NATURE OF ECONOMICS

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Introduction
Economics is a social science. Man performs different activities to fulfill his
desires. Desires can be different. Voting ones favorite political party, visiting
temples, dining with relatives are different activities which satisfy  different kinds
of desires like political, religious and social activities. However, economics is
concerned with economic activities only. Economic activities are those activities
which are concerned with the efficient use of scarce resources, which can satisfy
human wants. Production, consumption, distribution and exchange are the common
examples of economic activities.
 
History of Economics
The term 'Economics' is derived from the two Greek word 'Okios' and 'Nomikos'.
The Greek philosopher Xenophon (440-355 BC) in his treatise 'Oeconomics'
regarded economics as the science concerned with the problems of household
management. Aristotle (384-322 BC) regarded economics as an important pillar of
politics of the state. Economics was regarded as a part of other disciplines like
logics, politics, ethics etc. until Adam Smith made the first systematic analysis of
economics in his book 'An enquiry into the Nature and causes of Wealth of
Nations' published in 1776.
 
Definition of Economics
Different Economics at different periods of time have defined economics in their
own ways. However, we are concerned with three different definitions given by
three different economists which are as follows.
Wealth Definition/Classical Definition
Welfare Definition/ Neo-Classical Definition
Scarcity Definition/Modern Definition
Wealth Definition/ Classical approach
Adam Smith also known as the 'Father of Economics' made the first attempt to
present a systematic analysis of economics in his book 'An Enquiry into the Nature
and causes of Wealth of Nations' published in 1776. Adam Smith defined
economics as an enquiry into the nature and causes of wealth of nations or science
of wealth. He asserted that economics is concerned with the production,
consumption, exchange and distribution of wealth. Other classical economists like
J.S. Mill, F.A. Walker, J.B. Say, David Ricardo fully supported the classical
approach to Economics put forward by Adam Smith.
 
Characteristics/Features of the wealth Definition
Study of wealth: This definition regards economics as the study of wealth, its
production, consumption, exchange and distribution.
Study of economic man: This definition considers the study of economics
activities like production, distribution, consumption etc. all other activities of a
person are outside the orbit of this definition. This man is always guided by self
interest.
Inclusion of material goods: The definition of wealth given by Adam Smith
includes only material goods and ignores the non-material goods. Material goods
are those goods which can be seen, touched and transferred like pen, pencil, book,
car etc. whereas non- material goods cannot be seen, touched or transferred but felt
only like the ability to cure, sing etc.
Investigation of the source of wealth: This definition considers increment in
production of material goods through specialization and division of labor as the
source of wealth.
Criticisms of the wealth definition
Excess emphasis of wealth: This definition regards man as means and wealth as
ends. However, wealth is for the sake of man, man is not for the sake of wealth.
Hence, this definition has been criticized on the ground for giving excess
importance to wealth.
Narrow meaning of wealth: The classical definition includes only material goods
under wealth and excludes all non-material goods.
Unrealistic concept of economic man: This definition considers economics as the
study of economic man whose all activities are guided by self interest only.
However, this is not always the case in real life scenarios where love, friendship
also carry a lot of value.
Neglects economic welfare: This definition considers economics as the study of
wealth only and totally neglects the economic welfare of the society.
 
Welfare Definition/Neo-Classical Definition
The welfare definition of economics was given by Alfred Marshall, an eminent
English economist. The wealth definition given by Adam Smith received many
bitter criticisms on various grounds. Marshall enlarged the scope of economics by
shifting the focus of economics from material wealth to material welfare. In his
book, 'Principles of Economics' (1890), he defined economics as 'Economics is the
study mankind in ordinary business of life. It examines that part of individual and
social action, which is closely connected with the attainment, and the use of
material requisites of well being. It is on the one side a study of wealth, and on the
other and more important side , a part of the study of man'. A.C. Pigou, Cannan
and Beveridge have strongly supported the view of Marshall.
 
Characteristics of Welfare Definition
Primary concern on mankind: Unlike the classical definition, this definition gives
more emphasis on human welfare rather than wealth. It states that wealth is not for
its own sake but for the sake of human welfare.
Study of material welfare: Welfare definition gives emphasis on material welfare.
As such, it studies only material requisites of well being or causes of material
welfare and ignores non-material aspects.
Study of economic activities: People engage in various kinds of activities like
political, social and religious activities. However, the welfare definition
encompasses only economic activities related with the earning of income and
expense and excludes other activities.
Social science: Economics is a social science and it is concerned with the study of
economic activities of those people only who live in an organized society. People
living in isolation like saints are excluded in the study of economics.
 
Criticisms of Welfare Definition
Connection between economics and welfare: Marshall identifies economics as
the science which deals with human welfare. However, certain economic activities
which are disastrous for human health like production and consumption of wine
and cigarettes also fall within the purview of economics.
Material and non material welfare: Marshall defined economics as a science
concerned with material welfare. However, sometimes the same activity could be
material and non-material at other times. For example, A doctor's services in
exchange for fees would be a material activity whereas a doctor's service for
philanthropic reasons would be non-material because nothing is received in
exchange of such services.
Use of money as a measurement of welfare: Marshall used money as a
measuring rod of welfare. However, money itself is not an accurate measurement
of satisfaction. Different people like rich and poor may derive different level of
satisfaction even from the same amount of money.
Social science: Marshall stated economics as a social science. He considered
economics as a study of people living in organized societies only. But, the laws of
economics are universally applicable, be it a person living in an organized society
or be it a person living in isolation.
 
Scarcity Definition/ Modern Definition
Professor Lionel Robbins, London School of Economics took a new approach to
present a new dimension in the definition of economics in his book 'An Essay on
the Nature and Significance of Economic Science' published in 1932. In his words
'Economics is the science which studies human behavior as a relationship between
ends and scarce means which have alternative uses'. This definition of economics
has gained a worldwide popularity and consensus among the economists.
Economists like Karl Manger, Peter, Stigler, Scitovosky, etc. supported Robbins
notion of Economics.
 
Characteristics of Scarcity Definition
Unlimited Wants: Human wants are unlimited. No one can satisfy all of his/her
wants. After a want is satisfied, other wants come up and hence a person cannot be
fully satisfied.
Scarce/Limited means: Wants are unlimited but the means through which wants
can be satisfied are limited at a person's disposal. Here, scarcity is not in absolute
terms but in relative terms to the unlimited desires of people.
Alternative uses of scarce means: According to Professor Robbins the limited
resources can be put to alternative uses. For example, a sum of 300 rupees can be
used to watch a movie or eat at a restaurant.
Urgency of wants: Professor Robbins states that wants are different in urgency or
intensity. The wants which are more urgent are satisfied first than the wants that
are less urgent.
Problem of choice: Since the wants of people are unlimited in relation to the
limited means to fulfill those desires, people have to choose which want to satisfy
and which to postpone for a later date. Hence, it is the problem of choice that
haunts each and every person. If resources were abundant to fulfill every want,
then there would be no problem of choice. This problem of choice is the economic
problem which forms the subject matter of economics.
 
Criticisms of the Scarcity Definition/Modern Definition
Implicit concept of welfare: Marshall's definition of welfare has been criticized by
Robbins. However, the idea of welfare is implicit in the scarcity definition.
Whenever one makes choices to use scarce means into a use for maximum
satisfaction, it gives the same notion of choices to maximize welfare.
Abundance can create Problems: Robbins attributed scarcity of means in relation to
its demand as the source of the economic problem. However, abundance may also
result in problems too. The excessive number of working population might result
in unemployment, excessive money supply in the economy results in inflation etc.
Inseparability between means and ends: Something can be both means and ends
in life which creates a lot of confusion. A person studying M.B.B.S. wants to get a
medical officer degree. It is an end for him. But the same degree also acts as a
means to get an M.D. degree.
Self-contradictory: This definition states that economics is a positive science
which is neutral between ends. But, the idea of choice between alternative uses to
maximize satisfaction makes it a normative science. Hence, the definition is self
contradictory.
Comparison and Contrast between the three Definitions
Basis of Neo-Classical
Classical Definition Modern Definition
comparison Definition
Economics is a Economics is a
Economics is a
Nature of study science of material science of human
science of wealth.
welfare. behavior.
Aim of human To maximize To maximize To maximize
 pleasure or
beings wealth material welfare
satisfaction
Wealth is a scarce
Wealth is a means
Wealth is an end in resource to
Role of wealth for material
itself. maximize
welfare.
satisfaction.
It is pervasive and
It considers the
It considers the is applicable to all
concept of people
Scope of the study concept of people, living in a
living in organized
economic man only society or in
society only.
isolation.
  
Subject Matter of Economics/Scope of Economics
The subject matter of economics or its scope refers to the areas of study that falls
under the purview of economics. The scope of economics can be divided on the
basis of two criterions.
On the basis of economic activities
Human wants are unlimited. In order to satisfy those want people have to put
efforts. The fulfillment of wants gives satisfaction. This process consists of various
economic activities namely production, consumption, exchange and distribution.
Hence, all of these activities come under the scope of economics.
 
On the basis of Modern Analysis
The Modern analysis of economics divides the area of study of economics into two
parts namely Micro and Macro economics. Microeconomics deals with the
economic behavior of individual units like households, firms and industries.
Macroeconomics deals with aggregates of the economy or the economy as a whole.
As such it deals with total output, national income, general price level, inflation,
economic growth, consumption, investment etc.
 
Positive and Normative Economics
Positive Economics deals with factual statements of a phenomena.  It answers
questions like what is, what was and what will be about economic phenomena. It
describes the relationship between various economic variables in the light of theory
or empirical evidence. For example, when price of a commodity goes up, the
quantity demanded of the commodity decreases.
Normative economics deals with value judgments. It answers the question of what
ought to be rather than what is. Hence, it is also called prescriptive economics. It
deals with moral and ethical concerns in economics. It analyses economic events to
draw conclusion what must be done to increase welfare of the society as a whole.
For example, Tax rates should be reduced in export oriented industries to boost
exports for reducing BOP Deficit.
 
Microeconomics VS. Macroeconomics
 
Microeconomics
Micro is derived from the word 'Mikros' meaning small. Thus, Microeconomics
deals with the behavior of individual units of the economy like individual
consumer, individual producer, individual market , individual industry etc.
Microeconomics is the microscopic study of the economy. According to K.E.
Boulding, 'Microeconomics is the study of particular firms, particular households,
individual prices, wages, incomes, individual industries, particular commodities'.
 
Importance of Microeconomics
Helps to know the functioning of the economy: Microeconomics studies the
behavior of the individual units of the economy. It tells us how the individual units
of the economy take decisions regarding allocation of scarce resources to various
productive uses. It aids in knowing the working of the economy.
Aids in devising appropriate policies: The knowledge and understanding of
working and interactions, relationships between individual units of the economy
helps in the formulation of various policies and enhances their effectiveness.
Helps in business decision making: Microeconomics includes the process of price
determination, factors affecting demand, elasticity of demand, demand forecasting
tools and techniques which are extremely useful in the decision making process of
firms.
 
Macroeconomics
The word Macro is derived from the term 'Makros' meaning large. Hence,
macroeconomics is concerned with the study of the economy as a whole. It gives
the big picture of the large macroeconomic variables like production, consumption,
investment, savings, interest rate etc. In the words of K.E. Boulding,
'Macroeconomics deals not with individual quantities but with aggregate of these
quantities, not with individual incomes but with national income, not with
individual prices but with price level, not with individual output but with national
output'.
 
Importance of Macroeconomics
To understand the working of the economy: Macroeconomics studies the economy
in its aggregate form. It studies on how macroeconomic variables are determined,
how they are interrelated and how the change in one macroeconomic variable
influences other variables and aspects of the whole economy. Hence, it helps in
knowing the functioning of the economy.
Helps in devising suitable policies: The problem of inflation, unemployment and
economic growth are the major reasons of headaches of both developed and
underdeveloped countries. These problems carry so much weight that keeping
them under a certain level can keep a government stable and failure to address such
problems can collapse the whole government. The knowledge of working of the
economy and the interrelationship between economic variables helps the
government to devise appropriate policies to solve these serious problems.
Helps in comparison: The macroeconomic indicators like GDP, Inflation,
Unemployment percentage act as the standard against which relative developments
of countries over time can be compared. A country's relative development in the
present can be known compared to the past.
To know the effectiveness of policies: Macroeconomics gives various tools and
techniques to know the effectiveness of using various policies under given
situations. Basically, the IS-LM model helps to know the policy effectiveness of
using various policies. It also sheds light on the fact that sometimes a single policy
cannot help to achieve the stated objectives and hence the judicious mix of both the
policies is necessary. Moreover, it helps to throw light on the fact that
microeconomic laws do not apply under macro situations.
 
 
Distinction between Microeconomics and Macroeconomics
Basis of Difference Microeconomics Macroeconomics
Microeconomics is Macroeconomics is
concerned with the study concerned with the study
Economic unit
of individual units of an of aggregate units of an
economy. economy.
Macroeconomics is
Microeconomics is concerned with the
concerned with the use of objectives of full
objective
scarce means to achieve employment, price
maximum satisfaction. stability, economic growth
and favorable BOP.
Microeconomic theories
Macroeconomic theories
are based on the 'ceteris
are not based on such
paribus' or all other things
Methodology assumptions. Hence it is
being equal assumption.
known as general
Hence, it is known as
equilibrium analysis.
partial analysis.
The Aggregate demand
The demand and supply
Components of and Aggregate supply
forces interact to create an
equilibrium interact to reach the
equilibrium price.
general equilibrium.
Price theory, Theory of Theory of output, income
Theories
value and employment
National income, National
output, General Price
Examples of variables Price, demand, supply etc.
Level, Full Employment
etc.
 
Interdependence between Microeconomics and Macroeconomics
Though microeconomics and macroeconomics are different on many grounds, they
are interdependent, interlinked and exert influence on each other.
 
Dependence of microeconomics on macroeconomics
Although microeconomics is a small part of the economy, the changes in
macroeconomic variables shape and exert an influence on the microeconomic
variables. The change in the general wage level also helps shaping the wage of
labor in an individual firm. Here, general wage level is a macroeconomic variable
whereas wage of labor in an individual firm is micro variable.
 
Dependence of macroeconomics on microeconomics
microeconomics studies the behavior of individual units of an economy. But,
macroeconomic units are the sum of individual microeconomic units and hence the
changes in microeconomic units eventually give shape to the macroeconomic units.
For example, changes in the individual outputs of firms results in changes in
national output, saving of individual units determine the national saving. This is
because, macroeconomic variables are the collective result of microeconomic
variable. Hence, they are dependent on small microeconomic units.            

Basic Economics Issues

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Introduction
Before going on the topic of basic economic issue facing every society, we have to
know what an economy is. An economy is nothing except the sum of all economic
activities like production, consumption, exchange and distribution. If an economy is the
sum of all economic activities, then it should also include those institutions through
which all these economic activities become possible. Hence, it includes Households,
firms, government, external sector which are known as economic units. Thus, an
economy consists of economic units who perform economic activities to fulfill economic
wants. Economy includes people and institutions and the set of intricate interrelationship
between them. Economies are different from each other on different respects like size,
rich, poor, complex, simple etc.
Economic system is the platform which defines the role of every economic unit in the
economy. An economic system determines the scope of activities that an economic unit
can perform. Economic system are of various types. They are as follows.
Market economic system: The market economic system assumes no intervention of
the government in the allocation of resources or economic activities. The allocation of
resources are done by the forces of demand and supply or the market forces.
Planned economic system: There is no freedom in the allocation of resources in this
type of economic system. All the resources are controlled by the government and their
allocation is the decision of the government.
Mixed economic system: This economic system assumes the role of both the
government and the private sector. Some economic activities are controlled by the
government while other activities are left to the private sector.
 
Concept of scarcity
The economic problem or the problem of scarcity was first introduced by professor
Lionel Robbins in his modern definition of economics also known as the definition of
scarcity.  Human wants are limitless. Be it an individual, a community or a country,
everyone is faced with the problem of scarcity.  A person has unlimited desires. He
might want to eat a pizza, buy a car, buy a house, go to cinema etc.  Likewise a country
might have unlimited desires like producing TV's, Computers, Wheat, Rice, automobiles
etc. Not only are these wants recurring, but they expand as time passes by. For
example, a person who eats pizza today might want to eat pizza again after one week.
A person who buys an i-pad today might want to buy an i-phone too. Hence, wants or
desires are unlimited.
In order to produce these goods and services factors of production like land, labor,
capital and organization are required. However, these resources are not adequate in
relation to unlimited desires. Scarcity is never in absolute terms but in relation to the
unlimited desires which require unlimited resources.
 
Concept of choice
The concept of choice comes from the problem of unlimited wants. As wants are never
ending and the means through which these wants can be fulfilled are fixed or given,
people have to make choices. All wants cannot be satisfied, therefore making a choice
between what want to satisfy now and what to leave for future should be done. This is
known as the problem of choice. A country with its resources can do many things like
investing in agriculture sector, or investing in industrial sector or investing in social
sector. However, investment in all these areas is not possible due to the lack of different
resources like funds, skilled human resources, advanced technology etc. Hence, it has
to make choice by setting its priority sector.
 
Scarcity and choice
Scarcity and choice are two sides of the same coin. Choice exists because resources
are scarce and choice involves the use of scarce resources for some particular cause.
There are number of things that people, society, countries want. However, the means to
attain those needs, fulfill those desires are limited. Hence, an order of preference must
be listed or choice must be made among those viable and desirable alternatives
according to ones resource endowment. This is known as choice among alternatives.
Both affluent as well as poor countries have the problem of scarcity of resources. One
might argue that how could advanced economies have the problem of resource scarcity
but he/she has to understand that the desires of such economies are also massive in
proportion to their resource endowments. Hence, there arises the problem of scarcity
and choice in all sorts of economies.
 
Allocation of resources
Allocation of resources is defined as the process of selection of resources and their
proper utilization.  Possession of resources in an economy is limited and those
resources have various uses. Decision makers have to choose one among those
various uses which maximizes its satisfaction. Decision makers have to answer the
basic following questions in the allocation of resources.
The main problems relating to the proper allocation of resources are explained as
follows:
 
What to Produce?
An economy endowed with limited resources and unlimited wants have to make a
choice about what good to produce and in what quantities. If an economy decides to
produce more of consumer goods, it has to produce less of the capital goods. There
always exists tradeoff between various uses of the precious limited resources. If
resources were not limited, the problems would not arise because in that case we would
be able to produce all goods we wanted in desired quantities. Hence, the goods and
their quantity to be produced has to be prioritized by the economy.
 
How to produce?
The question of how to produce is related with the use of which resource to use in the
production process. It connects to the question of technique of production in an
economy and is concerned with producing the maximum output at the least cost. The
same goods and services can be produced using more labor (labor intensive technique)
or using more capital (capital intensive technique). An economy has to use that method
of production which gives the maximum output at the least production cost.
 
Whom to Produce?
After deciding on what to produce and how to produce, an economy has to decide on
the distribution of the produced goods and services to different sections of the society. It
has to decide how the national product be distributed among different factors of
production or among different individuals and families.
 
How to achieve fuller utilization or full employment of resources?
Economies have to decide how to optimize the resource use so that maximum output
can be produced efficiently. Every economy is plagued by the problem of scarcity of
resources in relation to the unlimited wants. Hence, idle resources are a curse for every
economy. In order to satisfy the demand of the economy full utilization of resource must
be ensured.
 
How to achieve growth of resources?
Another central problem of the economy is to increase the level of production. It is also
known as the problem of growth of resources. Each economy is faced with the problem
of how to increase its production capacity so that the total production can be increased.
An economy can achieve the objective of growth of resources through technological
advancement.
 
Concept of production possibility curve
Human wants are unlimited and resources to achieve those wants are limited. Every
society faces the problem of scarcity and choice. Hence, priorities are set and goods to
produce and their quantities are decided. A production possibility curve is the locus of
various combinations of two goods or services that an economy can produce with the
full use of its given resources and state of technology.
In the words of Samuelson, " Production possibility curve is the curve which represents
the maximum amount of a pair of goods or services that can both be produced with an
economy's given resources and technique, assuming that all resources are fully
employed". It shows the alternative combinations of maximum goods and services that
can be produced with the given assumptions. It is also called 'production possibility
boundary or frontier' because it shows the limit of what it is possible to produce with the
available limited resources. It is also called a 'transformation line or transformation
curve' because resources are transformed from one use to the other by switching to
different combinations of production.
 
Assumptions of Production Possibility Curve
Factors of production are fixed
There is full employment in the economy
Constancy in Technology
Short run basis
Substitution of factors of production
 
Production possibility Schedule
Production possibility schedule shows the alternative combinations of goods and
services that an economy can produce with its given resources in tabular format. For
example, Let the Nepalese economy with its given resources produces guns and butter.
The production possibility schedule shows the alternative combinations of both goods
that the economy can produce.
The following table shows the different combinations of guns and butter, guns or butter
that the Nepalese economy can produce. The production possibility schedule only
shows six different combinations. But there can be infinite number of alternative
combinations in a production possibility schedule.
Combination Guns Butter
A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0
 
Production Possibility Curve
When the production possibility schedule is plotted on a graph, the outcome is a
production possibility curve. A production possibility curve shows the different
alternative combinations of two goods that can be produced with the given resources. If
we plot the above combinations in a graph we get the production possibility curve of the
Nepalese economy.

In  the above production possibility curve AF the X axis shows the production of butter
while Y axis shows the production of guns. As we can see, the production possibility
curve shows six different combinations of guns and butter that the economy can
produce. At one extreme is the production of 15 units of butter without the production of
guns at point A. At the other extreme is the production of 5 guns without any butter.
Other combinations contain both guns and butter. One point to note in the production
possibility curve is that as we go on increasing the production of one commodity the
production of another commodity decreases. There is tradeoff between the productions
of these two goods. For example if we move from point B to point C, the production of
guns increases from 1 to 2 units. However, the production of butter decreases from 14
units to 12 units. There can be infinite points in the production possibility curve. An
economy can choose any Combination that lies on the production possibility curve. If an
economy decides to produce at any point that lies inside the production possibility
curve, it is not utilizing its resources fully. An economy cannot produce outside the
production possibility curve because the availability of means does not support such
production. Hence, it has to produce at any point that falls on the production possibility
curve.
 
Shifts in the production possibility curve
An economy's production possibility curve can shift inwards or outwards over time. This
might be due to the following reasons.
Change in resources
The amount of resources an economy has can change over a period of time. The
resources can increase due to population growth, forestation, finding of a new resource
source, training programs leading to the availability of skilled manpower etc. When
these resources increase, the production possibility curve shifts outwards. Resources
might decrease due to the depletion of renewable resources, natural calamities,
deforestation etc. When resources decrease, the production possibility curve shifts
inwards.
 
Change in technology
The advancement in technology can take place over a span of time. When such new
and efficient technology becomes available, it enhances the production capacity of an
economy. This results in an outward shift in the production possibility curve of an
economy.

Introduction
National Income Accounting is the systematic rendering of statements about the
performance of an economy during a period of time. National Income Accounting
is the process of measuring the national income of an economy over a period of
time. It tells us about the economic health of a country over a period of time. It is
very useful tool of measuring and comparing living standards as well as
formulating economic policies. It shows the share of different sectors of an
economy in the total income of the economy. It helps us to find the per capita
income of the country. It is also an important indicator of economic development.
 
Definitions of National Income
Different economists have defined national income in their own ways. Here are
some of the popular definitions given by the prominent economists.
 
Marshall's definition
According to Marshall, "The labor and capital of a country acting upon its natural
resources produce annually a certain net aggregate of commodities, material and
immaterial including services of all kinds. This is the net annual income or revenue
of a country or the national dividend."
 
Pigou's definition
According to Pigou, "National income is that part of objective income of the
community, including of course income derived from abroad which can be
measured in money."
 
Fisher's definition  
According to Fisher, "The national dividend or income consists solely of services
as received by ultimate consumers, whether from their material or from their
human environments. Thus, a piano or an overcoat made for me this year is not a
part of this year's income, but an addition to capital. Only the services rendered to
me during this year by these things are income."
 
Simon Kuznets` definition
According to Simon Kuznets, "National income is the net output of commodities
and services following during the year from the country's productive system in the
hand of the ultimate consumers."
 
Concepts of National Income
National Incomes can be of different types. Incomes in an economy can be derived
from many sources. Some types of income include something while others might
exclude something out of the income stream. Hence, it is necessary to know about
the various concepts of income, which are as follows:
 
Gross Domestic Product (GDP)
GDP is defined as the total market value of the final goods and services produced
in an economy over a period of time, usually one year is known as the Gross
Domestic Product. GDP is a monetary measure of national income. In order to
calculate the GDP, the quantity of various goods and services are multiplied with
their respective prices and added to come to a monetary figure.
                                              GDP=p1x1+p2x2+....pnxn=∑i=1npixiGDP=p1x1+p2
x2+....pnxn=∑i=1n⁡pixi
The above equation shows that for n number of goods and services produced in an
economy over a period of one year, the GDP equals the summed up monetary
value of all goods and services in the economy.
Gross National Product (GNP)
GNP is the total monetary value of the final goods and services in an economy
over a period of time plus the net factor income from abroad. It includes only those
goods, which are produced using domestic factors of production. In a time like this
where factor mobility is not a surprising phenomenon, ordinary residents of a
country work abroad and are paid for their services. Foreigners also render services
in the domestic economy and are paid their share of contribution. Hence, GNP
subtracts the income paid to the foreigners in the economy and adds the income
earned from giving services of nationals in the foreign economy. The difference
between income earned from abroad and income paid to foreigners is known as the
net factor income from abroad.
Therefore, GNP=GDP+netfactorincomefromabroadGNP=GDP+netfactorincomefr
omabroad
 
Difference between GDP and GNP
Basis
of
GDP GNP
distin
ction
It is the market value
of the final goods and It is the market value of final goods and services
Defin
services produced in produced by the ordinary citizens of a country over a
ition
a country during a period of time.
period of time.
Scope It is a narrow GNP is a broader concept than GDP.
 concept.
It focuses on the
Main value produced
It focuses on the value produced by the citizens of the
conce within a 'territory'.
country. The focus is on citizens, not boundary.
rn Here, territory is of
importance.
Inclus
ion of
net
factor It excludes the net
incom factor income from It includes the net factor income from abroad.
e abroad.
from
abroa
d
GDP is widely used
Frequ
for international GNP is less used in international comparisons than
ent
comparisons than GDP.
use
GNP.
Form    GDP=∑i=1npixiG                  GNP=GDP+netfactorincomefromabroadG
ula DP=∑i=1n⁡pixi NP=GDP+netfactorincomefromabroad
 
Net National Product (NNP)
There happens to be wear and tear of machineries and other fixed capital during
the production process. This is also known as depreciation or consumption of fixed
capital. NNP is the result of deduction of value of depreciation from the GNP.
NNP allows for the deduction of depreciation, maintenance of fixed capital and
gives the true value of goods and services after excluding such expenses.
                                                                                      NNP=GNP−DepreciationNN
P=GNP−Depreciation
 
National Income
National income is the total income accruing to all factors of production for the
services rendered in the production process. The household sector provides factors
of production in the form of land, labor, capital and organization in the production
of goods and services. They are paid in the form of rent, wages and salaries,
interest, profit, mixed income etc. for their contribution in the production of goods
and services by supplying the factors of production. The steps which are followed
to arrive at a figure of national income are as follows.
GDP=GDP=W+R+I+P+Depreciation +Net Indirect Taxes
GNP = GDP + Net factor income from abroad
NNP = GNP - Depreciation
NNP at factor cost = NNP - Indirect Taxes = National Income
 
                                                                                                    
 
 
One important thing to note in this regard is that some forms of income like
transfer payments, capital gains, second hand sales and illegal incomes do not
come under the purview of national income. This is because they are not earned
from expenditures on currently produced goods and services. Transfer payments
are not included in national income, because they simply function as the
redistribution of wealth. They are not earned in exchange of goods and services.
Capital gains are also mere claim on financial assets and do not represent
expenditure on currently produced goods and services. Second hand sales do not
fall under the national income, because nothing new is produced. It already must
have come under past year's GDP. Illegal incomes form illegal activities like
gambling, smuggling, robbery do not fall under national income because they do
not increase the productive capacity of the economy.
 
Personal Income
The total income received by all individuals and households of a country from all
possible sources before payment of direct taxes during a year is called personal
income. There are time when income is received by a firm but not by the members
of the firm. That is why there is a gap between national income and personal
income. All of the corporate profits do not go to shareholders. A part of it is paid as
tax and some portion of the corporate profit might be retained in the business. All
of the wages and salary accruing to the workers might not be received. A portion
of it is contributed for the provident fund, pension fund etc. Also, transfer
payments accrue to the individuals as income and are hence included in personal
income.
PI = National income - Undistributed corporate profits - Corporate taxes - social
security contribution + transfer payments
 
Disposable Income
The income left for consumption after paying the direct taxes is known as
disposable income. In other words, it is the income left for consumption available
at people's disposal. However, not all of the disposable income is used for
consumption.
Disposable income = Personal income - Direct taxes
 
Per Capita Income
Per Capita Income is the average income of the people of a country in a particular
year. It is the income received by a single person of a country in that year.
Per Capita Income = National Income in a particular year ÷ Total population in
that year
 

Measurement of National Income

The production of goods and services requires the use of resources which are in the
hands of the household sector of an economy. Households are paid for their
services in the production of goods and services which generates income for the
household. This income stimulates demand for goods and services. The demand of
goods and services from the household sector is satisfied by business firms in an
economy. Hence, household sector spend on goods and services of the firms which
acts as income to the firms. The income they get helps in further production of
goods and services. Hence, there is a circular flow of income. Therefore, the
national income of a country can be measured using three different approaches, i.e.
production, income as well as expenditure method. These three methods are
considered to end up giving the same figure because an income results into an
equal expenditure which again acts as an income to the producers and the cycle
goes on uninterrupted which is why these three approaches are believed to give the
same figure of national income.
 
Product Method
Product method measures national income by summing up the market value of all
the final goods and services produced in an economy during a certain period of
time. Here, final goods are those goods which are in the market for consumption
by the ultimate consumer. In this method, economy is divided into three sectors,
primary sector (agriculture, forestry, fishing, mining), secondary sector
(manufacturing, construction, electricity, gas, water supply) and tertiary sector
(banking, transport, insurance, trade and commerce) etc. respectively. The money
value of total product of each sector is calculated and summed up to find out GDP.
The GDP so derived can be changed into GNP by adding Net factor income from
abroad.
However, this method results in the problem of double counting. Double counting
means certain items are calculated more than once while calculating national
income. Avoiding the problem of double counting is difficult because the same
product is used as an intermediate goods by a firm and as final goods by
households. For example, flour is used as the intermediate good by biscuit
industries where it is used as final product by households for making Chapattis.
In order to avoid the problem of double counting, value added method is used. A
detailed description of these two methods are as follows:
Final Product Method
The final product method uses the market value of all the final goods and services
to come to a GDP figure from which national income is deduced.
GDP = p1q1 + p2q2 + … + pnqn
GNP = GDP + Net Factor Income From Abroad
NN P =GNP - Depreciation
National Income = NNP - Indirect Taxes
 
Value Added Method
Unlike final product method, the value added method does not take the final
market value of goods. In the process of production, there are many stages. Value
Added Method only takes the added value in each stage of production and adds
them all to come to a single GDP figure. This method is used to avoid the problem
of double counting. Value addition means the addition of the value of raw
materials and other inputs in the process of production. Net value added is the
difference between the value of output and intermediate good. The following
example will make the concept of value addition more clearer.
Cost of
Stage of production Value of Output Gross Value Added
Intermediate Goods
Wheat 1000 200 800
Flour 1400 1000 400
Bread 2000 1400 600
Total 4400 2600 1800
 
The above table shows the different stages in the production of bread. There are
three stages involved in the production of bread. The first stage is where a farmer
produces wheat. The wheat thus produced goes to the mill and the resulting output
is flour. The flour then goes further for processing to a factory from where the final
product, bread is produced. Hence, in all the process value is added in the form of
the raw material to produce something with more use. This addition in value can be
measured in terms of market price of the product in various stages of production.
The first stage of production in the production of bread starts with the production
of wheat by a farmer. Let us suppose, his inputs cost 200 rupees. He sells his
production to the mill for 1000 rupees. The mill processes the wheat to produce
flour and sells his product for 1400 rupees to the baker. The baker produces bread
and sells it in the market or to the final consumer for 2000 rupees. Here, there is
value addition at every stage involved. The farmer buys inputs worth 200 rupees
and sells the wheat for 1000 rupees. Here, the value addition is the difference
between the intermediate good and the value of the final output that the farmer
sells, i.e. 800 rupees. Likewise the value addition made by the mill is 400 rupees.
Finally the value addition done by the baker is 600 rupees. Hence, the total value
addition done by all three players in the production process of bread is 1800 rupees
which is the value of the bread.
                               NetvalueAddition=costoffinaloutput−costofintermediategoodN
etvalueAddition=costoffinaloutput−costofintermediategood
In an economy, if we sum up the value addition in the production of all goods and
services, we get the GDP. We can find out the national income then from the GDP.
                                         GDP=NV1+NV2+…
+NVn=∑i=1nNViGDP=NV1+NV2+…+NVn=∑i=1n⁡NVi
GNP = GDP + Net Factor Income From Abroad
NNP = GNP - Depreciation
NI = NNP - Indirect Taxes
 
Income Method
The income approach of measuring national income considers all the payments
made to the factors of production to arrive at a national income figure. Therefore, it
is also called the factor payment method. The household sector provide factors of
production like land, labor, capital and organization to produce goods and services.
For this, they are paid in terms of rent, wages and salaries, interest and profits. If
we sum up all these values we get the GDP of the country.
GDP = Rent + Wages and Salaries+Interest + Profits + Depreciation + Net indirect
taxes
GNP = GDP + Net factor income from abroad
NNP = GNP - Depreciation
NI = NNP - Net Indirect Taxes
 
Expenditure Method
Factors of production are paid for their contribution in the production of goods and
services. The income they get can be used in two ways that are consumption
expenditure and investment expenditure. Also, the government spends in the
economy. The domestic economy is also linked with the external sector through
imports and exports. The difference between imports and exports is known as net
exports. The expenditure method measures national income as the aggregate of all
the final expenditure on gross domestic product at market price in an economy
during an accounting year.
GDP = C + I + G + (X - M)
 
GNP = GDP + Net Factor Income From Abroad
NNP = GNP - Depreciation
NI = NNP - Net Indirect Taxes
where,
C= Private Consumption Expenditure
I= Private Investment Expenditure
G= Government Expenditure
X= Exports
M= Imports
 
Notes
While using expenditure method to measure national income, the following things
should be kept on mind:
The expenditure on currently produced goods within the period under
consideration should only be included. Previously produced goods should be
excluded.
It must also exclude all the expenditures for the purchase of used assets.
Purchase of financial assets such as stocks and bonds must be excluded.
Transfer payments provided by governments must be excluded.
Expenditure on intermediate goods must also be excluded.
 
Difficulties in Measurement of National Income
Measuring national income is a very important task, because it acts as an indicator
of the performance of an economy over a certain time period. It is useful in
international comparisons as well as time series comparison of the same economy.
However, there are many difficulties in the measurement of national income. Some
of the major difficulties are as follows:
Double Counting: The problem of double counting occurs because; the same good
is sold and resold many times in the stages of production. Moreover, it is very
difficult to identify which good is final or intermediate. Based upon its use, the
same good can sometimes act as final and sometimes as an intermediate good.
Therefore, there is a chance of overestimation of national income as a result of
double counting.
Method used in the calculation of depreciation: Calculating depreciation is a
very baffling task. This is because different firms use different methods to
calculate depreciation. There is no universal consensus on which method gives an
accurate measurement of the exact wear and tear of fixed capital used in the
production of goods and services. Moreover, there is also a debate whether
depreciation should be deducted from the original cost or replacement cost of the
fixed capital.
Non-marketed goods: All the goods do not come to the market. There are many
household services, value addition to the raw materials in the form of cooking,
cleaning, decorating, babysitting which do not come under the purview of national
income. However, the same activities done elsewhere would have generated
income.
Changes in price level: National income needs two variables for its calculation,
price and quantity of different goods and services produced in a economy.
However, the results can be confusing sometimes. National income may increase
without an increase in production because of increase in price level.
Unreported illegal income: Illegal incomes earned through illegal activities like
tax evasion, smuggling, bribery, gambling are not reported which underestimates
national income.
 
Practical Difficulties in Measuring National Income in Developing Countries
There are certain difficulties in measuring national income in developing countries,
which are unique to those countries. These kinds of difficulties are specific to those
countries. Nepal is also a developing country and hence these unique problems are
also relevant in our case. Hence, it is important to know about these problems.
They are as follows.
Large non-monetized sector: Nepalese economy is an agriculture-dominated
economy. In such economy, a considerable amount of agricultural produce does
not come to the market place because the production is used for self-subsistence.
Hence, there exists a large non-monetized sector, which makes the correct
estimation of national income a tedious task.
Illiteracy: Most of the farmers do not keep record of their production due to
illiteracy.
Lack of trained staff: There is a lack of adequate trained statistical staff for the
purpose of measuring national income.
Narrow Mindset: The people in these countries are superstitious and hence
reluctant to disclose their incomes. Moreover, people cannot disclose their actual
income if it is earned through illegal sources.
Lack of occupational specialization: People depend on various income sources for
continuing their livelihood and hence lack occupational specialization, which
makes measuring national income a difficult task.

What is the Harrod-Domar model of economic growth?

Developed after the Keynesian model of economic growth, Harrod-Domar model aims to tell us
the economies rate of growth by telling us in terms of savings and increase in capital. ... The
dialogue between the Harrod-Domar and the Classicalists led to the creation of Solow-Swan
model.

The Harrod-Domar model is a Keynesian model of economic growth. It is used in

development economics to explain an economy's growth rate in terms of the level of
saving and of capital. ... According to the Harrod–Domar model there are three kinds of
growth: warranted growth, actual growth and natural rate of growth.

Harrod v/s Solow Model of Economic growth

Developed after the Keynesian model of economic growth, Harrod-Domar

model aims to tell us the economies rate of growth by telling us in terms of
savings and increase in capital. The true essence of this model is based on
the assumption that there is actually no valid reason that can be explained
naturally for an economy to develop in a balanced fashion. The founders of
this theory were Roy F. Harrod and Evsey Domar . The followers of the
Classical Economy school of thought, argued for the failure of the Harrod-
Domar model because according to them the solution obtained from Harrod-
Domar model was unstable and didn’t fixed the solutions. The dialogue
between the Harrod-Domar and the Classicalists led to the creation of
Solow-Swan model.
In the Harrod-Domar model, employment and income’s analysis were done
for long duration of time and thus they considered the investment’s income
and capacity. Their model showed that for a capitalist economy to attain a
uniform growth the investment rate should be increased at a certain rate. In
the Harrod-Domar model accumulation of capital plays a key role to
determine the economic growth. The biggest difference between the
Keynesian economists theories and Harrod-Domar Model was that the latter
considered both sides such as long and short term while the Keynesian only
used one side that was the short-term side of the economy. According to
Harrod-Domar model, if one has to maintain full employability, the total
expenditure by investing must suffice the added output that was developed
by the investment. There should be a definite growth in the real national
income to make sure that full employability is present which would then lead
to steady growth rate. They also said that if we kept omn increasing the
annual investment and there was no demand in the market then it would
lead to underutilization of capital stock and such a situation is detrimental to
growth.

The Solow–Swan model being an exogenous growth model is an extension to

the Harrod–Domar model. The basic essence of this model provides an
explanation of long term economic growth using the fundamentals of
neoclassical theories like labor and productivity. The model was developed
by Robert Solow and Trevor Swan in the year 1956 and acted as the
extended version of the previous Harrod–Domar model. Now Solow
extended the previous model by adding few other variables in the picture of
Harrod-Domar model. The added variable includes labor which acted as the
production factor and the rigidity of capital-labor ratios was also removed.
The Solow-Swan Model had a short term implication that in short terms
growth could be found by referring the steady state that was now created by
capital investment change, growth of labor force and the rate of
depreciation, the rate of savings affected the capital investment. In Long
term implications, Solow model theorized that technological process can only
bring growth. The Solow-Romer model is used to find growth in long term
condition.

The various predictions of Solow-Swan model includes that the rate of

savings and technological progress does not have any influence over the
outputs growth rate. The increase in rate of savings is capital inductive as it
increases the capital accosted per labor. The biggest implication suggested
by the Solow-Swan model is the conditional convergence. Under the theory
of conditional convergence if countries have the same variables like rate of
savings, technology and growth rate of population which affect growth will
ultimately converge to a particular state and it would be equal for all the
countries. The other implication of this theory would be that if a poor nation
has the same variables like a rich nation then both of them will have same
constant growth rate in long duration. One can argue that the conditional
convergence could not be possible but the validity of this theory was justified
when the conditional convergence was observed in the northern states of the
United States of America in the section of education policies, arrangements
of institutions and trade policies with various other countries. Thus we can
say that the Solow model is more advanced and realistic than Harrod-Domar
model but without the Harrod-Domar maodel development of Solow model
might had took a very long time.

Growth Theory

5.1.1 HarrodDomar Model

5.2.1 Solow Model

5.1 Growth Theory

The discussion on the Keynes-Classics debate centered around the cyclical

fluctuation in the economy and the ways to correct it. This is just one part of
macroeconomics, the other part being the growth theories which discuss the long
run trend of national income. The development of growth theories has three
distinct phases: 1. Harrod-Domer model of growth (1947-48) 2. Neo-classical
growth Models pioneered by Solow and Swan (1956) 3. Endogenous growth
models (1962-)

5.1.1 HarrodDomar Model

Even though economists are talking about economic growth for ages, the first
formal growth model was worked out only in 1947-48, right after the Second
World War

The remarkable growth story of Soviet Union through forced savings triggered
interests in growth. It was specially because after the second World War Soviet
Union emerged as one of the super power.

Moreover, after the WW II, World Bank was established with the announced goal
of reconstructing the world economies. Hence, understanding the process of
growth became essential.
Rostow's stages of growth can be seen as the precursor of the Harrod-Domer
model. According to Rostow's theory there are five stages of development which
are:

1. The traditional society

2. Preconditions for takeoff

3. Takeoff

4. The drive to maturity

5. The age of high mass-consumption

It is the take off stage where Rostow predicted that the rate of savings and
investment would rise from 5% of the national income to 10%. Hence, this is the
stage an economy will take off to the path of high growth. But Rostow did not have
a proper theory identifying the path leading to take off.

Hence, Harrod-Domar theory characterizes an economy with fundamental

instability. In this model there is no guarantee that the system, once perturbed will
come back to the equilibrium. This property implies an inherent instability in the
capitalist system. Robert Solow however found the reason behind getting such a
result. It was an implication of the assumption of the fixed coefficient production
function. Solow in his model assumed the standard neo-classical production
function and the result changed radically. We shall see this in the next lecture

Introduction Background Robert M. Solow developed dynamic economic growth theory in 1956 based
on the neoclassical production function with factor substitutions and diminishing returns. Before that
Harrod (1939) and Domar (1946) attempted to integrate Keynesian analysis with elements of economic
growth focusing on role saving and productivity of capital. Solow (1956) argued that slip from knife-edge
equilibrium in Harrod and Domar would generate either growing unemployment or prolonged inflation
and this situation would happen due to fixed proportions of labor and capital and absence of
technological change. However, Solow (1956) admitted that the bulk of his paper was devoted to a
model of long-run growth which accepts all the HarrodDomar assumptions except that of fixed
proportions of labor and capital. The Solow model analyzed the dynamic changes in the level of output
in an economy as a result of changes in the population growth, the capital accumulation, and the
technological progress which are assumed to be determined exogenously. Contrary, endogenous growth
theory argued that factors such as capital accumulation, human capital, innovation, externality etc.,
which are endogenous, influence economic growth (Pack, 1994). For developing countries, the debate
between exogenous and endogenous models is less relevant because these models mostly concern on
the dynamics of motion growth of advanced industrial economy and not about escaping a poverty trap
or even initiating a growth boom (Rao & Cooray, 2009). One of the strong arguments in growth
literature is that the first-generation growth theories as well as existing growth models are not enough
to address the needs of developing country. The new growth literatures also are not particularly useful
for most developing countries because they focus on the very long run and incentives for expanding the
technological frontier (Pritchett, 2006). In view of Hicks (1965) as cited by Pritchett (2006), growth
theory (as we shall understand it) has no particular bearing on underdevelopment economics, nor has
the underdevelopment interest played any essential part in its development. Most of empirical
researches on growth models are conducted on cross country analysis considering “one size fits all” but
they are not appropriate for diverse economic structures and interpreting the coefficients of policy
variables as their growth elasticise. So, country specific studies are more appropriate for country specific
growth policies. However, the specifications used by many country specific studies are ad hoc and they
do not make clear whether their specifications are based on or how they have derived their
specifications from the theoretical growth models. In these studies, growth rate is simply regressed on
selected determinants of economic growth (Rao & Cooray, 2009).

Significance of the study Solow (1956) argued that higher capital accumulation increases the per capita
output but higher population growth lowers income because the available capital must be spread more
thinly over the population of workers. The economy reaches to unique steady-state equilibrium where
economy stagnates and technological change is essential to attain the new equilibrium with higher level
of living standard. In addition, conditional convergence is a major prediction of Solow growth models.
The growth of low per capita income country is higher in comparison to high per capita income country
(Mankiw, Romer and Weil, 1992). However the situation of developing countries may be different. Due
to lack of sufficient capital, contribution of capital in production process may be less in comparison to
contribution of labor. Many developing countries’ growth rate is very far from the conditions of a
steadystate. Many socioeconomic factors are responsible for slow economic growth rate of least
developed countries like Nepal, among them vicious circle of poverty is one. Saving rate is low due to
poverty which makes less investment gives less output in country. Average economic growth rate of
Nepal for last 60 years is 3.8 percent while GDP per capita growth rate is 2 percent. When we calculate
for last 30 years the economic growth rate is 4.6 percent and GDP per capita growth rate is 3 percent.
Similarly, gross of saving in Nepal in 1970, 1980s and 1990s decade was only 16 percent in average
(World Bank, 2020). In 2000s and 2010s decade, it increased to 30 percent and 44 percent in average.
Similarly the population growth rate of Nepal in 1980s, 1990s, 2000s and 2010s decade are 2.62
percent, 2.10 percent, 2.24 percent and 1.35 percent respectively (CBS, 2014). Endogenous models
focus of the on long run growth where the effect of expanding technological frontiers is analyzed. This is
not particularly useful for most developing nations, whose primary interest is in restoring short-to
medium-term growth and accelerating technological catch-up by adopting already known innovations
(Rao & Cooray, 2009). The Solow model, when extended, is simpler to estimate and simulate to
understand the dynamics of growth. Mankiw, Romer and Weil (1992) argued that the Solow model can
explain the observed facts better than the endogenous models. There are different findings regarding
the application of the Solow growth model. The basic Solow model explains the positive effect of saving
on growth or living standard of people and negative effect of population growth on it. As the model was
explained in context of developed economy and assumes, competitive market and constant returns to
scale, is it relevant to developing country like Nepal where market imperfection exists highly? Does
saving affect living standard of people? How does labor growth rate affect the growth of economy? Can
the model be extended by adding human capital? What will be the effect of human capital on economic
growth? These are the basic research questions of this study