Lesson 1

BASICS OF DEMAND
AND
SUPPLY
AND FORMS
OF
MARKET
COMPETITION

445
446 Economic & Business Environment

THEORY OF DEMAND AND SUPPLY

Meaning of Demand

Demand is an economic principle referring to a consumer's desire to purchase goods and services and
willingness to pay a price for a specific good or service.

Law of Demand

According to the law of demand, other things being equal, if price of a commodity falls, the quantity
demanded of it will rise, and if price of the commodity rises, its quantity demanded will decline. It implies
that there is an inverse relationship between the price and quantity demanded of a commodity,. In other
words, other things being equal, quantity demanded will be more at a lower price than at a higher price.

The law of demand describes the functional relationship between price and quantity demanded. Among
various factors affecting demand, price for a commodity is the most critical factor. Thus, demand of a
commodity is mainly determined by the price of commodity.

Dx = f(Px).

The law of demand may be understood from the following example:

PRICE PER CAN (INR) QUANTITY DEMANDED

80 0

70 200

60 400

50 600

40 800

30 1000

20 1200

10 1400

0 1600

Source: Economics Online

 Economic & Business Environment 447

Price per
Can

80
A
60
B
40

20
Demand
Curve

0 400 800 1200 1600

Quantity
Per week
Source : www.economicsonline.co.uk

Thus, it may be observed that with the rise in price per can, the demand for the cans is reducing.

Assumptions of the law of demand

The above stated law of demand is conditional. It is based on certain conditions as given. It is therefore,
always stated with the ‘other things being equal’. It relates to the change in price variable only, assuming
other determinants of demand to be constant. The law of demand is thus, based on the following ceteris
paribus assumptions:

1. No Change in Consumer’s Income

2. No Change in Consumer’s Preferences

3. No Change in the Fashion

4. No Change in the Price of Related Goods

5. No Expectation of Future Price Changes or Shortages

6. No Change in Size, Age Composition and Sex Ratio of the Population

7. No Change in the Range of Goods Available to the Consumers

8. No Change in the Distribution of Income and Wealth of the Community

9. No Change in Government Policy

10. No Change in Weather Conditions.

EXCEPTIONS TO THE LAW OF DEMAND
There are few exceptional cases where the law of demand is not applicable, which may be categorised as
follows:
Giffen Goods : In the case of certain inferior goods called Giffen goods (named after Sir Robert
Giffen), when the prices fall, quite often less quantity will be purchased than before because of the
negative income effect and people’s increasing preference for a superior commodity with the rise in
their real income. Examples of Giffen goods can include bread, rice, and wheat.
448 Economic & Business Environment

Articles of Snob Appeal : Sometimes, certain commodities are demanded just because they happen
to be expensive or prestige goods, and have a ‘snob appeal’. They satisfy the aristocratic desire to
preserve exclusiveness for unique goods.

Speculation : When people speculate about changes in the price of a commodity in the future, they
may not act according to the law of demand at the present price, say, when people are convinced
that the price of a particular commodity will rise still further, they will not contract their demand with
the given price rise: on the contrary, they may purchase more for the purpose of hoarding.

Consumer’s Psychological Bias or Illusion : When the consumer is wrongly biased against the
quality of the commodity with the price change, he may contract this demand with a fall in price.

Law of Supply

Supply represents how much the market can offer. The quantity supplied refers to the amount of a good
producers are willing to supply when receiving a certain price. The supply of a good or service refers to
the quantities of that good or service that producers are prepared to offer for sale at a set of prices over a
period of time. Supply means a schedule of possible prices and amounts that would be sold at each price.
The supply is not the same concept as the stock of something in existence, for example, the stock of
commodity X in Delhi means the total quantity of Commodity X in existence at a point of time; whereas,
the supply of commodity X in Delhi means the quantity actually being offered for sale, in the market, over
a specified period of time.
The law of supply states that a firm will produce and offer to sell greater quantities of a product or service
as the price of that product or service rises, other things being equal. There is a direct relationship
between price and quantity supplied. In this statement, change in price is the cause and change in supply
is the effect. Thus, the price rise leads to an increase in supply and not otherwise. It may be noted that at
higher prices, there is a greater incentive to the producers or firms to produce and sell more. Other things
including the cost of production, change of technology, prices of inputs, level of competition, size of the
industry, government policy and non-economic factors.
Thus ‘Ceteris Paribus’
(a) With an increase in the price of a good, the producer is willing to offer more quantity in the
market for sale.
(b) The quantity supplied is related to the specified time interval over which it is offered.
The law of supply is the microeconomic law that states that, all other factors being equal, as the price of a
good or service increases, the quantity of goods or services that suppliers offer will increase, and vice
versa. The law of supply says that as the price of an item goes up, suppliers will attempt to maximize their
profits by increasing the quantity offered for sale.

Assumptions of Law of Supply

The term “other things remaining the same” refers to the following assumptions in the law of supply:
1. No change in the state of technology.
2. No change in the price of factors of production.
3. No change in the number of firms in the market.
4. No change in the goals of the firm.
5. No change in the seller’s expectations regarding future prices.
6. No change in the tax and subsidy policy of the products.
7. No change in the price of other goods.
 Economic & Business Environment 449

The equilibrium price is the market price where the quantity of goods supplied is equal to the quantity of
goods demanded. This is the point at which the demand and supply curves in the market intersect.

Price

ly
pp
Su

P*

De
m
an
d

Q* Quantity

Source: Study.com
At equilibrium, there is no shortage or surplus unless a determinant of demand or a determinant of supply
changes. If a change in the price of a good or service creates a shortage, it means that consumers want to
buy a higher quantity than the one offered by producers. In this case, demand exceeds supply and consumers
are not satisfied. In contrast, if a change in the price of a product or a service creates a surplus, it means that
consumers want to buy less quantity than the one offered by producers. In this case, supply exceeds demand
and producers need to lower the price of the product or the service to avoid excessive inventory.
Let us take an example to understand the concept.

Price ($) Quantity Quantity Surplus Shortage

Demanded (Kg) Supplied (Kg) (kg) (kg)

100 5 50 45
90 12 41 29
80 18 35 17
70 22 28 6
60 25 25 0 0
50 34 22 12
40 41 18 23
30 47 14 33
20 50 9 41
10 55 5 50

Source : My Accounting Course

450 Economic & Business Environment

In the table above, the quantity demanded is equal to the quantity supplied at the price level of $60.
Therefore, the price of $60 is the equilibrium price. At any other price level, there is either surplus or
shortage. Specifically, for any price that is lower than $60, the quantity supplied is greater than the quantity
demanded, thereby creating a surplus. For any price that is higher than $60, the quantity demanded is
greater than the quantity supplied, thereby creating a shortage.

ELASTICITY OF DEMAND

In economics, the demand elasticity (elasticity of demand) refers to how sensitive the demand for a good
is to changes in other economic variables, such as prices and consumer income.

Demand elasticity is calculated as the percent change in the quantity demanded divided by a percent
change in another economic variable. A higher demand elasticity for an economic variable means that
consumers are more responsive to changes in this variable.

“Elasticity of demand is the responsiveness of the quantity demanded of a commodity to changes in one
of the variables on which demand depends. In other words, it is the percentage change in quantity
demanded divided by the percentage in one of the variables on which demand depends.” The variables
on which demand can depend are:

Prices of related Consumer’s income etc.

Price of the commodity
commodities

There are major three types of elasticity of demand, i.e. Price elasticity; Income elasticity and Cross elasticity.
However, this lesson focuses only on price elasticity of demand.

Price Elasticity of Demand

The price elasticity of demand is the response of the quantity demanded to change in the price of a
commodity. It is assumed that the consumer’s income, tastes, and prices of all other goods are steady. It is
measured as a percentage change in the quantity demanded divided by the percentage change in price.
Therefore, price elasticity of demand is:

Percentage Change in Quantity Demanded

Ep =
Percentage Change in Price

Change in Quantity Original Price

Or, Ep = x
Original Quantity Change in Price

Types of Price Elasticity of Demand

The extent of responsiveness of demand with change in the price is not always the same. The demand for
a product can be elastic or inelastic, depending on the rate of change in the demand with respect to
change in price of a product.

Elastic demand is the one when the response of demand is greater with a small proportionate change in
the price. On the other hand, inelastic demand is the one when there is relatively less change in the
demand with a greater change in the price.
 Economic & Business Environment 451

The various forms of price elasticity of demand are as under:

1. Perfectly Elastic Demand : When a small change in the price of a product causes a major change
in its demand, it is said to be perfectly elastic demand. In perfectly elastic demand, a small rise in
price results in a fall in demand to zero, while a small fall in price causes an increase in demand to
infinity. In such a case, the demand is perfectly elastic or ep = .

Source: Economics basics

2. Perfectly Inelastic Demand : A perfectly inelastic demand is one when there is no change produced
in the demand of a product with a change in its price. The numerical value for perfectly inelastic
demand is zero (ep=0).

Source: Economics basics

3. Relatively Elastic Demand : Relatively elastic demand refers to the demand when the proportionate
change produced in demand is greater than the proportionate change in price of a product. The
numerical value of relatively elastic demand ranges between one to infinity (ep>1).
452 Economic & Business Environment

Elastic demand
- change in price leads
to bigger percentage
change in demand

Source: Economics help

4. Relatively Inelastic Demand: Relatively inelastic demand is one when the percentage change
produced in demand is less than the percentage change in the price of a product. For example,
if the price of a product increases by 30% and the demand for the product decreases only by 10%,
then the demand would be called relatively inelastic. The numerical value of relatively elastic
demand ranges from zero to one (ep<1).

Inelastic demand
- change in price leads
to smaller percentage
change in demand

Source: Economics help

5. Unitary Elastic Demand : When the proportionate change in demand produces the same change
in the price of the product, the demand is referred as unitary elastic demand. The numerical
value for unitary elastic demand is equal to one (ep=1).

Source: Economics basics

 Economic & Business Environment 453

A quick recap

Perfectly Elastic Demand (EP = )

Perfectly Inelastic Demand (EP = 0)

Relatively Elastic Demand (EP > 1)

Relatively Inelastic Demand (Ep< 1 )

Unitary Elastic Demand ( Ep = 1)

Factors affecting Price Elasticity of Demand

1. Price Level : The demand is generally elastic for moderately priced goods but, the demand for
very costly and very cheap goods is inelastic. The rich do not bother about the prices of the goods
that they buy. Very costly goods are demanded by the rich people and hence their demand is not
affected much by the change in prices. For example, on increase in the price of Toyota car from
Rs. 5,00,000 to Rs. 5,20,000 will not make any noticeable difference in its demand. Similarly, the
change in the price of very cheap goods (such as salt) will not have any effect on their demand,
for their consumption which is very small and fixed.
2. Availability of Substitutes : If a good has close substitutes, the price elasticity of demand for a
commodity will be very elastic as some other commodities can be used for it. A small rise in the
price of such a commodity will induce consumers to switch their consumption to its substitutes.
For example gas, kerosene oil, coal etc. will be used more as fuel if the price of wood increases. On
the other hand, the demand of such commodities which have no close substitutes is inelastic,
such as salt.
3. Necessities : If a good is a necessity, then the demand tends to be inelastic. For example, if the price
for drinking water rises, then there is unlikely to be a huge drop in the quantity demanded since
drinking water is a necessity.
4. Time Period : Over time, a good tends to become more elastic because consumers and businesses
have more time to find alternatives or substitutes. For example, if the price of gasoline goes up,
over time people will adjust for the change, i.e., they may drive less or use public transportation or
form carpools.
5. Habits : The demand for addictive or habitual products is usually inelastic. This is because the
consumer has no choice but no pay whatever the producer is demanding. For example, if the
price for a pack of cigarettes goes up, it will likely not have any effect on demand.
6. Nature of the Commodities : The demand for necessities is inelastic and that for comforts and
luxuries is elastic. This is so because certain goods which are essential will be demanded at any
price, whereas goods meant for luxuries and comforts can be dispensed with easily if they appear
to become costlier.
7. Various Uses : A commodity which has several uses will have an elastic demand such as milk,
wood etc. On the other hand, a commodity having only one or fewer uses will have inelastic
demand. The consumer finds it easier to adjust the quantity demanded of a good when it is to be
used for satisfying several wants than if it is confined to a single or few uses. For this reason, a
multiple-use good tends to have more elastic demand.
454 Economic & Business Environment

8. Postponing Consumption : Usually the demand for commodities, the consumption of which can be
postponed, is elastic as the prices rise and are expected to fall again. For example, the demand for
mp3 is elastic because its use can be postponed for some time if its price goes up, but the demand
for rice and wheat is inelastic because their use cannot be postponed when their prices increase.

Income Elasticity of Demand

Income elasticity of demand is the degree of responsiveness of demand to the change in income. Prof.
Watson defines it as : "Income elasticity of demand is the rate of change of quantity with respect to
changes in the income, other determinants remaining constant." The income elasticity of demand can be
measured by the following formula :

Ey = Percentage change in quantity demanded/Percentage change in income

Percentage change in quantity demanded = New quantity demanded ( Q)/Original quantity

demanded (Q)

Percentage change in income = New income ( Y)/original income (Y)

Symbolically,

Ey = Q/Q x Y/Y
Income elasticity of demand, thus explains the responsiveness of demand to a change in income.
Ordinarily, demand for most goods increases with an increase in household's level of income.
Demand for inferior goods, however, shows a negative relation to change in income.

Types of Income Elasticity of Demand

Income elasticity of demand can be of five different types : These are tabulated with description below:

S.No. Numerical Measure of Verbal description

Income elasticity of demand

1. Negative Demand for a commodity falls The trend is visible in case of inferior
as income rises. goods.

2. Zero Demand for a commodity does not This is true in the case of essential goods.
change as income changes.

3. Greater than zero but less than one. Demand for commodity rises in proportion
to a rise in income.

4. Unity Demand for commodity rises in the same

proportion as rise in income.

5. Greater than the unity Demand for commodity rises more than
in proportion to rise in income.

Cross Elasticity of Demand

The responsiveness of demand to changes in prices of related commodities is called cross elasticity of
demand. Prof. Watson defines it as, "Cross elasticity of demand is the rate of change in quantity associated
with a change in the price of related goods." Thus cross elasticity of demand is the responsiveness of
demand for commodity X to change in price of commodity Y and is represented as follows :
 Economic & Business Environment 455

Symbolically :

Cross Elasticity of Demand Ec

% increase in quantity demanded of A

% increase in price of product B

The relationship between X and Y commodities may be substitutive as in case of tea and coffee or
complementary as in the case of ball pens and refills. Main measures of cross elasticity with description are
as follows :

1. Cross elasticity = Infinity (Commodity X is nearly a perfect substitute for commodity Y)

2. Cross elasticity = Zero (Commodity X and Y are not related)

3. Cross elasticity = Negative (Commodities X and Y are complementary)

Thus, if Ec approaches infinity, it means that commodity X is nearly a perfect substitute for commodity Y.
On the other hand, if Ec approaches Zero it would mean that the two commodities in question are not
related at all. Ec shall be negative when commodity Y is complementary to commodity X.

INCREASE AND DECREASE IN DEMAND AND EXPANSION AND CONTRACTION OF

DEMAND

Increase in Demand and Decrease in Demand

Changes in demand include an increase or decrease in demand. Due to the change in the price of
related goods, the income of consumers, and the preferences of consumers, etc. the demand for a
product or service changes.

(a) Increase in Demand : When demand changes not because of price but because of changes in
other determinants of demand, it is a case of either increase or decrease in demand. “Increase in
demand means more demand at same price”.

Increases in demand are shown by a shift to the right in the demand curve. This could be caused
by a number of factors, including a rise in income, a rise in the price of a substitute or a fall in the
price of a complement.

Price per Can

Quantity
Copyright :www.economicsonline.co.uk Per week

(b) Decrease in Demand: Decrease in demand means, “Less demand at same price”. Demand can
decrease and cause a shift to the left of the demand curve for a number of reasons, including a fall
456 Economic & Business Environment

in income, assuming a good is a normal good, a fall in the price of a substitute and a rise in the
price of a complement.

Price per Can

Quantity
Copyright :www.economicsonline.co.uk Per week

Expansion and Contraction of Demand

When the quantity demanded of a commodity increases as a result of the fall in the price, it is called
extension (or expansion) in demand and when the quantity demanded decreases as a result of an
increase in the price of the commodity, it is called contraction in demand. The following is the
diagrammatical presentation of expansion and contraction of demand:

Price

Contraction

Expansion

Demand

Quantity

Source: knowledgiate.com
 Economic & Business Environment 457

FORMS OF MARKET COMPETITION

A variety of market structures will characterize an economy. Such market structures essentially refer to
the degree of competition in a market.

There are other determinants of market structures such as the nature of the goods and products, the
number of sellers, number of consumers, the nature of the product or service, economies of scale etc. We
will discuss the five basic types of market structures in any economy.

(1) Perfect Competition

In a perfect competition market structure, there are a large number of buyers and sellers. All the
sellers in the market are small sellers in competition with each other. There is no one big seller with
any significant influence on the market. So, all the firms in such a market are price takers.

There are certain assumptions when discussing the perfect competition. This is the reason a perfect
competition market is pretty much a theoretical concept. These assumptions are as follows,

• The products on the market are homogeneous, i.e. they are completely identical
• All firms only have the motive of profit maximization
• There is free entry and exit from the market, i.e. there are no barriers
• And there is no concept of consumer preference

(2) Monopolistic Competition

This is a more realistic scenario that actually occurs in the real world. In monopolistic competition,
there are still a large number of buyers as well as sellers. But they all do not sell homogeneous
products. The products are similar but all sellers sell slightly differentiated products.

Now consumers have the preference of choosing one product over another. The sellers can also
charge a marginally higher price since they may enjoy some market power. So, the sellers become
the price setters to a certain extent.

For example, the market for cereals is a monopolistic competition. The products are all similar but
slightly differentiated in terms of taste and flavours. Another such example is toothpaste.

(3) Oligopoly

In an oligopoly, there are only a few firms in the market. While there is no clarity about the number
of firms, 3-5 dominant firms are considered the norm. So, in the case of an oligopoly, the buyers
are far greater than the sellers.

The firms in this case either compete with another to collaborate together, They use their market
influence to set the prices and in turn maximize their profits. So, the consumers become the price
takers. In an oligopoly, there are various barriers to entry into the market, and new firms find it
difficult to establish themselves.

(4) Monopoly

In a monopoly type of market structure, there is only one seller, so a single firm will control the
entire market. It can set any price it wishes since it has all the market power. Consumers do not
have any alternative and must pay the price set by the seller. Monopolies are extremely undesirable.
Here the consumers lose all their power and market forces become irrelevant. However, a pure
monopoly is very rare in reality.
458 Economic & Business Environment

(5) Duopoly
A duopoly is a kind of oligopoly: a market dominated by a small number of firms. In the case of a
duopoly, a particular market or industry is dominated by just two firms (this is in contrast to the
more widely-known case of a monopoly when just one company dominates).
In very rare cases, this means they are the only two firms in the entire market (this almost never
occurs); in practice, it usually means the two duopolistic firms have a great deal of influence, and
their actions, as well as their relationship to each other, powerfully shape their industry. Duopolistic
markets are imperfectly competitive, so entry barriers are typically significant for those attempting
to enter the market, but there are usually still other, smaller businesses persisting alongside the
two dominant firms.

ELASTICITY OF SUPPLY

The elasticity of supply establishes a quantitative relationship between the supply of a commodity and it’s
price. Hence, we can express the numeral change in supply with the change in the price of a commodity
using the concept of elasticity. Note that elasticity can also be calculated with respect to the other
determinants of supply.

However, the major factor controlling the supply of a commodity is its price. Therefore, we generally talk
about the price elasticity of supply. The price elasticity of supply is the ratio of the percentage change in the
price to the percentage change in quantity supplied of a commodity.

Es = [ q/q)×100] ÷ [( p/p)×100] = ( q/q) ÷ ( p/p)

q = The change in quantity supplied
q = The quantity supplied
p = The change in price
p = The price

Types of Price Elasticity of Supply

1. Perfectly Inelastic Supply : A service or commodity has a perfectly inelastic supply if a given quantity
of it can be supplied whatever might be the price. The elasticity of supply for such a service or
commodity is zero. A perfectly inelastic supply curve is a straight line parallel to the Y-axis. This is
representative of the fact that the supply remains the same irrespective of the price.

The supply of exclusive items, like the painting of Mona Lisa, falls into this category. Whatever
might be the price on offer, there is no way we can increase its supply.

(PES = 0), The Quantity Supplied doesn’t change as the price changes.

Source: Intelligent Economist

 Economic & Business Environment 459

2. Relatively Less-Elastic Supply : When the change in supply is relatively less when compared to the
change in price, we say that the commodity has a relatively-less elastic supply. In such a case, the
price elasticity of supply assumes a value less than 1.

(0 < PES < 1), Quantity Supplied changes by a lower percentage than a percentage change in
price.

Source: Intelligent Economist

3. Relatively Greater-Elastic Supply : When the change in supply is relatively more when compared to
the change in price, we say that the commodity has a relatively greater-elastic supply. In such a
case, the price elasticity of supply assumes a value greater than 1.

(PES > 1), The Quantity Supplied changes by a larger percentage than the percentage change in
price.

Source: Intelligent Economist

4. Unitary Elastic Supply : For a commodity with a unit elasticity of supply, the change in quantity
supplied of a commodity is exactly equal to the change in its price. In other words, the change in
both price and supply of the commodity is proportionately equal to each other. To point out, the
elasticity of supply in such a case is equal to one. Further, a unitary elastic supply curve passes
through the origin.
460 Economic & Business Environment

(PES = 1), Quantity Supplied changes by the same percentage as the change in price.

Source: Intelligent Economist

5. Perfectly Elastic supply : A commodity with a perfectly elastic supply has an infinite elasticity. In such
a case the supply becomes zero with even a slight fall in the price and becomes infinite with a slight
rise in price. This is indicative of the fact that the suppliers of such a commodity are willing to
supply any quantity of the commodity at a higher price. A perfectly elastic supply curve is a straight
line parallel to the X-axis.

(PES = ), Suppliers will be willing and able to supply any amount at a given price but none at a
different price.

Source: Intelligent Economist

Factors influencing the elasticity of supply

1. Price of the Good : The supply and elasticity of supply of a good depend upon the price of the good.
If the price of a good increases or decreases, the quantity supplied of it will also increase or
decrease, respectively. This is the law of supply. Also, the coefficient of price-elasticity of supply
(ES) will depend on the price of the good. ES may be greater than, less than, or equal to one,
depending on the price.

2. Probability that the Price would Change in Future : If the sellers think that the price of the good will
increase (or decrease) in near future, then, at any particular price at present, they would want to
decrease (or increase) their supply. In this case, the supply curve for the good would shift to the
left (or to the right).
 Economic & Business Environment 461

3. Conditions regarding Cost of Production : If the cost of production of good increases (or decreases),
i.e., if its cost curve shifts upwards (or downwards), then the quantity supplied of the good would
decrease (or increase) at any particular price, i.e., the supply curve would shift to the left (or to
the right).

4. Nature of the Good : The supply of a good depends upon the nature of the good, e.g., on the
perishability and lumpiness of the good. The more the perishability or lumpiness of the good, the
more would be its market localised, and, in a localised market, the supply of a good at any
particular price would be relatively small.

5. Length of Time : If the price of good rises, then by how much would supply rise, or, how large will
be the price-elasticity of supply, would depend on the length of time available for the necessary
adjustments (e.g., in the quantities of the factor inputs used) to complete. That is why; the elasticity
of supply in the long-period market would be larger than that in the short-period market.

***
462 Economic & Business Environment

Lesson 2

NATIONAL INCOME
ACCOUNTING
AND
RELATED CONCEPTS

462
 Economic & Business Environment 463

INTRODUCTION

National income is an uncertain term which is used interchangeably with national dividend, national output
and national expenditure. On this basis, national income has been defined in a number of ways. In common
parlance, national income means the total value of goods and services produced annually in a country.

In other words, the total amount of income accruing to a country from economic activities in a year’s
time is known as national income. It includes payments made to all resources in the form of wages,
interest, rent and profits.

National Income or Net National Income is Gross National Income or Gross National Product less
depreciation. It is to be noted that National Income includes Net Factor Income Earned from Abroad also. While
computing National Income only finished or final goods are considered as factoring intermediate goods used for
manufacturing would amount to double counting. It includes taxes but does not include subsidies.

METHODS TO MEASURE NATIONAL INCOME

There are three methods of measuring the national income of a country. They yield the same result.
These methods are:
(1) The Product Method or Value Added Method.
(2) The Income Method.
(3) The Expenditure Method
(1) The Product Method : The Product method measures the contribution of each producing
enterprise in the domestic territory of the country. This method involves the following steps:
(a) Identifying the producing enterprise and classifying them into individual sectors according
to their activities.
(b) Estimating net value added by each producing enterprise as well as each industrial sector
and adding up the net value added by all the sectors.
Goods and services are counted in gross domestic product (GDP) at their market values. The
product approach defines a nation's gross product as that market value of goods and services
currently produced within a nation during a one year period of time.
The product approach measuring national income involves adding up the value of all the final
goods and services produced in the country during the year. Here we focus on various sectors of
the economy and add up all their production during the year. The main sectors whose production
value is added up are:
(i) agriculture (ii) manufacturing (iii) construction (iv) transport and communication (v)
banking (vi) administration and defence and (vii) distribution of income.
Precautions for Product Method or Value Added Method
(i) Problem of double counting : When we add up the value of output of various sectors, we
should be careful to avoid double counting. This pitfall can be avoided by either counting
the final value of the output or by including the extra value that each firm adds to an item.
(ii) Value addition in particular year : While calculating national income, the values of goods
added in the particular year in question are added up. The values which had previously been
added to the stocks of raw material and goods have to be ignored. GDP thus includes only
those goods, and services that are newly produced within the current period.
464 Economic & Business Environment

(iii) Stock appreciation : Stock appreciation, if any, must be deducted from value added. This is
necessary as there is no real increase in output.
(iv) Production for self consumption : The production of goods for self consumption should be
counted while measuring national income. In this method, the production of goods for self
consumption should be valued at the prevailing market prices.
(2) Expenditure Method : The expenditure approach measures national income as total spending
on final goods and services produced within the nation during a year. The expenditure approach
to measuring national income is to add up all expenditures made for final goods and services at
current market prices by households, firms and government during a year. Total aggregate final
expenditure on final output thus is the sum of four broad categories of expenditures:
(i) Consumption (ii) Investment (iii) Government and (iv) Net export.
(i) Consumption expenditure (C) : Consumption expenditure is the largest component of national
income. It includes expenditure on all goods and services produced and sold to the final
consumer during the year.
(ii) Investment expenditure (I) : Investment is the use of today's resources to expand tomorrow's
production or consumption. Investment expenditure is expenditure incurred by business
firms on (a) new plants, (b) adding to the stock of inventories and (c) on newly constructed
houses.
(iii) Government expenditure (G) : It is the second largest component of national income. It includes
all government expenditure on currently produced goods and services but excludes transfer
payments while computing national income.
(iv) Net exports (X - M) : Net exports are defined as total exports minus total imports. National
income calculated from the expenditure side is the sum of final consumption expenditure,
expenditure by a business on plants, government spending and net exports.
Precautions for Expenditure Method
(i) The expenditure on second hand goods should not be included as they do not contribute to
the current year's production of goods.
(ii) Similarly, expenditure on purchase of old shares and bonds is not included as these also do
not represent expenditure on currently produced goods and services.
(iii) Expenditure on transfer payments by government such as unemployment benefit, old age
pensions, interest on public debt should also not be included because no productive service
is rendered in exchange by recipients of these payments.
(3) Income Method : Income approach is another alternative way of computing national income,
This method seeks to measure national income at the phase of distribution. In the production
process of an economy, the factors of production are engaged by the enterprises. They are paid
money incomes for their participation in the production. The payments received by the factors
and paid by the enterprises are wages, rent, interest and profit. National income thus may be
defined as the sum of wages, rent, interest and profit received or occurred to the factors of
production in lieu of their services in the production of goods. Briefly, national income is the sum
of all income, wages, rents, interest and profit paid to the four factors of production. The four
categories of payments are briefly described below:

(i) Wages : It is the largest component of national income. It consists of wages and salaries along
with fringe benefits and unemployment insurance.
 Economic & Business Environment 465

(ii) Rents : Rents are the income from properly received by households.
(iii) Interest : Interest is the income private businesses pay to households who have lent the
business money.
(iv) Profits: Profits are normally divided into two categories (a) profits of incorporated businesses
and (b) profits of unincorporated businesses (sole proprietorship, partnerships and producers
cooperatives).
Precautions for Income Method
While estimating national income through income method, the following precautions should be
undertaken.
(i) Transfer payments such as gifts, donations, scholarships, indirect taxes should not be included
in the estimation of national income.
(ii) Illegal money earned through smuggling and gambling should not be included.
(iii) Windfall gains such as prizes won, lotteries etc. are not to be included in the estimation of
national income.
(iv) Receipts from the sale of financial assets such as shares, bonds should not be included in
measuring national income as they are not related to the generation of income in the current
year’s production of goods.

KEY CONCEPTS OF NATIONAL INCOME

Gross Domestic Product (GDP)

GDP is the total value of goods and services produced within the country during a year. This is calculated
at market prices and is known as GDP at market prices. Dernberg defines GDP at market price as “the
market value of the output of final goods and services produced in the domestic territory of a country
during an accounting year.”

There are three different ways to measure GDP:

Methods of Measure GDP

The Product Method

The Income Method

Expenditure Method
466 Economic & Business Environment

(a) The Product Method : In this method, the value of all goods and services produced in different
industries during the year is added up. This is also known as the value added method to GDP or
GDP at factor cost by industry of origin. The following items are included in India in this: agriculture
and allied services; mining; manufacturing, construction, electricity, gas and water supply;
transport, communication and trade; banking and insurance, real estates and ownership of
dwellings and business services; and public administration and defence and other services (or
government services). In other words, it is the sum of gross value added.

(b) The Income Method : The people of a country who produce GDP during a year receive income
from their work. Thus GDP by income method is the sum of all factor incomes: Wages and Salaries
(compensation of employees) + Rent + Interest + Profit.

(c) Expenditure Method : This method focuses on goods and services produced within the country
during one year. GDP by expenditure method includes:

1. Consumer expenditure on services and durable and non-durable goods (C).

2. Investment in fixed capital such as residential and non-residential building, machinery, and
inventories (I).

3. Government expenditure on final goods and services (G).

4. Export of goods and services produced by the people of the country (X).

5. Less imports (M). That part of consumption, investment and government expenditure which
is spent on imports is subtracted from GDP. Similarly, any imported component, such as raw
materials, which are used in the manufacture of export goods, is also excluded.

Thus GDP by expenditure method at market prices = C+ I + G + (X – M), where (X-M) is net
export which can be positive or negative.

GDP at Factor Cost

GDP at factor cost is the sum of the net value added by all producers within the country. Since the net
value added gets distributed as income to the owners of factors of production, GDP is the sum of domestic
factor incomes and fixed capital consumption (or depreciation).

Thus GDP at Factor Cost = Net value added + Depreciation.

GDP at factor cost includes:

(a) Compensation of employees i.e., wages, salaries, etc.

(b) Operating surplus which is the business profit of both incorporated and unincorporated firms
[Operating Surplus = Gross Value Added at Factor Cost—Compensation of Employees—
Depreciation].

(c) Mixed Income of Self- employed.

Conceptually, GDP at factor cost and GDP at market price must be identical/This is because the factor cost
(payments to factors) of producing goods must equal the final value of goods and services at market
prices. However, the market value of goods and services is different from the earnings of the factors of
production.

In GDP at market price, indirect taxes are included and subsidies by the government are excluded.
 Economic & Business Environment 467

Therefore, in order to arrive at GDP at factor cost, indirect taxes are subtracted and subsidies are added
to GDP at market price.

Thus, GDP at Factor Cost = GDP at Market Price – Indirect Taxes + Subsidies.

(i) Net Domestic Product (NDP) : NDP is the value of the net output of the economy during the year.
Some of the country’s capital equipment wears out or becomes obsolete each year during the
production process. The value of this capital consumption is some percentage of gross investment
which is deducted from GDP. Thus Net Domestic Product = GDP at Factor Cost – Depreciation.

(ii) Nominal and Real GDP : When GDP is measured on the basis of current price, it is called GDP at
current prices or nominal GDP. On the other hand, when GDP is calculated on the basis of fixed
prices in some year, it is called GDP at constant prices or real GDP.

Nominal GDP is the value of goods and services produced in a year and measured in terms of rupees
(money) at current (market) prices. In comparing one year with another, we are faced with the problem
that the rupee is not a stable measure of purchasing power. GDP may rise a great deal in a year, not
because the economy has been growing rapidly but because of a arise in prices (or inflation).

On the contrary, GDP may increase as a result of a fall in prices in a year but actually it may be less as
compared to the last year. In both 5 cases, GDP does not show the real state of the economy. To rectify the
underestimation and overestimation of GDP, we need a measure that adjusts for rising and falling prices.

This can be done by measuring GDP at constant prices which is called real GDP. To find out the real GDP,
a base year is chosen when the general price level is normal, i.e., it is neither too high nor too low. The
prices are set to 100 (or 1) in the base year.

Now the general price level of the year for which real GDP is to be calculated is related to the base year on
the basis of the following formula which is called the deflator index:

Real GDP = GDP for the Current Year x Base Year (100) / Current Year Index

GDP Deflator

GDP deflator is an index of price changes of goods and services included in GDP. It is a price index which
is calculated by dividing the nominal GDP in a given year by the real GDP for the same year and multiplying
it by 100. Thus,

Nominal (or Current Prices) GDP

GDP Deflator = x 100
Real (or Constant Prices) GDP

Gross National Product (GNP)

GNP is the total measure of the flow of goods and services at market value resulting from current production
during a year in a country, including net income from abroad.

GNP includes four types of final goods and services:

1. Consumers’ goods and services to satisfy the immediate wants of the people;

2. Gross private domestic investment in capital goods consisting of fixed capital formation, residential
construction and inventories of finished and unfinished goods;

3. Goods and services produced by the government; and

468 Economic & Business Environment

4. Net exports of goods and services, i.e., the difference between the value of exports and imports of
goods and services, known as net income from abroad.

In this concept of GNP, there are certain factors that have to be taken into consideration:

First, GNP is the measure of money, in which all kinds of goods and services produced in a country during
one year are measured in terms of money at current prices and then added together.

Second, in estimating GNP of the economy, the market price of only the final products should be taken
into account. Many of the products pass through a number of stages before they are ultimately purchased
by consumers.

If those products were counted at every stage, they would be included many a time in the national
product. Consequently, the GNP would increase too much. To avoid double-counting, therefore, only
the final products and not the intermediary goods should be taken into account.

Third, goods and services rendered free of charge are not included in the GNP, because it is not possible
to have a correct estimate of their market price. For example, the bringing up of a child by the mother,
imparting instructions to his son by a teacher, recitals to his friends by a musician, etc.

Fourth, the transactions which do not arise from the produce of current year or which do not contribute
in any way to production are not included in the GNP. The sale and purchase of old goods, and of shares,
bonds and assets of existing companies are not included in GNP because these do not make any addition
to the national product, and the goods are simply transferred.

Fifth, the payments received under social security, e.g., unemployment insurance allowance, old age
pension, and interest on public loans are also not included in GNP, because the recipients do not provide
any service in lieu of them. But the depreciation of machines, plants and other capital goods is not
deducted from GNP.

Sixth, the profits earned or losses incurred on account of changes in capital assets as a result of fluctuations
in market prices are not included in the GNP if they are not responsible for the current production or
economic activity.

For example, if the price of a house or a piece of land increases due to inflation, the profit earned by selling
it will not be a part of GNP. But if, during the current year, a portion of a house is constructed anew, the
increase in the value of the house (after subtracting the cost of the newly constructed portion) will be
included in the GNP. Similarly, variations in the value of assets, that can be ascertained beforehand and
are insured against flood or fire, are not included in the GNP.

Last, the income earned through illegal activities is not included in the GNP. Although the goods sold in
the black market are priced and fulfil the needs of the people, but as they are not useful from the social
point of view, the income received from their sale and purchase is always excluded from the GNP.

There are two main reasons for this. One, it is not known whether these things were produced during the
current year or the preceding years. Two, many of these goods are foreign made and smuggled and
hence not included in the GNP.

Three Approaches to GNP

After having discussed the basic constituents of GNP, it is essential to know how it is estimated. Three
approaches are employed for this purpose. One, the income method to GNP; two, the expenditure method
to GNP and three, the value added method to GNP. Since gross income equals gross expenditure, GNP
estimated by all these methods would be the same with appropriate adjustments.
 Economic & Business Environment 469

1. Income Method to GNP : The income method to GNP consists of the remuneration paid in
terms of money to the factors of production annually in a country.

Thus GNP is the sum total of the following items:

(a) Wages and salaries : Under this head are included all forms of wages and salaries earned
through productive activities by workers and entrepreneurs. It includes all sums received or
deposited during a year by way of all types of contributions like overtime, commission,
provident fund, insurance, etc.

(b) Rents : Total rent includes the rents of land, shop, house, factory, etc. and the estimated rents
of all such assets as are used by the owners themselves.

(c) Interest : Under interest comes the income by way of interest received by the individual of a
country from different sources. To this is added, the estimated interest on that private capital
which is invested and not borrowed by the businessman in his personal business. But the
interest received on governmental loans has to be excluded, because it is a mere transfer of
national income.

(d) Dividends : Dividends earned by the shareholders from companies are included in the GNP.

(e) Undistributed corporate profits : Profits which are not distributed by companies and are retained
by them are included in the GNP.

(f) Mixed incomes : These include profits of an unincorporated business, self-employed persons
and partnerships. They form part of GNP.

(g) Direct taxes : Taxes levied on individuals, corporations and other businesses are included in
the GNP.

(h) Indirect taxes : The government levies a number of indirect taxes, like excise duties and sales
tax. These taxes are included in the price of commodities. But revenue from these goes to the
government treasury and not to the factors of production. Therefore, the income due to
such taxes is added to the GNP.

(i) Depreciation : Every corporation makes allowance for expenditure on wearing out and
depreciation of machines, plants and other capital equipment. Since this sum also is not a
part of the income received by the factors of production, it is, therefore, also included in the
GNP.

(j) Net income earned from abroad : This is the difference between the value of exports of goods
and services and the value of imports of goods and services. If this difference is positive, it is
added to the GNP and if it is negative, it is deducted from the GNP.

GNP according to the Income Method = Wages and Salaries + Rents + Interest +
Dividends + Undistributed Corporate Profits + Mixed Income + Direct Taxes + Indirect
Taxes + Depreciation + Net Income from abroad.

2. Expenditure Method to GNP : From the expenditure viewpoint, GNP is the sum total of
expenditure incurred on goods and services during one year in a country.

It includes the following items:

(a) Private consumption expenditure : It includes all types of expenditure on personal consumption
by the individuals of a country. It comprises expenses on durable goods like watch, bicycle,
470 Economic & Business Environment

radio, etc., expenditure on single-used consumers’ goods like milk, bread, ghee, clothes, etc.,
as also the expenditure incurred on services of all kinds like fees for school, doctor, lawyer
and transport. All these are taken as final goods.

(b) Gross domestic private investment : Under this the expenditure incurred by private enterprise
on new investment and on replacement of old capital. It includes expenditure on house
construction, factory- buildings, and all types of machinery, plants and capital equipment.

In particular, the increase or decrease in inventory is added to or subtracted from it. The
inventory includes produced but unsold manufactured and semi-manufactured goods during
the year and the stocks of raw materials, which have to be accounted for in GNP. It does not
take into account the financial exchange of shares and stocks because their sale and purchase
is not real investment. But depreciation is added.

(c) Net foreign investment : It means the difference between exports and imports or export surplus.
Every country exports to or imports from certain foreign countries. The imported goods are
not produced within the country and hence cannot be included in the national income, but
the exported goods are manufactured within the country. Therefore, the difference in value
between exports (X) and imports (M), whether positive or negative, is included in the GNP.

(d) Government expenditure on goods and services : The expenditure incurred by the government
on goods and services is a part of the GNP. Central, state or local governments spend a lot on
their employees, police and army. To run the offices, the governments have also to spend on
contingencies which include paper, pen, pencil and various types of stationery, cloth, furniture,
cars, etc.

It also includes the expenditure on government enterprises. But expenditure on transfer

payments is not added, because these payments are not made in exchange for goods and
services produced during the current year.

Thus GNP according to the Expenditure Method=Private Consumption Expenditure (C) +

Gross Domestic Private Investment (I) + Net Foreign Investment (X-M) + Government
Expenditure on Goods and Services (G) = C+ I + (X-M) + G.

3. Value Added Method to GNP : Another method of measuring GNP is by value added. In
calculating GNP, the money value of final goods and services produced at current prices during
a year is taken into account. This is one of the ways to avoid double counting. But it is difficult to
distinguish properly between a final product and an intermediate product.

For instance, raw materials, semi-finished products, fuels and services, etc. are sold as inputs by
one industry to the other. They may be final goods for one industry and intermediate for others.
So, to avoid duplication, the value of intermediate products used in manufacturing final products
must be subtracted from the value of total output of each industry in the economy.

Thus, the difference between the value of material outputs and inputs at each stage of production
is called the value added. If all such differences are added up for all industries in the economy, we
arrive at the GNP by value added. GNP by value added = Gross value added + net income from
abroad.

GNP at Market Prices

When we multiply the total output produced in one year by the market prices prevalent during that year
in a country, we get the Gross National Product at market prices. Thus GNP at market prices means the
gross value of final goods and services produced annually in a country plus net income from abroad.
 Economic & Business Environment 471

GNP at Market Prices = GDP at Market Prices + Net Income from Abroad.

GNP at Factor Cost

GNP at factor cost is the sum of the money value of the income produced by and accruing to the various
factors of production in one year in a country. It includes all items mentioned above under income
method to GNP less indirect taxes.
GNP at market prices always includes indirect taxes levied by the government on goods which raise their
prices. But GNP at factor cost is the income that the factors of production receive in return for their
services alone. It is the cost of production.
Thus GNP at market prices is always higher than GNP at factor cost. Therefore, in order to arrive at GNP
at factor cost, we deduct indirect taxes from GNP at market prices. Again, it often happens that the cost of
production of a commodity to the producer is higher than a price of a similar commodity in the market.
In order to protect such producers, the government helps them by granting monetary help in the form of
a subsidy equal to the difference between the market price and the cost of production of the commodity.
As a result, the price of the commodity to the producer is reduced and equals the market price of a similar
commodity.
For example, if the market price of rice is Rs. 3 per kg but it costs the producers in certain areas Rs. 3.50. The
government gives a subsidy of 50 paise per kg to them in order to meet their cost of production. Thus in
order to arrive at GNP at factor cost, subsidies are added to GNP at market prices.
GNP at Factor Cost = GNP at Market Prices – Indirect Taxes + Subsidies.
Net National Product (NNP)
NNP includes the value of the total output of consumption goods and investment goods. But the process of
production uses up a certain amount of fixed capital. Some fixed equipment wears out, its other components
are damaged or destroyed, and still others are rendered obsolete through technological changes.
All this process is termed depreciation or capital consumption allowance. In order to arrive at NNP, we
deduct depreciation from GNP. The word ‘net’ refers to the exclusion of that part of total output which
represents depreciation. So NNP = GNP—Depreciation.
NNP at Market Prices
Net National Product at market prices is the net value of final goods and services evaluated at market
prices in the course of one year in a country. If we deduct depreciation from GNP at market prices, we get
NNP at market prices.
NNP at Market Prices = GNP at Market Prices - Depreciation.
NNP at Factor Cost
Net National Product at factor cost is the net output evaluated at factor prices. It includes income earned
by factors of production through participation in the production process such as wages and salaries,
rents, profits, etc. It is also called National Income. This measure differs from NNP at market prices in that
indirect taxes are deducted and subsidies are added to NNP at market prices in order to arrive at NNP at
factor cost. Thus,
NNP at Factor Cost = NNP at Market Prices – Indirect taxes+ Subsidies
= GNP at Market Prices – Depreciation – Indirect taxes + Subsidies.
= National Income.
472 Economic & Business Environment

Normally, NNP at market prices is higher than NNP at factor cost because indirect taxes exceed government
subsidies. However, NNP at market prices can be less than NNP at factor cost when government subsidies
exceed indirect taxes.

Domestic Income

Income generated (or earned) by factors of production within the country from its own resources is
called domestic income or domestic product.

Domestic income includes:

(i) Wages and salaries, (ii) rents, including imputed house rents, (iii) interest, (iv) dividends, (v)
undistributed corporate profits, including surpluses of public undertakings, (vi) mixed incomes
consisting of profits of unincorporated firms, self-employed persons, partnerships, etc., and (vii) direct
taxes.

Since domestic income does not include income earned from abroad, it can also be shown as: Domestic
Income = National Income-Net income earned from abroad. Thus the difference between domestic
income f and national income is the net income earned from abroad. If we add net income from abroad
to domestic income, we get national income, i.e., National Income = Domestic Income + Net income
earned from abroad.

But the net national income earned from abroad may be positive or negative. If exports exceed imports,
net income earned from abroad is positive. In this case, national income is greater than domestic income.
On the other hand, when imports exceed exports, net income earned from abroad is negative and
domestic income is greater than national income.

Private Income

Private income is income obtained by private individuals from any source, productive or otherwise, and
the retained income of corporations. It can be arrived at from NNP at Factor Cost by making certain
additions and deductions.

The additions include transfer payments such as pensions, unemployment allowances, sickness and
other social security benefits, gifts and remittances from abroad, windfall gains from lotteries or from horse
racing, and interest on public debt. The deductions include income from government departments as
well as surpluses from public undertakings, and employees’ contribution to social security schemes like
provident funds, life insurance, etc.

Private Income = National Income (or NNP at Factor Cost) + Transfer Payments + Interest
on Public Debt — Social Security — Profits and Surpluses of Public Undertakings.

Personal Income

Personal income is the total income received by the individuals of a country from all sources before
payment of direct taxes in one year. Personal income is never equal to the national income, because the
former includes the transfer payments whereas they are not included in national income.

Personal income is derived from national income by deducting undistributed corporate profits, profit
taxes, and employees’ contributions to social security schemes. These three components are excluded
from national income because they do reach individuals.

But business and government transfer payments, and transfer payments from abroad in the form of gifts
and remittances, windfall gains, and interest on public debt which are a source of income for individuals
are added to national income.
 Economic & Business Environment 473

Personal Income = National Income – Undistributed Corporate Profits – Profit Taxes –

Social Security Contribution + Transfer Payments + Interest on Public Debt.

Personal income differs from private income in that it is less than the latter because it excludes undistributed
corporate profits.

Personal Income = Private Income – Undistributed Corporate Profits – Profit Taxes

Disposable Income

Disposable income or personal disposable income means the actual income which can be spent on
consumption by individuals and families. The whole of the personal income cannot be spent on
consumption, because it is the income that accrues before direct taxes have actually been paid. Therefore,
in order to obtain disposable income, direct taxes are deducted from personal income. Thus, Disposable
Income=Personal Income – Direct Taxes.

But the whole of disposable income is not spent on consumption and a part of it is saved. Therefore,
disposable income is divided into consumption expenditure and savings. Thus Disposable Income =
Consumption Expenditure + Savings.

If disposable income is to be deduced from national income, we deduct indirect taxes plus subsidies,
direct taxes on personal and on business, social security payments, undistributed corporate profits or
business savings from it and add transfer payments and net income from abroad to it.

Disposable Income = National Income – Business Savings – Indirect Taxes + Subsidies –

Direct Taxes on Persons – Direct Taxes on Business – Social Security Payments + Transfer
Payments + Net Income from abroad.

Real Income

Real income is national income expressed in terms of a general level of prices of a particular year taken as
a base. National income is the value of goods and services produced as expressed in terms of money at
current prices. But it does not indicate the real state of the economy.

It is possible that the net national product of goods and services this year might have been less than that
of the last year, but owing to an increase in prices, NNP might be higher this year. On the contrary, it is also
possible that NNP might have increased but the price level might have fallen, as a result, national income
would appear to be less than that of the last year. In both situations, the national income does not depict
the real state of the country. To rectify such a mistake, the concept of real income has been evolved.

In order to find out the real income of a country, a particular year is taken as the base year when the
general price level is neither too high nor too low and the price level for that year is assumed to be 100.
Now the general level of prices of the given year for which the national income (real) is to be determined
is assessed in accordance with the prices of the base year. For this purpose, the following formula is
employed.

Real NNP = NNP for the Current Year x Base Year Index (=100) / Current Year Index

Per Capita Income

The average income of the people of a country in a particular year is called Per Capita Income for that
year. This concept also refers to the measurement of income at current prices and at constant prices. For
instance, in order to find out the per capita income for 2018, at current prices, the national income of a
country is divided by the population of the country in that year.
474 Economic & Business Environment

National Income for 2018

Per Capita Income for 2018 = Population of 2018

Similarly, for the purpose of arriving at the Real Per Capita Income, this very formula is used.

Real NationalIncome for 2018

Real Per Capita Income for 2018 =
Population of 2018

This concept enables us to know the average income and the standard of living of the people. But it is not
very reliable, because in every country due to unequal distribution of national income, a major portion of
it goes to the richer sections of the society and thus income received by the common man is lower than
the per capita income.

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