MODULE : 1 INTRODUCTION TO MICRO & MACRO ECONOMICS

Economics is a social science, to study how people (individual, households, firms, and nations) maximize their gains from their limited resources and opportunities 1. Wants are unlimited 2. Resources are limited 3. Everybody tries to satisfy their maximum wants by using these limited resources

Therefore, Economics is study of such concepts, theories, tools and techniques, which help in satisfying maximum wants from these limited resources. For ex: Economics studies how households allocate their limited income between various goods and services they consume so that they are to maximize their total satisfaction.

‡ ‡ Ceteris Paribus Rationality .

. literally translated in English as with other things (being) the same or all other things being equal This assumption is applied to all economic analysis to create an environment where casual relationship between two variables is to be studied.Ceteris Paribus: Ceteris paribus is a Latin phrase.

If we assume all the other factors constant at a particular point of time. that may affect the demand for that commodity. it would be easier to find the effect of price on the quantity demanded of commodity. A part from price. . etc. price of the related commodities. there can be a host of other factors like income of the consumer.For ex: we want analyze the effect of the price of a commodity on its demand.

. and so on. whether to train the existing workers or recruit new workers for the newly opened unit of the firm. For ex: Whether eating at home is cheaper than going to a restaurant. This means that consumers and producers measure and compare the costs and benefits of a decision before going ahead.Rationality: Economist makes assumptions that people act rationally.

Positive and Normative 3. Micro and Macro 2.Economic analysis can be divided into the following categories: 1. Partial and General Equilibrium . Short run and long run 4.

MICRO AND MACRO Micro economics ( micro meaning small) looks at the smaller picture of the economy and is the study of the behavior of small economic units. . Such as that of an individual consumer. It focuses on the basic theories of demand and supply in individual markets and deals with how individual businesses will decide how much of something to produce and at what price to sell it. or a product. a seller.

. inflation etc. and not the firm. employment.Macro economics ( macro meaning large) is that branch of economic analysis that deals with the study of aggregates( as a whole). In macro analysis we study the industry as a unit. national income. In macroeconomics we talk about aggregate demand and aggregate supply.

and cannot be verified by empirical study of logic. as in the above example. For ex: 1. The distribution of income in India is unequal. The first statement is a positive one. while the second is a normative one. 2. Normative statements often imply a recommendation. that income should be redistributed.POSITIVE AND NORMATIVE Positive statements are factual by nature. The distribution of income in India should be equal. normative statements involve some degree of value judgment. .

It is what is in economic matters. . Normative economics is concerned with questions involving value judgments. It is what ought to be in economic matters.Positive economics establishes a relationship between cause and effect.

SHORT RUN AND LONG RUN A Short run is a time period not enough for consumers and producers to adjust completely to any new situation A long run is a planning horizon in which consumers and producers can adjust any new situation. .

this means that the effects are examined only in the market(s) which is directly affected. economic . and not on other markets General Equilibrium analysis explains phenomena in an economy as a whole.PARTIAL AND GENERAL EQUILIBRIUM Equilibrium is the state of balance that can occur in a model Partial Equilibrium analysis studies the internal outcome of any policy action in a single market only.

. In sharp contrast to this. a petroleum company would hike the price of petrol without considering its possible effects on the price of the other commodities whereas general equilibrium analysis would propose that the equilibrium price of fuel cannot be determined in isolation and would need to incorporate a host of several other variables. under partial equilibrium analysis. the fares of public commuting vehicles would go up. this may put a pressure on firms to hike the conveyance allowance given to the workers.For Ex: If the price of fuel goes up.

an activity with which one can be busy about. It is associated with. But in the economic sense.Business the word business in its literal sense means the state of being busy. the word business means human activities which are performed with the objectives of earning profits .

Men and Material) of every business are limited Business involve risk and uncertainty Therefore. crux of business is decision making and forward planning for earning the maximum profit by using these limited resources. .Primary objective of every business is to maximize its profit Resources (like Money. Machines.

in terms of finding the most efficient way of allocating scare organizational resources and reaching stated objectives. Managerial economics is thus constituted of that part of economic knowledge. logic. logic and tools of economic analysis that are used in the process of business decision making Economic theories and techniques of economic analysis are applied to analyze business problems. theories and analytical tools that are used for rational business decision-making. evaluate business options and opportunities with a view to arriving at an appropriate business decision. ‡ ‡ ‡ . Managerial economics is a means to an end to managers in any business.‡ Managerial economics is the study of economic theories.

Mansfield Managerial Economics is the integration of economic theory with business practice for the purpose of facilitating decision-making and forward planning by management.Managerial economics is concerned with the application of economic concepts and economics to the problem of formulating rational decision making. Spencer and Siegelman Managerial economics is the application of economic principles and methodologies to the decision-making process within the firm and organization. Douglas .

ecision ro lem Traditional Economics Managerial Economics ecision Sciences (Tools & Techniques of Analysis) Optimal solution to usiness pro lems .

Micro Economic in Character Normative Economics Use theory of firm Prescriptive nature Pragmatic and applied approach It is both conceptual and metrical Adequate importance to Macro-Economics . 7. 2. 6. 3. 4. 5.1.

demand and supply analysis. profit maximization. cost and revenue analysis. It determines the goal of the enterprises and then develops the way to achieve these goals. determination of price and quantity.Micro-economics in character: Managerial economics is Micro-Economic in character as it is only concerned with smaller units of the economy.e. Use theory of firm: Managerial Economics uses only those economic concepts and principles which are related with the theory of firm i. Normative Economics: Managerial economics belong to normative economics rather than positive economics. It studies the problem of particular business firm or industry not as a whole business economy. should do under particular circumstances. which is concerned with what management. etc. .

. It is an applied discipline of Economic theory which suggests how economic principles are applied to policy formulation. which deals with the things in a real & sensible way rather than being influenced by fixed theories. Pragmatic and Applied approach: Managerial economics is pragmatic. It tries to solve the problems in day-to-day functioning of the firm and avoid difficult and abstract issues of economic theory. decision-making and forward planning.Prescriptive nature: As it is prescriptive in nature it states what should be done .

.It is both Conceptual and Metrical: It takes help of conceptual framework to understand & analyze the decision problem and takes the help of quantitative techniques to measure the impact of different factors & policies. Adequate importance to Macro-Economics: Managerial Economics takes the help of MacroEconomic since it provides intelligent and understanding of environment in which the business of firm must operate.

which can be use to analyze the business environment and to find solution to practical business problems. .The scope of managerial economics comprehends all those economic concepts. theories and tools of analysis.

Operational or Internal Issues Demand Analysis & Forecasting Cost and Production Analysis Pricing decision policies & Practices Profit Management Capital Management Environmental or External Issues Issues related to Macro Variables Issues related to foreign Trade Issues related to Government Policies .

Cost estimates are most useful for management decision. costoutput relationships. economies and diseconomies of scale. It will help management to maintain or strengthen its market position and profit-base.Demand analysis and forecasting: -. . The chief topics covered under cost and production analysis are: cost concepts and classifications. Cost and production analysis: . A major part of managerial decision making depends on accurate estimates of demand. production. The different factors that cause variations in cost estimates should be given due consideration for planning purposes. A forecast of future sales as a guide to management for preparing production schedules and employing resources.

As price gives income to the firm. differential pricing. it constitutes as the most important field of managerial economics. pricing policies. There is always an element of uncertainty about profits because of variation in costs and revenues.Pricing decision. The important aspects covered under this area are: nature and measurement of profit.The chief purpose of a business firm is to earn the maximum profit. Profit management: . The various aspects that are dealt under it cover the price determination in various market forms. pricing method. profit policies and techniques of profit planning like break-even analysis. productive and price forecasting. policies and practices: . .

Capital management: - The problems relating to firm s capital investments are perhaps the most complex and troublesome. Capital management implies planning and control of capital expenditure because it involves a large sum and moreover the problems in disposing the capital assets of are so complex that they require considerable time and labor. The main topics dealt with under capital management are cost of capital, rate of return and selection of projects.

Issues related to Macro Variables: Firm Planning to set up a new unit or expand existing size would like to ask, what is the general trend in economy? What would be the consumption level? Will it be profitable to expand the business? These questions are answered on the basis of prevailing micro variables in the country. Issues related to Foreign Trade: Firm dealing in exports and imports would be interested in knowing the trends in international trade, prices, exchange rates and prospects in the international market. Answers to such problem are obtained through study of international trade. Issues related to Government Policies: As each firm has to operate their business under government rules and regulations. Therefore, it becomes important to understand the government policies, which can affect the interest of the firm.

Roles of Managerial Economist 1. Helping in decision-making a. Thinking function b. Selection function 2. Helping in forward planning 3. Administrative role 4. Economic intelligence 5. Participation in debates 6. Specific Roles: a. Sales forecasting b. Industrial market research c. Analysis of competitors d. Pricing decision e. Production schedule f. Investment analysis g. Public relation h. Social objectives

Thinking Function: This is identification of area of decision-making. development of different alternatives and collection of required facts. Selection Function: After the analysis of the problem. B. the managerial economist should select the most appropriate alternative according to the situation of the firm. . These functions are mainly divided into two categoriesA.Helping in Decision-making: Mostly the business decisions are taken in uncertain environment. The function of the managerial economist is to assure that correct decisions are taken on proper time. determination of essential facts and search of alternative decisions.

Helping in forward planning: The managerial economist help the management in the forward planning for the operation of the firm. He prepared a long-term plan by utilizing the resources of the firm. Practically, if there is any mistake, he revised it by making necessary correction. Administrative Role: A Managerial economist is an important executive of a concern. It is desired that he should give suggestion to the management regarding improvement in the organizational structure, proper coordination between rights and duties, developing effecting communication system and the optimum utilization of the resources of the firm

Economic Intelligence: Another important role of a Managerial economist is to provide useful economic intelligence to the management of the firm such as, nature and price of the products of the rival firms, tax rates, custom duties etc., Though such information are always available in various journals, newspaper, magazines and government ordinances, yet their proper analysis is the function of the managerial economist. Participation in Debates: The role of a qualified Managerial economist is take participate in government and public general debates. Due to this both government and the society are benefited by their practical experience and ideas. Actually such participation not only gives public recognition to one s own organization but also bring contact of subject specialists from various countries.

Specific Roles: Alexander, K.J.W and Kemp, A.G: revealed by a survey in U.K.; according to which some specific roles performed by Managerial Economist are following: A. Sales Forecasting : An economist have to make sales forecasting based on the past sales data and current performance, that how much sale of a particular product will take place in future and what will be the trend. So that other departments of the business can make arrangements accordingly. B. Industrial Market Research: An economist have to make a research about the buyers like-what are the taste and preferences of the buyers, what are the distribution channels available etc, so that business can plan accordingly. C. Analysis of Competitors: An economist have to find out that how many competitors are present in the market, at what price they are selling their products, what promotional strategies are they adopting, what are the views of customers about their product.

how much price elastic is product. Production Schedule: An economist has to plan the production as per the demand forecasted. by using different analytical techniques like Capital budgeting. For that it has to be studied that under what type of market is business working. Pricing Decision: An economist has to decide the pricing strategy for its product.D. Investment Analysis: An economist. etc. He has to arrange factors of production like men. money and material. F. takes decision that in which project investment should be made out of various available projects. E. what are the prices of competitors. Study about the availability of these factors in the market etc. machine. .

H. Public Relation: An economist has to work for maintaining good public relation. . Social Objectives: An economist to fulfill its role for society has to ensure better availability of goods at fair prices in proper quality. provide employment. and avoid unfair & anti-social practices.G. so that he can get feedback from market about the product.

2. To increase the profitability of the firm To make accurate and successful forecast To maintain relations with experts To aware availability of resources To simplify the decision making process Responsibility to minimize risk. But. some of which are following:1. 4.A Managerial economist plays a very significant role in decision-making and forward planning. 6. 5. 3. he must thoroughly recognize his responsibilities. . to serve his role successfully.

To maintain relations with Experts: The important responsibility of a managerial economist is to provide solution to complex business problems. sale and market research. To make Accurate and Successful Forecast: It is a responsibility of an economist to make successful research and use past data to find out the expected sales in future and the trend in sales. for this purpose he must establish and maintain the relations with such experts of different fields who can provide their service to the firm as and when required.To increase the profitability of the Firm: An economist has a responsibility to earn profit for the firm by taking right decision about investment. . production.

.To aware availability of Resources: A managerial economist should be aware of locations and situations of the specific markets. To minimize risk successful forecasting and right decisions are needed. by which he should be able to provide the resources of firm s operation quickly at reasonable price. It is the main responsibility of a managerial economist to make the decision making process as simple as possible so that quick and correct decision could be taken promptly. Responsibility to minimize risk: Minimizing risk is another responsibility to the economist. To Simplifying the decision making process: The management has to take many decisions in its day-today functioning. It can be done by minimizing future uncertainty by knowing about all the prospective facts present in the market.

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3. These principles are helpful for managers in solving their business related problems.Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the managers in his decision making practice. Opportunity cost Incremental principle Principle of time perspective Discounting principle Equi-marginal principle . 5. 2. 4. Following are the basic economic principles for decision making 1.

‡ The opportunity cost of any alternative is defined as the cost of not selecting the nextbest alternative. ‡ . The opportunity cost of availing an opportunity is the expected income foregone from the second best opportunity of using the resources.

Example: Suppose. This implies that manager has to sacrifice the annual return of Rs. 18 million Rs. 16 million All the other thing being same (Ceteris Paribus). . 20 million Rs.18 million expected from alternative 2. a firm has 100 million at its disposal and there are only three alternatives uses the expected annual return from the three alternative uses of finance are: To expand the size of the business Setting up new production unit Buying share in another firm Rs. rational decision-making suggest to invest the money in alternative 1.

18 million is an annual opportunity cost of an annual income of Rs.In economic terms. . 20 million The difference between actual earning and opportunity cost is called economic gain or economic profit.

emphasizing the changes in total cost and total revenue resulting from changes in prices. Incremental concept involves estimating the impact of decision alternatives on costs and revenue. procedures.It is related to the marginal cost and marginal revenue. products. for economic theory. investments or whatever may be at stake in decisions. The two basic components if incremental reasoning is: ‡ ‡ Incremental cost Incremental revenue .

It decreases some costs to a greater extent than it increases others 3. It reduces cost more than revenue . 4. It increases revenue more than cost 2.The incremental principle may be stated as under: A decision is obviously a profitable one if 1. It increases some revenues more than it decreases others and. .

1.800 Selling & Administrative expenses Rs. The cost estimated as under: Material Rs.Example: Suppose a new order is estimated to bring in an additional revenue of Rs. 700 (Allocated at 20% of labor and material cost) _________ Full cost Rs. 5000/-. .000 Labor Rs. 6000 The order appears to be unprofitable. 1. 2.500 Overhead (allocated at 120% of labor cost) Rs.

1000 by the way of labor cost because some idle workers already on the payroll will be deployed without added pay.500/. 3500) to profit .000 Rs. power and light. 3. If the order adds only Rs.However. 500 of overhead (that is. 1.000 Rs. 500 Total Incremental cost While it appeared in the first instance that the order will result in a loss of Rs. 500 ___________ Rs. the added wear and tear on machinery. 2. 5000 Rs. no extra selling & distribution cost.(Rs. 1. the incremental cost of accepting the order will be: Material Labor Overhead Rs. suppose there is idle capacity which can be utilized to execute this order. the added cost of heat. it now appear that it will lead to an additional of Rs. and so on) only Rs. the added cost of supervision. 1000.

Managerial economists are also concerned with the short run and the long run effects of decisions on revenues as well as costs. The very important problem in decision making is to maintain the right balance between the long run and short run considerations .

the contribution to overhead and profit is Rs. 1/. An order for 5000 units comes to management s attention.per unit for the whole lot but not more.for the lot) .per unit (Rs.3/. The short run incremental cost (ignoring the fixed cost) is only Rs. The customer is willing to pay Rs. 5000/.Example: Suppose there is a firm with temporary idle capacity.4/. Therefore.per unit.

they may demand a similar low price. ‡ If the other customers come to know about this low price. . Such customers may complain of being treated unfairly and feel discriminated against.Analysis: For the above example the following long run repercussion of the order is to be taken into account: ‡ If the management commits itself with too much of business at lower price or with a small contribution it will not have sufficient capacity to take up business with higher contributions. In the above example it is therefore important to give due consideration to the time perspective a decision should be taken into account both the short run and long run effects on revenue and costs and maintain the right balance between long run and short rum perspective .

if the present opportunity is not availed of Even if he is sure to receive the gift in future.today.100/. This is true for two reasons ‡ The future is uncertain and there may be uncertainty in getting Rs. Naturally he will choose Rs. Suppose a person is offered a choice to make between a gift of Rs. today s Rs. 100/.One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a rupee today.can be invested so as to earn interest say as 8% so that one year after Rs.next year. 100/.100/. ‡ .100/ will become 108.

an input should be allocated that the value added by the last unit is the small in all cases. . A. to make the marginal productivity of labor equal on the two fields.This rule has a name: it is the Equi-marginal Principle. This principle deals with the allocation of an available resource among the alternative activities.in this case. The firm is engaged in four activities which need labor services viz. B. The idea is to make two things equal "at the margin" -. According to this principle. This generalization is called the Equi-marginal principle. it can enhance any one of these activities by adding more labor but only at the cost of other activities. C and D. Suppose. a firm has 100 units of labor at its disposal.

Per capita income. methods of measuring national income Business Cycle & Business Policies . GNP. GDP. characteristics & scope of Macro economics Circular flow of Income National Income.Concept.

Mc Connell observes :Here we study forest. total employment. Since it studies aggregate form of the economy. It deals with the functioning of the economy as a whole. it is also referred to as 'Aggregate' Economics and income theory'. For example. macro-economic studies the big aggregates like national income." .The term 'macro' denoted' large'. Macro-economics is not the studies of individuals units. not the trees. Hence. national output. It gives us a bird's eye view of the economy. general prices level. saving and investment. but all the units combined together.

According to Edwin Mansfield. independently of tree which composes it". E. Bounding defines macro-economics in these words "macro-economics is that part of economics which studies the overall averages and aggregates of the system". K. national income. According to Gardner Ackley "Macro-economic deals with the economic affairs in large it concerns the overall dimension of economics life. . So we conclude that macro-economic deal not with individual s quantities. price level and national output. "Macro-economic deals with behavior of economics aggregates such as gross national product and level of employment". individual s prices. individual incomes. It studies the character of forest. individuals output but with aggregate of these quantities.

MICRO ECONOMICS 1. Study of micro economics is important for resource utilization. 4. 3. It deals with an individual's economic behavior. Study of macro economics is important for formulation of economic policy of the whole nation. etc. It deals with the general price level in the economy. It deals with the income of a particular set of people. 2. and for taking business decisions. public finance. These concepts have more theoretical value. 6. These concepts have more practical value. MACRO ECONOMICS 1. National income accounting. The concepts of macro economics are interdependent on one another. It deals with the pricing of a particular commodity in an industry. The concepts of microeconomics are independent concepts. 2. 5. 4. . 5. 3. It deals with aggregate economic behavior of the people in general.

2. 4.The characteristics that describe a macro economy are usually referred to as the key macroeconomic variables. Aggregate Output Or Income. The following four variables are considered to be the most important in gauging the state or health of an economy: 1. The Inflation Rate. And The Interest Rate. The Unemployment Rate. 3. .

Unemployment The level of employment is the next crucial macroeconomic variable.Aggregate Output or Income An economy's overall economic activity is summarized by a measure of aggregate output. any aggregate output measure is closely associated with an aggregate income measure. it is defined as consisting of those working and those not working but seeking work. . The GDP is a measure of all currently produced goods and services valued at market prices. Instead. As the production or output of goods and services generates income. The unemployment rate itself is defined as the fraction of labor force not working (but actively seeking employment). The employment level is often quoted in terms of the unemployment rate.

the commonly followed interest rate is actually the nominal interest rate. The nominal interest rate has two key attributes the duration of lending/borrowing involved and the identity of the borrower. which measures the level of prices of goods and services at given time. is measured by a price index. Thus. The interest rate is invariably quoted in nominal terms that is. . in turn. The Interest Rate The concept of interest rates used by economists is the same as the one widely used by ordinary people. it is not adjusted for inflation. The price level. Most economies face positive rates of inflation year after year.Inflation Rate The inflation rate is defined as the rate of change in the price level. The number of items included in a price index varies depending on the objective of the index.

The theory of business cycle is also covered by macro-economics. Hence. Aggregate demand is the sum of total consumption demand and total investment demand.A branch of economics theory macro-economic covers the following aspects: Theory of income and employment: Macro-economic studies what factors and how these factors determine the level of income and employment. The level of income and employment is determined by aggregate demand. consumption function and investment function are the important components of macro-economics. .

There are many theories of inflation. one of the grave problems of preset world. . The theories of money. is also an important component of macro-economics. The main aspect of general prices level is inflation.Theory of general prices level: Macro-economics is concerned with how general price level is determined. Inflation. banking and finance also fall under macroeconomics.

These theory suggest the way to accelerate the rate of growth of the economics. Many theories of economics growth have been developed . It is because economic growth is a prerequisite for the improvement in the levels of living of people and alleviation of poverty. .Theory of economic growth: Growth economics or the theory of economic growth is another important branch of macro-economics.

Macro-economic studies what factors and how these factors determine the relative share of different of people national income.Modern theory of distribution: National income is distributed among different classes of people of a country in different ways. .

between whom the circular flow of production of goods and services. ‡ ‡ Two Sector Economy Four Sector Economy . income and expenditure takes place.The crux of macroeconomics theory is based on the circular flow of income. The basis of this flow is the economic interdependence of consumers and sellers.

On the other side there are firms who supply the varieties of goods and services. A household include a set of individuals who live together and take joint decision about the consumption of goods and services. The term firm is used to describe the basic selling unit of consumption of goods and services. in order to derive satisfaction from them. . On one side of the flow is consumer.The simplest form of circular flow of economic activities and income features only consumers and firms. who is an individual (like you and me) who purchases goods and services for own consumption.

The nature of interdependence is such that consumer needs to pay the prices for these goods and services and firms require various factor of production to produce these goods and services. which they spend on consumption. Hence the households provide services in terms of factor input to the firm and get paid for these services. Thus the money and economic activities flowing between firms and households create a circular flow. .

Household do not spend their entire money on consumption. financial institutions. Since money is thus taken out of the circular flow. insurance companies and stock markets. instead they save a part of their income for the future. through banks. When household save. If these savings are kept with the household they will result in leakages in the money flow. and as a result money flow to the business firms would decrease by the same extent. But saving of households comes to the financial market. their consumption of goods and services would decline to the extent of saving. saving would be considered as a component of withdrawals . .

while investment is the injection of money into the circular flow.Firms. . borrow this savings from the financial market for their investment in capital goods. Thus the saving of the household deposited in the financial market go to firms as their investment expenditure. Saving is the withdrawal of money from the circular flow. which is termed as injection .

Labor & Capital .Savings Financial Market Investment Factor Payment Land.

E = Expenditure. we can state that: Y=O=E Y=C+S E=C+I Hence. the total income is used either for the purpose of consumption. the value of output produced (Y) is equal to the value of output sold (O). I = Investment expenditure. Since the value of output sold is equal to the sum of consumption expenditure and investment expenditure. C + S = C + I Where.In simple two sector economy. Thus. or for investment. ‡ ‡ ‡ ‡ ‡ ‡ Y = income. C = Consumption expenditure. S = Saving . O = Output.

e. government and external sector.The four sector model has been introduced to help us understand the more complex real life situation. Every economy has actually two or more sectors besides the consumers and produces i. .

electricity. communication and security is essential for growth of a system.The development of basic infrastructure. . At the same time government receive revenue from different sources such as taxes. like roads. These facilities are created by government therefore total expenditure in an economy will not only consist of C + I but also of government expenditure (G). interest on loans and profit on investment.

Some amount of saving also flow to government in the form of government bond and securities. i.e. where as government contributes to the generation of assets by the way of expenditure in form of salaries to government employees. . infrastructure development and public sector enterprises.Thus there is a third dimension to the circular flow of income. some money flowing between firm and household is diverted to the government in the form of taxes and other payments.

firms and government interacts with the foreign country through exports and imports of goods and services. flow of capital. services and people. other inputs.Every economy interacts with other economies through international trade. technology. hence there is a fourth sector in the economy know as external markets. . Thus households. capital investment. etc.

Taxes Salaries GOVERNMENT Taxes Remittance for purchases or Subsidiaries HOUSEHOLDS Financial Market FIRMS Imports Exports Imports FOREIGN NATION Exports .

Taxes Salaries GOVERNMENT Taxes Remittance for purchases or Subsidiaries Factor Payment Factor Inputs HOUSEHOLDS Savings Financial Market Consumption Expenditure Goods & Services FIRMS Investments Imports Exports FOREIGN NATION Imports Exports .

aggregate demand (AD) for consumer goods (C) and aggregate demand for capital goods (I). Thus we can write the above equation as: AD = C + I Aggregate supply is the total national output produced and supplied by all the factors of production in an economy. .AGGREGATE DEMAND AND AGGREGATE SUPPLY Aggregate demand is the total demand in terms of goods and assets at a given price by all the people in an economy. Aggregate demand consists of two components. Aggregate supply consists of supply of consumer goods and capital goods.

money supply is a stock. Flow includes the variables which increases (inflows) and decreases (outflows) the stock. saving and investment over a period of time. Thus. Stock may be defined as any economic variable which has been accumulated at a specific point of time.For better understanding of national income determination it is necessary to understand the difference between the concept of stock and flow. assets and wealth. with outflows subtracted from the stock. while national income is a flow Example STOCK INVENTORY BANK BALANCE POPULATION INFLOW INCOMING GOODS DEPOSITS BIRTH + IMMIGRATION OUTFLOW OUGOING GOODS WITHDRAWALS DEATH + EMIGRATION . Mathematically a stock can be seen as an accumulation and integration of flows over time. like income. consumption. like money.

NOTE: For the calculation of national income only final goods are considered. Final goods are demanded by the final consumer for using these goods as they are. . While calculation of national income if we add intermediate goods to final goods. We shall be counting the same product for more than once. which would give inflated figures of national income.Intermediate goods (and services) are items purchased by firms for using them in production of some other goods of utility.

Every country tries to achieve a full employment so that maximum economic growth with maximum social welfare can be achieved. .This is another important macro variable that affects the national economy. Employment is defined in different respects. Employment means where a person who is willing and capable to work in a productive activity is engaged for certain number of hours per week. whether working for self or someone else. for example in US it is defined as a contract between two party agrees to work under term specified by another party.

known as transfer payments. and free education and salary of government employees. national health.Government expenditure refers to outlay on national defense. retirement pension. . There is another type of expenditure. These include unemployment compensation. railways. road building and maintenance. unemployed. Since the receiver of such payments (such as old. It is an exchange of purchasing power from one group of people to another. etc. handicapped and needy families) do not contribute to national output therefore such payments are referred to as transfer payments and they are not treated as a part of the government s current output of goods and services. All government current expenditure is included in national output. which refers to payments made to certain sections of society as a social welfare measure.

. battleship and machines that any society produces with its land. . oranges. labor and capital resources.Paul A. Samuelson National Income National Income Committee of India 1951 defines National Income as follows: A national income estimate measures the volume of commodities and services turned out during a given period counted without duplication.National income or product is the final figure you arrive at when you apply the measuring rod of money to the diverse apples.

generally one year. . National income accounting is a set of rules and definition for measuring economic activities in an economy. National income gives us a means to measure the economic performance of an economy as a whole.National income is defined as the money value of all final goods and services produced in an economy during an accounting period of time.

Some of the common measures of national income are:  GROSS DOMESTIC PRODUCT (GDP)  GROSS NATIONAL PRODUCT (GNP)  NET DOMESTIC PRODUCT (NDP)  NET NATIONAL PRODUCT (NNP) .

GDP is the sum of money values of all final goods and services produced within the domestic territories of a country during an accounting year. as also subsidiaries are branches of foreign companies in your home country. If you look around. you would find any domestic companies which have their branches or subsidiaries in foreign countries. it does not include the earning of nationals working abroad as also of the foreign nationals working in our country. However. It includes income from exports and payments made on imports during the year. The output produced by all these individuals and businesses are however not included in the GDP of the country. This is done to avoid the incidence of double counting since the incomes earned by subsidiary firms in different countries are added to the income of the parent country .

GNP is defined as the sum of Gross Domestic Product and Net Factor Income from Abroad.GNP is the aggregate final output of citizen and businesses of an economy in a year. Net Factor Income from Abroad (NFIA) is the difference between income received from abroad for rendering factor services and income paid towards services rendered by foreign nationals in the domestic territory of a country. NOTE: GNP will be less than GDP when a country makes more payment than it receive from abroad. Thus. GNP = GDP + NFIA Thus GNP of India would count goods and services produced by all Indians. The difference between GDP and GNP arises because of the fact that a part of any country s total output is produced by factors which are actually owned by other nation(s). regardless of where they work. .

In order to arrive at NDP and NNP. or capital consumption allowance. And Or NDP = GDP Depreciation NNP = GDP Depreciation + NFIA NNP = GNP Depreciation . we deduct depreciation from GDP and GNP. The word net refers to the exclusion of that part of total output which represents depreciation. wear and tear and replacements during the year of accounting. But in reality the process of production uses up a certain amount of fixed capital by way of wear and tear by a process termed as depreciation. Hence.While calculating GDP and GNP we ignore depreciation of assets or capital consumption. else they would not reveal complete flow of goods and services through various sectors.

The average income of the people of a country in a particular year is called per capita income. Per capita income is income per head of a country for a year. National Income Per capita Income = --------------------------Total Population .

Personal disposable Income = Personal Income Taxes Personal . Personal Disposable Income is the income which can be spent on consumption by individuals and families.Personal income is the total income received by the individuals of a country from all sources before direct taxes in one year.

viz.National income is nothing but the measurement of aggregate production in an economy during a definite time period. Total Income and Total Expenditure respectively. Gross National Income (GNI) and Gross National Expenditure (GNE) represented by Total Output. There are three different ways of looking at the value of a nation s output. . Gross National Product (GNP)..

Gross National Income and Gross National Expenditure may be used synonymously. 2. 3. . aggregate expenditure on consumption and investment). for some statistical data problem. and statistical discrepancy may arise. that is GNP= GNI = GNE. The terms Gross National Product. GNP is the sum of value added of all firms in same period that is the total value of final goods and services produced. However. In principle. GNI values national output as a sum of total payments made to the factors of production for their services in production or alternatively. the earnings received by various factors. this may not happen. these three variants will always be equal. GNP is a monetary measure because there is no other way of adding up different sorts of goods and services produced except with their money value. GNE values national output by taking the value of expenditure on goods and services produced (that is.1. in practice.

Product (or Output) Method 2. Expenditure Method . Income Method 3.Based on these three ways there are three methods of measuring national income 1.

The product method adds up the market value of all final goods and services produced in the country by all firms across all industries. . also called national income by Industry of Origin.As per the product method of estimating national income.

by taking market price of all the products 3. i. The total values thus obtained are then added up. This gives the GDP or GNP. in order to arrive at NNP. depending upon what data are being used. fishing. as the case may be. electricity. The physical units of output are then interpreted in money terms. The economy is divided on basis of industries. such as agriculture. The net value is calculated by subtracting depreciation from the total value thus obtained. large scale manufacturing. small scale manufacturing..e. A word of caution to be repeated here is that goods produced in a particular year and only in their final form are to be considered. 2. gas. The indirect taxes are subtracted and the subsidies are added. 5. etc. . 4. mining.This method involves the following steps: 1.

if we do that. Instead we would either count the final value (Rs. 5000) or the value added at each stage (Rs. 5000. 8000? No. The sum of all such values added by all industries in the economy is known as Gross Value Added (GVA) at basic prices. it would be double counting. .2000 by the retailer). how much has the mobile contributed to GDP? Is it Rs.EXAMPLE: If a manufacturer sells a mobile phone to a retailer for Rs. 3000 and the retailer sell it to the consumer at Rs.3000 by the manufacturer and Rs.

Thus national income by Product Method can be calculated in two ways: ‡ Final Product Method ‡ Value Added Method .

the total value of final goods and services produced in a country during a year is calculation and assessed at market price. So in the previous example of mobile phone that we have taken. Only the final goods and services of all these sectors are included. and intermediary goods and services are not taken into account. This avoids chance of double counting. we shall only consider Rs.Final Product Method ‡ According to this method. which is the market price for final consumer. ‡ ‡ . 5000.

e. 2000. Rs. i. If all such differences are added up for all industries in the economy.Value Added Method ‡ ‡ Another method of measuring national income is the value added by each industry of the economy..e. we arrive at GDP Like in the above example national income added by value added method require calculating the value addition at retailer level. 5000. Rs. The difference between the values of material outputs and inputs at each stage of production is the value added. Thus national income will be Rs.3000 and again at final consumer level i. The value added method measures the contribution of each producing enterprise of the economy. ‡ ..

Exclusion of Non Marketed products: National income is always measured in money. Not applicable to tertiary sector: The method is useful only when output can be measured in physical terms.g. the possibilities of double counting cannot be fully eliminated. Hence. Thus it cannot be applied to the service sector due to the absence of input output relationship. but it does not go to the national income data .Problem of double counting: The greatest difficulty in calculating national income by the product method is that of unclear distinction between a final and intermediate product. painting as a hobby by an individual. e. It has an opportunity cost in terms of time and resources involved. but there are number of goods and services which are difficult to assess in terms of money. which is the basis of this method.

However. net wages. This is the GDP at factor. it is the net income received by all citizen of the country in a particular year that is added up. now we add the money sent by the citizens of the nation from abroad and deduct the payments made to foreign nationals (individuals and firms) we get Gross National Income (GNI) . net interest and net profits.According to the Income method. total rents..e. income received in the form of transfer payment is not included. i.

From (3). Income of each of these groups is calculated. In other words. income earned by foreigners and transfer payment made in the year are subtracted. including income from abroad and undistributed profits. GNP at factor cost = Rent + Interest + Profits + other Income + (Income from Abroad Payments made to foreigners) Transfer Payments. profit earners. rent earners. . Income of all the earners is added.The economy is divided on the basis of income groups. and so on. such as wages/salary earners.

. the calculated value of national income is less by this amount. These services are not included in national income as it is very difficult to count their true monetary value. All of these activities are economic in nature and contribute to national income.Exclusion of Non Monetary Income: The most significant limitation of this method is that it ignores the non monetized sector of economic activities. Example may be mother s services or housewife s services. Hence. and so on. they go unrecorded. but have opportunity cost and real cost implications. but due to their non monetary nature. such as a farmer and family working in own field. a retailer running business in own premises. Exclusion of Non Marketed Services: There may be cases when people take up a particular activity which is not economic in the strict sense.

and net foreign investment. government expenditure on goods and services.We have seen that whatever is earned is spent either on consumption or on investment. According to the expenditure method. the total expenditure incurred by the society in a particular year is added together to get the year s national income. Therefore. it is possible to calculate national income by expenditure method. such expenditure includes personal consumption expenditure. net domestic investment. .

they pay taxes out of it and save the rest. they can spend it on domestic goods or foreign goods (durables and non durables) and services. residential construction (construction of new housing units and renovation of existing structures) and inventory investment (unsold portion of output). Personal consumption expenditure refers to payments by households for goods and services.This concept rests on the assumption that national income equals national expenditure. ‡ . When individuals receive income. Investment Expenditure: This expenditure is divided into three major categories: capital spending (purchase of new materials and equipments by firms). ‡ Consumption expenditure: Consumption is the largest and most important of the flows.

Exports to foreign nations are added to total expenditures. because such spending escapes the system and does not add to domestic production.‡ Government Expenditure: Government expenditure refers to government payments for goods and services or investment in equipments and structures. . ‡ Net Exports: Spending on import is subtracted from total expenditure on exports.

 These data also help in determining the regional disparities.  National income is considered as a measure of economic welfare. National income data is necessary for economic planning of a country.  These data also help in comparing the situations of economic growth in two different countries. . income inequality and level of poverty in a country. Such data help in determining the output of each sector and therefore are useful aid in judging which sector should be given more emphasis.  A sustained increase in national income of a country over time is an indicator of economic growth. on the basis of per capita income and inflation indices.

it is very difficult to identify income of those who do not pay income tax. domestic servants.‡ Non Monetized Transactions: There are numerous incidents of exchange of goods and services. For ex: a businessman takes the help of his wife in managing his business but does not pay her any salary. How would you count the contribution of a road side tea shop? By income method? Output Method? Expenditure method? Secondly. but mostly goes unrecorded. which have no monetary payments as such. Unorganized Sector: The unorganized sector of any economy. courtesy or kindness. and household production unit contributes substantially to the national income. like services rendered out of love. including unskilled labor. These services have economic value but no money value. ‡ .

In such cases there would either be incidence of double counting. most of the small farmers cultivate only one crop a year. For ex: In India. Example: The computer bought by a student for personal use is a final product.Multiple Source of Earning: A person may have multiple source of income. But the problem in this is that there are many cases in which categorization are not very clear. and in lean session they work in unorganized sector. . The latter goes unrecognized. but the computer bought by the computer training institute is an intermediary good. or less than actual counting. of which one may be the main activity while the others may be executed on a part time basis. Categorization of Goods and Services: The validity of National Income accounting depends upon the belief that only final goods and services are counted and intermediary goods are excluded. as the final product in its case is trained person. Hence multiple source of earning makes collection of data difficult.

. which results in inaccurate computation of national income. partnership or nonprofit organizations.Inadequate Data: Lack on inadequate and reliable data is a major hurdle to the measurement of national income of underdeveloped countries. Often authentic data may not be available from any proprietorship firms.

Self reinforcing . Periodicity 2. It has been seen that economic activities measured in terms of production. employment and income move in a cyclical manner over a period of time. Synchronism 3. This cyclical movement is characterized by alternative waves of expansion and contraction.Business cycle is a periodic up and down movements in economic activities. and is associated with alternate period of prosperity and depression. Business cycles have three basic features or characteristics: 1.

. To understand it further you should know that when an economy continues to grow for certain period of time.Periodicity: These wavelike movements in income and employment occur at interval of 6 to 12 years. it is bound to slow down.

For ex: Suppose. and on the other hand would result in reduction in demand for capital. large sections of the economy experience the same phase. advertisers and so on. . This will. What will be the effect? This will result in closure of some of the units. It happens because of interdependence of various sectors of the economy.Synchronism: Another very interesting feature of business cycle is that their impact is all embracing i. intermediary products. on the one hand create unemployment of employees. raw material. and would thus create a chain of less economic activities.e.. due to any reason aggregate demand of electronic goods declines. marketing agents. Thus contraction of economic activities in one sector would lead recession in many other areas.

Self Reinforcing: This is one of the most critical features of business cycle. upward swing of the cycle is reinforced for further upward movement and vice versa. those faced by one economy spread to other economies as well. cyclical movements faced by one sector spreads to other sectors in the economy. Therefore. . You have seen that due to interdependence of various sector and economies.

A typical business cycle can be studied in four phase:     Expansion Peak Contraction (recession) Trough (depression). and two turning points upward and downward .

peak Expansion GNP % G contraction G trough Tine unit (Years) .

PEAK This is the highest point of growth. after some time it slows down and thus a turning point comes in the economy. At the same time. This is the stage beyond which no further expansion is possible.EXPANSION As the term itself denotes. income and consumption increase. . prices move up. money supply increase. In reality a process of growth cannot continue indefinitely. and it is that phase which sees the downward turning point. hence it is referred to as peak or boom in a business cycle. this is a phase when all macro economic variables like output. employment. and the self reinforcing features of business cycle pushes the economy upward.

because their income has been reduced. As a result. but cannot. but cannot. Let us see what happens in this phase. thus increasing unemployment and reducing income and consumption. because no one is willing to hire them. There are workers who are willing to work. When investment reduces. but cannot. . there are firm that would like to invest and produce and hire more workers. This marks the onset of recession. industrial production slows down. there are consumers who would like to spend.CONTRACTION Again you can understand from the term contraction that it means the slowing down process of all economic activities. because there is not enough demand for their product.

. this is the lowest ebb of economic cycle.TROUGH Also termed as slump or depression. one at peak when the economy starts sliding down. and the other at trough. And it is also followed by the next turning point in the cycle. when the economy picks up momentum for another phase of growth. Thus you can seen that there are two turning points in the cycle. when new growth process starts afresh.

EFFECTS DURING EXPANSION Expansion is the phase of high growth coupled with large investments, increase in employment, income and expenditure, but that is not all about it. Expansion also comes along with inflation and competition.

Inflation
Inflation is the necessary evil that comes with expansion. Increase in investment increases demand for capital, which forces more money supply in the system, demand for factor inputs increases, hence their prices increase which increases cost of production. So wages and prices of goods also increase. So, we can say inflation is by product of growth and expansion, therefore governments are busy controlling inflation during expansion phase.

Competition Another effect of expansion is intensive competition; firm vie for their share in the growth process and the only bad thing about this situation is that firms resort to large amount of non productive expenditure on advertisements and publicity. Especially in monopolistic and oligopoly firms, where the product differentiation is not generic or utility based, but is more due to consumers preferences and biases, the producers (or sellers) are forced to spend huge amount of funds on such expenditures which do not add real value to the product; thus the GNP may increase, but in money terms not in the real terms.

EFFECTS DURING RECESSION Recession is unwarranted and creates negative implications for the economy; hence there is no doubt that it should be controlled. During this phase, the basic problems that occur are that of unemployment, excessive inventory, below capacity operations and liquidation of firms. Excess Inventory One of the most important reasons for recession is fall in aggregate demand. Therefore, those firms which had produced in abundance during expansion phase face the problem of maintaining unsold items. This further dampens the spirit to investment. They not only have excess inventory of unsold finished goods, but also of raw material and semi finished goods which are in the production process. This creates unemployment for suppliers of these goods. Another problem is that inventory maintenance has a cost, which is in addition to cost of production. Thus the problem of the firm further aggravates.

the first axe falls on workers and recession phase is marked by large scale retrenchment. . many software majors in India have put recruitments on hold and have also cut down workforce in the name of rationalization.Retrenchment Firms employ more people if they increase production. in the event of reduction in investment. You would recall that with the news of a possible downswing of US economy.

This dichotomy of roles makes firm s responsibility more critical and crucial. During expansion firms gain.At Firm Level Firms are the main victims of cycles. at the same time they are one of the main players in the game. therefore expansion is the desired phase for them and the recession is the unwarranted phase. But the problem is that no one can choose just one. . during recession they suffer. Therefore the only therapy available to firms is to take preventive measures.

Financing pattern should be a balanced nix of debt and equity. . Pricing: Flexibility should be the right strategy. so that suffering during recession may be minimized Investment: Firms should deter from investing huge amount of funds in fixed assets. so that during recession prices may be adjusted to increase demand without eating away the margins.Precautionary Measures These include safe guards against swaying away the wave of expansion. Products: Firms should diversify in different markets and different products. Inventory: Firms should not create large inventory of raw material or finished goods. because in this way risk is also diversified. Just in time strategy helps in such cases.

The basic difference between the two is that while controlling inflation government s focus is only on prices whereas in case of business cycles the focus is on the stability in the economy.Since inflation is an important corollary of expansion. measures to control inflation also help in controlling business cycle. .

whereas in recession it reduces the rate to increase money supply. Note: increase in money supply encourages people to spend more and thus increases aggregate demand. the central bank of the country uses various methods of credit control. Reserve ratios: reserve ratios function in the same manner as rediscount rate. . Hence during expansion the ratio are increased so that banks are left with less cash to be extended as credit. while during recession the ratios are decreased so that bank can extend easy credit.Monetary Measures Under monetary measures. Rediscount rate: during expansion the central bank increases the rediscount rate to curb money supply.

Open market operations: during expansion. thereby providing a safety cushion against strong bouts of expansion and contraction in the economy. through which credit may be extended to certain areas and contracted other areas. And you know that it may not be always desirable to control credit at all levels. . either on the basis of use or amount. Therefore. central bank sells securities and thus takes away disposable income from people s hand. known as selective credit control. during recession it buys securities to give more in the hands of people for consumption. Actually this method is a very preventive tool. At the other extreme. central banks have devised another method. Selective credit control: all the above methods are aimed at controlling money supply in general without any segmentation.

Public expenditure: Public expenditure is an important measure to recover an economy from recession. communication. During recession government normally use public expenditure as a tool. while during expansion they use public revenue items as controlling device. So during recession it is desirable that government reduces taxes. Public revenue: As increase in expenditure boosts aggregate demand. When government spends money on various activities like health. increase in public revenue takes away portion of people s money income and thus bring down aggregate demand.FISCAL MEASURES Fiscal measures include managing public expenditure. . this in turn increases aggregate demand. transport.. etc. income of individuals increases. public revenue and public debt.

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