Study Note - 1

BASIC CONCEPTS OF ECONOMICS

This Study Note includes

1.1 Definition & Scope of Economics
1.2 Few Fundamental Concepts.
1.3 Demand
1.4 Supply
1.5 Equilibrium
1.6 Theory of Production
1.7 Theory of Cost

1.1 DEFINITION & SCOPE OF ECONOMICS

1.1.1 Definition of Economics

The analysis of economic environment requires the knowledge of economic decision making and
hence the study of “Economics” is significant.
There are 4 definitions of Economics.
(i) Wealth Definition:
Adam Smith defined “Economics as a science which inquired into the nature and cause of wealth
of Nations”.
According to this definition —
• Economics is a science of study of wealth only;
• It deals with production, distribution and consumption;
• This wealth centered definition deals with the causes behind the creation of wealth, and
• It only considers material wealth.
Criticisms of this definition:
(a) Wealth is of no use unless it satisfies human wants.
(b) This definition is not of much importance to man and welfare.
(ii) Welfare definition:
According to Alfred Marshall “Economics is the study of man in the ordinary business of life”. It
examines how a person gets his income and how he invests it. Thus on one side it is a study of wealth
and on the other most important side, it is a study of well being.
Features:
(a) Economics is a study of those activities that are concerned with material welfare of man.
(b) Economics deals with the study of man in ordinary business of life. The study enquires how an
individual gets his income and how he uses it.

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Basic Concepts of Economics

(c) Economics is the study of personal and social activities concerned with material aspects of
well being.
(d) Marshall emphasized on definition of material welfare. Herein lies the distinction with Adam
Smith’s definition, which is wealth centric.
(iii) Scarcity definition
This definition was put forward by Robbins. According to him “Economics is a science which studies
human behavior as a relationship between ends and scarce means which have alternative uses.
Features:
(a) human wants are unlimited
(b) alternative use of scarce resources
(c) efficient use of scarce resources
(d) need for optimisation
(iv) Growth Oriented definition
This definition was introduced by Paul. A. Samuelson. According to the definition “Economics is
the study of how man and society choose with or without the use of money to employ the scarce
productive resources, which have alternative uses, to produce various commodities over time and
distributing them for consumption, how or in the future among various person or groups in society.”
It analyses costs and benefits of improving patters of resource allocation.
1.1.2 Scope of Economics

• Economics is a social science.

• It studies man’s behaviour as a rational social being.
Traditional • It considered as a science of wealth in relation to human welfare.
Approach
• Earning and spending of income was considered to be end of all economic
activities.
• Wealth was considered as a means to an end – the end being human welfare.
• An individual, either as a consumer or as a producer, can optimize his goal is an
economic decision.
• The scope of Economics lies in analyzing economic problems and suggesting policy
measures.
• Social problems can thus be explained by abstract theoretical tools or by empirical
methods.
Modern • In classical discussion, Economics is a positive science.
Approach
• It seeks to explain what the problem is and how it tends to be solved.
• In modern time it is both a positive and a normative science.
• Economists of today deal economic issues not merely as they are but also as they
should be.
• Welfare economics and growth economics are more normative than positive.
1.1.3 Subject Matter of Economics
The subject matter of economics is presently divided into two major branches. Micro Economic and
Macro Economics. These two terms have now become of general use in economics.

1.2 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT

Micro Economics
• Micro economics studies the economic behaviour of individual economic units.
• The study of economic behaviour of the households, firms and industries form the subject-matter of
micro economics.
• It examines whether resources are efficiently allocated and spells out the conditions for the optimal
allocation of resources so as to maximize the output and social welfare.
• For example, micro economics is concerned with how the individual consumer distributes his
income among various products and services so as to maximize utility.
• Thus, micro-economics is concerned with the theories of product pricing, factor pricing and
economic welfare.
Macro Economics
• Macro economics deals with the functioning of the economy as a whole.
• For example, macro economics seeks to explain how the economy’s total output of goods and
services and total employment of resources are determined and what explains the fluctuation in
the level of output and employment.
• It deals with the broad economic issues, such as full employment or unemployment, capacity or
under capacity production, a low or high rate of growth, inflation or deflation.
• It is the theory of national income, employment, aggregate consumption, savings and investment,
general price level and economic growth.
Interdependence between Micro Economics and Macro Economics
• Micro Economic analysis and Macro Economic analysis are complementary to each other;
• They do not complement but supplement each other.
• The basic goal of both the theories is same: the maximization of the material welfare of the nation.
• From the micro economic point of view, the nation’s material welfare will be maximized by achieving
optimal allocation of resources.
• From the macro economic point of view, the nation’s material welfare will be maximized by
achieving full utilisation of productive resources of the economy.
• The study of both is equally vital so as to have full knowledge of the subject-matter of economics.
• The contemporary economists are concerned with both micro economics and macro economics.
1.1.4 Nature of Economics
Nature of economics refers to whether economics is a science or art or both, and if it is a science,
whether it is positive science or normative science or both.
Economics as a Science —
• We have often stated that economics is a social science.
• Economics as a social science studies economic activities of the people.
• Economics is a systematic body of knowledge as it explains cause and effect relationship between
various variables such as price, demand, supply, money supply, production, national income,
employment, etc.
• Economic laws, like other scientific laws, state what takes place when certain conditions
(assumptions) are fulfilled.

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Basic Concepts of Economics

• This is the traditional Deduction Method where economic theories are deduced by logical
reasoning.
• The law of demand in economics states that a fall in the price of commodity leads to a large
quantity being demanded ‘given other things’, such as income of the consumer, prices of other
commodities, etc., remaining the same.
• In economics we collect data, classify and analyse these facts and formulate theories or economic
laws.
• The truth and applicability of economic theories can be supported or challenged by confronting
them to the observations of the real world.
• If the predictions of the theory are refuted by the real-world observations, the theory stands rejected.
• If the predictions of the theory are supported by the real-world events, then the theory is formulated.
• The laws of economics or economic theories are conditional subject to the condition that other
things are equal.
• Economic theories are seldom precise and are never final; they are not as exact and definite as
laws of physical and natural sciences.
• The laws of physical and natural sciences have universal applicability, but economic laws are not
of universally applicable.
• The laws of physical and natural sciences are exact, but economic laws are not that exact and
definite.
Economics as an Art —
• Various branches of economics, like consumption, production, distribution, money and banking,
public finance, etc., provide us basic rules and guidelines which can be used to solve various
economic problems of the society.
• The theory of demand guides the consumer to obtain maximum satisfaction with given income.
• Theory of production guides the producer to equate marginal cost with marginal revenue while
using resources for production.
• The knowledge of economic laws helps us in solving practical economic problems in everyday life.
Economics as a Positive Science —
• A positive science is that science in which analysis is confined to cause and effect relationship.
• Positive economics is concerned with the facts about the economy.
• It studies the economic phenomena as they exist.
• It finds out the common characteristics of economic events.
• It specifies cause and effect relationship between them.
• It generalizes their relationship by formulating economic theories and makes predictions about
future course of these economic events.
Economics as a Normative Science —
• The objective of Economics is to examine real economic events from moral and ethical angles and
to judge whether certain economic events are desirable or undesirable.
• Normative economics involves value judgment.
• It deals primarily with economic goals of a society and policies to achieve these goals.
• It also prescribes the methods to correct undesirable economic happenings.

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Economics as a Science and an Art —
• Being a systematized body of knowledge and establishing the cause and effect relationship of a
phenomenon, Economics is a scientific study.
• The laws of economics are conditional.
• Economics cannot predict with so much certainty and accuracy as the subject deals with the
behaviour of human beings as such controlled experiment is not possible.
• Some economists prefer to treat economics as an art.
• Every science has an art or a practical side.
• Every art has a scientific side which is theoretical.
• Economics deals with both theoretical aspects as well as practical side of many economic problems
we face in our daily life.
• Thus, Economics is both science as well as an art.

1.1.5 Central Problem of all Economies

• In case of any economy, whatever the economy required cannot be satisfied fully.
• Economic resources or means of production are limited and they can be put to alternative uses.
• Every economy faces some common problems.

• A country cannot produce all goods because it has limited resources.

What to
• It has to make a choice between different goods and services.
produce?
• Every economy has to decide what goods and services should be produced.
• As an economy decides to produce certain goods, it faces the problem to decide
how these goods will be produced.

How to • The problem arises because of unavailability of some resources.

produce? • It also involves the choice of technique of production.
• A country may produce by labour intensive methods or by capital intensive methods
of production, depending upon its stock or man power.
• Goods and services are produced for people who have the means to pay for them.
For whom to • A country may produce mass consumption goods at a large scale or goods for
produce? upper classes.
• All it depends upon the policies of the government as well as private producing units.

1.1.6 Economic Organizations

It refers to the arrangements of a country’s economy in terms of production, distribution and consumption
of goods and services.

FUNDAMENTALS OF ECONOMICS AND MANAGEMENT I 1.5

Study Note - 3
NATIONAL INCOME

This Study Note includes

3.1 Concept of National Income

3.2 Measurement of National Income
3.3 National Income & Economic Welfare
3.4 Concept of Consumption, Saving & Investment Saving & Investment
3.5 Economic Growth & Fluctuation

3.1 CONCEPT OF NATIONAL INCOME

• The value of aggregate output produced by different sectors during a given time periods.
• In real terms — it is the flow of goods and services produced in an economy in a particular period
- a year.

3.1.1 Concepts Associated with National Income

Gross National • the market value of all final goods and services;
Product (GNP) • These are produced by domestically owned factors of production in a country
in that year.
Net National • NNP at market price = GNP minus depreciation of capital stock.
Product (NNP) • The productive power of physical capital stock diminishes gradually because
of the wear and tear that it undergoes in the process of production.
NNP at factor • NNP at factor cost = NNP at market price minus Indirect Business Tax minus Non
cost or National tax liabilities minus Business Transfer Payments plus Subsidy from Government =
Income National Income.
Gross Domestic • the sum total of values of all goods and services produced within the
Product (GDP) geographical boundary of the country;
• These are without adding the factor income received from abroad.

Distinction between Gross National Product and Gross Domestic Product –

Gross National Product (GNP) is different from Gross Domestic Product (GDP) in following respects:
(a) GNP refers to the total market value of all the final goods and services produced in a country
during a given year, plus net factor income from abroad.
But GDP refers to the total market value of all the goods and services produced in the given year
within the domestic territory of the country.
(b) GNP includes all income earned by the country in abroad (including foreign investments). But
GDP does not include the income earned by the country from abroad.

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National Income

3.2 MEASUREMENT OF NATIONAL INCOME

There are three alternative ways of estimating National Income of a country. Broadly it may be viewed
from income side, output side and expenditure side. Let us discuss these methods:
• It implies by adding the values of output produced and services rendered by
different sectors;
• The output method is unscientific;
Product • Only those goods and services are counted which are paid for, that is marketed;
method • The value added method can be used;
• Here only the value added by each firm in the production process is included in the
output figure,
• The value added output of all sectors makes up GNP at factor cost.
• All income from employment and ownership of assets before taxation received
from productive activities to be counted.
Income • It is the factor income method.
method • The undistributed profits of the private sector are added.
• The trading surplus of the public sector corporations is also added.
• These exclude some items which do not arise from productive activities, such as —
sickness benefits, interest on national debt etc.
• It depends on by measuring the total domestic expenditure;
• It comprises two elements;
Expenditure • Consumption expenditure of the household sector on goods and services,
Method consumption outlays of business sector and public authorities.
• investment expenditure is used for making a fixed capital like building, machinery
etc.

Usefulness of National Income estimates

1. It shows how the production is changing, to output and the effects of government policies and
programmes.
2. In analyzing the relation between input of one industry and the output of the other.
3. It reveals the distribution of income among economic units.
4. Changes of tastes and fashions are revealed which help businessmen in deciding what to
produce or for whom to produce.
5. The national income quantum indicates the ability of a country to pay its share for international
purpose e.g. membership of IMF or World Bank.
Difficulties in Estimating National Income
• No practicable methods exists for inclusion of some items in National Income (NI),
such as — services for which no remuneration is paid, goods that are marketed sold
at a price but are used for self-consumption etc.
• It is not always possible to make a clear distinction between primary, intermediate
and final goods.
Conceptual • The price that should be chosen to determine the money value of National product
Difficulties is a difficult question.
• Debate regarding inclusion of income of foreign companies in National Income
estimates since, a large part of such income is remitted out of the country.

3.2 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT

 • Changes in the price level involve the use of Index Numbers which have their
inherent difficulties.
• Official statistics are not always accurate as it is based on guess work and sample
Statistical
survey.
Difficulties
• Methods of computing NI are not the same in all countries.
• The statistical data are often not available.

3.3 NATIONAL INCOME AND ECONOMIC WELFARE

• Many things (pollution cost, disseminates of modern urban living, leisure etc.) that contribute to
human welfare are not included in the GNP (Gross National Product).
• GNP may not adequately reflect changes in the quality of products.
• GNP does not measure the quality of life.
• Increase in the general price level would bring a fall in the economic welfare.
• If the net National Product has increased on account of more production of capital goods, it will
not increase welfare.
• Welfare also depends upon the distribution of National Income.
• The unequal distribution of National Income decrease economic welfare.

3.4 CONCEPT OF CONSUMPTION, SAVING AND INVESTMENT

3.4.1 Consumption
Keynes held that current consumption depends upon current gross income minus tax liabilities.
He says “men are disposed as a rule and on the average, to increase their consumption as their
income increases by not by as much as the increase in their income.” Symbolically 1> C > 0. This is the
psychological law of consumption.
· Consumption Function
The propensity to consume shows income consumption relationship C = F(Y). here C is consumption,
a dependent variable and Y is an independent variable. It should be noted that propensity to
consume does not mean desire to consume but effective consumption. C is an increasing function
of income as Y and C move in the same direction.
Y
C = F(Y)

C = a + by
Consumption

L
C
a

o
45
X
O Income
Fig. 3.1

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National Income

OX measures real income and OY consumption. The C curve represents the propensity to consume.
It slopes upward to the right showing consumption rising along with income. At point a while income
is zero consumption is positive, and upto CL on the consumption curve, we find that consumption
exceeds income.
· Average Propensity to consume
It implies the ratio of total consumption to total income.
APC = c / y
· Marginal propensity to consume
This implies the effect of additional income on consumption. It is the ratio of additional consumption
to additional income : MPC = dc/dy, Or MPC < 1. That is to say MPC is less than unity. The propensity
to consume is a fairly stable function of income.
Determinants of Consumption Function
Consumption function depends on subjective and objective factors. Among objective factors we
may mention a few:
(a) Tax Policy – A higher rate of tax will reduce personal income and to that extent consumption
as well.
(b) The Rate of Interest – A higher rate of interest may induce more savings and so less consumption.
However a higher interest income may raise consumption by raising total income.
(c) Holding of Assets – If people want to hold more assets, like property, jewellery etc. they will
curtail consumption.
(d) Windfall Profits or Loss – Consumption level of those classes of people changes who gain
windfall profit or incur heavy loss.
Among subjective factors we may mention some motives that lead individuals to refrain from
spending. These are motive of precaution, motive of foresight, motive of improvement, motive of
avarice etc.

3.4.2 Saving
Definition
• Excess of income over expenditure on consumption.
• Symbolically S = Y – C.
• The unconsumed part of national income of all members of the community represents, National
Savings.
• Total domestic savings = households’ savings + business sector’s savings + government’s savings.
Determinants
(i) Income:
• Savings is functionally related to income S = f(Y).
• The saving income ratio tends to rise with increase in income.
• The savings function is a stable function of income in the short run.
• Savings as such is not a stable function of income.
• Marginal propensity to save (ds/dy) is always greater than zero but less than unity.
• People save part of additional income but not the entire income.
• Symbolically, 1 > MPS > 0 or 1 > ds/dy > 0.

3.4 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT

The saving function is explained by three income concepts in macro economics.
(a) Absolute Income – current savings depend on current disposable income i.e. income minus taxes
paid.
(b) Relative Income – savings of an individual depends upon his percentile position in the total income
distribution.
(c) Permanent Income – it is current income plus the expected income received over a period of
time. Actual or measure income is the sum of permanent and transitory income Ym = Yp + Yt.
Transitory income implies unanticipated addition or subtractions in income.
(ii) Distribution of income:
• Inequality of income distribution helps the process of savings.
• “Demonstration effect”, that is man’s desire to imitate the superior consumption standard of
neighbours or relatives.
• This induces a man to buy expensive goods and so saving decline.
(iii) Sound financial instruments and the rate of interest:
• A higher rate of interest motivates us to save more.
• Existence of diverse type of financial instruments gives people incentive to save more.
(iv) Subjective or psychological factors:
• A man’s attitude towards savings depends on his farsightedness, his desire to bequeath a fortune,
to enjoy a better living in future or to possess some physical asset.
• A man saves or insures as a precaution against future uncertainty and insecurity.

3.4.3 Investment
Definition
Investment has dual aspect. It implies the production of new capital goods like plants and equipments.
Secondly, a change in inventories or stocks of capital of a firm between two periods.
Determinants:
• There are two determinants — (a) the marginal efficiency of capital (MEC) and (b) the rate of
interest.
• MEC implies the prospective yield from the capital asset and the supply price of this asset.
• Symbolically C = Q/P. Where Q is the prospective yield from capital asset and P is the supply of this
asset.
• In considering a particular investment project the investor must have some idea of future returns,
that is yields from the real asset in its life span.
• To find the present value of all expected future returns we have to discount all future returns.
• Generally there exists a negative relation between interest rate and investment expenditure.
• A fall in the rate of interest may induce an increase in investment expenditure whereas a higher
rate, investment is likely to be less.
• At a higher interest rate, a firm instead of using funds for capital equipments may invest in financial
assets.
• Thus the level of investment is a negative function of the rate of return.
• Risk, uncertainty and instability tend to discourage business to undertake investment projects.
• A firm may expand investment outlay for innovation viz. introducing a new good or a new technique.

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National Income

• Innovations either by increasing sale or by reducing cost may help the innovating firm a larger
return on its investment.
• Investment decisions are influenced by the cost of capital goods.
• A firm normally calculates the initial cost of acquisition, and the subsequent cost of maintenance
and operation of capital goods.
Marginal Productivity of Capital (MPC):
• The additional physical product obtained due to the employment of one extra unit of capital (do/
dc) per unit of time.
• The MPC is net current product of the capital good minus the cost of capital good.
• In contrast, MEC denotes the series of increments in output anticipated over the life of the capital
equipment.
Investment Multiplier:
• The Keynesian multiplier shows how many times the total income increases by a given amount of
initial investment.
• If dI represents increase in investment, dY represents increase in income and M the multiplier, then
M = dY/dI.
• The multiplier is the number by which the initial investment is to be multiplied to get the resulting
change in income.
• With the help of the marginal propensity to consume the relation between a given dose of
investment and the resulting change in income can be shown.
Acceleration Principle:
• Change in output of consumption goods cause investment for production of capital goods used in
producing those consumption goods.
• The ratio between the induced investment and the net change in consumption outlay is known as
acceleration coefficient.
• a = dI/dC, where dI is net change in investment and dC for net change in consumption expenditure
and for accelerator.
• The value of accelerator depends on capital output ratio, the durability of capital goods.
• The acceleration effect will be high if capital equipments have more durability and capital output
ratio is high.

3.5 ECONOMIC GROWTH AND FLUCTUATION

3.5.1 Economic Fluctuation

• The business world in capitalistic economy is said to experience ups and downs in its economic
activities.
• The fluctuations take the form of Wave are known as Trade Cycle or Business Cycle, in economics.
• Every trade cycle pass through four phases, such as —
• The main spring of business prosperity is profit.
• In a capitalist economy as profits inflate, industrialists and businessmen get necessary
Prosperity incentive to produce more and invest more.
• More investment leads to more employment and so more income more effective
demand.

3.6 I FUNDAMENTALS OF ECONOMICS AND MANAGEMENT

 • Excessive expansion leads to diseconomies of large scale production, rising cost,
higher wages and much shortages.
Recession
• When demand for bank credit being high and rising, interest rates tend to move up.
• These diminish profit to a lower level.
• Income, employment and output decline sharply by the recessionary trends.
Depression • Investments fall and enterprise is discouraged.
• Pessimism leads to depression and deflation.
• Depression does not continue for indefinite period.
• It is an improving stage of trade.
Recovery • Weaker units are liquidated, old debts are repaid, and enterprises are reorganized.
• Unemployment rate gradually decreases.
• Income is generated.

Anti Cyclical Policy

• Government of a country may take some measures to control cyclical fluctuations.
• Through an expansionary or contractionary credit policy the central bank can control business
cycle.
• In a period of depression government should spend more and tax less.
• The objective should be the increasing effective demand that is buying power of people.
• In prosperity phase government should spend less and tax more.
• The socialists think that cyclical fluctuations are the outcome of a capitalistic economy.
• Here profit motive is the main driving force.
• The problem can be uprooted if the system moves from capitalism to socialism.

3.5.2 Economic Growth

Definition
• The expansion in the capacity of an economy to produce goods and services over a period of
time.
• An outward shift of production possibilities frontier of an economy.
• It shows the different maximum possible combinations of quantities of two goods if it employs all its
available resources full and given the existing state of technology.
Measurement
• Different methods have been suggested for measuring economic growth.
• One measure is a country’s overall capacity to produce goods and services.
• The money value of GNP can change because of change in price.
• It is necessary to measure economic growth rate by using constant Rupees, or real income.
• An increase in real GNP if followed by a higher rate of growth of population may lead to
deterioration or no change in the standard of living of the population.
• Real GNP per capital = Real GNP/ Population
• If the numerator (GNP) grows faster than the denominator (Population), real GNP per capita will
grow and quality of life will improve.

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National Income

Components of Economic Growth

• Population helps economic growth by enlarging demand.
Size of population (P)
• It paves the way for producing large quantity of output
Fraction of population that • If this proportion (L/P) is high more will be productive capacity of
constitute labour force L/P (L = PX) an economy and vice versa.
The total number of labour hours • The length of the average work hour of the labour force generally
actually worked by the labour seems to have a direct impact on the rate of economic growth.
force L x H = P x L/P x H
• Output per labour hour has a direct bearing on the level of GNP.
Output per labour i.e. labour
productivity Q/(L x H) • The more productive labour, the more will be the total output of
an industry.
Relation between Stability and Growth
• Financial stability is essential for economic growth.
• A stable economy can help the formation of capital by stimulating the inflow of foreign capital.
• Stability of currency is necessary to stimulate a rapid increase in productivity.
• If prices are not stable, firms can make ‘easy’ profit and repay their old debts in depreciated currency.
• The existence of well-organised financial institutions is likely to quicken economic growth by mobilizing
savings for investment purposes.

EXERCISE

1. Distinguish between –
(a) GDP & GNP
(b) GDP & NDP
(c) NNP & GNP
(d) GDPMP & NDPFC
2. Explain the ‘production method’ of measuring national income. State the difficulties in this method.
3. Explain the income and expenditure method of calculating national income, along with the
difficulties associated.
4. Point out the difficulties in the measurement of national income.
5. What is the meaning of ‘double counting’ in national income accounting and what does it lead to?
6. Why are the services of house wives not included in national income?
7. Why are the following not included in national income :
(a) Sale of an old car;
(b) Winning of a lottery;
(c) Income of a smuggler.
8. Give an example of transfer payment.
9. What is meant by Consumption functions? What is the distinction between Average propensity to
consume and Marginal Propensity to consume? Discuss the factors determining Marginal Propensity
to consume.
10. What is meant by Economic Growth? What are the components of economic growth?
11. Discuss whether savings is a virtue or a vice for –
(a) an individual
(b) the society

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