Basics of Economy

ECONOMICS AND THE ECONOMY

The relation between economics and the economy is that of theory and practice. While the former is a discipline studying economic behaviour of human beings, the latter is a still-frame picture of it. Economics will come out with theories of market, employment, etc., and an economy is the real picture of the things which emerges after the application of those theories.

The main challenge of any economy is to fulfil the needs of its population. Every population needs to be supplied with some goods and services for its survival and well-beings. These goods might include basic needs such as food, shelter, garments, etc., while it might also consist of refrigerators, cars, medicines, computers, etc.

DISTRIBUTION MODELS

In the arena of distribution network, we have three historically existing models—state, market and state-market mix.

• In the first type of distribution system, the state (i.e., the government) takes the sole responsibility of supplying goods and services required by the population with no payments being done by the consume. Ex: China
• In second system, goods and services are made available in the market and on the basis of their demand and supply, their prices are determined in the open market and finally they get distributed to the population. Ex: Euro America
• The third and the most prevalent mode of distribution, the state-market mix, developed out of the experiences of the former two systems. Ex: India.

SECTORS OF AN ECONOMY

The economic activities are broadly classified into three broad categories –

• Primary Sector: This sector includes all those economic activities where there is the direct use of natural resources.
• Secondary Sector: This sector is rightly called the manufacturing sector, which uses the produce of the primary sector.
• Tertiary Sector: This sector includes all economic activities where different ‘services’ are produced.

TYPES OF ECONOMIES

There are following 3 Types of Economies-

• Agrarian Economy: An economy is called agrarian if its share of the primary sector is 50 per cent or more in the total output (the GDP) of the economy.
• Industrial Economy: If the secondary sector contributes 50 per cent or more to the total produce value of an economy, it is an industrial economy.
• Service Economy: An economy where 50 per cent or more of the produced value comes from the tertiary sector is known as the service economy.

National Income Accounting:

It refers to a set of rules and techniques that are used to measure the output of a country. Various macroeconomic identities like GDP, GVA, NNP are used for calculation of national income.

1. Gross Domestic Product (GDP)

The size of a nation’s overall economy is typically measured by its Gross Domestic Product (GDP). It involves counting of all the production of goods and services (such as phones, laptops, cars etc) within the nation’s boundary. GDP is the market value of all the final goods and services produced within a country for a given time period.

• The word “domestic” in Gross Domestic Product pertains to the fact that only the goods and services produced within a country are counted in the GDP.
• For example: Many Indians reside and work in USA. They earn their wages in the same country. The wages earned by Indians in USA will be counted in their GDP. It will not be counted in the India’s GDP. Similarly, USA firm Dominos produces pizza in India. This will be counted in the Indian’s GDP.
• A final goods and services mean goods and services meant for final consumption. It is unlike the intermediate goods and services which acts as component for final goods and services.
• Goods and Services produced during a certain period (usually a year) is counted. In India, GDP is computed quarterly and yearly.

2. Gross National Product (GNP)

Indian economy is not closed economy but an open economy. India has transactions with the rest of the world in the form of exports, imports, loans etc. This gave rise to the concept of national or domestic Income.

• In case of GDP, we calculate the market value of all the final goods and services produced within the country. However, it may be the case that resident of India work and earn in some other foreign countries. This is measured by the Gross National product.
• It is measured as the GDP plus the Net Factor income from Abroad

  • GNP = GDP + ‘Net’ factor income from abroad
  • Net Factor income from abroad = income earned by the domestic factors of production employed in the rest of the world - Factor income earned by the factors of production of the rest of the world employed in the domestic economy.
  • Net Factor Income from abroad = income earned by Indian resident in foreign countries - Income earned by foreign resident in India.

• Gross national Product provides a way to capture the trans boundary economic activity of nationals. For example: Profits earned by Xiaomi by selling smartphones in India will not be included in the GNP of India. Similarly, Profits earned by ONGC Videsh from its subsidiaries in different countries will be included in the GNP of India.

3. Net National Product (NNP)

• Factors of production undergo wear and tear. This wear and tear is called Depreciation. A part of capital is used for this wear and tear which is not used in production of goods and services.

  • Net National Product (@Market Price) = Gross National Product - Depreciation
  • NNP (@Factor Cost) = NNP (@Market Price) - Taxes + Subsidies

• The Net National Product at factor cost is known as National Income.
• However, the Central Statistics Office (CSO) under the Ministry of Statistics and Program Implementation defines National Income of India as Net National Income at Market Price.

4. Personal Income (PI)

• Personal Income is the part of National Income which is received by the households.

  • Personal income (PI) = NI - Undistributed profits - Net interest payments made by households - Corporate tax + Transfer payments to the households from the government and firms.

• Undistributed profits - these are the profits which is not distributed to the households.
• Corporate Tax - It also does not accrue to the households.

5. Personal Disposable Income

• Income that is available to the households that they can spend as they wish. All the Personal Income is not available to individuals to spend. They have to pay taxes such as Income tax and payments such as fines.

  • Personal Disposable Income (PDI) = PI - Personal tax payments - Non-tax payments (fines etc.)

• Thus, Personal Disposable Income is the part of aggregate income which belongs to the households. They may decide to consume a part of it, and save the rest.

6. National Disposable Income

• National Disposable Income gives us an idea of what is the maximum amount of goods and services the domestic economy has at its disposal.

  • National Disposable Income = Net National Product at market prices + Other current transfers from the rest of the world

• Current transfers from the rest of the world includes items such as gifts, aids etc.

7. Private Income

• Private Income = Factor income from net domestic product accruing to the private sector + National debt interest + Net factor income from abroad + Current transfers from government + Other net transfers from the rest of the world

Important Concepts:

Gross vs Net Value Added

• Production factors such as machines, equipment, tools, factory buildings, tractors etc., depreciate over a period of time during the process of production. It may be the case that after certain time these capital goods need replacement. The capital used for this wear and tear is not part of any body’s income.

• Net GDP = GDP - Depreciation
• Net National Product (NNP) = GNP - Depreciation

Current vs Constant Prices

National income can be measured in terms of money in two ways –

1. National Income at Current Prices [Nominal National Income]

• Current prices refer to the prices prevailing in the year in which goods and services are produced. In determining national income at current prices, not only physical output produced during the year is important, but also the prices prevailing in that year are equally important.

  • National Income at current prices = Final goods and services produced in a year x Prices of goods and services in that year

• The National Income at Current Prices is also called Nominal National Income. In order to eliminate the effect of price changes, national income is also estimated at a constant price.

2. National Income at Constant Prices [Real National Income]

• It means that goods and services which are produced in a year are valued at fixed prices, i.e., prices of the base year. In India, the base year for GDP is 2011-12.
• For example - if goods and services produced during the year 2020-21 are valued at the prices of the base year (2011-12), it will be called national income at constant prices for the year 2020-21.
• The need for estimating national income at constant price arises because national income at current price may give a misleading picture of economic performance if the prices are continuously rising or falling. With a high rate of inflation in India, nominal national income may create a false sense of economic growth.
• National income measured at constant prices truly reflects the real change in physical output of a country.

Factor Price and Market Price

• Factor Price is the total cost of all factors of production (such as labour, capital, land etc.) used in producing goods or services. It is the price of the commodity from the producer’s side.
• Market Price is the price at which a product is sold in the market. It includes the cost of production in the form of wages, rent, interest, input prices, profit etc. It also includes the taxes imposed by the government. It excludes Government subsidy.

  • Market Price = Factor Price + Indirect Taxes - Subsidies

Why is National Income Important?

• The budget of the country is highly dependent on the net national income and its concepts. The Government formulates the yearly budget with the help of national income statistics in order to avoid any cynical policies.
• National income data assists the government in comparing the standard of living amongst countries and people living in the same country at different times.
• National Income statistics can help economists in formulating economic policies for economic development.
• For timely anti-inflationary and deflationary policies, we need aggregate data of national income.
• National income estimates help us to bifurcate the national product between defence and development purposes of the country.

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Subject: Economics

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