National Income and Related

Aggregates (Test Questions)

Article Shared by Diptimai Karmakar

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National Income and Related Aggregates! 

Q.1. Define the concept of value added.
Ans. Value Added is the excess of value of output over that of
intermediate consumption.
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Q.2. What are factor incomes?

Ans. Land, Labour, Capital and Entrepreneurship are the four
factors of production and rent, wages, interest and profits are the
respective factor incomes.
Q.3. When will national income be less than domestic
income?
Ans. When net factor income from abroad is negative, national
income will be less than the domestic income.
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Q.4. What is the difference between Indirect taxes and Net

Indirect taxes?
Ans. The difference between indirect taxes and net indirect taxes is
of subsidies because.
Net Indirect Taxes = Indirect Taxes – Subsidies

Q.5. What is meant by production?

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Ans. Production means any activity which creates value or

increases the value of a commodity already produced.
Q.6. What is meant by consumption?
Ans. Using goods and services for satisfying human wants is called
consumption.
Q.7. When can national income and domestic income be
equal?
Ans. National Income and domestic income will be equal in a
closed economy in which net factor income from abroad is zero.
Q.8. What is meant by net exports?
Ans. It is the difference between exports and imports of a country.
Net Exports = Exports – Imports

Q.9. What do you understand by double counting?

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Ans. Counting the value of any good more than once while

calculating the national income is called double counting.
Q.1O. What is the difference between factor cost and
market price?
Ans. The difference between factor cost and market price is Net
Indirect Taxes. Market Price – Net Indirect Taxes = Factor Cost.
Q.11. What are transfer payments?
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Ans. Transfer payments are unilateral payments which are received

without rendering any productive services. For example old age
pension, scholarships etc.
Q.12. What are the two types of final goods?
Ans. The two types of final goods are:
(i) Consumption goods and

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(ii) Capital goods.

Q.13. Define capital goods

Ans. Durable goods used in the production process are called
capital goods.
Q.14. Define consumption goods?
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Ans. Goods used for satisfying wants are called consumption goods.

Q.15. Define ‘depreciation’.
Ans. Depreciation means fall in the value of fixed capital goods due
to normal wear and tear or foreseen obsolescence.
Q.16. What are intermediate goods?
Ans. Goods which are used for further production or for resale are
called intermediate goods.
Q.17. What are final goods?
Ans. Goods which are used for final consumption purpose and/or
final investment are called final goods.
Q.18. What is a circular flow?
Ans. Circular flow means the flow of money income and the flow of
goods and services among different sectors of economy.
Q.19. What is product flow?
Ans. Product flow means flow of factor services and flow of goods
and services.
Q.20. What are injections?
Ans. Additions to the circular flow of income are called injections.
Q.21. Give an example of injection?
Ans. Investment, Government expenditure and Exports.
Q.22. What are leakages?
Ans. Withdrawals from the circular flow of income are called
leakages.
Q.23. Give an example of leakage.
Ans. Savings, Taxes and Import.
Q.24. What is economic territory?
Ans. The geographical area administered by a government in which
there is free movement of goods, human resources and capital is
called economic territory.
Q.25. Who is a normal resident?
Ans. A person who lives in a country and whose centre of economic
interest also lies in the economic territory of that country is called a
normal resident of that country.
Q.26. What is meant by net factor income from abroad?
Ans. The difference between factor income received from abroad
and factor income paid to abroad is called net factor income from
abroad.
Q.27. What are the broad groups in which the economic
territory is divided?
Ans. The broad groups in which an economic territory is
divided are:
(i) Primary Sector

(ii) Secondary Sector

(iii) Tertiary Sector

Q.28. What is meant by ‘Private Income’?

Ans. Income accruing to private sector from all sources i.e. by way
of factor income as well as transfer income, is called private income.
Q.29. What is ‘Personal Income’?
Ans. Income received by individuals from all sources i.e. as factor
income and transfer income is called personal income.
Q.30. When can private income be equal to personal
income?
Ans. Private income will be equal to personal income if corporate
tax and undistributed profits are nil.
Q.31. What is ‘Disposable Income’?
Ans. The part of personal income which is either spent on
consumption by the household or saved is called disposable income.
Q.32. What is national disposable income?
Ans. The income of the residents of a country net of current
transfers from rest of the world is known as national disposable
income.
Q.33. Why is income from sale of second hand goods not
included in national income?
Ans. Sale of second hand goods is not included in national income
because their value has already been counted in the year in which
they were produced.
Q .34. What is real national income?
Ans. National income at constant prices is called real national
income.
Q.35. What is nominal national income?
Ans. National income at current prices is called nominal national
income.
Q.36. What is meant by real gross domestic product.
Ans. GDP expressed in physical quantities is ‘real GDP’.
Q.37. Give the formula for converting national income at
current prices into national income at constant prices.
Ans. National Income at Constant Prices = National Income at
Current Prices / Price Index of Current Year x Price Index of Base
Year
Q.38. Give the formula for GNP Deflator.
Ans. GNP Deflator = Nominal GNP/ Real GNP x 100
Q.39. What is nominal GDP?
Ans. When GDP of a given year is estimated on the basis of price of
the same year it is called nominal GDP.
Q.40. What is green GNP?
Ans. Green GNP is the GNP which would help to attain a
sustainable use of natural environment and equitable distribution of
benefit s of development.
Q.41. Define GDPMP
Ans. GDPMP is the market value of all final goods and services
produced within the domestic territory of a country during one
accounting year.
Q.42.Define flow variables.
Ans. Any variable whose magnitude is measured over a period of
time is called a flow variable.
Q.43. Define stock variable.
OR
What are stock variables?
Ans. Stock variables are the variables whose magnitude is
measured at a particular point of time.
Q.44. Give examples of Non Factor Inputs?
Ans. Raw Material, power, fuel, transportation, stationery etc.
Q.45. What is the name given to the cost incurred due on
Non Factor Inputs?
Ans. Intermediate consumption.
Q.46. Name the Vital (Basic) Economic activities?
Ans. (a) Production
(b) Consumption, and

(c) Capital formation.

Q.47. In what kind of Economy is GNP = GDP

Ans. Closed Economy because in such economy NFIA = Nil.
Q.48. What are the final two uses of a commodity?
Ans. A commodity can either be consumed or used for investment
purpose.
Q.49. How would you treat interest paid by Govt. on public
debt (loan taken from public) while Estimating National
Income.
Ans. No, It is not included In National Income because loan taken
by govt. is treated as Consumption Borrowing.
Q.50. What are the Various Components of “All Current
Transfers’?
Ans. (a) National Debt Interest
(b) Net current transfer within the country e.g., Scholarships, Old
Age Pensions.

(c) Net current transfers from Rest of the World.

Q.51. How will you treat “Work in Progress” while

estimating National Income?
Ans. Yes, it will be included in National Income because it is a part
of capital formation.
Q.52. Name that Macro Economic variable which is
obtained when Net Indirect Taxes are added with Net
current transfers from Rest of the world and National
Income.
Ans. Net National Disposable Income.
Q.53. Name the items which are excluded from domestic
territory?
Ans. (a) Embassies (Territorial Enclaves) of foreign governments
(b) Offices of International Organisations like WHO, World Bank
etc which are located within the political boundary of a country.

Q.54. Which areas are covered under the study of Gross

Domestic fixed capital formation?
Ans. (a) Construction
(b) Machinery and Equipment’s.

Q.55. How are the following treated while estimating

National Income? Give reasons also in brief.
Ans. (i) Interest on Debentures etc.:
Yes, it is included being a bilateral income and hence part of
operating

(ii) Sale of Shares (old/new both):

Not included since it is just a financial transaction with mere change
in ownership.

(iii) Money/gifts received from foreign relations:

Being unilateral transfer payments, these are excluded.

(iv) Dividends:
Yes, because it is a bilateral income and thus part of operating
surplus.

(v) Retirement Pension:
Included as this is an account of services rendered earlier.

(vi) Production for Self Consumption:

Yes, imputed value of production for self consumption is included.

(vii) Old Age pension:

Being unilateral transfer payment, it is not considered.
(viii) Expenses by a firm on medical treatment of its
employees families:
It is duly included as it is part of Compensation of Employees
(COE).

(ix) Compensation for an injured worker:

Not accounted for since it’s a one way transfer payment.

(x) Income Tax:
Obviously not because it is a compulsory transfer payment.

(xi) Gift/Wealth Tax:
Excluded. In-spite of being direct taxes, they are considered to be
paid from past savings/wealth.

(xii) Entertainment allowance to employees for

entertaining clients:
No, since same can be reimbursed as business expense.

(xiii) Free ration to Defence Personnel:

Yes, being part of compensation in kind.

(xiv) Travelling expenses for sales personnel:

No, because these are expenses that get reimbursed. There is no
income for the recipients.

(xv) National Debt Interest/Interest on public debt:

Outside the purview of NI as it is just a one way transfer payment.

(xvii) Destruction of Buildings/Machinery by earthquake

etc.:
Not included as it’s just a capital loss that doesn’t impact flow of
income.

(xviii) Self occupied house:

Yes, its imputed value is indeed part of NI.

(xix) Profit earned by a foreign bank in India:

Excluded as it is factor income getting paid to that bank abroad.

(xx) Rent from building rented out to foreign embassies:

Yes as it’s factor Income coming from abroad i.e. part of NFIA.

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National Income and Related
Aggregates (Top 22 FAQs)
Article Shared by Diptimai Karmakar

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Read this article to learn about the top twenty-two

frequently asked questions on the National Income and
Related Aggregates.
Q.1. Give the meaning of primary, secondary and tertiary
sector of an economy.
Ans. Primary Sector:
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i. Production units producing goods by utilizing natural resources

like land, water, forests, mines etc. come under this sector.

ii. It includes agriculture and allied activities like fishing, forestry,

mining, quarrying etc.

iii. Its output being input for secondary sector, it is of basic

importance; hence its name.

Secondary Sector:
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i. This sector is also called manufacturing sector.

ii. It includes all those producing units which transform one type of
commodity into another with the help of “3Ms” i.e. “Men, Materials
and Machines”.

iii. For example cloth from cotton, sugar from sugarcane etc. Being
dependent or being second to Primary Sector, it is called Secondary
Sector.
Tertiary Sector:
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i. This sector is also known as service sector consisting of units

which provide services like banking, transport, insurance, trade,
commerce etc.

ii. Its growth is obviously wholly dependent on the earlier two

sectors.

Q.2. Explain the basis of classifying goods into

intermediate and final goods. Give suitable examples.
Ans. Goods which are purchased by a production unit from other
production units and meant for resale or for using up completely
during the same year are called intermediate goods.
Example:
Raw materials or any other example.

Goods which are purchased for consumption and investment are

called final goods.

Examples:
Purchase of machinery for installation in factor or any other
example.

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Q.3. What are the various heads into which factor incomes
are classified? Explain them briefly.
Ans. Factor incomes or payments are classified into
following heads:
(i) Compensation of Employees

(ii) Operating Surplus

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(iii) Mixed Income of self employed

(iv) Net factor income from abroad

(i) Compensation of Employees:
Compensation of employees includes pa5anent of wages and
salaries in cash and kind and employer’s contribution to social
security schemes like pension or retirement fund, provident fund,
life insurance etc.

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(ii) Operating Surplus:
The sum of income from property and income from
entrepreneurship is called operating surplus. Rent, Interest and
Royalty are incomes from property and profit is income from
entrepreneurship. Profit includes corporation tax, corporate savings
and dividends.

(iii) Mixed Income of Self Employed:

In case of self-employed persons, all factors of production are
owned by the entrepreneur himself. Their income is thus a mixture
of wages, rent, interest and profit. Since it is not possible to
bifurcate their income into rent, interest etc. it is added as it is
under the head “mixed income of self-employed.”

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(iv) Net factor income from Abroad:

Net factor income from abroad is the difference between
factor income received by residents from abroad and
factor income paid to the residents of other countries. It
includes:
(a) Net compensation of employees

(b) Net income from property and entrepreneurship

(c) Net retained earnings of resident companies abroad

Q.4. What are the components of net factor income from
abroad?
Ans. The main components of net factor income from
abroad are the net values of following:
(i) Compensation of employees

(ii) Income from property and entrepreneurship

(iii) Retained earnings of resident companies abroad

(i) Net Compensation of Employees:

Net compensation of employees means the difference between
compensation of resident workers of a country temporarily living
and working abroad and similar payment made to nonresident
workers in that country.

(ii) Net Income from Property and Entrepreneurship:

It is equal to the difference between rent, interest and profit
received by residents of a country living abroad and similar
payments made by that country to non residents staying in that
country.

(iii) Net Retained Earnings of Resident Companies:

Net retained earnings of resident companies of a country is the
difference between the retained earnings (undistributed profits) of
the resident companies located abroad and retained earnings of
foreign (non resident) companies located in that particular country.

Thus,

Net factor income from Abroad = Net Compensation of employees

from abroad + Net Income from property and entrepreneurship
from abroad + Net retained earnings of resident companies from
abroad.

Q.5. Explain the circular flow of income.

Ans.
Income are first generated in production units due to the joint
efforts of factor owners from households. These incomes are
distributed to the factor owners who in turn spend the income on
purchasing goods and services produced in production units. This
makes the circular flow of income complete.

Q.6. Distinguish between intermediate products and final

products. Give examples. Distinction between
Intermediate goods and Final goods is as follows:
Ans.

Q.7. Difference between stock and flow variables.

Ans. Differences between stock and flow variables are as
follows:

Q.8. Distinguish between consumer goods and capital

goods. Which of these are final goods?
Ans. Goods purchased for satisfying wants are consumer goods.
Durable goods purchased for use in production are capital goods.

Both are final goods.

Q.9. Explain domestic territory.

Ans. In economics, economic territory of a country is also
called its domestic territory and it includes the following:
(i) Area lying within the political frontiers of the country including
territorial water and air space too;

(ii) Its embassies, consulates, military bases etc. located abroad;

(iii) Ships, aircraft etc. owned by its residents and operated by them
between two or more countries; Fishing vessels, oil and natural gas
rigs etc. operated by the residents in the international waters or
other areas where the country has exclusive rights.

Q.10. Distinguish between National Income and Private

Income.
Ans. Distinction between National Income and Private
Income is as follows:

Q.11. Distinguish between real and nominal gross

domestic product.
Ans. When GDP is calculated at current prices, it is nominal GDP.
When GDP is calculated at constant prices, it is real GDP.
Q.12. Distinguish between Personal Income and National
Income.
Ans. Distinction between Personal Income and National
Income is given here below:

Q.13. Distinguish between Income from domestic product

accruing to private sector and Private income.
Ans. The distinction between Income from domestic
product accruing to private sector and Private Income is
as follows:

Q.14. Giving reasons categories the following into stock

and flow:
(i) Capital
(ii) Saving
(iii) Gross domestic product
(iv) Wealth
Ans. (i) Capital is stock because it is measured at a point of time.
(ii) Saving is flow because it is measured during a period of time.

(iii) Gross domestic product is a flow because it is measured during

a period of time.

(iv) Wealth is stock because it is measured at a point of time.

Q.15. (a) Distinguish between stock and flow, (b) Between

net investment and capital, which is a stock and which is a
flow? (c) Compare net investment and capital with flow of
water into a tank.
Ans. (a) Main differences between stock and flow are as
follows:
(i) Stock of a commodity is always linked to a point of time whereas
flow of a commodity is based on period of time.

(ii) Consequently while flow does have some time dimension, stock
has none of same. For example, national income is a flow concept,
whereas national capital is a stock concept.

(b) Net investment is a flow; Capital is a stock.

(c) Capital is a stock like water in a tank at a given point of time

whereas net investment is a flow like amount of water flowing into
the tank during some period of time.

Q.16. What is the difference between planned and

unplanned inventory accumulation? Write down the
relation between change in inventories and value added of
a firm.
Ans. Planned Inventory:
Any conscious increase in the inventories as per a specific plan is
called planned inventory accumulation. Depending on the market
situation, a firm may plan to increase or decrease its inventory level.

Unplanned Inventory:
On the other hand, any unexpected increase in inventories because
of internal/external factors is called unplanned inventory
accumulation. Here again the factors can lead to unexpected drop
also in the inventories. This is usually generated by some unsold
part of output.

Gross Value Added of firm (GVA) = Gross Value of Output produced

by the firm (Q) – Value of intermediate goods used by the firm (Z)

Or

GVA = Value of Sales by the firm (V) + Value of change in

inventories (A) – value of intermediate goods used by the firm (Z)
Q.17. Write down the three identities of calculating the
GDP of a country by the three methods. Also briefly
explain why each of these should give us the same value of
GDP.
Ans. (a) The three identities are:
National Income = National Product = National Expenditure

(b) Each one of the above gives the same result.

The only difference lies in the manner of calculation of

National Income (NI) as shown below:

Q.18. Calculate NDPFC from the following: (Rs in cores)

Ans. i. Gross national product at MP – 68,400
ii. Depreciation – 4,300

iii. Indirect taxes – 9,000

iv. Subsidies – 1,000

v. Net factor income from abroad – 1,340

NDPFC = GNPMP-Depreciation-NFIA-I.T. +Subsidies

NDPFC = (i) – (ii) – (v) – (iii) + (iv)
NDPFC= 68,400-4,300-1,340-9,000 +1,000
NDPFC = Rs 54,760 Crore
Q.19. (i) Net domestic products at MP – 64,800
(ii) Net Indirect taxes – 6,833

(iii) Net factor income from abroad – (-) 132

(iv) Depreciation – 4,367

From the data given above, calculate:

(a) GDPMP (b) NNPFC (Rs in Crores)
(i) GDP MP= NDP + Depreciation
GDP MP=(i) +(iv)
GDPMP= 64,800= 4,367
GDPMP= Rs 69,167
(ii) NNPFC = NDP MP + NFIA – NIT
NNPFC = (i) + (iii) – (ii)
NNPFC = 64,800+ (-132) – 6,833
NNPFC = Rs 57,835 Crores
Q.20. From the following data about a firm ‘X’ calculate
gross value added at factor cost
 

Ans.

Q.21. Calculate ‘intermediate consumption’ from the

following date:
 
Ans.

Q.22. Calculate ‘Sales’ from the following date:

 

Ans.

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Top 3 Forms of Organization |
Business
Article Shared by Nipun S

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The following points highlight the top three forms of organisations.

The forms are: 1. The Sole Proprietorship Concern 2. Partnership 3.
Corporation.

Form # 1. The Sole Proprietorship Concern:

The sole proprietorship is the least complex form of business
enterprise. This form of business is owned by one individual who
makes all the business decisions receives the profits that the
business earns, and bears the financial responsibility for losses.

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From this description, the simplicity of the individual

proprietorship is apparent. Barring legal restrictions any individual
can simply decide to go into business except in areas of enterprise
where business licences are required. Such restrictions aside, the
individual who has accumulated or borrowed sufficient funds to set
up a business can do so. No legal work is required to set up a sole
proprietorship, although the individual proprietor will often seek
legal and accounting advice.
Once in business, the proprietor is responsible for all business
decisions. The owner determines how many employees to hire,
when they should be rewarded or penalised, what products to
produce, how they are to be marketed. The owner need not seek any
one’s permission to make such decisions. The basic limitation upon
decision-making is that the owner must observe the law and honour
contracts. Otherwise, the owner is free to make wise or foolish
decisions.

Advantages:
The first advantage of the sole proprietorship is that, decision-
making authority is clear-cut; it resides with the owner who need
not consult anyone.

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The second advantage of the sole proprietorship is that the profits of

the business enterprise are taxed only once. The individual
proprietor will receive any profits that the business earns after
meeting its expenses. The proprietor has to pay personal income
taxes on these profits.

Disadvantages:
There are three basic disadvantages of the sole proprie-
torship:
1. Unlimited liability:
The first is that the owner must assume unlimited liability
(responsibility) for the debts of the company. The owner enjoys the
profit of the business if it is successful, but if the business suffers a
loss, the owner is personally liable. If the company borrows money,
purchases materials, and incurs other bills that it cannot cover out
of its revenues, the owner must personally cover the losses. The
owner stands to lose personal wealth accumulated over the years in
paying off the debts of the company.

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2. Limited capital:
The second disadvantage of the sole proprietorship is its limited
ability to raise financial capital. This limitation makes it difficult for
sole proprietorships are small businesses. Financial capital for the
expansion of the company can be raised in several ways in the case
of the sole proprietorship. The owner can choose to flow profits back
into business.

The owner can use the personal wealth to invest in the company, or
the owner can borrow money from relatives, friends, and lending
institutions. The ability of the owner to borrow is determined by the
owner’s earning capacity (which will depend upon the success of the
business) and personal wealth.

Lending money to an individual proprietorship can be risky because

the success of the business depends very much on one person, and if
that person dies or becomes incapacitated, the lender will have to
stand in the line with other creditors.
3. Non-permanence:
The third disadvantage is that the business will typically die with the
owner. Since the firm does not have a permanent existence, it may
be difficult to find reliable employees. In fact, most employees
prefer to work in firms that will exist for long and thus offer
employees bright carrier prospects.

Form # 2. Partnership:

A partnership is much like an individual proprietorship but with
more than one owner.

A partnership is a business enterprise that is owned by two or more

people (called partners) who make all the business decisions, who
share the profits of the business, and who bear the financial
responsibility for any losses.

Like the individual proprietorship, partnerships are easy to

establish. Most partnerships are based upon an agreement that
spells out the ownership of shares and duties of each partner. The
partners may contribute different amounts of financial capital to the
organisation; there may be an agreement on the division of
responsibility for running the business.

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One partner may make all the business decisions, while the other
partner (a “silent partner”) may simply provide financial capital. A
partnership can be a corner petrol pump owned by three friends or
brothers or a nationally known law firm or brokerage house.

Advantages:
The advantages of partnerships are much like those of the sole
proprietorship. Partnerships are easy to set up. The profits of the
company accrue to the partners and are taxed only once as personal
income.

1. Specialisation:
Unlike the sole proprietorship, however, there is a greater
opportunity to specialise and divide managerial responsibility be-
cause the partnership consists of two or more individuals. The
partner who is the better salesperson will be in charge of the sales
department. The partner who is a talented mechanical engineer will
be in charge of production. “Two heads are better than one”, when
each has different talents that are useful to the business enterprise.

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2. Large capital base:

Second a partnership can raise more financial capital than a sole
proprietorship because the wealth and borrowing ability of more
than one person can be mobilised. In fact, if a large number of
wealthy partners can be assembled, such partnership can indeed
raise huge sums of capital.

Disadvantages:
1. Limited capital:
The ability of the partnership to raise financial capital is limited by
the amount of money the partners can raise out of their personal
wealth or from borrowing.

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2. Unlimited liability:
The partners have unlimited liability for the debts of the
partnership. A business debt incurred by any of the partners is the
responsibility of the partnership. Each partner stands to lose
personal wealth if the company is a commercial failure. Clearly, a
conflict in goals can arise because the richer partner may be more
risk-averse than the poorer partner.

3. Complicated decision-making process:

“Two heads are better than one” if the two heads agree. But, if
partners fail to agree, decision-making can become quite
complicated. In a partnership where all partners are responsible for
management decisions, there is no longer one single person who is
in charge. Partnerships can be immobilised when partners disagree
on a fundamental policy. Partnerships involve a more complicated
decision-making process that can become more complicated as the
number of partners grows.

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4. Instability:
Partnerships can also be unstable. If disagreement over policy
causes one partner to withdraw from the partnership, the
partnership must be reorganised. When one partner dies, again the
partnership agreement must be renegotiated.

5. Great risk:
Finally, partnerships can involve a considerable risk for the
individual partners. The sole proprietor does bear unlimited liability
for the debts of the company, but at least the owner is the one who
makes the business decision that may turn out to be bad. In case of
partnership, each partner is responsible for business debts incurred
by another partner even if that partner acted without the consent of
the other partners.

For this reason partnerships are often made up of family members,

close relatives, and close personal friends, who have come to trust
one another over the years Partnership with more partners would
have a greater ability to raise capital. However, because additional
partners complicate decision-making and increase the like-hood of
an irresponsible act being committed by a partner, many
partnerships have a limited number of partners.

Form # 3. Corporation:

The corporation or the corporate form of business was set up to
overcome some of the disadvantages of the proprietorship and
partnership.
A corporation is a form of business enterprise that is owned by a
large number of shareholders. The corporation has the legal status
of a fictional individual and is authorised by law to act as a single
person. The shareholders elect a board of directors that appoints the
management of the corporation, usually headed by a president.
Management is charged with the actual operation of the
corporation.

Unlike the sole proprietorship and partnerships that can be

established with minimal paperwork, a corporate charter is required
to set up a corporation. The laws of each state are different, but
typically, for a fee, corporations can be established (incorporated)
and can become legal “persons” subject to the laws of that state.

According to state and Central laws, the corporation has the legal
status of a fictional individual. Officers of the corporation can act in
the name of the corporation without being personally liable for its
debts. If corporate officers commit criminal acts, however, they can
be prosecuted.

The corporation is owned by individuals (shareholders) who have

purchased equity shares of stock in the corporation. A shareholder’s
share of ownership of the corporation will equal the number of
shares owned by that individual divided by the total number of
shares outstanding (owned by shareholders).

If a person owns 1,00,000 shares of PAL stock and there are 630
million PAL shares outstanding, then the person would own only
0.016 per cent of PAL. Owners of shares of stock have the right to
vote for the board of directors and to vote on special referenda at the
annual meeting of the corporation.

The management of the corporation is required by law to issue

periodic reports to its shareholders describing the financial and
business activities of the corporation during the reporting period.
The shareholders may cast their votes in person at the annual
meeting (the greater is the number of shares owned, the greater is
the weight of the individual’s vote) or can vote by proxy (that is, turn
over voting privileges to the current management or to some other
group).

The shareholder who owns 1 percent of the stock of PAL will receive
1 per cent of the dividends; the PAL management choose to pay to
its shareholders out of profits. In the case of the sole proprietorship
and partnership, the owners decide what to do with the profits.

In the case of the corporate stockholder, the management

determines what to do with the profits of the corporation. The
shareholder who does not approve of the way these profits are
handled can vote to change the current board of directors or sell the
stock and buy some other asset. Ordinary shares preference shares
and convertible bonds are three types of corporate stock!

Ordinary shares confers voting privileges but no prior claim on divi-

dends. Common stock dividends are paid only if they are declared
by the board of directors in any given year.

Preference shares confer a prior claim on dividends but no voting

privileges. Dividends on preference shares must be paid before
paying dividends on ordinary shares but after meeting interest
obligations.

Convertible stock is a hybrid between a stock and a bond. The owner

of convertible stock receives fixed interest payments but has the
privilege of converting the convertible stock into ordinary share at a
fixed rate of exchange.

Corporations often have thousands or millions of shares are

typically owned by a large number of stockholders. In the case of
closely held corporations, the number of shareholders is limited and
each shareholder owns a substantial share of the corporation’s
stock.
Unlike the sole proprietor or the partner, shareholders do not
participate directly in the running of the corporation unless they
happen to own a substantial share of the outstanding stock.
Moreover, even if an effort was made to involve shareholders in
corporate decision-making, there would be too many of them they
would be graphically dispersed, and they would be too involved in
their own business affairs.

For these reasons, there is usually a separation of ownership and

management in the modern corporation. The board of directors
appoints a professional management team that makes decisions for
the corporation. The professional management team serves as
agents for the corporation.

As long as the corporation is run successfully, the management team

is allowed to continue. If the corporation falls on hard times, then
the shareholders may vote out the current board of directors or the
board of directors itself may decide to bring in a new management
team.

Statistical studies of modern corporations have demonstrated the

magnitude of the separation of ownership and management.
Shareholders, however, can exercise substantial indirect control
over management by simply selling their shares. The sale of shares
by a large number of unhappy stockholders will depress the price of
each share and invite possible takeovers by other corporate teams.

Advantages:
1. Limited liability:
The first advantage of the corporation is limited liability. The
owners of the corporation (the shareholders) are not personally
liable for the debts of the corporation. If a corporation incurs debts
that it cannot meet, its creditors will have claim to the assets of the
corporation (its bank accounts, equipment, supplies, buildings and
real-estate holdings), but they cannot file claims against the
shareholders. The worst thing that can happen to shareholders is
that the value of their stock will decline (in extreme circumstances,
it can become worthless).

2. Large capital base:

Limited liability contributes to a second advantage of the
corporation. Corporation can raise large sums of financial capital by
selling corporate bonds, by issuing stock, and by borrowing from
public financial institutions.

3. Separate legal status:

The third advantage of the corporation follows from its status as a
legal individual distinct from the officers of the corporation. A
change in the board of directors, the death or resignation of the
current president, or a transfer ownership could destroy a
partnership or sole proprietorship, but these events do not alter the
legal status of the corporation.

The continuity of the corporation is a distinct advantage. Many

major US corporations are more than a century old. Few
corporations have the same owners and officers that they had when
the corporations started their operations.

New shareholders can also be brought into the operation because

they know that the existence of the corporation is not dependent
upon the individuals that currently run the corporation. Continuity
also makes it easier for the firm to hire a carrier-minded and
talented labour force.

4. Separation of ownership from management:

The fourth advantage of the corporation follows from the separation
of ownership and management.

Because, the two functions are separated, professional managers

who specialise in running different parts of the corporation’s
operations can be hired. Experience shows that the owners of
businesses (those individuals with money to invest) do not always
make the best managers. In the modern corporation, talented
officers can be brought into the business who own little (or no)
capital to invest.

Disadvantages:
1. Double taxation:
The major disadvantage of the corporation is the double taxation of
corporate income. The profits (earnings) of the corporation can
either be distributed to shareholders as dividends or kept as
retained earnings to be reinvested (ploughed back) in the corpora-
tion. The profits of the corporation are subject to a Central income
tax.

If the corporation chooses to plough back all profits into the

company, corporate profits will be taxed only once, but if it
distributes some of its profits to shareholders in the form of
dividends, shareholders must pay personal income tax on these
dividends. Corporate profits can, therefore, be taxed twice, first by
the corporate income tax and second by the personal income tax on
dividends.

The double taxation of corporate earnings is indeed a disadvantage,

but the prevalence of the corporate form of business enterprise
suggests that the advantages of corporations (more specifically
limited liability) can compensate for double taxation.

2. Complexity:
A second disadvantage of the corporation is its complexity. A
modern corporation can have thousands or even millions of
different owners (shareholders). Often ownership is so dispersed
that it is difficult to get the owners to agree (or even assemble), even
when important issues are at stake. Power struggles among
shareholding groups can break out and paralyse decision-making.

It is difficult to mobilise widely dispersed stockholders to get rid of

incompetent management. The costs of gathering information about
the complex dealings of the corporation are high to individual
shareholders, who are often poorly informed about the corporation.
3. Conflicting objectives:
A third disadvantages of the corporation is the possibility of
conflicting objectives between the principals (the shareholders) and
the agents (the corporation’s professional management team).
Share-holders are interested in maximising the long-run profits of
the corporation (thereby getting the best return from their shares of
stock.) The professional management team may be more interested
in preserving their jobs or in maximising their personal income or
perquisites than in profit maximisation.

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