NATURE OF ECONOMICS

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

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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

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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.

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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
Neo-Classical
Basis of comparison Classical Definition Modern Definition
Definition

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 Economics is a science Economics is a science Economics is a science
Nature of study
of wealth. of material welfare. of human behavior.
To maximize material To maximize pleasure
Aim of human beings To maximize wealth
welfare or satisfaction
Wealth is a scarce
Wealth is an end in Wealth is a means for
Role of wealth resource to maximize
itself. material welfare.
satisfaction.
It considers the It is pervasive and is
It considers the
concept of people applicable to all
Scope of the study concept of economic
living in organized people, living in a
man only
society only. society or in 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.

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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

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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 concerned Macroeconomics is concerned
Economic unit with the study of individual with the study of aggregate
units of an economy. units of an economy.
Macroeconomics is concerned
Microeconomics is concerned
with the objectives of full
with the use of scarce means
objective employment, price stability,
to achieve maximum
economic growth and
satisfaction.
favorable BOP.
Microeconomic theories are Macroeconomic theories are
based on the 'ceteris paribus' not based on such
Methodology or all other things being equal assumptions. Hence it is
assumption. Hence, it is known as general equilibrium
known as partial analysis. analysis.
The demand and supply forces The Aggregate demand and
Components of equilibrium interact to create an Aggregate supply interact to
equilibrium price. reach the general equilibrium.
Theory of output, income and
Theories Price theory, Theory of value
employment
National income, National
Examples of variables Price, demand, supply etc. output, General Price Level,
Full Employment etc.

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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.

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Basic Economics Issues
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.

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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.

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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

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'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

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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

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National Income Accounting
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."

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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+netfactorincomef
romabroad

Difference between GDP and GNP

Basis
of
GDP GNP
distin
ction
It is the market value of
the final goods and
Defini It is the market value of final goods and services produced by
services produced in a
tion the ordinary citizens of a country over a period of time.
country during a period
of time.
Scope It is a narrow concept. GNP is a broader concept than GDP.

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 It focuses on the value
Main produced within a
It focuses on the value produced by the citizens of the
conce 'territory'. Here,
country. The focus is on citizens, not boundary.
rn 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
Frequ GDP is widely used for
ent international GNP is less used in international comparisons than GDP.
use comparisons than GNP.
Form GDP=∑i=1npixiGD GNP=GDP+netfactorincomefromabroadG
ula P=∑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−DepreciationN
NP=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

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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

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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

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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 Intermediate
Stage of production Value of Output Gross Value Added
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−costofintermediatego
odNetvalueAddition=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

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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

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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

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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.

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