Micro and Macro Economics
The terms ‘micro-‘ and ‘macro-‘ economics were first coined and used by Ragnar Fiscer in 1933. Micro-economics studies the economic actions and behaviour of individual units and small groups of individual units. In micro-economics, we are chiefly concerned with the economic study of an individual household, individual consumer, individual producer, individual firm, individual industry, particular commodity, etc. Whereas, when we are analysing the problems of the economy as a whole, it is a macro-economic study. In macro-economics, we do not study an individual producer or consumer, but we study all the producers or consumers in a particular economy.
Micro-Economics or Price Theory:
The term ‘micro-economics’ is derived from the Greek prefix ‘micro’, which means small or a millionth part. Micro-economic theory is also known as ‘price theory’. It is an analysis of the behaviour of any small decision-making unit, such as a firm, or an industry, or a consumer, etc. For micro-economics, in contrast to macro economic theory, the statistics of total economic activity are valueless as far as providing clues to policy decisions. It does not give an idea of the functioning of the economy as a whole. An individual industry may be flourishing, whereas the economy as a whole may be suffering.
In respect of employment, micro-economics studies only the employment in a firm or in an industry and does not concern to the aggregate employment in the whole economy. In the circular flow of economic activity in the community, micro-economics studies the flow of economic resources or factors of production from the resource owners to business firms and the flow of goods and services from the business firms to households. It studies the composition of such flows and how the prices of goods and services in the flow are determined.
A noteworthy feature of micro-approach is that, while conducting economic analysis on a micro basis, generally an assumption of ‘full employment’ in the economy as a whole is made. On that assumption, the economic problem is mainly that of resource allocation or of theory of price. Importance of Micro-Economics: Micro-economics occupies a very important place in the study of economic theory.
1. Functioning of free enterprise economy: It explains the functioning of a free enterprise economy. It tells us how millions of consumers and producers in an economy take decisions about the allocation of productive resources among millions of goods and services.
2. Distribution of goods and services: It also explains how through market mechanism goods and services produced in the economy are distributed.
3. Determination of prices: It also explains the determination of the relative prices of various products and productive services.
4. Efficiency in consumption and production: It explains the conditions of efficiency both
in consumption and production and departure from the optimum.
5. Formulation of economic policies: It helps in the formulation of economic policies
calculated to promote efficiency in production and the welfare of the masses.
Thus the role of micro-economics is both positive and normative. It not only tells us how the economy operates but also how it should be operated to promote general welfare. It is also applicable to various branches of economics such as public finance, international trade, etc. Limitations of Micro-Economics: Micro-economic analysis suffers from certain limitations:
1. It does not give an idea of the functioning of the economy as a whole. It fails to analyse the aggregate employment level of the economy, aggregate demand, inflation, gross domestic product, etc.
2. It assumes the existence of ‘full employment’ in the whole economy, which is practically impossible.
Macro-Economics or Theory of Income and Employment:
The term ‘macro-economics’ is derived from the Greek prefix ‘macro’, which means a large part. Macro-economics is an analysis of aggregates and averages of the entire (large) economy, such as national income, gross domestic product, total employment, total output, total consumption, aggregate demand, aggregate supply, etc. Macro-economics is the economic theory which looks to the statistics of a nation's total economic activity and holds that policy change designed to alter these total statistical aggregates is the way to determine economic policy and promote economic progress. Individual is ignored altogether. Sometimes, national saving is increased at the expense of individual welfare.
It analysis the chief determinants of economic development, and the various stages and processes of economic growth. Different macro-economic models of economic growth have been suggested, one of which most famous is Harrod-Domar Model. It can be applied to both developed and under-developed economies.
Importance of Macro-Economics:
1. It is helpful in understanding the functioning of a complicated economic system. It also studies the functioning of global economy. With growth of globalisation and WTO regime, the study of macro-economics has become more important.
2. It is very important in the formulation of useful economic policies for the nation to remove the problems of unemployment, inflation, rising prices and poverty.
3. Through macro-economics, the national income can be estimated and regulated. The per capita income and the people’s living standard are also estimated through macro-economic study. It explains the fluctuations in national income, per capita income, output and employment.
Limitations of Macro-Economics:
1. Individual is ignored altogether. For example, in macro-economics national saving is increased through increasing tax on consumption, which directly affects the consumer welfare.
2. The macro-economic analysis overlooks individual differences. For instance, the general price level may be stable, but the prices of food grains may have gone spelling ruin to the poor. A steep rise in manufactured articles may conceal a calamitous fall in agricultural prices, while the average prices were steady. The agriculturists may be ruined. While speaking of the aggregates, it is also essential to remember the nature, composition and structure of the components.
Equilibrium
The term equilibrium has often to be used in economic analysis. In fact, Modern Economics is sometimes called equilibrium analysis. Equilibrium means a state of balance. When forces acting in opposite directions are exactly equal, the object on which they are acting is said to be in a state of equilibrium.
Basically, there are three types of any equilibrium:
(a) Stable Equilibrium: There is stable equilibrium, when the object concerned, after having been disturbed, tends to resume its original position. Thus, in the case of a stable equilibrium, there is a tendency for the object to revert to the old position.
(b) Unstable Equilibrium: On the other hand, the equilibrium is unstable when a slight disturbance evokes further disturbance, so that the original position is never restored. In this case, there is a tendency for the object to assume newer and newer positions once there is departure from the original position.
(c) Neutral Equilibrium: It is neutral equilibrium when the disturbing forces neither bring it back to the original position nor do they drive it further away from it. It rests where it has been moved. Thus, in the case of a neutral equilibrium, the object assumes once for all a new position after the original position is disturbed.
When the word equilibrium is used to qualify the term value, then according to Professor Schumpeter, a stable equilibrium value is an equilibrium value that if changed by a small amount, calls into action forces that will tend to reproduce the old value; a neutral equilibrium value is an equilibrium value that does not know any such forces; and an unstable equilibrium value is an equilibrium value, change in which calls forth forces which tend to move the system farther and farther away from the equilibrium value.
In the following figure 2, the stable equilibrium is shown. When in equilibrium at point P, the producer produces an output OM and maximises his profits. In case the producer increases his output to OM2 or decreases it to OM1, the size of profits is reduced. This automatically brings in
forces that tend to establish equilibrium again at P.
Figure 3 represents the case of unstable equilibrium. Initially the producer is in equilibrium at point P, where MR = MC and he is maximising his profits. If now he increases his output to OM1,
he would be in equilibrium output at point P1, where he will obtain higher profits, because, at this
output, marginal revenue is greater than marginal cost. Thus there is no tendency to return to the original position at P.
Figure 4 represents the situation of neutral equilibrium. In this case, MR = MC at all levels of output so that the producer has no tendency to return to the old position and every time a new equilibrium point is obtained, which is as good as the initial one.
Other Forms of Equilibrium
(a) Short-term and Long-term Equilibrium: Equilibrium may be short-term equilibrium or
long-term equilibrium as in case of short-long-term and long-long-term value. In the short-long-term equilibrium, supply is adjusted to change in demand with the existing equipment or means of production, there being no time available to increase or decrease the factors of production. However, in case of long-term equilibrium, there is ample time to change even the equipment or the factors of production themselves, and a new factory can be erected or new machinery can be installed.
(b) Partial Equilibrium: Partial equilibrium analysis is the analysis of an equilibrium position for a sector of the economy or for one or several partial groups of the economic unit corresponding to a particular set of data. This analysis excludes certain variables and relationship from the totality and studies only a few selected variables at a time. In other words, this method considers the changes in one or two variables keeping all others constant, i.e., ceteris paribus (others remaining the same). The ceteris paribus is the crux of partial equilibrium analysis.
The equilibrium of a single consumer, a single producer, a single firm and a single industry are examples of partial equilibrium analysis. Marshall’s theory of value is a case of partial equilibrium analysis. If the Marshallian method (i.e., partial equilibrium analysis) is to be effective, even in its
own terms, when applied to a hypothetical and idealised market, it necessary that the market should be small enough so that its inter-dependence with the rest of the hypothetical economy could be neglected without much loss of accuracy.
(i) Consumer’s Equilibrium: With the application of partial equilibrium analysis, consumer’s equilibrium is indicated when he is getting maximum aggregate satisfaction from a given expenditure and in a given set of conditions relating to price and supply of the commodity.
(ii) Producer’s Equilibrium: A producer is in equilibrium when he is able to maximise his aggregate net profit in the economic conditions in which he is working.
(iii) Firm’s Equilibrium: A firm is said to be in long-run equilibrium when it has attained the optimum size when is ideal from the viewpoint of profit and utilisation of resources at its disposal.
(iv) Industry’s Equilibrium: Equilibrium of an industry shows that there is no incentive for new firms to enter it or for the existing firms to leave it. This will happen when the marginal firm in the industry is making only normal profit, neither more nor less. In all these cases; those who have incentive to change it have no opportunity and those who have the opportunity have no incentive.
(c) General Equilibrium Analysis: Leon Walras (1834-1910), a Neoclassical economist, in his book ‘Elements of Pure Economics’, created his theoretical and mathematical model of General Equilibrium as a means of integrating both the effects of demand and supply side forces in the whole economy. Walras’ Elements of Pure Economics provides a succession of models, each taking into account more aspects of a real economy. General equilibrium theory is a branch of
theoretical microeconomics. The partial equilibrium analysis studies the relationship between
only selected few variables, keeping others unchanged. Whereas the general equilibrium analysis enables us to study the behaviour of economic variables taking full account of the interaction between those variables and the rest of the economy. In partial equilibrium analysis, the determination of the price of a good is simplified by just looking at the price of one good, and assuming that the prices of all other goods remain constant.
General equilibrium is different from the aggregate or macro-economic equilibrium. General equilibrium tries to give an understanding of the whole economy using a bottom-top approach, starting with individual markets and agents. Whereas, the macro-economic equilibrium analysis utilises top-bottom approach, where the analysis starts with larger aggregates. In macro-economic equilibrium models, like Keynesian type, the entire system is described by relatively few, appropriately defined aggregates and functional relationships connecting aggregate variables such as total consumption expenditure, total investment, total employment, aggregate output and the like. In macro-economic analysis, many important variables and relationships tend to be disappeared in the process of aggregation.
There are two major theorems presented by Kenneth Arrow and Gerard Debreu in the framework of general equilibrium:
(i) The first fundamental theorem is that every market equilibrium is Pareto optimal under certain conditions, and
(ii) The second fundamental theorem is that every Pareto optimum is supported by a price system, again under certain conditions.
Uses of General Equilibrium
1. To get an overall picture of the economy and study the problems involving the
economy as a whole or even large segments / sectors of it.
2. It shows that the quantities of demanded goods / factors are equal to the quantities
supplied. Such a condition implies that there is a full employment of resources.
3. It also provides with an ideal datum of economic efficiency. It brings out the fact that
long-run competitive equilibrium is a standard of efficiency for the entire economy. Only when the competitive economy obtains general equilibrium shall its economic efficiency be at its peak and there shall be no further gains made by any reallocation of resources.
4. General equilibrium also represents the state of optimum production of all
commodities, because there can be no over-production or under-production under such conditions.
5. It also provides an insight into the way the multitudes of individual decisions are
integrated by the working of the price mechanism. It, therefore, solves the fundamental
problems of a free market economy, viz., what to produce, how to produce, how much
to produce, etc. This analysis shows that such decisions with regard to innumerable consumers and producers are co-ordinated by the price mechanism.
6. The general equilibrium analysis also gives us the clue for predicting the
consequences of an economic event.
7. It also helps in the field of public policy. The formulation of a logically consistent
public policy requires a complete understanding of the various sector markets and aspects of individual decision-making units, and the impact of policy on the whole economy.
Limitations of General Equilibrium Analysis
1. The Walrasian general equilibrium system is essentially static. It treats the coefficient
of production as fixed. It considers the supply of resources to be given and consistent. It also takes tastes and preferences of the society as fixed.
2. It ignores leads and lags, for it considers everything to happen instantaneously. It is
supposed to work just in the same way as an electric circuit does. In the real world, all economic events have links with the past and the future.
3. Walrasian general equilibrium analysis is of little practical utility. It involves
astronomical volumes of calculations for estimating the various quantities and practices. This makes its application practically impossible. Even the use of computers cannot be of much help because such a system cannot aid in collecting and recording the innumerable sets of prices and quantities that are required to formulate these equations. The critics further argue that even if such a solution exists, the price mechanism may not necessarily cover it.
4. Last but not least, the general equilibrium analysis falls to the ground as its star assumption of perfect competition is contrary to the actual conditions prevailing in the
General Disequilibrium (Keynesian Theory)
Neoclassical economics thinks in terms of a market system in which supply equals demand in every market, so that no unemployment could ever occur. But this is an assumption. Keynes suggests a market system in which Disequilibrium can occur in some markets, including labour market, and in which the disequilibrium can spread contagiously from one market to another. Keynes’ idea was that, when this spreading disequilibrium settles down, there would be a kind of equilibrium – not supply and demand equilibrium, but often termed as ‘general disequilibrium’. Take an example of a commodity, say cellular telephone sets, its equilibrium of demand and supply is shown in the following figure:
In the above figure, MC curve is the marginal cost curve for the commodity. Originally, the market is in equilibrium at price P1 with demand curve D1. Then, for any reason, demand for that
commodity decreases to D2, Neoclassical economists tells us that the new equilibrium will be at
price P3. But, in fact, the prices do not drop quite that far, instead, prices drop to P2. Perhaps this
is because the businessmen do not know just how far they need to cut their prices, and are cautious to avoid cutting too much. At a price P2, the seller can sell only Qd amount of output. By
producing Qd amount of output at price P2, the producers are not maximising their short-run profit.
We have ‘disequilibrium’ in the sense that production is not on the marginal cost curve. At P2, the
sellers can sell Qd amount of output, but they cannot produce the same amount of output. Here
is a qualification. Producer might temporarily produce more that Qd, in order to build up their
inventories. But there is a limit to how much inventories they want, so they will cut their production back to Qd eventually.
With a reduction of demand for cellular phones, any economist would expect a reduction in the quantity of that commodity produced. Neoclassical economics leads us to expect that the price would drop to P3 and output cut back to Qe. At the same time, a certain number of workers would
be laid off and would switch their efforts into their second best alternatives, working in other industries, perhaps at somewhat lower wages. But the ‘disequilibrium model’ states that the production and layoffs would go even further, with output dropping to Qd. A reduction in income
does not only reduce the demand for cellular phones, but it also reduces the demand for all other normal goods as well. This disequilibrium will spread contagiously through many different goods markets, through the effect of disequilibrium on income. So every other industry will face a reduction in demand because of the reductions in productions in many other industries.
As we know that one of the principal strategies of development is mobilisation of domestic and foreign saving in order to generate sufficient investment to accelerate economic growth. The economic mechanism by which more investment leads to more growth can be described in terms of Harrod-Domar growth model, often referred to as the AK model.
Every economy must save a certain proportion of the national income, if only to replace worn-out or impaired capital goods (buildings, equipment, and materials). However, in order to grow, new investments representing net additions to the capital stock are necessary. If we assume that there is some direct economic relationship between the size of the total capital stock, K, and total GNP, Y – for example, if $3 of capital is always necessary to produce a $1 stream of GNP – it follows that any net additions to the capital stock in the forms of new investment will bring about corresponding increases in the follow of national output, GNP. This relationship is known as
‘capital-output ratio’ and is represented as ‘k’. in the above case ‘k’ is roughly 3:1.
If we further assume that the national savings ratio ‘S’ is a fixed proportion of national output (e.g. 6%) and that total new investment is determined by the level of total savings. We can construct the following simple model of economic growth:
· Saving (S) is some proportion, s, of national income (Y) such that we have the simple equation:
S = s .Y --- (i)
· Net investment (I) is defined as the change in the capital stock, K, and can be represented by ΔK such that:
I = ΔK --- (ii)
But because the total capital stock, K, bears a direct relationship to total national income or output, Y, as expressed by the capital-output ratio, k, it follows that:
K = k Y Or ΔK = k ΔY Or ΔK = k.ΔY --- (iii)>
· Finally, because net national savings, S, must equal net investment, I, we can write this equality as:
S = I --- (iv)
I = ΔK = k. ΔY
Therefore, we can rewrite the equation (iv) as follows:
S = s.Y = k.ΔY = ΔK = I --- (v)
Or simply
s.Y = k.ΔY ---(vi)
Dividing both the sides of equation (vi) first Y and then by k, we obtain the following expression:
ΔY = s --- (vii)
Y k
Note that the left-hand side of the equation i.e., ΔY / Y represents the rate of change or rate of
growth in GNP (i.e., the percentage change in GNP).
The Harrod Domar Model, more specifically says that in the absence of government, the growth rate of national income will directly or positively related to the savings ratio (i.e., the more an economy is able to save and invest out of a given GNP, the greater the growth of that GNP will be. Harrod Domar Model further states that the growth rate of national income will be inversely or negatively related to the economic capital-output ratio (i.e., the higher k is, the lower the rate of GNP growth will be).
The additional output can be obtained from an additional unit of investment and it can be measured by the inverse of the capital-output ratio, k, because this inverse, 1 / k, is simply the output-capital or output-investment ratio. It follows that multiplying the rate of new investment, s
= I / Y, by its productivity, 1 / k, will give the rate by which national income or GNP will increase.
For example, the national capital-output ratio in an under-developed country is, let say, 3 and the aggregate saving ratio (s) is 6% of GNP, it follows that this country can grow at a rate of 2% (i.e., 6% / 3 or s / k or ΔY / Y). Now suppose that the national saving rate increased from 6% to 15%
through increased taxes, foreign aids, and / or general consumption sacrifices – GNP growth can be transferred from 2% to 5% (15% / 3).
According to Rostow and other theorists, the countries that were able to save 15% to 20% of GNP could grow at a much faster rate than those that saved less. Moreover, this growth would then be self-sustained. The mechanisms of economic growth and development, therefore, are simply a matter of increasing national savings and investment.
The main obstacle or constraint on development, according to this theory, was the relatively low level of new capital formation in most poor countries. But if a country wanted to grow at, let say, a rate of 7% per annum and if it could not generate savings and investment at a rate of 21% (i.e., 7% × 3) of national income but could not only manage to save 15%, it could seek to fill this saving gap of 6% through either foreign aid or private foreign investment.
Limitations of the model:
1. Economic growth and economic development are not the same. Economic growth is a
2. Harrod Domar model was formulated primarily to protect the developed countries from
chronic unemployment, and was not meant for developing countries.
3. Practically it is difficult to stimulate the level of domestic savings particularly in the
case of LDCs where incomes are low.
4. It fails to address the nature of unemployment exists in different countries. In developed
countries, the unemployment is ‘cyclical unemployment’, which is due to insufficient effective demand; whereas in developing countries, there is ‘disguised unemployment’.
5. Borrowing from overseas to fill the gap caused by insufficient savings causes debt repayment problems later.
6. The law of diminishing returns would suggest that as investment increases the
productivity of the capital will diminish and the capital to output ratio rise.
The Harrod-Domar model of economic growth cannot be rejected on the ground of above limitations. With slight modifications and reinterpretations, it can be made to furnish suitable guidelines even for the developing economies.
National Income Accounts
What is National Income Accounting?
National income accounting is a term which is applied to the description of the various types of economic activities that are taking place in the community in a certain institutional framework. In national income accounting, we are concerned with statistical classification of the economic activity so that we are able to understand easily and clearly the operation of the economy as a whole. In national income accounting the following distinctions are drawn between:
(a) forms of economic activity, namely, production, consumption, and accumulation of wealth;
(b) sectors or institutional division of the economy; and
(c) types of transactions, such as sales and purchases of goods and services, gifts, taxes, and other current transfers.
In national income accounting, a transactor is supposed to keep a set of three accounts in which transactions are recorded:
(i) In the first account, incomes and outgoings relating a productive activity of the transactor are brought together. The difference between the two shows the profit or gain.
(ii) The second account seeks to show how this profit and any other income that accrues to the transactor are allocated to different uses. The excess of income over outlay is saving.
(iii) The third account shows how this saving and any other capital funds are used to finance the capital expenditure or to give loans to other transactors.
Since in an economy, there are numerous transactors, therefore, they are grouped into sectors. In a sector, accounts of a same type are consolidated. The ‘sector accounts’ form the units in a system of national income accounting.
Comparison of National Income Accounting and Individual Income Accounting:
(a) Double entry book-keeping: Both national income accounting system and individual
income accounting system are based on the method of double-entry book-keeping. For example, under individual income accounting, a cash sale is recorded as a debit in Cash Account and as a credit in Sales Account. Whereas, in national income accounting, the cash transactions are not separately presented. Cash balances are recorded in the capital transaction account. The difference is that the national income accounting does not record the second entry in detail.
(b) Individual vs. collective individuals: Individual income accounts or private accounts
relate to an individual businessman or a corporate firm. Whereas, the national income accounts are closely related to all the businessmen or corporate firms in the community.
(c) Profit and loss account: Individual income accounts are usually presented in the form
of a Profit and Loss Account or Income Statement which shows the flow of income and its allocation during a year. The Balance Sheet shows the stock of assets and liabilities at the end of the year. The Profit and Loss Account of a private businessman resembles in national income accounting to what is called the Appropriation Account. The only difference is that in private accounting, the profit often includes some elements of costs such as depreciation on plant and machinery and fees paid to the directors of the company. On the other hand, in national income accounting, these incomes are shown net. There is no counterpart at all of a Balance Sheet in national income accounting since there is a great difficulty in collecting such a huge bank of data accurately and completely especially on uniform basis.
Income Statement of a Typical Firm For the year ended on December 31, 2005
Debits Rs. Credits Rs. To Sales Account (50,000 units @ Rs. 25) 1,250,000 By Cost of Sales: Wages Rent Interest Profit (residual) 750,000 150,000 150,000 200,000 Total 1,250,000 Total 1,250,000
National Product Account 2004-05 (Millions of rupees)
Final Output (500 million units @ Rs. 25) 12,500 Costs or Earnings: Wages Rent Interest Profit 7,500 1,500 1,500 2,000 Total 12,500 Total 12,500
Uses of National Income Accounting:
(a) Clear picture of the economy: The national income accounts or social accounts give a
clear picture of the economy regarding the GDP, national income, per capita income, saving ratio, production, consumption, disposable income, capital expenditure, etc. It gives a clear view of the health of the economy and the way in which it functions. It also gives a view on the living standard of the people.
(b) Promotion of efficiency and stability of the economy: To foster the economic growth,
any government has to see what she has achieved in the past and what has to be done in the future. For this purpose, the preparation of national income accounts is quite inevitable for the promotion of economic efficiency and stability. It helps the government to set the national priorities, such as education, inflation, unemployment, defence, social development, and industrialisation, etc., in long-term and medium-term planning. It also helps the planner to set the economic objectives to be achieved in the near future. Thus it serves the purpose of planning and controlling tool for public administrators.
(c) Measurement of economic welfare: Measurement of economic welfare is another
purpose of the preparation of social accounts. Through social accounting, we can know at a glace to what extent the masses are better off than at the time when planning started.
(d) Interrelationship of different sectors of the economy: Through the study of national
income accounts, the reader is in a position to inter-relate different sectors of the economy. For example, through the study of national income accounts, we can know that Pakistan’s industrial sector is largely dependant on agriculture sector, because most of the raw materials like cotton, silk, leather, sugarcane, milk, poultry, etc. are supplied from agriculture.
(e) Monetary, fiscal and trade policies: The national income accounts are very essential
for the statesmen, governments, and politicians, because they help them to efficiently formulate different economic policies, including monetary policy, fiscal policy and trade policy. In the absence of national income accounts, the economic planning would be disastrous.
Gross National Product (GNP):
GNP is the basic national income accounting measure of the total output or aggregate supply of goods and services. It has been defined as the total value of all final goods and services produced in a country during a year. GNP is a ‘flow’ variable, which measures the quantity of final goods and services produced during a year. For calculating GNP accurately, all goods and services produced in any given year must be counted once, but not more than once.
Approaches of Measuring GNP/GDP:
The primary purpose of national accounts is to provide a coherent and comprehensive picture of the economy. To be concise, these estimates tend to answer questions such as:
(a) What is the output of the economy, its size its composition, and its uses? And
(b) What is the economic process by which this output is produced and distributed? These questions are addressed below in relation to estimation of GDP/GNP and final uses of the GNP.
The gross national product (GNP) is the market value of all final goods and services, produced in the economy during a year. GNP is measured in Rupee terms rather than in physical units of output. Gross domestic product (GDP) is a better idea to visualize domestic production in the economy. GDP may be derived in three ways or in combination of them.
(i) Production Approach: It measures the contribution to output made by each producer.
It is obtained by deducting from the total value of its output the value of goods and services it has purchased from other producers and used up in producing its own output, i.e.:
VA = value of output – value of intermediate consumption.
Total value added by all producers equals GDP.
(ii) Income/Cost Approach: In this approach, consideration is given to the costs incurred
by the producer within his own operation, the income paid out to employees, indirect taxes, consumption of fixed capital, and the operating surplus. All these add up to value added.
(iii) Expenditure Approach: This approach looks at the final uses of the output for private
consumption, government consumption, capital formation and net of imports & exports. According this approach, GDP is the sum of following four major components:
Personal consumption expenditure on goods and services, Gross private domestic investment,
Government expenditure on goods and services, and Net export to the rest of the world.
The concepts of expenditure approach and cost approach have been illustrated in the following diagram of circular flow of a simplified two-sector economy:
In the above diagram, the upper loop represents the ‘expenditure’ side of the economy. Through this loop, all the products flow from business sector to household sector. Each year the nation consumes a wide variety of final goods and services: goods such as bread, apples, computers, automobiles, etc.; and services such as haircuts, health, taxis, airlines, etc. But we include only the value of those products that are bought and consumed by the consumers. In our ‘two-sector economy’ illustration, we have excluded the investment expenditure, government expenditure and taxes from GDP calculation.
The lower loop represents the ‘cost or revenue’ side of the economy. Through this loop, all the costs of doing business flow. These costs include wages paid to labour, rent paid to land, profits paid to capital, and so forth. But these business costs are revenues that are received by households in exchange of supplying factors of production to the business sector.
Precautions in Measuring GNP/GDP / Problems in National Income Measurement / Dangers of National Income Accounts:
The federal statisticians and economists have to be very careful in measuring GDP or preparing national income accounts. The following precautionary measures should be taken:
(a) Reliable source of data: All the data for national accounts are collected from different
sources, including surveys, income tax returns, retail sales statistics, and employment data. Inaccurate or incomplete data can severely damage the integrity of the national accounts. The economists have to be very careful in collection and selection of national income accounting data.
(b) Difficulties of Measuring Some Services in Money Terms: National Income of a
country is always measured in money terms, but there are some goods and services, which cannot be measured, in monetary terms. Such goods include, the services of the housewife, housemaid and the singing as a hobby by an individual. Exclusion of these services from the national income, underestimate the national income account.
(c) Illegal Activities in the Economy/The Growth of “Black Economy”: The “Black
Economy” refers to that part of economic activity, which is undeclared and therefore unrecorded for tax purposes and is therefore deemed to be ‘illegal’. Many illegal activities in the economy generally escape both the law and measurement in the national income. Such illegal activities include, smuggling, drug trafficking and all parallel market
transactions. Since such activities are outlawed, income earned, through them are not captured in the national income, thus, under estimating the national income account.
(d) Danger of double counting: While measuring GDP, we have to distinguish between
the three forms of goods:
(i) Final product: A final product is one that is produced and sold for consumption or
investment.
(ii) Intermediate good: Intermediate goods are semi-finished goods or
goods-in-process.
(iii) Raw material: Raw materials are unfinished and unprocessed goods.
To avoid double or multiple counting, it is necessary to add the value of only those goods which have reached their final stage of production, i.e., final goods, and to not add the value of intermediate goods and raw materials, which are already included in the value of final goods. GDP, therefore, includes bread but not wheat, cars but not steal.
(e) Problem of Including All Inventory Change in GNP: Firms generally record
inventories at their original cost rather than at replacement costs. When prices rise, there are gains in the book value of inventories but when prices fall, there are losses. So, the book value of inventories overstates or understates the actual inventories. Thus, for correct computation of GNP, inventory evaluation is required. This is achieved when a negative valuation of inventory is made for inventory gains and a positive valuation is made for losses.
(f) Problem of Price Instability: Since national income is measured in money terms,
fluctuation in the general price level will render unstable the measuring rod of money for national income. When prices are rising, the national income figures are rising even though production might have gone down. On the other hand, when prices are falling, GNP is declining even though the production might have gone up. To solve this problem, economist and statisticians have introduced the concept of real income.
(g) Exclusion of Capital Gain or Losses from GNP: Capital gain or losses accruing to
property owners by increase or decrease in the market value of their asset are not included in GNP computation because such changes do not result from current economic activities. Such exclusions underestimate or overestimate the GNP.
(h) Value added: ‘Value added’ is the difference between a firm’s sales and its purchases
of materials and services from other firms. In calculating GDP earnings or value added to a firm, the statistician includes all costs that go to factors other than businesses and excludes all payments made to other businesses. Hence business costs in the form of wages, salaries, interest payments, and dividends are included in value added, but purchases of wheat or steel or electricity are excluded from value added. The following table illustrates the concept of value addition in GDP:
Table 1
Bread Receipts, Costs, and Value Added Rupees Per Loaf
Stages of Production (1) (2) (3) Sales Receipts Cost of Intermediate Materials Value Added (wages, profit, etc.) (1 – 2) Wheat 2.00 0 2.00 Flour 5.50 2.00 3.50 Baked dough 7.25 5.50 1.75 Delivered bread 10.00 7.25 2.75 Total 24.75 14.75 10.00
(i) Non-productive transactions are excluded from GDP: The non-productive
transactions are excluded from GDP measurement. There are two types of non-productive transactions:
(i) Purely financial transactions: Purely financial transactions are:
All public transfer payments, which do not add to the current flow of goods such as social security payments, relief payments, etc.
All private financial transactions, such as receipt of money by a student from his father, etc.
Buying and selling of marketable securities, which make no contribution to current production.
(ii) Sale proceeds of second-hand goods. Difference between GDP and GNP:
GDP is the most widely used measure of national output in Pakistan. Another concept is widely cited, i.e., GNP. GNP is the total output produced with labour or capital owned by Pakistani residents, while GDP is the output produced with labour and capital located inside Pakistan. For example, some of Pakistani GDP is produced in Honda plants that are owned by Japanese corporations. The profits from these plants are included in Pakistani GDP but not in Pakistani GNP. Similarly, when a Pakistani university lecturer flies to Japan to give a paid lecture on ‘economies of under-developed countries’, that lecturer’s salary would be included in Japanese GDP and in Pakistani GNP.
Net National Product (NNP):
Net national product (NNP) or national income at market price can be obtained by deducting depreciation from GNP. NNP is a sounder measure of a nation’s output than GNP, but most of the economists work with GNP. This is so because depreciation is not easier to estimate. Whereas the gross investment can be estimated fairly-accurately.
NNP equals the total final output produced within a nation during a year, where output includes net investment or gross investment less depreciation. Therefore, NNP is equals to:
NNP = GNP – Depreciation
It is the net market value of all the final goods and services produced in a country during a year. It is obtained by subtracting the amount of depreciation of existing capital from the market value
of all the final goods and services. For a continuous flow of money payments it is necessary that a certain amount of money should be set aside from the GNP for meeting the necessary expenditure of wear and tear, deterioration and obsolescence of the capital and ‘it should remain intact’.
In the above definition, the phrase ‘maintaining capital intact’ is meant to make good the physical deterioration which has taken place in the capital equipment while creating income during a given period. This can only be made by setting aside a certain amount of money every year from the annual gross income so that when the income creating equipment becomes obsolete, a new capital equipment may be created out. If the depreciation allowance is not set aside every year, the flow of income would not remain intact. It will decline gradually and the whole country will become poor.
National Income or National Income at Factor Cost:
National income (NI) or national income at factor cost is the aggregate earnings of all the factors of production (i.e., land, labour, capital, & organisation), which arise from the current production of goods and services by the nation’s economy. The major components of national income are:
(i) Compensation of employees (i.e., wages, salaries, commission, bonus, etc.); (ii) Proprietors income (profits of sole proprietorship, partnership, and joint stock
companies);
(iii) Net income from rentals and royalties; and
(iv) Net interest (excess of interest payments of the domestic business system over its interest receipts and net interest received from abroad).
National income can be calculated as follows:
National Income = NNP – Indirect Taxes + Subsidies Personal Income:
Personal Income is the total income which is actually received by all individuals or households during a given year in a country. Personal income is always less than NI because NI is the sum total of all incomes earned, whereas, the personal income is the current income received by persons from all sources. It should be noted here that all the income items which are included in NI are not paid to individuals or households as income. For instance, the earnings of corporation include dividends, undistributed profits and corporate taxes. The individuals only receive dividends. Corporate taxes are paid to government, and the undistributed profits are retained by firms. There are certain income items paid to individuals, but not included in the national income, commonly known as ‘transfer payments’. Transfer payments include old age benefits, pension, unemployment allowance, interest on national debt, relief payments, etc. Personal income can be measured as follows:
Personal Income = NI at Factor Cost – Contributions to Social Insurance – Corporate Income Taxes – Retained Corporate Earnings + Transfer Payments
Disposable Income:
Disposable income is that income which is left with the individuals after paying taxes to the government. The individuals can spend this amount as they please. However, they can spend in categorically two ways, i.e., either they can spend on consumption goods, or they can save. Therefore, the disposable personal income is equal to:
Disposable Income = Personal Income – Personal Taxes
or
Disposable Income = Consumption + Saving
Details of National Income Accounts:
It is very important to take a brief tour of major components or particulars of national accounts or product accounts. In this way, we can thoroughly understand the concept of GDP/GNP:
(a) GDP Deflator: The problem of changing prices is one of the problems
economists have to solve when they use money as their measuring rod. Clearly, we want a measure of the nation’s output and income that uses an invariant yardstick. This problem can be solved by using ‘price index’, which is a measure of the average price of a bundle of goods. The price index is used to remove
inflation from GDP or to deflate the GDP, that is why, it is also called ‘GDP deflator’. The function of GDP deflator is to convert the ‘nominal GDP’ or the ‘GDP at current prices’ to ‘real GDP’. The formula of real GDP is as follows:
Real GDP = Nominal GDP GDP Deflator
or
Q = PQ
P
Nominal GDP or PQ represents the total money value of final goods and services produced in a given year, where the values in terms of the market prices of each year. Real GDP or Q removes price changes from nominal GDP and calculate GDP in constant prices. And the GDP deflator or P is defined as the price of GDP.
Example:
A country produces 100,000 litres of coconut oil during the year 2005 at a price of Rs. 25 per litre. During the year 2006, she produces 110,000 litres of coconut oil at a price of Rs. 27 per litre. Calculate nominal GDP, GDP deflator and real GDP (using 2005 as base year).
Solution: Nominal GDP: Year Price P Quantity Q Price × Quantity PQ Nominal GDP 2005 25 100,000 2,500,000 2006 27 110,000 2,970,000
Hence, during 2006, the nominal GDP grew by 18.8%.
GDP Deflator:
P1 = Current year price ÷ Base year price = Rs. 25 ÷ Rs. 25 = 1
P2 = Current year price ÷ Base year price = Rs. 27 ÷ Rs. 25 = 1.08 Real GDP: Year Nominal GDP PQ GDP Deflator P Real GDP (PQ/P) Q 2005 2,500,000 1 2,500,000 2006 2,970,000 1.08 2,750,000
Hence, during 2006, the real GDP grew by 10%.
(b) Investment and Capital Formation: Investment consists of the additions to the
nation’s capital stock of buildings, equipment, and inventories during a year. Investment involves sacrifice of current consumption to increase future consumption. Instead of eating more pizzas now, people build new pizza ovens to make it possible to produce more pizza for future consumption.
To economists, investment means production of durable capital goods. In common usage, investment often denotes using money to buy shares from stock exchange or to open a saving account in a bank. In economic terms, purchasing shares or government bonds or opening bank accounts is not an investment. The real investment is that only when production of physical capital goods takes place.
Investment can be further categorised as:
(i) Gross investment: Gross investment includes all the machines, factories,
and houses built during a year – even though some were bought to replace some old capital goods. Gross investment is not adjusted for depreciation, which measures the amount of capital that has been used up in a year.
(ii) Net investment: Gross investment does not adjust the deaths of capital
goods; it only takes care of the births of capital. However, the net investment takes into account the births as well as deaths of capital goods. In other words, net investment is adjusted for depreciation. Therefore, the net investment plays a vital role in estimating national income:
Net Investment = Gross Investment – Depreciation
(c) Government Expenditure: Government expenditures include buying goods
like from roads to missiles, and paying wages like those of marine colonels and street sweepers. In fact, it is the third great category of flow of products. It involves all the expenditures incurred on running the state. However, it does not mean that GDP includes all the government expenditures including ‘government transfer payments’. The government transfer payments, which include payments to individuals that are not made in exchange for goods and services supplied, are excluded from GDP measurement. Such transfers payments include expenditures on pensions, old-age benefits, unemployment allowances, veterans’ benefits, and disability payments. One peculiar government transfer payment is ‘interest on national debts’. This is a return on debt incurred to pay for past wars or government programmes and is not a payment for current government goods and services. Therefore, the interests are excluded from GDP calculations.
(d) Net Exports: ‘Net exports’ is the difference between exports and imports of
goods and services. Pakistan is facing negative net export situation since her birth, except for few years. The biggest reason is that Pakistan is a developing nation and consistently importing capital goods and final consumption goods from developed countries at much higher prices. Whereas, we export raw materials and intermediate goods at lower prices, which have less demand due to their poor quality or because of availability of much cheaper substitute goods in the market.
Circular Flow of Income
The amount of income generated in a given economy within a period of time (national income) can be viewed from three perspectives. These are:
Income, Product, and Expenditure.
The above assertion implies that we can view national income as either the total sum of all income received within a particular period (income); the total good and services produced within a particular period (product) or total expenditure on goods and services within a given period (expenditure). Whichever approach is used, the value we get is the same.
The circular flow of income and product is used to show diagrammatically, the equivalence between the income approach and the product approach in measuring gross national product (GNP).
In analysing the circular flow of income, there are three scenarios:
1. A simple and closed economy with no government and external transactions, i.e., two-sector economy;
2. A mixed and open economy with savings, investment and government activity, i.e., three-sector economy; and
3. A mixed and open economy with savings, investment, government activity and external trade, i.e., four-sector economy.
1. Circular Flow of Income in a Two-Sector Economy:
According to circular flow of income in a two-sector economy, there are only two sectors of the economy, i.e., household sector and business sector. Government does not exist at all, therefore, there is no public expenditure, no taxes, no subsidies, no social security contribution, etc. The economy is a closed one, having no international trade relations. Now we will discuss each of the two sectors:
(i) Household Sector: The household sector is the sole buyer of goods and services, and the sole supplier of factors of production, i.e., land, labour, capital and organisation. It spends its entire income on the purchase of goods and services produced by the business sector. Since the household sector spends the whole income on the purchase of goods and services, therefore, there are no savings and investments. The household sector receives income from business sector by providing the factors of production owned by it.
(ii) Business Sector: The business sector is the sole producer and supplier of goods and services. The business sector generates its revenue by selling goods and services to the household sector. It hires the factors of production, i.e., land, labour, capital and organisation, owned by the household sector. The business sector sells the entire output to households. Therefore, there is no existence of inventories. In a two-sector economy, production and sales are thus equal. So long as the household sector continues
spending the entire income in purchasing the goods and services from the business sector, there will be a circular flow of income and production. The circular flow of income and production operates at the same level and tends to perpetuate itself. The basic identities of the two-sector economy are as under:
Y = C
Where Y is Income
C is Consumption
Circular Flow of Income in a Two-Sector Economy (Saving Economy):
In a two-sector macro-economy, if there is saving by the household sector out of its income, the goods of the business sector will remain unsold by the amount of savings. Production will be reduced and so the income of the households will fall. In case the savings of the households is loaned to the business sector for capital expansion, then the gap created in income flow will be filled by investment. Through investment, the equilibrium level between income and output is maintained at the original level. It is illustrated in the following figure:
The equilibrium condition for two-sector economy with saving is as follows: Y = C + S or Y = C + I or C + S = C + I or S = I Where Y is Income C is Consumption S is Saving I is Investment
When saving and investment are added to the circular flow, there are two paths by which funds can travel on their way from households to product markets. One path is direct, via consumption expenditures. The other is indirect, via saving, financial markets, and investment.
Savings: On the average, households spend less each year than they receive in income. The portion of household income that is not used to buy goods and services or to pay taxes is termed
‘Saving’. Since there is no government in a two-sector economy, therefore, there are no taxes in this economy.
The most familiar form of saving is the use of part of a household’s income to make deposits in bank accounts or to buy stocks, bonds, or other financial instruments, rather than to buy goods and services. However, economists take a broader view of saving. They also consider households to be saving when they repay debts. Debt repayments are a form of saving because they, too, are income that is not devoted to consumption or taxes.
Investment: Whereas households, on the average, spend less each year than they receive in income, business firms, on the average, spend more each year than they receive from the sale of their products. They do so because, in addition to paying for the productive resources they need to carry out production at its current level, they desire to undertake investment. Investment includes all spending that is directed toward increasing the economy’s stock of capital.
Financial Market: As we have seen, households tend to spend less each year than they receive in income, whereas firms tend to spend more than they receive from the sale of their products. The economy contains a special set of institutions whose function is to channel the flow of funds from households, as savers, to firms, as borrowers. These are known as ‘financial markets’. Financial markets are pictured in the center of the circular-flow diagram in the above figure. Banks are among the most familiar and important institutions found in financial markets. Banks, together with insurance companies, pension funds, mutual funds, and certain other institutions, are termed ‘financial intermediaries’, because their role is to gather funds from savers and channel them to borrowers in the form of loans.
2. Circular Flow of Income in a Three-Sector Economy:
We have so far discussed the two-sector economy consisting of household sector and business sectors. Under three-sector economy, the additional sector is the government. Two-sector economy is a hypothetical economy, whereas the three-sector economy is much more realistic. The inclusion of the government sector is very essential in measuring national income. The government levies taxes on households and on business sector, purchases goods and services from business sector, and attain factors of production from household sector. The following figure illustrates three-sector economy:
In the above diagram, in one direction, the household sector is supplying factors of production to the factor market. Business sector demands the factors of production from factor market. Inputs are used by the business sector, which produces goods and services that are purchased back by the households and the government. Personal income after tax or disposable income that is received by households from business sector and government sector is used to purchase goods and services and makes up consumption expenditure (or C). The money spent in the product market is the market value of final goods and services (or GDP). That money goes to business sector that pays it back in the form of wages, rent, profits and interests.
Total spending on goods and services is known as ‘aggregate demand’. The total market value of output produced and sold is also known as ‘aggregate supply’. To measure aggregate demand in a closed economy, we simply add consumption spending (C), investment spending (I) and government spending (G). Therefore:
Y = C + I + G
Where Y is Income, C is Consumption, I is Investment, and
G is Government Spending.
Note that government spending (G) includes its buying of labour from factor market, buying of goods and services from product market, and transfer payments to the household sector. Transfer payments are payments the government makes in return for no service, for example, welfare payments, unemployment compensation, pension, etc. The government collects its money in the form of tax, which makes up most of the government revenue. But the government does not always balance their budgets. The government always tends to spend more than it takes in as taxes. The federal government almost always runs a deficit. The government deficit must be financed by borrowing in financial markets. Usually this borrowing takes the form of sales of government bonds and other securities to the public or to financial intermediaries. Over time, repeated government borrowing adds to the domestic debt. The ‘debt’ is a stock that reflects the accumulation of annual ‘deficits’, which are flows. When the public sector as a whole runs a budget surplus, the direction of the arrow is reversed. Governments pay off old borrowing at a faster rate than the rate at which new borrowing occurs, thereby creating a net flow of funds into financial markets.
3. Circular Flow of Income in a Four-Sector Economy:
Two-sector economy and three-sector economy are briefly discussed in previous sections. These are hypothetical economies. In real life, only four-sector economy exists. The four-sector economy is composed of following sectors, i.e.:
(i) Household sector, (ii) Business sector, (iii) The government, and
(iv) Transaction with ‘rest of the world’ or foreign sector or external sector.
The household sector, business sector and the government sector have already been defined in the previous sections. The foreign sector includes everyone and everything (households, businesses, and governments) beyond the boundaries of the domestic economy. It buys exports produced by the domestic economy and produces imports purchased by the domestic economy, which are commonly combined into net exports (exports minus imports). The inclusion of fourth sector, i.e., foreign sector or transaction with ‘rest of the world’ makes the national income accounting more purposeful and realistic. With the inclusion of this sector, the economy becomes an open economy. The transaction with ‘rest of the world’ involves import and export of goods and services, and new foreign investment. It is illustrated in the following figure.
In four-sector economy, goods and services available for the economy’s purchase include those that are produced domestically (Y) and those that are imported (M). Thus, goods and services available for domestic purchase is Y+M. Expenditure for the entire economy include domestic expenditure (C+I+G) and foreign made goods (Export) = X. Thus:
Y + M = C + I + G + X Y = C + I + G + (X – M)
Where, C = Consumption expenditure I = Investment spending
G = Government spending X = Total Exports
M = Total Imports X – M = Net Exports
Economy Leakages and Injections:
Leakages: When households engage in savings and purchase of goods and services from abroad, we experience temporary withdrawal of funds from circulation. Therefore, leakages in the circular flow are savings, taxes and imports
Injection: On the other hand, when we sell abroad (export) we receive income. More so when foreigners invest in our country the level of income will also increase. These two activities are injection into the income stream. Therefore, injections are investment, government spending and exports.
Total Leakages = Total Injections C + I + G + (X-M) = C + S + Net Taxes
S + Net Taxes + Imports = I + G + Exports S = I + (G – NT) + (X – M)
One way of thinking about the circular flow of income is to imagine a water tank. Investment, government spending and spending by foreigners is injected into the tank, and savings, taxes and spending on imports leak out. The injections and the withdrawals are equal to each other so the level in the tank is stable, or as economists like to say in equilibrium.
If injections are greater than withdrawals or leakages then the level in the tank will rise. If withdrawals are greater than injections then the level in the tank falls. If planned (I+G) is equal to planned (S+T), so that injections is equal to leakages and total spending is equal to total income and total demand is equal to total supply. Then we have a ‘stable economy’. If leakages are higher than injections i.e., planned savings plus taxes are greater than planned investment plus government spending (S+T > I+G), economy contracts resulting in inventory accumulation, too
