E-LESSON-7

IDOL Institute of Distance and Online Learning ENHANCE YOUR QUALIFICATION, ADVANCE YOUR CAREER.

MBA 2 All right are reserved with CU-IDOL MANAGERIAL ECONOMICS Course Code: MBA601 Semester: First SLM UNITS : 8&9 E-Lesson : 7 www.cuidol.in Unit-8 & 9 (MBA601)

MACRO ECONOMICS 33 OBJECTIVES INTRODUCTION Student will be able to : T“nhaetiotontaall iinnccoommee.”oTf thheeangagtiroengaistecaelcleodnomic Explain the Concept of National Income performance of the whole economy is - The Concepts Associated With National Income measured by the national income data. - Analyse the Methods of Estimating National Income A simple circular flow model of the macro Explain the simple circular flow model economics containing two sectors (business and household) and two markets (product and Explain the Supply-oriented Classical Theory of factor) that illustrates the continuous Employment movement of the payments for goods and services between producers and consumers. Discuss the various assumption of Full Employment KKeeyynneess’isandiescaognreoemmicesnitswthiteh othuetccolamsesiocfal economists who avowed a strong belief in the Elaborate Say's Law of Markets operation of market forces resulting in automatic adjustment at full employment level. www.cuidol.in Unit-8 & 9 (MBA601) . INASllTITriUgThEt aOrFeDreISsTeArNveCdE AwNitDh OCNUL-IIDNOE LLEARNING

TOPICS TO BE COVERED 4 > Concept of National Income -Concepts Associated with National Income -Methods of Estimating National Income > Assumptions of Circular Flow Model - Simple Circular Flow Model with Two-Sector, Two-Market ; in a Three-Sector Model and in a Four-Sector Model > Supply-oriented Classical Theory of Employment Assumption of Full Employment > Say’s Law of Markets > Interest Rate Flexibility > Classical Model of Employment www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

CONCEPT OF NATIONAL INCOME  National income is a flow and not a stock, i.e., income is generated every year, and at different rates and, 5 therefore, it is necessary to mention the period during which that income is generated. National income is usually measured and shown with reference to a year or as annual flow; it is, thus, an amount of total production per unit of time.  In national income accounting, thus, the concept of national income has been interpreted in three ways, as: (1) National Product, (2) National Dividend, (3) National Expenditure. National Product. It consists of all the goods and services produced by the community and exchanged for money during a year. National Dividend. It consists of all the incomes, in cash and kind, accruing to the factors of production in the course of generating the national product. National Expenditure. This represents the total spending or outlay of the community on the goods and services (of all types, capital as well as consumption) produced during a given year. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Concepts Associated with National Income 6 There are three alternative definitions of national income. 1. The first definition is that it is the money value of goods and services produced by agents of production during the course of a year. We might call this “total production approach.” 2. The second definition is that it is the sum of incomes of agents of production, profits of public enterprises, income from government companies. This we might describe as “income approach.” 3. The third definition is that national income is the sum of total expenditure of agents of production. We might call it “Total expenditure approach.” www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Concepts Associated with National Income 7 Gross National Product (GNP): GNP may be defined as the aggregate market value of all final goods and services produced during a given year. The concept of final goods and services stands for finished goods and services, ready for consumption of households and firms, and exclude raw materials, semi-finished goods and such other intermediary products. In an open economy (an economy subject to international trade), GNP may be obtained by adding up: 1. The value of all consumption goods which are currently produced. 2. The value of all capital goods produced which is defined as Gross Investment. Gross investment, in the real sense, here implies the increase in inventories plus gross products of buildings and equipment. It, thus, includes the provision for the consumption of capital assets, i.e., depreciation, or replacement allowances. 3. The value of government services which are measured in terms of governmental expenditure on various goods and services for rendering certain services to the benefit of the entire community www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

4. The value of net products, viz., the difference between total exports and total imports of the nation. This value 8 may be positive or negative. 5. The net amount earned abroad. This represents the difference between the income received by the nationals from abroad on their foreign investment, minus the income paid by them abroad on the foreigner’s investment. GNP at market price, thus, represents: GNP = C + I + G + (X – M) + (R – P), where, C stands for consumption goods, I stands for capital goods/or gross investment, G stands for government services, X stands for exports, M stands for imports, R stands for income receipts from abroad, and P stands for income paid abroad. In a closed isolated economy, however, GNP = C + I + G. GNP is the basic social accounting measure of the total output. It represents the final products, ready for consumption, valued at current market prices. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

2. Gross Domestic Product (GDP) : 9 All right are reserved with CU-IDOL When we take the sum total of values of output of goods and services in the country, without adding net factor incomes received from abroad, the figure so obtained is called Gross Domestic Product (GDP). GDP = C + I + G + (X – M) GDP at factor cost is obtained as follows: GDP at market price + (S – T), where, S = Government subsidies, and T = Indirect taxes. 3. Net National Product (NNP): It refers to the value of the net output of the economy during one year. NNP is obtained by deducting the value of depreciation or replacement allowance of the capital assets from the GNP. To put it symbolically: NNP = GNP - D, where D = depreciation allowances. www.cuidol.in Unit-8 & 9 (MBA601)

4. National Income at Market Price and National Income at Factor Costs: 10 National income at market price means the money value of goods and services produced. It is the price of the aggregate output and services at current market prices. Gross domestic product at factor cost = Income earned by the factor of production + Depreciation. Net Domestic Product at factor cost = Income earned by the factor of production – Depreciation + Taxes – Subsidy. National Income at market price + National Income at factor cost + Taxes – Subsidies – Depreciation. Other Related Concepts 1. Personal Income: Personal income is the total money income received by individuals in the community. Personal income is the aggregate earned and unearned income. Thus, personal income (PI) = NNP + transfer payments (R) 2. Disposable Personal Income: Disposable personal income is the sum of the consumption and saving of individuals. Thus, DI = C – S. 3. Personal Savings: Personal savings refer to the difference between disposable personal income and personal consumption expenditure. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Methods of Estimating National Income 11 There are three methods of estimating national income: (i) the census of products method, (ii) the census of income method and, (iii) the expenditure method. The Census of Products Method or Output Method This method measures the output of the country. It is also called the inventory method and involves the assessment, through census, of the gross value of production of goods and services produced in different economic sectors by all the productive enterprises in the economy. (For instance, the producing sectors in India are agriculture, forestry, fisheries, mining, industries, transport, commerce and other services.) Y = (P – D) + (S – T) + (X – M) + (R – p) where, Y = Total income of the nation, P = domestic output of all production sectors, D = depreciation allowance, S = subsidies, T = indirect taxes, X = exports, www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

M = imports, 12 R = receipt from abroad, and p = payments made abroad. Mostly, this method is adopted in the calculation of national income. However, there are certain precautions against the danger of double counting, etc., which must be strictly avoided if a correct result is to be achieved. The following precautions are necessary: 1. To avoid double counting, we must add only the final products. Raw materials and intermediate goods should not be included, as that would lead to double counting. 2. Goods for self-consumption by the producer should be excluded; they have not been marketed, so it is difficult to ascertain their true market value. 3. While evaluating the output, changes in the price levels between the years must be taken into account. It is usual to denote national income with reference to prices of a particular year. 4. Indirect taxes, included in prices, are to be deducted for getting the exact value of the products. Similarly, subsidies given by government to certain products should be added in evaluation of the product. 5. Add the value of exports or the income earned abroad and deduct the value of imports. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Census of Income Method 13 In this method, income of all factors of production is added together. The data are compiled from books of accounts, reports, and published accounts. The following classification of incomes is considered as comprehensive: (a) wages and salaries, (b) supplemental labour income (social security, etc.), (c) earnings of self-employed or professional incomes, (d) dividends, (e) undistributed profits, (f) interest, (g) profit of state enterprises. However, transfer payments like gift subsidies etc. are to be deducted from the total of factor incomes. Thus, National Income is equal to the factor incomes minus transfer payments. This method is also called the Factor Cost Method. Thus, the national income of a country, at factor cost, is equivalent to the sum total of the disbursements of their (factors) income. The symbolic expression of this method is as follows: Y = (w + r + i + n ) + (X - M) + (R – P) where w = wages, r = rent, i = interest, n = profits. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

14 However, certain precautions are necessary while following this method. 1. All transfer payments (government and personal) like gifts pension, etc., are to be deducted. Similarly, gambling, being transfer activity, is to be excluded. 2. All unpaid services (like services of housewife) are to be excluded. Thus, only those services for which payments are made should be included. 3. Financial transactions and sales of old property (including land) are to be excluded, as they do not add anything to the real national income. Thus, all capital gains and losses which are related to wealth, but not to real income, should be excluded. 4. Direct tax revenue to the government should be subtracted from the total income as it is only a transfer of income. Or else, it should not be reckoned at all. 5. Similarly, government subsidies should be deducted. 6. Add the value of exports and deduct the value of imports. 7. Add undistributed profit of companies, income from government property, and profits from public enterprises. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

The Expenditure or Outlay Method 15 All right are reserved with CU-IDOL National income on the expenditure side is equal to the value of consumption plus investment. In this method, we have to: (i) estimate private and public expenditure on consumer goods and services, (ii) add the value of investment in fixed capital and stocks, with due consideration for net positive or negative inventories, and (iii) add the value of exports and deduct the value of imports. This method is not as popular as the previous ones. To express it in symbolic terms, Y = (C + I + G) + (X – M) + (R – P) where, C = Consumption Expenditure, I = Investment Expenditure, and G = Government Purchases. www.cuidol.in Unit-8 & 9 (MBA601)

Circular Flow of Activity 16  Incidentally, the economic system contains the flow of goods and services in the transactions between two economic sectors: households and firms. There is a circular flow of economic activity. Households sell their productive services as factors of production to the firms and earn their income. Thus, firms’ spending's become households’ income. Households buy the final goods and services produced by the firms. Thus, households’ total expenditure becomes the income of the firms which is equal to the value of final output by the firms. The range of transactions which take place within the boundaries of firms — “the productive area” — are regarded as intermediate transactions or inter-industry relations. Values are created in the productive area. All net values added together determine the value of the final output, i.e., GNP. The final output flows from the productive area of firms to the consumption area of households. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Assumptions of Circular Flow Model 17 (i) There are only two sectors in the economy, household sector and business sector. (ii) The business sector (or the firms) hires factors of production owned by the household sector and it is the sole producer of goods and services in the economy. (iii) The household sector (or the households) is the sole buyer of goods and services. It spends its entire income on the goods and services produced by the business sector. They are also suppliers of labor and several of other factors of production. (iv) The business sector sells the entire output to households. It does not store. There are, therefore, no inventories. (v) There are no savings and investment in the economy. (vi) The household sector receives income by selling or renting the factors of production owned by it. (vii) Government does, not exist for all such practical purposes (No public expenditures, no taxes, no subsidies, no social insurance contribution, etc.). (viii) The economy is closed one having no international trade relations. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Simple Circular Flow Model with Two-Sector, Two-Market 18  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.In this Y=C Where Y is Income C is Consumption www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Circular Flow of Income in a Two-Sector 19 Economy (Saving) 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. 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 and I is Investment www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Circular Flow of Income in a Three-Sector Model 20  Under three-sector model, 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. In this Y=C+I+G Where Y is Income, C is Consumption, I is Investment, and G is Government Spending. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Circular Flow of Income in a Four-Sector Model 21 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. 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 and X – M = Net Exports www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Circular Flow of Income in a Four-Sector Model 22 www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Supply-oriented Classical Theory of Employment 23  The classical theory of employment refers to the theory and ideas about determinants of employment propounded by the classical writers like Adam Smith, Ricardo, Mill and others including Pigou, who is a noted classical thinker of the modern era. To Keynes, however, all his predecessors are classicists.  The classical theory of employment is essentially a supply-oriented theory. The economists were basically concerned with the long-run problem of growth of the economy’s productive capacity and the efficient allocation of the given resources at full employment. The classical economics has, therefore, focused its attention more on the supply side with a little emphasis on the demand side of the growth process. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Assumption of Full Employment 24 The classical belief in full employment as a normal economic condition was essentially based on the following assumptions:  As supply creates its own demand (Say’s Law), there can never be any deficiency in demand; and  Any unemployment that might result in the process of a competitive system is automatically eliminated by the mechanism of the free market-price system. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Say’s Law of Markets The core of Say’s Law of markets is that the 25 supply of a product through the process of Say’s Law of markets was rooted in the production generates the necessary income mainstream of supply-oriented classical (earned by the factors of production in the form economics. of wages, interest, rent and profits) to demand the goods produced. Any productive process J.B. Say, a French economist of the 19th has generally two effects: Century, asserted that: “supply creates its own demand.” (1) Due to the employment of factors of production in the process, an income stream is Basically, Say’s Law contends that the generated in the economy on account of the production of output in itself generates payment of remuneration to the factors of purchasing power, equal to the value of that production; and output: supply creates its own demand. It is argued that, “Production increases not only (2) a certain output results which is supplied to the supply of goods but, by virtue of the the market. requisite cost payments to the factors of production, also creates the demand to Thus, according to Say’s Law, additional output purchase these goods.” creates additional incomes, which create an equal amount of extra expenditure. Therefore, www.cuidol.in Unit-8 & 9 (MBA601) every product produced generates an equivalent amount of purchasing power (income) in the economy which ultimately leads to its sale. All right are reserved with CU-IDOL

Two Main Propositions of Say’s Law: Implications of Say’s Law: 26 1. Production is the Sole Cause of Demand 1. Automatic Attainment of Full Employment 2. There can be no Overproduction of 2. Self –adjusting Mechanism Goods any Time Assumptions Underlying Say’s Law: 3. There can be no Deficiency of Aggregate Demand 1. Optimum Allocation of Resources 2. Perfect Equilibrium 4. No Problem of General Unemployment 3. Perfect Competition 4. Market Economy 5. Automatic Resource Adjustment and Utilisation in 5. Laissez-Faire Policy of the Government an Expanding Capitalist Economy 6. Elastic Market 7. Market Automatism 6. Money has only a Passive Role: Supply creates its 8. Circular Flow own demand in real terms. 9. Savings-Investment Equality 10. Long Term 7. Built-in-flexibility and Automatic Optimisation 8. Rate of Interest is a Strategic Variable — an Equilibrating Force in the Classical Model www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Interest Rate Flexibility In the classical theory of employment, the rate of interest is 27 regarded as a strategic variable which brings about equality between savings and investment. According to the classical economists, thus, the function of the rate of interest is to maintain savings and investment equilibrium. The flexibility of the rate of interest as such helps in maintaining the circular flow of income expenditure. To illustrate it graphically, the two flows, investment (I) and saving (S), are brought into equilibrium by the rate of interest i. If the community as a whole decides to increase savings at all levels of the rate of interest, the S curve shifts to S'. Eventually, the rate of interest falls to i’. Investment being the inverse function of the rate of interest, it expands to OQ', hence, once again saving equals investment www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Classical Model of Employment 28  According to classical theory, in real terms, the aggregate production function and the demand and supply function of labour basically determine the equilibrium level of total output and employment at full employment level in the economy. The classical aggregate production may be stated as under: Q = f (N.C.T.) where, Q = level of output, f = functional relationship, N = level of employment, C = fixed stock of capital, T = given stage of technology. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Classical Model of Employment 29 www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Wage Rate Flexibility and Employment 30  The classicists have advocated “the money wage cut policy” to solve the problem of unemployment. The classical economists believed that involuntary unemployment, if it existed in an economy, was a consequence of the rigid wage structure.  If wages are lowered sufficiently, all involuntary unemployment would disappear. They, thus, assumed that a self-adjusting system of wage rates would push the economy towards full employment stage. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

Keynes’s Criticisms Against Classical Theory 31 1. Unrealistic Assumption of Full Employment Condition 2. Undue Importance to the Long Period 3. Keynes’s Denial of Say’s Law of Markets 4. Attack on Money Wage Cut Policy 5. Keynes’s Attack on Interest Rate to be Strategic Variable www.cuidol.in Unit-8 & 9 (MBA601) 6. Keynes’s Attack on Laissez-faire Policy All right are reserved with CU-IDOL

SUMMARY  Money measures of the net aggregates of all commodities and services accruing to the inhabitants of a 32 community during a specific period.  In National Income Accounting, thus, the concept of national income has been interpreted in three ways, as: (1) National Product, (2) National Dividend, (3) National Expenditure.  GNP may be defined as the aggregate market value of all final goods and services produced during a given year. The concept of final goods and services stands for finished goods and services, ready for consumption of households and firms, and exclude raw materials, semi-finished goods and such other intermediary products.  Net National Product (NNP) refers to the value of the net output of the economy during one year. NNP is obtained by deducting the value of depreciation or replacement allowance of the capital assets from the GNP. To put it symbolically: NNP = GNP - D, where D = depreciation allowances  Gross National Net Domestic Product at factor cost = Income earned by the factor of production – Depreciation + Taxes – Subsidy. National Income at market price + National Income at factor cost + Taxes – Subsidies – Depreciation  Personal income is the total money income received by individuals in the community. Personal income is the aggregate earned and unearned income  The classical theory of employment is essentially a supply-oriented theory. The economists were basically concerned with the long-run problem of growth of the economy's productive capacity and the efficient allocation of the given resources at full employment. The classical economics has, therefore, focused its attention more on the supply side with a little emphasis on the demand side of the growth process. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

MULTIPLE CHOICE QUESTIONS 1. National income does not include: (a) Service of an actor (b) Profit of a firm 33 (c) Export earnings (d) Transfer payments 2.Total spending on goods and services is known as ____________. (a) Total Demand (b) Aggregate demand (c) Average demand (d) None of them. 3. National income does not include: (b) Profit of a firm (a) Service of an actor (d) Transfer payments. (c) Export earnings 4. The total market value of output produced and sold is also known as ____________. (a) Minimum supply (b) Total supply (c) Aggregate supply (d) None of the above. 5. The classical theory of employment is essentially a (a) Market-oriented theory (b) Demand-oriented theory (c) Supply-oriented theory (d) All the above Answers: 1. (a) 2.(b) 3. (a) 4. (c) 5. (c) www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

FREQUENTLY ASKED QUESTIONS 34 Q1. Define GNP. Ans: GNP may be defined as the aggregate market value of all final goods and services produced during a given year. The concept of final goods and services stands for finished goods and services, ready for consumption of households and firms, and exclude raw materials, semi-finished goods and such other intermediary products. For further detail please Refer to SLM. Q2. What are the assumptions of Full Employment. Ans. As supply creates its own demand (Say’s Law), there can never be any deficiency in demand; and Any unemployment that might result in the process of a competitive system is automatically eliminated by the mechanism of the free market-price system. For further detail please Refer to SLM. www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

REFERENCES 35  Edey, H.C. and Peacock, A.T.: National Income and Social Accounting.  Sloman, John (1999). Economics, 3rd edition. Prentice Economics. Europe: Prentice-Hall.  Mankiw, Gregory (2006). Principles of Economics. Thomson Europe.  Peterson, Lewis and Jain, Managerial Economic, Prentice Hall of India, Fourth edition, New Delhi.  V.L. Mote, Samuel Paul, G.S. Gupta: Managerial Economics: McGraw Hill Eduation, New Edition www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL

36 THANK YOU For queries Email: [email protected] www.cuidol.in Unit-8 & 9 (MBA601) All right are reserved with CU-IDOL