Pre Evaluation & Assessment Test ( Flashcard Quiz Game )
- The Flashcard Quiz contains questions that are based on this unit in the following tabs.
- Attempt this quiz and pay sufficient attention to each question and think for the probable answer.
- This exercise will give you a clear insight needed to approach the topics in this unit for a better understanding.
- Re-attempt this test after you finish reading the topics for a deep rooted interpretation of basic concepts.
- Happy Learning !!
The main objective of an economy is to provide goods and services for the satisfaction of different types of wants of the people. This objective is achieved through production process. During production process, income is generated in the economy.
In the economy we receive different types of incomes. We receive wages and salaries from our employers. We receive interest on capital for lending money. We also receive gifts and donations from others without giving anything in return. All these incomes can be grouped into two types of incomes.
- (A) Factor incomes
- (B) Non-factor incomes
A factor income is the income accruing to a factor of production in return for the services rendered to the production unit. Production is result of the joint efforts of the four factors of production. These four factors of production are –
Labour includes all physical and mental efforts of human beings used for production of goods and services. These physical and mental efforts are inseparable. A worker requires both. Some of the jobs requires more of physical labour than mental labour and some jobs require more mental labour than physical labour.
The remuneration paid to the workers is popularly termed as wages and salaries. In national income accounting, it is termed as compensation of employees.
By land in economics we mean all that is given to us free by nature, on, below or above the surface of the earth.
- On the surface it includes, surface area of the soil, water, forests etc.
- Below the surface it includes mineral deposits, water streams, petroleum etc.
- Above the surface it includes the sun, light, wind etc.
As the land became scarce, sale and purchase of land started. Those who owned land started charging price for the use of land. Such a payment to the land owner/landlord is termed as rent.
(iii) Capital Accounting
Capital includes all the man-made resources used for producing goods and services like structures on land, machines, equipments, vehicles, stock of materials etc.
The payment made to the owner of capital for the use of capital is termed as interest.
It refers to the initiative taken by a person or a group of persons in starting and organising a business. Unless somebody takes this initiative, no business can be started. The one who takes this initiative is termed as entrepreneur.
The income accruing to the entrepreneur is termed as profit.
Thus compensation of employees, rent, interest and profit are factor incomes of the factor owners.
There are certain money receipts which do not involve any sacrifice on the part of their recipients, the examples are gifts, donation charities, taxes, fines etc. No production activity is involved in getting these incomes. These income are called transfer incomes because such income merely represent transfer of money without any good or service being provided in return for the receipts. These incomes are not included in national income.
Basis Economic Activities
Production, Consumption and Investment are three basic economic activities that take place in every economy.
Production is addition of value to an existing commodity. During production process already existing commodities are made more useful by combined efforts of factors of production which increase their value. This increase in value is known as production.
Suppose, a carpenter purchase wood worth ₹ 1000/- and makes furniture from it sells it for ₹ 2000/- In this production process he has added value of ₹ 1000/- (₹ 2000 – 1000)
Using produced goods and services for the direct satisfaction of individual and collective wants of the people is called consumption. It includes all goods and services purchased –
- by households like food items, clothes shoes etc. and
- by the government for collective consumption like, roads, bridges, parks, schools etc.
Investment is that part of production which is left after consumption and used for creating physical assets like machines, equipments, material etc. It is that part of production which is used for further production. It increases the future production capacity of the economy.
The three activities of production, consumption and investment are interrelated and interdependent –
- Increase in production, increases both consumption and investment.
- Increase in consumption induces the producers to produce more in future.
- Increase in investment increases the future production capacity of a country which increases both production and investment.
With out production there can be neither consumption nor investment.
These three economic activities are responsible for generating the income flows in the economy.
Closed Economy vs Open Economy
In modern age, nearby every country has some economic relations with other countries. All the countries buy goods and services from other countries. Borrowing and lending also takes place among different countries. The people of one country also visit other countries. If the two countries have economic relations with each other, the real flows (flows of goods and services) and money flows also take place between them.
An open economy is a term used for a country which has economic relations with the rest of the world. Most of the countries of the world are open economies.
The closed economy is the term used for a country which has no economic relations with the rest of the world. Such economies are rare in the present day world.
Stock And Flow
The distinction between stock and flows is very significant for national income estimates.
Stock : A stock is a quantity which is measured at point of time. For example measuring wealth, population, money supply etc., at 4 p.m. on 31st March, are stock concepts. It has no time dimension.
Flow : A flow is a quantity which is measured over a period of time i.e. in days, month, years etc. It has time dimension. National income, population growth are flow concepts as they are measured over a period of time.
Production, consumption and investment are important economic activities of an economy. In carrying out these economic activities, people make transactions between different sectors of the economy. Because of these transactions, income and expenditure move in circular form. This is called circular flow of income. It is based on two principles –
- (i) The expenditure of the buyer is the cause of the income of the sellers.
- (ii) Good and services flow in one direction from sellers to buyers while money payment for these goods and services flow in opposite direction i.e. from buyers to sellers.
In this way, the flow of goods and services (real flow) and flow of money payments (money flow) together make a circular flow.
Real flow : Households render factor services as owners of land, labour, capital and entrepreneurship to firms. The firms produce good and services to meet the demand of the households. Such flow of factor services from households to firms and flow of goods and services from firms to households is known as real flow.
Money flow : In modern economies, goods and services and factor services are valued is terms of money. Households receive rent for land, wages for labour, interest for capital and profit for entrepreneurship from firms and make payment for goods and services supplies by firms. This flow of money between firms and households is called money flow.
Circular flow Of Income In A Two Sector Economy Without Savings.
An open economy can be divided into following five sectors –
- (i) Producing sector
- (ii) Household sector
- (iii) Government sector
- (iv) Financial sector
- (v) Rest of the world sector.
The circular flow of income among these sectors can be shown with the help of a chart given below –
Different Sectors Of The Economy And Their Inflows And Outflows
1. Flows from and to the production units
- (a) They buy factor services from households (real inflow). In return they make payment in the form of wages, vent, interest and profits (money out flows)
- (b) They deposit savings in financial sector (money outflow)
- (c) They deposit savings in financial sector (real inflow) and in return make payments for import. (money outflow)
- (d) They export goods and services (real outflow) and in return they get payments for the exports (money outflow)
- (e) They pay taxes to the government (money outflow)
- (f) They sell goods and services to households and government. (real outflow). In return, they get payment from households, (private consumption expenditure) and general government (government consumption expenditure) (money inflow)
- (g) They receive subsidies from government. (money inflow)
- (h) They borrow from the financial sector (money inflow)
2. Flows from and to the households
- (a) They buy goods and services from the production unit (real inflow) and in return make payments in the form of consumption expenditure (money outflow)
- (b) They pay personal taxes to the government (money outflow)
- (c) They deposit savings in the financial sector (money outflow)
- (d) They sell factor services to the enterprises (real flow) and in return get factor incomes (money inflow)
- (e) They get free services (real inflow) and transfer payment (money inflow) from government.
3. Flows from and to government
- (a) It purchased goods and services from production units (real inflow) and in return makes payments i.e. government consumption expenditure (money outflow)
- (b) It pays subsidies to the production units (money outflow)
- (c) It provides free services to households (real outflow) and make transfer payments (money outflow)
- (d) It deposits savings in the financial sector (money outflow)
- (e) If receives taxes from production units (money inflow)
- (f) It receives personal taxes from households (money inflow)
4. Flows from and to the financial sector
- (a) It lends capital to the production units (money outflow)
- (b) It receives savings from production units, households and government (money inflow)
5. Flows from and to the rest of the world
- (a) Goods and services are imported from the rest of the world (real inflow) and in return payment are made (money outflow)
- (b) Goods and service are exported to rest of the world (real outflow) and in return payment are received (money inflow)
Not all the flows influence the generation of national income. Some of these are non-factor or transfer incomes flows and have no effect on national income.
The concept of domestic territory (Economic territory) is different from the geographical or political territory of a country. Domestic territory of a country includes the following –
- (i) Political frontiers of the country including its territorial waters.
- (ii) Ships, and aircrafts operated by the normal residents of the country between two or more countries for example, Air India’s services between different countries.
- (iii) Fishing vessels, oil and natural gas rigs and floating platforms operated by the residents of the country in the international waters or engaged in extraction in areas where the country has exclusive rights of operation.
- (iv) Embassies, consulates and military establishments of the country located in other countries, for example, Indian embassy in U.S.A., Japan etc. It excludes all embassies, consulates and military establishments of other countries and offices of international organisations located in India.
Thus, domestic territory may be defined as the political frontiers of the country including its territorial waters, ships, aircrafts, fishing vessels operated by the normal residents of the country, embassies and consulates located abroad etc.
The term normal resident is different from the term nationals (citizens). A normal resident is a person who ordinarily resides in a country and whose centre of economic interest also lies in that particular country. Normal residents include both nationals (such as Indians living in India) and foreigners (non-nationals living in India). For example –
- Nepalese living in India for more than one year and performing economic activities of production, consumption and investment in India, will be treated as normal residents of India.
- On the contrary, Indian citizens, living abroad (say in USA) for more than one year and performing their basic economic activities there, will be treated as normal resident of that country where they normally reside. They will be considered as non-residents of India (NRIs).
- Intermediate goods are those goods which are meant either for reprocessing or for resale.
- Goods used in the production process during an accounting year are known as intermediate goods.
- These are non-durable goods and services used by the producers such as raw materials, oil, electricity, coal, fuel etc. and services of hired engineers and technicians etc.
- Goods which are purchased for resale are also treated as intermediate goods. For example, Rice, wheat, sugar etc. purchased by a retailer/whole-seller.
- Goods which are used either for final consumption by the consumers or for investment by the producers are known as final goods.
- These goods do not pass through production process and are not used for resale. For example, bread, butter, biscuits etc. used by the consumer.
Whether a good is a final good or an intermediate good depends on its use. For example; milk used by a sweet maker is an intermediate good but when it is used by the consumer it becomes a final good.
Intermediate goods are not included in the calculation of national income. Only final goods are included in the calculation of national income because value of intermediate goods is included in the value of final goods. If it is included in national income it will lead to the problem of double counting.
Value Of Output
Production units use non-factor inputs like raw materials (intermediate goods) and factor inputs (factors of production i.e. land, labour, capital and entrepreneurship) for production. Various firms and production units produce different types of goods. Money value of all goods and services produced is known as value of output. (It means value of output includes value of intermediate goods also).
Value Of Output = Quantity × Price
Producing units sell their output in the market. However, it is not necessary that the whole of the output produced during an accounting year is sold during that very year. Therefore, the unsold produce forms a part or the stock or inventories. So, change in stock or inventories is also a part of value of output. Thus, value of output can also be measured as
Value Of Output = Sales + change In stock
It is clear that value of output includes value of intermediate consumption also. National income does not include intermediate consumption expenditure. So for calculation of National Income it must be deducted from value of output to avoid the problem of double counting.
After deducting value of intermediate goods from value of output we get value added. So, value added is the difference between value of output and intermediate consumption expenditure.
Value Added = Value Of Output – Intermediate Consumption Expenditure
The concept of value of output and Value Added can be explained with the help of an example. Suppose a farmer produces cotton worth ₹ 500 and sells it to the cloth mill. The cloth mill produces cloth worth ₹ 1,500. (Say produces 300 metres of cloth and market price of cloth is ₹ 5 per metre). But in this value, value of cotton is also included and cotton used by cloth mill is an intermediate good so value of cotton i.e. ₹ 500 will be intermediate cost. Therefore value added will be ₹ 1000/- ( ₹ 1500 – ₹ 500 = ₹ 1,000/- ).
Gross and Net Measure : The concept of ‘Gross’ and ‘Net Measure’ is very important for the calculation of national income. The value of output and value added calculated above is a gross measure because when goods are sold out in the market these include all type of costs. During production process fixed capital assets like machines, building etc. get depreciated and their value goes down. This is known as normal wear and tear of machinery or consumption of fixed capital or depreciation. So every production unit makes provision for depreciation. When it is included in value, of output and value added, these are called Gross Value of output and Gross Value added respectively.
If depreciation is not included in value of output and value added these are called Net Value of output and net value added respectively.
Net Value Of Output = Gross Value Of Output – Depreciation
Net Value Of Added = Gross Value Of Added – Depreciation
The buyers purchase goods from the market and the price paid by them is known as ‘market price’. The sellers pay a part of this price as ‘indirect taxes’ to the Government.
(i) Indirect Taxes are those taxes which are levied by the government on sales and production and also on imports of the commodities in the form of sales tax, excise duties, custom duties etc. These taxes increase the market price of the commodities.
(ii) Subsides : Sometimes, Government gives financial help to the production units for selling their product at lower prices fixed by the government. Such help is given in case of those selected commodities whose production the Government wants to encourage. If we deduct these subsidies from indirect taxes, we get net indirect taxes.
(iii) Net Indirect Taxes : It is the difference between indirect tax and subsidy.
Net Indirect Tax = Indirect Tax – Subsidy
(iv) Value Added At Factor Cost
Value Added At Factor Cost (FC) = Value Added At Market Price (MP) – Net Indirect Tax
Value Added At FC = Value Added At MP – Indirect Tax + Subsidy
The sum total of value added by all production units within domestic territory of a country is called domestic product. Both residents and non-residents render factor services to these units. Therefore, the income generated in these units is shared by both the residents and non-residents as their factor income.
To get contribution of only normal residents (or their factor income earned within the domestic territory) we have to deduct the factor payments made to the non-residents. These factor payments are known as factor payments made to the rest of the world.
The residents, in addition to their factor services to the production units located in the economic territory of a country, also provide factor services to the production units outside the economic territory i.e., to the rest of the world (ROW). In return for these services they receive factor incomes from the rest of the world.
Thus, National income is the sum total of factor incomes earned by the normal residents of a country within and outside the economic territory. Therefore,
National Income = Domestic Income
+ ( Factor Income Received From ROW – Factor Payments Made To ROW )
Net Factor Income from ROW : It is the difference between factor income’s received from ROW and factor payments made to ROW.
National Income/Product = Domestic Income/Product + Net Factor Income Form Abroad
- Gross Domestic Product At Market Price + Net factor Income From Abroad
= Gross National Product At Market Price
- Net Domestic Product At Market Price + Net factor Income From Abroad
= Net National Product At Market Price
- Net Domestic Product At Factor Cost + Net factor Income From Abroad
= Net National Product At Factor cost
It is Net National Product at factor cost which is called National Income of a country.
Nominal and Real GDP
When the money value of goods and services included in GDP is estimated on the prices of current year, it is called GDP at current prices or nominal GDP. Here current prices mean the prices of the year of which GDP is estimated. For example, for estimating GDP for the year 2012-13 if we use the prices prevailing in the year 2012-13, we shall get nominal GDP.
On the other hand, when the value of goods and services included in GDP is estimated on the prices of base year, we get GDP at constant prices or real GDP. Increase in real GDP implies increase in the production of goods and services.
Therefore, the calculation of GDP at constant prices or real GDP gives us the correct picture of the economic performance of an economy.
A production unit is formed by the four factors of production, land, labour, capital and entrepreneurship. During production process they generate income. This generated income is known as Net Value Added AT Factor Cost (NVAFC). Net value added at factor cost is distributed among the owners of four factors of production in the form of following factor incomes.
- (a) Compensation of employees
- (b) Rent
- (c) Interest
- (d) Profit
- (e) Mixed Income of self-employed
Compensation of employees
Compensation of employees includes all monetary and non-monetary benefits that accrue to the employees on account of labour services rendered by them in the production process. The employees get wages or salaries. In addition they may get many other benefits as employees like bonus, employer’s contribution to provident fund, free accommodation, free conveyance, free medical facilities, free holiday trips, etc.
It is a factor income earned from lending the services of buildings and subsoil assets for production of goods and services.
Interest is the income earned by those who provide funds to the production units. Any interest payment against loans given to consumers to meet consumption expenditure is not a factor payment and so can not be treated as factor income.
Profit is the income accruing to the entrepreneur for his entrepreneurial services (i.e. bearing risks and uncertainties in the business) to the production units. It is a residual income left after making factor payments out of the value added in the form of compensation of employees, rent and interest.
Mixed Income of self-employed
Mixed income of self-employed is the income generated by self employed persons like doctors, lawyers, farmers, shop keepers etc. A self employed person provide his labour as well as his property in his work and generally does not keep accounts in a manner so that the factor payments are clearly identified. For example, a small shopkeeper starts his business in his own house employing his own labour and capital. Hence, the income of this small shopkeeper will be termed as mixed income of self employed.
National Income As Aggregate Of Factor Incomes
National Income = Compensation Of Employees
+ Mixed Income
+ Net Factor Income From ROW.
National Income = Net Domestic Product At Factor Cost (NDPFC)
+ Net Factor Income From ROW.
Income generated during production process in the form of factor incomes is spent by the factor owners on final consumption and investment goods. All consumer goods are generally final goods. Durable producer’s goods like machines and buildings which are used again and again in the production process are also final goods because they are not further sold.
Demand for final goods are made by all the three sections of the economy, namely households, firms and the government. The purchases for final consumption are made by the households and the government. The purchases for investment are made by the production units within the economic territory. Accordingly, the final expenditure is classified into
- (a) Private final consumption expenditure
- (b) Government final consumption expenditure
- (c) Investment Expenditure
- (d) Net exports.
Private Final Consumption Expenditure
Private Final Consumption Expenditure includes purchases by the households and the non-profit institutions serving households. The households purchase goods and services for satisfaction of wants of their family members. The non-profit institutions serving households consist of institutions like mosque, temples, churches, gurdwaras, charitable hospitals, etc. who provide goods and services to the households free of cost.
Final consumption Expenditure includes expenditure made by the households and non-profit institutions on the purchase of the following items –
- (i) Consumer non-durable goods like fruits, vegetables etc. These goods are used up in a single act of consumption.
- (ii) Consumer durable goods like washing machines, furniture etc. These goods are used for a longer period of time.
- (iii) Consumer services like education facilities, transport facilities, doctor’s services etc. All these services are consumed as soon as they are produced.
Government Final Consumption Expenditure (GFCE)
Government Final Consumption Expenditure is the expenditure on the free services provided to the people by the government. The main examples of these services are that of police, military, educational institutions, hospitals, roads, bridges, legislatures and other government departments.
Expenditure incurred by production units on the purchase of physical assets such as machines, building etc. during an accounting year, is known as investment expenditure. There are five categories of investment (Gross domestics capital formation). These are –
- (i) Gross Business fixed investments : Business fixed investment is the amount spent by the business units on the purchase of new capital assets like plants, machinery, equipments etc. These are durable producers goods that is why we call these expenditures as a fixed investment. If we deduct depreciation from it will be net business fixed investment.
- (ii) Inventory investment or stock investment : Inventory investment includes net increase in the stock of raw materials, semi finished goods and finished goods with producers,. It is essential for continuous supply of goods and services by the producers.
- (iii) Residential construction investment : The amount spent on the building of housing units is regarded as residential construction investment in national income accounting.
- (iv) Public Investment : It includes all investment by the Government such as expenditure on building roads, hospitals, schools etc.
- (v) Net exports.
Exports refer to expenditure by foreigners on goods and services produced in our domestic territory whereas, imports refer to our expenditure on foreign Good and services. Net exports are a difference of exports and imports.
The related aggregates of national income are –
- Gross Domestic Product at Market Price (GDPMP)
- Gross Domestic Product at Factor Cost (GDPFC)
- Net Domestic Product at Market Price (NDPMP)
- Net Domestic Product at Factor Cost (NDPFC)
- Net National Product at Factor Cost / National Income (NNPFC / NI)
- Gross National Product at Factor Cost (GNPFC)
- Net National Product at Market Price (NNPMP)
- Gross National Product at Market Price (GNPMP)
Gross Domestic Product at Market Price
It is the money value of all the final goods and services produced within the domestic territory of a country during an accounting year.
GDPMP = Net Domestic Product at Factor Cost (NDPFC) + Depreciation + Net Indirect Tax
Gross Domestic Product at Factor Cost
It is the value of all final goods and services produced within domestic territory of a country which does not include net indirect tax.
GDPFC = GDPMP – Indirect Tax + Subsidy
GDPFC = GDPMP – NIT
Net Domestic Product at Market Price
It is the money value of all final goods and services produced within domestic territory of a country during an accounting year and does not include depreciation.
NDPMP = GDPMP – Depreciation
Net Domestic Product at Factor Cost
It is the value of all final goods and services which does not include depreciation charges and net indirect tax. Thus it is equal to the sum of all factor incomes (compensation of employees, rent, interest, profit and mixed income of self-employed) generated in the domestic territory of the country.
NDPFC = GDPMP – Depreciation – Indirect Tax + Subsidy
Net National Product at Factor Cost
It is the sum total of factor incomes (compensation of employees + rent + interest + profit) earned by normal residents of a country in an accounting year.
NNPFC = NDPFC +
( Factor Income earned by normal residents from ROW – Factor Payments made to ROW )
Gross National Product at Factor Cost
It is the sum total of factor incomes earned by normal residents of a country along with depreciation, during an accounting year.
GNPFC = NNPFC + Depreciation
Net National Product at Market Price
It is the sum total of factor incomes earned by the normal residents of a country during an accounting year including net indirect taxes.
NNPMP = NNPFC + Indirect Tax – Subsidy
Gross National Product at Market Price
It is the sum total of factor incomes earned by normal residents of a country during an accounting year including depreciation and net indirect taxes.
GNPMP = NNPFC + Depreciation + NIT