitting equation.
"albhir: t is important that we predict the estimated cost more correctly, than giving a
7alla: f we use statistical methods our prediction will be with less error.
We can have a good prediction interval.
(a) Do you agree with Balla?
(b) What method should be used?
(c) Give the best fitting equation.
(d) Predict the level of overhead when the production of units = 50.
(e) Calculate the standard error of estimate.
(f) Give the upper and lower level of prediction interval, for a confidence level of 95 per
*A*ER 1
UNT 15 Time Series
15.0 Objectives
15. 1 ntroduction
15.2 Variations in Time Series
15.3 Trend Analysis
5.4 Cyclical Variation
15.5 Seasonal Variation
15.6 rregular Variation
n this unit, we will deal with changes that occur with time. Projecting such time based
changes is called time series. We will learn the four components of a time series. We
will look at seasonal indices and see how to use them to de-seasonalise a time series.
We will learn how to analyse cyclical component of the time series and use regression
based techniques to estimate and forecast the trend in a time series.
We will deal simultaneously with all four components of the time series and see how to
use time series for forecasting.
Nothing stays the same. With time everything changes. t is always assumed that
growth is good and the economy becomes better. 'Either grow or stagnate' used to be
the slogan earlier. But growth is not necessarily always good. n fact, we want to limit
the growth of some cities/ regions to avoid pollution and environment problems.
n an environment like this, we have to define growth and change so as to help in
planning. We will have to forecast changes over time, as they are an important part of
decision making.
n this module, we will learn how to measure amounts and rates of change. For
example, we need to be careful while predicting the changes in the level of inventory in
a factory. Unless we predict correctly, we may either have excess or less. Secondly, this
may lead to liquidity problems, if we have to arrange for sudden ordering of materials.
Thirdly, this may lead to cost escalations, or delivery problems due to unavailability of
raw materials.
We will also see how to describe the long-term patterns of change or secular trend.
Along with long term trends, we will study about short term fluctuations like seasonal
trends, business cycles and irregular variations.
Secular trend is caused by basic inherent factors. Business cycle trends are mostly
upward. The quality of forecast depends on the information provided by past data and
its validity. Data or statistical information accumulated at regular intervals is called TIME
There are 4 types of variations in time series. See graphs a, b, c, d of Figure 4.1.
1. Secular Trend
2. Cyclical Fluctuation
3. Seasonal Variation
4. rregular Variation.
1. Se%7lar Tren&
n this first type of variation the change comes over a long period of time. A steady
increase in cost of living recorded by Consumer Price ndex is a good example. From
year to year there is a fluctuation but there is a steady increase in the trend. Let us see
the series given here.
Let us try to detect patterns in the information over regular intervals of time. Then let us
try to predict to cope with uncertainty.
TABLE 15.1
Year 1997 1998 1999 20W 2001 2002 2003
Number 98 105 116 119 135 156 177
There is an increase over time of 7 years. But the increases are not equal.
!. C3%li%al +l7%t7ation
Most common example of a cyclical fluctuation is a business cycle. Over time, there are
years when business cycle hits peak above the trend line. There are also times when
business activity slumps, and hits a point below the trend line. Fluctuations in business
activity occur many times, and they have irregular periods and vary widely in amplitude
from cycle to cycle. The time between hitting peaks and lows are periods it can be one
or many. The cyclical moves do not follow any regular pattern, they are irregular.
(. Seasonal Variation
There is a pattern of change within a year. A doctor can expect the number of flu cases
to increase in winter. Hill resorts can expect more tourists during summer. These are
regular patterns and can be used for forecasting the amount of flu vaccines required
during winter, the doctor's income during winter, the hotel bookings in resorts and
availability of air and train bookings.
.. Irre,7lar Variation
The value of the variable is unpredictable, changing in a random manner. The effects of
earthquakes, floods, wars, etc., cannot be predicted.
As a result of flood, the agriculture output suffers. Then the prices go up at an
unprecedented rate. This could not be predicted by using time series.
Even though we described time series as exhibiting one or another variation, in most
instances real time series will contain several of these components. Then the question
is how to measure them.
Of the 4 variations, secular trend represents long-term direction (see Fig. 15. la). We
can visually fit a line in the graph sheet. A study of the trend helps us to understand
historical patterns and events (for sudden unusual change). Studying trend also helps
us to project trends into the future (see Fig. 15.1). Even a sudden change in the past
due to a situation (like war, etc.) can be used to predict the trend if a similar sudden
change happens (see Fig. 15.2).
Trends can be linear or curvilinear. Trend that can be described by a straight line is
called a linear trend. Equation for estimating a straight line, ybar is equal to b multiplied
by x
Where ybar is estimated value of the dependent variable
x is an independent variable
a is equal to y minus intercept (the value of y, when x is equal to 0)
b is equal to the slope of the trend line.
Some trends like pollutants in the environment increase, but they need not be a straight
line. Another example of curvilinear relationship is the life cycle of a business product.
When introduced, a product has a low sales volume. As the product gains recognition
and success, the sales go up. After the product is firmly established, there is a stable
rate of growth. As the product reaches the end of its cycle (new products, more
competition, etc.) the sales decrease (see graph Fig. 15.2b).
There are three main reasons, why we should study the trends:
(a) We will be able to describe historical patterns, which will help us to evaluate the
success of previous policies long-term direction of the time series is given by secular
(b) Past trends will help us to project the future some growth rate of population, GDP.
(c) We will be able to separate the trend component and eliminate it from the series, to
get an accurate idea of other components like seasonal fluctuations.
n the last unit, we have seen how to draw scatter diagram and a regression line to the
data on two variables. n time series, the independent variable x is time. Applying the
same method, we fit the line
ybar is equal to a plus b multiplied by x
b is equal to Sum x multiplied by x minus n multiplied by xbar
multiplied by y bar divided by Sum x square minus n x square and
a is equal to y bar minus b. xbar
Here the independent variable time is measured in terms of years, weeks, months, etc.
We use a process for coding to simplify computation. To use coding, we find the mean
time and then subtract that value from each of the sample times.
Suppose our time series consists of 2000, 2001, 2002, 2003 and 2004. f we have to
use them in equations and find squares, the calculation becomes tedious. So we use
coding. The mean is 2002. The corresponding coded values are minus 2, minus 1, 0,
plus 1, and plus2. When the time series is an odd number of data, there is no problem
as you get whole numbers and the mean is equal to 0.
n the case of even number of data like, 1990, 1991, 1992, 1993, 1994 and 1995. When
we code this, mean is 1992.5; then the codes are minus2.5, minus 1.5, minus 0.5,
plus0.5, plus 1.5, plus 2.5. Now the fraction becomes part of the calculation. To avoid
this complication, we multiply this by 2, and call it coded time. Mean of the coded time
becomes 0.
Then it is easier to use the equations.
Odd Number of x
Even Number of x Values
x x-mean x c. time x x- mean time (c. time x2)
20002000-2002 minus2 1990 Minus 2.5 Minus 5.0
20012001-2002 minus1 1991 Minus 1.5 Minus 3.0
20022002-2002 0 1992 Minus 0.5 Minus 1.0
20032003-2002 1 1993 0.5 1.0
20042004-2002 2 1994 1.5 1.5
1995 2.5 5.0
Sum x is equal to 10010; mean is equal to 2002 Sum x is equal to 11,955; mean
is equal to 1992.5
Code time mean is equal to 0 Code mean is equal to 0
Slope b is equal to Sum x multiplied by y (since coded mean of x divided by Sum x
square is equal to 0, the second part of the equation becomes 0).
Then a is equal to y bar.
Let us take the problem of number of ships loaded in a harbor as in Table 15.2, which is
reproduced below
TABLE 15.2
Year 1997 1998 999 2000 2001 2003 2004
Number 98 105 116 119 135 156 177 208
m is equal to Sum T divided by n is equal to 2000.5; Dry is equal to 1266; Sum x square
is equal to 168;
Sum y is equal to 1114; y bar is equal to 139.25; x bar is equal to 0
b is equal to 1266/168 is equal to 7.536; a is equal to 139.25
Then the general equation for loading ships is y bar, is equal to 139.25 plus 7.536x
Here x is the coded time; so when we want to predict for a particular year, we must
convert that to coded time. For example, year 2007, will be equal to
x is equal to 2(2007 2000.5) is equal to 13.0, then
is equal to 139.25 plus (7.536 multiplied by 13)
is equal to 139.25 plus 97.97 is equal to 237.22; that is 237 ships loaded.
General equation for a parabolic curve: Y is equal to a + ox + cx2
FGURE 15.3
Using Second "egree trends in Time Series: Till now we have been talking about
fitting straight lines for the data. But many series can be best described by curves. n
these cases, the linear model does not adequately describe the change in the variable
as time changes. To overcome this, we use parabolic curves (Fig. 15.3)..
The general form of the equation is: y bar is equal to a plus b multiplied by x plus cx2
square, where a, b, c are numerical constants.
Here also, we first code the time variable. Then we use the following three equations to
find out the numerical constants.
. Sum y is equal to a multiplied by n plus c Sum x square.
2 Sum x square y is equal to a Sum x square plus c sum x to the power of 4.
3. b is equal to Sum xx divided by Sum x square.
We find these values simultaneously.
We have given the annual sales data of quartz watches. (in lakh)
TABLE 15.3
m is equal to Mean T is equal to 2003; Sum Y is equal to247
After coding Sum x square is equal to 10; Sum x to the power of 4 is equal to 34; Sum
xy is equal to 227; Sum x square y is equal to 565
By substituting, we get 247 5a plus 10c; 565 is equal to l0a plus 34c; b is equal to
227/10 is equal to 22.7 By solving the equations we get, a 39.3 and c is equal to 5.07;
Y bar is equal to a + bx plus c multiplied by x square
is equal to 39.3 + 22.7 x plus 5.07 multiplied by x square.
Let us draw the graph to check how well the parabola fits the time series (Fig. 15.4)
f we want to forecast for the year 2010, code x is equal to T minus m is equal to 7
Y bar is equal to 39.3 plus 22.7(7) plus 5.07(49) is equal to 446.6
So we conclude, watch sales will be 446, 60,000 by 2010.
Cyclical variation is a component of the time series, which tends to oscillate above and
below the secular trend line for periods longer than a year. Seasonal variation makes a
complete regular cycle within each year and does not affect one year any more than
another. Once we identify the secular trend, we can isolate the remaining cyclical and
irregular components of the trend. Let us assume cyclical component explains most of
the variations left unexplained by the trend analysis.
Resi&7al Metho&
We will start with dividing the actual, observed data by the trend, predicted data. This
will give the cyclical variation as a percentage of the trend, (y divided by y bar)
multiplied 100 where y v is actual time series value and y bar is predicted value.
Another measure of the variation is called Relative cycle residual. n this we find the
(Table 15.4) percentage of deviation from trend for each value. This is equal to [(y
minus y bar divided by y bar multiplied by 100. Then we can attribute the variation to
factors known and unknown. (see Fig. 15.5)
The result shows during the years 1996, 2001 and 2002 the actual was less than the
estimates by 1.3per cent, 1.2per cent and 1.1per cent. n the years 1997, 1999 and
2000, the estimates were correct. n the years 1998 and 2003, the estimates were more
than the actual. n the per cent of trend around the trend line data we try to isolate
cyclical components. t is necessary to note that this technique can be used only for
analyzing past cyclical variation and not for predicting future cyclical variation.
Time series also includes seasonal variation. Seasonal variation is repetitive and
predictable. This can be defined as movements around the trend line in one year or
less. n order to measure seasonal variations, time intervals must be measured in small
units, like days, weeks, etc.
1. We can establish the pattern of past changes.
2. Then we can predict the future.
3. Once we establish the seasonal patterns, we can eliminate its effects from the time
series. This will help us to calculate the cyclical variation that takes place each year-
Eliminating seasonal variation from time series is called 'deseasonalization'.
Ratio to Moving 2verage Method
To measure seasonal variation we use Ratio to Moving Average method. This
technique provides an index.
This index is based on a mean of 100. The degree of seasonality is measured by
variations away from the base. We know that more boats are rented in a lake resort
during summer and the number decreases in winter.
f in a year 20,000 boats are rented out, the average per quarter should be 5,000. f the
index for spring quarter is 142, then we estimate the number of boats rented out during
summer will be 5,000 (142 divided by100) is equal to 7,100.
The resort wants to establish the seasonal pattern of rooms demanded by tourist. This
will help them to plan and improve customer service. They will employ more staff during
peak period.
TABLE 15.5
Year 1 2 3 4
1998 1861 2203 2415 1908
1999 1921 2343 2514 1986
2000 1834 2154 2098 1799
2001 1837 2025 2304 1965
2002 2073 2414 2339 1967
Step (: Compute seasonal index:
(a) Add total values of all four quarters of the 1st year. Write it in the middle of the set of
4 values.
(b) Then to get the moving total, start from second quarter of first year and go up to first
quarter of 2nd year. (Drop the first value and add the fifth value This is called 'sliding'.)
(c) n this way, continue the process of sliding till the end. (see Table 15.5.)
Step -: Find the four quarter Moving Average by dividing each value derived in Step 1
by 4. (col. 5).
Step .: Since we have 4 quarters, the centering becomes necessary. f we have odd
number like a 7-day data for a week, then centering is not essential. n order to centre
the moving averages, we again find the moving average for the values in step 2 - add 2
values and average it. Follow the process of sliding. (Column 5).
We can see that moving average has smoothed down the peaks and troughs of the
original time series (see Fig. 15.7).
Step 1: We will now calculate S1 the percentage of actual value to moving average
values. Percentage 100 (actual value/average). For example, we see that for 1998, 3rd
quarter is equal to 100 (2415/2104.25) 114.8 See column (6).
TABLE 15.6
Year q. Occu Step 1Step 2Step 3Step 4
Column number (1) (2) (3) (4) (5) (6) Si
1998 1 1861
V 1908 8447 2111.75 2129.25 89.6
1999 1 1921 8587 2146.75 2159.125 89.0
V 1986 8677 2169.25 2145.625 92.6
2000 1 1834 8488 2122.00 2070.00 88.6
V 1799 7888 1972.00 1955.875 92.0
2001 1 1837 7759 1939.75 1965.5 93.5
V 1965 8367 2091.75 2140.375 91.8
2002 1 2073 8756 2189.00 2193.375 94.5
V 1967
Step ?: Draw a new table from Step 4 to calculate the modified mean of the seasonal
indices [S]. Calculate modified mean by discarding the highest and the lowest value for
each quarter.
Year 01 02 03 04
1998 114.8 89.6
2002 94.5 109.8
Modified means are: 91.25; 107.70; 113.25; 91.90 Total of indices is equal to 404.10
By discarding the highest and lowest values of each quarter, we try to eliminate the
extreme cyclical and irregular components of variation in the time series. When we
average the remaining values, we further smooth the cyclical and irregular components.
Then modified mean is an index of the seasonality component.
Step E: Adjusting the modified mean to base 100. Note that the modified mean sum is
404.1 in this case. The four quarterly indices should total 400. To correct this error, we
use the adjusting constant, (400/404.1) is equal to 0.9899. We multiply the values of
modified mean by this number.
Q1 is equal to 91.25 multiplied by 0.9899 is equal to 90.3; Q2 is equal to 106.6; Q3 is
equal to 112.1; Q4 is equal to 91.0.
Use of Seasonal In&e6
Seasonal indices are used to find out the seasonal variation. Then we remove the
seasonal variations, to get the residual cyclical and irregular variations. We
deseasonalize the time series, by dividing each of the actual value in the series by the
appropriate seasonal index (expressed as a fraction of 100). Working with our data, for
the year 1998, we get the deseasonalised values as follows:
Q1 1861 divided by90.3 divided by 100 is equal to 2061
Q2 22203 divided by 106.6 divided by100 is equal to 2067
Q3 2415divided by 112.1 divided by 100 is equal to 2154
Q4 1908divided by 91.0divided by 100 is equal to 2097
This deseasonalised value reflects only the trend, cyclical and irregular components of
the time series. Now, we can compute the trend line and use it for prediction.
Suppose, our resort manager estimates from the deseasonalised trend line, that the
deseasonalised average occupancy for the fourth quarter of next year will be 2121.
Then to get the correct picture, we must take seasonality into account. Therefore,
multiply the deseasonalised predicted estimate by the fourth quarter seasonal index and
obtain the estimate for the season.
2121 multiplied by (91.0divided by100) is equal to 1930. There will be an average
occupancy of 1930 rooms in the fourth quarter of next year.
(?)E 'RR*!UL2R 52R'2T'8&
The final component is irregular variation. After we have eliminated trend, cyclical and
seasonal variations from the time series, we may still have unpredictable factor left.
rregular variations occur over very short intervals and follow random patterns. We may
not be able to isolate them mathematically, but we may isolate the causes for the same.
For example, an unusually very cold winter in a region may increase electricity
consumption significantly. Wars may increase air and train travel because of the
movement of troops. We may not be able to identify all causes. But over time, these
random variations tend to correct themselves.
nvolving all Four Components (TSC) of the Time Series
The data is given on a quarterly basis, and let us first deseasonalize the series. This is
sales per quarter of dresses, in a fashion store.
TABLE 15.7
Modified means: Q1 is equal to 94.45; Q2 is equal to 129.05; Q3 is equal to 60.80; Q4
is equal to 113.15 Sum of modified mean is equal to 397.45
Adjusting factor is equal to 400/397.45 is equal to 1.0064
Multiplying the adjusting factor and modified mean, find the seasonal indices. Seasonal
indices are: Q is equal to 95.1; Q2 is equal to 129.9; Q3 is equal to 61.2; Q4 is equal to
113.9 Then the deseasonalised sales value is equal to (actual multiplied by seasonal
index) divided by 100
16.8 16.2 14.7 15.8
18.9 20 22.9 21.9
Now, the second step is to develop the trend line.
Code the time series. We have 20 values, i.e. 20 time intervals. This is even number.
Then to avoid fraction, multiply by 2.
Mean is equal to 0. yr 1 ql is equal to minus 9.5, then minus 8.5, and so on. Then they
become; minus19, minus 17, minus15... plus 17, plus19.
Mean Y is equal to 1Sumydivided by n is equal to 360.9divided by 20 is equal to 18.0
Sum x is equal to 0; Sum xy is equal to 420.3; Sum x square is equal to 2660; b is equal
to 420.3 divided by 2660 is equal to 0.16
a is equal to mean y is equal to 18 plus 0.16x
Trend line is equal to a plus bx ; Trend line is equal to 18 plus 0.16x
Now we have identified seasonal and trend components of the time series. Calculate
the trend values. see Table 4.7 Column 4.
Next we have to find cyclical variation around the trend line.
Use the Residual method. Find the percent of trend.
Per cent of trend is equal to (deseasonalized value divided by trend value) multiplied by
100 (Table 4.7, column 5)
f we assume irregular variation is generally short-term and relatively insignificant, then
we have analyzed this time series fully.
See the graph for the original time series, moving average containing both seasonal and
cyclical components and the trend line (deseasonalized).
Suppose the management wants to determine the sales value for the 3rd quarter of
year 6, First code the time of third quarter of year 6. Code is equal to 19 plus (2
multiplied by 3) is equal to 25
Substituting this value, is equal to a plus bx is equal to 18 plus 0.16multiplied by (25) is
equal to 22
Thus the deseasonalized estimate is equal to 22,000 units.
Now, seasonalize this data by multiplying it by the third q. seasonal index. 22 multiplied
by (61.2 divided by100) is equal to 13.5 is equal to 13,500 units.
The four components of time series Trend, Seasonal, Cyclical and rregular (TSC);
Time Coding; Moving Averages; Seasonal index calculation; Deseasonalization;
Residual method for cyclical variation; Secular trend; Cyclical fluctuation; Seasonal
variation; rregular variation
1. What is Time Series? What is the use of old data.
2. What are the four components of time series?
3. What is coding of time measures? Why is it done?
4. What are the four errors that can affect forecasting with a time series?
5. Define seasonal variation. What are the principal causes for seasonal variations?
Name ten products, processes, or activities in business that exhibit strong seasonal
variation. Specify two products that have no seasonal variation.
6. Define a business cycle. s it different from seasonal fluctuations'?
7. What is deseasonalization? Why it is necessary to do these calculations on the time
series data?
8. llustrate 5 irregular variations with their effects.
9. A time series data for 9 years for the sale of tables by a furniture mart is given below
from year 1993-2001, sequentially.
(a) Find the linear equation that describes the trend of sales.
(b) Give a forecast for the year 2003.
10. The data for number of solar homes built in the region during the last 7 months is
given (variable x is month) sequentially.
Number of homes: 16, 17, 25, 28, 32, 43, 50
(a) Plot the data, develop a linear equation that best describes the data and draw the
(b) Develop a second degree equation for this data that best describes this data. Plot
this curve also on the same graph.
11. A gas company has supplied cooking gas to the city of Mumbai. t has supplied, 18,
20, 21, 25, 26 lakh cubic feet of gas for the years 1996 to 2000, respectively.
(a) Find the linear equation that best describes the data.
(b) Calculate the per cent of trend for this data.
(c) Calculate the Relative cyclical residual for this data.
(d) n which years does the largest fluctuation from trend occur?
s it the same for both methods?
12. A department store is expanding its market share during the past 7 years, the sales
are as follows (Rupees in crore):
Year 1996 1997 1998 1999 2000 2001 2002
Sales 14.8 20.7 24.6 32.9 37.8 47.6 51.7
Find the linear estimating equation that best fits the data.
Calculate percent of trend for this data.
Calculate the relative cyclical residual for this data.
n which years does the largest fluctuations from the trend occur?
s it same for both models.
13. We have given you the percentages of actual to moving average in the following
table from a bank data describing the amount of cash circulation in a small branch.
Year Spring Summer Fail Winter
1998 87 106 86 125
1999 85 110 83 127
2000 84 105 87 128
2001 88 104 88 124
Calculate the seasonal index for each quarter.
14. The record of sales data for the past 10 years is given below. The company knows
there is a strong seasonal variation.
(a) Find the index of seasonal variation using the method of Ratios to Moving Average.
(b) Now, deseasonalize the original data.
(c) Plot the deseasonalised data and give your observations. What is the trend?
(d) Try to fit a geometric line of least squares and calculate the trend values.
(e) Divide the deseasonalised data by the trend values and isolate business cycle and
irregular components (take short-term moving averages).
The sales forecast for the next year is Rupees 84 lakh. The seasonal indexes for the
sales are Q. 35; Q2. 96; Q3. 150; and Q4. 119.
Determine the sales quota for each quarter.
The following table gives the marketing performance of a company. (sales in lakhs).
1998 19 24 38 25
1999 21 28 44 23
2000 23 31 41 23
2001 24 35 48 21
Calculate seasonal index for this data. (Use 4 - quarter centered moving average)
Deseasonalize the data.
Find the least squares line that best describes the trend in deseasonalised data.
dentify the cyclical component by computing the percent of trend.
*A*ER 1
UNT 16 Estimation
16.0 Objectives
16.1. ntroduction
16.2 Estimates
16.3 Estimator and Estimates
16.4 nterval Estimates
16.5 nterval Estimates and Confidence ntervals
16.6 nterval Estimates of the Mean from Large Samples
16.7 nterval Estimates of the Proportion from Large Samples
n this unit, we will deal with estimates and estimators. We will learn the criteria
for good estimators. We will discuss point estimates of mean, variance, and proportion,
understand the concept of interval estimate and apply the same for mean, variance and
proportion from large samples; how interval estimate is more meaningful than the point
estimate. We will discuss standard error and probability of correctness of estimates.
Everyone makes estimates. When you are ready to cross a street, you estimate
the speed of any car that is approaching the distance between you and that car, and
your own speed. Having made these quick estimates, you decide whether to wait, walk
or run.
Credit managers estimate whether a borrower will eventually pay his dues.
Prospective home buyers make estimates concerning the behaviour of interest rates in
the mortgage market. All these people make estimates based on their experiences,
outlook for future, etc.
Statistical inference is a branch of statistics concerned with using probability
concepts to deal with uncertainty in decision-making. t is based on estimation. We shall
be making inferences about characteristics of population from information contained in
How do managers use sample statistics to estimate population parameters? The
department head attempts to estimate enrollments next year from current enrollments in
the same courses. The credit manager attempts to estimate the creditworthiness of
prospective customers from a sample of their past payment habits. The home buyer
attempts to estimate the future course of interest rates by observing the current
behaviour of those rates. n each case, somebody is trying to infer something about a
population from information taken from a sample.
We will discuss the methods that enable us to estimate with reasonable accuracy
the population proportion (the proportion of the population that possesses a given
characteristic) and the population mean. To calculate the exact proportion or the exact
mean would be an impossible goal. Even so, we will be able to make an estimate, make
a statement about the error that will probably accompany this estimate, and implement
some controls to avoid as much of the error as possible. As decision makers, we will be
forced at times to rely on blind hunches. Yet in other situations, in which information is
available and we apply statistical concepts, we can do better than that.
We can make two types of estimates about a population: a point estimate and an
interval estimate. A point estimate is a sin&le num%er that is used to estimate an
un"nown population parameter f, while watching a cricket team on the field, you say.
'Why, bet they will get 350 runs,' you have made a point estimate. A department head
would make a point estimate if she said, 'Our current data indicate that this course will
have 350 students next year.'
A point estimate is often insufficient, because it is either right or wrong. f you are
told only that her point estimate of enrollment is wrong, you do not know how wrong it is,
and you cannot be certain of the estimate's reliability. f you learn that it is off by only 10
students, you would accept 350 students as a good estimate of future enrollment. But if
the estimate is off by 90 students, you would reject it as an estimate of future
enrollment. Therefore, a point estimate is much more useful if it is accompanied by an
estimate of the error that might be involved.
An inter$al estimate is a ran&e of $alues used to estimate a population
parameter. t indicates the error in two ways: by the extent of its range and by the
probability of the true population parameter lying within that range. n this case, the
department head would say something like, ' estimate that the enrollment in this course
next year will be between 330 and 380 and that it is very likely that the exact enrollment
will fall within this interval.' She has a better idea of the reliability of her estimate. f the
course is taught in sections of about 100 students each, and if she had tentatively
scheduled five sections, then on the basis of her estimate, she can now cancel one of
those sections and offer an elective instead.
A sample statistic that is used to estimate a population parameter is called an
estimator. The sample mean + %ar can be an estimator of the population mean mu, and
the sample proportion can be used as an estimator of the population proportion. We can
also use the sample range as an estimator of the population range.
When we have observed a specific numerical value of our estimator, we call that
value as estimate. n other words, an estimate is a specific value of a statistic. We form
an estimate by taking a sample and computing the value taken by our estimator in that
sample. Suppose we calculate the mean odometer reading (mileage) from a sample of
used taxis and find it to be 98,000 miles. f we use this specific value to estimate the
mileage for a whole fleet of used taxis, the value 98,000 miles would be an estimate.
Criteria of a Ioo& Esti'ator
Some statistics are better than others. Fortunately, we can evaluate the quality of
a statistic as an estimator by using four criteria:
() Unbiased: This is a desirable property for a good estimator to have. The term
unbiased refers to the fact that a sample mean is an unbiased estimator of a population
mean %e#ause the mean of the samplin& distri%ution of sample means ta"en from the
same population is equal to the population mean itself. We can say that a statistic is an
unbiased estimator if, on average it tends to assume values that are above the
population parameter being estimated as frequently and to the same extent as it tends
to assume values that are below the population parameter being estimated.
-) *fficiency: Another desirable property of a good estimator is that it be
efficient. Efficiency refers to the size of the standard error of the statistic. f we compare
two statistics from a sample of the same size and try to decide which one is the more
efficient estimator, we would pick the statistic that has the smaller standard error, or
standard deviation of the sampling distribution. Suppose we choose a sample of a given
size and need to decide whether to use the sample mean or the sample median to
estimate the population mean. f we calculate the standard error of the sample mean
and find it to be 1.05 and then calculate the standard error of the sample median and
find it to be 1.6, we would say that the sample mean is a more efficient estimator of the
population mean because its standard error is smaller. t makes sense that an estimator
with a smaller standard error (with less variation) will have more chance of producing an
estimate nearer to the population parameter under consideration.
.) /onsistency: A statistic is a consistent estimator of a population parameter if
as the sample size increases, it becomes almost certain that the value of the statistic
comes very close to the value of the population parameter. f an estimator is consistent,
it becomes more reliable with large samples. Thus, if you are wondering whether to
increase the sample size to get more information about a population parameter, find out
first whether your statistic is a consistent estimator. f it is not, you will waste time and
money by taking larger samples.
4. Sufficiency: An estimator is sufficient if it makes so much use of the
information in the sample that no other estimator could extract from the sample
additional information about the population parameter being estimated.
*oint Esti'ates
The sample mean + bar is the best estimator of the population mean mu. t is
unbiased, consistent, the most efficient estimator, and as long as the sample is
sufficiently large, its sampling distribution can be approximated by the normal
f we know the sampling distribution of x, we can make statements about any
estimate we may make from sampling information. Let's look at a medical supplies
company that produces disposable hypodermic syringes. Each syringe is wrapped in a
sterile package and then jumble-packed in a large corrugated carton. Jumble packing
causes the cartons to contain differing numbers of syringes. Because the syringes are
sold on a per unit basis, the company needs an estimate of the number of syringes per
carton for billing purposes. We have taken a sample of 35 cartons at random and
recorded the number of syringes in each carton. Table 16.1 illustrates our results.
TABLE 16.1
(Syringes per Carton)
101 103 112 102 98 97 93
105 100 97 107 93 94 97
97 100 110 106 110 103 99
93 98 106 100 112 105 100
114 97 110 102 98 112 99
We can obtain the sample mean + bar by finding the sum of all our results, Sum
x, and dividing this total by n, the number of cartons we have sampled 7 is equal to Erin
Using this equation to solve our problem, we get
x is equal to 3570/35 is equal to 102 syringes
Thus, using sample mean x as our estimator, the point estimate of the population
mean is 102 syringes per carton. The manufactured price of a disposable hypodermic
syringe is quite small (about Re 1), so both the buyer and seller would accept the use of
this point estimate as the basis for billing, and the manufacturer can save the time and
expense of counting each syringe that goes into a carton.
*oint Esti'ate of the *o57lation Varian%e an& Stan&ar& De=iation
Suppose the management of the medical-supplies company wants to estimate
the variance and/or standard deviation of the distribution of the number of packaged
syringes per carton. The most frequently used estimator of the population standard
deviation sigma is the sample standard deviation s. We can calculate the same e
standard deviation, as given in Table 16.2, and discover that it is 6.01 syringes.
Sum x is equal to3, 570 Sum x square is equal to 3, 65,368 Sum(x minus s bar)
whole square is equal to 1, 228
Now, if we use the formula s square is equal to Sum(x minus x bar) whole square
divided by n to calculate the sample variance- s, the result would have some bias as
estimator of the population variance.
nstead, using the formula s square is equal to Sum(x minus x bar) whole square
divided by n minus 1; makes s square an unbiased estimator. This observation has n-1
mathematical basis. But we need not discuss it here.
So we get s square is equal to Sum(x minus x bar) whole square divided by n minus 1
as the estimate of the population variance.
*oint Esti'ate of the *o57lation *ro5ortion
The proportion of units that have a particular characteristic in a given population
is denoted by p. f we know the proportion of units in a sample that have the same
characteristic (p bar) we can use this p bar as an estimator of p. t can be shown that p
bar has all the desirable properties we discussed earlier. t is unbiased, consistent,
efficient, and sufficient.
Continuing our example of the manufacturer of medical supplies, we shall try to
estimate the population proportion from the sample proportion. Suppose the
management wishes to estimate the number of cartons that will arrive damaged, owing
to poor handling in shipment after the cartons leave the factory. We can check a sample
of 50 cartons from their shipping point to the arrival at their destination and then record
the presence or absence of damage. f, in this case, we find that four cartons were
damaged; the proportion of damaged cartons in the sample is 0.08. We would say that
p bar is equal to 0.08 <-- Sample proportion damaged
Because the sample proportion p bar is a convenient estimator of the population
proportion p, we can estimate that the proportion of damaged cartons in the population
will also be 0.08. Putting all of the definitions aside, the reason we study estimators is
that we can learn about populations by sampling, without counting every item in the
population. Of course, there is no free lunch here either, and when we give up counting
everything, we lose some accuracy. But we would like to know the accuracy that is
achieved when we sample.
Statisticians can tell how the standard error behaves as you increase or
decrease the sample size, and market researchers can tell you what the cost of taking
more or larger samples will be. But it's you who must use your judgement to combine
these two inputs to make a sound managerial decision.
The purpose of gathering samples is to team more about a population. We can
compute this information from the sample data as either point estimates, which we have
just discussed or as interval estimates, the subject of the rest of this chapter. An inter$al
estimate des#ri%es a ran&e of $alues within whi#h a population parameter is li"ely to lie.
Suppose the marketing research director needs an estimate of the average life in
months of car batteries his company manufactures. We select a random sample of 200
batteries, record the car owners' names and addresses as listed in store records, and
interview these owners about the battery life they have experienced. Our sample of 200
users has a mean battery life of 36 months. f we use the point estimate of the sample
mean x bar as the best estimator of the population mean x bar; we would report that the
mean life of the company's batteries is 36 months.
FGURE 16.1
Distribution of the Mean *f Samples of -200ba
But the director also asks for information about the uncertainty tagged with this
estimate. We need to know the range within which the population mean is likely to lie.
We need to find the standard error of the mean for this purpose.
We already saw, that if we select and plot a large number of sample means from
a population, the distribution of these means will approximate a normal curve.
Furthermore, the mean of sample means will be the same as the population mean. Our
sample size of 200 is large enough that we can apply the central limit theorem, to
measure the spread, or dispersion, in our distribution of sample means. We can use the
following formula and calculate the standard error of the mean:
Standard error of the mean for an infinite population sigma x bar is equal to
sigma divided by root of n where sigma is standard deviation of the population.
Suppose we have already estimated the standard deviation of the population of
the batteries and reported that it is 10 months. Using this formula for standard error, we
can calculate the standard error of the mean:
Sigma x bar is equal to sigma divided by root of n is equal to 10 divided by root of200
s equal to 10/14.14 is equal to 0.707 month. This is standard error of the mean.
We could now report to the director that our estimate of the life of the company's
batteries is 36 months, and the standard error that accompanies this estimate is 0.707.
n other words, the actual mean life for all the batteries may lie somewhere in the
interval estimate of 35.293 to 36.707 months. This is helpful but we still need to know
the chance that the actual life will fall within this interval. f we take a larger interval, the
chances would tend to improve.
*ro"a"ilit3 of the Tr7e *o57lation *ara'eter +allin, 8ithin the
Inter=al Esti'ate
We know about normal probability distribution and learned that specific portions
of the area under the normal curve are located between plus and minus any given
number of standard deviations from the mean. We also saw how to relate these portions
to specific probabilities.
We can apply these properties to the standard error of the mean and make the
following statement about the range of values used to make an interval estimate for our
battery problem.
The probability is 0.955 that the mean of a sample size of 200 will be within plus
or minus 2 times the standard error of the population mean. Stated differently, 95.5
percent of all the sample means are within plus or minus 2 times the standard error from
mu, and hence mu is within plus or minus 2 times the standard error of 58.8 per #ent of
all the sample means.
Theoretically, if we select 1,000 samples at random from a given population and
then construct an interval of plus or minus 2 times the standard error around the mean
of each of these samples, about 955 of these intervals will include the population mean.
Similarly, the probability is 0.683 that the mean of the sample will be within plus or
minus1 time the standard error of the population mean, and so forth. This theoretical
concept is basic to our study of interval construction and statistical inference.
We have illustrated the concept graphically in Fig. 16.2 showing five such
intervals. Only the interval constructed around the sample mean T4 does not contain
the population mean.
As far as any particular interval in the given figure is concerned, it either contains
the population mean or it does not, because the population mean is a fixed parameter.
n 95.5 per cent of all samples, the interval will contain the population mean. Therefore,
we are 95.5 per cent confident that the interval contains the population mean.
Applying this to the battery example, we can now report to the director. Our best
estimate of the life of the company's batteries is 36 months, and we are 68.3 percent
confident that the life lies in the interval from 35.293 to 36.707 months (36plus or minus
multiplied by sigma x bar). Similarly, we are 95.5 percent confident that the life falls
within the interval of 34.586 to37.414 months (36plus or minus 2 multiplied by sigma x
bar) , and we are 99.7 percent confident that battery life falls within the interval of
33.879 to 38.121 months (36plus or minus3 multiplied by x bar ) .
Every time you make an estimate, there is an implied error in it. t is impossible to
watch and measure every set of data. t's a lot less expensive and a lot faster to use
sampling to find the answer.
n using interval estimates, we are not confined to plus or minus 1, 2, and 3
standard errors. According to Probability Table given in Annexure of Unit 2, plus or
minus 1.64 standard errors include about 90 per cent of the area under the curve; it
includes 0.4495 of the area on either side of the mean in a normal distribution. Similarly,
plus or minus 2.58 standard errors cover about 99 per cent of the area, or 49.51 per
cent on each side of the mean.
The probability that we associate with an interval estimate is %alle& the
%onfi&en%e le=el. This probability indicates how confident we are that the interval
estimate will include the population parameter. A higher probability means more
confidence. n estimation, the most commonly used confidence levels are 90 per cent,
95 per cent and 99 per cent, but we are free to apply any confidence level.
The #onfiden#e inter$al is the ran&e of the estimate we are ma"in&. f we report
that we are 90 per cent confident that the mean of the population of incomes of people
in a certain community will lie between Rupees 8000 and Rupees 24,000, then the
range Rupees 8,000 Rupees 24,000 is our confidence interval. Often, however, we
will express the confidence interval in standard errors rather than in numerical values.
Thus, we will often express confidence intervals like this: x plus or minus 1.64 multiplied
by sigma x bar where
x plus1.64 multiplied by sigma xbar is equal to upper limit of the confidence
x minus1.64 multiplied by sigma x bar f is equal to lower limit of the confidence
Thus confidence limits are the upper and lower limits of the confidence interval.
n this case, (x + 1.64 multiplied by sigma xbar is equal to the upper confidence limit
(UCL) and (x minus 1.64 multiplied by sigma xbar is) is called the lower confidence limit
Relationshi5 "et8een Confi&en%e De=el an& Confi&en%e Inter=al
You may think that we should use a high confidence level, such as 99 per cent,
in all estimation problems. After all, a high confidence level seems to signify a high
degree of accuracy in the estimate. n practice, however, high confidence levels will
produce large confidence intervals, and such large intervals are not precise; they give
very fuzzy estimates.
There is a direct relationship that exists between the confidence level and the
confidence interval for any estimate. As you set a tighter and tighter confidence interval,
you would get to a lower and lower confidence level.
Usin, Sa'5lin, Confi&en%e Inter=al Esti'ation
n our discussion of the basic concepts of interval estimation, we described
samples being drawn repeatedly from a given population in order to estimate a
population parameter. We also mentioned selecting a large number of sample means
from a population. n practice, however, it is often difficult or expensive to take more
than one sample from a population. Based on just one sample, we estimate the
population parameter. We must be careful, then, about interpreting the results of such a
Suppose we calculate from one sample in our battery example the following
confidence interval and confidence level: 'We are 95 per cent confident that the mean
battery life of the population lies within 30 and 42 months.' t means that if we select
many random samples of the same size and calculate a confidence interval for each of
these samples, then in about 95 per cent of these cases, the population mean will lie
within that interval.
A large automotive parts wholesaler needs an estimate of the mean life, it can
expect from windshield wiper blades under typical driving conditions. Already,
management has determined that the standard deviation of the population life is 6
months. Suppose we select a simple random sample of 100 wiper blades, collect data
on their useful lives, and obtain these results.
n is equal to100 ... Sample size
x bar is equal to 21 months ... Sample mean
Sigma is equal to 6 months.... Population Standard Deviation
Because the wholesaler uses tens of thousands of these wiper blades annually,
he requests that we find an interval estimate with a confidence level of 95 per cent. The
sample size is greater than 30, so the central limit theorem allows us to use the normal
distribution as our sampling distribution even if the population isn't normal. See unit 2.
We calculate the standard error of the mean
Sigma x bar is equal to sigma divided by square root of n is equal to 6 divided
by10 is equal to 0.6 standard error of the mean for an infinite population.
Now, we consider the confidence level with which we are working. Because a 95
per cent confidence level will include 47.5 percent of the area on either side of the mean
of the sampling distribution, we can see Probability Table in Annexure to Unit 2 for the
0.475 value. We discover that 0.475 of the area under the normal curve is contained
between the mean and a point 1.96 standard errors to the right of the mean.
Therefore, we know that (2) (0.475) is equal to 0.95 of the area is located
between plus or minus 1.96 standard errors from the mean and that our confidence
limits are
X bar plus 1.96 multiplied by sigma xbar ...Upper confidence limit
Xbar minus1.96 multiplied by sigma xbar ...Lower confidence limit
Thus we substitute numerical values into these two expressions:
7 plus 1.96 multiplied by sigma x bar is equal to 21 months plus1.96 multiplied by0.6
is equal to 21 plus 1.18 months is equal to 22.18 months UCL.
Xbar minus1.96 multiplied by sigma x bar is equal to 21 months minus 1.96 multiplied
by 0.6 month is equal to 21 minus 1.18 months is equal to 19.82 month LCL.
We can now say that we estimate the mean life of the population of wiper blades to be
between 19.82 and 22.18 months with 95 per cent confidence.
A more complex interval estimate problem comes from a social-service agency in a
local government. t is interested in estimating the mean annual income of 700 families
living in a four square block section of a community. We take a simple random sample
and find these results.
n is equal to 50 ... Sample size
x bar is equal to Rupees 11,800 ... Sample mean
s is equal to Rupees 950 ... Sample standard deviation
The agency asks us to calculate an interval estimate of the mean annual income of all
700 families so that it can be 90 per cent confident that the population mean falls within
that interval. The sample size is over 30, so once again the central limit theorem
enables us to use the normal distribution as the sampling distribution.
Notice that one part of this problem differs from our previous examples: we do
not know the population standard deviation, and so we will use the sample standard
deviation to estimate the population standard deviation:
Estimate of the population standard deviation sigma hat is equal to s is equal to
whole root of Sum(x minus x bar) whole square divided by n minus 1
The value Rupees 950.00 is our estimate of the standard deviation of the population.
We can also symbolize this estimate value by sigma hat)
Now we can estimate the standard error of the mean. Because we have a finite
population size of 700, and because our sample is more than 5 per cent of the
population, we will use the formula for deriving the standard error of the mean of finite
populations (see unit 2):
Sigma xbar is equal to sigma divided y root of n multiplied by whole root of N minus n
divided by N minus 1
But because we are calculating the standard error of the mean using an estimate of the
standard deviation of the population, we must rewrite this equation so that it is correct
*stimate of the #opulation Standard "eviation
Symbol that indicates an estimated value sigma hat equal to sigma hat
divided by root of n multiplied by whole root of N minus n divided by N
minus 1
We find sigma that is
equal to
s equal to
950 divided by square root of 50 multiplied by whole root of
700 minus 50 divided by whole root of 700 minus1
(950divided by 7.07) multiplied by (650 divided by 699) is
equal to 134.37 x multiplied by0.9643 Rupees 129.57
as an estimate of the standard error of the mean of a finite population (derived
from an estimate of the population standard deviation)
At 90 per cent confidence level, 45 per cent of the area on either side of the
mean of the sampling distribution would be included. Looking in Probability Table in
Annexure to Unit 2 for the 0.45 value, we find that about 0.45 of the area under the
normal curve is located between the mean and point 1.64 standard errors away from
the mean. Therefore, 90 per cent of the area is located between plus and minus 1.64
times standard error away from the mean, and our confidence limits are:
xbar plus 1.64 sigma hat is equal to 11,800 plus 1.64 multiplied (129.57)
is equal to 11,800 plus 212.50
is equal to Rupees 12,012.50 UCL
x bar minus 1.64 sigma hat is equal to 11,800 minus1.64 multiplied by (129.57)
is equal to 11,800 minus 212.50
is equal to Rupees 11,587.50 LCL
With 90 per cent confidence, we estimate that the average annual income of all 700
families living in this four square block section falls between Rupees 11,587.50 and
Rupees 12,012.50.
We can also use a sample to estimate a proportion of occurrences in a
population. For example, the government estimates by a sampling procedure the
unemployment rate, or the proportion of unemployed people, in the work force.
Binomial distribution is a distribution of discrete variables. We do not have
continuous data. The two formulas for deriving the mean and the standard deviation of
the binomial distribution are mu is equal to in multiplied by p; and
Sigma is equal to square root is equal to square root of n multiplied by p
multiplied by q
Where n is equal to number of trials
p is equal to probability of success
q is equal to 1 minus p is equal to probability of a failure
Theoretically, the binomial distribution is the correct distribution to use in
constructing confidence intervals to estimate a population proportion.
The computation of binomial probabilities is tedious. Using the binomial
distribution to form interval estimates of a population proportion is a complex
proposition. Fortunately, as the sample size increases, the binomial can be
approximated by an appropriate normal distribution, which we can use to approximate
the sampling distribution. n estimation, n should %e large enough for both n multiplied p
and n multiplied by q to be at least 5. When you use normal distribution as a substitute;
mu is equal to n multiplied by p shows that the mean of the binomial distribution is equal
to the product of the number of trials n, and the probability of success p; that is n
multiplied byp equals the mean number of successes. To change this number of
successes to the proportion of successes, we divide n multiplied p by n and get p alone.
Hence, we have mean of the Sampling Distribution of the Proportion mu
multiplied by p bar is equal to P. and Standard Error of the Population mu p bar is
equal to whole root of p multiplied by q divided by n
We now illustrate how to use these formulas. Suppose we want to estimate
proportion of the employees of a very large organization who prefer to provide their own
retirement benefits in lieu of a company sponsored plan. First, we select a simple
random sample of 75 employees and find that a proportion of 0.4 of them are interested
in providing their own retirement plans. Our results are
n is equal to75; p is equal to0.4; q is equal to 0.6
Next, management requests that we use this sample to find an interval about
which they can be 99 per cent confident that it contains the true population proportion.
But what are p and q for the population? We can estimate the population
parameters by substituting the corresponding sample statistics p bar and q bar in the
formula, for
Estimated Standard Error of the Population sigma p bar is equal to whole root of p bar
multiplied by q bar
s equal to whole root of 0.4+0.6 divided by 75
s equal to square root of.0.0032 is equal to 0.057
Estimated standard error
is equal to 0.057
Now we can provide the
Now we can provide the etimate by using the same normal curve is located between the
mean and a point 2.58 times standard error from the mean. Thus, 99 percent of the
area is contained between plus and minus 2.58 times standard error from the mean.
Our confidence limits then become
p plus 2.58 sigma p bar is equal to 0.4 plus2.58 multiplied by 0.057
is equal to 0.4 plus 0.147 is equal to 0.547 UCL
p bar minus 2.58 sigma p bar , is equal to 0.4 minus 2.58 multiplied by 0.057
is equal to 0.4-0.147 is equal to 0.253 LCL
Thus, we estimate from our sample of 75 employees that with 99 per cent confidence
we believe that the proportion of the total population of employees who wish to establish
their own retirement plan lies between 0.253 and 0.547.
*stimates: Numbers that represent parameters of population. They are derived from
the samples.
#oint *stimate: A single number that is used to estimate an unknown population
'nterval estimate: Describes a range of values within which a population parameter is
likely to lie.
/onfidence level: The probability associated with an interval estimate. This indicates
how confident we are that interval estimate will include the population parameter.
1. Which are the two basic tools that are used in making statistical inferences?
2. Why do decision-makers often measure samples rather than entire populations?
What is the disadvantage?
3. Explain the advantages of an interval estimate over a point estimate.
4. What is an estimator? How does an estimate differ from an estimator?
5. List and describe briefly the criteria of a good estimator.
6. What role does consistency play in determining sample size?
7. The CC Stadium is considering expanding its seating capacity and needs to know
both the average number of people who attend events there and the variability in this
number. The following are the attendances (in thousands) at nine randomly selected
sporting events. Find point estimates of the mean and the variance of the population
from which the sample was drawn.
8.8 14.0 21.3 7.9 12.5 20.6 16.3 14.1 13.0
8. The Pizza Shop has developed business by delivering pizza orders promptly. The
shop guarantees that Pizzas will be delivered in 30 minutes or less from the time the
order was placed, and if the
delivery is late, the pizza is free. The time that it takes to deliver each pizza order that is
on time is recorded and the delivery time for those pizzas that are delivered late is
recorded as 30 minutes. Twelve random entries from the register are listed.
15.3 29.5 30.0 10.1 30.0 19.6
10.8 12.2 14.8 30.0 22.1 18.3
(a) Find the mean for the sample.
(b) Can this sample be used to estimate the average time that it takes for the shop to
deliver a pizza? Explain.
9. A meteorologist for a television station would like to report the average rainfall for
today on this evening's newscast. The following are the rainfall measurements (in
inches) for today's date for 16 randomly chosen past years. Determine the sample
mean rainfall.
0.47 0.27 0.13 0.54 0.00 0.08 0.75 0.06
0.00 1.05 0.34 0.26 0.17 0.42 0.50 0.86
10. A bank is trying to determine the number of tellers available during the lunch rush on
Fridays. The bank has collected data on the number of people who entered the bank
during the last three months on Fridays from 11 a.m. to 1.00p.m. Using the data below,
find point estimates of the mean and standard deviation of the population from which
the sample was drawn.
242 275 289 306 342 385 279 245 269 305 294 328
11. A Company was considering national distribution of its regionally successful product
and was compiling proforma sales data. The average monthly sales figures (in
thousands of Rupees) from its 30 current distributors are listed. Treating them; as (a) a
sample and (b) a population, compute the standard deviation.
7.3 5.8 4.5 8.5 5.2 4.1
2.8 3.8 6.5 3.4 9.8 6.5
6.7 7.7 5.8 6.8 8.0 3.9
6.9 3.7 6.6 7.5 8.7 6.9
2.1 5.0 7.5 5.8 6.4 5.2
12. For a population with a known variance of 185, a sample of 64 individuals leads to
217 as an estimate of the mean.
(a) Find the standard error of the mean.
(b) Establish an interval estimate that should include the population mean 68.3 per cent
of the time.
13. An undergraduate is interested in purchasing a used TV. She randomly selected
125 advertisements and found that the average price of a TV in this sample was
Rupees 3,250. She knows that the standard deviation of used TV prices in this city is
Rupees 615.
(a) Establish an interval estimate for the average price of a TV so that she can be 68.3
per cent certain that the population mean lies within this interval.
(b) Establish an interval estimate for the average price of a TV so that she can be 95.5
per cent certain that the population mean lies within this interval.
14. From a population known to have a standard deviation of 1.4, a sample of 60
individuals is taken. The mean for this sample is found to be 6.2.
Find the standard error of the mean.
Establish an interval estimate around the sample mean, using one standard error of the
15. From a population with known standard deviation of 1.65, a sample of 32 items
resulted in 34.8 as an estimate of the mean.
Find the standard error of the mean.
Compute an interval estimate that should include the population mean 99.7 percent of
the time.
16. A company managing the flyover is concerned about the number of cars 'running'
the toll gates and is considering altering the toll-collection procedure to make it more be
cost-effective. t randomly sampled 75 hours to determine the rate of violation. The
resulting average violations per hour were 7. f the population standard deviation is
known to be 0.9, estimate an interval that has 95.5 per cent chance of containing the
true mean.
17. A CHS manager wants to inform potential renters about how much electricity they
can expect to use during each month. She randomly selects 61 residents and discovers
their average electricity usage in August to be 894 kilowatt hours (kWh). She believes
the variance in usage is about 131 (kWh)2.
Establish an interval estimate for the average August electricity usage so he can be
68.3 per cent certain the true population mean lies within this interval.
Repeat part (a) with a 99.7 per cent certainty.
18. Given the following confidence levels, express the lower and upper limit of the
confidence interval for these levels in terms of x and
(a) 54%
(b) 75%
(c) 94%
(d) 98%
19. Define the confidence level for an interval estimate.
20. Suppose you wish to use a confidence level of 80 per cent. Give the upper limit of
the confidence interval in terms of the sample mean y, and the standard, ay .
21. As each customer enters his barbershop, Shyam yells out the number of minutes
that the customer can expect to wait before getting his haircut. The only statistician in
town, after being frustrated by Shyam's inaccurate point estimates, has determined that
the actual waiting time for any customer is normally distributed with mean equal to
Shyam's estimate in minutes and standard deviation equal to 5 minutes divided by the
customer's position in the waiting line. Help Shyam's customers to develop 95 per cent
probability intervals for the following situations:
(a) the customer is second in line and Shyam's estimate is 25 minutes.
(b) the customer is third in line and Shyam's estimate is 15 minutes.
(c) the customer is fifth in line and Shyam's estimate is 38 minutes.
(d) the customer is first in line and Shyam's estimate is 20 minutes.
(e) How are these intervals different from confidence intervals?
22. A social psychologist, surveyed 150 top graduate students and found that 42 per
cent of them were unable to add fractions correctly.
(a) Estimate the standard error of the proportion.
(b) Construct a 99 per cent confidence interval for the true proportion of graduate
students who cannot correctly add fractions.
23. A computer store that buys wholesale, untested computer chips, is considering
switching to another supplier who would provide tested and guaranteed chips for a
higher price. n order to determine whether this is a cost-effective plan, Pascal must
determine the proportion of faulty chips that the current supplier provides. A sample of
200 chips was tested and of these, 5 per cent were found to be defective.
(a) Estimate the standard error of the proportion of defective chips.
(b) Construct a 98 per cent confidence interval for the proportion of defective chips
24. The owner of the Home Loan Company randomly surveyed 150 of the company's
3,000 accounts and determined that 60 percent were in excellent standing.
Find a 95 per cent confidence interval for the proportion in excellent standing.
Based on part (a), what kind of interval estimate might you give for the absolute number
of accounts that meet the requirement of excellence, keeping the same 95 per cent
confidence level?
*A*ER 1
UNT 17 Bond nvestment
17.0 Objectives
17.1 ntroduction
17.2 Government Bonds
17.3 How do Bonds Work?
17.4 Bond Prices and Yields
17.5 Bond Prices and nterest Rates Yield to Maturity
17.6 Rate of Return
17.7 Risks in Bond nvestments
1B.0 o"Ae%ti=es
n this chapter you will learn the basics of bond valuation. You will be able to:
1. distinguish among the bond's coupon rate, current yield and yield to maturity.
2. find the market price of a bond given its yield to maturity, find a bond's yield given its
price, and demonstrate why prices and yields may vary inversely.
3. appreciate why bonds exhibit interest rate risk.
4. understand why investors pay attention to bond ratings and demand a higher interest
rate for bonds with low ratings.
nvestment in new plant and machinery requires money often a lot of money.
Sometimes firms may be able to save enough out of previous earnings to cover cost of
investments, but often they need to raise cash from investors. n broad terms, we can
think of two ways to raise new money from investors, either through debt or equity. f
companies need cash for a short while they may borrow from a bank. f they require
funds for medium/long term, they generally issue bonds which are essentially long-term
When companies issue bonds, they promise to make a series of fixed interest
payments and then repay the debt. As long as the company generates sufficient cash,
the payments on the bonds are certain. n this case, bond valuation involves
straightforward time-value-of-money computations. But there is some chance that the
company may not repay its debts. nvestors take this default risk into account when they
price the bonds and demand a higher interest rate to compensate it. Governments also
may need to raise funds. They issue bonds in a similar fashion.
Governments and corporates borrow money by selling bonds to investors. The
money they collect when the bond is issued, or sold to the public, is the amount of the
loan. n return, they agree to make specified payments to the bondholders, who are the
lenders. When you own a bond, you generally receive a fixed interest payment each
year until the bond matures. This payment is known as the coupon because most bonds
used to have coupons that the investors clipped off and mailed to the bond issuer to
claim the interest payment. At maturity, the debt is repaid: the borrower pays the
bondholder the bond's face value (or par value).
Thus, a bond is a debt investment in which an investor loans a certain amount of
money, for a certain amount of time, with a certain interest rate, to a company. A
government bond is a bond issued by a national government denominated in the
country's own currency. They are normally issued for tenure of five to thirty years.
Bonds issued by ndian Government in ndian Rupees are government bonds.
However, bonds issued by Pone Municipal Corporation will not be considered as
government bonds.
Bonds issued by a national government in foreign currencies are referred to as
sovereign bonds. Bonds issued by ndian government in US Dollars or Japanese Yen
are therefore sovereign bonds. ncidentally, these would be also euro-bonds, as they
are not in home currencies.( Please note that name euro-bonds has nothing to do with
currency Euro).
The first ever government bond was issued by the English Government in 1693,
to fund its war against France. Government bonds are normally considered as risk-free
bonds. Here risk-free means free of credit risk. The government bonds still have market
Bonds issued by different countries/governments have come to be known by
some generic names. For example, US Government bonds are referred to as US
Treasuries, bonds issued by France in Euro are called as OATS, German bonds are
called as Bands, and UK bonds are known as Gilts. These bonds are quoted and traded
on major exchanges.
Consider a government bond as an example. Suppose the ndian Government
raised money by selling 6 per cent coupon, 2012 maturity, and Treasury bonds. Each
bond has a face value of Rupees 1,000/-. Because the coupon rate is 6 per cent, the
government makes coupon payments of 6 per cent of Rupees 1,000 or Rupees 60 each
year. When the bond matures in July 2012, the government must pay the face value of
the bond, Rupees 1000, in addition to the final coupon payment.
Suppose you have purchased this bond in the year 2009. f you plan to hold this bond
till maturity, then the cash flow is shown on the time line below. The initial cash flow is
negative and equal to the price you have to pay for the bond. Thereafter the cash flows
equal the annual coupon payment, until the maturity date. On maturity you receive the
face value of the bond, Rupees 1,000, in addition to the final coupon payment.
Dealers and brokers quote the figures or the prices which prevail in the bond market.
This is essentially part of the debt market and you can see the prices quoted on the
National Stock Exchange or NSE in the papers. Details such as the rate of interest, the
year of maturity, price are reported in NSE website/ financial papers. A sample of some
such trades is given as follows:
Bond details Coupon Price YTM (%)
GS-CG-2011 6.57 101.40 5.3274
GS-CG-2012 7.40 101.9690 6.4881
GS-CC-2020 6.35 91.28 7.6069
n this example we examined the cash flows for a 6 per cent treasury bond. How
much would you be willing to pay for this stream of cash flows? To find out we have to
compare with the interest rate on similar securities prevailing at that point in time. Let us
presume the interest rate on three year maturities offer a return of 5.6 per cent. Thus we
use this rate as the discount rate to value the cash flows from the bond.
PV is equal to Rupees 60divided by 1 plus r plus Rupees 60divided by 1 plus whole
square Rupees 1060 divided by 1 plus r whole cube.
s equal 60 divided by 1.056 plus 60divided by 1.056 square plus 60 divided by 1.056
56.82 plus 53.80 plus 900.15
s equal to 1,010.77
Bond Prices are usually quoted as a percentage of their face value. Thus we can
say that our 6 per cent treasury bonds are worth 101.077 per cent of face value, and its
price would usually be quoted as 101.077.
As you can notice that the coupon or interest payments on bonds and
debentures are an annuity. n other words, the holder of our 6 per cent treasury bond
receives a regular stream of Rupees 60 for three years. Thus we can also use the
annuity formula to value the coupon payments and then add on the present value of the
final payment or final face value.
PV is equal to PV (Coupons) plus PV (face value)
is equal to PV (A, r, n) plus PV (face value)
is equal to PV (60, 0.056,3) plus PV(1000)
is equal to 60*0.177584/0.056*1.177584 plus 1000divided by1.177584 is equal to
10.65504divided by 0.0659447 plus 849.19
is equal to 161.58 plus 849.19
is equal to 1010.77
f we need to value a bond of many years to run before maturity, it is usually
better to use the annuity formula and separate the coupon or interest payments from the
face value.
Bon& *ri%es an& GalfE)earl3 Co75on4Interest *a3'ents
We have assumed that interest payments occur annually but there are many countries
where interest payments occur semi-annually. Thus if an interest rate is a semiannually
compounded a rate of 5.6 per cent means that the 6 month rate is 5.6/2 is equal to 2.8
per cent. Thus the present value of such bonds is higher because half the interest is
received six months earlier. The actual cash flow for the example given earlier of 6 per
cent coupon bond maturing in 2007 is given here for semiannual coupon payments by a
semiannual rate of interest.
PV is equal to 30 divided by1.028 plus30 divided by 1.028 square plus30 divided by
1.028 cube plus30 divided by1.028 to the power of 4 plus 30 divided by 1.028 to the
power of 5 plus 30 divided by 1.028 to the power of 6
is equal to 1,010.91 which is slightly more than the value of Rupees 1,010.77 that we
obtained when we treated the coupon payments as annual rather than semi-annual.
However we will assume annual interest payments here.
As interest rates change, so do bond prices. For example, suppose that investors
demanded an interest rate of 6 per cent on 3 year Treasury bonds. What would be the
price of the Treasury bond valued earlier? Just repeat the last calculation with a
discount rate of r is equal to 0.06
PV at 6 per cent is equal to 60 divided by 1.06 plus 60divided by1.06 square plus 1060
divided by1.06 cube
is equal to 56.60 plus 53.40 plus 890
is equal to 1000
Thus when the interest rate is the same as the coupon rate (6% in our example), the
bond sells for its face value.
Now if, we discount the cash flows at a rate higher than the bond's coupon rate, the
bond is worth less than its face value. Let us see the following example.
nvestors will pay Rupees 1,000 for a six per cent 3 year Treasury bond, when the
interest rate is 6 per cent. Suppose that the interest rate is 10% when coupon is 6%.
Now what is the value of the bond? We just repeat our initial calculation but with r is
equal to 0.10
PV at 15% is equal to 60 divided by1.10 plus 60 divided by 1.10 square plus 60 divided
by 1.10 cube
is equal to 54.55plus 49.60plus 796.40 is equal to 900.55
The bond sells for 90.055 per cent of face value.
We conclude that
1. when the market interest rate exceeds the coupon rate, bonds sell for less than face
2. when the market interest rate is below the coupon rate, bonds sell for more than face
Suppose you are considering the purchase of a 3-year bond with a coupon rate
of 10 per cent. Your investment advisor quotes a price for the bond. How do you
calculate the rate of return the bond offers?
For bonds priced at face value the answer is easy. The rate of return is the
coupon rate. We can check this by setting out the cash flows on your investment.
Cash Paid to You in Year
You pay 1 2 3 Rate of Return
Rupees 1,000 100 100 1,100 10%
Notice that in each year you earn ten per cent on your money (100divided by1,
000). n the final year you also get back your original investment of Rupees 1,000.
Therefore, your total return is 10 per cent, the same as the coupon rate.
Now, suppose the market price of the three year bond is Rupees 1136.16. Your
cash flows are as follows: Cash Paid to You in Year
You pay 1 2 3
Rupees 1,136 100 100 1,100
What is the Rate of Return now?
Notice that you are paying out Rupees 1,136.16 and receiving an annual income
of Rupees 100. So your income as a proportion of the initial outlay is 100divided
by1136.16 is equal to 0.088 or 8.8 per cent. This is sometimes called bond's current
However, total return depends on both interest income and any capital gains or
losses. A current yield of 8.8 per cent may sound attractive only until you realize that the
bond's price must fall. The price today is Rupees 1136.16, but when the bond matures 3
years from now, the bond will sell for its face value or Rupees 1,000. A price decline
(i.e. capital loss) of Rupees 136.16 is guaranteed, so the overall return over the next 3
years must be less than the 8.8 per cent current yield.
Let us generalize. A bond that is priced above its face value is said to sell at a
premium. nvestors who buy a bond at a premium face a capital loss over the life of the
bond. Hence the return on these bonds is always less than the bond's current value.
A bond priced below face value sells at a discount. nvestors in discount bonds
face a capital gain over the life of the bond. The return on these bonds is greater than
the current yield.
Because it focuses only on current income and ignores prospective price
increases or decreases, the current yield mis-measures the bond's total rate of return. t
overstates the return of premium bond and understates that of discount bonds,
We need a measure of return that takes account of both current yield and the
change in a bond's value over its life. The standard measure is called yield to maturity.
The yield to maturity is the answer to the following question: At what interest rate would
the bond be correctly priced?
The yield to maturity is defined as the discount rate that makes the present value
of the bond's payments equal to its price.
f you can buy the 3-year bond at face value, the yield to maturity is the coupon
rate, 10 per cent. We can confirm this by noting that when we discount the cash flows at
10%, the present value of the bond is equal to its Rupees 1000 face value.
PV at 10% is equal to 100 divided by 1.1. plus100 divided by 1.1 square plus 100
divided by1.1cube.
is equal to 90.90 plus 82.65 plus 826.45
is equal to 1,000
But if you have to buy the 3 year bond for Rupees 1136, the yield to maturity is only 5
per cent. At that discount rate, the bond's present value equals its actual market price,
PVat5% is equal to 100 divided by1.05 plus 100 divided by 1.05 square plus 100
divided by 1.05 cube
is equal to 95.24 plus 90.70 plus 950.22
is equal to 1136.16.
Cal%7latin, )iel& to Mat7rit3 for the Treas7r3 Bon&
We have found the value of the 6 per cent coupon treasury bond by discounting
at a 5.6 interest rate. We could have phrased the question the other way around: f the
price of the bond is Rupees 10 10.77, what return do investors expect? We need to find
the yield to maturity, in other words, the discount rater that solves the following
PV at 10 per cent is equal to 100 divided by 1.1 plus 100 divided by1.1 square plus 100
divided by 1.1. cube.
s equal to 90.90 plus 82.65 plus 826.45
s equal to 1000
But if you have to buy the 3 year bond for Rupees 1136, the yield to maturity is only 5
per cent. At that discount rate, the bond's present value equals its actual market price,
Rupees 1136.16
PV at 5 percent is equal to 100 divided by 1.05 plus 100 divided by 1.05 square plus
100 divided by 1.05 cube.
s equal to 95.24 plus 90.70 plus 950.22
s equal to1135.15
Cal%7latin, 3iel& for the Treas7r3 Bon&
We have found the value of the 6 percent coupon treasury bond by discounting
at 5.6 percent interest rate. We could have phrased the question the other way around:
if the price of the bond is Rupees 1010.77, what return do investors expect? We need to
find the yield to maturity in other words the discount rate r that solved the following
Price is equal to 100 divided by (1 plus r) plus 100 divided (1 plus r) square plus 100
divided by (1 plus r) cube.
To find the yield to maturity most people use a financial calculator. For example
Periodic Payment is PMT, Final payment is FV, number of periods is n and interest
rates as the yield to maturity of the bond. From this, present value can be calculated.
You can also feed in PV and get the Yield to maturity-YTM of the bond. The calculator
will display the answer.
The earlier example illustrates that the yield to maturity depends on the coupon
payments that you receive each year (Rupees 60), the price of the bond - (Rupees
1010.77), and the final repayment of face value (Rupees 1000). Thus it is a measure of
the total return on this bond, accounting for both coupon income and price change, for
someone who buys the bond today and holds it until maturity. Bond investors often refer
loosely to a bond's 'yield'. They are usually talking about its yield to maturity rather than
its current yield.
The only manual procedure for calculating yield to maturity is trial and error. You
guess an interest rate and calculate the present value of the bond's payments. f the
present value is greater than the actual price, your discount rate must have been too
low, so you try a higher interest rate (since a higher rate results in a lower PV).
Conversely, if PV is less than price, you must reduce the interest rate. n fact, when you
use a financial calculator to compute the yield to maturity, you will notice that it takes the
calculator a few moments to compute the interest rate. This is because it must perform
a series of trial and-error calculations.
Figure 17.3 is a graphical view of yield to maturity.
t shows the present value of the 6 per cent Treasury bond for different interest
rates. The actual bond price, Rupees 1,010.77, is marked on the vertical axis. The
figure illustrates relationship between interest rates and bond prices.
When the interest rate rises, the present value of the payments to be received by
the bondholder falls, and bond prices fall. Conversely, declines in the interest rate
increase the present value of those payments and result in higher prices.
FGURE 17.3
At times there is some confusion about the interest rate the return that
investors currently require with the interest, or coupon, payment on the bond.
Although interest rates change from day to day, the Rupees 60 coupon payments on
our treasury bonds are fixed when the bond is issued. Changes in interest rate affect
the present value of the coupon payments but not the amount paid/payable.
When you invest in a bond, you receive a regular coupon payment. As bond
prices change, you may also make a capital gain or loss. For example, suppose you
buy the 6 per cent Treasury bond today for a price of Rupees 1010.77 and sell it the
next year at a price of Rupees 1,020.
The return on your investment is Rupees 60 coupon payment plus the price change of
Rupees 1,020 minus 1,010.77 Rupees 9.33. The rate of return on your investment of
Rupees 1,010.77p is
Rate of Return is
equal to
(Coupon income plus Price change)
divided by nvestment (60+9.33)is
equal to 60 plus 9.33 divided by
1010.77 is equal to69.33 divided by
1,010.77 is equal to 0.686 i.e. 6.86
Bond prices fall when market interest rates rise and bond prices rise when
market rates fall. Resultantly, the rate of return that you earn on a bond will fluctuate
with market interest rates. This is why we say bonds are subject to interest rate risk.
Do not confuse the bond's rate of return over a particular investment period with
its yield to maturity. The yield to maturity is defined as the discount rate that equates the
bond's price to the present value of all its promised cash flows. t i s a measure of the
average rate of return you will earn over the bond's life if you hold it to maturity. n
contrast, the rate of return is calculated for any particular holding period and is based on
the coupon income and the capital gain or loss on the bond over that period. The
difference between yield to maturity and rate of return for a particular period is explained
in the following example.
Rate of Ret7rn Vers7s )iel&
A six year coupon bond with maturity 2012 has 3 years left until maturity and
sells today for Rupees 1010.77. ts yield to maturity is 5.6 per cent. Suppose that by the
end of the year, interest rates have fallen and the bond's yield to maturity is now only 4
per cent. What will be the bond's rate of return?
At the end of the year, the bond will have only two years to maturity. f investors then
demand an interest of 4 per cent, the value of the bond will be
PV at 4% is equal to 60 divided by 1.04 plus 1060 divided by 1.04 square
1.04 1.042
is equal to 57.69 + 980.03
is equal to 1,037.72
You invested Rupees 1,010.77p. At the end of the year, you receive a coupon payment
of Rupees 60 and have a bond worth Rupees 1,037.72. Your rate of return is therefore
is worked out as follows:
Rate of return is equal to (60+1037.72-1010.77) divided by 1010.77
s equal to86.95 divided by 1010.77.
s equal to 0.860 i.e. 8.6 percent
The yield to maturity at the start of the year was 5.6 per cent. However, because
interest rates fell during the year, the bond price rose and this increased the rate of
s there any connection between yield to maturity and the rate of return during a
particular period? Yes: f the bond's yield to maturity remains unchanged during an
investment period, its rate of return will equal that yield.
When interest rates do not change, the bond prices change with time so that the
total return on the bond is equal to the yield to maturity.
f the bond's yield to maturity increases, the rate of return during the period will
be less than that yield. f the yield decreases, the rate of return will be greater than the
Figure 6.4 plots the price of a 30 year maturity, 6 per cent Treasury bond over
time assuming the yield to maturity per centage remains at ?)E per cent) The price
declines gradually until the maturity date, when it finally reaches face value. n each
period, the price decline offsets the coupon income by just enough to reduce total return
to 5.6 per cent.
The dashed curve in the figure shows the corresponding price path for a low
coupon bond currently selling at a discount to face value. n this case, the coupon
income would provide less than the rate of return. ts price gradually approaches face
value, however, and the price gain each year brings its total return up to the market
interest rate.
FGURE 17.4
Interest Rate Ris2
We have seen that bond prices fluctuate as interest rates change. n other words,
bonds exhibit interest rate risk. Bond investors cross their fingers that market interest
rates will fall, so that the price of their bond will rise. f the market interest rate rises, the
value of their investment falls.
But all bonds are not equally affected by the changing interest rates. Compare
the two curves in the Fig. 6.5. The black dark line shows how the value of the three
year, 6 per cent coupon bond varies with the level of the interest rate. The thinner line
shows how the price a 30 year, 6 per cent coupon bond varies with the level of interest
rate. You can see that a 30 year bond is more sensitive to interest rate fluctuations than
the 3 year bond. This should not surprise you. f you buy a three year bond when the
interest rate is 5.6 per cent and the rates then rise, you will be stuck with a bad deal
you have just loaned your money at a lower interest rate than if you had waited.
However, think how much worse it would be if the loan had been for 30 years rather
than three years. The longer the loan, the more the income you have lost by accepting
what turns out to be a low coupon rate. This illustrates a bigger decline in prices of a
long-term bond. Of course there is a flip side too. When interest rates fall, the longer-
term bonds respond with a greater increase in price.
Defa7lt Ris2
Our focus has so far been on Government bonds. But Governments are not the
only issuers of bonds. State Governments and local bodies as well as corporations
issue bonds. Bonds can be issued in different currencies also. Normally governments
do not go bankrupt so we do not perceive a default risk. However bonds issued by
corporations have a default risk in case the company is not able to repay the money.
The risk that the bond issuer may default on his obligations is called default risk (or
credit risk). Thus companies have to offer a higher interest rate in order to compensate
for the higher risk of non-payment. The difference in the yield of a government bond and
the corporate bond is called default premium or risk premium. Usually bonds are rated
for safety by a ratio-, agency. Rating agencies, like CRSL and CRA perform this task,
in ndia.
Variations in Cor5orate Bon&s
There are varieties of bonds to suit various investors. Some of these are Zero
Coupon Bonds: These are bonds which are redeemed at their face value and priced at
a nominal value below their face value. The investor gets a return from the difference in
purchase price and face value.
0loating rates bonds: Sometimes the coupon rate/interest rate can change over
time. Thus the coupon payment is linked to some interest rate. The rate is reset
according to the changes in the interest rate. Thus the return on the bond always
approximates current market returns.
/onvertible bonds: These bonds can be converted into a share at a later
specified date. Thus they give an opportunity to a bond investor to participate in equity if
the company is doing well.
/allable bonds The issuer reserves the right to call back the bond, and pay a fixed
price (generally at a premium over par value). This is less attractive to investors. As
interest rate goes down, when the bond prices increase, the bonds are likely to be
called back.
7onds: Bonds have fixed maturity period, fixed value at maturity and interest rate
specified. They are generally redeemed at par.
&egotiable bonds are traded in the market, and their market value changes,
depending upon the current interest rates.
/oupon rare: This is the interest rate specified in the bond and the yearly fixed income
depends on this rate.
Cield to maturity is defined as that discount rate, which makes the present value of
bond's payment equal to its price.
/urrent yield focuses only on current payments. This ignores fluctuations in prices.
Actually, it overstates the return on premium bonds and under states the return on
discounted bonds. This is not a correct measure of return.
#rice risk: The price of the bond changes, while the investor is holding it. Another
important point to note is, the longer the period for maturity, greater the risk. f there is
an increase of 1 per cent in interest rate, (say from 10 to 11), the price of a 3 month
maturity bond of face value Rupees 10,00,000 will decrease by Rupees 2,500 where as
the corresponding price drop on a 9 month bond would be Rupees 7,600.
Long-term bonds that pay no interest are referred to as zero coupon bonds. These
bonds sell at a discount from its value of maturity, since any market interest rate will be
more than 0 per cent
/onvertible bonds: These bonds can be converted into equities of the firm.
1. What is a bond? How it is different from equity?
2. Why there is a interest rate risk, when interest amounts (nominal) are fixed?
3. Why do prices and yield to maturity vary inversely?
4. A 6 year bond with par value Rupees 1,000 has a current yield of 7.5 per cent and a
coupon rate of 8 per cent. What is the bond's price? (Rupees.1066.7)
5. A 6 year bond pays interest Rupees 80 annually, and sells at Rupees 950. What is its
coupon rate, current yield and yield to maturity? (Coupon rate is equal to 8 per cent;
current yield is equal to 8.42; yield to maturity is equal to 9.12)
6. There are 2 bonds, and A wants to decide in which one he should invest.
Bond 1:10 year maturity, coupon rate 8 per cent, yield to maturity is 10 per cent.
Bond 2: 10 year maturity, coupon rate 12 per cent, yield to maturity is 10 per cent
Next year also yield to maturity is same 10 per cent for both.
7. A bank sells bonds of face value Rupees. 1000, carry a coupon rate of 8 per cent,
with a maturity period of 3 years. The bond sells at a yield to maturity of 9 per cent.
(a) What is the interest payment a bond holder receives each year? (Rupees 80)
(b) What is the selling price of the bond?(Rupees.974.13).
(c) What will happen to the bond price, if the yield to maturity falls to 7 per cent? (The
bond will sell at Rupees 1001.98)
8. Discuss the current Yield calculation and the calculation of yield to maturity, in terms
of their usefulness to investors in decision-making.
9. RB issues a 30 year bond at 8 per cent par value Rupees 1000. f the market yield
increases shortly afterwards, what happens to the following parameters?
(a) coupon rate; (b) price; (c) current yield; and (d) yield to maturity.
(no change) (decreases) (increases) (increases)
10. A corporation has a 14 per cent bond, which matures in 20 years. The bond is
callable in 5 years at Rupees 114. This bond currently sells for Rupees 105.
(a) What is the current yield? (13.33 per cent)
(b) Yield to call?
11. What is the present worth of the bond where final payment at the end of 3 years is
equal to Rupees 1000; n is equal to 3 years, coupon rate 6 per cent. nterest paid twice
a year?
(Hint: use Present Value. Rupees 948)
12. buy a bond of 10 year maturity and 8 per cent coupon rate, for Rupees 980. A year
later the bond price is Rupees 1050.
(a) What is the new yield to maturity on the bond? (7.23 per cent)
(b) What is the rate of return over the year'? (15.31 per cent)
13. Calculate the present value of 6 year bond with 9 per cent coupon rate.
Current interest rate is 12 per cent. (Rupees 876.66).
14. The interest rate increases from 5.6 to 10 per cent suddenly. Find the present
values of the two bonds given below, both before and after the change.
(a) Both the bonds have same coupon rate of 6 per cent,
(b) Bond 1 has a maturity of 3 years and bond 2 has a maturity of 30 years.
(3 year bond sells at Rupees 1010.77 before the increase in interest rate. Now the bond
price falls to Rupees 900.53. Decrease is 10.9 per cent. The 30 year bond sells at
Rupees 1,057.50 and the price falls to Rupees 622.92. There is a larger percentage
decrease of 41.1 per cent)
*A*ER 1
UNT 18 Linear Programming
18.1 ntroduction
18.2 Graphic Approach
18.3 Simplex Method
Linear Programming refers to several related mathematical techniques that are used to
allocate limited resources among competing demands in an optimal way. For obtaining
the optimal solution the problems should be structured into a particular format. t has
been found that linear programming has many useful applications to financial decisions.
The type of problems should have linear constraints and the decision maker must be
trying to maximize some linear objective function.
n this chapter we will discuss graphical and 'simplex' methods.
Let us assume that the selling prices, production and marketing costs are known for
each of the 'n' products. The firm also has to operate under certain economic, financial
and physical constraints.
Some examples of resource and marketing constraints:
(a) Bank may stipulate certain working capital requirements.
(b) Market may not absorb the whole output
(c) Capacity constraints
(d) Labour availability
(e) Raw materials, availability
These constraints can be used to formulate the problem. The question is how to attain
maximum profit, in the given circumstances?
Under what conditions a Linear Programming problem can be formulated?
1) As the name implies all equations are linear- This implies proportionality. For
example, if it takes 4 persons to produce one unit, then we require 12 persons to
produce 3 units.
2) The constraints are known and deterministic. That is, the probabilities of occurrence
are presumed to be 1.0.
(3) Most important rule is that all these variables should have non-negative values.
(4) Finally, decision variables are also divisible.
Let us illustrate the graphic approach with simple numerical two-decision variables. (3
variables require 3-D graphing). This gives a quick insight into the nature of L.P.
Let firm A produce radios and television sets.
Each radio costs Rupees 500 in wages and Rupees 500 in materials.
Each television set costs Rupees 2,500 in wages and Rupees 1,500 in materials. The
firm pays the labour and material expenses in cash.
The price of a radio is Rupees 2,000 and the price of a television is Rupees 6,000.
As there is a strong consumer demand, the firm is able to sell as many units as it
produces at prevailing prices.
The firm also gives one period credit to consumers.
The firm has 10 hours of machine time and 4 hours of assembly time per day.
The production of radio requires 3 hours of machine time and 1 hour of assembly time.
The production of television requires hour of machine time and 1 hour of assembly
The firm has Rupees 12,000 as cash balance (liquidity to pay for labour and materials).
Now, given the financial and capacity constraints, how many radios and televisions
should the firm produce in period 1, to maximize its profits?
Let x and y be respectively, the units of radios and television sets produced in period 1.
Then the constraints are:
(a) (capacity constraint machine time) 3x plus y is less than or equal to 10
(b) (capacity constraint assembly time) x plus y is less than or equal to 4
(c) (financial constraint) 1000x plus 4000y is less than or equal to12, 000 ~ same as x
plus 4Y <is less than or equal to12
(d) 1 (non-negativity) x is greater than or equal to0;
(e) Objective function Maximize Profit is equal to1, 000x plus 2,000y
Now, let us draw the graph.
FGURE 18.1
Line 1 x plus Y is equal to 4
Data 0 2 4
V 4 2 0
218 'A'
Line 2
3x plusY is equal to 10
Data X 3 2 1 0
Line 3 X plus 4 yis
equal to 12
1 4 7 10
Data X 0 4 8 12
3 2 1 0
We have plotted the above three constraints in the graph. Find all the combinations of x
and y, which satisfy the constraint and plot the points for all 3 lines. The graph is in the
First quadrant. This satisfies the non-negativity condition.
1. All points on or below (inside) the line satisfy, x plus y is less than 4.
2. All points on or below the line 3x plus v <_ 10, satisfy the machine time constraint.
3. All points on or below the lines plus 4v < 12,satisfy financial constraint.
Even though all constraints are listed separately, they should be satisfied
simultaneously. When these restrictions are placed one on top of the other, we obtain a
common area, which in this case is shaped like a pentagon. (say ABCDE). Every
point in this pentagon satisfies the constraints. This area is referred to as a set of
feasible solutions.
Now, our objective is not to pick any feasible solution.
Although x is equal to y is equal to 0 is also a feasible solution, the profit will be zero.
This means no. production, S.
So, our objective is to pick that feasible solution (that particular combination of x and y),
from the set of feasible solutions which maximizes profit.
FGURE 18.2
We already know that each radio contributes Rupees 1000 and each television
contributes Rupees 2000. The optimal solution is obtained by drawing the 'so-profit'
line. The term 'so-Profit' refers to the fact that any point on that line, (any combination
of x and y) produces the same profit as any other combination on the same line.
That is, in this case, the contribution of 2 radios is equal to the contribution of one
television. This gives the concept that any point on a line with a slope of (-1 /2) is the
'iso-profit' line in this case.
Starting from the origin, we move this line parallel to itself in the north-eastern direction
as far as possible without removing it completely from the region of solutions n the
adjacent figure, this movement depicted by the continuous upward shift in the objective
function T. The optimal solution is given by the final point of contact 'D' (the meeting of
the pentagon vertex and iso-profit line).
The firm can earn a maximum profit of Rupees 6,670 by producing 4/3 radios and 8/3
television sets. f we have integer constraints, we should settle for the next best.
But for the present, we find that assembly centre is fully utilized, and cash is fully
exhausted. Machine centre has a surplus capacity. Hence the bottlenecks for greater
profits arise from lack of assembly centre capacity, and liquidity crunch.
We see that if an optimal solution exists, at least one such solution is an extreme point
of the polygonal region representing the feasible solutions. This is also intuitively clear.
As there is only finite number of vertices, we can straight away calculate the maximum
Only exception to this rule will be, that when the iso-profit line and the boundary
coincide (i.e. the slope of the objective function is the same as the boundary line). Then
we will have many optimal solutions with the same maximum profits, along that line.
The main drawback of this approach is that in problems with large number of constraint
equations, there will be more possible points to evaluate and this becomes inefficient.
Another method of linear programming is Simplex Method. The method is complex.
With computer programmes, spread sheets available, it is possible to use this method
effectively and solve equations with as many as 10-12 variables.
Let us take the following problem to use Simplex Method.
A company manufactures cricket bats and chess sets. Each cricket bat gives a profit of
Rupees. 2 and chess set give a profit of Rupees 4.
f the company wants to maximize the profit, how many cricket bats and chess sets
should be produced per day?
Formulate the problem.
Let the production be 'B' bats and 'C' chess sets.
(a) Objective function: Maximize Z is equal to 2B plus 4C
(b) 4B plus 6C is less than or equal to 120 (Workshop 1)
(c) 2B plus 6C is less than or equal to 72 (Workshop 2)
(d) 1C less than or equal to10
(e) B, C greater than or equal to 0
We now change this to standard LP format.
n the standard LP form, all the constraints are converted into equations with the help of
slack variables. Also make sure that these equations have non-negative right hand side.
For example, 4B plus 6C less than or equal to 120 is changed to 4B plus 6C plus m is
equal to 120 Here m is called a slack variable. t takes non-negative values.
n fact all the variables in these equations take non-negative values. The standard LP
format is as follows:
(a) Objective function Maximize Z is equal to 2B plus 4C plus 0 m plus 0 n plus 0 p
(b) 4B plusplis6C plus m is equal to 120 (Workshop 1)
(c) 2B plus 6C plus n is equal to 72 (Workshop 2)
(d) 1C plus 1pis equal to 10
(e) B, C greater than or equal to 0 m, n, p z 0 where m, n, p are the slack variables.
Z equation is also written as Z minus 2B minus 4C minus 0 m 0 n 0 p is equal to 0.
Now, make a tableau as follows
This tableau gives the coefficients of the variables Z, B, C, m, n, p in the four equations
written in the standard LP format, starting with the Z-equation. This tableau is a
convenient way of setting up the information. This gives,
. The variables which are in the solution at that point.(Z, m, n, p)
2. Profit associated with the solution.(0 when B is equal to 0, C is equal to 0)
3. The variable that will add most to profit, if brought into the solution. This is indicated
by the variable which has most negative coefficient in the Z-row.
Here the most negative coefficient is minus4 for C. So C is called the entering variable.
Next, we need to rewrite the tableau by replacing one of the basic slack variables by C.
To decide which current basic variable is to be replaced by C, we concentrate on the C-
column and the solutions column. Take the ratio of the corresponding entries in these
columns. Look at the following table:
Solution Ratio
-4 0
6 120 120/6 is
equal to 20
6 72 72/6 is equal
1 10 10/1 is equal
to 10
Then we choose the smallest positive value in the ratio column, which is 10. The slack
variable corresponding to this is p.
Thus we decide to replace p by C. Look at the tableau below which is a reproduction of
the previous one. We have highlighted the column under C, and the p-row, which is
called the pivot row. The intersection of the highlighted row and column is called the
pivot entry, which is here.
Now we forma new tableau where
(1) new pivot row is equal to (current pivot row) divided by(pivot entry)
(2) all other rows is equal to current row minus (pivot entry) multiplied by(new pivot
So we have completed one iteration of the problem.
Second 'teration
Basic variables
1 0 0 0
4 2 0
-4 6
0 1 0 0
0 0 1 0
0 0 0 1
120 72 10
Z B C n n . P Solution
222 (
)<, o tid t ( alia it
Now, the entering variable is B, which has the most negative entry in the Z-row. The
variable to be replaced is n which corresponds to the smallest positive ratio 60/4, 12/2,
10/0 is n.
The new tableau then becomes
Look at the highlighted row and column. Since p has the only negative coefficient in the
Z-row, it should be the entering variable. Then p should replace m, as the ratio
corresponding tom (36/6is equal to6) is the smallest positive one.
The next tableau is as follows
Since there are no negative numbers in the Z-row, we stop here. The value in the
solutions column against B is 24 and that against C is 4.
Thus 24 bats and 4 chessboards should be made to get the maximum profit of Rs 64
under the given constraints.
Let us now look at various steps of Simplex Method.
1. Formulate problem in terms of an objective function and a set of constraints.
2. Write it in the standard LP format.
3. Set up initial tableau.
4. Determine which variable to bring into solution (largest negative number in the Z-
5. Determine which variable to replace (smallest ratio of solution column to its
comparable value in the optimum column).
6. Divide the identified row by the pivot entry to arrive at the new pivot row..
7. Update remaining row values.
8. f there is no negative number in the Z-row, you have reached the optimum solution.
Otherwise repeat steps 4 to 7.
Mini'i-ation *ro"le's
The steps are identical for solving minimization problems. The objective is to minimize,
rather than maximize. Therefore, a positive Z-row value now indicates potential
improvement. The variable associated with the largest positive value in the Z-row would
be the entering variable. The variable to be replaced is decided as before, by choosing
the smallest positive ratio.
The last tableau, which is called the optimum tableau, gives us a lot more information
than just the values of the main variables. The values of the slack variables help us
understand the status of resources. For instance, in the above example, mis equal to 6
in the optimum tableau. This positive value of m means that particular resource is not
fully used up. Such a resource is called abundant resource. Here it means that
workshop is not fully utilized in producing the optimal quantity of bats and chess
boards. So the management may decide to put it some other use. The other two slack
variables n and p do not appear to be basic variables in the optimal tableau, This means
their value is zero .This suggests that the resources corresponding to n and p i.e.
workshops 2 and 3 are working to their full capacity in producing 24 bats and 4 chess
boards. When the value of slack variable is zero, the corresponding resource is called
Further analysis of this method can help us in decision-making:
1. L.P. can be used to find the sensitivity of results to changes in costs, availability of
raw materials, labour, etc. For a % change in cost, the % change in profit can be
2. We can analyse the marginal effects of financial and other constraints on the liquidity
and profitability of the company. When there are uncertainties in demand, we can use
the probabilities while formulating the problem.
3. We can use L.P. in Profit planning also. We have a special type of L.P. called Goal
Programming. The goals which are desired are incorporated into the objective function.
n goal programming, all goals, one or many are incorporated into the objective function.
This helps us to do break-even analysis and take financial decisions.
4. n the same way, we can use L.P. for Financial Budgeting. We should represent
accounts in a matrix form in a spreadsheet. We can use this method to make multi-
period budgeting also.
Linear Programming; Maximize; Constraints; Objective Function; Non-negativity
Conditions; Graphical Method; Basic Feasible Solution; Extreme Point; Optimum
Utilization; Slack Variables; teration; Entering Variable; Replacement Variable;
Substitution Rate; Shadow Prices; Artificial Variable; Sensitivity Analysis.
1. What structural requirements of a problem are needed in order to solve by L.P.? 2, 2.
2. What type of information is provided by final Simplex Tableau'?
3. What are shadow prices? How are they useful in business decision-making?
4. What are slack variables? Why are they necessary'?
n a graphical solution, it is said the corner point will give the result. When do you have
more than one solution (many solutions) along a constraint line?
6. Attempt the problem which was done by simplex method as example, by graphical
(a) Plot the constraint equations.
(b) Determine the area of Feasibility.
(c) Plot the objective function.
(d) Find the optimum point.
7. Solve the problem by simplex method.
5x plus 2y plus 3z less or equal to 100; x, y, z greater or equal to 0
4x plus y plus 2z is less than or equal to 60
Maximize f is equal to 3x is equal to 2y plus z.
8. Solve by graphical method:
3x plus y less than 15; 2x plus 5y less than or equal to 24; x plus y less than or equal to
x, y greater or equal to 0. Maximize f is equal to x divided by2 plus y
The fuel company wants to mix 2 fuels (A & B) for its trucks in order to minimize costs. t
needs no less than 3000 litres in order to run its fleet during the next month. t has a
maximum storage capacity of 4000 litres.
There are 2,000 litres of fuel A and 4,000 litres of fuel B available. Mixed fuel must have
an octane rating of no less than 80.
When mixing the fuels, the amount of fuel obtained is just equal to the sum of parts put
in. Octane rating is the weighted average of individual octanes, weighted in proportion
to the respective volumes. Fuel A has an octane of 90 and costs Rupees 20 per litre
and fuel B has an octane of 75 and costs Rupees 13.33 per litre.
. Write the required equations and the objective function.
State any assumption to solve the problem.
Solve the problem graphically. Give the quantity of each fuel to be used.
The dietician of the hospital is asked to prepare food which will have low cost, but at the
same time provide the required nourishments.
The diet should have between 1,800 to 3,600 calories.
No more than 1,400 calories can be starch.
No less than 400 calories of protein.
The varied diet will be made of 2 foods A and B.
Food A has 200 calories of starch and 400 calories of protein; it costs Rupees 150 per
kg Food B has 700 calories of starch, 100 calories of protein and 100 calories of fat.
t costs Rupees 30 per kg
We should not give more than 1 kg of A to any one.
Write the equations representing the information.
Solve the problem both graphically and through Simplex Method.
*A*ER 1
19.1 ntroduction
19.2 Simulation Exercise
19.3 Simulation Methodology
Simulation is a way of studying effects of changes in the real system through
models. t is the imitation of some real thing or process. n simulation, we try to imitate a
system or environment in order to predict actual behaviour.
Simulation can be defined as acting out or mimicking an actual or probable real
life condition, event or situation to find cause of a past occurrence or to forecast future
effects of assumed circumstances or factors.
A simulation may be performed through solving a set of equations (mathematical
model), constructing a physical model, stage rehearsal, a computer graphics or game.
Simulations can be useful tools that allow experiments without actual exposure or
risk, but they may be gross simplification of reality. They are as good as underlying
In financial world, it generally refers to using a computer system to perform
experiments on a model of a real system. Such experiments can be undertaken before
the real system is operational so as to aid in its design. We can see how the system
might react to changes in its operating rules. We can evaluate how system's response
to changes in its structure.
Simulation is appropriate to situations where size and/or complexity of the
problem make the use of other techniques difficult or impossible. For example, queuing
problems have been extensively studied through simulation. Some types of inventory
problems, layout and maintenance problems also can be studied through simulation.
Simulation can be used with traditional statistical and management techniques.
Simulation is useful in training managers and workers in how the real system
operates, in demonstrating the effects of changes in system variables and real-time
control. Simulation is extensively used in driving lessons. The person who learns driving
is made to face the real road situations (traffic jams and other problems) during
learning, so that serious accidents can be avoided. Simulation is commonly used in
financial world such forex, investment and risk management areas.
A55li%ation of si'7lation 'etho&s:
1. Air Traffic control queuing
2. Aircraft maintenance scheduling
3. Assembly line scheduling
4. nventory reorder design
5. Railroad operations
6. Facility layout
7. Risk modeling in finance area.
9. Foreign exchange market
10. Stock market
The best way to learn about simulation is to simulate. So, let us take an example.
The owner of an outlet wishes to evaluate his daily ordering policy. His current
rule is order the demand of the previous day. But he has started thinking recently that
he should follow better methods to decide the quantum of order.
Ge purchases milk at Rs 12 and sells at Rs 16. He orders his requirement at the
end of the day and gets the milk in the morning. From past experience, the vendor
assessed that his demand is between 30 and 80 liters per day.
Ge also kept a record of relative frequency of the quantity demanded during the
last 10 days. Now he thinks of a new ordering rule mean of quantity sold in the last
10 days.
Ge maintained the sales in a tabular form. The table has two columns. The first
column shows the Demand and the second one shows the Relative frequency, that is,
in the selected period of 10 days, how many times such demand occurred.
Demand per day in Litres Relative Frequency
35 1 by 10, that is, only one day, out of ten
days, demand of 35 litres occured
45 3 by 10, that is, only three days, out of
ten days, demand of 45 litres occured
55 2 by 10, that is, only two days, out of
ten days, demand of 55 litres occured
65 3 by 10, that is, only three days, out of
ten days, demand of 65 litres occured
75 1 by 10, that is, only one day, out of ten
days, demand of 75 litres occured

He settles for the ordering rule
[(35 into 0.1) plus (45 into 0.3) plus (55 into 0.2) plus (65 into 0.3) plus (75 into 0.1)] is
equal to 55 litres.
So we have 2 rules: Old rule and New rule. Representing mathematically,
Old rule is equal to quantity demanded on previous day is equal to D(n minus 1).
New rule is equal to Mean of the past 10 days is equal to 55
Now let us compare these orders in terms of profits.
Profit 'P' is equal to (Sold Quantity into selling price) minus (Ordered quantity into cost
Assume that the unsold milk packets are thrown away as they are perishable. Now to
prepare for simulation, we have to develop a method for demand generation. Let us use
the probability distribution of demand and random numbers to generate a demand for
the next 20 days.
Now arrange the chance process to generate occurrences in the system.
Demand Per Day Relative
Probability Random Number
35 1 by 10 0.1 00 to 09
45 3 by 10 0.3 10 to 39
55 2 by 10 0.2 40 to 59
65 3 by 10 0.3 60 to 89
75 1 by 10 0.1 90 to 99
With the above table and random numbers, we develop the demand for 20 days.
Step 1: Choose a random number.
Step 2: Find the random number interval associated with the random number.
Step 3: Read the daily demand corresponding to the random number interval.
Step 4: Assume D = 55 litres for day 0
Step 5: Calculate the quantity sold. Quantity sold will be lesser of the demand D or
Quantity ordered Q1 (or Q2)
Step 6: Profit = (Sold quantity into selling price) minus (Ordered quantity into cost price).
Selling Price is Rs 16 per litre and cost price is Rs 12 per litre
Step 7: Do all steps for 20 days to simulate.
Day RN
related to
e random
of D and
) profit
(16 into
(12 into
sold in
last ten
of D and
(16 into
(12 into
0 55
1 6 35 55 35 100 55 35 100
2 39 45 35 35 140 55 45 60
3 89 65 45 45 180 55 55 220
4 61 65 65 65 260 55 55 220
5 99 75 65 65 260 55 55 220
6 95 75 75 75 300 55 55 220
7 55 55 75 55 -20 55 55 220
8 35 45 55 45 60 55 45 60
9 57 55 45 45 180 55 55 220
10 59 55 55 55 220 55 55 220
11 30 45 55 45 60 55 45 60
12 81 65 45 45 180 55 55 220
13 2 35 65 35 -220 55 35 -100
14 18 45 35 35 140 55 45 60
15 87 65 45 45 180 55 55 220
16 68 65 65 65 260 55 55 220
17 28 45 65 45 -60 55 45 60
18 44 55 45 45 180 55 55 220
19 80 65 55 55 220 55 55 220
20 84 65 65 65 260 55 55 220
Total 1120 1110 1000 2680 1100 1010 2960
56 55.5 50 134 55 50.5 148
;e now see that the average demand according to simulation is 56 litres,
Average sales is 50 litres, according to old method; and 50.5 litre according to new
method. Average order is 55.50 litres under old method, whereas 55 hires under new
Thus you would find that profitability improves under the new method.
Det us draw the flow chart for a simulation model. We will list the key factors or
decisions on the right hand side.
Det us define the problem. Problem definition for simulation differs a little from
problem definition for any other tool of analysis. Essentially, it requires the specification
of objectives and identification of the relevant controllable and uncontrollable variables
of the system to be studied. The variables affect the performance and determine the
extent to which the objectives are achieved.
In our example, the objective is to maximize profits. The relevant controllable
variable is the ordering Rule (under the control of the decision maker). The
uncontrollable variable is the daily demand (amount sold).
START Key factors
DEFNE PROBLEMDefine objectives and variables
Specification of variables, parameters, decision rules, probability distribution and time
incrementing procedure (fixed or variable)
Determine starting conditions and run length
Determine statistical tests Compare with other information
I'5ortant +eat7res
1. A model has to be representative of the system. A simulation model is one in which,
the system's elements are represented by arithmetic, analog or logical processes that
can be executed, manually or otherwise, to predict the dynamic properties of the real
!. Specification of time incrementing procedure: n simulation models, time can be
incremented by fixed time increments or variable time increments. Under both methods,
a simulated clock is a must. The events occur at regular intervals we have fixed
increments like hour, days, months, etc. The simulation proceeds from one time period
to another. At each point in 'clock time' the system is scanned to determine if any event
has happened. Then the events are simulated and time is advanced. Even if events do
not occur, time is advanced by one unit.
In the variable time incremental method, clock time is advanced by the amount
required to initiate the next event.
If we have a situation, where order is placed only if the inventory goes down to
certain level, instead of daily (as in our example), we can follow this method.
;hen events occur with regularity, follow fixed time method. When events are
infrequent, and happen in hop-jump fashion, follow variable time increments. You may
have to simulate time increments also with probabilities.
(. The ability to deal with the dynamic systems is one of the features that distinguishes
these models from other models used for general problem solving.
Even in the above example, an inventory formula along with cost of inventory
could have been used to determine optimum ordering rule. Still a simulation run will be
necessary to determine the effects of this inventory rule.
.. Simulation models are custom built for the problem to be solved. On the other hand,
a linear programming model can be used in a variety of situations with only a
restatement of the values for the objective function and constraints.
?. Building and executing a model is only a guideline, and they are not rigid rules.
@. Discrimination of run length:
#a$ One approach is to run for a specified set period.
#"$ Another approach is to set run length long enough to get large samples. this
is no problem as we can run the model in computers.
#%$ Third approach is to run the model till an equilibrium is achieved simulated
data corresponds to historical data. n our example, simulated demands correspond to
their historical frequencies.
Simulation is desirable when experiments on the real system
1. would disrupt ongoing activities;
!. would be too costly to undertake;
(. require many observations over an extended period of time;
.. do not permit exact replication of events; and
?. do not permit control over key variables.
Simulation is preferable when a mathematical model
1. is not available to handle the problem;
!. is too complex and arduous to solve;
(. is beyond the capability of available personnel; and
.. is not robust enough to provide information on all factors of interest.
1. Time consuming.
!. Requires computer experience and expertise on the part of the user.
(. mpossibility of quantifying and difficulty of casting complex problems in a format may
cause difficulties; but simulations can be made to run under any type of assumption and
these flaws can be overlooked.
.. n spite of widespread applications, there are very few principles to guide the user in
making decisions on what to include in the model and the length and number of
simulation runs. This will be more like an art than science. The user has to use his
intuitive judgments.
Simulation methodology; Problem definition; Real system/dynamic system; Specification
of parameters; Controllable and uncontrollable variables; Set run length of simulation;
Fixed time increments and variable time increments.
1. Case St7&3
Shrimps Galore is a firm in Cochin. With the blue revolution of the 1990's the firm
became famous. They started exporting fresh shrimp to European countries. t places
orders for cases of shrimp from fleet representatives at the beginning of each week to
meet the demand from its customers at the middle of the week. The shrimp is delivered
to Shrimps Galore and then, at the end of the week, to its customers.
Both the supply of shrimp and demand for shrimp are uncertain. The supply may
vary as much as 10% from the amount ordered, and by contract Shrimps galore must
purchase this supply.
The probability associated with this variation in supply is 10%, 30 % of the time;
0%, 50% of the time and +10 %. 20% of the time.
The weekly demand for shrimp is normally distributed with a mean of 800 cases
and a S.D. of 100 cases.
A case of shrimp costs Rs 300, and it sells at Rs 500. Any shrimp not sold at the
end of the week are sold to a cat-food company at Rs 40 per case.
Shrimps Galore may, if it chooses, order the shrimp 'Flash-Frozen'by the supplier
at dockside. This raises the cost of a case by Rs 40 and the cost will become Rs 340.
+lash freezing enables Shrimps Galore to maintain an inventory of shrimp. But it
will cost Rs 20 per case per week to store the shrimp at the local ice-house.
The customers are indifferent to regular or flash-frozen shrimp. Shrimps Galore
has calculated that its shortage cost is equal to the mark-up that is, each case
demanded but not available costs the company (500 300) = Rs 200
Now, the game requires that each week a decision be made as to how many
cases to order of regular shrimp and flash-frozen shrimp.
The steps are as follows:
#a$ Decide on the order amount of regular and/or flash-frozen shrimp and record
the data.
#"$ Assume that there is no opening inventory of flash-frozen shrimp.
#%$ Determine the quantity that arrives and enter it in orders received in rows 4
and 5 respectively. (Accomplish through Random numbers & its associated level of
random number intervals).
00-29=-10%; 30-79=0%; 80-99=10%.
#&$ For example, if you decide to order 1000 cases of regular and 100 cases of
flash-frozen, the quantity you will actually receive would be 1000 minus (0.10 into1000)
is equal = 900 regular cases and flash-frozen is equal to 90 cases.
Note that variation in supply in both cases is same.
#e$ Add the flash-frozen in inventory (if any), to the quantity of regular and flash-
frozen, just received enter in row 6.
#f$ Determine the demand for shrimp. We know the demand is normally
distributed with a mean of 800 and a S.D. of 100. Use random normal deviate value and
calculate demand. f the random deviate value is 1.76, the demand is [800 minus (1.76
into 100)] is equal to 624 cases. Enter demand in row 7.
#,$ Determine the quantity sold (Row 8).This will be lesser of the amount
demanded and amount available Le row 7 and row 8. f the firm receives 990 and
demand is 624, they can only sell 624.
#h$ The remaining goes to excess. Always sell regular before flashfrozen. Then
regular is sold as cat-food.
i$ n the same way, determine shortages, quantity of unsatisfied demand - enter
in row 11.
1. Week 1 2 3 4 5 6 7 8 9 10
2. Random number
3. Frozen nventory
4. Order Regular
5. Order Frozen
6. Available catch-regular
7. Demand
8. Quantity sold
9. Cat food sold
10. Frozen extra
11. Deficit
!. Cal%7late *rofit
1. (a)Revenue from sales is equal to 500 into column 7
(b) Revenue from excess is equal to 40 catfood into column 8
(c) Cost of regular purchases is equal 300 x col. 3
(d) Cost of flash-frozen 340 x col. 4
(e) Cost of holding flash-frozen 20 x col. 9
(f) Cost of shortages 200 x col. 10
(h) Profit is equal (a plus b) minus c is equal d plus e plus f).
!. Enumerate with examples of areas wherein you can use simulation
(. f a box contains 100 balls, of which, 10 per cent are green balls, 40 per cent are red
balls, and 50 per cent are spotted balls, develop a simulation model. Each time a ball is
drawn, colour is noted and replaced. Use random numbers.
.. The Supermarket Chain has hired a consultant to decide 'how many items per
customer should be allowed in the fast checkout line'. You are expected to use
simulation and you have one month and 2 assistants to gather data.
Stores are located throughout the country is 10, Working hours are 12 hrs a day.
Average size: 9 checkout lines per store including fast checkouts.
Available checkers: 7 to 10; some engage in stocking activities, when not in checking
(a) How do you set up the study?
(b) What additional data you will need?
(c) How would you gather preliminary data?
(d) How would you set up the problem for simulation?
(e) The criteria you would use for making recommendations?
(f) What factors will affect the application of your recommendations to all the stores?
*A*ER 1
UNT 20 Fundamentals of Human Resources
20.0 Objectives
20.1 ntroduction
20.2 The Perspective
20.3 Relationship between H R M & H R D and their Structure and Functions
Check Your Progress (A)
20.4 Role of H R Professionals
Check Your Progress (B)
20.5 Development of H R Functions in ndia
Check Your Progress (C)
Let Us Sum Up
Answers to Check Your Progress (A, B, C)
Terminal Questions
Suggested for Further Reading
After reading this unit, you should be able to:
#a$ appreciate the fundamentals of Human Resource Management;
#"$ understand the comprehensive perspective of H R M and the relationship with
Human Resource Development;
#%$ understand the role of H R professionals; and
#&$ get to know the development of H R functions in ndia.
The effective utilization of people in any organized effort has always been a
pressing problem in society. For a long time management theories have been
characterized by a search of universal solution to provide practitioners with principles
that can be applied to all kinds of organizations with universal success. This is mainly
due to the fact that the organizations are primarily social systems. They combine people
and science humanity and technology. t is, therefore, not possible for every
organization to have the same type of people and same level of technology. Thus, the
human behavior in relation to an organization has assumed a great significance and
forms the major subject matter of various studies conducted in the field of human
resources management to provide the basis for the organizational development process
and to improve the organizational effectiveness. n his book THE LAND -MARKS OF
TOMORROW, Peter Drucker the famous management guru observes: 'no matter how
much we can quantify, the basic phenomena are qualitative one's: change and
innovations, risk and judgments, growth and decay, dedication, vision, rewards and
motivation, so on and so forth. The discipline we need cannot be a technical discipline
though it will have many technical areas. t must be a truly humanistic discipline'.
*ractitioners and managers have come to recognize the complex world in which
they must operate and have become increasingly willing to accept help from behavioral
scientists in identifying and resolving organizational problems. An organization is a
planned coordination of the activities of a number of people for the achievement of
common organizational objectives through involvement of people to assigned functions
and through a hierarchy of authority and responsibility using appropriate technology.
The characteristics of an organization and its success are largely influenced by various
managerial and organizational factors. Thus, the study of human behavior at work
cannot be studied in isolation, ignoring various inter-dependent complexities. ndustrial
work, originally, was organized around the technology available and rules of checks and
Organizations today have realized that they need to respond to changes
occurring in the environment; be it technology, business dimension, strategies,
customer expectations or the emerging markets. Their experience reveals that after due
analysis, it is relatively easy to think and decide upon a response to business or
technology dimension; but, the implementation is often a slow process or a difficult one
to go through. This is because it involves convincing people, changing their habits and
mindset, the established ways of thinking and perception. And even the 'best' strategy
can fail if not implemented in the right spirit. The people component is thus becoming
the key factor to success of the strategy; be it for survival or growth or achieving
*eople management has been the most intriguing aspect of managing an
organization all along. The organizations have recognized its contribution in the total
framework but this aspect is so dynamic that it does not seem to reach a level of
stability. The technology, the system and its subsystems or the infrastructural resources
tend to get stabilized at least for a certain period in their evolution process, but people
management tends to remain an 'alive* issue.
One of the reasons for this lies in its being different in nature compared to any
other resource the organization depends upon. The other resources are passive in
the sense that they do not react or their reaction can be controlled or predicted. But
human resource is not so. This resource is capable of responding to the treatment given
to it and the response is not standard or uniform. Even a slight variation can create
waves. Ultimately, organizations exist for producing products and services to meet
human needs. Thus, manpower occupies the central place, looked at from any point or
any organizational activity.
Organizations have attempted to deal with people its employees according
to the understanding prevalent about human behavior at any point in time. The
variations have been characterized from a rather mechanistic approach to a
philosophical one. The evolution of new approaches has been triggered by research in
the field of management as well as social sciences. Human affairs in any organization
are influenced by a wide variety of emotions like love and hate, human needs and
expectations, human values, beliefs and perceptions, traditions and culture, and also by
technical, social, economic, demographic and political changes and developments. This
unit examines how these approaches have converged in the present perspective of H R
An appropriate beginning to understand the fundamentals of people
management would be to appreciate the foundations of an organization. An
organization is primarily a ramification of the fact that there is an interdependency
implied in the satisfaction of needs of individuals alongside with the achievement of
organizational objectives. An organization is coming together of individuals in order to
attain a common goal/purpose. As defined by Edgar Schein, 'An organization is the
rational coordination of the activities of a number of people for the achievement of some
common explicit purpose or goal, through division of labour and function and through a
hierarchy of authority and responsibility.' (Schein, 1979). Such a coming together can be
formal or informal. n a formal setup, there is a given goal, a structure, explicit roles and
relationships in order to coordinate the activities whereas in an informal organization,
these aspects evolve as an outcome of the group process.
Drawing from this definition we can see that there are two interdependent
aspects, i.e. one about people and the other about activities. Historically, two streams of
thoughts have developed; one, on how to organize the activities most systematically
and analytically so that specificity in the work processes and operations can be brought
about, and the other, on how to understand an individual's relation to a given activity
now recognized as 'work'. Obviously, enough thinking has developed in both these
spheres over the years and the two perspectives have affected each other due to the
high degree of their association and interdependence.
The beginning of these two perspectives can be seen in the work of Robert
Owen (1771-1858) and Charles Babbage (1792-1871). Owen, a manager by
profession, claimed that a manager's best investment was in his workers ('vital
machines' as he called them). He believed in providing better conditions for workers
which he thought would result in higher productivity. Whereas Babbage, a professor of
mathematics, was an early advocate of division of labour. He believed in applying
scientific principles to work processes to increase productivity and reduce expenses.
Whichever may be the focal point, cooperation of individuals to coordinate the activities
in an organization is the beginning of people management. Organizations have
attempted to explore the best way of achieving this and continue to do so. The genesis
of people management lies in the evolution of management thoughts itself. Therefore, in
order to trace the development of people management as a function, we have to study
the various theories of management.
During the flurry of the industrial revolution, the view of the coordination of
activities taken by organizations was very simplistic. t focused on the 'activities' that
related to the work situation alone, i.e. doing the work. t was assumed that people
would do the work they have been employed for (paid for). This was also supported and
subsequently highlighted by the 'scientific management' approach conceptualized and
pioneered by Frederick Taylor (1850-1915) famous for his 'division of labour' concept
and 'time and motion' studies and further substantiated by Gantt and Gilberths. Some of
the major assumptions in this approach could be summarized as:
#a$ the tasks can be broken down to simple units for people to understand and perform
#"$ people will do a given activity in return for money
#%$ people will have to do what is defined by the organization and in turn by technology.
The simplicity of this approach ignored many important and vital aspects of
human behavior which were later brought to the forefront. First of all, it concentrated
only on the activities implied in the 'work' but certain other activities (behavior) which
take place as a natural outcome were not considered. For instance, fatigue, boredom,
the need to converse with others (not related to work), the relationships that may grow
out of the interactions, etc., were not seen as relevant for managing. The perspective
controlled and predicted the activities of people strictly related to work; and it chose to
let go of the other aspects. t was this simplistic mechanical approach that primarily was
responsible for the rise of labor unions and labor unrest. Though certain factors like
periodic economic depression, immigration of workers, aggressive stance of the
management in combating the efforts of labor to unionize, delayed strengthening of the
collective bargaining as a process, the genuineness of issues made it a permanent
formal factor of organizations. The concept of unionism also for the first time made the
organizations aware of the role of external socio-political pressures.
In addition to this, certain developments in the internal environment of the
organization gave rise to a few new issues. For instance, the tightly structured and
planned work systems could not instill meaning/ pride in the work that individuals did
and this had an adverse effect on productivity. This was the beginning of the awareness
about the crucial role played by emotions in work situations. This realization led to the
entire spectrum of research in the area of work motivation. The impact of 'Hawthorne
Studies' carried out by Elton Mayo and others at Western Electric Company during
1924-33, is a landmark in the evolution of the management thought and human
approach in management. These studies pointed out to various dimensions of human
behavior that were not considered to be of any significance in the restricted approach
taken earlier. The human relations movement that followed replaced the 'rational-
economic man' by the 'social man' perspective. t focused on the role played by the
various relationships that develop at work as an outcome of the organizational
interactions. Following the revelations, the people management systems were geared to
take care of the relationships with supervisors, colleagues and groups.
Later researchers like Chris Argyris, Abraham Maslow, Douglas McGregor and
Fredrick Herzberg highlighted dimensions of motivation that are rooted in the growth
need of an individual. The central theme of their arguments was that individuals are
motivated by other than monetary factors too. They emphasised that individuals like to
perceive meaning in the activities they do, they like to experience a sense of
responsibility while performing a task, and have a sense of achievement when the task
is complete. f some of these elements are missing in the 'work' they do, the
performance can be limited. n other words, they need to feel proud about what they are
doing. Their involvement in the process of deciding their activities may determine the
level of their performance and satisfaction. Therefore, the perspective of people
management should provide for these components. This was the beginning of the
present developmental approach towards people management.
The De=elo5'ent of *eo5le Mana,e'ent +7n%tions
The history of management of people as a distinct managerial function goes back
to the end of the nineteenth and the beginning of the twentieth century. With a
significant increase in the number and size of organizational units as a sequel to the
ndustrial Revolution, there was a need to have special departments like finance,
accounting, production, etc. However, it was much later that the need for a department
to manage people in the organizations was felt. n ndia the experiment on group
behavior in Ahmedabad mills by Prof. A. K. Rice in 1952 is a significant contribution.
A +ew organizations had a post of welfare secretary to meet the needs of the
workers and prevent workers from forming unions, (Werther and Davis, 1982). These
social secretaries, as they were called, marked the birth of specialized human resource
management as distinct from the day-to-day supervision of personnel by operating
managers. The units dealing with such activities were mostly termed as Time Office in
textile mills and factories and as establishment section in banks and commercial offices.
They were, in fact, engaged almost entirely in promoting the organizational
maintenance objective, although this was not widely recognized (Miner, 1969). Perhaps
it was in the chemical and pharmaceutical industries, the term personnel officer was
initially used in 1960s.
Although the fundamental activities involved in people management, viz.,
acquiring, training, evaluating and compensating the employees continued, the
broadened understanding of human behaviour contributed to the maturing of this
function. As Fred Luthans observes, 'These examples offer ample evidence that the
personnel function was very much in existence before the 1930s. However, the major
change in the practice of management that included the personnel function, with its
accompanying concern for the human element, did not occur until the socio-
psychological upheavals in the late 1920s and early 1930s. (F. Luthans, 1985)
In general, it appears that there have been two major traditions or trends within
personnel management over the years. One of these, stemming largely from economics
and accounting, emphasized a hardheaded, profit-minded approach to the utilization of
human resources; the other, with its origins in social work and certain subfields within
social psychology, took more of a social welfare viewpoint. This duality of approach
appears to have hampered the development of the profession within certain segments
of the American industry, and the signs of the split have still not entirely disappeared.
The social welfare tradition has been viewed as antithetical to the 'real' organizational
goal of productivity by many managers, both within and outside the personnel field. On
the other hand, the feeling among those with a social welfare orientation has been that
management generally paid more emphasize to productivity and profit and less to
employee satisfaction.
Only in relatively recent years there has been some lessening of this conflict as
an increasing number of firms have come to accept the view that there are really two
primary types of organizational goals productivity and maintenance. Both appear to be
essential, yet some policies and procedures which maximize one may well do so at the
expense of the other (Miner, 1969).
As can be observed, the changing perspective of HRM was triggered by greater
and wider understanding of human behavior in relation to the formal organization.
Therefore, the evolution of approaches is characterized by the addition of the
dimensions rather than substitution. n this framework of change, the H R M as a
function in an organization matured to encompass the newer dimensions and deeper
aspects of given dimensions. n other words, none of the earlier aspects of people
management were wiped out. They have become stabilized, reutilized and therefore
become less crucial in comparison to the newer dimensions.
The present perspective of H R M, to quote Sheth:
=> ? M assumes that the mana&ement of people is an inte&ral part of the
resour#e mana&ement tas" within an enterprise for a#hie$ement of or&ani@ational
o%Ae#ti$es. >uman %ein&s de$elop a sta"e in the enterprise as they wor" in it and hen#e
their moti$ation( de$elopment and &rowth #onstitute a #riti#al fa#tor in the de$elopment
and &rowth of the or&ani@ation. A #ru#ial mana&erial responsi%ility is to ma"e a
#ontinuin& effort to harmoni@e the interest and &rowth of the or&ani@ation with those of
the employees at all le$els. >uman sensiti$ity( trust in people and parti#ipati$e
mana&ement are treated as a part of mana&erial #ulture and philosophyB 1!heth( 1552/.
As implicit in the above quotation, H R M serves as an umbrella for all functions
old and new. t provides a guiding principle for developing new people related systems
and also provides a yardstick to evaluate any existing subsystems in the area of people
management. n addition, it subtly emphasizes that managing people is a line-and-staff
function both. Every manager has to implement/practice a component of this function
through his day-to-day actions. n other words, every system has a process
requirement. Preparing the line manager to appreciate a system, its rationale and the
linkage to the H R philosophy, forms a crucial component of the H R functionary today.
The process of adopting the changing perspective of H R M by any organization
is evident in the changing nomenclature of the function/department. Thus, at the first
stage the labour and welfare department' being substituted or renamed as 'Personnel'
and in the next stage brought under one HR functionary. A careful look reveals that the
traditional activities still continue as sub-modules of the broad HRM function. Experts
have put these either in the four traditional sub-modules of Acquisition, Development,
Motivation and Maintenance (De'Cenzo, 1988) or Planning and Administration, H R D,
Job and Salary, and Workers Affairs. (Pareek and Rao, 1981) The differences here are
those of classifying. But by and large it can be observed that the conventional
component of people management is categorized under (Personnel) Administration and
Maintenance. The systems related to acquisition, (evaluation) promotion, administration,
salary and long-term benefits are under administration and the traditional labour
management, grievance and discipline management activities are covered under the
maintenance systems. The developmental systems such as induction and socialization
of the individuals, development and growth, performance appraisal and counselling,
career planning are covered under the nomenclature of Human Resource Development
(H R D). Another classification views two subsystems under HRM, viz. administrative,
developmental and preventive (Mankidy, 1998). Looking at the comprehensive
coverage one tends to agree that H R M function as the continuation and enlargement
of the conventional areas of people management, certainly signifies 'maturation of the
function of management of people as an integral part of enterprise management'
(Sheth, 1992).
Organizations increasingly compete with each other on the basis of effective
people management and development by tapping into the ideas of workers and
organizing their work in more effective manner and even by following the best practices
of other organizations. This can be possible if the organizations procure right type of
people with right type of skills and attitude for right jobs who can be developed to meet
the present as well as future needs of manpower requirements. Besides the traditional
role of maintenance and management of manpower, the H R M has to play a crucial
role in human resource development, appraisal and utilization. Thus, H R D is
sometimes considered as a significant subsystem of H R M.
;ide range of activities are included within the boundaries of H R M. The roots of
people management and development reside in the welfare tradition with focus on
improving organizational efficiency and effectiveness. t should also emphasize the
need for continuous professional development (C P D) to meet the organizational
requirements. The development of professionals should be continuous because there is
always scope for improvement of skills and performance. The individuals, however,
have to own and manage their developmental needs. The development process should
have clear learning objectives that aim to satisfy individual and organizational needs.
There is no conflict between the structure and functions of H R M and H R D the
difference is only in the approach and emphasis. While routine functions become a part
of H R M, the H R D functions emphasize on organizational interventions for climate
development, employee and organizational development linked with organizational
goals/objectives and change management process. t may involve some element of
conducting surveys and research to seek employees' feedback and opinion, their
aspirations, and suggestions to handle the present organizational issues. t may also
involve some element of innovations to formulate people related policies. Thus, the
emphasis of H R D is on overall organizational development process which also
includes development of people.
Che%2 )o7r *ro,ress #A$
State 8hether the follo8in, state'ents are tr7e or false:
1. People component of an organization has always received due attention. ---- False.
2. ndustrial revolution led to the rise of unions. ---- False
3. Management theories and approach to people management are very closely related.
4. Scientific Management approach is the foundation of today's concept of Human
Resource Management. ---- False.
5. Labour Management to Human Resource Management is not just a quantitative
expansion of the people management function but is qualitatively different. ---- True.
6. Personnel Management and H R D are synonymous terms. ---- False.
7. H R D and human relations movement are not the same. ---- True.
8. H R M and H R D are unrelated to each other. ---- False.
9. H R D is a subsystem of H R M. ---- True.
10. H R M is a subsystem of H R D. ---- False.
11. H R D and H R M are more or less same concepts. ---- False.
Corresponding to the evolution of the H R M, the role of the individuals handling
this function (activities) has undergone change. This change is not only quantitative in
terms of added activities or responsibilities but also qualitative. The shift has taken
place from traditional people's management to modern people's development. Thus, the
role of HRD professionals assumes a greater significance.
Traditionally, this function was perceived merely in terms of the activities, and
was a part of the duties of supervisors/managers. The focus as a specialized function
came along with external, socio-legal influences needing awareness of the employment-
related legislations and their implications. As the function further developed in terms of
systems for recruitment, training, promotion, etc. this knowledge became essential.
Slowly, individuals who acquired this knowledge were relied upon by the shop-floor
managers. This led to the perception of personnel being a specialist job a staff
function. Academics responded by designing courses with specific coverage of the
required skills and techniques. ndividuals acquiring such qualifications joined the
organizations as specialists-professionals and were mainly required to deal with people-
related matters.
Gowever, the maturing of this function from personnel to H R M and H R D,
highlighted that it cannot be totally delinked from the line managers, and that the line
managers are the delivery points of this function. Hence, line-managers have to develop
the ability of people management including their development.
On the second platform, the professionalization of this function raised the issue
whether it should become a specialist function or could the line managers become H R
functionaries. mplied in the debate is the fact that the contents of the role of the
functionaries include specialized skills and knowledge on one hand, and equally
important and pivotal, the philosophical orientation. The knowledge and skills are helpful
in developing systems but the ultimate success is decided by the human relation
orientation. The H R philosophy makes the difference. Such philosophical orientation
need not and is not the property of any profession per se. n other words, can one with
such orientation pick up the professional knowledge and skills? Experience of industries
indicates both the patterns.
The traditional function of people management existed in the narrow sense of the
term in ensuring the attendance, ensuring output and quality, good working conditions,
safety, hygiene, etc. Since these were to be ensured on the shop floor, the
responsibilities were with the supervisors/managers. However, when some of these
functions became a part of statutory obligations special personnel had to be appointed.
ndividuals with knowledge of these laws, rules and regulations started getting
preference in employment and the function was viewed as special. The bank unions
became important power centers in the 1960s, 1970s and 1980s, and for dealing with
unions, industrial relations functions emerged and occupied a special position in the
banks. They also dealt with individual misconduct and disciplinary enquiries. The focus
on administering the personnel activities like recruiting, training, promoting and
compensating made the personnel functions all the more a specialized function. With
further turn of events when the developmental perspective was recognized, the
orientation of the functionaries became crucial.
The emerging perspective highlighted 'along with the development of the whole
man, an integration of the people with the organization so as to make cooperative action
easier and more meaningful, improve understanding between people, reduce useless
frustration, enabling (he individuals to serve the organizational objectives without losing
personal identity' (Pandey, 1990). This perspective implies that the staff-line
functionaries need to be partners in achieving the objectives of the H R D. Every activity
/ system has a component that needs to be dealt with by the personnel / H R M
department and the line managers.
;hile viewing the functions of the developmental perspective as more dynamic
than the traditional personnel function, Pareek and Rao (1981) have grouped the
multiple functions under five headings as follows:
1. S755orti=e Role: This relates to the strengthening of the operating and executive
levels and consolidating the strengths in an organization.
!. Role of S3ste' De=elo5'ent an& Resear%h: This pertains to developing systems
that deal with people, their problems and organizational dynamics. This was already
present in the traditional role.
(. Mana,erial role: This relates to performing managerial functions like planning future
manpower, recruiting, utilizing by placement, returning, motivating-integrating people
and their role, performance and potential assessment, planning the growth of
individuals, etc.
.. Role of De=elo5in, Co'5eten%e: This refers to developing technical, managerial,
and processing competence among the human resource. The new perspective also
includes helping and coping competence.
?. *ro%ess Role: An effective organization needs to respond to the changing
environment for which it has to develop coping skills. Creating necessary culture and
values in the organization, diagnosing the problem at organizational level and taking
corrective steps are the related responsibilities of the HR functionaries.
The above description reveals the qualitative orientation required in the HRD
perspective. As Sheth (1992) has pointed out 'underlying H R M is a progressive
reinforcement of values of democracy, liberalism, humanism and shared control over
the workplace. t implies social commitment to the need for widening the base of
individual rights and corporate obligations.'
*areek and Rao have identified the critical attributes for dispensing such a role.
These include:
1. Knowledge of performance appraisal systems and their functioning in various
!. Knowledge of potential appraisal and mechanism of developing a system
(. Knowledge of various tests and measurements of behaviour
.. Ability to design and coordinate training programmes at worker, supervisor and
managerial levels.
?. Professional knowledge of personnel and management
@. Knowledge of behavioural sciences
B. Understanding of overall organizational culture
C. Knowledge of career planning, processes and practices
F. Knowledge and skills in counselling
10. Knowledge of techniques in behavioural research
1. Organizing ability
2. Systems development skills
1. nitiative
!. Faith in human beings and their capabilities
(. Positive attitude to others
.. magination and creativity
?. Concern for excellence
@. Concern for people and their development
B. Friendly, sociable and affable
C. Attitude for research and development work
F. nterest in learning new things
10. Ability to work as a team member
In view of the objectives of H R M and the critical attributes listed above, it is
apparent that certain personality characteristics like initiative, faith in human beings,
concern for the development of employees, and ability to work as a team member are
crucial. n the absence of these the first two sets of attributes may not achieve much.
G R functions in banks are generally not performed professionally, unlike other
corporates, Banks still consider H R D as a generalist discipline and any one from the
cadre occupies the position of H R head. The C H has developed a H R Competency
Model (E T 26 February 2004) listing out 19 interlinked competencies for the H R heads
in the organizations. These competencies include nine behavioral competencies viz.
communication, initiative, drive, creativity, self-confidence, teamwork, influence,
problem solving and inter-personal skills. These nine behavioral competencies have
been embedded in ten functional competencies, viz. business knowledge, change
management, diversity management, service orientation, execution excellence, financial
perspective, building expertise, personal credibility, relationship management and
strategic thinking and alignment.
The H R functions in banks will have to undergo drastic changes keeping in view
the challenges faced by the banks. H R D departments can no longer function in
isolation. They have to play an important role in coordinating various organizational
activities for improving overall effectiveness of banks.
Strate,i% Role in the +7t7re
Accepting the importance of HR in the 21st century, Ulrich (1998) opines that 'HR
has never been more necessary (as it is today). The efforts to achieve excellence
through a focus on learning, quality, teamwork and re-engineering, are driven by the
way organizations get things done and how they treat their people. Those are
fundamental HR issues.' He gives a new mandate for HR asking the professionals in
this field:
1. To become a partner with senior and line managers in strategy execution, helping to
move planning from the conference room to the marketplace.
!. To become an expert in the way work is organized and executed, delivering
administrative efficiency to ensure that costs are reduced while quality is maintained.
(. To become a champion for employees, vigorously representing their concerns to
senior management and at the same time, working to increase employee contribution,
that is, employees' commitment to the organization and their ability to deliver results.
.. And finally, to become an agent of continuous transformation, shaping processes and
a culture that together improve an organization's capacity for change.
This new agenda for H R is a radical departure from the status quo. n most
companies today, H R is sanctioned mainly to play policy police and regulatory
watchdog. t handles the paperwork involved in hiring and firing, manages the
bureaucratic aspects of benefits, and administers compensation decisions made by
others. When it is more empowered by senior management, it might oversee recruiting,
manage training and development programmes, or design initiatives to increase
workplace diversity. But the fact remains: the activities of H R appear to be and often
are disconnected from the real work of the organization. The new agenda, however,
would mean that everyone engaged in H R's activities would in some concrete way help
the organization better serve its customers or otherwise increase shareholder value. To
that extent they are termed as HR Relationship Managers in some banks.
After conducting a study to find out the level of professionalism of H R M
functionaries, Agrawal and others (1990) conclude that the individual, his organization,
academic institutions and the professional bodies, all have played a role in improving
capabilities of these professionals. Let us see what an individual, today, can do to
enhance his role as an H R functionary.
;hat an GR *rofessional %an Do>
1. Acquiring additional professional qualifications relevant to their role requirements.
!. Regular holding of study circle meetings amongst personnel officer/employees with a
commitment for bringing improvements in HR professionals. The forum should be used
for sharing of experiences and latest developments in the field.
(. Exchange of ideas, views and sharing of experience amongst personnel fraternity
from different companies.
.. Association with and participation in the activities organized by various professional
bodies such as National nstitute of Personnel Management, Management Association,
ndian Society for training and Development.
?. Regular interaction between HR professionals and technologists; HR professionals
should he familiar with latest technological developments affecting the organization so
that they can plan to disseminate new knowledge, skills and capabilities amongst
@. HR professionals should undertake problem-based project studies particularly as a
part of various professional examinations. They should present their findings to the
executives from the organization and should try to implement their project findings.
Dastly. there is debate about who should become an H R functionary. Whether
organizations should employ those with specific academic qualifications or could the
line managers with the right perspective become H R functionaries? The academics
guarantee knowledge but that can be acquired at any time. f one accepts the criticality
of values and beliefs in becoming effective H R Managers, then anybody with such
values could be suitable. These values are not the prerogative of any particular
discipline or knowledge base. Secondly, the future role of H R Manager is to become a
partner in strategic planning in which case he needs to have technical knowledge about
what the business activity of the organization is. n this case a line manager with the
right attitude could subsequently acquire the knowledge to become an H R functionary.
The aim of the organization should he to place an individual with the required attributes
and so both the options could be kept open.
Che%2 )o7r *ro,ress #B$
State 8hether the follo8in, state'ents are tr7e or false:
1. The role of the H R Functionaries has undergone qualitative change. ---- True.
!. H R functionaries have total responsibilities about the management of human
resource in the organization. ---- False.
(. H R functionaries arc responsible for development of H R-related systems. ---- True.
.. H R professionals must have qualifications in H R M. ---- True.
?. Line Managers should not meddle with the management of H R. ---- False.
@. Role of H R professionals is confined to H R activities of the organizations hence they
should not be involved in strategic planning. ---- False.
Evolution of Human Resource as a function needing specific attention has gone
through similar stages the world over. Primarily, whatever happened in the industrial era
in the U S or U K was during the British-Raj and as such its ripples were felt in ndia.
The communication was facilitated by the scientific advancement, and knowledge
travelled faster compared to earlier times. The world wars too contributed by creating
similar welfare issues across the nations.
At the time of independence very few ndian industrialists were seen.
Management and business perspective was not very obvious. However, in the area of
people management, ndians were visible as Labour Welfare Officers under the
provisions of the Factories Act. Their role was, initially, confined to being recruitment
officers for the multitude of workers and badhlies, floating at the gates, keeping the
muster rolls and leave records, running shabby canteens and toilet and change room
facilities, and in wielding the security-cum-discipline stick. By the early 1950s the
provisions of the ndustrial Disputes Act of 1947 were beginning to percolate down and
to this list of unattractive duties were added all the legalistic aspects of labour
management. Labour officers now had to become experts at drawing up charge sheets,
evolving the intricacies of domestic enquiries, attending long drawn out conciliation
proceedings, and briefing, the mushrooming breed of labour lawyers.
By the 1960s the result of the focus on the activities required in the area of
people management was reflected in the demand for personnel professionals with
specific knowledge about people management systems and laws. Unlike other
professions like medicine, law or engineering, there were no definite academic
requirements for personnel executives (even today) but the personnel specialists
expanded their sphere of influence by cashing on the inadequacies and trained
incapabilities of engineers in line management. Most of the functions now performed by
personnel were the forte of line managers. The growth of unionism, state interventions
through a spate of legislation and code of practices, the stress on statutory welfare and
need for broader and consistent policies made it easy for personnel specialists to
expand their role and enhance their status. The need for equipping individuals with
specific knowledge was satisfied by the forums like ndian nstitute of Personnel
Management ( P M) and National nstitute of Labour Management (N L M)
established in the early phase of personnel management. The National Commission on
Labour has observed that PM has the credit of making Personnel Management as a
profession. Any area of knowledge to gain the status of a profession has to fulfill three
main criteria, i.e. having a corpus of knowledge, a period of learning and apprenticeship
and a code of conduct. ndian nstitute of Personnel Management ( P M) established
in 1947 played a significant role in this movement.
Another professional body created around the same time was the National
nstitute of Labour Management. ts main aim was to foster, encourage and promote the
development of cordial relations between employers and employees. There is an
overlap in the purpose of both the institutes though the latter focused more on the
relation between the two forces, viz., employers and employees. Appropriately,
subsequently in 1982 these two bodies merged to form the National nstitute of
Personnel Management.
Thus, even though the subsequent era witnessed growth in the industry, the
personnel function still remained something to be interpreted by the individuals rather
than by the organization per se. So it mattered as to who is in charge and what he
thinks about people management. The activities related to people management
remained restricted to their perspective of the duties of labour and welfare officers. This
is seen in the survey conducted by Monappa (1979) in which he has listed that
personnel activities typically included employment, training, watch and ward, first-aid
facilities, safety, housing, employee education, employee benefits, industrial relations,
insurance programmes, etc. The multinational companies were. to some extent,
influenced by the parent company and in many cases had well-established Personnel
department and gave more attention to this due to their western experience; the large
family controlled firms were slowly moving from the paternalistic to professional style
and hence changed their outlook to personnel function. The public sector with an urge
to demonstrate being 'model employers' paid more attention to strengthening this
It is pertinent at this point to mention even during the early phases, ndia had
visionaries like J.N.Tata who sowed the seeds of Tata ron and Steel Company at
Jamshedpur, had long back emphasized human factors in an organization. His
philosophy of building people in the organization was subsequently followed and
crystallized by his successors, making TSCO a successful and proactive organization.
The kind of perspective and actions taken by TSCO in an environment which was
novice to H R M was highly progressive at that point of time. This is important for two
reasons. First, the history of TSCO which is indicative of how the personnel function
matures in an organization and secondly, it highlights what pro-activity means. There
were a number of actions taken by TSCO which was unheard of at that point in time.
The government has also enacted a few legislations related to employment and
employee welfare. The first and fundamental of these is the Article 16(1) of ndian
Constitution which ensures equal opportunity for employment. Drawing from this is the
Employment Exchanges (Compulsory Notification of Vacancies) Act, 1959, which
requires employers to notify the vacancies. The Apprentices Act of 1961 provides for
training linked to employment. Certain other Acts like Child Labor Act, 1986, Bonded
Labor System Act, 1976, nterstate Migrant Workmen Act, 1979 aim at safeguarding
interest and controlling exploitation of specific groups. The state and central level
directive principles as guidelines, ensure attention to neglected sections of society like
the S C/S T, Ex-servicemen, physically handicapped, etc. Through legislations, the
government indirectly focused on eliminating any kind of exploitation by the employers.
At times, such legislations are perceived as blocks to business growth by the
organizations. To avoid such government interventions, the organization needs to adopt
proactive, futuristic strategies to people management visualized through the H R M
perspective. An organization which is sensitive to the emerging issues with an
orientation to concern for people's welfare and growth in the organization can be said to
have an H R M perspective. t does not mean that there cannot be problems but the
dynamism to face them is crucial.
The next transformation came in the 1980s; this approach was introduced by
ndian academicians around the same time when the western world started talking
about H R D. The pioneering work done by Uday Pareek and T V Rao in the area of
clarifying the H R D focus and developing H R D systems is a benchmark in the
evolution of H R D in ndia. The focus of their work was on clarifying the developmental
dimensions and its implication on other conventional systems. The government too
introduced employee participation and allocating share holding to workers. The
emerging hi-tech industries introduced 'knowledge workers' and in general an enlarged
outlook for personnel was envisaged. The H R D as a subsystem of H R M emerged as
a feature of this era.
A few organizations from the banking sector who initiated processes during this
period were State Bank of ndia, State Bank of Patiala. Bank of Baroda, and Canara
Bank. The establishment of National H R D Network in 1985 brought under focus the
experiences of organizations which had initiated H R D activities. As the name
suggested, it aimed at networking between the H R D professionals. The ndian Society
for Training and Development established in 1970 gained specific focus as it could give
academic and developmental support to H R D functionaries through their training
programmes. Annual conferences of forums created by institutes like N P M, National
H R D Network, Management Associations, S T D, etc provided opportunities for
organizations especially to H R functionaries to get exposed to the developments
taking place in F R M in organization across industries. Such networking can enhance
the speed with which H R M perspective becomes a way of life for more and more
ndian organizations.
It can be observed that the ndian organizations are aware of the crucial role of
management and development of human resource with respect and dignity and the
integrative perspective of bringing the individual and the organization closer. Some of
the organizations have already adopted the approach formally meaning that they have
policies which state this perspective.
A large number of organizations have the new approach on their anvil but are
perhaps still debating on the pros and cons. To them, T V Rao has to say, 'We must
understand that corporations are not in the business of human resource development.
They are in their own business. But human resource development is an important tool
which, unfortunately is being used in a limited sense. The corporate vision has not been
attached to it. Actually, human resources must become the business of everyone in the
organization.' (Business Today, January 1996)
The principal mandate for the emerging people management is to develop and
execute policy programmes and practices that align all human activity to corporate
objectives. As Abhijit Gangopadhyay of Tata nstitute of Social Sciences puts it, 'The
major paradigm shift taking place in the management of human resources is the
progressive integration of conceptual values with operational values.' (Business Today,
January 1996). Since this includes a change in the mind set, conscious steps are
required to be taken.
Che%2 )o7r *ro,ress #C$
State 8hether the follo8in, state'ents are Tr7e or +alse:
1. ndustrial Disputes Act was the beginning of management of people in ndia. ----
2. At the time of independence, ndians were not among the industrialists but personnel
and welfare officers were visible. ---- True.
3. Labour welfare, industrial relations, personnel administration were synonymous to
Personnel Management. ---- False.
4. The Personnel Management was accepted as a profession by 1960s. ---- True.
5. Some ndian organizations had adopted H R M approach long time ago even when it
was not talked about. ---- True
Det Us S7' U5
In this unit, we examined how people management, a crucial element of any
organization, developed over the years maturing in its coverage and philosophy. We
briefly sketched how the research in social sciences and management sciences helped
organizations to seek answers to the problems / situations created by the growing
complexity of the organizations. We have examined the relationship between H R M,
the traditional personnel function and the humanistic, growth-oriented H R D
perspective. We have also traced the development of H R M as a function in the ndian
context. When compared to the trend in the West, we observed similar orientations in H
R M function in ndia. There has been a marked shift from labour welfare perspective to
the emerging concern and the need to integrate individual and organizational needs
through conducive processes encompassed in the H R M perspective. Besides
identifying the landmarks we also observed the understanding of a few ndian
organizations past and present.
Organization; Management Thought; Unions; Collective Bargaining; Staff; Labour;
Howthorne Studies; Scientific Management; Human Relations; Rational Man; Social
Man; ndustrial Relations; Personnel Management; Human Resource Development;
Human Resource Management: Royal Commission; Factories Act; ndustrial Disputes
Act; National nstitute of Labour Management (N L M); ndian nstitute of Personnel
Management ( P M); National nstitute of Personnel Management (N P M);
Management Ethos; National H R D Network; ndian Society for Training and
Development ( S T D)
Ter'inal 97estions
1. Compare the situations in ndia and other part of the world which influenced the
development of management of H R as a function?
!. Would you say that development of H R M in ndia has been subjected to peculiar
conditions substantiate your argument.
(. Describe the various stages of development of H R M.
.. Why is it imperative to study the evolution of management theory and thought to
understand the evolution of the function of managing people'?
?. What are the benchmark research findings which have contributed to the changes in
the perspective of management A human resource?
@. What is the relation between H R M, P M, R and H R D?
B. How modern H R D approach is different from traditional H R M?
C. Critically examine the role of H R professionals in banks. How can the role be made
more effective?
F. Suggest the structure, role and functions of an ideal H R department in a medium-
size bank.
10. dentify the role of line manager vis-a-vis H R manager for the development of
employees. s there any role conflict or overlap? Examine critically.
S7,,este& for +7rther Rea&in,
Banerjee, R, 'FRM Profession Past and Present' in HRM 2000: ndian
Perspective, ed. K B Akhilesh, D R Nagaraj, NPM, Wiley Eastern Ltd., 1990.
Business Today, 'Managing People', The Business Today Experiential Guide to
Managing Workforce 2000, Fourth Anniversary ssue; January, 1996.
De'Cenzo and Robbins; PersonneHRM, Prentice-Hall, 1988.
Luthans, R Organisational Behaviour, McGraw-Hill, 1985.
Miner, J B, Personnel and ndustrial Relations A Managerial Approach,
Macmillan, 1969. Monappa, A, Personnel Management, Tata McGraw-Hill, 1979.
Pandev. S N, Human Side of Tata Steel, Tata McGraw-Hill, 1989.
Pareek, U and Rao T V, Designing and Managing Human Resource System,
Oxford and BH, 1981.
Ramesha, K, 'Human Resources Management in ndia' in HRM 2000: ndian
Perspective, EEd. K B, Akhilesh and D R Nagraj, Wiley Eastern. 1990.
Schein. E; Or-ganisational Psvchologi-, Prentice-Hall. 1979.
Sheth, N R; 'Some Thoughts on HRM' in Emerging ssues in HRM, Pramod
Varna, Oxford and BH Publishing Co, 1992.
Tripathi, P C. Personnel Management, Sultan Chand & Sons, New Delhi.
Venkata, Raman C S, and Srivastava B K: Personnel Managetnent and Human
Resources. Tata McGraw-Hill Publishing Company Ltd.. New Delhi, 1991.
Werther, W B, and Davis K, Personnel Management and Human Resources,
McGraw-Hill, 1982
*A*ER 1
Advanced Bank Management
UNT 21 Development of Human Resources
!1.0 Objectives
!1.1 ntroduction
!1.! HRD and its Subsystems
Check Your Progress (A)
!1.( Training and Development Role and mpact of Training
Check Your Progress (B)
!1.. Attitude Development
Check Your Progress (C)
!1.? Career Path Planning
Check Your Progress (D)
!1.@ Self-Development
Check Your Progress (E)
Let Us Sum Up
Answers to Check Your Progress (A, B, C, D & E) Terminal Questions
Suggested for Further Readings
After reading this unit, you should be able to:
#1$ understand how HRD philosophy is translated into the various systems
#!$ appreciate how the HRD sub-systems are developed and how some of the existing
#($ need to get modified in the process of aligning themselves with the developmental
#.$ understand the importance of right attitude and issues in attitude development and
#?$ appreciate the importance and need for career path planning and self-development.
The perspective of managing people in the organization over a period of time has
become matured to include the totality of human beings. As such, it now encompasses
all aspects of dealing with people and is today termed as Human Resource
Management (HRM). Originating as a mere set of activities, HRM today has acquired
the status of a crucial function in the organization. This has happened as a result of the
realization that people cannot be treated as just another factor of production but are an
important resource in determining the overall success of the organization. Researchers
and practicing managers have tried to evolve strategies to answer the human related
issues. They certainly have accepted the linkage between the individual's satisfaction
and the organization's growth. Time and again systems have been developed to attain
this congruence. n this context, new systems have been developed and a few
traditional ones have been modified. Since this happened at different points in time,
there is a need to view these systems and their linkages with a conscious and critical
outlook, with a view to guarding against contradictions in their implementations. n this
unit, we will be focusing on the developmental subsystems of HRM.
The industrial revolution with its emphasis on quantity output and the prevalent
understanding of how people could be made to produce more (work), had led to the de-
humanization of the workplace. People were viewed as mere substitutes for machines,
and the important components of human beings, namely, emotions, needs, aspirations,
expectations, values, feelings, etc., had no place. This realization had given way to
various optional human focused strategies. Primarily, they were related to motivation in
the context of work. n other words, efforts were directed to make the work more
interesting, valuable, and meaningful to people so that they were involved in doing the
activities beyond a mechanical perspective. For this, one approach was to recognize the
emotions and needs of human beings, and the other was to change the 'content' of the
activity so that the individual is motivated, and looks forward to doing this activity
willingly. Both the aspects, that is, the feelings and the job content, are interlinked and
therefore, organizations sometimes tinkered with the job content and sometimes paid
attention to human feelings and needs. These approaches had roots in the earlier
theories which either focused on how the jobs should be organized or how to make
people do what they are supposed to do.
At this juncture, it is pertinent to understand the linkage of individual development and
organizational development/growth. Every organization sets certain goals towards
which their entire efforts are directed. The goal may be in terms of productivity, better
work culture and the like, with the ultimate objective of satisfying business goals besides
the needs of the society at large. To achieve these goals, the organizations have
systems for production, finance, sale, control and monitoring and the people employed
fit in the entire gamut of systems to produce what is intended. The organization has a
structure, a pattern to manage the entire process. There is differentiation in units,
hierarchical and horizontal, with given sets of relationship and interdependence
between these units. The success of the organization depends on effective performance
of these units/levels which, in turn, is the performance of people occupying various roles
in the organizational structure. Thus the structure can be viewed as the edifice around
which processes are built. Each unit (job or role) of this edifice requires certain
knowledge, skills and attitude in an individual, without which the individual may not be
able to give the expected level of performance. Therefore, to make sure that the
organizational goals are achieved, it is necessary to ensure performance of individuals
at all levels in the organization and that the individuals have the required knowledge,
skills, temperament and attitude.
There can be various means by which this can be examined and achieved. For
instance, whether the individuals have the required knowledge or skills could be
checked prior to putting them on the tasks or even before recruiting them. When the
jobs change (technology change), a new set of individuals, with new skills, could be
recruited or the existing one could be retrained. There would be another scenario where
individuals may be required to be shifted to another job in which case one has to search
for a job that needs the skills the individual possesses. n other words, assessment of
employee is essential. The Performance/Potential appraisal is an essential component
and the training can play an important role in ensuring performance. Primarily there are
two ways the organization can ensure that people have the required skills, that is, either
upgrade the skills of the existing people or get new people with the required skills.
Historically, these questions have been dealt with by organizations in a different manner
perhaps on the basis of the then situational context. Let us examine how this issue was
tackled by organizations over the time.
As Nadler (1984) puts it, Human Resource Development defined as the Cor&ani@ed
learnin& e+perien#e in a definite time period to in#rease the possi%ility of impro$in& Ao%
performan#e &rowthC. While tracing the history of HRD as 'organized learning' as defined
by him, he notes that during the early twentieth century which was a period of industrial
revolution, employers provided the necessary learning for employees new and old.
During this period, learning programmes were also developed by unions: as they
needed a specific group to become their members. Many unions were craft-oriented
and to be able to become their member, individuals would have to attain a certain level
of job skills. t was the first realization of what training could contribute to the workplace.
The period 1920-40 saw some development in this trend. For making production more
profitable companies began tenting in outside people (researchers) to consider various
ways in which the workplace could be manipulated to increase production. The famous
Howthrone studies conducted at Western Electric Company in Chicago were a pointer
to new directions. However, the impact of the Great Depression of 1930's that followed,
left many experienced workers unemployed and as a result since the companies could
now get skilled workforce, the need for training was not felt. They could get the skills
they needed by hiring new employees and firing the old ones.
The Second World War brought up new issues with respect to developing people. n the
private sector, there was need to expand but as young men were drafted for war, the
only alternate source available was the women and the old men and a few ethnic
groups. Women were so far not trained in this matter and the old were viewed as not
suitable. However, ultimately this period revealed that 'most of the people in these
groups could learn and could become productive members of the organization.' This
realization culminated in the establishment of the American Society for Training and
The 1960s primarily witnessed enhancement in technology and application of
behavioural science to workplace. This development was in a way a reaction to the
earlier feeling that HRD training has not been showing the desired impact on
organizations. Attention was then shifted to 'efforts to change the workplace as one way
of improving performance. t was accompanied by increased interest in people, as well
as in the technical aspects of organization.'
Several significant changes came through in the 1970s and 1980s and HRD went
beyond mere training activity. n the 1990s, there was a continued surge for industrial
democracy. Workers demanded a larger, more autonomous role in decision-making,
market selection, product identification, work planning and even supervisor selection. As
a result of this 'managers needed continual training in participative leadership, conflict
resolution, interpersonal communication and matrix/task force management.
The 1990s focused on massive computerization of work place mainly to improve
operational efficiency and cost reduction. The PC revolution during the period changed
totally the work processes and required Computer literacy at all operating levels without
any loss of time. This has put a lot of pressure on the training system. The seniors who
could not pick up the computer skills started feeling powerless and developed fear and
anxiety. This period also saw a massive outsourcing initiative by the organizations to
Curtail costs.
The present decade, that is, the first decade of the twenty first century saw extensive
competition due to liberalization, privatization and globalization of ndian economy. The
organizations mainly focused on improving customer service by meeting customers'
expectations through customization of products and services in a highly competitive
environment. The focus was again on training to equip the work force for inter-personal
and customer relations skills. The customers are now dictating their terms as they have
wider choice and their brand loyalties are diminishing.
The traditional ndian banks both public sector and old private sector faced challenges
in the form of competitive pressures and changing customer demands from foreign
banks and new private sector banks. Most of the public sector and old private sector
banks had their existence for more than a century with a number of legacy issues to
tackle. While the new private sector banks could adopt the best practices,
organizational culture: and could implement latest technology in their operations, the
foreign hanks acquired the practices and technology akin to their host countries within
the regulatory framework of ndia. Faced with the threat of competition from the foreign
and new private sector banks the banks employed a number of measures like going for
fully automated systems (Core Banking Solution based operations) preceded with
business process reengineering (BPR), offering VRS to its employees, training and
retraining, of staff, lateral recruitment of specialists, emphasis on marketing, advertising,
customer relationship management and improving brand image, diversification of
activities, introduction of electronic based multiple service delivery channels, setting up
of back offices and data centres, business process outsourcing, etc, to improve the
operational efficiency, meeting customer expectations and reduction in operating costs.
Productivity is the real test of performance in any organization. Some of these banks
have undergone restructuring exercise with the involvement of international consulting
agencies to adopt best practices and remove bottlenecks in their operations. These
changes needed well thought of HR policies to attune the existing staff to adapt to the
changes and to train them to learn new skills.
GRM is now being called upon to become a strategic initiative to make its efforts more
effective and performance-oriented. Thus, strategic HRM is gaining its significance.
While imparting new technology based training, the organizations have to focus on
development of behavioural and inter-personal skills. HRM initiatives can be initiated
through involvement of line managers.
GRD today is a process by which the employees of an organization are helped in a
continuous and planned way to:
#1$ Acquire or sharpen capabilities required to perform various functions associated with
their present or expected future jobs;
#!$ Develop their general capabilities as individuals and discover and exploit their own
inner potential for their own and/or organizational development purpose; and
#($ Develop an organizational culture in which supervisor-subordinate relationships,
teamwork and collaboration among subunits are strong and contribute to the
professional well-being, motivation and pride of employees (Rao and Pereira, 1986).
This definition highlights that HRD is not only a training for operational skills but also
includes behavioural skills as it ultimately aims to create an enabling culture wherein the
capabilities are 'acquired, sharpened and used'.
In this context the specific goals of HRD (as pointed out by Rao and Pereira) are to
#1$ capabilities of each employee as an individual;
#!$ capabilities of each individual in relation to his or her present role;
#($ capabilities of each employee in relation to his or her expected future role(s);
#.$ dyadic relationship between each employee and his or her supervisor;
#?$ team spirit and functioning in every organizational unit (department, group, etc.);
#@$ collaboration among different units of the organization; and
#B$ organization's overall health and self-renewing capabilities, which, in turn, increase
the enabling capabilities of individuals, dyads teams, and the entire organization.
The typical systems developed to enhance achievement of these HRD goals include:
#1$ Training and Development
#!$ Performance Appraisal, Feedback and Counselling
#($ Potential Appraisal, Career Planning and Counselling
#.$ Organizational Development
#?$ Human Resource nformation System
Det us now briefly examine the linkages between and amongst these sub-systems.
The HRM broadly has three sub-systems, viz., administrative, developmental and
maintenance. There are strong inter-linkages between these three. However, for the
purpose of discussion and detailed study we are focusing only on developmental
subsystems in this unit.
It must be highlighted, in this context, that since work is the pivotal point for
development of individuals, the job analysis is fundamental to any of the sub-systems
mentioned above. We may therefore, understand various aspects of Job or Role
Jo" or Role Anal3sis
Job Analysis is a technique which facilitates the listing of what is required to perform a
task or a job. A typical job analysis comprises three parts - job description, job
specification and job evaluation.
Jo" Des%ri5tion: This simply records each and every component of the job which an
individual has to perform in a given set-up. For example: for a job of a stenographer or a
private secretary, the job description may include taking dictation, typing the matter,
keeping the record of boss's engagements, dealing with and taking care of visitors,
record keeping of inward and outgoing cases, preparing travel plan of boss, filing letters,
Jo" S5e%ifi%ations: On the basis of the job description a list of requirements is
prepared in terms of educational qualification, age, work experience, specific
knowledge, skills, expertise, temperament, etc. Again in the example of a stenographer
or a private secretary, a certain temperament and skills are required. For example,
besides the shorthand and typing skills, the person need to have a good knowledge of
language (English or Hindi or both), maturity, charming personality, sharp
understanding, patience, etc.
Jo" e=al7ation: This is primarily used to compare similarity between jobs within an
organization or between organizations or even in an industry. Thus, this is often the
base for wage settlements and is used for comparison of two or more jobs in terms of
their complexities and competence. f we compare a stenographer with a private
secretary attached to a senior executive, we may observe that the technical skills
required, viz., taking dictation, typing, etc., may be similar but the complexity of job of a
private secretary to a senior executive will be much more hence he may deserve a
higher compensation package compared to a stenographer who just takes dictation and
It may be noticed that the first two aspects can provide the basic data for training, need
identification as well as for performance appraisal in order to get the right man for the
right job. Having listed out all specifications, a few crucial ones can be identified for
decisions related to training and appraisal.
It is relevant to note that there are various terms which are used to describe the work
people do in an organization. Terms like task, job, position, role, and work are often
used interchangeably but in academics these have a certain relationship with each
other. Pareek and Rao (1986) have explained the relationship as follows:
Tas2: This is a basic element of a job and as such requires a person to achieve a
specific product. n the process the individual is isolated from others.
Jo": This is a complex system of tasks requiring an individual to achieve an overall
product and still making the relationship irrelevant.
*osition: Puts an individual in a hierarchical pattern, expecting those below to report or
surrender to higher positions and conform to their expectations while those higher up
may be led to exploit the relationship and demand conformity.
Role: Emphasizes on the pattern of (mutual) expectations.
;or2: nvolves a more complex pattern as it goes a step further to encompass socio-
psychological relationship.
The traditional concept of task and Job has the problem of treating individuals as the
means to achieve the product as an isolated machine. Perhaps, it is such a perspective
that alienates the individuals from what they do. The concept of position too, makes one
person powerful in relation to others and is likely to have a de-humanizing effect like the
earlier two. t is the concept of role or work which takes an individual out of the
traditional framework and puts in a complex relationship involving job-self others. n the
HRD perspective, role is a very relevant and imperative concept.
Dike a job analysis technique, the roles can be analyzed by using the Role Analysis
Technique (RAT) of which job analysis is a significant component. n addition to merely
listing the activities, expectations of the counterparts - all those related to the given role
- (role set) are also considered. n the framework of role, the Key Performance Areas
(KPA) are identified and the critical attributes that an individual needs to perform
effectively are listed.
Che%2 )o7r *ro,ress #A$
State 8hether the follo8in, state'ents are Tr7e or +alse:
#1$ Even though the focus on people management underwent change, the systems
which were developed in the past could continue and need not change. ---- False.
#!$ Performance Appraisal, Training and Development are critical elements
(subsystems) in the entire Human Resource Development System of HRM. ---- True.
#($ For HR functionaries, major challenge in training is to keep the workforce updated
with current knowledge; what is not significant now can be forgotten. ---- False.
#.$ New skills can be easily blended with the old ones. ---- False.
#?$ Job Analysis is the basic framework for most of the HRD systems. ---- True.
#@$ Performance Appraisal is one system which has qualitatively got modified. ---- True.
#B$ Performance and Potential Appraisal systems have lot in common. ---- False.
#C$ Career Planning is a motivational exercise. ---- True.
#F$ When an organization develops in size and its business, it is called organizational
development. ---- False.
In the earlier approaches related to employees and their utilization, an individual was
hired for a specific job and he continued doing it all through his work-life, one was
discarded when he was not able to do it due to his age or due to change in technology.
t has subsequently, been realized that the individual has also a basic need to grow.
ndividuals are not static and they change by acquiring new knowledge, skills, attitudes
and beliefs. They also tend to demonstrate certain capabilities which may not get
adequate opportunity for expression in the normal course. Some critical event brings
forth the capability. t appears as if individuals have a lot more in store. Maslow's
explanation of the need hierarchy highlighted the point that it is as natural a need for an
individual to realize his potential, self-actualization, as satisfying the physical need. t is
recognition of the fact that 'ndividuals change over time'. They find new capacities
within themselves and learn to interact with each other more productively. They learn to
cope with stress, or to help others to do so. The problem of managing development
within organizations is to understand how one may hasten and channelise this process
of 'learning and discovery' (Handy, 1976).
The rationale of training and development is to comprehend how this concept of
learning could be applied in the organizational context. What aspect of this learning
could be made a part of the formal system, what could be left to the specific individuals,
and how the organization can enhance the process of individuals' becoming mature and
effective in their environment, are its prime concern. We will examine the details of
establishing Training and Development system as part of the HRD efforts and this
#1$ identification of training needs;
#!$ conducting the training;
#($ evaluation of training; and
#.$ selection and development of trainers.
These aspects have adequately been covered in Systematic Approach to training in a
subsequent section.
*7r5ose of Trainin, an& De=elo5'ent
GRD as an approach to management of HR and as also a function, is based on the
premise that employees should be provided with learning opportunities to enable the
individual and the organizations to achieve their goals. The organizations on their part
have to consciously analyze their requirements, define them, specify the time and level
at which these are required so that the system can take care of them. This need of the
organization can be linked to the career progress of individuals so that it may implicitly
satisfy the growth need of individual. The activities which relate to this area are:
#1$ improved performance of individual on his present job;
#!$ his preparation for an identified job in a not-too-distant future; and
#($ his general growth (development) not related to any specific job.
According to Nadler (1984) if these activities are not identified or separated, the learning
can be less effective. For the purpose of facilitating communication, a label can be
applied to each of these levels:
#1$ Training is for learning related to present job;
#!$ Education is for learning to prepare the individual for a different but identified job;
#($ Development is learning for growth of the individual not related to a specific present
or future job.
There could be different categorization available for these three activities. Some experts
may call futuristic learning as development and general (non-work-specific) learning as
'education'. Some authors classify training as specific to a given job whereas
management development as 'attempts to instill sound reasoning processes - to
enhance one's ability to understand and interpret knowledge - rather than imparting a
body of serial facts or teaching a specific set of motor skills'. Development, in this
perspective focuses more on the employee's personal growth and organizational
development initiatives. Whether one uses Nadler's classification or any different
categorization, it does not make a difference so long as it is understood uniformly in the
organization but some kind of segregation is necessary.
Such segregation helps in differentiating objectives for these three activities. The
objectives are qualitatively different. First, when the goal is to improve performance,
training should be conducted and evaluated to check on the improvements. f the goal is
futuristic, then one cannot evaluate performance until the individual moves to a new job.
But if the objective is development then it has to be remembered that no direct impact
may be seen on the performance. Secondly, the differentiation helps clarifying mental
expectations. Both the parties - the individual and the organization (the superior) - are
clear about what should be the outcome; the chances of misunderstanding are reduced.
Thirdly, and most importantly, the differentiation helps in identifying who is responsible
for what activity, for example, for training, the responsibility of identifying the need and
ensuring that opportunity is given, has to be with the immediate superior but for
education and development, it could be the central department or the overall HR
functionary who decides when and how to conduct the activity.
I'5erati=es of A&7lt Dearnin,
It is interesting to note that though most of the people think that Adult Education is a
recent phenomenon, but it is not so. n ancient times great teachers like Confucius, Lao
Tse, Hebrew Prophets, Jesus, Socrates, Plato, Aristotle - were 'teachers of adults'. To
these teachers 'learning was a process of active inquiry on the part of the learners'; they
invented 'techniques for involving the learners in active inquiry.' n case of child learning
the teacher has full responsibility for making all decisions about what should be learned,
how it should be learned, when it should be learned and if it had been learned ... the
student was left passive ... when adult education is organized with the model available
for children known as Pedagogy it does not give the desired results.
Ultimately, in and around the 1920s-30s, some thought was given to adult learning. t
was Lindeman's work which can be cited as the first instance of defining the perspective
of adult learning. He explains his idea of adult education as, 'a cooperative venture in
non-authoritarian, informal learning, the chief purpose of which is to discover the
meaning of experience, a quest of mind which digs down to the roots of the
preconceptions which formulate our conduct; a technique of learning for adults which
makes education coterminous with life and hence elevates living itself to the level of
adventurous experiment'. The special efforts to define and understand adult learning
includes Thorndike's early explanation that ability to learn diminishes with age which
subsequently was modified to that it is the speed to learn that diminishes and not the
power to learn. These efforts were then substantiated by the experience of teachers
involved in adult teaching, and most of the social sciences like sociology, social
psychology, also contributed their bit. Thus, a new term Andragogy was coined to
differentiate adult learning process from that of child learning. Today, what we
understand commonly is that learning is concerned with bringing about relatively
permanent change as a result of experiences. There are, indeed, a number of theories
to explain 'how' we learn. Knowles (Nadler, 1984) categorizes them in three sets as
Me%hanisti% or Beha=io7rist Theories: These theories hold that the learner is passive
in the process of learning. f one introduces an input (stimulus) into a human being, you
will get a predetermined response. n other words, learning occurs only when a learner
is conditioned to give the 'right' response to a given stimulus.
Co,niti=e Theories: These theories equate man with his brain, based on the
proposition that one thing that distinguishes human beings from other living things is
that they possess brains that are capable of critical thinking and problem solving. The
purpose of learning therefore is to teach the brain to engage in such critical thinking and
problem solving.
Or,anis'i% or G7'anisti% Theories: These theories hold that learning occurs only
when learners have the 'freedom to learn' what is particularly relevant to their personal
life situation. The purpose of learning is to encourage each individual to develop his or
her full, unique potential.
;hen we examine the training and development function in the organizational context, it
becomes apparent that all the three sets are relevant as all the three types of situations
exist in the organization.
Besides the specific framework of the theories, most of them have certain common
assumptions, there are theories related to the variables associated with the actual
Teaching-Learning situation. Decenzo and Robbins (1995) list some as:
#1$ Dearnin, is enhan%e& 8hen the learner is 'oti=ate&: This means that the
learning experience must be so organized that it should create desire to learn.
#!$ Dearnin, reJ7ires fee&"a%2: Knowledge of results is necessary for learner to
improve upon his mistakes. The feedback also tends to act as motivator when the
learner knows that he is proceeding in the right direction.
#($ Reinfor%e'ent in%reases the li2elihoo& that a learne& "eha=ior 8ill "e
re5eate&: Behavior that is positively reinforced are encouraged and therefore
(4) Practice increases a learner's performance: Learners need to practice what they
#?$ Dearnin, '7st "e transfera"le to the Ao": Learning a skill just for the sake of it will
not work; it must be possible to apply what is learnt.
;hile establishing an effective training sub-system, all the aspects related to adult
learning should be considered and kept as backdrop, namely, who needs training? The
different groups could be: #1$ young recruits, #!$ Specialists, #($ middle level executive,
#.$ senior and top executives, etc. The contents and nature of training for the groups will
vary. For the young one's it may be modem management techniques, for those with
experience, it may centre around to their being enabled to take up more responsible
positions. For specialists, the training should keep them abreast with the latest
developments in their field of specialization. For the senior and top management, it
could relate to development of vision, entrepreneurship and business strategy.
S3ste'ati% A55roa%h to Trainin, #SAT$
;ith the developmental emphasis accepted by the organization, it becomes imperative
that organizations establish training systems. There needs to be a systematic approach
to manage training which has to answer a few basic queries like:
#1$ Will the training to be done internally or externally? Does the organization have or
intend to develop an in-house training centre?
#!$ How much and what kind of training will be done externally and is this also an
essential part?
#($ Who are the functionaries responsible for administering the training system?
It is a fact that majority of the organizations today have some kind of in-house
establishment which primarily caters to the training of operational knowledge and skill
requirements specific to the organization. This implies that the need for certain
advanced, specialized training is met by sending people to other (external) institutions.
The most common among these are specialized institutes which impart training in
management, finance or behavioural skills.
Whether the actual training is done internally or externally, organizations have to follow
certain logical processes for enhancing knowledge, skills, and attitudes of their
personnel. These are:
Ste5 1: Training Need Analysis (TNA) and dentification of Training Needs
Ste5 !: Preparation of a Training Plan;
Ste5 (: Conduct of the training which includes designing the programme in terms
of the time, duration, target group, sequence of inputs and methodology;
Ste5 .: Evaluation of the Training Programmes and the Plan; and
Ste5 ?: Selection and Development of Trainers.
Det us examine each one of these a bit more in detail.
Ste5 1: Trainin, Nee& Anal3sis #TNA$ an& I&entifi%ation of Trainin, Nee&s
Identification of training needs through the TNA (training need analysis) is the first step
for successful implementation of any training initiative. One has to consider that the
training needs are perceived in the present as well as future context. The present
context refers to the level of skills the existing employees have and in what direction
they need to be upgraded. The information for such gap can come from their
performance appraisals done by their superiors, the productivity measure (norm) set by
the organization, the larger rejects for the job done by an employee or a department, the
number of accidents, the inspection reports, etc. n other words, the level of an
individual's performance and the errors that he/she makes can be indicative of the gap
in his knowledge, skills and attitude which can be bridged through training. t may
however be noted that all performance problems cannot be tackled through training
intervention. The poor performance on account of poor technology, outdated processes,
poor working conditions, etcetera, cannot be solved by training.
The future needs of an organization also indicate the gaps to be filled by training. The
organization's future business plan may include expansion in new or old business
domains. The organization needs to take a look at the skill levels of the existing
workforce and compare it against the requirement, to determine the total training efforts
required by the organization. Sometimes, organizations may have some specific focus
in the training as an offshoot of change in technology or a business strategy adopted by
the organization.
The training needs can be identified in formal or informal ways. Formal processes are
part of the administration of the training system. They are obvious, explicit links and
processes. For example, the training needs identified as offshoot of the business
consideration would be the result of conscious deliberations between the business plan
and the HR functionaries. There should be an accepted mechanism or forum for this to
happen at a given point in time.
Another formal way for identifying present needs would be to gather data from the micro
level from different stakeholders. Either the mechanism of performance appraisal or an
independent exercise by an individual may spell out what, in his opinion, are his training
needs to perform better on the job he is assigned. This statement is then qualified by his
superior. Such data is collected from all levels and an analysis can be carried out to find
out if there is any particular trend. t may happen that a specific department or a
particular geographical area is indicating specific needs. Thus, the analysis can
highlight the major-minor specific groups of employees which can be considered while
preparing the annual training plan.
TNA requires collection of data systematically. t should include data to: #a$ define the
need; #"$ identify solution; #%$ specify those needing training; and #&$ provide the
planning details of the delivery of training (Rao, 1995). TNA can stem from different
objectives, that is, it can be for employee development concern, personnel and staffing
concern, administrative and management concern or organization development
concern. t is possible to determine this with a set of questions to identify what concerns
are being focused upon.
Ste5 !: *re5aration of a Trainin, *lan
The training need identification process provides the basic data for preparing the Annual
Training Plan. The primary focus at this stage is to prioritize the various issues thrown
up by the data and seek an appropriate balance between meeting the needs and
resources required. The training plan is expected to specify:
#1$ Number of training programmes to be conducted nternal External.
#!$ Level of employees what will be the coverage of employees through the plan?
#($ What will be the subject areas that will be highlighted and what will be left out of the
plan for future?
#.$ What will be the plan for allocation of resources what are the contingencies worked
#?$ What arrangements are made to accommodate something that emerges beyond the
Rao (1995) has suggested a framework to facilitate the process of deciding priorities. Of
the factors mentioned by him, 'organizational policy and priorities' is a vital factor.
Without a favourable and committed policy for training and development the entire
exercise of collecting data, analyzing it and prioritizing will be a waste of effort.
Another related aspect is to decide whether training should be given on the job or in a
formal classroom set-up. There are situations where certain knowledge or skill based
training can be given on the job. Apprenticeship programmes, Job instruction training,
Understudy assignment (Mentor-prototype relationship), Programmed instruments (self-
learning), Job rotation are commonly used on the job training methods. As may be
observed, very often organizations use this channel to train employees in the routine,
procedural, operational aspects. The advantages are to the extent that the individual is
actually contributing to the events in the organization and secondly, the individual sees
the relevance and gets the 'feel of things' of what is to be done. This has its own
significance in the initial period of joining the organization. An individual is likely to be
motivated as he is on the scene of the work and not in the classroom.
Ste5 (: Con&7%t of the Trainin, *ro,ra''es
In most cases the first two steps are handled by the training department of corporate
office and this third step is specific to the actual delivery system, that is, training centre.
When there is an in-house training setup available, this is their responsibility. But in
cases where such an arrangement is not available and the organization out-sources this
facility, the organization could specify their concern vis-a-vis the contents, emphasis,
methodology and output expected from conducting the training programmes.
The logical beginning for any training programme is to spell out the objectives of the
programme. This facilitates the decision regarding the inputs in the training programme.
For instance, if the objective is to impart a particular skill, then it is obvious that enough
time should be allocated to practice the skill after the participants have been given the
specifics of the skill.
The objectives also indicate what methodology could be adopted to communicate the
ideas. Of course, the profile of the participants/target group influences the methodology
too. For instance, if the target group has no work experience then work related
discussions may not serve any fruitful purpose as they may have nothing in particular to
share. The teaching methodology may include: ?eadin&s( Le#turetts( E+perimental
Le#tures( Dis#ussion( -arti#ipati$e Trainin&( Case !tudies( ?ole -lays(
Instrumentations 1use of tests and instruments/( !imulation Games( !tru#tured
E+perien#es( Intensi$e !mall Groups and Intensi$e Growth Groups( et#.
As is apparent when the involvement is the lowest, the meaning of what the learner is
exposed to is external to him - which means that the learning process is aimed at
making him or her aware of it. While on the other extreme of involvement, the meaning
of what the learner is exposed to is internal to him and the learning process is to
facilitate the learner to be responsible for his learning. t is his or her experience that he
is analyzing and drawing conclusions about. The selection of the methodology from this
continuum among other things is based on the objectives, subject matter to be covered,
target group, profile, trainer's skills and capabilities.
It must be observed that the more one moves towards interactive side of the continuum,
the trainer's ability to deal with the data generated becomes crucial factors in facilitating
learning. The trainer needs to have clarity of the concepts he is dealing with in the
training sessions and should be able to draw and summarize learning points.
Ste5 .: E=al7ation of Trainin,
The primary purpose of evaluation is to improve training by discovering whether the
training processes have been successful in achieving their objectives. Some experts
choose to make a distinction between `validation' and 'evaluation'. Validation means
assessment of whether the training has achieved its laid down objectives and evaluation
means the measurement of the total effect of the training programme. However, in
practice it is difficult to obtain information on the total effects of training.
Most commonly evaluation is done at four levels as the processes that occur as a result
of successful training, are at these levels. The levels are:
#1$ Rea%tion De=el: Participants form opinions about the content, the method, the
trainers, the usefulness, the relevance and their enjoyment, etcetera. n other words,
these are the reactions of the trainees.
#!$ Dearnin, De=el: Trainees learn-knowledge, skills and attitudes about the subject
matter which are acceptable for translating into behaviour ... what is learnt. This can be
measure through some type of tests conducted before and after the training.
#($ The "eha=ior De=el: Trainees apply the learning to actual situations, and this can
be observed in terms of change in behaviour at work, that is, transfer of learning to
workplace. This may reflect in the work performance after the training which can be
assessed with the help of their superior.
#.$ +7n%tionin, De=el: The changes in behaviour on the job affect the functioning of
the organization. This can be measured by indices which generally are expressed in
terms of financial benefits or return on training investment. The modern organizations
view the raining expenditure as an investment so they look for the return on investment.
t is quite difficult to segregate the financial benefits on account of training alone.
Ste5 ?: Sele%tion an& De=elo5'ent of Trainers
;hen there is an in-house training set-up, selection and development of the trainers is
another important activity. Both the aspects need to be consciously looked at if the
training has to be effective.
The first question that arises is that: should the trainers be practicing
managers/operational people or should they be recruited specially as 'core faculty' from
academics? Both the options have their own merits. The advantage of having
operational people lies in the fact that they can relate to the actual work situations while
communicating in the classroom. They can speak the same language that trainees
understand. The disadvantage can be the danger of adopting a narrow approach. t is
like in-breeding; new ideas may not emerge. The advantage of professional trainers is
their ability to view matters from a different outlook and the professional knowledge
about the concepts, teaching, methodology, etc. The disadvantage will be seen if the
trainer is unable to relate to the work situations. He may remain an alien and be
perceived as a mere theoretician. n in-house training programmes, often a combination
of the two has proved to be effective. Whichever mode of selecting trainers is adopted,
development of their skill is imperative.
In case of the operational personnel, the selection process should ensure their
willingness, communication skills, and concern for others (trainees). The specific
knowledge and skills that they may be required to teach can be checked or developed
in the second stage. Having ensured this the first developmental step for them would be
the exposure to a course on Teaching Methodology which, by and large, covers the
issues discussed earlier about designing and delivering the training. n case of the
recruitment of professional trainers, the teaching skills are available but the trainers
need to be oriented towards organizational issues. They could be placed in the actual
work situations for a couple of months so that they are in a position to relate to the
organizational scenario.
S755ort S3ste's for Trainin, an& De=elo5'ent
Since HRM is a commitment to philosophy, the linkages and congruence among the
sub- systems is significant for its success, more so with training and development. ts
most important link is to the 'Performance' and, therefore, how the performance
appraisal system functions and how far there is information flow from it to the training
and development system is a significant determinant. n the absence of such
information, the training system has a danger of becoming a mechanical process and
not a developmental one.
The Human Resource nformation System (HRS) is another support system for
effective training. Since the data regarding the on-the-job experience, placements, and
skills acquired by way of professional qualifications or training attended is stored here,
this serves as a useful database for training. A comprehensive updated HRS enhances
the developmental efforts.
The most critical support is in terms of the organizational culture. As we understand, it
refers to the shared beliefs and values of the people at various levels. The superior who
sends his subordinate for training, the HR functionary, the top management are the key
players in emphasizing the importance of training. f their actions give a contradictory
message, the purpose of training for development will be wiped out. f the superior
hesitates to nominate or to relieve an employee for attending training or placement
elsewhere, if the top management itself gives a passive treatment to the training
subsystem by way of not sanctioning enough budget or flexibility, one can imagine what
level of motivation can exist among those who deliver and those who receive the
training. n one of the ndian companies, in the case of a covenanted staff, at the time of
the performance appraisal, the DGM (training) acts as the mentor and an undertaking
from the appraiser is taken for training the appraises in certain agreed areas. This
undertaking is incorporated in the key result area for the superior for the following year.
t is important, therefore, that certain positive notion or beliefs should exist in the
organization culture about usefulness of training. t is relevant to look at them
consciously and make sure that these are again and again talked about explicitly within
the organization. Top management's commitment to the following beliefs (Rao, 1988)
and their reiterating them, is significant.
#1$ Human resources are the most important assets in the organization.
#!$ Unlike other resources, human resources can be developed and increased to an
unlimited extent.
#($ A healthy climate, characterized by the values of openness, enthusiasm, trust,
mutuality, and collaboration, is essential for developing human resources.
#.$ HRD can be planned and monitored in ways that are beneficial both to the individual
and to the organization.
#?$ Employees feel committed to their work and the organization if the organization
generates a feeling of 'belonging'.
#@$ Employees are likely to have this feeling if the organization provides for their basic
needs and for their higher needs through appropriate management styles and systems.
#B$ Employee commitment is increased with the opportunity to discover and use one's
capabilities and potential in one's work.
#C$ t is every manager's responsibility to ensure the development and utilization of the
capabilities of subordinates, to create a healthy and motivating work climate, and to set
examples for subordinates to follow.
#F$ Higher the level of manager, in the hierarchy, the more attention should be paid to
the HRD function in order to ensure its effectiveness.
#10$ The maintenance of a healthy working climate and development of its human
resources are the responsibility of every organization.
Che%2 )o7r *ro,ress #B$
State 8hether the follo8in, state'ents are Tr7e or +alse:
#1$ Training should be given in the organization because people like to learn new things.
---- False.
#!$ Employees can learn anything that they want for their development. ---- False.
#($ Training, education and development have different meanings, they need to be
differentiated. ---- True.
#.$ Pedagogy and androgogy mean the same thing. ---- False.
#?$ Learning will not take place if there is no motivation. ---- True.
#@$ t is better to do all the training in-house. ---- False.
#B$ Training need analysis is a systematic process of looking into the gaps between
what is there and what is desired. ---- True.
#C$ Training plan is a summary of all training needs identified. ---- False.
#F$ The methodologies adopted in training situations are decided by the trainer's skill.
---- False.
#10$ Evaluation of training is an important step but it may not be possible to quantify all
the aspects. ---- True.
#11$ Operational personnel do not need training in teaching methodology. ---- False.
#1!$ Primary purpose of training is learning related to present job. ---- True.
#1($ The purpose of development is learning for growth and not related to any specific
job. ---- True.
The term 'attitude' is frequently used to describe people in terms of their behaviour and
its impact on behaviour. More precisely, an attitude can be defined as a persistent
tendency to feel and behave in a particular way towards some object. For example:
Ram does not like a job involving touring. Attitude can be characterized in three ways.
First, attitude tends to persist unless something is done to changes. Second, attitude
can fall anywhere along a continuum from very favourable to very unfavourable or
positive to negative. Third, the attitude is directed towards some object about which a
person has perception, feelings and beliefs, which in many cases may result into
emotionally charged opinion and prejudices.
Co'5onents of Attit7&es
Attitude can be broken down into three basic components, viz., emotional, informational
and behavioural. The emotional component involves the person's feelings or their affect
positive, neutral or negativeabout an object. Emotions play a very important role in
organizational behaviour of employees. The expression of emotions, either positive or
negative, is also important to work behaviour.
The information component consists of beliefs and the information that an individual has
about that object. Generally, the beliefs or the information are founded on insufficient
observations or opinions which may not be empirically correct. A manager may believe
that 2 week's training is sufficient for an employee to effectively work as systems
administrator. n reality, minimum 4 weeks training may be required. The belief of the
manager represents his attitude about the training.
The behavioural component consists of a person's tendency to behave in a particular
way towards the object. For example, the manager in the above example may assign
only 2 weeks for the Systems Administration training to an employee which may not be
sufficient for the employee to perform his job effectively. Thus, the attitudes have
significant impact on workplace for achieving the organizational objectives.
Si,nifi%an%e of Attit7&e at ;or25la%e
An understanding of the role of attitudes is important to study and understand its impact
on human behaviour at work for a number of reasons. Attitudes help predict work
behaviour. For instance, if an attitude survey shows that workers are upset by a change
in the work rules, it may have an impact on their work behaviour. t may result large
absenteeism. The management may conclude that the negative attitude towards work
rule has resulted into absenteeism. Another reason why an understanding of attitude is
important is that attitudes help people adapt to their work environment. Attitudes serve
four important functions in the process. These are: #1$ The Adjustment Function, #!$ The
Ego-Defensive Function, #($ The Value-Expression Function, and #.$ The Knowledge
The A&A7st'ent +7n%tion
Attitudes often help people adjust to their work environment. When the employees are
properly treated by their boss, they are likely to develop a positive attitude towards
supervision and the organization. These attitudes therefore help employees to adjust to
their environment and area basis for future behaviour.
The E,oEDefensi=e +7n%tion
Besides helping employees to adjust, attitudes also help them defend their self-image.
For example, an older manager whose decisions are continually challenged by a
younger subordinate may feel that the latter is brash, cocky, immature and
inexperienced. May be the younger subordinate is right in challenging the decisions.
The older manager may not be effective and may be taking poor decisions but he is not
going to admit this and will try to protect his ego. As a result, the older manager will
have a negative attitude towards the younger officers.
The Val7eEE65ression +7n%tion
Attitudes provide people with a basis for expressing their values. For example, a
manager who believes strongly in the work ethic will tend to voice attitudes toward
specific individuals or work practices as a means to reflect this value. A supervisor who
wants a subordinate to work harder might put in this way:
`You have to work harder. That has been the tradition of the company since it has been
founded'. This also helps to subscribe the ethics.
The /no8le&,e +7n%tion
Attitudes help supply standards and frames of reference that allow people to organize
and explain the world around them. For example, a union office bearer may have a
negative attitude toward management. This attitude may not be based on facts, but it
does help the individual to relate to management. As a result, everything that
management says is regarded by the unions as a pack of lies, a distortion of truth, or an
attempt to manipulate. Regardless of how accurate a person's view of reality is,
attitudes toward people, event and objects impact the individual make sense out of what
is going on.
Chan,in, Attit7&es
As we have seen the attitudes of employees have significant impact on their behaviour
at workplace. t is therefore necessary to develop the right attitude of the employees for
the benefit of both, the organization as well as the employees. A positive attitude helps
a person in all spheres of life including his organizational life. Though it may be difficult,
it is possible to change the attitudes of people. The level of difficulty depends upon
various factors including to what extent a particular attitude about a particular object is
deep routed and emotionally charged. The major barriers for attitude change are prior
commitment and lack of information. A prior commitment occurs when a person feels a
commitment to a particular course of action and is unwilling to change. The insufficient
information can distort the attitude about some object. For example, someone goes to
meet his old friend. The friend could not devote much time to his old friend because of
his other urgent commitments. Because of one incidence he may develop a negative
attitude about the behaviour of his friend who otherwise was considered as a very good
There are ways in which the barriers can be overcome and attitudes can be changed.
One of these is by providing new information. Sometimes this information will change a
person's beliefs and, in the process, can change his or her attitudes. The second way of
changing the attitude is through the use of fear. Researchers have found that fear can
cause some people to change their attitudes. However, the degree of fear seems to be
important to the final outcome. f low levels of fear arousal are used, people often ignore
them. The warnings are not strong enough to warrant attention. f moderate levels of
fear arousal are used, people often become aware of the situation and are likely to
change the attitudes. However, if high degrees of fear arousal are used, people often
reject the message because it is too threatening and thus not believable. A good
example is provided in the case of anticigarette smoking campaigns. When the
department of health runs ads using patients who are dying of cancer, the message is
so threatening to smokers that many of them shut it out. They refuse to listen. The third
way of changing the attitude is by resolving the discrepancies between attitude and
behaviour. For example, when a job seeker has more than one job offer and is forced to
choose one, he often feels that his final choice may go wrong. However, once he has
chosen a particular job he will start feeling that he has taken a right decision. He will
start to have negative feeling toward the job that was not chosen and positive feeling
toward the company that was chosen.
Influence of friends, peers and opinion leaders also has a great role on attitude change.
Thus, the role of leaders becomes very crucial for changing and developing right
attitudes of the followers. The leaders have to develop interpersonal trust and present
themselves as rational persons interested in other's wellbeing. Additionally, when a
particular matter is of personal interest to people, they are likely to reject extreme
discrepancies between their current behaviour and that of others. This is why unethical
behaviour is so difficult to combat because of other motives.
The managers are the formal leaders of an organization. Their attention is focused on
organizational objectives and performance of employee. f a person intends to improve
the attitude of an individual employee he needs to be friendly with him. Then only, in
due course, he will know the employee and what motivates him. He will also know the
employee's potential and shortcomings. n this process the manager can identify the
learning needs of individual employees and can decide how to help the employee for
acquiring deficient skills. For this to happen, the manager will have to know the
employee and should be genuinely interested in the development of the employee.
A final way in which attitude changes often take place is by co-opting, which means
taking people who are dissatisfied with a situation and getting them involved in
improving things. For example, John is not satisfied with the present welfare schemes,
as a result the company appoints him as a member of the employee welfare committee.
Once he begins realizing how these benefits are determined and how long and hard the
committee works to ensure that the people are given the best benefits possible, he is
likely to change his attitude.
Che%2 )o7r *ro,ress #C$
State 8hether the follo8in, state'ents are Tr7e or +alse:
#1$ Attitude is directed towards some object about which a person has feelings and
beliefs. ---- True.
#!$ Attitudes do not have any impact on the emotions of a person. ---- False.
#($ Attitudes of employees have significant impact on their work performance. ---- True.
#.$ Attitudes are formed based on facts and objective criteria. ---- False.
#?$ Changing attitude is not possible for most of the people. ---- False.
#@$ There are ways in which the barriers can be overcome and attitudes can be
changed. ---- True.
It is not uncommon to find that after the initial excitement in the job, individuals tend to
lose interest or get 'disillusioned' and feel that they have no `career' in a particular
organization or a profession. What is implied in such a feeling is that things have not
happened as expected. n other words, individuals expect certain
changes/advancements to take place time-bound or as a result of certain behaviour.
When these changes do not occur it leads to the feeling of frustration or alienation. The
mismatch between expectations and actual events could be in terms of the time for
results being too long, or the absence of result itself. Sometimes there may have been
irrationality in expectations leading to wrong perceptions. Organizational experts have
tried to identify the variables responsible for this and explained the process in the
context of organizational realities and expectations about careers.
t is relevant therefore, to examine the underlying concepts in the generic observation
#1$ individuals desire and expect change at certain stages in life:
#!$ there is a (predictable) pattern in these changes; and
#($ there is a feeling of frustration if things do not happen as desired or expected.
There area number of explanations available about the career in general and the career
in organizational context. They refer to different aspects of career like the stages, the
movements, the perspectives at the stages, etc. We will take a look at the career in
general and also elaborate the same in the organizational context.
The most commonly used framework for understanding the Life Stages is the one
given by Erik Erikson. He has divided the life into eight stages of which four are in the
childhood and four in the adulthood. The adulthood stages are relevant to understand
what individuals expect in organizational careers. According to Erikson the first stage in
adulthood is:
A&oles%en%e: n this stage individual's development is to achieve an ego identity.
ndividual is involved in reconciliation process of what he perceives himself to be, what
he thinks others perceive him to be and make an adjusted assessment to form his
)o7n, A&7lthoo&: t is the next stage where he/she starts developing relationships
with individuals, group or occupation. This could be establishing a close relationship,
developing an interest group or a work group.
A&7lthoo&: The stage is that of guiding the next generation and during this stage one is
passing on the knowledge, values or sponsoring the younger colleagues and in the
Mat7rit3: A stage when person attempts to achieve ego integrity by examining whether
life has been meaningful or satisfying.
Devinson and his colleagues have offered explanation about /areer Transitions on the
basis of the study of careers of a group of 40 individuals from different occupational
groups. He maintains that every five to seven years the individuals have to pass through
some kind of personal or career related crisis with apparently a fairly predictive
sequence. The transitions are from early adulthood to late adulthood and as such are
similar to Erikson's four stages.
Devinson's age-specific transitions correspond to Erikson's four adult stages. Erikson's
perspective is more generic and do not spell out specific age per se. t is relevant to
notice that similar stages are perceived in relation to the careers within the
organizations in the concept of CAREER ROLES given by Dalton, Thompson and Price
( 1977). They have emphasized on the sequence of roles and relationships an individual
may experience in the four career roles labelled as Apprentice, Colleague, Mentor and
Sponsor. At each of these stages, the tasks are different; relationships are different
requiring personal adjustments:
A55renti%e: This is the beginning of the career. An individual does routine work under
the supervision of the mentor, who helps to learn. At this stage the individual needs to
accommodate himself to a certain degree of dependency.
Collea,7e: This is the beginning of making an independent contribution though still in a
subordinate role. There is less dependence on superiors for advice and direction.
Mentors: This stage signifies the beginning of complex functions. The individual
develops ideas, manages others, and must learn to assume responsibility for his
subordinates' work.
S5onsors: At this stage the individual needs to broaden his perspective and think long-
term as he is now a part of the top management. He is required to define the direction in
which the entire organization or at least a major segment of it would develop. He needs
to develop the capability to choose the right people in the organization who can support
the process of influencing.
Career *atterns
The expected changes emerge as the pattern of movements that occur in the life
related to work. Driver (1985) has listed these patterns as Carver Concepts. He says
there are some individuals who enter into an occupation and develop a plan for upward
movement within the same profession using organizational hierarchy. This is Linear
Career concept. n another pattern, individuals choose a profession, acquire higher
skills but do not choose to go higher up in the hierarchy. This is a Steady State Career.
n the Transitory pattern individuals shift from one job to another not necessarily related
to the previous one without acquiring any excellence. Lastly, in Spiral Career individuals
take on a new job, work hard, perform well, move up in status and rank, then move on
to another type of work and follow the same pattern of development and performance.
They tend to be geared up to take on new challenges at regular intervals and as such
can be viewed as motivated by personal growth. n addition to the four patterns
described by Driver, one can observe a Plateau career which indicates reaching a level
higher than where one started but then continuing on the same level a plateau.
Schein has given another comprehensive framework of Three Dimensional Movement.,
viz., Vertical, Circumferential, and Radial. Vertical movement is along the hierarchy of
the organization, Circumferential movement is along the different divisions and functions
while Radial is towards the centre of the organization. He then explains the conical
career movement which incorporates sequential movements in all the three dimensions.
Schein has visualised all the three dimensional movements to occur in the career
pattern aiming to reach the top level of the hierarchy.
;hen these movements are predetermined in a logical sequence to enable an
individual to have knowledge of all activities of the organization (horizontal movement),
different perspectives of management (field and controlling) and different levels of
management (hierarchical) it could be said that the organization has developed a
Career Path.
In practice, this means that after an individual joins a bank, he/she will have to go
through the assignments that are along the horizontal plane, i.e. branches with different
business focus. This also being his apprentice stage, these assignments can be viewed
as teaming opportunities. Only after he has passed through some testing grounds, he
becomes eligible to try for higher levels. At this level he may enter in the colleague role
and make his independent contribution to the organization. t may be that as he moves
up with promotion he is allowed to have exposure to the activities associated with the
centre, that is, the controlling function and after a specified period he again moves along
the peripheral assignment in the branch with more and complex business mix. The next
level puts him in the mentor's role. As a regional manager he will be responsible for the
development of the region, the business, and the people internal (employees) as well
as external (the customers).
The concept of career path thus, relates to the sequencing of movements, deciding the
time period for each one, and so on. t implies that there is a destination to reach either
at the hierarchical level or at the level of expertise. t denotes the distance one has to
cover, the crossroads and the turns one has to encounter. t requires the individual to
take decisions and for that there has to be a signboard indicating direction and
It is logical to realize that in an organization, the movement will be decided by its
structure and the signboards are the criteria laid down for the eligibility to move on.
ndividuals will have to travel through these, while acquiring knowledge and skills and
learn to face issues of higher/different levels. This process is expected to enable the
organization to have competent personnel at all levels and at all times enhancing
simultaneously the growth and development of the individuals. n the context of
organizational career this implies that the organization can provide opportunities for
individuals through a defined career path to develop, and individuals will have to live up
to those challenges to satisfy the implicit need for growth. With an established Career
Path Planning subsystem, the organization can have a continuous supply of individuals
with required capabilities for future roles.
A word of caution is needed here. Career Development does not take place merely by
having a path and a desire to go in a direction. On this path there are benchmarks
which the individuals must cross in terms of achievements, skills, attitudes, etcetera.
Moreover, the organizational structures are pyramidcal in shape, that is, lesser and
lesser positions are available at higher levels thus the career path does not ensure a
smooth movement for everyone. The competitive environment in the organizations has
adversely affected the smooth movements in the ladder of hierarchy.
There are some more factors to remember. The employees including executives at
every level are likely to face frustration. Circumstances may be created by the
management to enable them to get over the frustration. Every one cannot reach the top,
people should be made to realize and accept the ground realities. There may be
supersession due to performance, appraisal system and bottlenecks. These may also
create great degree of frustration.
Career An%hors
Schein's concept of Career Anchor provides one explanation why individuals try to
follow a particular pattern. The concept of career anchor refers to a personal sense of
type of work individual wants to pursue and what that work or career means to an
individual. These anchors start developing early in the career as an individual goes
through various types of assignments. t is a mutual discovery of the individual and the
organization with respect to developing occupational self-concept. This has three
#1$ Self-perception of talents and abilities based on one's performance;
#!$ Self-perceived motives and needs based on self-diagnosis and feedback; and
#($ Self-perceived attitudes and values based on interactions with the norms and values
implicit in the organization.
Schein maintains that an individual needs to work in organizations for a considerable
period to develop these meet anchors. On the basis of his research, he has found five
such career anchors:
1. Te%hni%al or +7n%tional Co'5eten%e: Some individuals 'fall in love' with a
particular field or function. They desire to be outstanding in the field; their self-concept is
associated with their skills in that area.
!. Mana,erial Co'5eten%e: Some individuals like to manage. Their early career
experiences indicate to them that they will be able to rise in the management hierarchy.
(. Se%7rit3: Some individuals seek a secure work environment and career by tying
themselves to a particular organization or geographical location.
.. Creati=it3: There are some individuals who want to create something new. They like
to start something and make it a success.
?. A7tono'3: Another group of individuals finds organizational life unpleasant or
difficult. They prefer to maintain their freedom.
Schein has sought to explain the matching between the opportunities and the
individual's inclination through the concept of external and internal careers. n his
perspective the opportunities are available externally in the education system, in
society, in organizations. The internal career refers to the individual's career anchors,
that is, an individual's self-concept about what he is good at and has proved to be so.
Career *ath *lannin,: A S3ste'
The Career Planning in an organization is primarily an HRD sub-system. t establishes
the linkages between and amongst other subsystems like manpower planning, job
rotations, transfer, placement, training and performance appraisal. t is essentially
directed towards structuring employees' aspirations for upward movement through the
organization and moderating these aspirations if they are found unrealistic (Pareek and
Rao, 1986). As such, it need not mean any commitment on part of the management to
promote an employee. t only implies that the individual, after becoming aware of some
of his capabilities and career advancement opportunities, chooses to develop himself in
that direction. The prime responsibility of the organization for developing and
implementing the career plan is to see that:
1. The policy of career planning is made explicit. t lays down the benchmarks for
performance at critical stages which the employees must attain.
!. t is made clear that career path is a facility for growth and not a right for
(. The career path - a sequence of job assignments, training requirements and
promotion to higher level - is made known to the employees from the time of entry.
Performance feedback is a part of the career path.
.. The career path is followed uniformly for all employees without any bias/ prejudices.
?. t should be flexible to accommodate variations which may be needed to deal with the
given circumstances.
Besides working out the general policy guidelines, the HR functionaries will have to
chalk out the career path. For this purpose knowledge of all the activities performed in
the organization is a definite requirement. t is only with such knowledge that
sequencing of assignments is possible. The specific steps that follow then are:
1. For instance, if we take the concept of Career Roles then up to what level the
'apprentice' role would continue? At what level would it be considered as a colleague or
mentor or sponsor?
!. dentify the Core Jobs at Each Level: At each level, the jobs that are comparable in
terms of the knowledge, skill required can be identified and categorized as a group.
These identified clusters are called 'Job Families'. t is necessary to have such job
families because all units may not have identical jobs or assignments. The rationale is
that an individual must be assigned at least one job from such job family.
(. Define and Spell out the Criteria for Each Successive level: The mechanism to move
on to the next level (promotion) should be transparent in terms of the criteria, the
weightages, and the measurements. n a way, an open appraisal system makes it
explicit as to what is expected and how it is to be measured. t must be mentioned that
sometimes promotions may take place within a career stage, that is, in the apprentice
stage itself.
.. Placement is the Next Career Role: t is to be ensured that only those who clear
these criteria can move on to next level. And when the career stage changes, the
transition is facilitated by training and counselling. This is to highlight the change in
orientation that is associated with changing career role. This is particularly significant
when one moves from the role of colleague to mentor. The entire emphasis is on
shifting to a developmental role. The transition from mentor to sponsor is crucial too as
these calls for conceptual skills like visioning, planning, creative problem-solving,
The experiences and practices in the organizations speak of more than one career and
a choice for individuals to opt. Conventionally, in any industry, the topmost position is
looked as the ultimate of the career aspiration and, therefore, logically one thought of
only one career. However, there are reasons to visualize multiple careers (discussed
below) even within a given organization having single business focus.
M7lti5le Careers 8ithin Or,ani-ation
Traditionally, organizations were simple and smaller. They were engaged in single
business and their activities were focused. The other activities like finance, personnel,
marketing, planning, etcetera, were together clubbed in the administrative functions and
these were perceived as not requiring much heterogeneity in skills. However, as
organizations visualized the wider canvas and as management science grew, it was
realized that many of the aforesaid activities need special attention and skills. Today,
these are clearly understood as separate independent functions, which require
expertise. Thus, in the manufacturing industry, one can see specialization at the top
management level for finance, personnel, marketing, planning, and quality besides the
traditional focus on production and maintenance. n this scenario it is feasible to
perceive and develop multiple careers within the organization.
Individuals may join the organization with basic technical knowledge required for the
given job but during his work life he could become expert in any, other than core,
technical area. For instance, a few decades ago we did not have financial managers as
experts as we have today. Financial Management has achieved a status of expert
function which a technical person can strive for. That has emerged as a career within.
Currently, nformation Technology (T) has emerged as an area of specialization. Since
the potential of T in any industry is tremendous; it is almost impossible to have a
readymade expertise. An otherwise technical person like engineer, medical
professional, artist, accountant can with a little bit of effort, develop expertise in T within
the boundary of the organizational activities. The same holds good in service
organizations too.
In fact, in the larger context, even the management profession is getting into
specialization for different industrial sectors as well as industries. Therefore, we have
specialization in poultry management, hotel management, hospital management and so
Thus, a majority of the functions in the organizations are offering specific careers. n
view of this, career plans could be drawn up to ensure that attention is given in an
organized way to develop specific competencies required for these functions. n the
traditional context, the practice was to recruit specialists but now one can think of
creating experts within the organization by using the system of career planning. This
implies that the general career path drawn up must ensure that the core assignments of
these specialized functions are also incorporated in that path. HR professionals must be
careful to find out whether the employee/executive has a detailed understanding of the
new job, insight into the culture, technology and the social atmosphere in the new
Schein has talked about career counselling workshops at different stages of career
wherein the individual is facilitated to understand his/her career anchors in the light of
his/her performance and introspection. Counselling is seen as a process to facilitate the
individual in realizing his strengths and weakness vis-a-vis the competencies listed for
various career options. Career Workshops can be the forum for making the individual
aware of his career anchors and giving him opportunity to express his desire to follow a
particular direction.
The concept of multiple careers is becoming more and more relevant as we are moving
towards flatter organizations. The emphasis and the chances of aiming at the apex level
position do not exist in such an organization. n flatter organizations, hierarchy is neither
desired nor available and what is needed is to develop expertise in different areas.
Expertise building in one or more areas is crucial and challenging. n a way, the spiral
career concept given by Driver is becoming an ideal one for meeting the emerging
situation. This makes the multiple-career concept more relevant for the future.
Che%2 )o7r *ro,ress #D)
State 8hether the follo8in, state'ents are Tr7e or +alse:
1. Organizations cannot take responsibility of individual's career. ---- False.
!. Career Planning is not one time exercise, plans have to change. ---- True.
(. Career Planning is sequencing events for development. ---- True.
.. Career Progression is the right of the individual. ---- False.
?. Career Planning is a new concept for ndian organizations. ---- False.
@. Career Planning can become successful when the HR functionaries, the individual
and the immediate supervisor perceive this as a joint responsibility. ---- True.
The Con%e5t of SelfE&e=elo5'ent: *ersonal Effi%a%3
Before discussing about the self-development and personal efficacy, it may be
worthwhile to understand the concept of self. Self can be categorized into two parts,
namely,. the 'patent self' and the 'inner self'. The patent self can also be called the
external self which normally comprise individual's identity and physical features. On the
other hand the 'inner self' signifies the behaviour patterns, values and other
psychological factors including strengths and weaknesses. Before coming in close
contact with someone, we normally identify a person from his patent self, that is, a tall
man or a fair complexioned women, etcetera. Once we come into close contact with
someone the identifying parameters change. Now, we start identifying a person as a
very kind man or very helpful woman or very emotionally strong person or very sensitive
person, etcetera.
The self-development essentially refers to developing a mature personality who can
handle different tasks and situations with comparative ease. And in this direction
seeking self improvement becomes an ongoing process. t is the process of discovering
and utilizing the tremendous potential within one's individual personality.
*resently organizations are experiencing much uncertainty vis-a-vis their human
resource. They are forced to bring about strategic changes involving business
diversification, expansion, and structural changes in response to the emerging demands
in a liberalized and globalised environment. There are two challenges to be met viz. (1)
keep and improve the existing things and (2) look for new opportunities in a changing
world. This is where we find it difficult to change people, i.e. their mindset. Most of the
organizations need to do that since their strategies can bring result only if the 'true spirit'
behind those changes is understood and appreciated by the people involved in the
tasks. As Pareek (1994) states, 'structures are modified and new reporting relationships
are put down on paper but unless the individuals' mindsets are altered to this effect the
change would be deceptive. While addressing issues one cannot avoid looking at 'what'
is to be changed but must also address simultaneously 'how' individuals can be
facilitated to change. n other words, organizational renewal implies similar renewal at
the level of the individual and organizations must address this.' As a part of the
organizational development, the organizations need to make individuals understand this
and accordingly initiate their development process in line with the organization's
expectations and vision.
;ith a view to creating learning organizations, individuals in the organization should be
perceived as the `focal' point. Unless they are sensitized to the need for self-renewal,
the organizational efforts for change may remain only at the cosmetic level. To achieve
a lasting effect, they now have to concentrate on how the Human Resource could be
oriented towards such a self-renewal. The attempt could be specific to those having
problems in adjusting but more generic effort would be to give an emphasis on 'being
learning individuals' throughout the organization. This is related to the process
dimension of change and can be achieved through an appropriate focus on 'Personal
The factors that contribute to personal efficiency are motivation, self-awareness,
proactive behaviour and action-orientation (Pareek, 1997). This includes the perception
of an individual with respect to his suitability to the activity he is doing presently, how
much he values that activity, how much he thinks others value the activity, and how
much scope for improvement he perceives in it. Thus, it includes awareness about one's
capabilities the desire to do well, belief that improvements are possible and efforts
made to enhance the capabilities and competencies.
It is not merely for the benefit of the organization that the individual needs to develop, in
his own interests he must do so. ndividuals need to be sensitized to the fact that unless
they change and develop, they would not survive and grow. The change can come
about if and when the individual senses the changes occurring, evaluates them and
then decides to take corrective steps so that he does not become a misfit.
`Of primary importance at the personal level is the process of self-awareness, i.e. to
what extent the person is aware, of what is happening to him, of social reality, of his
relationship with others and so on. This process also relates to his awareness of the
various aspects of his personal life which are primarily concerned with self-actualization,
that is, achieving those goals which are important to him in his life' (Pareek, [994). Thus
personal efficacy is not only in relation to his job but in the process of exploring himself.
This would include the motivational processes, such as how the individual copes with
the problems he faces, and the creative processes which are important aspects of self
actualization. Such processes are important for the integration of the individuals with the
The prerequisite for introspection and learning is to understand the fundamentals of
human behaviour. There area number of aspects one needs to understand about
oneself. However, in the context of our discussion on self- development in relation to the
organization, the following aspects will be discussed.
At ndividual level Motivational Pattern, Locus of Control,
Power Bases
At nterpersonal level nterpersonal Needs, Transactional
At Group level Being effective member in the Work
At In&i=i&7al De=el
The needs and expectations of employees have drastically changed during recent
years. They have a better exposure to the outside world; the environment has become
quite competitive, and the opportunities have also increased. Technology has played a
major role in influencing the needs and expectations. Organizational loyalties and long
term association with a single organization are disappearing.
Moti=ational *attern
An individual has to make conscious efforts to be aware of what his life goals are.
Awareness of one's own need bases can enhance an individual's acceptance of self-
concept. How the individual attempts to balance self-concept with what he feels others
think of him. Many a time, at a superficial level an individual may feel he is aware of
what he wants but that may not be the reality. ndividuals have to be actively helped
with some questionnaires and discussions to assess their orientation; to develop a more
reliable and meaningful understanding. ndividuals could become aware about what
motivates them, whether it is individual achievements or contribution to the group
activities or in exerting influence. Such analysis can reveal that for job satisfaction one
can look for those opportunities. t would facilitate creating awareness about career
anchor and then deciding what is the most suitable action for development and for
increasing effectiveness. t is important to realize that people work for a variety of
reasons like money, status, appreciation, work satisfaction, self-growth etc. and the
emphasis on a given goal keeps changing. HR Policy has to remain sensitive to the
changing needs & enable people to give their best.
Do%7s of Control
*ersonal efficacy is also related to an individual's ability to take the initiative which
closely relates to his belief that he can change things. The concept of locus of control
given by Leftcourt (1969) and Levenson (1972) explains that individuals have beliefs
about who is responsible for what happens in life. Some believe that events are
determined by external forces like other influential persons in society, luck, destiny and
so on. Whereas some others believe that the individuals can determine events. Thus,
we have individuals with more external locus of control and some with more internal
locus of control. These beliefs definitely have impact on the action orientation of
individuals. For instance, it is logical to expect a person with internal Locus of Control to
be generally geared up to look for resources around him, anticipate events and do not
wait for things to happen. On the contrary, individuals who believe that there is not
much they can do, will wait for external forces to push and exhibit a general
dependency. Conscious examination of one's orientation about 'who controls', can
reveal areas of development. Specific strategies could then be given or suggested to
individuals to bring about change in the orientations in the desired direction. For
instance, to reorient a person with more external locus of control to internality, he could
be facilitated to realize that it was his efforts or his ideas which have contributed to his
success in an assignment and not the ease of the task or the luck. A feedback of this
type can enhance the process of his conscious thinking about his contribution to the
outcome of his actions. t is obvious that organizations would like to have managers
who have belief in their capabilities.
*o8er Bases
Another important concept related to influencing others is Power, Kotter (1979) has
defined power as 'a measure of person's potential to get others to do what he or she
wants them to do, as well as avoid being forced to do what he or she does not want to
do.' Distinction is also made in terms of fear or love being used as base of exercising
this power. Flanders (1970), Hersey and Blanchard (1982) and Pareek ( 1997) have
contributed to the present understanding that coercive bases include organizational
position, punishment, charisma, personal relationship, (emotional power), closeness to
a source of power and withholding information on resources. The persuasive bases
include expertise, competence, and modelling (example set by behaviour). n using the
power bases concept, a person becomes aware of the power he/ she has and how
much more is needed which is quite relevant. Perception of having and using power
empowers a person. After all, the exercise of authority (power) is essential for the
functioning of any organization. This is the power dimension of working. From this, one
develops the power dimension of rewarding employees by deciding as to who should
get what differential compensation.
Inter5ersonal Intera%tions: D3a&i% Relationshi5
In organizations most of the situations imply interacting and influencing others. While
certain roles it may be more specifically labeled, so the process is common to all
transactions that take place in the organization. t is therefore advantageous for
individuals robe aware of the process of influence through interpersonal interaction and
about the various influencing styles that lead to the desired effect.
In the focus of influencing others we need to understand our interpersonal interaction
pattern. Here we will discuss the concept of Interpersonal Needs and Interpersonal
Intera#tions 1throu&h transa#tional analysis/.
Inter5ersonal Nee&s
Schutz (1958, 66) drew attention to three basic interpersonal needs implied in
interaction among people; viz., inclusion, control and affection. As Schutz defined, 'The
interpersonal need for inclusion is defined behaviourally as the need to establish and
maintain a satisfactory relationship with people with respect to interaction and
association. Satisfactory relationship includes: #a$ a psychologically comfortable
relationship with people somewhere on a dimension of initiating interaction, and #"$ a
psychologically comfortable relationship with people with respect to eliciting the
behaviour from others. On the level of feeling, the need for inclusion means need to
establish and maintain a feeling of mutual interest' (Pareek, 1996).
The interpersonal need to control is to establish and maintain satisfactory relationship
including: #a$ a psychological comfortable relationship in controlling all behaviour of
other people, and #"$ eliciting behaviour from them which controls one's own behaviour.
It may be understood that these concepts are to be examined in the framework of one-
to-one relationship and not in a group situation. They facilitate the process of creating
awareness about one's tendency to be wanted to be loved, acknowledged, belonged or
controlled. t is educative for individuals to learn about themselves as they can observe
and analyse their own interactions with their colleagues, subordinates, superiors and
other work related people external to the organization.
Transa%tional Anal3sis
Another framework available to understand interpersonal relationship and interaction is
in terms of Transactional Analysis a concept developed by Eric Berne and in terms of
existential positions conceptualized by Harries (1969). A transaction is a combination of
a stimulus and its response in an interpersonal interaction. The personality of an
individual comprises collection of behaviour patterns developed over a period of time.
These behaviour patterns are evoked in different degrees from three ego states,
namely, Parent, Adult and Child. As Berne states, 'although we cannot directly observe
these ego states, we can observe behaviour while individuals are interacting or
transacting and from this we can infer which of the three ego states is operating at that
moment.' The three ego states are discussed below:
An individual's personality has a combination of these three ego states which could be
unique to an individual. t would also not have a direct relation to the age or any other
demographic parameter of an individual. Thus, we may have an individual who is
proportionately more adult (orientation) at the age of sixteen and have another
individual who is more child (orientation) at the age of sixty. This profile of the ego
states of an individual determines his interaction with another individual. Thus one could
behave in a more regulatory or analytical or a very casual orientation while dealing with
others. n the context of influencing others in the organization an appropriate behaviour
suited to the situation is required.
Eric Berne defined the ego states as 'consistent pattern of feeling and experience
directly related to a corresponding consistent pattern of behaviour.' The terms parent,
adult, child are related to orientations an individual has. For instance,
1. The parent ego state regulates behaviour and nurtures it, More of ethical,
conscientious behaviour and influenced by preaching's from parents and elders
!. The adult ego state collects information and processes it. More of a analytical,
rational and practical orientation
(. The child is concerned with creativity, curiosity, reactions to others and adjusting
behaviour. More of instinctive behaviour with motive of enjoyment.
The parent ego state is a result of the messages (conditioning) people receive from their
parents, elders, teachers and others during their childhood. These messages are
recorded in people's heads. These messages help in regulating one's behaviour by
telling what is right, what is wrong, what is desirable and what is undesirable. There are
two kinds of Parent ego: #1$ Nurturing parent and #!$ Critical parent. Nurturing parent is
that part of a person which is understanding and caring about other people. Critical
parent behaviour criticizes others for their undesirable behaviour. When a person is in
critical parent ego state he is very much evaluative and judgmental and makes others to
feel that they are not OK.
The adult ego state evokes behaviour that could be described simply as logical,
reasonable, rationale and unemotional. Behaviour from the adult ego state is
characterized by problem solving, analytical and rationale decision making. These
people examine alternatives based on facts and figures and probabilities prior to
engaging in behaviour.
The child ego state is associated with the behaviour that appears when a person is
responding emotionally. A person's Child contains the 'natural' impulses and attitudes
learned from experiences. The child ego state can be classified into Adopted child,
Natural child and Little Professor. The part of child state which adapts to what must be
done to others to get along. A natural child tries to enjoy every bit and take the things as
they come. The little professor is the 'thinking' part of child. t is creative, intuitive,
imaginative and does experimentation. He dreams up new ideas. The compatibility of
people largely depends on the ego states of interacting people. f the transaction is
complementary, namely, from Parent to Child and back from Child to Parent or Adult to
Adult, situation is classified as desirable. But, if the transaction is crossed, i.e. Parent to
Child and again from Parent to Child, it is not a desirable situation, the transaction is
blocked. n an organizational situation for improving the effectiveness through better
interpersonal relations and interactions it is desirable to avoid any crossed transaction.
*eople make basic assumptions about their own self-worth as well as about the
significant people in their environment. Harris called these combinations as Life
#ositions) These life positions are described in terms of 8kayness. Thus the
individuals are either 8 or &8T 8. Four life positions can be described as:
1. am 8 you are 8 (both have value)
!. am 8 you are &8T 8 ( have value but you don't have value)
(. am &8T 8 you are 8 (You have value but don't have value)
.. am &8T 8 you are &8T 8 (neither person have value)
Subsequently expanding on the work of Avary (1980), James (1975), Pareek (1984) has
developed twelve influencing style, six of them in the O/ states and six in the NOT O/
states. Pareek's application of this to the organizational role in the form of Styles Profile
of nteraction Roles provides relevant framework.
The purpose of understanding the Ego State (personality orientation) profile is to make
necessary modifications in one's behaviour. Behaviour scientists have suggested
certain behavioural patterns in the framework of Ego State Profile and Life Position
('OK' and 'NOT OK') as desired while certain others as undesirable and therefore to be
avoided. Awareness of one's own pattern and intensity in these styles can be a step
towards developing healthy influencing relationships.
;or2in, in Tea's
Synergy is the highest activity of life, it creates new untapped alternatives; it values and
exploits the mental, emotional and psychological differences between people. n any
situation requiring the real time combination of multiple skills, experiences, and
judgments, a team inevitably gets better results than a collection of individuals operating
within confined job roles and responsibilities.
A group of people with high degree of interdependence geared towards the
achievement of a goal or the completion of task is known as a team. 'Group' and 'team'
are used interchangeably, though there are some differences. The term 'Group
Dynamics' was coined in 1930s by Kurt Lewin t refers to the:
1. internal nature of groups
!. how they form
(. their structure and processes
.. how they function and affect individuals and organization
An individual's interactions do not stop at one to one situation they exist in the context
of work groups. How effectively one performs the role as a member, can be meaningful
information for self-development. To this effect, understanding group dynamics and the
roles in the group is a necessary input for increasing effectiveness. ndividuals must
understand that the members have two major sets of roles to play. One set is geared
towards the task of the group. The other one is to maintain the cohesiveness of the
group. t is the second set which is crucial and has a long-term perspective. The issues
involved here are about listening to other members, respecting them and their views,
contributing meaningfully to the group activities and understanding the appropriate
meaning of consensus and group decision-making process. Consensus is often
mistaken for compromise, or majority view. There is a kind of negative emotion implied
for those who compromise or those who are in minority. Such feelings are not healthy
for the group in the long-term. t is necessary that members understand that consensus
means debating over the pros and cons with full respect for each other.
t is useful to understand the stages in group formation and group behaviour namely:
1. Forming (Awareness): Members with varied experience get acquainted, Understand
the Team's goal and its role
!. Storming (Conflict): Conflict among the members, through this conflict team attempts
to define itself
(. Norming (Cooperation): Norms are laid as to how the task will be accomplished, the
manner in which the team will behave, and the rules and regulations it will follow.
.. Conforming (Adjustment): Adjusting one with the team expectations and norms
?. Performing (Productivity): Members behave in mature fashion and focus on
accomplishing their goal. Members can devote full energy to work
Understanding self helps in self-development and using one's potential better. t is
always useful to do the SWOT analysis of self to understand the Strength, Weaknesses,
Opportunities and Threats. This may help in better use of strengths, overcoming
weaknesses, capitalizing the opportunities and safeguarding against threats. t is
relevant to refer to the concept of Johari Window given by Loft and ngham (1973)
which explains what is meant by self-awareness. The authors refer to the two
dimensions, namely, #1$ how much of one's behaviour is known to him or her, and #!$
how much he feels others know him or her. These two dimensions give four windows
called Arena, Blind, Closed, Dark. The diagram below explains the model. As can be
seen the area which is known to self and others is the Arena (open) aspect of one's
personality and one which is not known to both is the Dark aspect. The Blind section is
known to others but not the self and the Closed section is closed to others so to say.
The closed window is also referred as Private, being private to self.
Known to self Not known to self
Known to others ARENA is known to
others and known to self
BLND is known to others
but not known to self.
Not known to others CLOSED is not known to
others but known to self
DARK is neither known to
others nor to self.
In this, the size of arena or open space is critical for improving effectiveness. t is
implied that he more the person feels, the others know him or her; more and better
conducive the environment becomes and the stronger the self-concept. As we
deliberated, the more one knows about oneself, the better equipped he is to face the
challenges. The strategy to increase the Arena (open-self) implies that the individual
sensitizes himself to receive feedback from others and by making more and more
disclosures. Thus, the receiving feedback and self disclosures help in increasing the
Arena (open-self). Such persons are more trustworthy, open to other's ideas and
suggestions, have better self awareness.
E'otional Intelli,en%e
The contemporary research by experts has revealed that for success in life the
traditional concept of Q is not enough as a predictor. Daniel Goleman has cited a
number of recent researches indicating that `link between Q test scores and the
achievements in life is dwarfed by the totality of other characteristics that one brings to
life' (Goleman. 1995). He has visualized these other characteristics as 'Emotional
ntelligence: abilities such as being able to motivate oneself and persist in the face of
frustration; to control impulse and delay gratification; to regulate one's moods and keep
away distress from swamping the ability to think; to empathize and to hope'. Goleman
has drawn on the understanding developed by Gardner in his 1983 work on "intelligence
and success in life". Goleman states that unlike the Q, which is stable from childhood,
Emotional ntelligence grows throughout adulthood. t can be learnt as one matures with
proper awareness assessment and efforts to correct.
The five components of Emotional ntelligence which relate to how we manage
ourselves and manage others are:
1. Self A8areness: Ability to recognize, understand one's mood, emotions and drives,
as well as their effects on others.
!. Sell Re,7lation: Ability to control or redirect disruptive impulses and moods and
propensity to suspend judgment to think before acting.
(. Self Moti=ation: Passion to work for reasons that go beyond money or status and
propensity to pursue goals with energy and persistence.
.. E'5ath3: Ability to understand the emotional make-up of others and skill to treat
people according to their emotional reactions.
?. So%ial s2ills: Proficiency in managing relationships and building networks and ability
to find common ground and build rapport.
Self 2wareness includes ability to recognizing one's emotions and their effects, Self
Assessment i.e. knowing one's strengths and limits and Self Confidence, that is, A
strong sense of one's self worth and capabilities
Self Regulation includes self Control i.e. Keeping disruptive emotions and impulses in
check, Trustworthiness i.e. Maintaining standards of honesty and integrity,
Conscientiousness i.e. Taking responsibility for personal performance, Adaptability, i.e.
Flexibility in handling changes and innovation, i.e. Being comfortable with novel ideas,
approaches and new information
Self Motivation includes achievement Drive i.e. striving to improve or meet a standard
of excellence, Commitment, that is, aligning with the goals of the group or organization,
nitiative, that is, readiness to act on opportunities and Optimism, that is, persistence in
pursuing goals despite obstacles and setbacks
*mpathy signifies: understanding Others i.e. sensing others' feelings and perspectives
and taking an active interest in their concerns, Developing Others i.e. sensing others'
development needs and bolstering their abilities, Service Orientation i.e. anticipating,
recognizing and meeting other's needs, Leveraging Diversity, i.e. Cultivating
opportunities through different kinds of people and Political Awareness, i.e. reading a
group's emotional currents and power relationships
Social Skills $:andling Relationships% cover: influencing, that is, wielding effective
tactics for persuasion, Communication, that is, listening openly and sending convincing
messages, Conflict Management, that is, negotiating and resolving disagreements,
Leadership, that is, inspiring and guiding individuals and groups, Change Catalyst, that
is, nitiating or managing change, Building Bonds, that is, nurturing relationships,
Collaboration and Cooperation: working with others toward shared goals, Team
Capabilities, that is, creating group synergy in pursuing collective goals. n the arena of
management of human relationships it is wise to remember that no single style of
management is likely to hold good all the time. One, therefore, has to be adaptive to
different types of style to suit the given situation.
Che%2 )o7r *ro,ress #E$
State 8hether the follo8in, state'ents are Tr7e or +alse:
1. Organizational changes are not effective unless the people also change their way of
thinking accordingly. ---- True.
!. ndividuals can accept only those changes that relate to the work. ---- False.
(. Organizations need to make the individual change. ---- False.
.. Self-perceptions are enough to bring about improvements. ---- False.
?. Personal efficacy is how efficiently one is doing his job. ---- False.
@. 'Locus of Control' refers to one's belief about who is responsible for the events in
one's life. ---- True.
B. People have different motivational bases. Some receive satisfaction in achieving by
themselves, some others by working in groups while some others by exerting influence.
---- True.
C. With experience, age and hierarchy in the organization, the Child component of the
personality should be eliminated. ---- False.
F. The Adult ego state is mainly responsible for creativity, curiosity and reactions to
others. ---- False.
10. The Parent ego state mainly regulates behaviour and nurtures it. ---- True.
11. ARENA refers to the part of personality known to 'self' but not known to others. ----
1!. BLND refers to the part of personality known to self but not known to others. ----
1(. CLOSED refers to the part of personality known to self but not known to others. ----
1.. DARK refers to the part of personality not known to self or known to others. ----
1?. Emotional ntelligence refers to being emotional. ---- False.
1@. Emotional ntelligence refers to being empathetic. ---- True.
1B. Emotional ntelligence refers to being self-motivated. ---- True.
1C. Emotional ntelligence refers to being self- regulated. ---- True.
Morale is an important mental state and the spirit of a person or group which is
dependent on a number of intangible factors within the organization. High morale of an
individual or a group contributes significantly to the achievement of organizational goals.
Morale is generally exhibited by confidence, cheerfulness, discipline, and willingness to
perform assigned tasks. The morale denotes a spirit, as of dedication to a common goal
that unites a group: the high morale of the troops; the esprit of an orchestra; the esprit
de corps of the swim team; the morale of the troops. t also displays the emotional or
mental condition with respect to cheerfulness, confidence, zeal, etc., especially in the
face of opposition, hardship, etc. The spirit and the desire of a group that makes the
members of the group succeed is influenced by the level of morale.
*ositive employee morale is highly dependent on employee motivation; and also on
rewards and recognition. Organizations want a workplace in which high morale
translates into positive motivation, increased productivity, exceeding expectations for
performance and happy employees. Like a disease, poor morale can infect every
aspect of a business. t can lead to reduced productivity, reduced revenue, high staff
turnover and more. According to Sirota Consulting, the share price of low morale
companies saw only a 3 per cent increase in price versus an industry average of 16per
E'5lo3ee Morale Booster
;el%o'e I&eas: Employee morale improves when staff feels they are valued. Share
and implement their innovations and ideas.
/ee5 S%ore: Mount a large score board in the office to recognize top performers and to
motivate those on the bottom of the list.
Ins5e%t: The old management adage, inspect what you expect is true. Companies with
a lack of focus can confuse staff and lead to less morale.
Than2 )o7 Note: Send a special 'thank you' letter to your staff's family or spouse,
praising their good work and efforts.
G7&&le: Have a daily morning huddle to highlight tasks for the day and to cheer
yesterday's wins.
O5en U5: Provide an open forum or one-on-one time to allow employees to express
their concerns and feelings can be an easy means to boost morale.
Ga=e +7n: Special events and outside work activities can take the pressure off the day-
to-day grind in the office.
Sho8 Charit3: Get your staff involved in a bigger cause to help them see there is more
to life than work.
A&& *er2s: Use low cost perks such as a Foosball table in the lunch room.
+ire Staff: Sometimes the root cause of low employee morale can be a staff member
whose negativity brings down the group. Even a top performer can bring down staff
behind your back.
Meas7re It: Keep tabs on the levels of morale in your business by regularly measuring
employee satisfaction.
The backbone of business success resides in the productivity and output of employees.
Those companies who remain vigilant to the signs of low morale and who focus on
improving morale can thwart off the impact of a low morale workplace.
This is a best case scenario. You have received feedback about negative rumors and
you know that the underlying cause of the negativity is based on faulty information,
incorrect assumptions, or deliberate misinformation. You may receive feedback that a
new policy or procedure is not understood correctly. People may be misinterpreting a
corporate memo. An industry newsletter might have referenced an industry problem
your company does not share. You may have fired an individual who is circulating false
information about the company. n each of these circumstances, you have some control
over the information, the situation, and the communication. You can solve the problem
and communicate well to overcome the negativity.
;hen you can control or influence the situation, use a systematic problem-solving
process with the affected employees to improve the identified areas of negativity. Do
this as quickly as you determine that negativity exists. (Many Human Resources offices
launch a complete investigation, and by the time the facts are gathered, the negativity is
out of control). nclude the employees who are closest to the negative situation in the
problem-solving process. Do a good cause analysis so that all possible causes of the
negativity are identified. t is not enough to say, 'We have low morale.' You need to
identify exactly what is causing the low morale to have any chance of improving it.
Solicit widespread input to each step of the action plan you develop so that solutions
are 'owned' across your organization. nvolve as many people as you can in its
development and particularly in its implementation. mplement the chosen solutions
quickly. Then, periodically assess that the plan is working. At each step of the problem-
solving process, communicate as much information as you have about the negativity
and the solutions. When the solutions selected in the action plan are rolled out, people
in the organization are not surprised. They have participated in the information
exchange as each step or opportunity was discussed.
Det Us S7' U5
In this unit we examined how the present HRD perspective aims at integration of
individual needs and growth with the satisfaction of organizational needs and growth.
This understanding being fundamental to developing human resource, we considered a
few important subsystems that relate to the developmental aspect. These are training
and development, attitude development, career path planning, and self-development.
;e also focused on the training and development as a specific subsystem of HRD. To
appreciate the importance of the system per se, we initially examined the present
understanding of 'Training', `Development' and 'Education'. We examined the concept of
adult learning and why it is different from what we commonly understand by teaching.
We, then, elaborated on the systemic issues of training and development. Specifically
we studied the various steps involved in the introduction and maintenance of a formal
training system in an organization. We also discussed the importance of attitudes at
workplace and the need methods of attitudinal change.
;e examined the relevance of the concept of career with its implications in
organizations. We reviewed the terms Career Stages, Career Transitions, Career
Movements, Career Roles, and Career Anchors. n the organizational context, Career
planning as a system plays an enhancing role in the Human Resource Development.
We discussed the steps in establishing this HR sub-system and the emerging need to
develop multiple careers.
;e focused on the individual's role and responsibility vis-a-vis the developmental efforts
initiated by the organization for self-development. As such we examined the concepts
underlying human behaviour which can be appreciated by the individuals in the process
of development. The 'Personal Efficacy' is the process intervention to substantiate some
of the HRD systems that aim at individual's growth and development. n the emerging
profile of organizations, interpersonal styles, group behaviour, facilitating leadership and
empowerment of subordinates are going to be behavioural benchmarks. n this context
we also discussed the concepts, role and application of Transactional Analysis as tool
of inter-personal skills/behaviour. The concept and content of Johan window as a
framework to improve personal efficacy though the mechanism of feedback and
disclosure have also been discussed. The factors associated with improving emotional
ntelligence viz. Self Awareness, Self Regulation, Self Motivation, Empathy and Social
Skills for improving personal and inter-personal effectiveness have also been
discussed. We also discussed the concept of employee and group morale and its
impact on organizational productivity. The impact of motivation, reward and recognition
on employee morale has been identified. The morale boosters are also discussed.
Case St7&3 1
Mr. Mansorie has been working on the Pension Desk of Establishment Section in the
Zonal Office of a Public Sector Bank for last eight years and is now due for inter
departmental transfer. He has been very sincere, hardworking and knowledgeable
worker. His boss Mr. Natrajan, Assistant Manager was having full confidence in his
sincerity and ability, therefore, he was not worried about this aspect of work and was
concentrating on other establishment matters like payment of salary in time, preparation
of PF statement, payment of bills etc. Mr. Mansorie was rarely taking leave and was not
considered for training for a long time. Mr. Natrajan received a communication from the
training department nominating Mr. Mansorie for a week's training to the Staff Training
Centre (STC) on 'Public Relation' in the last week of month. The communication was
received from the training department in time. The STC is located in the same building.
Three days before the commencement of training Mr. Natrajan approached the Chief
Manager pleading for not relieving Mr. Mansorie for the training on the plea that the
disbursement of the pension is a time-bound activity, if he is relieved for the training the
work will suffer. The other clerks were not very much conversant with the work being
performed by Shri Mansorie.
Case St7&3 !
A large public sector bank having an apex training college and 10 Staff Training Centres
(STCs) at different locations across the country runs regular courses on different
aspects of banking, T and HRM. While the apex training college caters to the needs of
middle and senior management, the STCs are mainly training to award staff and junior
management officers. The top management of the bank is not satisfied with the training
system as a whole because it is not producing the right type of trained staff to meet the
emerging challenges. Training initiatives are implemented as rituals. The syllabi of the
courses are not periodically revised. The course coverage is decided by the trainers
themselves based on their own knowledge and exposure, training infrastructure is
inadequate, selection of trainees is based on adhocism resulting into uneven training
opportunities to employees, there is also gap between the type of skills required and
available and this gap is widening due to ageing profile of the employees, training
opportunities are underutilized mainly because of lack of motivation and also non
cooperation of line managers to spare the right staff for the training. The training
department is playing a passive role. t has become hard to increase the training
budget, as there is wide feeling that training is a wasteful expenditure, people are not
taking training seriously and the trainers are not competent. Training job was
considered as risk free and comfortable. Training is considered as a cost centre and line
managers perceive no visible benefits out of training. No evaluation is taking place
except a reaction level at the time of conclusion of training. There is lack of coordination
between different stakeholders of training system.
Human Resource Development; Training and Development, Education; Job Analysis,
Job Description, Job Specification, Job Evaluation Attitude and Attitudinal Change;
Career Development, Career Path Planning, Career Counselling; Life Career Stages,
Career Transitions, Career Concepts Liners, Spiral, Steady, Transitory; Career
Anchors, Career Paths, External-nternal Career Path; Career Roles: Apprentice,
Colleague, Mentor, Sponsor; Personal Efficacy; Self-awareness; Johari Window;
Motivational Base; Power Bases; Locus of Control; nterpersonal nteraction: Needs;
nterpersonal nteraction: Styles; Transactional Analysis; Working in Teams;
Consensus; Emotional
Answers to Check Your Progress
1. False; 2. True; 3. False; 4. False; 5. True; 6. True; 7. False; 8. True; 9. False.
1. False; 2. False; 3. True; 4. False; 5. True; 6. False; 7. True; 8. False; 9. False; 10.
True; 11. False; 12. True; 13. True
1. True; 2. False; 3. True; 4. False; 5. False, 6. True.
D 1. False; 2. True; 3. True; 4. False; 5. False; 6. True.
1. True; 2. False; 3. False; 4. False; 5. False; 6. True; 7. True, 8 False; 9. False; 10.
True; 11. False; 12. False; 13. True; 14. True; 15. False; 16. True; 17. True; 18. True.
Ter'inal 97estions
1. What is HRD? How did the concept develop?
!. Examine the rationale why special focus is needed to be given to Human Resource
Development as a subsystem.
(. What were the events that lead the organizations to learn that the existing workforce
can be developed to do new things?
.. Explain the linkage between the individual performance and organizational
performance and HRD system.
?. What are the HRD subsystems? How do they connect with each others? Explain any
one of them in detail with its linkages to others.
@. Human Beings are learning beings - Discuss.
B Organizations must provide learning opportunities because human beings have a
desire to learn. Do you agree?
C. Why is Pedagogy not suitable for adults?
F. What is the difference between adult and child learning?
10. Describe the various stages in establishing Training and Development system.
11. State the reasons for having a systematic approach to organise training.
1!. What is Training Need Analysis?
1(. Discuss the various teaching methodologies.
1.. What is the purpose of training, development and education? How are they
different? Should organizations have emphasis on all of them?
1?. What is the significance of having right attitudes? Discuss in the context of bank's
efficiency and productivity.
1@. How can we change the attitude of dissatisfied staff?
1B. The organizational career is the responsibility of the organization and the individual -
1C. All the concepts that have been developed around 'Life Stages and Transition' can
be applied to organizational careers - Elaborate this statement.
1F. Write short notes on:
Career Movements/Patterns
Career Roles
Career Path
Career Anchors
!0. What is meant by multiple careers?
!1. Why is there a need for individuals to appreciate that they need to change? Explain.
!!. What are the aspects that individuals need to understand about themselves?
Explain any two aspects discussed in the unit on self-development.
!(. What is the relevance of understanding interpersonal interactions in the
organizational context?
!.. Write short notes on:
Personal Efficacy
Locus of Control
Working in Teams
S7,,este& for +7rther Rea&in,
10 David, Decenzo A and Stephen Robbins P; -ersonnel)>uman ?esour#e
Mana&ement( Prentice-Hall of ndia, 1995.
!. Luthans, Fred, ;r&ani@ational Eeha$iour( McGraw-Hill nternational Edition, 1995
(. Mankidy, J; >uman ?esour#e Mana&ement in Ean"s< Contemporary Issues( National
nstitute of Bank Management, 1998.
.. Nadler, L; The >and%oo" of >uman ?esour#e De$elopment( A Wiley-nterscience
Publication, 1984.
?. Pareek, U and Rao, T V; Desi&nin& and Mana&in& >uman ?esour#es !ystems(
Oxford & BH, 1986.
@. Rao, P L; >?D Throu&h InFhouse Trainin&( STD and Vikas Publishing House, 1995.
B. Rao, T V; Pereira D F, ?e#ent E+perien#es in >uman ?esour#es De$elopment(
Oxford & BH Publishing, 1988.
C. Sahani, A; CCareer -lannin& for >?D and tili@ationC( ndian Management, June 1984.
F. Schein, E; CCareer De$elopment< Issues for ;r&ani@ationsC( B Taylore and G Lipitt
(ed). Management Development and Training, Handbook, McGraw Hill Co., 1983.
10. Stoner, J; and Wankel, E; =;r&ani@ational Careers and Indi$idual De$elopmentB in
Management, Prentice-Hall ndia, 1987.
*A*ER 1
Advanced Bank Management
UNT 22 Human mplications of Organizations
22.0 Objectives
22.1 Human Behaviour and ndividual Differences
22.2 Employees Behaviour at Work
Check Your Progress (A, B and C)
22.3 Diversity and Gender ssues
2'.4 Theories of Motivation and their Practical mplications
Check Your Progress (D, E and F)
22.4 Role Concept and Analysis
Check Your Progress (G)
Let Us Sum Up
Answers to Check Your Progress (A, B, C, D, E, F and G) Terminal Questions
Suggested for Further Reading
1 29
After rea&in, this 7nit0 3o7 sho7l& "e a"le to:
1. understand the various facets of human behaviour and individual differences,
!. understand the various aspects of employees' behaviour at work and its significance
in organizational performance,
(. appreciate the diversity and gender issues at workplace, and
.. appreciate the motivational aspects and their practical implications at work,
?. appreciate and analyze the significance of role in the context of organizations.
Understanding and appreciating the importance of individual differences and its impact
on human behaviour is a most crucial aspect of human resource management. As each
individual is different from the other in his/her physical appearance, he or she is also
different from other person in his/her behaviour and other psychological parameters,
viz., feelings, perception, values, etc. One finds striking differences in intelligence,
physical features and personality traits, etc., among people. From the day of birth, each
person is unique; individual experiences after birth, make people even more different.
Guman behaviour is a complex phenomenon. t is most difficult to define in absolute
terms. t is primarily a combination of originating and responding behaviour. The
behaviour reflects the psychological structure of a person. t is also the result of
biological, psychological and social processes.
According to psychologist Kurt Lewin, behaviour is a function of the person and the
environment around him. These two factors are linked with each other. Any one of these
individually cannot explain fully the behavioural characteristics. Thus, different people
behave differently in the same or similar environment.
After explaining the foundations of human behaviour, the individual differences are
examined in this Unit. Various personality theories have also been discussed in detail.
The Unit also brings out the connection between the employee and the organization.
The employees' motivation and its practical implications at work have also been brought
out in this unit.
The behaviour of an individual is influenced by several factors. These can be grouped
under the following heads:
1. En=iron'ental +a%tors: #a$ Economic, #"$ Social (norms and cultural values), and
#%$ Political;
!. *ersonal +a%tors: #a$ Age, #"$ Sex, #%$ Education, #&$ Abilities, #e$ Marital Status, #f$
No. of dependants, etcetera;
(. Or,ani-ational +a%tors: (a) Physical Facilities, (b) Organization Structure and
Design, (c) Leadership, (d) Compensation and Reward System, etcetera.; and
.. *s3%holo,i%al +a%tors: (a) Personality, (b) Perception, (c) Attitudes, (d) Values. (e)
Learning, etcetera.
En=iron'ental +a%tors: These factors are mainly external and they influence
individual's behaviour. These, broadly include the social, cultural, political and economic
environments. Among these, economic environment determines the behaviour of an
individual to a great extent. Economic environment consists of the level of employment,
wage rates, economic outlook, etcetera. Cultural factors such as work ethic,
achievement needs, values, etcetera., form part of the environmental factors. The
political climate also influences individual behaviour. The stability of the government can
contribute to employment opportunities. The quality of the political system also has a
bearing on individual behaviour. The social environment, which includes societal norms
and the family atmosphere, also influences to some extent the individual behaviour.
*ersonal +a%tors: Every individual brings to his workplace several personal
characteristics such as age, sex, education, knowledge, intelligence, abilities, family
dependents and similar other related factors. Performance of an individual depends on
these factors to a great extent.
Or,ani-ational +a%tors: The structure of the organization, the availability of physical
facilities, the existence of reward and compensation system, the personnel policies, the
organizational culture, etc influence the behaviour of an individual in an organization.
The quality of leadership also influences individual behaviour.
*s3%holo,i%al +a%tors: The individual behaviour is determined to a great extent by the
physical and mental personalities of that individual. The values, perceptions and
attitudes also contribute to the individual behaviour.
Since each person is individually different implying that in order to motivate the
employees they have to be treated differently keeping in view the needs and motives of
the employees. f the needs and motives of two persons are different they must be
treated differently. f it were not for individual differences, some standards could have
been adopted for dealing with employees and minimum judgment would have been
required thereafter. There might have not been any difference in dealing with men and
+rom the organizational angle, managers usually view their employees as rational
human beings who are primarily motivated by money. Accordingly, they adopt
'economic man' and the 'rational man' approach to understand and predict human
behaviour. However, it has also been realized that man is also a social being. He wants
to belong to a group, and his behaviour at the workplace emanate from his social needs
as well. One of the well-known studies (Hawthorne studies) has made it clear that
economic motives alone do not explain human behaviour. Social interactions at
workplace, especially how they are treated, and how their contributions are
acknowledged, make a big difference in their attitude to perform. Thus the idea of 'social
man' was developed.
Gowever, as time passed by, the 'social man' approach was also considered somewhat
simplistic. This approach does not pay adequate attention to work, its intrinsic nature
and its organization. Nor does it concern itself with the economic functions and
responsibilities of the enterprise. And at times, it is plainly manipulative. Organizational
behaviour theorists such as Argris G C, Likert R, and McGregor D argued that people in
organizations need opportunities to use their creativity and this growth need should be
met to enable them to contribute effectively.
At the same time, all employees may not want to develop and grow on their job; they
may have their preference elsewhere. Hence, the current thinking is to accept man as a
complex being and to recognize that personalities always differ. An understanding of the
concept of personality and the influence of its components on the behaviour at work is
necessary to provide a congenial environment in which employees can perform. Such
an understanding may help managers to adjust their own behaviour also and contribute
to organizational cohesiveness. Besides, this may enable them to predict employee-
behaviour at work (absenteeism, turnover, work involvement, etc.) and take timely
preventive measures.
The behaviour of people at workplace plays an important role in organizational success.
The behaviour of an employee as an individual as well as his behaviour in a group
makes a difference in achievement of organizational and group objectives. The
technical competence of an individual is important but beyond that his behaviour and
interpersonal skills are extremely important. The people in the organizations do not work
in isolation, their role and performance is interdependent. They work in teams where
contribution of each member is important and significant. The team-building skills which
are founded on individual behaviour and interpersonal skills can help in getting synergy
at workplace where the cooperation and collaboration can improve the group
performance and output beyond the individual contributions. Synergy is the highest
activity of life, it creates new untapped alternatives; it values and exploits the mental,
emotional and psychological differences between people.
There are some basic assumptions about human behaviour at work:
1. There are differences between individuals.
!. Concept of a whole person.
(. Behaviour of an individual is caused.
.. An individual has dignity.
?. Organizations are social systems.
@. There is mutuality of interest among organizational members.
B. Organization behaviour is holistic.
;hile the first four concepts centred around people, the next two are concerned with
organizations. The last one is a combination of the first six assumptions.
*ersons differ and again, there are certain 'commonalities' in the persons. Every person
is, in certain respects,
1. like all other persons,
!. like some other persons, and
(. like no other person.
This position indicates that an individual possesses some common characteristics of
most of the people. He may have some features of some other people. He may also
have some characteristics which other persons do not have, i.e. the features unique to
an individual. Human personality is thus a complex and multidimensional phenomenon.
There is indeed no simple definition of what personality is. However, personality can be
examined in terms of certain stable characteristics, tendencies and behaviour patterns.
Salvotore Maddi defined personality as a stable set of characteristics and tendencies
that determine those commonalities and differences in the psychological behaviour
(thoughts, feelings, and actions) of people that have continuity in time and that may not
be easily understood as the sole result of the social and biological pressures of the
moment. This definition does not imply that people do not ever change. t simply
indicates that individuals do not change drastically overnight and their thoughts,
feelings, values and actions remain relatively stable over time. Changes in personality
behaviour pattern that take place in individuals occur slowly over an extended period of
time. Thus by understanding certain dimensions of personality and behaviour,
managers can, to a great extent, predict the likely behaviour in terms of actions and
outcomes of actions in respect of employees.
There are several theories to explain the concept of personality.
One dimension of personality which is getting attention both from organizational as well
as medical researchers is the Type A and Type B behaviour profiles.
A person exhibiting Type A behaviour is generally restless, impatient with a desire for
quick achievement and perfectionism.
Type 'B' personality people are much more easy going, relaxed about time pressure,
less competitive and more philosophical in nature.
+riedman, Meyer and Ray Roseman have mentioned the following characteristics of
Type W personality:
1. Restless by nature, so that he always moves, walks and eats rapidly.
!. s impatient with the pace of things, dislikes waiting and is impatient with those who
are not impatient.
(. Multitasker does several things at once.
.. Tries to schedule more and more in less and less time, irrespective of whether
everything is done or not.
?. Usually does not complete one thing before starting on another.
@. Often displays nervous gestures such as clenched fist and banging on a table.
B. Does not have time to relax and enjoy life.
Type B personality exhibits just the opposite characteristics and is more relaxed,
sociable and has a balanced outlook on life.
;e come across both Type A and Type B Managers in banks. Usually Type A
Manager's cabin is untidy, and gives a Messy appearance. Further, his table is full of
papers and many a time, it is difficult to trace important papers kept on his table. He has
a tendency even to lose some papers and to blame others for such a loss.
Type B personality, however, is systematic and methodical in his day-to-day work. He
has full control over time and does not complain of lack of time even due to pressure of
work. This is because he plans the work in such a way that urgent and important
matters are disposed of in time. Although he is busy like many other managers, he
appears to take things easy and normally does not get disturbed.
A development model of personality described by E H Erikson also helps us to
understand the concept of personality. Erikson has identified eight developmental
stages in explaining the personality. These stages which are based on a person's state
of mind at a given point of time are mentioned below:
Sta,e 1: Tr7st =ers7s Mistr7st
As children we depend on others for our various needs. n the process we develop
feelings of trust or mistrust towards others depending on our experience about the
fulfillment of our needs. Similarly, in the workplace, we may not know everything about
the job and therefore, we are dependent on others for guidance. n the process we also
develop feelings of trust or mistrust towards others in the organization depending upon
how well they respond to our needs and help us to find our place in the system.
Sta,e !: A7tono'3 =ers7s Sha'e an& Do7"t
As children we experienced a great need to be on our own and whenever we
succeeded, we felt we are independent and autonomous. When we failed in such
attempts, we experienced a sense of shame and doubt. Similarly, in the workplace after
induction and initial training, we feel happy when we can function independently. But
when we commit mistakes we start doubting our own competence and experience a
sense of shame for not doing things right.
Sta,e (: Initiati=e =ers7s I7ilt
This stage indicates the child's efforts at trying to do things on its own initiative and
feeling guilty if mistakes are committed. Similarly as employees we take initiative and
use our talents to settle down in the jobs; if things go wrong, we may experience a
sense of guilt that we have wasted our energy and the resources of the organization.
Stale .: ln&7str3 =ers7s Inferiorit3
As we grow up we become diligent and industrious. We want to pursue our goals and
manage our life. f we are successful in these efforts, we feel good about ourselves; if
we fail, we develop a sense of inferiority. Similarly, in the workplace we try to work hard
to find a place in the organization; if we are not successful, we tend to suffer from a
feeling of low self-concept and low self-esteem.
Sta,e ?: I&entit3 =ers7s Role Diff7sion
As we grow, we experience conflict due to the socially imposed requirement of
becoming an independent and effective adult. This, at times, becomes difficult. n the
workplace also, we are expected to prove ourselves as high, performing members.
Obviously, this is not always easy for everybody. n the process some may find their
role identity diffused rather than identified and distinguished.
Sta,e @: Inti'a%3 =ers7s Isolation
As a youth, one feels the need to develop intimate relationship with others. However,
there may be impediments to develop such relationship and hence some might feel
isolated. Same is the experience in the workplace also. We may develop close contact
with others and we may also feel a sense of isolation.
Sta,e B: Iro8th =ers7s Sta,nation
In middle adulthood, there are compulsions to forego one's immediate needs in favour
of developing one's children. f this is not effectively resolved within the individual, a
sense of stagnation creeps in. Similarly, in an organization as one reaches mid-career,
there is an expectation and need to develop others in the system and help them to
grow. f this is not done properly, the person senses a feeling of stagnation.
Sta,e C: Inte,rit3 =ers7s Des5air
During the later part of life, there is a natural decline of social and biological roles due to
the ageing process. As a result one may experience a sense of uselessness. f he is in
a position to accept reality, he may resolve the conflict and feel happy about his lifelong
achievements. Likewise, in an organization, as one approaches retirement age, he may
experience either a high sense of self-worth due to his perceived accomplishments in
the career or he may withdraw himself with a sense of purposelessness and despair.
The two theories (Type A and B) and Erikson's model of personality bring out different
aspects of the concept. While Type A and B focus on certain personality features,
Erikson's model narrates different stages of an individual's growth and their effects on
his mental personality.
Che%2 )o7r *ro,ress #A$
Ans8er the follo8in, H Tr7e or +alse:
1. Type 'A' person feels a chronic of time urgency. ----,, True.
2. Type 'B' is an easy going individual. ----,, True.
3. Type 'A' person is not achievement oriented. ----,, True.
4. Type 'B' person does not experience any competitive drive in his activity. ----,, False.
5. Erikson's model of personality has eight stages. ----,, True.
6. During youth, according to Erikson, one develops a need for intimate relationship with
others. ----,, True.
7. There is mutuality of interest among organizational members. ----,, True.
8. Type 'B' person does several things at a time. ----,, False.
There are certain common patterns and variables which determine the personality of the
people. The patterns of behaviour can be to some extent predicted if we can identify the
type of personality. People with similar attributes can be classified in one category and
their behaviour can be predicted. Accordingly, experts have developed certain
personality theories.
*s3%hoEanal3ti%al Theor3 #*T$
*T is based primarily on the Freudian concept of unconscious, subconscious and
conscious nature of personality. Freud noted that his patient's behaviour could not
always be explained. This led to him believe that the personality structure is primarily
founded on unconscious framework and that human behaviour and motivation are the
outcome of psychoanalytic elements, namely, id, the ego, and the super ego. d is the
foundation of the unconscious. t strives for sexual pleasure and other biological
pleasures and has animal instincts of aggression, power and domination. Ego is
conscious in nature and relates our conscious urges to the outside world. t keeps the id
in check through the realities of the external environment. While id demands immediate
pleasure, whatever the cost, ego controls it so that these pleasures are granted at an
appropriate time and in an acceptable manner. Because of difficulty of keeping the id
under control, ego is supported by super ego. The super ego is the higher level
restraining force and can be described as the conscience of the person. The conscience
creates standards of what is wrong and what is right and is generally subconsciously
developed by the absorption of cultural and ethical values of the social environment. All
these three Freudian elements are interrelated and each cannot exist in isolation from
others. n order to create a 'normal' personality, there must be a balance in the
relationship among these three forces. For example, an overdeveloped super ego would
make the person highly moral and make him feel guilty for every little thing that slightly
deviates from the norm. This would not be considered practical or rational. Similarly, an
underdeveloped super ego would let id urges loose and would characterize the person
as one having weak morals and values. This psychoanalytical approach to personality
structure analysis has made some impact on organizational behaviour. For example,
stages of creative process are unconscious in nature and can be brought out by
psychoanalysis. Similarly, such employee behaviour as daydreaming, forgetfulness,
absenteeism, tardiness, sabotage, alcoholism and drug abuse, can be analysed through
psychoanalytical studies and analysis.
Trait Theor3
Trait theory believes that the traits of a person which determine his personality and
behaviour are basically inherent to a person, that is, more of a heredity impact than the
environment .Trait theory explains personality as a demonstration of certain traits of the
individual. While there are many traits common to most people, there are many other
traits that are unique to a person and are not shared by other individuals. On the basis
of Trait theory, people can be described as aggressive, loyal, pleasant, flexible,
humorous, sentimental, impulsive, cool and so on. Traits are the basic elements of
personality and can be used to explain their behaviour. People behaving in a forceful
manner in most situations could be described as aggressive. Similarly, if a person
allows others to take the initiative, he is 'submissive'.
SelfECon%e5t Theor3
This theory believes that personality and behaviour are to a great extent determined by
the individual himself. We have an image of our own and our actions would be
consistent with that image. Carl Rogers is closely associated with this theory. According
to him, the best vantage point for understanding behaviour is from the internal frame of
reference of the individual himself. An individual himself is the centre of experience. His
self-image is an integral of how he views himself and his perception of how others view
him. This self-concept is a result of a person's interaction with his environment. This
interaction in the form of learning experience helps us to grow and mature, and we
modify our self-concept as a result of these experiences. When we get positive
feedback from others in response to our behaviour, our self-concept is positively
reinforced. On the other hand, when we get negative feedback, our self-regard is
lowered, resulting in tension and anxiety. Thus, an employee with a self-concept of high
intelligence, independence, and confidence may not look for such reinforcement
techniques as monetary rewards, job security or directive supervision. He may look for a
challenging environment where he gets recognition, responsibility and achievement. On
the other hand, the monetary rewards and job security may be more effective on
employees who have a self-concept of dependence, insecurity and who lack confidence
in themselves.
So%ial Dearnin, Theor3
This theory believes that personality development is more a result of social variables
than biological factors. Much of human behaviour is either learnt or modified by
learning. Through learning, one acquires knowledge, attitudes, values skills, etcetera.
Further motives can be traced to known and conscious needs of the individuals.
Personality is the sum total of all that a person has learned. The social learning theory
uses 'reinforcement and punishment' approach in understanding personality. For
example, frustration caused by external environment, causes and reinforces aggression
as a personality trait. Also, good behaviour is rewarded by the society in terms of praise
which further reinforces good behaviour. Thus, behaviour and external environment
have mutual interaction. Behaviour partly creates the person's environment and the
environment affects the person's behaviour as well.
Che%2 )o7r *ro,ress #B$
Ans8er the follo8in, Tr7e or +alse:
1. d is the foundation of the unconscious. .. True.
!. n order to create a normal personality there should be a balance in the relationship
among the id, the ego and the super ego. .. True.
(. People behaving in a forceful manner in most situations could be described as
sentimental. .. False.
.. We have an image of our own and our actions are consistent with that image. ..
?. Personality is a sum total of all that a person has learnt. .. True.
*ersonalit3 an& Brain #Deft an& Ri,ht Brain$
An important biological factor which influences personality is the role of brain of an
individual. Two types of contribution can be found in this area: Electrical stimulation of
the brain (ESB) and split brain psychology. Human brain is believed to contain certain
definite pleasurable and painful areas. Accordingly it may be possible physically to
manipulate personality through ESB. t may also be possible to use ESB as a method of
reducing stress and tension and stimulate creative thinking. Split brain, right versus left,
psychology is closely related to ESB and is probably more popular. The characteristics
and dimensions attributed to the left and right hemispheres of the brain are indicated in
the following table:
Left Hemisphere
Controls Right side of body
Right Hemisphere
Controls Left side of body
1. Speech and Verbal 1. Spatial and musical
2. Logical and Mathematical 2. Holistic
3. Linear and Detailed 3. Artistic and symbolic
4. Sequential 4. Simultaneous
5. Controlled 5. Emotional
6. ntellectual 6. ntuitive, creative
7. Dominant 7. Minor (quiet)
8. Active 8. Spiritual
9. Analytic 9. Synthetic, gesalt-oriented
10. Reading, writing, naming 10. Facial recognition
11. Sequential ordering 11. Simultaneous
12. Perception of significant order 12. perception of abstract
13. Complex motor sequence patterns 13. Recognition of complex figures
Note: Adapted from Freed Luthans, Organizational Behaviour, 6th Ed.
The Left and Right hemispheres of the brain are attributed with some specific
dimensions and characteristics as shown in this table. These areas are, however, still
open for further research.
Mat%hin, *ersonalit3 8ith Jo"s
John Holland's personality job fit theory is of late receiving increasing attention. The
theory is based on the match of personalities with jobs. Holland presents six personality
types and proposes that satisfaction and dissatisfaction with the job depends on how
individuals successfully match their personality with their occupations. Table describes
the six types, their personality characteristics, and gives examples of congruent
TABDE !!.1 Gollan&s T35olo,3 of *ersonalit3 an& Con,r7ent
Type Personality
Congruent Occupation
1. Realistic: Prefers
physical activities that
require skill, strength and
1. Shy, genuine,
persistent, stable,
conforming, practical.
1. Mechanic, drill press
operator, assembly-line
worker, farmer.
2. nvestigative: Prefers
activities that involve
thinking, organizing and
2. Analytical, original,
curious, independent.
2. Biologist, economist,
mathematician, news
3. Social: Prefers
activities that involve
helping and developing
3. Sociable, friendly,
3. Social worker, teacher,
counseller, clinical
4. Conventional: Prefers
rule-regulated, orderly,
and unambiguous
activities, flexible file
4. Conforming, efficient,
practical, unimaginative,
bank teller.
4. Accountant, corporate
5. Enterprising: Prefers
verbal activities where
there are opportunities to
5. Self-confident,
ambitious, energetic,
5. Lawyer, real-estate
agent, public relations
specialist, small business
influence others and
attain power.
6. Artistic: Prefers
ambiguous and
unsystematic activities
that allow creative
6. maginative, disorderly,
idealistic, emotional,
6. Painter, musician,
writer, interior-decorator
Che%2 )o7r *ro,ress #C$
Ans8er the follo8in, state'ents in Tr7e or +alse:
1. Human brain is believed to contain definite pleasurable and painful areas. .. True.
!. Extroverts are quiet, reflective people. .. False.
(. Successful people have high tolerance for ambiguity. .. True.
.. ndividuals with low self-esteem take more risk in their career. .. False.
?. Personality job fit theory was developed by John Holland. .. True.
@. Right brain controls intuitive and creative behaviour. .. True.
B. Left brain controls analytical behaviour. .. True.
C. Right brain controls Speech and Verbal ability. .. False.
Di=ersit3 an& Di=ersit3 Mana,e'ent
Many organizations have acknowledged the importance of the increasing diversity in the
workforce. They have begun to question the effectiveness of the human resource (HR)
systems that are largely designed for a more homogeneous workforce. There is a need
to consider the implications of diversity for the development and synthesis of specific
HR policy areas. There is also need to study the degree to which the current theories
and practice have incorporated issues of diversity management. While race/ ethnicity
and gender are the most recognized forms of diversity, there are other types with
important implications for HR systems and management. They include disability, family
background, age, lifestyle and culture. Each of these identity group memberships can
affect an employee's attitudes and behaviour at workplace as well as influence his or
her ability to work well with other organizational members.
Organizations have traditionally HR systems based on models of homogeneity. They
promote similarity not diversity, provide a number of examples illustrating how traditional
HR management models foster workforce homogenization, viz., recruiting practices
emphasise people from sources that have historically been reliable or selecting
candidates similar to those who have been successful. Similarly, decision-makers have
tempted to hire, promote and evaluate people in terms of the degree to which they are
like their own image. Such an approach has been coined 'homogeneous reproduction'
referring to the tendency of selection and promotion systems to allow only those
employees to pass through who fit with the characteristics of the dominant coalition.
The aptitude tests used for mass selections and recruitment are also designed in such a
way that it selects the candidates with similar abilities and competence. Once that ability
or the competence becomes obsolete the entire work group becomes redundant. For
example, in 1970s and 1980s the ndian banks had recruited a large workforce with
numerical ability to meet the growing demand of employees in the banking services due
to rapid branch expansion. With large scale computerization in banking sector in 1990s
and current decade of this century the numerical ability became an obsolete skill as the
reconciliation and all back office jobs have been taken over by the computers. With
growing competition between the banks, the selling and marketing skills have become
more in demand and banks are facing a problem of re-skilling the staff into the
marketing skills. There is a drastic shift of orientation of people of back office work and
front office jobs requiring inter-personal skills. Thus, having people with heterogeneous
and complementary skills are always beneficial for the organizations. Too much
similarity in the work force in an organization can be detrimental to long-term growth,
renewal, and ability to respond to important environmental changes such as dynamic
market conditions, new technologies and ideas, societal shifts, or the expectations. HR
policies supporting diversity can help the culture to continually adapt in response to new
environmental demands. Such systems are critical for attracting, selecting, motivating,
developing and retaining highly skilled diverse workforce.
Modern employers now encourage diversity at workplace. When workgroup diversity is
managed effectively, groups develop processes that can enhance creativity, problem
solving, workgroup cohesiveness and communication. At organizational level,
performance, and the quality of product and service may improve. Diverse group of
employees who possess the key success factors are needed to compete in today's
changing marketplace. Despite these reported benefits, their realization has remained
elusive for most of organizations. This is because traditional HR strategies manage
diversity, which has largely been introduced in piece meal, without taking a holistic view,
lacking integration with other systems. For example, in most of the countries,
legislations have been enacted for equal pay for similar work irrespective of gender,
race, etc. without changing the culture and human beliefs. The three predominant
traditional HR approaches for managing diversity are: di$ersity enlar&ement( di$ersity
sensiti$ity and #ultural audits.
Diversity enlargement approach increases the representation of individuals of different
ethnic and cultural backgrounds in an organization. The goal of this strategy is to create
diversity by changing an organization's demographic composition. Employers seem to
assume that increasing diversity and exposure to minority employees will result in
improved individual and organizational performance. The employers have wider choice
from diversified groups.
Diversity sensitivity approach acknowledges the existence of cultural distance and
attempts to teach individual members about cultural differences via training. Often
training sessions are held to help sensitize employees to stereotyped differences of
various employee racial, ethnic and gender groups. The purpose is to promote
communication and understanding, and to build relationships among members of
different backgrounds.
A third strategy, the cultural audit, generally tries to determine what is blocking the
progress of nontraditional employees. Data is collected through surveys to assess
various demographic groups' identification of major obstacles they face in the current
culture. This helps in bringing out their feelings about the predominant culture and the
dominant ethnic groups. Conducting cultural assessment as an isolated strategy is likely
to fail unless it is linked to HR systems. Managing diversity is a mutual process and the
new culture and HR strategies must be designed to be inclusive to allow all members to
contribute to their potential. Cultural audit not only needs to focus on the differences
between groups but also identify the similarities between groups that the culture and
supportive HR systems can reinforce to achieve organizational objectives.
There are several issues and problems associated with achieving objectives in terms of
hiring and managing diverse employees. One problem that emerges is the issue of
'critical mass'. Organizations planning for diversity often find themselves 'spinning their
wheels' because of inability to bring enough diverse workers into the organization. The
problem here is that it may need a critical mass of diverse workers in order for such
employees to feel welcome and accepted. Entrance of few diverse workers into the
organization may fall flat because of sense of isolation and/or overexposure in the role
as 'token' (Kanter.1977). Another problem with achieving diversity objective is that it
takes considerable time before the organization with best of intentions begins to show a
complete demographic profile which reflects their objectives and efforts. Finally, the
nature of underlying business conditions may limit achieving business objectives. When
the organization is growing/expending and hiring with greater frequency, it allows faster
achievement of diversity goals. However, when the expansion is slow or nonexistent or
during downsizing, it becomes difficult to achieve the diversity objective.
Ien&er Iss7es
The major factors for diversity are gender and race differentiation. Many jobs have
preference for a particular gender both from employer's and worker's points of views.
This differentiation is basically on account of physical, social, psychological and
emotional considerations. For jobs requiring greater physical strength, men are
preferred, whereas for the jobs requiring hospitality and emotional aspects, women are
preferred. Gradually the difference is getting blunted. Now, women are willing to accept
all sorts of jobs and have proved themselves successful in the jobs which were
predominantly being occupied by men. The jobs like aero plane pilot, police, etcetera
are successfully being handled by women. The women, however, also have the
responsibility of managing their household affairs in addition to their jobs.
*owel (1987) conducted a major review of the empirical literature on gender as it relates
to recruitment and selection decisions in the organizations. He found that gender did not
significantly affect the selection decisions. The greater the amount and relevance of
information (namely past performance) about the job and applicant received by the
evaluator, the lesser gender biased the decisions. Research also suggests that
attributes of success and failures may explain the relationship between gender and
personnel decisions.
There has been whole host of initiatives by the governments worldwide to remove the
discriminations in employment and employment conditions based on gender. The
initiatives have been generally in the nature of legislations. The employment
opportunities for women have considerably improved in recent years in almost all
sectors and areas of specializations. The employment rate of women has gone up
considerably in recent times. Lots of opportunities for part-time employments for women
have emerged. Women are disproportionately represented in secretarial occupations
whereas the men are highly represented in machine operative works and craft related
occupations. n spite of government policies, there has been large number of instances
of pay disparities to the disadvantage of women employees for similar jobs. n a survey
conducted in UK (Labour Market Trend 2001) women got 82 per cent of the average
hourly earnings as compared to male counterparts in full time employment. The pay gap
varies between sector to sector and job to job.
In ndia, the representation of women in employment is still quite poor. The recent years
have seen some significant improvement in the proportion of women representation.
Women workers are visible almost in all sectors and all occupations. A large number of
women workers are seen in manual work like construction activities. Banking, teaching
and health care have traditionally been seen as the preferred occupations for women.
As women are generally required to shoulder dual responsibility, they prefer a job with
regulated working hours so that they can devote sufficient time to their family and
household affairs. There are avenues for women in almost every job. Government
policies and legislations also do not permit any gender discrimination in pay or any other
service conditions. The Equal Remuneration Act, 1976 has provided for the payment of
equal remuneration to men and women employees and for prevention of discrimination
on the grounds of gender against women. The act also seeks to provide for more
opportunities to women in specialized employments. However, keeping in view the
vulnerability of women at workplace, jobs requiring odd hours of work require
permission under the Factories Act, 1948: to allow women workers to work during odd
hours and shift duties under special circumstances and proper protection.
The preference for a male child is predominant in ndian society. Recent Census
conducted by the Government of ndia indicated that there has been a significant sex
imbalance in many of the states. There is also significant gap in the literacy level
between male and female. To improve the literacy level of women and girl child for the
purpose of making them self-reliant, government is encouraging literacy by providing
various incentives, concessions and encouragements. To improve the status of women
in society, the government has recently amended the Hindu Succession Act 1956 to
give equal rights to female successors at par with their male counterparts in ancestral
property. There has been significant representation of women in village panchayats,
state legislations and the parliament but the number is disproportionately low compared
to their ratio in the population. The proposed legislation giving 33 per cent
representation to women in parliament is pending for a long period. t could not be
passed due to vested interests and lack of will on the part of male counterparts
occupying power centres.
The security of women at workplace has always been a major concern. A number of
cases are being reported of exploitation, sexual harassment and discrimination at
workplace. The Supreme Court of ndia has taken a serious view of the matter and
issued a comprehensive directive to avoid such incidences. t has defined what
constitutes sexual harassment and the manner it should be dealt in the organizations. n
spite of Supreme Court's directive, a number of cases of sexual harassment still
continue and there is under-reporting of such cases because of job insecurity and social
;hat is Moti=ation>
To begin with, we will define the term motivation. The word motivation is derived from
Latin word 'movere' (to move). Accordingly, it attempts to account for the 'drives' and
'wants' of an individual rather than just focusing on the individual's actions. The term
motivation is commonly used and understood by everyone but there is no uniform
definition of the term. One can find as many definitions as number of books on the
subject. n its simplest form motivation in an organizational context is referred as 'the
extent of willingness of an employee to respond to the organizational requirements'.
Motivation is generally directed, consciously or unconsciously, towards satisfaction of
needs (motives). Motivation has direct impact on the job performance of individuals.
Motivation is a process beginning from inner state of a person and ending with need
fulfillment. For example, when an employee works hard, his level of motivation may be
considered as high and if he avoids work, his motivation level may be considered as
low. The level of motivation of an employee can be judged by his actual work behaviour.
The managers are, therefore, interested in knowing the factors which motivate
employees to work hard and also the factors which contribute to 'de-motivation'. Every
human being has a given level of satisfaction at a given point of time.
Motivation as a behavioural concept is of great interest to the executives and managers
in organizations today. One of the biggest problems a manager faces is how to motivate
the people working under him. What is motivation and how can employees be motivated
to work'? What is the relationship between motivation and performance? Whether a
highly motivated employee is necessarily a good performer or an employee whose
performance is not good can be considered as de-motivated? These are some of the
issues which are drawing the attention of the organizations.
Theories of Moti=ation
The various theories of motivation are:
1. Scientific Management or Rational Economic View
!. Human Relations Model
(. Abraham Maslow's Need Hierarchy Theory
.. Frederick Herzberg's Two-Factor Theory
?. Clayton Alderfer's ERG Theory
6. Achievement Motivation Theory
7. Victor H Vroom's Expectancy Model
8. James Stacy Adams' Equity Theory
9. Lyman W. Porter and Edward E Lawler - Performance Satisfaction Model.
10. Reinforcement Theory
S%ientifi% Mana,e'ent or Rational E%ono'i% Vie8
+ W Taylor, who is known as the Father of Scientific Management, has contributed
much to the theory of motivation. Scientific Management is a set of methods and
techniques applied to organization of work at the operational level for the purpose of
increasing efficiency. He believed that the best way to increase output was to improve
the techniques and methods used by workers. Workers had to adjust to the
management and not the management to the people.
Taylor's logical and rational approach to management explained that people are
primarily motivated by economic considerations and will exert more if offered
opportunity to improve their economic gains. Put simply, Taylor's theory stated that:
1. Physical work could be scientifically studied to determine the optimal method of
performing a job.
2. Workers could thereafter be made more efficient by giving prescriptions for how they
were to do their jobs.
3. Workers would be willing to adhere to these prescriptions if paid on a differential
piece work basis.
Scientific approach to motivation based on rational economic view has however been
criticized severally. n particular, behavioural scientists have argued that Taylor and his
colleagues de-humanized workers by treating them as mere factors of production, who
could be manipulated completely through economic incentives.
The most fundamental problem with Taylor's approach from a motivational viewpoint is
concerned with his rather simplistic assumption about human behaviour. Taylor
believed that workers would be motivated more by the need for money (this assumption
is called 'rabble hypothesis'). He thought that the primary interest of the worker is
economic gain in the form of higher wages. Contrary to this rabble hypothesis, workers
seek satisfaction of a variety of needs in the workplace like need for security, social
fulfillment, and a challenging job, including pay.
G7'an Relations Mo&el
Elton Mayo in 1920s and early 1930s conducted Hawthorne Studies at Western Electric
Company. He found that in addition to finding the best technological methods to
improve output, management needs to look into human affairs. The real power centres
within an organization were the interpersonal relations that developed within the working
unit. The organizations were to be developed around the workers and had to take into
consideration human feelings and attitudes. The leader was to facilitate co-operation for
attainment of goals by followers. Leader was to provide opportunity for the personal
growth and development of workers. The main focus was on individual needs rather
than the organizational needs
Eventually it became clear that the assumption that workers are primarily motivated by
money, may not be correct. Elton Mayo and his team found that the social contacts
which the workers have at workplaces are also important. Mayo and others also
believed that the managers could motivate employees by acknowledging their social
needs and by making them feel useful and important.
As a result, employees were given some freedom to make their own decisions on their
jobs. Greater attention was paid to the organization's informal work groups. More
information was provided to employees about the manager's intentions and about the
operations of the organization.
In the Scientific Management Model the workers were expected to accept
management's authority in return for higher wages. n the Human Relations Model,
workers were expected to accept management's authority because supervisors treated
them with consideration and were attentive to their needs.
The problem with the Human Relations Model is its undue reliance on social contacts at
work situation for motivating employees. Social contacts, though desirable, by
themselves do not always help motivate workers.
Che%2 )o7r *ro,ress #D$
Ans8er the follo8in, state'ents in )es or No:
1. The term Motivation has been derived from the Latin word 'movere' (to move). ..
!. Taylor's Scientific Management theory belongs to Content Theories of Motivation. ..
(. Human Relations Model is one of the early theories of Motivation. .. Yes
.. Elton Mayo contributed to a great extent to Human Relation Model. .. Yes
Maslo8s Gierar%h3 of Nee&s
Abraham Maslow, a clinical Psychologist from USA submitted (1954, 1968) that people
have the following five basic levels of needs. He identified five needs in an order of
hierarchy, namely, #hysiological &eeds< Safety and Security &eeds< Social &eeds<
Self-esteem &eeds< Self-actuali=ation &eeds) The prominence of these needs
generally follow a hierarchy i.e. when a need is satisfied then only the next need
becomes prominent in that hierarchal order. But there have been found exceptions to
this order for certain persons. They are prepared to sacrifice a lower order need for
achieving a higher need.
*h3siolo,i%al Nee&s
This group of need includes the needs for food, drink, shelter, oxygen, sleep, sex,
weather, etc. These physiological needs are required to maintain the physical entity of
the individual. These are the basic needs in the sense that they satisfy the very
livelihood of the individual for survival.
*hysiological needs dominate human desires and only when these needs are
reasonably satisfied, one's attention turns to other needs. n the organizational context,
physiological needs are represented by the employee's concern for salaries and good
physical working conditions. The organization should therefore endeavour to satisfy the
physiological needs of the employee. Only then they will be motivated to perform better.
Safet3 an& Se%7rit3 Nee&s
Safety needs become motivators after physiological needs are met. Maslow suggested
that the safety needs are most readily observed in infants and young children because
of their relative helplessness and dependence on adults.
Safety and security needs in the organizational context relate to such factors as job
security, salary increases, safe working conditions, unionization, and lobbying for
protective legislation. Managerial practices to satisfy the safety needs of the employee
include pension scheme, group insurance, provident fund, gratuity, safe working
conditions, grievance procedure, etcetera. Arbitrary or unpredictable actions, which
create a feeling of uncertainty (particularly regarding continued employment),
favouritism, or discrimination on the part of the management do not create a feeling of
security in the employee's mind.
So%ial Nee&s
This need is expressed through the desire to belonging and affection in a social context.
n the organizational context, social needs represent the need for a compatible work
group, peer acceptance, professional friendship, and friendly supervision. These are the
needs one acquires, learns or adopts through experience and these needs are mostly
culturally determined. They are largely a manifestation of the desire to belong and be
accepted by others. Managers would do well to encourage informal groups amongst the
employees so that this need is adequately met. Care should be taken that the informal
groups should not work contrary to the requirements of the organization. May be, if
workers have the freedom to form their own work teams and decide upon the
distribution of work within the teams and to that effect organize the team, one may be
able to see a productive outcome.
SelfEestee' Nee&s
The esteem needs for self-respect and recognition and for respect of others are often
referred to as ego or status needs. The satisfaction of this need generates a feeling of
self-confidence and of being useful and necessary in the world. n contrast, the
thwarting of this need leads to a feeling of inferiority, ineptness, weakness, and
helplessness. Maslow emphasized that the healthiest self-esteem is based on earned
respect from others rather than on fame, status or adulation.
In the context of workplace, self-esteem needs correspond to job title, merit, pay
increase, peer and supervisory recognition, challenging work, responsibility, etcetera.
Managerial practices to fulfill these needs include challenging work assignments,
performance feedback, performance recognition, personal encouragement and
involving employees in goal setting and decision-making.
SelfEa%t7ali-ation Nee&s
In an organization, self-actualization needs correlate to the desire for excelling in one's
job, advancing an important idea, successfully managing the unit and the like. This level
of needs encompasses the ability to accomplish and achieve something in life, i.e. to
maximize one's potential and the desire to become what one is capable of becoming-
By being aware of the self-actualization needs of subordinates, managers can use a
variety of approaches to enable the former to achieve their personal as well as the
organizational goals. The workers who operate at self-actualization need do prefer
autonomy and do not require supervision.
;hile Maslow's needs classification theory makes good sense, problems arise with his
contention that they are arranged in a hierarchical fashion and that the lower level
needs must be first satisfied before the higher level needs in the pyramid will be
activated. Take for instance the case of teachers, poets, artists and musicians all over
the world who have tried to self-actualize themselves by their immortal work without
ever having satisfied their lower level needs. Thus, it is possible for some at least, not to
go through every step in the hierarchy. Another problem with Maslow's theory is the
operationalisation of some of his concepts which make it difficult for researchers to test
his theory. For instance, how does one measure self-actualization? Despite the
problems the theory has useful practical implications for managers. t is a fact that the
vast majority of employees joining organization at lower levels, are by and large,
seeking to satisfy their physiological needs first and then move up the levels step by
step. t thus offers a good conceptual scheme for managers to understand and deal with
issues of employee motivation at the workplace.
Ger-"er,s T8oE+a%tor or Moti=ationEG3,iene Theor3
+rederick Herzberg (1959) extended the work of Maslow and developed a specific
content theory of work motivation. He conducted a widely reported study on about 200
accountants and engineers from eleven industries in Pittsburg, USA. He used the
critical incident method of obtaining data for analysis. He asked them two questions:
1. When did you feel particularly good about your job what turned you on?
!. When did you feel exceptionally bad about your job what turned you off?
He then asked them to describe the conditions that led to these feelings.
Gerzberg found that employees named different types of conditions for good and bad
feelings. His study revealed that the factors responsible for job satisfaction are quite
different from the factors that led to dissatisfaction. Reported good feelings were
generally associated with job experiences and job content. Reported bad feelings, on
the other hand, were generally associated with the surroundings, peripheral aspects of
the job the job context. These two feelings were not adverse to each other. f a person
was satisfied with a job in a particular condition, the absence of such condition would
not mean job dissatisfaction, but it might be called no job satisfaction.
Similarly, opposite of job dissatisfaction is not job satisfaction but it might be no job
Thus Herzberg suggested that the opposite of satisfaction is not dissatisfaction, as was
traditionally believed. Removing dissatisfying characteristics from a job does not
necessarily make the job satisfying.
Gerzberg's theory is based on a two-factor hypothesis, that is, factors leading to job
satisfaction and the factors leading to job dissatisfaction. The factors so identified were
classified by him into two categories:
1. Motivational Factors; and
2. Hygiene or Maintenance Factors.
Moti=ational +a%tors
These factors are related directly to the job itself. The presence of such factors creates
a highly motivating situation, but their absence does not cause dissatisfaction. People
tend to respond positively to the presence of such factors. Herzberg mentioned six such
1. Recognition
!. Advancement
(. Responsibility
.. Achievement
?. Possibility of Growth
@. Work itself
Factors like achievement and responsibility are related to job itself and others emanate
from it. This set of factors has been designated as motivators or satisfiers and are
related to job contents.
G3,iene or Maintenan%e +a%tors
This set of factors is such that their presence does not significantly motivate the
employees but their absence cause serious dissatisfaction. The non-availability of such
factors is likely to affect motivation and bring down the level of performance.
Maintenance factors mostly are related to environment, outside the job.
Herzberg named ten such factors:
1. Company policy and administration
!. Technical supervision
(. nterpersonal relations with subordinates
.. Salary
?. Job security
@. Personal life
B. Working conditions
C. Status
F. nterpersonal relations with supervisors
10. nterpersonal relations with peers and colleagues
Hygiene or maintenance factors are the context factors. They provide a background on
which people work. They create an atmosphere for doing work, but there is nothing in
them that motivates them. According to Herzberg, they can dissatisfy by their absence
but cannot satisfy by their presence.
Che%2 )o7r *ro,ress #E$
*lease 'ention 8hether the follo8in, state'ents are tr7e or false:
1. There are five types of needs according to Maslow's theory. .. True.
!. Self-esteem needs is the highest need in Maslow's Need Hierarchy. .. False.
(. Herzberg theory is prescriptive in nature. .. True.
.. Herzberg's theory is based on two factors namely motivators and hygiene. .. True.
ERI Theor3
This theory is based on existence, relatedness and growth. These are the three sets of
needs in organization. ERG theory was advanced by Clayton Alderfer. Alderfer argued
on the same lines of Maslow that people have needs in a hierarchy and that these
needs are important determinants of human behaviour relating to work performance.
These needs are related to survival and growth.
However, the ERG theory differs from the Maslow's theory in following respects:
+irst0 instead of five levels of needs, the ERG theory indicates only three.
Se%on&0 Maslow's theory postulates a rigid step like progression. The ERG theory,
instead, postulates that more than one need may be operative at the same time.
Thir&0 Maslow argues that a person will stay at a certain level until that need is
satisfied. The ERG counters by noting that when a higher level need is frustrated, the
individual's desire to increase a lower level need takes place.
A%hie=e'ent Moti=ation Theor3
This theory was developed by David C. McCelland and his associates. According to this
theory, there are three needs, namely, need for achievement, need for power and need
for affiliation.
Nee& for A%hie=e'ent
Employees with high achievement motivation derive satisfaction from achieving goals.
Succeeding at a task is important to them. Although people with a high need for
achievement are often wealthy, their wealth comes from their ability to achieve goals.
However, high achievers are not motivated by money per se; money is their indicator of
achievement. They prefer to work independently and dislike easy tasks which do not
throw any challenge or a competitive situation.
Nee& for *o8er
The employees exhibiting the need for power derive satisfaction front the ability to
control others and having control over resources. Actual achievement of goals is less
important to them than the means by which goals are achieved.
ndividuals with a high need for power derive satisfaction from being in positions of
influence and control. Organizations that foster the power motive tend to attract
individuals with a high need for power (for example, military, civil services and political
Nee& for Affiliation
ndividuals exhibiting this need as a dominant motive derive satisfaction from being
social with interpersonal activities. They have a strong need for interpersonal ties and to
'get close' to people psychologically. f asked to choose between working at a task with
those who are technically competent and those who are their friends, individuals with
high need for affiliation will choose their friends.
Vroo'Ls E65e%tan%3 Mo&el
This theory has several names such as instrumentality theory, path-goal theory and
valence-instrumentality e+pectancy theory. The theory was developed by Victor H
Vroom. The expectancy model is based on the belief that motivation is determined by
the nature of the reward people expect to get as a result of their job performance. The
underlying assumption is that a man is a rational being and will try to maximize his
perceived value of such rewards. He will choose an alternative that would give him the
maximum benefit. People are highly motivated if they believe that a certain type of
behaviour will lead to a certain type of outcome and their extent of personal preference
for that type of outcome.
There are three important elements in the model. These are:
This is a person's perception of the likelihood that a particular outcome will result from a
particular behaviour or action. This likelihood is probabilistic in nature and describes the
relationship between an act and its outcome. For example, if a student works hard
during the semester, he will expect to do well in the final examination though he cannot
be hundred per cent certain. There is some probability attached to this outcome.
This factor relates to a person's belief and expectation that his performance will lead to
a particular desired reward. t is the degree of association of first level outcome of a
particular effort to the second level outcome which is the ultimate reward. For
example, working hard may lead to better performance which is the first-level
outcome, and it may result in a reward such as salary increase or promotion or both
which is the second-level outcome. f a person believes that his high performance will
not be recognized or lead to expected and desired rewards, he will not be motivated to
work hard. The instrumentality is the performance-reward relationship.
Valence is the value a person assigns to his desired reward- He may not be willing to
work hard to improve performance if the reward for such improved performance is not
what he desires. t is not the actual value of the reward but the perceptual value of the
reward in the mind of the person that is important. An employee may be motivated to
work hard not to get pay raise but to get recognition and status. Another employee may
be more interested in job security than status.
A&a's EJ7it3 Theor3
Although several authors have contributed to this theory, it was James Stacy Adams
whose formulation became prominent. The following terms are relevant to this theory:
1. *erson: The individual for whom equity or inequity exists.
!. Co'5arison: Any group or individual used by a person as a reference regarding
inputs and outcomes.
(. In57ts: Characteristics which individuals bring with them to the job, namely,
education, knowledge, skills, attitudes, experience, etc.
.. O7t%o'es: Salary, promotion, perquisites received from a job.
The theory proposes that the motivation to act develops after the person compares
inputs and outcomes with the identical ratio in comparison to the other person. nequity
is defined as the perception that person's job inputs and outcomes ratio is not equal to
the inputs and outcomes ratio in comparison to the other.
The basic equity proposal assumes that, upon feeling inequity, the person is motivated
to reduce it. Further, the greater the felt inequity, the greater would be the motivation to
reduce it.
When attempting to reduce inequity, the person may try a number of alternatives.
He may alter his inputs or, alter his outcomes or, distort his inputs and outcomes
cognitively or, leave the field or try to alter or cognitively distort input and outcomes in
comparison to the other, or force him to leave the field.
*orters *erfor'an%e Satisfa%tion Mo&el
This model starts with the premises that: #a$ motivation (effort or force) does not equal
satisfaction and, or, performance. Motivation, satisfaction and performance are all
separate variables and related in different ways; #"$ effort (force or motivation) does not
directly lead to performance. t is mediated by abilities/ traits and role perceptions; and
#%$ the rewards that follow and how these are perceived will determine satisfaction. The
model suggests that performance leads to satisfaction.
Reinfor%e'ent Theor3
This theory assumes that the consequences of an individual's behaviour in one situation
influence that individual's behaviour in a similar situation. Techniques based on this
principle have been developed to change human behaviour. Such a technique,
generally known as 'operant conditioning', has been advocated by B F Skinner. ts
implication is that individual behaviour can be predicted, from a person's past
The operant conditioning approach to behaviour is based on the law of effect, which
states that behaviour which has a rewarding consequence is likely to be repeated.
There is positive reinforcement. On the other hand behaviour that leads to negative or
punishing consequence, tends not to be repeated. There is negative reinforcement.
When operant conditioning is used to control behaviour of employees in an
organization, it is called organizational behaviour modification or OB Mod in its
acronym. Many of the negative traits and behaviour pattern are developed because the
earlier similar behaviour was rewarding or encouraged. For example, a thief has not
been caught several times earlier; he will have courage to repeat his act and behaviour
again and again. Similarly a ticket-less traveler in a Mumbai local train repeats his act
because he has not been caught.
Che%2 )o7r *ro,ress #+$
State 8hether the follo8in, state'ents are Tr7e or +al8:
1. ERG theory was developed by Alderfer.
!. There are four needs as per Achievement Motivation theory.
(. nstrumentality theory is another name for Expectancy Model.
.. There are five items in Equity theory.
?. Reinforcement theory has positive and negative reinforcements.
@. ndividual's behaviour in one situation does not influence that individual's behaviour in
a similar situation.
Moti=ation an& Beha=io7r
Behaviour of an individual is generally motivated by a desire to achieve some goal.
Sometimes goal may not always be known to the individual but still he may behave in a
particular way. 'Why did do that?' or 'Why did not do that?' Answers to these
questions will indicate the reason for a particular behaviour. Behaviour is either an
'activity' or, 'a series of activities'. Each activity is supported by motivation. To predict
behaviour, managers must know which motives or needs of people evoke a certain
action at a particular time.
Every individual carries a set of inner motivations and drives that influence the way he
behaves much more radically than he realizes. ndividuals differ not only in their ability
to do but also in their will to do, or motivation. Motives are sometimes defined as needs,
wants, drives, or impulses within the individual. These are directed towards goals, which
may be conscious or subconscious. Motives are the 'whys' of behaviour. They arouse
and maintain activity and determine a general direction of the behaviour of an individual.
n essence, motives or needs are the mainsprings of action. When we use these two
terms interchangeably motives and needs we refer to something within an individual
that prompts that person to action.
Goals are outside an individual. Goals are sometimes referred to as 'hoped for' rewards
towards which motives are directed. Psychologists use the term 'incentives' for these
goals. ncentives include tangible financial rewards such as increased pay and also the
non-financial intangible rewards such as praise or power; and both tangible as well as
intangible rewards are crucial in evoking behaviour.
Moti=ation to ;or2
A mere knowledge of theories of motivation is not sufficient for the manager. He should
also know specific ways and techniques to motivate employees in the work situation.
Most of these techniques are practical in nature and can be adopted by him in the
normal course. While there are several ways of motivating employees in the work
situation, some of the common incentives like money, appreciation, job enlargement,
job enrichment, job rotation, participative management, and quality of work are
frequently used in organizations.
Most of the motivational theories have indicated that money is an important motivator
for several reasons. Money is capable of purchasing several things which in turn meets
several needs of a person. For example, Maslow's physiological needs like food,
clothing and shelter can be met through money. So in organizations the wage/salary
structure becomes an important and powerful motivator for the employees. The levels of
salary should not only satisfy all the basic needs of the employee but should also meet
his higher needs like entertainment, pleasure, etcetera.
Money has limited impact as a motivator. t has a diminishing return with regard to its
utility. Employees look for something beyond salary and monetary benefits. The most
effective non-monetary benefit is the recognition and appreciation for a good job. t
satisfies the self-esteem need and the employee feels important and tries to perform still
better to be recognized as a distinct member of the work group. t also has an impact on
other group members. They also try to improve their performance to get recognition.
The managers must use this incentive wherever possible to acknowledge the
contribution of the employees. However, it should be done in an objective and impartial
manner so that it does not have any adverse impact on the other members of the work
Jo" Enlar,e'ent
Job enlargement refers to assigning more and more jobs of same level to diversify the
skills of a person. For example, in BM a machine operator was waiting fora machine
setter to come and set the machine. He started setting the machine himself. Later he
became an expert in setting the machine. Job enlargement helps both the organization
and the individual. The individual gets the satisfaction of working on a variety of jobs
and learns more and more skills whereas the organization gets a person who can
handle different jobs.
Jo" Enri%h'ent
A job is enriched when it is exciting, challenging and creative and involves higher
responsibility. t should give the employee more decision-making, planning and
controlling powers. A few studies conducted in the United States demonstrated the
usefulness of job enrichment. For example, employees at AT&T showed improvement
in job performance after job enrichment. Another study with technicians, engineers, and
sales representatives showed similar results. Job enrichment is generally effected either
by promotion to a higher post or by delegation of authority.
Jo" Rotation
Job rotation means, shifting an employee from one job to another at a same level with
different functionality. For example, somebody may be working in the dispatch seat. He
maybe asked to do typing. Job rotations are quite common in banks. When employees
are rotated in different jobs, the manager will know what type of job suits which
employee. Further, it removes boredom of the employee as he is not required to do the
same job for a long period. n spite of the advantage of job rotation a large number of
employees prefer to continue on the present job because of inertia and fear of unknown.
The time duration required for job rotation depends upon the nature of job being carried
out and the nature of the learning curve of a job in relation to one's capabilities. For
example, a highly qualified employee is placed on a routine job; he will reach to highest
level of efficiency in a shorter time and will start getting disinterested and over confident
resulting in a lowering of his performance. Before reaching such a stage the person
should be rotated to some other job. On the other hand there are certain jobs which will
provide more and more challenges and will provide learning opportunities all the time.
Employee participation in management is one of the tools available to increase the
motivation levels of employees. Participative management refers to associating
representatives of employees at every stage of decision-making. Starting at the shop,
participation may extend right to the board level. Participation encourages employees'
contributions to managerial decisions, goals and plans along with suggestions on how
these can be implemented. Employees feel their importance in the organization, and
their power need is satisfied to some extent. Such participation by the key employees
reduces the resistance to change. Many times it is used as a strategy by the
management before initiating any major change. Thus, participation fosters greater
acceptance of change.
The motivational basis of participation is that employees like to be asked their views
about the problems affecting them and feel happy when they know that their ideas have
some influence in the ultimate management action taken. The underlying assumptions
are: people derive satisfaction from being a part of the decision-making process, from
doing an effective job, and from having self-control rather than management control.
Most people readily agree more to what, in part, they have created than what is alien to
them. Besides, participation fosters the feeling of belonging and being wanted. t inflates
or at least recognizes a person's ego and provides a needed sense of importance. n
addition, it encourages better decision-making, gets people to accept responsibility,
promotes teamwork, and emphasizes the use of creativity.
Some feel that in the exercise of workers participation, the worker should be given some
well-defined authority so that he can make his own decision independently. When one
has to make a decision, he acts with responsibility.
97alit3 of ;or2 Dife
The term 'quality of work life' means, different things to different persons. t is a
combination of physical and emotional comforts. For example, to a clerk in dispatch
seat, it may just mean a fair day's pay. To a mine worker, it means safe working
conditions. Shop floor workers want their supervisors to treat them with dignity. A
probationary officer, who has just joined the bank, may look forward to opportunities for
promotion, creative tasks and a successful career. The following factors contribute to
the quality of work life:
1. Adequate and fair compensation.
!. A safe and healthy environment.
(. Jobs aimed at developing and using employee's skills and abilities.
.. Growth and security; jobs aimed at expanding employees' capabilities rather than
leading to their obsolescence.
?. An environment in which employees develop self-esteem and a sense of identity.
@. Protection and respect for employee's rights to privacy, dissent, equity. etc.
B. A sensible integration of job career and family life and leisure time.
Role means a set of expected behaviour patterns attributed to someone occupying a
given position in a social unit. The idea of 'role' comes from Sociology. t is the pattern
of actions expected of a person in activities involving others. t includes both rights and
obligation. t refers to the part that an individual is required to play as a result of
occupying some position or status in life. Human beings, as a result of occupying
various positions play such roles as father, mother, worker, manager, nurse, friend and
soldier. All these are separate and well defined roles. But every human being plays
many roles. Thus an individual may be a worker, a father, a son, a trade union leader,
and so on. All these constitute what is called the role space of that person. At the centre
of the role space is the self.
Con%e5ts an& Anal3sis
Role and position are two sides of the same coin. But they are different concepts. Role
is a position one occupies in a social system. t is defined by the functions one performs
in response to the expectations of the significant members of the social system. Position
is a relational and power-related concept, but role is an obligational concept. The
concept of role is important for the integration of the individual with the organization.
The organization has its own structure, systems and procedures and goals. Similarly the
individual or a person connected with the organization, has his own personality and
needs. All these aspects interact with each other and get integrated into a role.
The concept of role is central to an organization. Similarly, the concept of self is central
to the several roles of a person. A person performs various roles that are centred
around the self and are at varying distances from the self (and from each other). These
relationships define the role space, which is then a dynamic interrelationship between
the self and the various roles an individual occupies.
Similarly, role set is a pattern of interrelationships between one role (called a focal role)
among many others. For example, all the different persons with whom a supervisor
interacts have role expectations concerning the way in which the supervisor should act,
and these expectations collectively make up the role set for the job. n a role set map,
the focal role is in the centre.
The concept of role widens the meaning of work and the relationship of the employee
with other significant persons in the system. The concept of job is more prescriptive in
nature, while role includes more discretionary part of work. A job assumes relationship
of the employee with his supervisor whereas the role emphasizes his relationship with
all those who have expectations from him (as he has from them). Recently, much
emphasis has been given to the development of roles and making them more effective
in organizational context. Certain important aspects of role are discussed now:
Role Sta,nation
Most of the organizations have definite promotion policies. They promote persons
based on the appraisal of their performance. When a person gets a promotion, he
enters into a new role. The new role demands that an individual outgrow the previous
one and take charge of the new role effectively. But the person may fail in his new role.
This is bound to produce role stress and he may experience role stagnation even
though he has occupied a new role in the organization. For example, a senior clerk, who
has put fifteen years of service in a bank, may be promoted as a junior officer. Apart
from the changes in the position, he is now occupying a new role. The role expectations
from the position of a junior officer in the bank are different from that of a clerk. This
person may not be able to take charge of this new role effectively, he may therefore,
experience role stagnation which in turn causes role stress.
InterERole Distan%e
When an individual occupies more than one role, there are bound to be conflicts
between them. For example, a bank manager quite often faces a conflict between his
organizational role as a manager and his role as a husband and a father. His wife and
children may place demands on his time. He may not be able to cope with their
expectations, if he has to perform his organizational role effectively. He may therefore
experience inter-role conflicts which in turn cause role stress.
Role Set Confli%ts
The role set consists of important persons who have different expectations from the role
that an individual occupies. The conflicts arise due to incompatibility among the
expectations of significant others and the individual himself. These role set conflicts take
the following forms:
1. Role a'"i,7it3
Sometimes an individual may not be clear about the various expectations that people
have from his role and this causes role ambiguity. t may be due to lack of information
available to a role occupant or may be due to lack of understanding of the cues
available to him. Role ambiguity may be in relation to activities, responsibilities, priorities
or general expectations. Generally role ambiguity is experienced by persons occupying
roles that are newly created or roles that are undergoing change. For example, a bank
has set up a branch computerization department. A new post of Deputy General
Manager (DGM) has been created to head this department. Somebody who is already a
DGM has been posted to this department. Many computer professionals who have been
recruited to work in this department are reporting to him. A doubt may arise regarding
the eligibility of the DGM to head the department. Perhaps this DGM has been selected
on the basis of relatively better computer knowledge possessed by him than his
!. Role E65e%tation Confli%t
When there are conflicting expectations or demand from a role, the role occupant
experiences conflict and stress. The conflicting expectations may come from the boss,
subordinates, peers, customers, etc., and his role occupant is not sure how he should
act in such situations.
(. Role O=erloa&
Sometimes a role occupant feels that there are too many expectations from the
significant others in his role set. For example, a bank branch accountant may face
different types of problems. When the branch is set to commence business, he may
have to allocate duties to take care of vacant seats to his employees. At the same time,
some customers may rush to him for certain clarifications. Simultaneously, the branch
manager may call him for certain important discussions. n such situations, this branch
accountant may experience role overload. Role overload may also occur when the role
occupant lacks power or where there are large variations in the expected output or
when there is no proper delegation.
.. Role Erosion
Sometimes a role occupant feels that certain functions which he would like to perform
are being done by some other person having a different role. Role erosion is the
individual's subjective feeling that some important expectations that he has from a role
are shared by other roles within the role set. Some organizations create new positions
as a part of their reorganization exercise. Such new positions, which also create new
roles, may take away certain functions of the existing roles. n such situations, the
existing role occupants may experience role erosion. Sometimes, the organizations may
also redefine the existing roles and this may result in the present role occupants
experiencing role erosion. For example, in one small sized bank, the sole general
manager was looking after both planning and operations. As the business of the bank
increased, it created another post of a general manager and the planning was assigned
to the new general manager. The existing general manager felt that his role has been
eroded as he was now not connected with planning.
?. Reso7r%e Ina&eJ7a%3
A role occupant may experience resource inadequacy when the resources required by
him to perform his role effectively are not available. Resources may include information,
people, material, finance, facilities. etc. For example, in these days of rapid
communication facilities, a bank official may experience resource inadequacy if the
branch is not provided with certain latest communication equipment like fax, nternet,
@. *ersonal Ina&eJ7a%3
When a role occupant feels that he does not have enough knowledge, skills or
experience to perform a role effectively, he may experience role stress. Sometimes
persons who are given new roles without adequate training are likely to experience
personal inadequacy. The difference between role ambiguity and personal inadequacy
is that: in the former, the role occupant has certain amount of knowledge of his new
role, but he experiences some ambiguity whereas in case of personal inadequacy the
role occupant suffers from lack of knowledge or skills to perform his new role.
B. Role Isolation
n a role set, the role occupant may feel that certain roles are closer to him, while other,
are at a greater distance. The main criterion of distance is the frequency and ease with
which he performs the role. When linkages are strong, the role isolation is low and vice
versa. For example, when the branch accountant goes on leave in a bank, the branch
field officer, (person in charge of advances), may be asked to perform the accountant's
role as it is felt that the field officer's role can be kept in abeyance temporarily in small
branches. n such cases, the field officer may experience role isolation, if he is unable to
perform the accountant's role effectively.
n organizations, generally roles are expected to be well-defined and set so that one can
say that an employee has a given role. This is only partially true. n course of time, he is
likely to experience a variety of incidents and develops expertise to deal with similar
situations even proactively. For example, a paying cashier may know the credential of
the customer well and is likely to pay-out even before checking the balance available in
the account. A personnel manager, because of his closeness with certain government
authorities may take decisions without consulting the union, etc. Thus, apart from the
given role, the role may be person driven as well. Hence, we find differences in the way
a predecessor and a successor handle the same function.
Now, in this background, the H.R. man has the role or duty to design the role of
employees, especially in today's turbulent times where technology, markets and
products are changing all the time, impacting the roles drastically. Hence, functions, the
need to decentralize control and decision-making, systems that operate at any given
time, clarity of individual's task and position, economy of effort, vision for attaining the
objective of the company and enable the employee to become more competent in his
field should be the criteria. For this purpose, knowledge must be built into products and
services to get benefits of excellence. For example, a highly sophisticated computer and
technology backed bank cannot have experts in manual systems managing branches.
The technology will not be used to the possible extent, if the manpower using the
technology is not competent and trained.
Che%2 )o7r *ro,ress #I$
Mention 8hether the follo8in, state'ents are Tr7e or +alse:
1. The role integrates an individual with an organization. .. True.
!. Role and position are one and the same concept. .. False.
(. Each individual occupies and plays several roles. .. True.
.. Role ambiguity is caused due to personal inadequacy. .. False.
?. ntra-role conflict leads to role isolation. .. True.
@. Role set conflicts for a role occupant refers to erosion of role due to creation of new
roles and positions. .. False.
Det Us S7' U5
Organizations are social systems. They are composed of individuals. Each individual's
behaviour in the organization is affected by several factors. These factors are personal,
psychological, organizational and environmental. We have examined in this unit several
theories of personality and human behaviour. We also discussed certain critical
dimensions of personality that influence human behaviour at work. Personality and its
interaction with the environment help us to understand why employees behave as they
do. We also saw how managers can help employees by understanding the effects of
personality on behaviour and coping mechanisms. The connection between personality
and brain has been discussed with a view to examining the influence of biological
factors on personality. The factors affecting employee behaviour have also been studied
in detail.
We have also studied the impact of diversity in the organizational context and the role of
HR policies in diversity management. One of the major factors of diversity is the gender
difference. We have studied the gender issues with reference to recruitment, service
conditions and protection of interest of women at workplace.
We have surveyed different theories of motivation and their practical implications on
human behaviour. While each theory is unique and has several interesting features, no
single theory brings out clearly all the complexities of motivation and its impact on
performance. However, all the theories put together contribute to our understanding the
concept of motivation and its applicability in organizational setting.
Role is a position one occupies in a social system. Role and position are, however,
separate concepts. They are two sides of the same coin. Concept of role is important for
the integration of an individual within an organization. The organization has its own
structure and its goals. Similarly, the individual has its personality and its needs. All
these aspects interact with each other and get integrated into a role.
Ego; Extroversion; Heredity; ntroversion; Locus of Control; Machiavellianism;
Personality; Psychoanalysis; Self-Esteem; Behaviour Modification; Expectancy;
Hygiene Factors; nstrumentality; Job Enlargement; Job Enrichment; Motivation; Money;
Need for Affiliation; Need for Achievement; Need Hierarchy; Need for Power; Quality of
Work Life; Role Ambiguity; Role-Coping; Role Distance; Role Efficacy; Role Erosion;
Role solation; Role-Making; Role Stress.
Answers to Check Your Progress
1. True; 2. True; 3. True; 4. False; 5. True; 6. True; 7. True; 8. False R 1. True; 2.
True; 3. False; 4. True; 5. True;
1. True; 2. False; 3. True; 4. False; 5. True; 6. True; 7. True; 8. False D, 1. Yes; 2. No;
3. Yes; 4. Yes;
1 1. True; 2. False; 3. True; 4. True;
1 1. True; 2. False; 3. True; 4. False; 5. True: 6. False (1: 1. True; 2. False; 3. True;
4. False; 5. True; 6. False
Ter'inal 97estions
1. What are Erikson's stages of Personality Development?
2. What are the advantages of employing Type A personality in organizations?
3. Write a note on factors affecting human behaviour.
4. What are the factors of diversity and their impact at workplace? How to manage
diversity through effective HR system?
5. What is motivation? Why is it a critical issue of interest to managers in organizations?
6. Compare and contrast Maslow's Need Hierarchy Theory with Herzberg's Two-Factor
Theory of Motivation.
7. Write a brief note on the following:
(1) ERG theory of motivation
(2) Vroom's expectancy model of motivation
(3) Equity theory
(8) Write a note on Achievement Motivation theory advocated by David McCelland.
(9) How the concepts of job enlargement, enrichment and rotation can be applied to
motivate the employees?
10. Explain the following:
(1) Role space conflicts
(2) Role set conflicts
Case 1
ABC Limited is a major manufacturer of refrigerators in ndia. While the main
components of the refrigerator are manufactured by the company, other parts of the
final product are produced by the subcontractors. The company employs around 300
hundred workers. t does not have state-of-the-art manufacturing facilities and also
suffers from low productivity of the employees. Due to secured working conditions
productivity was low. The employees' morale also remained low due to less market
share for its product.
The company decides to introduce a profit sharing plan in terms of which they would be
encouraged to improve upon productivity and quality of product. The company promised
share in the extra cost saved or extra profit earned. nitially the workers were skeptical
about the programme. n due course workers started getting monetary benefits as per
the company's promise. While their programme was successful, some workers were
unhappy due to sharing of gains by all workers equally.
1. Do you think gains-sharing programmes are considered to be motivators for workers
as individuals? Explain how the programme has motivated the workers at ABC Limited.
2. Should the management continue with the current manufacturing facilities or should it
invest capital in upgrading the technology of production? Which option would help the
management more and why?
3. What can the management do about the unproductive workers who are getting the
same benefits as the productive workers?
Case !
Mr. Satwant Singh joined a bank as a specialized officer as economist. He got first
promotion quite early alongwith his batch mates and his performance as well as
motivation level was quite high. Being the youngest in his batch he was expecting to
reach the level of DGM to head the Research Department of the bank. He used to have
difference of opinion with his boss Mr. Mohanty, both on official and other issues. Mr.
Mohanty was not happy with the behaviour of Mr. Singh and used to criticise him
publicly. Mr. Singh was trying to ignore his comments and was concentrating on his job
performance. Since both Mr. Mohanty and Mr. Singh belonged to the specialised
department there was no chance of getting rid of each other. When the time for next
promotion came, Mr. Singh was hopeful to get the promotion because of his
performance. To his surprise, he was not selected. He came to know informally that his
Performance Appraisal Report (PAR) was not up to the mark. He was thoroughly
disappointed but continued to perform. He did not get the promotion next year also.
Most of his batch mates have superceded him. He decided to leave the bank. He got an
opportunity in another bank and decided to join at the same level losing all the benefits
of his seniority.
Discuss the above case with reference to different motivational theories.
S7,,este& for +7rther Rea&in,
De, N R; Alternative Design of Human Organizations, Sage Publications, New Delhi.
Dwivedi, R S; Human Relations and Organizational Behaviour. Oxford & BH, 1993.
Ellen Ernst Kossek and Sharon A, Lobel, Human Resource Management
Transforming the Workplace, A Maya Blackwell mprint, New Delhi, 2001.
Freidman, Meyer and Ray, Roseman; Type A behaviour and your heart, Alfred A Knopf,
Holland, J L; Making Vocational Choices: A Theory of Vocational Personalities and
Keith, Davis; Human Behaviour at Work: Organizational Behaviour McGraw-Hill, NY,
Lorsch, J W and Morse, J J; Organization and their Members: A Contingency Approach,
Harper and Row, New York, 1974.
Luthans, Fred; Organizational Behaviour, New York: McGraw-Hill, 1989.
Pareek, Udai; Motivating Organizational Roles: Role Efficacy Approach, Rawat
Publications, 1984.
Rogers, C R; The Concept of Fully Functioning Person, Mimeograph Paper, 1955.
Stephen, P Robbins; Organizational Behaviour Concepts, Controversies and
Applications, Prentice-Hall of ndia, New Delhi, 1989.
*A*ER 1
Unit 23 Employees' Feedback and Reward
..0 Objectives
..1 Employees' Feedback
Check Your Progress (A)
..! Reward and Compensation System
Check Your Progress (B)
Let Us Sum Up
Answers to Check Your Progress (A & B)
Terminal Questions
Suggested for Further Reading
After studying this Unit, you should be able to:
1. appreciate the use of employees feedback in formulating HR policies,
2. understand the process of getting employees feedback through surveys,
3. understand the process of reward and compensation, and
4. have an idea about the compensation system in the ndian Banking ndustry.
Satisfaction of employees at workplace is considered an important parameter for
achieving organizational objectives. Progressive organizations always try to get the
regular feedback from the employees on various human resource management
aspects, and new initiatives taken in this regard through some satisfaction or climate
surveys. The information is gathered both formally and informally about the attitude and
satisfaction of employees. This information is used for refining and fine tuning the policy
initiatives from time to time. At formal level the information and feedback is gathered
through well designed questionnaires, psychological instruments, suggestion schemes,
etc. The informal information is also gathered through discussions with the
representatives, observations of managers and superiors based on the behaviour
pattern of the employees. Vital information can also be gathered while conducting
appraisal interviews and also through exit interviews of employees particularly those
who leave the organization unexpectedly. These interviews provide useful clues to the
management to understand the expectations of the employees and to fine tune the
personnel policies and human resource development initiatives.
Many organizations are attempting to use climate survey data and performance
data to measure and evaluate the quality of their management of human resources.
Research conducted by Schuster (1982) based on a survey called Human Resource
ndex (H R ) provides some insight into current H R M practices. When several
thousand employees in a cross section of twenty-eight diverse organizations were
surveyed for fifteen factors in their work situations, they strongly expressed that they
were least satisfied with the opportunities they had to participate in the decision-making
of the organization. They also voiced that they did not get enough information about
business objectives, goals, and plans of the organization. The employees were also
relatively dissatisfied with their reward systems and their relative distribution within their
Perhaps the most important conclusion that can be drawn from such surveys is
that how effectively an organization is managing its people. Moreover, the survey data
have proved helpful in diagnosing specific problems and in initiating organizational
development initiatives by opening up two-way communication about matters of
practical significance to the organization and its employees.
+ee&"a%2 Thro7,h Cli'ate S7r=e3s<
Climate surveys are most popular and prevalent means to gather feedback from
the employees. f designed properly, these surveys can provide very useful information
and clues to the management for effective human resource management. Organizations
used to measuring employees' perceptions of the prevailing climate in an organization
are called climate surveys. Although climate is usually measured for the organization as
a whole, scores are typically analyzed department/division wise so that the
management can assess the climate in different units and compare them with other
units. The Human Resources Development/Management department ordinarily
coordinates the entire exercise, from designing the questionnaire to administering the
questionnaire and tabulating and presenting the results. The assistance of line
managers is also sought in administering the questionnaire. The results of the survey
are presented to the top management by the HR Department and the view of the
departmental heads/unit heads are obtained to analyze the position and finding out
viable solutions for improvement.
Although the content of the climate surveys may vary from organization to
organization, the coverage of a typical survey can be as follows:
1. Str7%t7re: The feeling that employees have about the constraints on the groups,
rules, regulations, procedures, communications channels (layers in decision making),
delegation and authority, etc.
!. Res5onsi"ilit3: The feeling of being your own boss, clarity of role and responsibility
vis-a-vis superior, subordinates and peers, etc.
(. Re8ar&: The feeling of being rewarded for a job done well, perception about reward
and punishment system, perception about pay and promotion, etc.
.. Ris2: The sense of riskiness and challenge in the job and in the organization, and
any emphasis on taking calculated risk (risk taking is encouraged and bona fide errors
are protected) or playing safe is encouraged and accepted.
?. ;ar'th: The general feeling of fellowship that prevails in the workgroup atmosphere,
the prevalence of informal supporting culture and social groups.
@. S755ort: The perception about helpfulness of managers and other employees in the
group, emphasis on mutual support from above and below in the heirarchy.
B. Stan&ar&s: The perceived importance of implicit and explicit goals and performance
standards, the emphasis on doing a good job, the challenge represented in personal
and group goals.
C. Confli%t: The feeling that the managers and other workers want to hear different
opinions, the process of conflict resolution, opportunity to express the views, etc.
F. I&entit3: The feeling of belonging to the organization and perceived value in the
organization and work group, etc.
The survey should be conducted from time to time at reasonable intervals to
analyze trends in the matters of attitude, expectations, satisfaction, and frustrations, if
any. The survey may be completed utilizing variety of instruments, both standard
(already available in published form) and/or custom-tailored to a particular organization.
The consequences of unfavourable climate characteristics include using job time
to confer with peers in order to cope, high stress, looking for another job, considering
reporting sick, reduced communication with superiors and considerable job
dissatisfaction. n contrast, the likely advantages of favourable climate characteristics
are open problem solving, loyalty, cooperation, among peers and across groups,
enhanced motivation and satisfaction, and high quality customer service. We can also
infer that the top management in the banks with the help of HRD department should
formulate a conscious strategy to create and maintain the favourable climate.
There are many pros and cons regarding employee survey, and if some bank
decides to conduct such survey, help of some expert may be taken especially in
designing the questionnaire, selection of sample respondents, interpretation of results
and deciding strategy to overcome some genuine problems. f the survey is not done
scientifically and the employees are not prepared to voice their genuine opinion in a
constructive way, employee survey can create more problems than they can solve. t is
always desirable to communicate the results of the survey to the employees may be in
a summarized form otherwise it will create more confusion.
Che%2 )o7r *ro,ress #A$
State 8hether the follo8in, state'ents are Tr7e or +alse:
1. Employees' feedback is useful for the organization. .. True
!. Conducting climate surveys does not serve much purpose as employees do not
come out with their views freely. .. False.
(. The surveys have to be designed well otherwise they can be counter productive. ..
.. The survey questionnaire should be customized for different organizations keeping in
view the peculiarity of the organization. .. True
?. t is beneficial to take the help of a consultant for organizing a climate survey. ..
@. There is no need to develop a questionnaire for the organization as they are available
in the marked which can be used across the organizations. .. False.
The prime motive of a person to take up a job is to meet his basic needs first.
The basic needs are adequately met by the wages he gets for his contribution to the
organization. The wages in the form of compensation is viewed as the main attraction to
join or change a job. The compensation should be reasonable and justifiable to keep the
employee happy and committed to the organization. There should also be an inbuilt
reward system for better performance. Thus, the basic goal of an individual in an
organization is to earn satisfactory wages or compensation and perform well to be
recognized for other financial and non-financial rewards. The salary and wage structure
of any organization is an important part of its personnel policy. t is necessary that the
efforts of the employees are adequately compensated. f the compensation is
disproportionate to the type of work and the industry trend, either the company will
attract only a poor quality of employee or there will be a very high turnover ratio. The
compensation should not be so meagre that employees do not feel motivated to put in
their best. n such cases all good employees will leave and the organization will be left
only with mediocre performers. Too high a level of compensation may also prove to be
counter-productive. deally, the compensation should be such that it continually attracts
talent, it is a major source of retention of the existing manpower and has an edge which
motivates them to give their best. This is, however, a sort of over simplification of the
situation. At this stage let us note that there are different motivating factors and
compensation is one of them. We will see how the compensation gets decided, theories
and philosophies behind it, and other related issues.
T35es of Co'5ensations
Let us first understand what 'compensation' means. t may be defined as money m
remuneration received for the performance of work plus the kinds of benefits provided
by the organization. f these benefits are quantifiable in terms of money they get added.
Compensation is expressed in terms of money. t would thus include: wages or salary,
bonus, cash allowances and benefits such as accident, health insurance cover,
employer's contribution to the retirement funds, provision of accommodation, etc. The
jobs are broadly classified in four groups and the compensation for them is commonly
referred to as shown below:
1. Managerial (top, middle, junior) ... remuneration
!. Supervisory ... salary
(. Clerical or Administrative ... salary
.. Unskilled, semi-skilled, skilled and highly skilled ... wages
The words remuneration, salary and wages are generally used interchangeably
in different context and form part of compensation. The compensation can also be
grouped by the method of payment. Compensation could be payable to an individual for
his contribution, to a team of a group for certain measurable results, a certain fixed
component every month and a variable portion related directly to the performance of an
individual or of the team.
Co'5ensation Base
Compensation policy is an important element in personnel management. What is
the basis or factors on which compensation gets decided? t could be:
1. Company objectives
!. Market situation or prevailing market rate
(. nternal and external pressures.
Co'5an3 o"Ae%ti=e is the main basis on which the level of compensation gets
determined. There are certain companies which aim to be the highest pay masters and
try to attract people. The company philosophy in such cases could be to attract the best
talent at a high salary but keep the size of the company very lean. Some companies
recruit people only from the prestigious professional institutions to gain professional
edge. To attract people from these sources will obviously take the compensation level
quite high. The company objectives in turn will depend on its capacity to pay and its cost
benefit analysis.
Mar2et sit7ation is another factor which will decide the compensation level. Certain
types of skilled people and certain kind of experienced candidates are very scarcely
available. For example. in banking, exposure in the area of foreign exchange trade,
treasury or risk management is available to a very few candidates. Naturally, their
market demand and value is high. The market situation depends upon prevailing market
rates for certain types of employees and expertise to be recruited and their demand and
supply situation. The requirement goes up if the new companies come into existence.
The organization's policy of 'overall growth' or 'the right man on the right job' also has an
impact on market condition. f the policy of overall growth is followed it may be possible
to develop from internal source a hand, to man such a position and the company may
not be totally at the mercy of the market situation.
Internal an& e6ternal fa%tors determine the levels of compensation. nternal factors
could be: capacity of the company to pay, bargaining power of the unions, attraction and
retention pressures, the motivational factor, etc. External factors include: labour laws
governing the subject of wages, provisions of Companies Act in respect of remuneration
of managers, different wage concepts, compensation surveys, recommendations of
arbitrations, pay commissions, etc.
Co'5ensation Theories
Let us now consider conceptual and theoretical aspects of compensation. A good
compensation package should cover factors like adequacy, societal considerations,
supply and demand position, fairness, equal pay for equal work an