Introduction to Economics- Basic Concepts
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Introduction to Economics- Basic Concepts
Economics can be defined as the science of logically oriented or rational human beings-
- with unlimited wants, and
- limited resources.
The limited resources available with an individual forces him to make a choice among his unlimited wants and choose the one he prioritizes the most.
Economics is a behavioral, or social science. It is the study of how people make choices.
- The best alternative that we choose and the others that we forgo, or give up when we make a choice is called the Opportunity cost of that decision.
- 2 divisions of economics:
It deals with the functioning of an individual and industries and the behavior of individual economic decision-making units: business firms and households.
2 Schools of Economics:
- Classical Economics
- Keynesian Economics
- According to this school, the government should not interfere in the economy (markets) and if any distortions arise in the economy, then they get automatically solved by the forces of demand and supply.
- In 1929, the world was hit by a deep recession, and this crisis is famously called the ‘Great Depression.
- During this time, the economy was unable to correct itself.
- Then John M. Keynes said that the economy will not correct on its own. The government would have to intervene and help the economy to regain and move on the path of recovery.
Keynes is known as the father of modern economics.
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Actions taken by the government to influence its economy are termed economic policy. A good economic policy should aim at :
- Efficiency, allocation of resources at least possible cost.
- Equity, more equal distribution of income and wealth.
- Growth, increase in total output of the economy.
Stability, a steady increase in national output with low inflation and full employment of resources.
- It is the study of aggregates.
- Instead of trying to understand what determines the output at the individual level, Macroeconomics examines the factors that determine national output, national product.
Economic Growth vs Economic Development
Sectors of Economy
- It includes all those activities which involve direct use of natural resources.
- Ex. Agriculture, Forestry, Fishing, Fuels, Metals, Minerals, Mining, etc.
- It is known as the manufacturing sector which uses the produce of the primary sector as its raw materials.
- Since manufacturing is done by industries, it is also known as the industrial sector.
- Ex. Cakes, Bread and Biscuits, Automobiles, Textiles, etc.
- It is also known as the Services sector.
- It includes all those economic activities where different ‘services’ are produced.
- Ex. Education, Banking, Insurance, Transportation, Tourism, etc.
Organizing an Economy
- It is an economic system in which investment in and ownership of the means of production, distribution, and exchange of wealth is made and maintained mainly by private individuals or corporations.
- It is also known as the Laissez-Faire economy.
It is an economic system in which the means of production (property and assets) are held in common and not individually. Common ownership means individuals having authority to make decisions in the name of the collective group.
- It is an economy in which private corporate enterprises and public sector enterprises exist side-by-side, and decisions taken through market mechanisms are supplemented by some form of partial planning.
- India has opted for a mixed economy.
Features of Mixed Economy:
- Coexistence of both the public sector and private sector.
- Market forces are present but are closely monitored by the government.
- Monopolies may be existing but under close supervision of the government.
Advantages of Mixed Economy:
- Producers and consumers have the freedom to choose what to produce and what to consume but production and consumption of harmful goods and services may be stopped by the government.
- It may have less income inequalities because of the role of the government.
- It represents an achievable balance between individual initiative and social goals.
- ‘Factors of production is an economic term used to describe the inputs that are used in the production of goods and services in the attempt to make an economic profit.
Circular flow of Economy
- The circular flow of income and spending shows connections between different sectors of an economy.
- It shows the flow of goods and services and factors of production between firms and households.
- It shows how National income or GDP is calculated.
Businesses produce goods and services and in that process, incomes are generated for factors of production.
Leakages from the circular flow:
- Leakages or Withdrawals are increased in savings, taxes, or imports leading to a decrease in the circular flow of income and thus leading to a contraction in output.
- The circular flow shows that some part of the household income will be:
- Savings in bank accounts or other types of deposits.
- Paid as taxes to the government.
- Spent on Imports.
Injections into the circular flow:
They are in addition to the investment, government spending, or exports to boost the circular flow of income and thus leading to an expansion in output. It includes:
- Investment expenditure, i.e. capital spending by the firms.
- Government expenditure
- Exports to foreign countries.
Domestic circular flow of Income & Spending:
- The external sector involves businesses exporting goods and services overseas (X) and consumers and businesses buying imported products from other countries (M).
National Income Accounting
National Income (NY):
- National Income is used as a measure of economic growth and reflects the productive power of an economy to turn out goods and services for the satisfaction of human wants.
- The key measure of economic growth used by all countries all over the world in Gross Domestic Product.
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Personal Income (PY):
- It is the income received by an individual.
PY = NY - ( corporate taxes + corporate retained earnings ) + Transfer payments
Disposable Income (DY):
- It is the income received by the individuals and is at their disposal.
DY = PY - Direct taxes
- It is the income which the individual can spend at their free will.
Discretionary Income = DY - Compulsory savings & Loan payments
Gross Domestic Product
- It is the market value of all final goods and services produced within a financial year by factors of production located within a country irrespective of ownership.
- GDP ignores all transactions in which goods are exchanged for money but in which no new goods and services are produced.
- Ex. The sale of securities is not counted in GDP. These exchanges are the transfer of ownership of assets and do not correspond to current production. But fees paid to the broker are counted in GDP.
Final Goods and Services:
- They are produced for absolute final use.
- Intermediate goods are produced by one firm for use, in further processing by another firm. Ex. Tires sold for use in the automobile industry.
Types of Final goods:
- Capital goods are the goods produced by the economic system that are used as inputs to produce other goods. Ex. Machinery, Building roads, etc.
- Consumer goods are the goods produced for present consumption. Ex., Perishable commodities, Clothing, etc.
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Gross National Product
- It is defined as the total market value of all final goods and services, produced within a financial year by factors of production owned by a country’s citizens regardless of where the output is being produced.
- GNP = GDP + NFIA, where,
NFIA is Net Factor Income from Abroad. NFIA = Factor Income received abroad by Indian normal residents - Factor Income paid to foreign residents in Indian domestic territory
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Concept of NET
- During the process of production, capital produced previously gradually wears out.
- GDP includes newly produced capital goods but does not take into account goods “consumed” in the production process.
- The amount by which an asset’s value falls each period is called Depreciation.
NDP = GDP - Depreciation
NNP = GNP - Depreciation, where,
NNP = Net National Product
Market Price vs Factor Price
NNP (factor cost) = NNP (market price) - Net Indirect Taxes
Net Indirect taxes = Indirect taxes - Subsidies
- Factor costs are the actual costs at which goods and services are produced by the firms and industries in an economy. They are actually the cost of all the factors of production.
- When to these factor costs, taxes are added then it becomes Market Price.
Which is a better index?
GDP and GNP:
- GDP takes into account the income earned within the territory which may not always be the right income.
- GNP takes into account the income earned by an Indian citizen whether in India or abroad.
- GNP is a better index than GDP.
Factor cost and Market price:
- Factor cost is better than Market Price as we get the actual cost of production which gives a true picture of the economy producing goods at a particular cost.
A better measure is GNP (Factor cost).
Taking into account ‘Net’:
- NDP is a better measure than GDP.
- NNP is a better measure than GNP.
A better measure is NNP (Factor cost).
Therefore, NNP (Factor cost) is the best index.
Measurement of National Income:
- Value Added Method
- Income Method
- Expenditure Method
Value Added method
- It is also known as the Production Method and Output Method.
- It is used to calculate GDP at Market Price, which is the total values of outputs produced at different stages of production.
- The calculation is done by taking the value of final goods and services and not intermediate goods, as it results in double counting.
- Following goods and services should be included in production:
- Goods and services actually sold in the market.
- Goods and services not sold but supplied free of cost.
- Multiple final outputs with the market price. It is commonly used for calculating the GDP of the Primary sector.
- It emphasizes aggregating the payments made by:
- firms to households
- households and firms to government
- banks to households/ firms
- banks to the government called factor payments.
- Measures the income - wages, rents, interest, and profits, received by all factors of production in producing final goods.
- It is used for calculating GDP for the services sector where calculating total output is difficult.
- Any income corresponding to which there is no flow of goods and services or value-added, should not be included in calculation by Income method.
- It measures the final expenditure on GDP.
- Amount of expenditure refers to all spending on final goods and services only in an economy.
- In an economy, there are 3 main agencies, which buy goods and services.
- This method is commonly used for calculating GDP for the manufacturing sector.
The final expenditure is made up of the sum of 4 expenditure items:
- Personal consumption made by households, payment of which is paid by households directly to the firms which produced the goods and services desired by the households.
Investment Expenditure (I):
- Investment is an addition to the capital stock of an economy in a given time period. This includes investments by firms as well as the government sector. Ex. Purchase of new housing, plants by the private sector.
Government Expenditure (G):
- It includes the value of goods and services purchased by the government.
- Government expenditure on pension schemes, scholarships, unemployment allowances is not included in this as all of them come under transfer payments.
Net Exports (X - IM):
- Expenditure on foreign-made products (Imports) are expenditures that escape the system and must be subtracted from total expenditures.
- Goods produced by domestic firms which are demanded by foreign economies involve expenditure by other economies on our production (Exports) and are included in total expenditure.
GDP = C + I + G + ( X - IM )
Per Capita Income
Per capita income = National income/ Total population
- It is the income earned per person in the economy.
- This measure does not reflect inequality i.e. distribution of income is not taken into consideration.
Limitation of GDP concept
GDP and Social Welfare:
- If crime goes down, society would be better but a decrease in crime is not an increase in output, therefore it is not reflected in GDP.
- Inequality of income among different sections is not reflected in GDP.
- Most of the household activities done by housewives are not included in GDP. But if the same job is done by a nanny or a house cleaner then it gets included in the GDP.
Underground/ Black Economy:
- Most illegal transactions are missed.
- Tax evasion is a major incentive for people to participate in the black economy.
- Because of the black economy, the GDP reflects only a part of economic activity instead of a complete measure of what the economy is producing.
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Other Important Value Added Facts
Total Factor Productivity:
- It is the ratio of total Output (e.g. GDP) and weighted average of inputs (e.g. Labour & Capital).
- A higher TFP implies higher growth with the same set of labor and capital employed.
Gross Value Added:
- It is a measure of value-added in goods and services produced in the economy i.e. GVA = economic output - input.
- GVA is sector-specific while GDP is calculated by summation of GVA of all sectors of the economy with taxes added and subsidies are deducted.
First Advance Estimates of National Income, 2019-20:
- It was released by the National Statistical Office (NSO), Ministry of Statistics, and Programme Implementation.
- Advance estimates are based on key benchmark indicators like the Index of Industrial Production (IIP), the financial performance of Listed Companies in the Private Corporate sector, accounts of Central & State Governments, information on indicators like Deposits & Credits, etc.
- It seeks to find an extrapolated version of what happened in the economy in the first eight months of the fiscal year.
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