MBA I

UNIT V Notes

Managerial Economics

Concepts of National Income

National income means the value of goods and services produced by a country during a financial year.
Thus, it is the net result of all economic activities of any country during a period of one year and is
valued in terms of money.

National income is an uncertain term and is often used interchangeably with the national dividend,
national output, and national expenditure. National Income is the total amount of income accruing to a
country from economic activities in a fixed period of time (i.e., One Year).

It includes payments made to all resources either in the form of wages, interest, rent, and profits. The
progress of a country can be determined by the growth of the national income of the country. There are
mainly two types of view to define national income.

(i) Traditional Definition,

(ii) Modern definition

Traditional Definition According to Marshall:

“The labour and capital of a country acting on its natural resources produce annually a certain net
aggregate of commodities, material and immaterial including services of all kinds. This is the true net
annual income or revenue of the country or national dividend.”

The definition as laid down by Marshall is being criticized on the following grounds. Due to the
varied category of goods and services, a correct estimation is very difficult. Because, there is a
chance of double counting, hence National Income cannot be estimated correctly.

For example, a product runs in the supply from the producer to distributor to wholesaler to retailer
and then to the ultimate consumer. If on every movement commodity is taken into consideration
then the value of National Income increases.

Modern Definition

Simon Kuznets defines national income as “the net output of commodities and services flowing
during the year from the country’s productive system in the hands of the ultimate consumers.”
Whereas, in one of the reports of United Nations, national income has been defined on the basis of
the systems of estimating national income as net national product (NNP).

There are various concepts pertaining to national income are as follows: Gross Domestic Product
(GDP) Gross domestic product relates to the product of the factors of production employed within
the political boundaries
i.e., within domestic territory. It is defined as a measure of the total flow of goods and services
produced by an economy over a specified time period, usually a year.

All value of intermediate products is excluded. So only the market value of final products is included
to define GDP. Gross National Product (GNP) Gross national product is the total measure of the flow
of goods and services at market value resulting from current production during a year in a country,
including net income from abroad.

GNP= GDP + Net income from abroad(X-M)

where X= Export, M= Import

If the value of (X-M) is negative then,

GDP > GNP Net National Product (NNP) Net national product is considered a true measure of
national product or income.

It is defined as GNP minus depreciation or capital consumption allowance or wear and tear.

NNP = GNP – Depreciation Unlike GDP,

GNP, net national product (NNP) may also be categorized as: NNPmp (Net national product at
market price) :

Net national product at market prices is net value of final goods and services evaluated at market
prices in the course of one year in a country

Some other concepts of national income Private income:

Private income is income obtained by private individuals from any source, produce or otherwise and
retained income of corporations. It can be obtained from NNP at factor cost by making certain
additions and deductions.

Personal Income: Personal income is the total income received by the individuals of a country from
all sources before direct taxes in one year. Personal income is never equal to the national income
because the former includes the transfer payments whereas they are not included in national
income. Personal income is derived from national income by deducting undistributed corporate
profits, profit taxes, and employee’s contributions to social security schemes. Personal income is
differs than private income actually it is less than private income because it excludes undistributed
corporate profits
Real Income: Real Income is the income expressed in terms of a general level of prices of a particular
year taken as base year. National income in terms of money at current prices does not indicate the
real state of the economy. So the concept of real income has been propounded to rectify such
illusions. This is also known as National Income at constant prices.

Circular Flow

Macroeconomics is the branch of economics that studies the economic behaviour of all the agents
in the economy; i.e. it is the study of the economy as a whole. In other words, macroeconomics is
the study of aggregate outcomes of the decisions taken by the different sectors in an economy.

the concept of the circular flow of Income. The circular flow of income forms the basis for all the
macroeconomic models of the economy and it is imperative to understand the circular flow model
for understanding essential concepts like national income, aggregate demand and aggregate supply.
The circular flow of income describes the movement of goods or services and income among the
different sectors of the economy. It illustrates the interdependence of the sectors and the markets
to facilitate both real and monetary flow.

The Household Sector This sector includes all the individuals in the economy. The primary function
of this sector is to provide the factors of production. The factors of production include land, labour,
capital and enterprise. The household sectors are the consumers who consume the goods and
services produced by the firms and in return make payments for the same.

The Firms Sector This sector includes all the business entities, corporations and partnerships. The
primary function of this sector is to produce goods and services for sale in the market and make
factor payments to the household sector.
 The Government Sector This sector includes the center, state, and local governments. The prime
function of this sector is to regulate the functioning of the economy. The government sector incurs
both revenue as well as expenditure. The government earns revenue from tax and non-tax sources
and incurs expenditure to provide essential public services to the people.

The Foreign Sector This sector includes transactions with the rest of the world. Foreign trade
implies net exports (exports minus imports). Exports include goods and services produced
domestically and sold to the rest of the world and imports include goods and services produced
abroad and sold domestically.

The Circular Flow of Income in a Two-Sector Model -

In this model, the economy is assumed to be a closed economy and consists of only two sectors, i.e.,
the household and the firms.

A closed economy is an economy that does not participate in international trade. In this model, the
household sector is the only buyer of the goods and services produced by the firms and it is also the
only supplier of the factors of production.

The household sector spends the entire income on the purchase of goods and services produced by
the firms implying that there is no saving or investment in the economy.

The firms are the only producer of the good and services. The firms generate income by selling the
goods and services to the household sector and the latter earns income by selling the factors of
production to the former. Thus, the income of the producers is equal to the income of the
households is equal to the consumption expenditure of the household. The demand of the economy
is equal to the supply.

In this model, Y = C where, Y is Income and C is Consumption. The circular flow of income in a two
sector model is explained with the help of the following diagram, called Model 1
The Circular Flow of Income in a Three – Sector Model

The three sector model of circular flow of income highlights the role played by the government
sector. This is a more realistic model which includes the economic activities of the government
however; we continue to assume the economy to be a closed one. There are no transactions with
the rest of the world. The government levies taxes on the households and the firms and it also gives
subsidies to the firms and transfer payments to the household sector.

Thus, there is income flow from the household and firms to the government via taxes in one
direction and there is income outflow from the government to the household and firms in the other
direction. If the government revenue falls short of its expenditure, it is also known to borrow
through financial markets. This sector adds three key elements to the circular flow model, i.e., taxes,
government purchases and government borrowings.

This is explained with the help of the following diagram called, Model 2.
The Circular Flow Of Income in a Four Sector Model

This is the complete model of the circular flow of income that incorporates all the four
macroeconomic sectors. Along with the above three sectors it considers the effect of foreign trade
on the circular flow. With the inclusion of this sector the economy now becomes an ‘open
economy’. Foreign trade includes two transactions, i.e., exports and imports. Goods and services are
exported from one country to the other countries and imports come to a country from different
countries in the goods market. There is inflow of income to the firms and government in the form of
payments for the exports and there is outflow of income when the firms and governments make
payments abroad for the imports. The import payments and export receipts transactions are done in
the financial market. This is explained with the help of a following diagram, called Model 3.
Inflation: Meaning and Types In economics, inflation is defined a sustained increase in the general
price level of goods and services in an economy over a period of time. It is measured as an annual
percentage increase. When the general price level rises, each unit of currency buys fewer goods and
services. This implies that inflation reflects a reduction in the purchasing power per unit of money.
In other words, inflation indicates a loss of real value in the medium of exchange and unit of account
in the economy. Different definitions of inflations have been given by different Economists some of
which are as follows:

1. In the words of Peterson, “The word inflation in the broadest possible sense refers to any
increase in the general price-level which is sustained and non-seasonal in character.”

2. According to Coulborn inflation can be defined as, “too much money chasing too few goods.”

3. According to Samuleson-Nordhaus, “Inflation is a rise in the general level of prices.

4. As per Johnson, “Inflation is an increase in the quantity of money faster than real national output
is expanding”.

5. Keynes has presented his view that true inflation is the one in which the elasticity of supply of
output is zero in response to increase in supply of money.
 Types of inflation Inflation is usually categorized on different basis which are given as below:

A. On the basis of Rate: Inflation has been categorized into following types on the basis of its
different rates:

1. Creeping Inflation: Creeping Inflation also known as a Mild Inflation or Low Inflation refers to that
type of inflation when the rise in prices is very slow.

It is the mildest form of inflation with less than 3% per annum.

2. Chronic Inflation: If creeping inflation persist for a longer period of time then it is often called as
Chronic or Secular Inflation. It is called chronic because if an inflation rate continues to grow for a
longer period without any downturn which may possibly lead to Hyperinflation.

3. Walking or Trotting Inflation: When prices rise moderately with a single digit of more than 3% but
less than 10% per annum it is called as Walking Inflation

Demand-pull inflation:
An increase in aggregate demand over the available output leads to a rise in the price level. Such
inflation is called demand-pull inflation

Classical economists attribute this rise in aggregate demand to money supply. If the supply of money
in an economy exceeds the available goods and services, DPI appears. It has been described by
Coulborn as a situation of “too much money chasing too few goods.”

Cost-push inflation:
Inflation in an economy may arise from the overall increase in the cost of production. This type of
inflation is known as cost-push inflation (henceforth CPI). Cost of production may rise due to an
increase in the prices of raw materials, wages, etc. Often trade unions are blamed for wage rise
since wage rate is not completely market-determined. Higher wage means high cost of production.
Prices of commodities are thereby increased.

Deflation- Deflation is defined as a sustained fall in an aggregate measure of prices (such as the
consumer price index). By this definition, changes in prices in one economic sector or falling prices
over short periods (e.g., one or two quarters) do not qualify as deflation. Declining prices can be
driven by an increase in supply due to technological innovation and rapid productivity gains. These
supply-induced shocks are usually not problematic and can even be accompanied by robust growth,
as experienced by China. A fall in prices led by a drop in demand - due to a severe economic cycle,
tight economic policies or a demand-side shock - or by persistent excess capacity can be much more
harmful, and is more likely to lead to persistent deflation. Japan has in recent years been
experiencing such a general fall in the level of prices, with great economic and social pain.

What causes deflation?

Prices may fall in response to a shock to confidence such as the bursting of an asset bubble (equities,
housing) or a shock to commodities (such as a fall in oil prices). If the fall is thought to be one-off, it is
unlikely to lead to a deflationary process. Generally, short periods of falling prices do not break
underlying inflationary expectations. However, if expectations are changed, deflation could follow.
Persistent excess capacity is another source of falling prices. Sectors subject to excess capacity include
telecommunications, airlines, steel, banking (including investment banking), cars and other durable
goods.
However, it is necessary to distinguish between falling prices of some goods and services from a fall in
the general level of prices. Changes in sectors and relative prices take place all the time. In some sectors,
such as investment banking, excess capacity is taken out quickly. In other sectors (cars, airlines, steel),
excess capacity can persist for a long time, putting downward pressure on prices.
When faced with deflationary pressures, companies meet a number of difficulties: -
 Falling prices result in slower growth in nominal sales. - The real value of debt contracted rises
in nominal terms.
 Companies with large corporate debts may face bankruptcies and sometimes cause bank
failures.
 Similarly, the real cost of pensions and wages becomes an increasing burden for companies
unless they can cut in nominal terms.
 As more debtors default, banks reduce lending and companies find it harder to obtain new
financing.

Business Cycle or Trade Cycle

Economies follow cycles of economic activity. Periods of expansion are followed by periods of
contraction. Output and employment increase during periods of expansion. On the other hand, output
and employment decrease during periods of contraction. This pattern of real GDP rising and then falling
is called a business cycle or trade cycle.
This pattern, however, is not regular. The duration of business cycles and the rate at which real GDP
rises or falls vary considerably.
A business cycle represents fluctuations in the level of economic activity (output or real GDP ) over time
around the economy’s long-term trend rate of growth.
A typical business cycle has four phases: the Peak, the Contraction, the Trough, and the Expansion
phase.
Peak: Peak is defined as a period when aggregate demand reaches a peak and output grows faster than
its long-term trend. As output grows faster than its potential trend , it becomes unsustainable.
Contraction: During this phase the aggregate demand falls and it is accompanied by a decline in
economic activity and rising unemployment. These factors lead to a recession.
Trough: It represents the phase when the level of economic activity is at its lowest point in the business
cycle.
Expansion: It represents the phase after a trough when aggregate demand increases. It results in an
expansion in output and falling unemployment.
These phases of a business cycle are often collectively referred to as a ‘boom-bust’ cycle. The
contraction phase of a business cycles leads to recession. A recession is commonly defined as a situation
when the level of economic activity has fallen for at least two consecutive quarters (i.e. at least two
three-month periods). The National Bureau of Economic Research (NBER) of USA defines recession as “a
period of significant decline in total output, income, employment, and trade, usually lasting from six
months to a year, and marked by widespread contractions in many sectors of the economy.”
A prolonged and severe recession results into depression – a period of sustained trough in the economy
accompanied by high unemployment levels and, usually falling prices resulting from a collapse in
domestic and international demand.

Causes of Business Cycle

The possible factors that cause business cycles are generally grouped under following categories:
political factors, international economic factors, and domestic economic factors.
Political Factors: There is some correlation between volatility in GDP and electoral cycles. Governments
tend to adopt expansionary fiscal policy and easy monetary policy, if it has control over the monetary
policy committee, before elections. On the other hand, in the face of rising prices and growing budget
deficits, governments tend to adopt contractionary fiscal policy and tight monetary policy after
elections.
Expansionary fiscal policy along with easy monetary policy leads to an economic boom. This results into
increased output and an inflationary pressure in the economy, depending on the degree of spare
capacity in the economy. On the other hand, contractionary policies may cause a slowdown in the
economy, leading to a recession.

International Economic Factors:

Globalisation has increased the interdependence between countries and there is an international
transmission of volatility from one country to another.
In an era of ever increasing financial integration, it has become more and more difficult for a country to
pursue an independent monetary policy with respect to interest rates and exchange rates.
Greater product market integration leads to international transmission of business cycles through
exports and imports.
Though these international factors do explain the transmission mechanism, they fail to provide a
convincing explanation of genesis of a business cycle in the first place.
Domestic Economic Factors:
Political or international economic factors produce some kind of economic ‘shocks’ within the economy.
There is sluggish adjustment within the economy to these economic shocks. In the short run aggregate
demand changes when prices, employment and wages adjust in a sluggish fashion.