MANAGERIAL ECONOMICS

MODULE : 1INTRODUCTION TO MICRO & MACRO ECONOMICS

Introduction to 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 unlimited2. Resources are limited3. 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.

Basic Assumptions in Economics

• Ceteris Paribus

• Rationality

Ceteris Paribus:

Ceteris paribus is a Latin phrase, 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.

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

Rationality: Economist makes assumptions that people act rationally. This means that consumers and producers measure and compare the costs and benefits of a decision before going ahead.

For ex: Whether eating at home is cheaper than going to a restaurant; whether to train the existing workers or recruit new workers for the newly opened unit of the firm, and so on.

Types of Economic Analysis

Economic analysis can be divided into the following categories:

1. Micro and Macro

2. Positive and Normative

3. Short run and long run

4. Partial and General Equilibrium

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, a seller, or a product. 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.

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, and not the firm. In macroeconomics we talk about aggregate demand and aggregate supply, national income, employment, inflation etc.

POSITIVE AND NORMATIVE

Positive statements are factual by nature; normative statements involve some degree of value judgment, and cannot be verified by empirical study of logic.For ex:1. The distribution of income in India is

unequal.2. The distribution of income in India should

be equal.

The first statement is a positive one, while the second is a normative one. Normative statements often imply a recommendation, as in the above example, that income should be redistributed.

Positive economics establishes a relationship between cause and effect. 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.

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.

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; this means that the effects are examined only in the market(s) which is directly affected, and not on other markets

General Equilibrium analysis explains economic phenomena in an economy as a whole.

For Ex: If the price of fuel goes up, 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. In sharp contrast to this, under partial equilibrium analysis, 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.

BUSINESS

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

Primary objective of every business is to maximize its profit

Resources (like Money, Machines, 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.

Introduction to Managerial Economics

• Managerial economics is the study of economic theories, 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, evaluate business options and opportunities with a view to arriving at an appropriate business decision.

• Managerial economics is thus constituted of that part of economic knowledge, logic, theories and analytical tools that are used for rational business decision-making.

• Managerial economics is a means to an end to managers in any business, in terms of finding the most efficient way of allocating scare organizational resources and reaching stated objectives.

Definition of Managerial Economics

“Managerial economics is concerned with the application of economic concepts and economics to the problem of formulating rational decision making.”

Mansfield

“Managerial Economics is the integration of economic theory with business practice for the purpose of facilitating decision-making and forward planning by management.”

Spencer and Siegelman

“Managerial economics is the application of economic principles and methodologies to the decision-making process within the firm and organization.”

Douglas

ME provides link between traditional economics and decision sciences for managerial decision making

Managerial Economics

Decision Problem

Decision Sciences (Tools & Techniques of

Analysis)

Optimal solution to business problems

Traditional Economics

Characteristics of Managerial Economics

1. Micro Economic in Character2. Normative Economics3. Use theory of firm4. Prescriptive nature5. Pragmatic and applied approach6. It is both conceptual and metrical7. Adequate importance to Macro-

Economics

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

Prescriptive nature: As it is prescriptive in nature it states “what should be done”. It is an applied discipline of Economic theory which suggests how economic principles are applied to policy formulation, decision-making and forward planning.

Pragmatic and Applied approach: Managerial economics is pragmatic, which deals with the things in a real & sensible way rather than being influenced by fixed theories. It tries to solve the problems in day-to-day functioning of the firm and avoid difficult and abstract issues of economic theory.

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 Macro-Economic since it provides intelligent and understanding of environment in which the business of firm must operate.

Scope of Managerial Economics

The scope of managerial economics

comprehends all those economic concepts,

theories and tools of analysis, which can be

use to analyze the business environment

and to find solution to practical business

problems.

Scope of Managerial Economics

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

Operational or Internal Issues

Demand analysis and forecasting: -. A major part of managerial decision–making depends on accurate estimates of demand. A forecast of future sales as a guide to management for preparing production schedules and employing resources. It will help management to maintain or strengthen its market position and profit-base.

Cost and production analysis: - Cost estimates are most useful for management decision. The different factors that cause variations in cost estimates should be given due consideration for planning purposes. The chief topics covered under cost and production analysis are: cost concepts and classifications, cost-output relationships, economies and diseconomies of scale, production.

Pricing decision, policies and practices: - As price gives income to the firm, it constitutes as the most important field of managerial economics. The various aspects that are dealt under it cover the price determination in various market forms, pricing policies, pricing method, differential pricing, productive and price forecasting.

Profit management: - The chief purpose of a business firm is to earn the maximum profit. There is always an element of uncertainty about profits because of variation in costs and revenues. The important aspects covered under this area are: nature and measurement of profit, profit policies and techniques of profit planning like break-even analysis.

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.

Environmental or External Issues

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 and Responsibilities of Managerial Economist

Roles of Managerial Economist1. Helping in decision-making

a. Thinking functionb. Selection function

2. Helping in forward planning3. Administrative role4. Economic intelligence5. Participation in debates6. Specific Roles:

c. Sales forecastingd. Industrial market researche. Analysis of competitorsf. Pricing decisiong. Production scheduleh. Investment analysisi. Public relationj. Social objectives

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. These functions are mainly divided into two categories-

A. Thinking Function: This is identification of area of decision-making, determination of essential facts and search of alternative decisions.B. Selection Function: After the analysis of the problem, development of different alternatives and collection of required facts, the managerial economist should select the most appropriate alternative according to the situation of the firm.

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 co-ordination 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.

D. Pricing Decision: An economist has to decide the pricing strategy for its product. For that it has to be studied that under what type of market is business working, what are the prices of competitors, how much price elastic is product, etc.

E. Production Schedule: An economist has to plan the production as per the demand forecasted. He has to arrange factors of production like men. machine, money and material. Study about the availability of these factors in the market etc.

F. Investment Analysis: An economist, by using different analytical techniques like Capital budgeting, takes decision that in which project investment should be made out of various available projects.

G. Public Relation: An economist has to work for maintaining good public relation, so that he can get feedback from market about the product.

H. 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.

Responsibilities of Managerial Economist

A Managerial economist plays a very significant role in decision-making and forward planning. But, to serve his role successfully, he must thoroughly recognize his responsibilities, some of which are following:-

1. To increase the profitability of the firm2. To make accurate and successful

forecast3. To maintain relations with experts4. To aware availability of resources5. To simplify the decision making process6. Responsibility to minimize risk.

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, 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.

To maintain relations with Experts: The important responsibility of a managerial economist is to provide solution to complex business problems, 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 aware availability of Resources: A managerial economist should be aware of locations and situations of the specific markets, by which he should be able to provide the resources of firm’s operation quickly at reasonable price.

To Simplifying the decision making process: The management has to take many decisions in its day-today functioning. 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. It can be done by minimizing future uncertainty by knowing about all the prospective facts present in the market. To minimize risk successful forecasting and right decisions are needed.

Basic Economic Principlesor

Five Fundamental Principles

BASIC ECONOMIC PRINCIPLES

Economic theory offers a variety of concepts and analytical tools which can be of considerable assistance to the managers in his decision making practice. These principles are helpful for managers in solving their business related problems.Following are the basic economic principles for decision making

1. Opportunity cost2. Incremental principle3. Principle of time perspective4. Discounting principle5. Equi-marginal principle

Opportunity cost Principle

• The opportunity cost of any alternative is defined as the cost of not selecting the “next-best” alternative.

• The opportunity cost of availing an opportunity is the expected income foregone from the second best opportunity of using the resources.

Example:

Suppose, 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 Rs. 20 millionSetting up new production unit Rs. 18 millionBuying share in another firm Rs. 16 million

All the other thing being same (Ceteris Paribus), rational decision-making suggest to invest the money in alternative 1. This implies that manager has to sacrifice the annual return of Rs.18 million expected from alternative 2.

In economic terms, 18 million is an annual opportunity cost of an annual income of Rs. 20 million

The difference between actual earning and opportunity cost is called economic gain or economic profit. 

INCREMENTAL PRINCIPLE

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

• Incremental cost

• Incremental revenue

The incremental principle may be stated as under:

“A decision is obviously a profitable one if –

1. It increases revenue more than cost2. It decreases some costs to a greater

extent than it increases others3. It increases some revenues more than

it decreases others and,4. It reduces cost more than revenue”.

Example: Suppose a new order is estimated to bring in an additional revenue of Rs. 5000/-. The cost estimated as under:Material Rs. 2,000 Labor Rs. 1,500 Overhead (allocated at 120% of labor cost) Rs. 1,800 Selling & Administrative expenses Rs. 700 (Allocated at 20% of labor and material cost) _________

Full cost Rs. 6000 The order appears to be unprofitable.

However, suppose there is idle capacity which can be utilized to execute this order. If the order adds only Rs. 500 of overhead (that is, the added cost of heat, power and light, the added wear and tear on machinery, the added cost of supervision, and so on) only Rs. 1000 by the way of labor cost because some idle workers already on the payroll will be deployed without added pay, no extra selling & distribution cost, the incremental cost of accepting the order will be:

Material Rs. 2,000Labor Rs. 1,000Overhead Rs. 500

___________ Total Incremental cost Rs. 3, 500

While it appeared in the first instance that the order will result in a loss of Rs. 1000, it now appear that it will lead to an additional of Rs. 1,500/- (Rs. 5000 –Rs. 3500) to profit

 

PRINCIPLE OF TIME PRESPECTIVE

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

Example:

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

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.

• If the other customers come to know about this low price, they may demand a similar low price. Such customers may complain of being treated unfairly and feel discriminated against.

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”.

DISCOUNTING PRINCIPLE

One of the fundamental ideas in Economics is that a rupee tomorrow is worth less than a rupee today. Suppose a person is offered a choice to make between a gift of Rs.100/- next year. Naturally he will choose Rs.100/- today. This is true for two reasons –

• The future is uncertain and there may be uncertainty in getting Rs. 100/- if the present opportunity is not availed of

• Even if he is sure to receive the gift in future, today’s Rs. 100/- can be invested so as to earn interest say as 8% so that one year after Rs.100/ will become 108.

EQUI-MARGINAL PRINCIPLE

This rule has a name: it is the Equi-marginal Principle. The idea is to make two things equal "at the margin" -- in this case, to make the marginal productivity of labor equal on the two fields. 

This principle deals with the allocation of an available resource among the alternative activities. According to this principle, an input should be allocated that the value added by the last unit is the small in all cases. This generalization is called the Equi-marginal principle.

Suppose, a firm has 100 units of labor at its disposal. The firm is engaged in four activities which need labor services viz, A, B, C and D. it can enhance any one of these activities by adding more labor but only at the cost of other activities.

MACRO ECONOMICS

Concept, characteristics & scope of Macro economicsCircular flow of IncomeNational Income, GDP, GNP, Per capita income, methods of measuring national incomeBusiness Cycle & Business Policies

Introduction to Macro Economics

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

Definitions of Macro EconomicsAccording to Edwin Mansfield, "Macro-economic deals with behavior of economics aggregates such as gross national product and level of employment".

According to Gardner Ackley "Macro-economic deals with the economic affairs in large it concerns the overall dimension of economics life. It studies the character of forest, independently of tree which composes it".

K. 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".

So we conclude that macro-economic deal not with individual’s quantities, individual incomes, individual’s prices, individuals output but with aggregate of these quantities, national income, price level and national output.

Difference between Micro and Macro Economics

MICRO ECONOMICS

1. It deals with an individual's economic behavior.

2. It deals with the pricing of a particular commodity in an industry.

3. It deals with the income of a particular set of people.

4. Study of micro economics is important for resource utilization, public finance, and for taking business decisions.

5. The concepts of micro-economics are independent concepts.

6. These concepts have more theoretical value.

MACRO ECONOMICS

1. It deals with aggregate economic behavior of the people in general.

2. It deals with the general price level in the economy, National income accounting, etc.

3. Study of macro economics is important for formulation of economic policy of the whole nation.

4. The concepts of macro economics are interdependent on one another.

5. These concepts have more practical value.

Characteristics of Macro Economics

The characteristics that describe a macro economy are usually referred to as the key macroeconomic variables. The following four variables are considered to be the most important in gauging the state or health of an economy:

1. Aggregate Output Or Income, 2. The Unemployment Rate, 3. The Inflation Rate, And 4. The Interest Rate.

Aggregate Output or Income

An economy's overall economic activity is summarized by a measure of aggregate output. As the production or output of goods and services generates income, any aggregate output measure is closely associated with an aggregate income measure. The GDP is a measure of all currently produced goods and services valued at market prices.

Unemployment

The level of employment is the next crucial macroeconomic variable. The employment level is often quoted in terms of the unemployment rate. The unemployment rate itself is defined as the fraction of labor force not working (but actively seeking employment). Instead, it is defined as consisting of those working and those not working but seeking work.

Inflation Rate

The inflation rate is defined as the rate of change in the price level. Most economies face positive rates of inflation year after year. The price level, in turn, is measured by a price index, which measures the level of prices of goods and services at given time. The number of items included in a price index varies depending on the objective of the index.

The Interest Rate

The concept of interest rates  used by economists is the same as the one widely used by ordinary people. The interest rate is invariably quoted in nominal terms—that is, it is not adjusted for inflation. Thus, 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.

Scope of Macro EconomicsA 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. Aggregate demand is the sum of total consumption demand and total investment demand. Hence, consumption function and investment function are the important components of macro-economics. The theory of business cycle is also covered by macro-economics.

Theory of general prices level:

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

Theory of economic growth:

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

Modern theory of distribution:

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

CIRCULAR FLOW OF ECONOMIC ACTIVITIES AND INCOME

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, between whom the circular flow of production of goods and services, income and expenditure takes place.

• Two Sector Economy• Four Sector Economy

TWO SECTOR ECONOMY

The simplest form of circular flow of economic activities and income features only consumers and firms.

On one side of the flow is consumer, who is an individual (like you and me) who purchases goods and services for own consumption, in order to derive satisfaction from them. A household include a set of individuals who live together and take joint decision about the consumption of goods and services.

On the other side there are firms who supply the varieties of goods and services. The term “firm” is used to describe the basic selling unit of consumption of goods and services.

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. Hence the households provide services in terms of factor input to the firm and get paid for these services, which they spend on consumption.

Thus the money and economic activities flowing between firms and households create a circular flow.

Household do not spend their entire money on consumption, instead they save a part of their income for the future. When household save, their consumption of goods and services would decline to the extent of saving, and as a result money flow to the business firms would decrease by the same extent.

Since money is thus “taken out” of the circular flow, saving would be considered as a component of “withdrawals”. If these savings are kept with the household they will result in “leakages” in the money flow.

But saving of households comes to the financial market, through banks, financial institutions, insurance companies and stock markets.

You would wonder as to what happen to this saving in the financial market?

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, which is termed as “injection”.

Saving is the withdrawal of money from the circular flow, while investment is the injection of money into the circular flow.

Land, Labor & Capital

Factor Payment

Financial MarketSavings Investment

In simple two sector economy, the value of output produced (Y) is equal to the value of output sold (O). Thus, the total income is used either for the purpose of consumption, or for investment. Since the value of output sold is equal to the sum of consumption expenditure and investment expenditure, we can state that:

Y = O = EY = C + SE = C + IHence, C + S = C + I

Where,

• Y = income, • E = Expenditure, • O = Output, • C = Consumption expenditure,• I = Investment expenditure,• S = Saving 

FOUR SECTOR ECONOMY

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.e. government and external sector.

The development of basic infrastructure, like roads, electricity, communication and security is essential for growth of a system.

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).

At the same time government receive revenue from different sources such as taxes, interest on loans and profit on investment.

Thus there is a third dimension to the circular flow of income, i.e. some money flowing between firm and household is diverted to the government in the form of taxes and other payments, 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. Some amount of saving also flow to government in the form of government bond and securities.

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

GOVERNMENT

HOUSEHOLDS

FOREIGN NATION

FIRMS

Taxes Taxes

Remittance for purchases or Subsidiaries

Salaries

Exports Exports

Imports

Imports

Financial Market

GOVERNMENT

HOUSEHOLDS

FOREIGN NATION

FIRMS

Taxes TaxesRemittance for purchases or Subsidiaries

Salaries

Exports Exports

Imports

Imports

Financial MarketSavings

Investments

Factor Inputs

Factor Payment

Goods & Services

Consumption Expenditure

MACRO ECONOMIC VARIABLESAGGREGATE 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 demand (AD) for consumer goods (C) and aggregate demand for capital goods (I). Thus we can write the above equation as:

AD = C + IAggregate supply is the total national output produced and supplied by all the factors of production in an economy.Aggregate supply consists of supply of consumer goods and capital goods.

STOCKS AND FLOWS

For better understanding of national income determination it is necessary to understand the difference between the concept of stock and flow.Stock may be defined as any economic variable which has been accumulated at a specific point of time, like money, assets and wealth.Flow includes the variables which increases (inflows) and decreases (outflows) the stock, like income, consumption, saving and investment over a period of time.Mathematically a stock can be seen as an accumulation and integration of flows over time, with outflows subtracted from the stock. Thus, money supply is a stock, while national income is a flowExample

STOCK INFLOW OUTFLOW

INVENTORY INCOMING GOODS OUGOING GOODS

BANK BALANCE DEPOSITS WITHDRAWALS

POPULATION BIRTH + IMMIGRATION DEATH + EMIGRATION

INTERMEDIATE AND FINAL GOODS

Intermediate goods (and services) are items purchased by firms for using them in production of some other goods of utility.Final goods are demanded by the final consumer for using these goods as they are.NOTE: For the calculation of national income only final goods are considered. 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.

EMPLOYMENT

This is another important macro variable that affects the national economy. Employment is defined in different respects; for example in US it is defined as a contract between two party agrees to work under term specified by another party.

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.

Every country tries to achieve a full employment so that maximum economic growth with maximum social welfare can be achieved.

GOVERNMENT EXPENDITURE AND REVENUEGovernment expenditure refers to outlay on national defense, road building and maintenance, railways, national health, and free education and salary of government employees.

All government current expenditure is included in national output.There is another type of expenditure, known as transfer payments, which refers to payments made to certain sections of society as a social welfare measure. It is an exchange of purchasing power from one group of people to another.

These include unemployment compensation, retirement pension, etc.Since the receiver of such payments (such as old, unemployed, 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.

CONCEPTS OF NATIONAL INCOME

“National income or product is the final figure you arrive at when you apply the measuring rod of money to the diverse apples, oranges, battleship and machines that any society produces with its land, 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 is defined as the money value of all final goods and services produced in an economy during an accounting period of time, generally one year.

National income gives us a means to measure the economic performance of an economy as a whole.

National income accounting is a set of rules and definition for measuring economic activities in an economy.

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)

GROSS DOMESTIC PRODUCT (GDP)

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.

It includes income from exports and payments made on imports during the year. However, it does not include the earning of nationals working abroad as also of the foreign nationals working in our country.

If you look around, you would find any domestic companies which have their branches or subsidiaries in foreign countries, as also subsidiaries are branches of foreign companies in your home country.

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

GROSS NATIONAL PRODUCT (GNP)

GNP is the aggregate final output of citizen and businesses of an economy in a year.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). Thus, 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.GNP is defined as the sum of Gross Domestic Product and Net Factor Income from Abroad.

GNP = GDP + NFIA Thus GNP of India would count goods and services produced by all Indians, regardless of where they work.

NOTE: GNP will be less than GDP when a country makes more payment than it receive from abroad.

NET DOMESTIC PRODUCT and NET NATIONAL PRODUCT

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. 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, or capital consumption allowance.In order to arrive at NDP and NNP, 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. Hence, NDP = GDP – DepreciationAnd NNP = GDP – Depreciation + NFIAOr NNP = GNP – Depreciation

PER CAPITA INCOME

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

Personal disposable Income = Personal Income – Personal Taxes 

MEASUREMENT OF NATIONAL INCOME

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

1. GNP is the sum of value added of all firms in same period that is the total value of final goods and services produced. 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.

2. 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.

3. GNE values national output by taking the value of expenditure on goods and services produced (that is, aggregate expenditure on consumption and investment).

The terms “Gross National Product, Gross National Income and Gross National Expenditure” may be used synonymously. In principle, these three variants will always be equal, that is GNP= GNI = GNE. However, in practice, for some statistical data problem, this may not happen, and statistical discrepancy may arise. 

Based on these three ways there are three methods of measuring national income

1. Product (or Output) Method

2. Income Method

3. Expenditure Method

PRODUCT (OR OUTPUT) METHOD

As per the product method of estimating national income, also called national income by Industry of Origin.

The product method adds up the market value of all final goods and services produced in the country by all firms across all industries.

This method involves the following steps:1. The economy is divided on basis of industries,

such as agriculture, fishing, mining, large scale manufacturing, small scale manufacturing, electricity, gas, etc.

2. The physical units of output are then interpreted in money terms, i.e., by taking market price of all the products

3. The total values thus obtained are then added up.4. The indirect taxes are subtracted and the

subsidies are added. This gives the GDP or GNP, as the case may be, depending upon what data are being used.

5. The net value is calculated by subtracting depreciation from the total value thus obtained, in order to arrive at NNP.

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. 

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

Thus national income by Product Method can be calculated in two ways:

• Final Product Method

• Value Added Method

Final Product Method • According to this method, the total value of

final goods and services produced in a country during a year is calculation and assessed at market price.

• 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.

• So in the previous example of mobile phone that we have taken, we shall only consider Rs. 5000, which is the market price for final consumer.

Value Added Method • Another method of measuring national income is

the value added by each industry of the economy.

• The value added method measures the contribution of each producing enterprise of the economy. The difference between the values of material outputs and inputs at each stage of production is the value added. If all such differences are added up for all industries in the economy, we arrive at GDP

• Like in the above example national income added by value added method require calculating the value addition at retailer level, i.e., Rs.3000 and again at final consumer level i.e., Rs. 2000. Thus national income will be Rs. 5000.

LIMITATIONS OF PRODUCT METHOD

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. Hence, the possibilities of double counting cannot be fully eliminated.

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

INCOME METHOD

According to the Income method, it is the net income received by all citizen of the country in a particular year that is added up, i.e., total rents, net wages, net interest and net profits. However, income received in the form of transfer payment is not included.

This is the GDP at factor; 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) 

Income method involves the following steps:

The economy is divided on the basis of income groups, such as wages/salary earners, rent earners, profit earners, and so on.Income of each of these groups is calculated.Income of all the earners is added, including income from abroad and undistributed profits.From (3), income earned by foreigners and transfer payment made in the year are subtracted. In other words,

GNP at factor cost = Rent + Interest + Profits + other Income + (Income from Abroad – Payments made to foreigners) – Transfer Payments.

LIMITATIONS OF INCOME METHOD

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

EXPENDITURE METHOD

We have seen that whatever is earned is spent either on consumption or on investment. Therefore, it is possible to calculate national income by expenditure method.

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; such expenditure includes personal consumption expenditure, net domestic investment, government expenditure on goods and services, and net foreign investment. 

This concept rests on the assumption that national income equals national expenditure.

• Consumption expenditure: Consumption is the largest and most important of the flows. When individuals receive income, they can spend it on domestic goods or foreign goods (durables and non durables) and services; they pay taxes out of it and save the rest. Personal consumption expenditure refers to payments by households for goods and services.

• Investment Expenditure: This expenditure is divided into three major categories: capital spending (purchase of new materials and equipments by firms), residential construction (construction of new housing units and renovation of existing structures) and inventory investment (unsold portion of output).

• 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, because such spending escapes the system and does not add to domestic production. Exports to foreign nations are added to total expenditures.

USES OF NATIONAL INCOME DATA

National income data is necessary for economic planning of 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.

These data also help in comparing the situations of economic growth in two different countries.

These data also help in determining the regional disparities, income inequality and level of poverty in a country, on the basis of per capita income and inflation indices.

National income is considered as a measure of economic welfare.

Difficulties in the measurement of National Income

• Non Monetized Transactions: There are numerous incidents of exchange of goods and services, like services rendered out of love, courtesy or kindness, which have no monetary payments as such. These services have economic value but no money value. For ex: a businessman takes the help of his wife in managing his business but does not pay her any salary.

• Unorganized Sector: The unorganized sector of any economy, including unskilled labor, domestic servants, and household production unit contributes substantially to the national income, but mostly goes unrecorded. How would you count the contribution of a road side tea shop? By income method? Output Method? Expenditure method? Secondly, it is very difficult to identify income of those who do not pay income tax.

Multiple Source of Earning: A person may have multiple source of income, of which one may be the main activity while the others may be executed on a part time basis. For ex: In India, most of the small farmers cultivate only one crop a year, and in lean session they work in unorganized sector. The latter goes unrecognized. Hence multiple source of earning makes collection of data difficult.

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. But the problem in this is that there are many cases in which categorization are not very clear.

Example: The computer bought by a student for personal use is a final product, but the computer bought by the computer training institute is an intermediary good, as the final product in its case is trained person. In such cases there would either be incidence of double counting, or less than actual counting.

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, partnership or nonprofit organizations, which results in inaccurate computation of national income.

BUSINESS CYCLES

Business cycle is a periodic up and down movements in economic activities. 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. This cyclical movement is characterized by alternative waves of expansion and contraction, and is associated with alternate period of prosperity and depression. Business cycles have three basic features or characteristics:

1. Periodicity2. Synchronism3. Self reinforcing

FEATURES OF BUSINESS CYCLES

Periodicity:

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

Synchronism:

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

Self Reinforcing:

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

PHASES OF BUSINESS CYCLES

A typical business cycle can be studied in four phase:

Expansion Peak Contraction (recession) Trough (depression), and two turning

points upward and downward

peak

trough

Expansion

contraction

G

G’

GNP %

Tine unit (Years)

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

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

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

EFFECTS OF BUSINESS CYCLES

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.

InflationInflation 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 InventoryOne 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.

Retrenchment

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

CONTROLLING BUSINESS CYCLES

At Firm Level

Firms are the main victims of cycles; at the same time they are one of the main players in the game. This dichotomy of roles makes firm’s responsibility more critical and crucial. During expansion firms gain, during recession they suffer; 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. Therefore the only therapy available to firms is to take preventive measures. 

Precautionary MeasuresThese include safe guards against swaying away the wave of expansion, so that suffering during recession may be minimized

Investment: Firms should deter from investing huge amount of funds in fixed assets. Financing pattern should be a balanced nix of debt and equity.

Inventory: Firms should not create large inventory of raw material or finished goods. Just in time strategy helps in such cases.

Products: Firms should diversify in different markets and different products, because in this way risk is also diversified.

Pricing: Flexibility should be the right strategy, so that during recession prices may be adjusted to increase demand without eating away the margins.

At Government Level

Since inflation is an important corollary of expansion, measures to control inflation also help in controlling business cycle.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. 

Monetary MeasuresUnder monetary measures, the central bank of the country uses various methods of credit control.

Rediscount rate: during expansion the central bank increases the rediscount rate to curb money supply, 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. 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.

Open market operations: during expansion, central bank sells securities and thus takes away disposable income from people’s hand. At the other extreme, during recession it buys securities to give more in the hands of people for consumption.

Selective credit control: all the above methods are aimed at controlling money supply in general without any segmentation, either on the basis of use or amount. And you know that it may not be always desirable to control credit at all levels. Therefore, central banks have devised another method, known as selective credit control. Actually this method is a very preventive tool, through which credit may be extended to certain areas and contracted other areas, thereby providing a safety cushion against strong bouts of expansion and contraction in the economy.

FISCAL MEASURES

Fiscal measures include managing public expenditure, public revenue and public debt. Public expenditure: Public expenditure is an important measure to recover an economy from recession. When government spends money on various activities like health, transport, communication, etc., income of individuals increases; this in turn increases aggregate demand.

Public revenue: As increase in expenditure boosts aggregate demand, increase in public revenue takes away portion of people’s money income and thus bring down aggregate demand. So during recession it is desirable that government reduces taxes.  During recession government normally use public expenditure as a tool, while during expansion they use public revenue items as controlling device.