| Non-Rationalised Economics NCERT Notes, Solutions and Extra Q & A (Class 9th to 12th) | |||||||||||||||||||
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| 9th | 10th | 11th | 12th | ||||||||||||||||
| Class 12th Chapters | ||
|---|---|---|
| Introductory Microeconomics | ||
| 1. Introduction | 2. Theory Of Consumer Behaviour | 3. Production And Costs |
| 4. The Theory Of The Firm Under Perfect Competition | 5. Market Equilibrium | 6. Non-Competitive Markets |
| Introductory Macroeconomics | ||
| 1. Introduction | 2. National Income Accounting | 3. Money And Banking |
| 4. Determination Of Income And Employment | 5. Government Budget And The Economy | 6. Open Economy Macroeconomics |
Chapter 2 National Income Accounting
Some Basic Concepts Of Macroeconomics
Economists are fundamentally concerned with understanding the economic wealth and well-being of nations.
The prosperity of a country doesn't solely depend on possessing abundant natural resources like minerals or fertile land. Historically, many resource-rich nations have remained poor, while some prosperous ones have limited natural wealth.
Economic wealth is generated through the effective use of resources in production processes to create a flow of goods and services, which in turn generates income and wealth.
This flow of production arises from people combining their efforts with the natural and man-made environment within specific social and technological structures.
In modern economies, this flow is the result of commodities (goods and services) produced by numerous enterprises, from large corporations to small businesses.
Producers intend to sell their output. Commodities are sold to consumers, which can be individuals or other enterprises.
Final Goods And Intermediate Goods
Commodities bought by consumers can be for final use or for further production.
- Intermediate Goods: These are goods used up or transformed in the process of producing other goods (e.g., cotton sold to a spinning mill to become yarn; wheat bought by a baker to make bread; steel used to make cars). They are inputs for further production.
- Final Goods: These are goods and services meant for final use and will not undergo further transformation by a producer. Once sold, they exit the active economic flow from producers. The nature of the good is less important than the *economic nature of its use* in determining if it is final (e.g., tea leaves brewed at home for consumption are final; tea leaves bought by a restaurant to sell tea are intermediate).
It is crucial to distinguish between these because in calculating the total output of an economy, only the value of final goods is included to avoid the error of **double counting**, where the value of intermediate goods would be counted multiple times within the value of the final products.
Consumption Goods And Capital Goods
Final goods can be further classified:
- Consumption Goods (or Consumer Goods): Goods and services purchased and consumed by ultimate consumers to satisfy their wants (e.g., food, clothing, recreation services). These can be durable (like consumer durables such as TVs or cars, which have a relatively long life) or non-durable (like food, which is consumed immediately).
- Capital Goods: Durable goods used in the production process but not transformed or used up in a single production cycle (e.g., tools, implements, machinery, buildings, infrastructure). They are final goods but not meant for ultimate consumption; they form part of a firm's capital stock and enable production.
Stocks And Flows
Economic variables can be measured as either stocks or flows:
- Flows: Variables measured over a specific period of time (e.g., income per year, output per quarter, profits per month). These concepts only make sense with a time dimension specified.
- Stocks: Variables measured at a particular point in time (e.g., amount of water in a tank at 3 PM, value of capital goods in a factory on a specific date, total wealth on December 31st). Stocks exist independently of a specific time period, although changes in stocks are flows (e.g., change in inventory over a year).
Investment And Depreciation
That part of the final output comprising capital goods constitutes the gross investment of an economy. Investment refers to the addition to the stock of capital.
However, the existing stock of capital goods (machines, buildings) undergoes wear and tear during production over time. This wear and tear is called depreciation, or consumption of fixed capital.
A part of the capital goods produced in a year goes towards replacing or maintaining the existing capital stock that has depreciated. This is accounted for as an annual depreciation cost, typically calculated based on the expected useful life of the capital asset.
To find the actual new addition to the capital stock, we calculate Net Investment:
Net Investment º Gross Investment – Depreciation
Net Investment represents the true increase in the economy's capital stock or new capital formation.
The total production of final goods in a year can thus be categorised into consumption goods and capital goods (investment).
There is a trade-off: at a specific point in time, if more resources are used to produce capital goods, fewer are available for consumption goods.
However, over time, producing more capital goods increases the economy's productive capacity, allowing for higher levels of total output and consequently potentially higher levels of consumption goods production in the future.
The ability of people to purchase commodities (demand) comes from the income they earn as owners of factors of production (wages, profits, rents, interest).
This highlights a circular flow in the economy: firms demand factors of production from households, paying them income. Households, in turn, use this income to demand goods and services from firms, enabling firms to sell their output.
Production generates income for factors, and income creates demand for goods, enabling production and sales, including capital goods which sustain future production.
Circular Flow Of Income And Methods Of Calculating National Income
In a simple economy model (with no government, external trade, or savings), households receive income from firms for productive activities (wages, interest, profit, rent). Households spend this entire income on goods and services produced by domestic firms.
The total income distributed by firms as factor payments equals the total expenditure households spend on goods and services, which equals the value of goods and services produced. This creates a circular flow of income and expenditure between firms and households (Fig 2.1).
Money representing the aggregate value of goods and services flows circularly. This means we can estimate the aggregate value of goods and services produced in a year by measuring the flow at different points in the circle. This leads to three methods of calculating National Income:
- Expenditure Method: Measuring the aggregate value of spending on final goods and services produced by firms (point A in Fig 2.1).
- Product Method (or Value Added Method): Measuring the aggregate value of final goods and services produced by all firms (point B).
- Income Method: Measuring the sum total of all factor payments made by firms to households (point C).
The aggregate spending must equal the aggregate income earned by factors (A=C). In this simple model, aggregate consumption expenditure equals total sales revenue for firms, which equals total factor payments.
While a single household's spending is limited by its income, in the aggregate, increased spending can lead to increased income in the economy, as the circular flow expands to match the higher spending level. This is a key insight of macroeconomics.
Even in more complex economic systems (with savings, government, external trade), the fundamental conclusion that the aggregate value of goods and services is the same whether calculated by the product, expenditure, or income method remains true.
The Product Or Value Added Method
This method calculates the aggregate annual value of goods and services produced by summing up the Gross Value Added (GVA) by each producing unit (firm or sector) in the economy.
To avoid **double counting** the value of intermediate goods (inputs used up in production), only the value added at each stage of production is counted.
Gross Value Added (GVA) of a firm º Gross value of output produced by the firm – Value of intermediate goods used by the firm.
Example: Wheat producer produces wheat (value Rs 100, no intermediate goods). Baker buys Rs 50 worth of wheat and produces bread (value Rs 200). * Farmer's VA = Rs 100 - Rs 0 = Rs 100. * Baker's VA = Rs 200 (value of bread) - Rs 50 (intermediate wheat) = Rs 150. * Total value of production = Sum of Value Added = Rs 100 + Rs 150 = Rs 250.
Gross Value Added (GVA) includes depreciation (consumption of fixed capital). Net Value Added (NVA) is GVA minus depreciation, representing the net contribution after accounting for capital wear and tear.
Inventory is the stock of unsold goods, semi-finished goods, or raw materials held by a firm. Change in inventory over a year is a flow variable and is treated as investment by the firm (Production - Sales = Change in Inventories).
Gross Domestic Product (GDP) is the sum total of the Gross Value Added (GVA) of all firms in the economy during a year. It measures the aggregate value of goods and services produced within the domestic territory.
$GDP \equiv \sum_{i=1}^{N} GVA_i$ (Sum of GVA of all N firms)
This is the GDP calculated by the product method.
Expenditure Method
This method calculates GDP by summing up the final expenditures made on domestically produced goods and services. Final expenditures are spending on goods/services for end use, not for intermediate purposes.
The components of aggregate final expenditure on domestically produced goods and services are:
- Final Consumption Expenditure (C): Spending by households on consumption goods and services (excluding spending on imports).
- Final Investment Expenditure (I): Spending by firms on capital goods (including change in inventories) and residential investment (excluding spending on imports).
- Government Final Expenditure (G): Spending by the government on consumption and investment goods/services (excluding spending on imports).
- Net Exports (X - M): Value of exports (X, spending by foreigners on domestic goods) minus value of imports (M, spending by domestic residents on foreign goods).
GDP calculated by the expenditure method is given by the identity:
$GDP \equiv C + I + G + (X - M)$
Where C, I, G represent expenditures on domestically produced goods and services, and X and M represent exports and imports of goods and services, respectively.
Income Method
This method calculates GDP by summing up the incomes earned by all factors of production for their contribution to the production of goods and services within the domestic territory of the economy during a year.
The total revenue earned by firms is distributed among the factors of production as their remuneration.
The components of income by factor type are:
- Wages and Salaries (W): Income earned by labour.
- Profits (P): Income earned by entrepreneurs/firms.
- Interest (In): Income earned by owners of capital.
- Rent (R): Income earned by owners of land or fixed natural resources.
GDP calculated by the income method is given by the identity:
$GDP \equiv W + P + In + R$
Summing up the incomes of all households in the economy gives the aggregate factor income.
Equivalence of Methods: The three methods (Product/Value Added, Expenditure, Income) yield the same value for GDP. This is represented by the identity:
$GDP \equiv \sum_{i=1}^{N} GVA_i \equiv C + I + G + (X - M) \equiv W + P + In + R$
The total value of goods and services produced is equal to the total spending on these goods and services, which is also equal to the total income generated in producing them.
Factor Cost, Basic Prices And Market Prices
The valuation of production or income can be done at different prices, which differ based on taxes and subsidies.
- Production Taxes and Subsidies: Paid/received by producers, independent of the volume of output (e.g., land revenue, registration fees, production subsidies). Net Production Taxes = Production Taxes - Production Subsidies.
- Product Taxes and Subsidies: Paid/received per unit of product (e.g., excise duty, sales tax, service tax, export/import duties, product subsidies). Net Product Taxes = Product Taxes - Product Subsidies.
Valuation Concepts:
- Value Added at Factor Cost (GVA at FC): Reflects the payments to factors of production. It excludes all production and product taxes and includes all subsidies.
- Value Added at Basic Prices (GVA at Basic Prices): Includes production taxes (less subsidies) but excludes product taxes (less subsidies). GVA at FC + Net production taxes = GVA at Basic Prices.
- Value Added at Market Prices (GVA at Market Prices): The price consumers pay, includes all taxes (less subsidies). GVA at Basic Prices + Net product taxes = GVA at Market Prices. GDP at Market Prices is the sum of GVA at Market Prices across all firms.
GDP at Market Prices º GVA at Basic Prices + Net product taxes.
The Central Statistics Office (CSO) in India now primarily reports GVA at basic prices and GDP at market prices (simply referred to as GDP).
Some Macroeconomic Identities
Various measures of aggregate income and product are used, differing based on scope (domestic vs. national) and valuation (gross vs. net, market price vs. factor cost).
- Gross Domestic Product (GDP): Value of final goods/services produced *within the domestic territory* in a year.
- Net Factor Income from Abroad (NFIA): Difference between factor income earned by domestic residents abroad and factor income earned by foreigners domestically.
- Gross National Product (GNP): Value of final goods/services produced by the *normal residents* of a country in a year, regardless of location. $GNP \equiv GDP + NFIA$.
- Depreciation (D): Wear and tear of capital stock.
- Net National Product (NNP): GNP minus depreciation. Measures aggregate national income net of capital consumption.
- NNP at Market Prices: $NNP_{MP} \equiv GNP_{MP} - D$.
- NNP at Factor Cost (NNP FC) or National Income (NI): Income accruing to factors owned by residents. $NI \equiv NNP_{MP} - \text{Net Indirect Taxes}$ (Indirect taxes - Subsidies). $NI \equiv NNP_{FC}$.
National Disposable Income And Private Income
Other important aggregates include:
- National Disposable Income: Total income available to the domestic economy for consumption or saving. $National Disposable Income \equiv NNP_{MP} + \text{Net current transfers from rest of the world}$ (gifts, aid, etc.).
- Private Income: Income accruing to the private sector (households and private firms). It includes factor income from domestic product and abroad, plus transfers from government and rest of the world, minus property income and savings of government enterprises.
- Personal Income (PI): Income received by households before paying personal direct taxes. PI is derived from NI by subtracting undistributed corporate profits and corporate taxes, adjusting for net interest payments by households, and adding transfer payments received by households.
- Personal Disposable Income (PDI): Income households have left after paying personal direct taxes and non-tax payments (fines). PDI is the income households can spend or save. $PDI \equiv PI - \text{Personal tax payments} - \text{Non-tax payments}$.
Nominal And Real Gdp
Comparing GDP over time can be misleading if prices change. A rise in GDP might be due to increased production or just inflation.
- Nominal GDP: Value of GDP calculated using current market prices of the goods and services produced. Changes in Nominal GDP reflect changes in both quantity and price.
- Real GDP: Value of GDP calculated using a constant set of prices from a base year. Changes in Real GDP reflect only changes in the volume of production, as prices are held constant. Real GDP is a better measure for comparing economic output across different time periods or countries.
The ratio of Nominal GDP to Real GDP provides a measure of the change in the overall price level in the economy between the base year and the current year.
GDP Deflator $\equiv \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100\%$. It acts as a price index.
Other important price indices include:
- Consumer Price Index (CPI): Measures changes in the retail price of a fixed basket of goods and services typically purchased by a representative consumer. It includes prices of imported consumer goods.
- Wholesale Price Index (WPI): Measures changes in the wholesale price of goods traded in bulk, including raw materials, intermediate goods, and some finished goods.
CPI and WPI may differ from the GDP deflator because they cover different baskets of goods (consumer basket vs. all final goods in GDP), include/exclude imports differently, and use fixed weights for items in the basket (unlike GDP deflator weights based on current production shares).
Gdp And Welfare
While higher income often correlates with improved material well-being for individuals, treating GDP as a sole index of a country's overall welfare has limitations.
Reasons why GDP is not a perfect measure of welfare:
- Distribution of GDP: A high or rising GDP doesn't indicate how equally income or output is distributed among the population. GDP growth concentrated among a few wealthy individuals may not improve the welfare of the majority.
- Non-monetary Exchanges: Many economic activities that contribute to well-being, such as unpaid domestic work (e.g., services performed by women at home) or barter exchanges in informal sectors, are not valued in monetary terms and are thus excluded from GDP calculation. This can lead to underestimation of actual economic activity and welfare, especially in less monetized parts of the economy or developing countries.
- Externalities: These are positive or negative side effects of economic activities that affect others but are not reflected in market prices or included in GDP calculations.
- Negative Externalities: Harm caused by production/consumption for which the responsible party is not penalised (e.g., pollution from a factory harming river users or fishermen). GDP includes the value of the output but does not subtract the cost of the harm, overestimating welfare.
- Positive Externalities: Benefits provided for which no payment is received (e.g., a beekeeper benefiting an orchard). GDP includes the value of the direct output but not the value of the external benefit, underestimating welfare.
Therefore, while GDP is a useful measure of aggregate economic activity, it does not fully capture the complex dimensions of societal welfare, which also depends on income distribution, non-market activities, and externalities.
Key Concepts
Final goods
Consumption goods
Consumer durables
Capital goods
Intermediate goods
Stocks
Flows
Gross investment
Net investment
Depreciation
Wage
Interest
Profit
Rent
Circular flow of income
Product method of calculating National Income
Expenditure method of calculating National Income
Income method of calculating National Income
Macroeconomic model
Input
Value added
Inventories
Planned change in inventories
Unplanned change in inventories
Gross Domestic Product (GDP)
Net Domestic Product (NDP)
Gross National Product (GNP)
Net National Product (NNP) (at market price)
NNP (at factor cost) or National Income (NI)
Undistributed profits
Net interest payments made by households
Corporate tax
Transfer payments to the households from the government and firms
Personal Income (PI)
Personal tax payments
Non-tax payments
Personal Disposable Income (PDI)
National Disposable Income
Private Income
Nominal GDP
Real GDP
Base year
GDP Deflator
Consumer Price Index (CPI)
Wholesale Price Index (WPI)
Externalities
Summary
• The macroeconomy operates cyclically, with income flowing between firms and households.
• Production generates factor payments (income) for households, who then spend this income on goods and services, enabling firms' sales.
• The aggregate value of goods and services produced in an economy can be calculated equivalently by three methods: **Product/Value Added Method** (sum of value added by firms, avoiding double counting intermediate goods), **Expenditure Method** (sum of final expenditures on goods/services: C+I+G+X-M), and **Income Method** (sum of factor incomes: W+P+In+R).
• Goods are classified as final (consumption goods, capital goods) or intermediate (inputs).
• Concepts like stocks (measured at a point, e.g., capital, inventories) and flows (measured over time, e.g., income, output, investment, depreciation) are crucial.
• Gross investment is total capital goods produced. Net investment subtracts depreciation (wear and tear of capital).
• Inventories are unsold stocks; change in inventories is investment (planned or unplanned).
• Key macroeconomic aggregates include GDP, NDP (GDP - Depreciation), GNP (GDP + NFIA), NNP (GNP - Depreciation), National Income (NNP at Factor Cost), Personal Income, and Personal Disposable Income.
• Valuations differ at factor cost (excluding taxes/subsidies), basic prices (including net production taxes), and market prices (including net product taxes).
• Comparing GDP over time requires distinguishing Nominal GDP (current prices) from Real GDP (base year prices), which reflects volume changes. The GDP Deflator measures overall price level changes.
• Other price indices like CPI and WPI track price changes for specific baskets of goods.
• GDP is an imperfect index of welfare due to unequal income distribution, exclusion of non-monetary exchanges, and unaccounted externalities (positive or negative side effects).
Review Questions
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Exercises
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