Fundamentals of Financial Instruments. Sunil K. Parameswaran
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result in those economic agents being denied access to the resources being sought by them.
In such systems the prices of both inputs and outputs are determined by factors of supply and demand. These economies, in contrast to command economies, are characterized by decentralized decision making. In principle, agents are expected to make a rational decision by evaluating competing resource needs based on their ability to generate surpluses. In practice, every decision maker will have a required rate of return on investment. The threshold return, or the return exceeding which the venture will be deemed to be profitable, is the cost of capital for the decision maker. A project is deemed to be worth the investment only if the expected rate of return from it is greater than the cost of the capital that is being invested.
As can be surmised, the key decision variables in these economies are the prices of inputs and outputs. Hence, for such economies to work in an optimal fashion, it is imperative that prices accurately convey the value of a good or a service, from the standpoints of producers who employ factors of production and consumers who consume the end products. The informational accuracy of prices results in the efficient allocation of resources for the following reasons. If the inputs for the production process, such as labor and capital, are accurately priced, then producers can take optimal production-related decisions. Similarly, if the consumers of goods and services perceive their prices to be accurate, they will make optimal consumption decisions. The accuracy of input-related costs and output prices will manifest itself in the form of profit maximization, which is the primary motivating factor for agents in such economies to engage in economic enterprise.
How do such systems ensure that prices of inputs and outputs are informationally accurate? In practice, this is ensured by allowing economic agents to trade in markets for goods and services. If an agent has the perception that the price of an asset is different from the value that he places on it, he will seek to trade. If the prevailing price is lower than the perceived value, buyers will seek to buy more of the good than the quantity on offer. If so, the market price will be bid up due to demand being greater than the amount on offer. This demand supply disequilibrium will persist till the price reaches the optimal level. Similarly, if the price of the good is perceived to be too high relative to the value placed on it by agents, sellers will seek to offload more than what is being demanded. Once again, the supply-demand imbalance will cause prices to decline till equilibrium is restored. Thus, differing perceptions of value will manifest themselves as supply-demand imbalances; resolving these will ultimately help ensure that the prices of assets accurately reflect their value.
Opinion: While free market economies have to a large extent been more successful than command economies, no one would advocate a total absence of the government's role in economic decision making. Unfettered capitalism is unlikely to find acceptance anywhere. There are disadvantaged sections of every society whose fate cannot be left to the market, and whose well-being must be ensured by policy makers to promote overall welfare. While societies characterized by command economies have historically not permitted free speech, in a country like the United States, even mild criticism of the market is considered to be heresy.
CLASSIFICATION OF ECONOMIC UNITS
Economic agents are usually divided into three categories or sectors:
The government sector
The business sector
The household sector
The government sector consists of the central or federal government of a country, state, or provincial governments, and local governments or municipalities. The business sector consists of sole proprietorships, partnerships, and private as well as public limited companies. Sometimes business units are broadly subclassified as financial corporations and nonfinancial corporations.
Proprietorships: A proprietorship, also known as a sole proprietorship, is a business owned by a single person, and represents the easiest way to start a business. The owner may do business in their name or else in a trade name. For instance, a consultant named John Smith may run the business in his name, or choose a name like “Business Systems.” The owner is fully responsible for all debts and obligations of the business. That is, creditors, or entities to which the business owes money, may stake a claim against all assets of the proprietor, whether they are business-related assets or personal assets. In legal parlance this is referred to as unlimited liability, as opposed to a corporation where the owners have limited liability, which we will shortly discuss in greater detail.
The start-up costs of a sole proprietorship are usually lower than those of other forms of business. Unlike a corporation, however, such businesses face relative difficulties in raising additional capital when they choose to expand the scope of their operations. Usually, in addition to the owner's personal investment, the only source of funds is a loan from a commercial bank.
Legally, the proprietorship is an extension of the owner. The owner is permitted to employ other people. The net profits from the business are clubbed with the proprietor's other income, if any, for the purpose of taxation. The lifespan of these entities is uncertain. For instance, if the owner were to die, the business would cease to exist.
Partnerships: A partnership is a business entity that is owned by at least two people or partners. One of the partners may be a corporation, which we will explain next. Legally, the partnership is an extension of the partners. Like a proprietorship, a partnership is permitted to employ others, and can conduct a business under a trade name. For instance, two lawyers named John Smith and Mike Jones may conduct their business as Smith & Jones, or else under a trade name such as “Legal Point.” In a general partnership the partners have unlimited liability, and the partners are personally responsible not only for their own acts, but also for the actions of other partners and employees.
There are two categories of partnerships in many countries: general partnerships and limited partnerships. A general partnership is what we have just discussed. In a limited partnership there are two categories of partners: general partners and limited partners. The general partners are usually a corporation and have management control. They are characterized by unlimited liability. The limited partners, on the other hand, are like the shareholders of a corporation. Their potential loss is limited to the investment that they have made.
Like a sole proprietorship, a partnership is also easy to establish. However, unlike a proprietor, who is the sole decision maker, partners must share authority with the others. Consequently, it is important to draw up a partnership agreement at the outset, where issues such as profit sharing are clearly spelled out. Compared to corporations, partnerships also find it relatively difficult to raise capital to expand their businesses.
Corporations: A corporation or a limited company is a legal entity that is distinct and separate from its owners, who are referred to as shareholders or stockholders. A corporation may and usually will have multiple owners as well as many employees on its payroll. It must necessarily do business under a given trade name. Because a corporation is a separate legal entity, it has the right to sue and be sued in its own name. Shareholders of a corporation enjoy limited liability. Unlike a proprietorship or partnership, the ownership of a company can easily change hands. Each shareholder will possess shares of the company that can be usually bought and sold in a marketplace known as the stock exchange. While such share transfers may result in one party relinquishing majority control in favor of another, the transfers per se have no implications for the corporation's continued existence or its operations. Unlike proprietorships and partnerships, corporations find it relatively easier to raise both debt or borrowed capital, as well as equity or owners' capital. In most countries, however, corporations are extensively regulated, and are required by statutes to maintain extensive records pertaining to their operations. The cost of incorporation, and the costs of raising equity through share issues, can also be substantial. While owners of a corporation may be a part of its management team, very often ownership and management are segregated by entrusting the management of day-to-day activities to a team of professional managers. In some countries there exist entities known as Private Limited Companies. These companies cannot offer shares to the public, and