Parikshit's Notebook

Economics: The Discipline

economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people.

Economics studies how individuals, firms, governments, and other organisations within our society make choices and how these choices determine a society’s use of its resources.

we need to make some choices before we utilise the scarce resources by prioritising some of our needs.

A Working Definition

Economics studies the economic activities of mankind. Similarly, political, social and administrative activities of mankind are studied under Political Science, Sociology and Public Administration, respectively. That is why these disciplines are broadly categorised as humanities as all of them study human activities.

The activities which involve profit, loss, livelihood, occupation, wage, employment, etc., are economic activities. Economics studies all these activities.

Economics and Economy

Economics will come out with theories of market, employment, etc., and an economy is the real picture of the things which emerges after the application of those theories.

many countries selecting the same remedy and tools to fight the same problems might have similar or dissimilar results during a given period. At the same time, two economies selecting different tools to solve the same economic problems might experience the same results or completely different results.

The level and quality of natural resources, the quantity and quality of human resources, the socio-political milieu, the historical background, the psychic make of the human resource, etc., are some of the factors which individually as well as collectively impact an economy while carrying out economic activities

Distribution Network Models

We have 3 types of models

• State: In the first type of distribution system, the state (i.e., the government) takes the sole responsibility of supplying goods and services required by the population with no payments being done by the consumer—the former Soviet Union and Communist China being the best examples.
• Market: In this system, goods and services are made available in the market and on the basis of their demand and supply, their prices are determined in the open market and finally they get distributed to the population.
• State-market mix: This distribution system has certain goods and services which might be made available to the population freely or at the subsidised prices by the state and some might be supplied by the market for which consumers need to pay.

Organising an Economy

Types of Economy

• Capitalistic Economy: The decisions of what to produce, how much to produce and at what price to sell are taken by the market, by the private enterprises in this system, with the state having no economic role.

• State Economy: socialistic economy emphasised collective ownership of the means of production (property and assets), it also ascribed a large role to the state in running the economy, while communist economy, on the other hand, advocated state ownership of all properties including labour with absolute power to state in running the economy. Here we see two versions of the state economy—in erstwhile USSR known as the socialist economy and in pre-1985 China as the communist economy.

• Mixed Economy: The impact of the great depression (1929) spread from the USA to other economies of Western Europe escalating large scale unemployment, downfall in demand and economic activities and lockouts in industrial enterprises. English economist at Cambridge University, John Maynard Keynes (1883–1946) questioned the very principles of ‘laissez-faire’ and the nature of the ‘invisible hand’(Wealth of Nation). He even opined that the invisible hand brings equilibirium to the economy but by ‘strangulating the poor’. He suggested that prices and wages are not flexible enough to provide employment to all. It means there will be some people unemployed when the economy will be at its full potential.

  Laissez-faire is an economic system in which transactions between private parties are absent of any form of economic interventionism such as regulation and subsidies. As a system of thought, laissez-faire rests on the axioms that the individual is the basic unit in society and has a natural right to freedom; that the physical order of nature is a harmonious and self-regulating system; and that corporations are creatures of the state and therefore the citizens must watch them closely due to their propensity to disrupt the Smithian spontaneous order.

  To get the economy out of the depression, Keynes suggested an increase in government expenditures, discretionary fiscal policy (fiscal deficit, lower interest rates, cheap money supply, etc.) to boost the demand of goods and services as this was the reason behind the depression.

  In the capitalist economies of the time, all the basic goods and services were part of the market mechanism, i.e., being produced and supplied by the private sector. It meant that almost everything the people required was supplied by the private enterprises via the market which was ultimately an undimensional movement of money and wealth (from the mass of people to the few who controlled the production and supply chain) and the masses were going through the process of pauperisation every day, thereby weakening their purchasing power. In the end, it affected overall demand and culminated in the Great Depression.

  As a follow up to the Keynesian advices, governments of the time started producing and supplying some basic goods and services which are known as ‘public goods’. These goods basically intended to guarantee minimum level of nutrition to all, healthcare, sanitation, education, social security, etc. The expenditure on public goods were incurred on the public exchequer even if it required deficit financing.

The concluding consensus emerged with the publication of the World Development Report (1999) titled Entering the $21^{st}$ Century in which the WB said, “Governments play a vital role in development, but there is no simple set of rules that tells them what to do.” The World Bank went on to suggest that every country should determine the areas and the extent of the market and the state intervention, depending upon its own stage of economic development, socio-political and other historical factors.

In the process of organising the economy, some basic and important infrastructural economic responsibilities were taken up by the state/governments (centre and state) and rest of the economic activities were left to private enterprises, i.e., the market.

Role of the State in a Economy

Possible roles for the state/government in an economy:

1. As a regulator of the economic system (where the state takes important economic decisions, announces the required kind of economic policies, takes the sole responsibility to get them implemented, and controlling and punishing those who don’t oblige to those economic decisions).
2. As a producer and/or supplier of ‘private goods and services’ (these include all those goods and services which constitute the part of market and which will be distributed among the needy according to the principles of market mechanism. Here the state earns profit as a private enterprise).
3. As a producer and/or supplier of ‘public goods’ or ‘social goods’ (these include goods and services which look essential from the perspective of social justice and well-being for the people. like ducation, healthcare, sanitation, drinking water, nutrition, caring for the differently abled and old, etc.)

The economy which selected both the roles (2 and 3) for the state under monopoly we called them the state. socialist economy at least the labour was not owned and exploited by the state unlike the other—the communist economy where labour used to be under complete state control.

The economic system which left both the roles (2 and 3) as the sole responsibilities of the private sector was called the capitalistic economic system.

Mixed economies had at least kept one economic role fixed for the state (i.e., 3), of supplying public goods to the needy people.

Compulsory roles for the state in economy

1. As a regulator of the economic system because If the regulation and control of an economy is left to private individuals or groups (i.e., firms) they will be using the regulatory powers to maximise their profits and returns at the cost of others.
2. The responsibility of producing and supplying the social/public goods to the needy cannot be left to the private sector as this is a loss-making exercise. It means, the state will have to take the sole responsibility or may need to expand its role in such areas—as we see it in post-reform India.

What should be left for market?

The responsibility of producing and distributing private goods to the people could be well handled by the private sector as this is a profit-fetching area. As the private sector became capable, in some countries this responsibility was given up by the state in favour of the private sector and better development has been possible in those economies. In this sense, India delayed this process while in Indonesia, Malaysia, Thailand and South Korea allowed entry of the private sector much earlier.

Basically, the WB study, the East Asian Miracle (1993), recognises the above-given shift of one kind of mixed economy to another kind of mixed economy—in the cases of the Malaysian, Thai and South Korean economies—taking place since the mid-1960s. Experts believe that this shift could not take place in time in India. And once it started (1991–92) it was too late and this choice was not voluntary but obligatory.

Washington Consensus

The term ‘Washington Consensus’ was coined by the US economist John Williamson (in 1989) under which he had suggested a set of policy reforms which most of the official in Washington (i.e., International Monetary Fund and World Bank) thought would be good for the crisis-driven Latin American countries of the time.

Ten propositions in Washington Consensus

1. Fiscal policy discipline, with avoidance of large fiscal deficits relative to GDP.
2. A redirection of public expenditure priorities toward fields offering both high economic returns and the potential to improve income distribution, such as primary health care, primary education, and infrastructure.
3. Tax reform (to lower marginal rates and broaden the tax base)
4. Interest Rates that are market determined and positive (but moderate) in real terms.
5. Competitive exchange rate i.e. rate that is very near to mid market rate.
6. Trade liberalisation: liberlization of imports, with particular emphasis on elimination of quantitative restrictions (licensing etc), any trade protection to be provided by low and relatively uniform tariffs.
7. Liberalisation of FDI inflows
8. Privatisation of state enterprises
9. Deregulation (in the sense of abolishing barriers to entry and exit except those justified on safety, environmental and consumer protection)
10. Legal security for property rights.

In the aftermath of the Great Recession (after the ‘US sub-prime’ crisis) in the Western economies, it is believed that dependence on market to correct the growth and development may not sustain any longer. and solution to this problems is the Keynesian idea of ‘interventionist state’ seems the ultimate alternative in the present times.

Sectors of an Economy

1. Primary Sector: This sector includes all those economic activities where there is the direct use of natural resources as agriculture, forestry, fishing, fuels, metals, minerals, etc. Broadly, such economies term their agricultural sector as the primary sector.
2. Secondary Sector: This sector is rightly called the manufacturing sector, which uses the produce of the primary sector as its raw materials.
3. Tertiary Sector: This sector includes all economic activities where different ‘services’ are produced such as education, banking, insurance, transportation, tourism, etc. This sector is also known as the services sector.

Types of Economies

1. Agrarian Economy: An economy is called agrarian if its share of the primary sector is 50 per cent or more in the total output (the GDP) of the economy. In monetary terms, India is no more an agrarian economy, however the dependency ratio makes it so—India being the first such example in the economic history of the world.
2. Industrial Economy: If the secondary sector contributes 50 per cent or more to the total produce value of an economy, it is an industrial economy.
3. Service Economy: An economy where $50$ or more of the produced value comes from the tertiary sector is known as the service economy.

Idea of National Income

Income level is the most commonly used tool to determine the well-being and happiness of nations and their citizens.

Education and life expectancy can only be enhanced once the required amount of ‘investment’ (expenditure on them) could be mobilised.

GDP

Gross Domestic Product (GDP) is the value of the all final goods and services produced within the boundary of a nation during one year period.

For India, this calendar year is from $1^{st}$ April to $31^{st}$ March.

It is also calculated by adding national private consumption, gross investment, government spending and trade balance (exports-minus-imports). The use of the exports-minus-imports factor removes expenditures on imports not produced in the nation, and adds expenditures of goods and service produced which are exported, but not sold within the country.

Uses of GDP

1. Per annum percentage change in it is the ‘growth rate’ of an economy.
2. It is a ‘quantitative’ concept and its volume/size indicates the ‘internal’ strength of the economy. But it does not say anything about the ‘qualitative’ aspects of the goods and services produced.
3. It is used by the IMF/WB in the comparative analyses of its member nations.

NDP

Net Domestic Product (NDP) is the GDP calculated after adjusting the weight of the value of ‘depreciation’. GDP minus the total value of the ‘wear and tear’ (depreciation) that happened in the assets while the goods and services were being produced.

The governments of the economies decide and announce the rates by which assets depreciate (done in India by the Ministry of Commerce and Industry) and a list is published, which is used by different sections of the economy to determine the real levels of depreciations in different assets.

If the value of the domestic currency falls following market mechanism in comparison to a foreign currency, it is a situation of ‘depreciation’ in the domestic currency, calculated in terms of loss in value of the domestic currency.

NDP = GDP - Depreciation

Uses of NDP

1. For domestic use only: to understand the historical situation of the loss due to depreciation to the economy. Also used to understand and analyse the sectoral situation of depreciation in industry and trade in comparative periods.
2. To show the achievements of the economy in the area of research and development, which have tried cutting the levels of depreciation in a historical time period.
3. depreciation and its rates are also used by modern governments as a tool of economic policymaking.

NDP is not used in comparative economics, i.e., to compare the economies of the world. This is due to different rates of depreciation which is set by the different economies of the world.

GNP

Gross National Product (GNP) is the GDP of a country added with its ‘income from abroad’.

The items which are counted in the segment ‘Income from Abroad’ are:

1. Private Remittances: the net outcome of the money which inflows and outflows on account of the ‘private transfers’ by Indian nationals working outside of India (to India) and the foreign nationals working in India (to their home countries)

Today, India is the highest recipient of private remittances in the world—as per the World Bank projected at $ 72 billion in 2015 (in 2013 it was $ 70 billion, the year’s highest). China falls second ($ 64 billion) in 2015.

2. Interest on External Loans: balance of inflow (on the money lend out by the economy) and outflow (on the money borrowed by the economy) of external interests. In India’s case it has always been negative as the economy has been a ‘net borrower’ from the world economies.

3. External Grants: the net outcome of the external grants i.e., the balance of such grants which flow to and from India. Today, India offers more such grants than it receives.

   In the wake of globalisation, grant outflows from India has increased as its economic diplomacy aims at the playing bigger role at international level.

GNP = GDP + income from abroad

Uses of GNP

1. This is the ‘national income’ according to which the IMF ranks the nations of the world in terms of the volumes—at purchasing power parity (PPP). India is ranked as the 3rd largest economy of the world (after China and the USA), while as per the nominal/ prevailing exchange rate of rupee, India is the 7th largest economy (IMF, April 2016).
2. It is the more exhaustive concept of national income than the GDP as it indicates towards the ‘quantitative’ as well as the ‘qualitative’ aspects of the economy, i.e., the ‘internal’ as well as the ‘external’strength of the economy.
3. It enables us to learn several facts about the production behaviour and pattern of an economy, such as, how much the outside world is dependent on its product and how much it depends on the world.

NNP

Net National Product (NNP) of an economy is the GNP after deducting the loss due to ‘depreciation’.

The formula to derive it may be written like:

NNP = GNP - Depreciation
NNP = GDP + Income from abroad - Depreciation

Uses of GNP

1. This is the ‘National Income’ (NI) of an economy. Though, the GDP, NDP and GNP, all are ‘national income’ they are not written with capitalised ‘N’ and ‘I’.
2. When we divide NNP by the total population of a nation we get the ‘per capita income’ (PCI) of that nation,

Cost and Price of National Income

Cost

Income of an economy, i.e., value of its total produced goods and services may be calculated at either the ‘factor cost’ or the ‘market cost’.

Factor cost is the ‘input cost’ the producer has to incur in the process of producing something (such as cost of capital, i.e., interest on loans, raw materials, labour, rent, power, etc.). This is also termed as ‘factory price’or ‘production cost/price’.

market cost is derived after adding the indirect taxes to the factor cost of the product, it means the cost at which the goods reach the market, i.e., showrooms (these are the cenvat/central excise and the CST which are paid by the producers to the central government in India).

India officially used to calculate its national income at factor cost (though the data at market cost was also released Since January 2015, the CSO has switched over to calculating it at market price (i.e., market cost).

Once the GST has been implemented it will be easier for India to calculate its national income at market price.

Price

Income can be derived at two prices, constant and current. The difference in the constant and current prices is only that of the impact of inflation.

Inflation is considered stand still at a year of the past (this year of the past is also known as the ‘base year’) in the case of the constant price, while in the current price, present day inflation is added. Current price is, basically, the maximum retail price (MRP) which we see printed on the goods selling in the market.

As per the new guidelines the base year in India has been revised from 2004–05 to 2011–12 (January 2015)

India calculates its national income at constant prices —so is the situation among other developing economies, while the developed nations calculate it at the current prices.

Basically, inflation has been a challenging aspect of policymaking in India because of its level (i.e., range in which it dwindles) and stability (how stable it has been)

• nominal income: The wage someone gets in hand per day or per month.
• real income: this is nominal income minus the present day rate of inflation—adjusted in percentage form.
• disposable income: the net part of wage one is free to use which is derived after deducting the direct taxes from the real/nominal income, depending upon the need of data.

Taxes and National Income

While accounting/calculating national income the taxes, direct and indirect, collected by the government, needs to be considered.

• Direct Taxes: individual income tax, corporate income tax, i.e., the corporate tax, divident tax, interest tax, etc.)

  There is no need of adjustment whether the national income is accounted at factor cost or market cost. This is so because at both the ‘costs’ they have to be the same.

• Indirect Taxes: cenvat, customs, central sales tax, sales tax/vat, state excise, etc.

  If the national income is calculated at factor cost then the corpus of the total indirect taxes needs to be deducted from it. This is because, indirect taxes have been added twice: once at the point of the people/group who pay these taxes from their disposable income while purchasing things from the market, and again at the point of the governments (as their income receipts)

  Collection/source of indirect taxes are the ‘disposable income’ (which individuals and companies have with them after paying their direct taxes—from which they do any purchasing and finally, the indirect taxes reach the government)

National Income at Factor Cost = NNP at Market price - Indirect taxes

Subsidies and National Income

Subsidies which are forwarded by the governments need to be adjusted while calculating national income. They are added to the national income at market cost, in the case of India.

National Income at Factor Cost = NNP at Market price - Subsidies

If the national income is derived at the market cost and governments forward no subsidies there is no need of adjustments for the subsidies but after all there is not a single economy in the world today which does not forward subsidies in one or the other form.

National Income at Factor Cost = NNP at Market price - Indirect taxes + Subsidies

Revision in the base year and method of National Income Accounting

The Central Statistics Office (CSO), in January 2015, released the new and revised data of National Accounts, effecting two changes:

1. The Base Year was revised from 2004–05 to 2011–12. This was done in accordance with the recommendation of the National Statistical Commission (NSC), which had advised to revise the base year of all economic indices every five years.
2. This time, the methodology of calculating the National Accounts has also been revised in line with the requirements of the System of National Accounts (SNA)-2008, an internationally accepted standard.

Changes in Methodology of calculating the National Accounts

1. Headline growth rate will now be measured by GDP at constant market prices, which will henceforth be referred to as ‘GDP’. Earlier, growth was measured in terms of growth rate in GDP at factor cost and at constant prices.

2. Sector-wise estimates of Gross Value Added (GVA) will now be given at basic prices16 instead of factor cost.

   The relationship between GVA at factor cost, GVA at basic prices, and GDP (at market prices) is given below:

   GVA at basic prices = CE + OS/MI + CFC + production taxes less production subsidies.

   GVA at factor cost = GVA at basic prices – production taxes less production subsidies.

   GDP = GVA at basic prices + product taxes – product subsidies.

   Where,

   • CE : compensation of employees;
   • OS: operating surplus;
   • MI: mixed income;
   • CFC: consumption of fixed capital (i.e., depriciation)
   • Production taxes: land revenues, stamps and registration fees and tax on profession.
   • production subsidies are subsidies to Railways, input subsidies to farmers, subsidies to village and small industries, administrative subsidies to corporations or cooperatives, etc.

     Production taxes or production subsidies are paid or received with relation to production and are independent of the volume of actual production.

   • Product taxes: excise tax, sales tax, service tax and import and export duties.
   • Product subsidies: include food, petroleum and fertilizer subsidies, interest subsidiesgiven to farmers, households, etc.,through banks, and subsidies for providing insurance to households at lower rates.

     Product taxes or subsidies are paid or received on per unit of the product.

3. Comprehensive coverage of the corporate sector both in manufacturing and services by incorporation of annual accounts of companies as filed with the Ministry of Corporate Affairs (MCA) under their e-governance initiative, MCA21. Use of MCA21 database for manufacturing companies has helped in accounting for activities other than manufacturing undertaken by these companies.

4. Comprehensive coverage of the financial sector by inclusion of information from the accounts of stock brokers, stock exchanges, asset management companies, mutual funds and pension funds, and the regulatory bodies including the Securities and Exchange Board of India (SEBI), Pension Fund Regulatory and Development Authority (PFRDA) and Insurance Regulatory and Development Authority (IRDA).

5. Improved coverage of activities of local bodies and autonomous institutions, covering around 60 per cent of the grants/transfers provided to these institutions.