Category: Management Notes

Management Notes

Hicks Theory of Trade Cycle

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Hicks put forward a complete theory of business cycles based on the interaction between the multiplier and accelerator by choosing certain values of marginal propensity to consume (c) and capital- output ratio (v) which he thinks are representative of the real world situation.

According to Hicks, the values of marginal propensity to consume and capital-output ratio fall in either region C or D of Fig. 1.

As seen above, in case values of these parameters lie in the region C, they produce cyclical movements (i.e., oscillations) whose amplitude increases overtime and if they fall in region D1 they produce an explosive upward movement of income or output without oscillations. To explain business cycles of the real world which do not tend to explode, Hicks has incorporated in his analysis the role of buffers.

On the one hand, he introduces output ceiling when all the given resources are fully employed and prevent income and output to go beyond it, and, on the other hand, he visualizes a floor or the lower limit below which income and output cannot go because some autonomous investment is always taking place.

Another important features of Hicks’ theory is that business cycles in the economy occur in the background of economic growth (i.e., the rising trend of real income of output over time). In other words, cyclical fluctuations in real output of goods and services take place above and below this rising line of trend or growth of income and output. Thus in his theory he explains business cycles along with an equilibrium rate of growth.

In Hicks’ theory of long-run equilibrium growth that is determined by rate of increase of autonomous investment over time and, therefore, long-run equilibrium growth of income is determined by the autonomous investment and the magnitudes of multiplier and accelerator. Hicks assumes that autonomous investment, depending as it is on technological progress, innovations and population growth, grows at a constant rate.

With further assumptions of stable multiplier and accelerator, equilibrium income will grow at the same rate as autonomous investment. It follows therefore that the failure of actual output to increase along the equilibrium growth path, sometimes to move above it and sometimes to move below it, determines the business cycles.

Hicks’ theory of business cycles has been explained with the help of Fig. 13.7. In this figure, AA line represents autonomous investment. Autonomous investment is that investment which is not induced by changes in income and is made by entrepreneur as a result of technological progress or innovations or population growth. Hicks assumes that autonomous investment grows annually at a constant rate given by the slope of the line AA.

Given the marginal propensity to consume, the simple multiplier is determined. Then the magnitude of multiplier and autonomous investment together determine the equilibrium path of income shown by the line LL. Hicks calls this the floor line as this sets the lower limits below which income (output) cannot fall because of a given rate of growth of autonomous investment and the given size of the multiplier. But induced investment has not yet been taken into account.

If national income grows from one year to the next, as it would move along the line LL, there is some amount of induced investment via accelerator. The line EE shows the equilibrium growth path of national income determined by autonomous investment and the combined effect of the multiplier and accelerator. FF is the full employment ceiling. It is a line that shows the maximum national output at any period of time when all the available resources of the economy are fully employed.

Given the constant growth of autonomous investment, the magnitude of multiplier and the induced investment determined by the accelerator, the economy will be moving along the equilibrium growth path line EE. Thus starting from point E, the economy will be in equilibrium moving along the path EE determined by the combined effect of multiplier and accelerator and the growing level of the autonomous investment.

Suppose when the economy reaches point P0 along the path EE, there is an external shock—say an outburst of investment due to certain innovation or jump in governmental investment. When the economy experiences such an outburst of autonomous investment it pushes the economy above the equilibrium growth path EE after point P0.

The rise in autonomous investment due to external shock causes national income to increase at a greater rate than that shown by the slope of EE. This greater increase in national income will cause further increase in induced investment through acceleration effect. This increase in induced investment causes national income to increase by a magnified amount through multiplier.

So under the combined effect of multiplier and accelerator, national income or output will rapidly expand along the path from P0 to P1. Movement from PQ to P1 represents the upswing or expansion phase of the business cycle. But this expansion must stop at P1 because this is the full employment output ceiling. The limited human and material resources of the economy do not permit a greater expansion of national income than shown by the ceiling line CC.

Therefore, when point P1 is reached the rapid growth of national income must come to an end. Prof. Hicks assumes that the full employment ceiling grows at the same rate as autonomous investment. Therefore, CC slopes gently unlike the very steep slope of the line from P0 to P1. When point P1 is reached the economy must grow at the same rate as the usual growth in autonomous investment.

For a short time the economy may crawl along the full employment ceiling CC. But because national income has ceased to increase at the rapid rate, the induced investment via accelerator falls off to the level consistent with the modest rate of growth determined by the constant rate of growth of autonomous investment. But the economy cannot crawl along its full employment ceiling for a long time.

The sharp decline in growth of income and consumption when the economy strikes the ceiling causes a sharp decline in induced investment. Thus with the sharp decline in induced investment when national income and hence consumption ceases to increase rapidly, the contraction in the level of the income and business actually must begin.

Once the downswing starts, the accelerator works in the reverse direction. That is, since the change in income is now negative the inducement to invest must begin to decrease. Thus there is slackening off at point P2 and national income starts moving toward equilibrium growth path EE. This movement from P2 downward therefore represents the downswing or contraction phase of the business cycle.

In this downswing investment falls off rapidly and therefore multiplier works in the reverse direction. The fall in national income and output resulting from the sharp fall in induced investment will not stop on touching the level EE but will go further down. The economy must consequently move all the way down from point P2 to point Q1. But at point Q1 the floor has been reached.

Whereas the upswing was limited by the output ceiling set by the full employment of available resources, in the downswing the national income cannot fall below the level of output represented by the floor. This is because the floor level is determined by simple multiplier and autonomous investment growing at constant rate, while during the downswing after a point accelerator ceases to operate.

It may be noted that during downswing the limit to negative investment (disinvestment) and therefore the limit to the contraction of output is set by the depreciation of capital stock. There is no way for the businessmen to make disinvestment at a desired rate higher than the depreciation.

When during downswing such conditions arise, accelerator becomes inoperative. After hitting the floor the economy may for some time crawl along the floor through the path Q1 to Q2. In doing so, there is some growth in the level of national income. This rate of growth as before induces investment and both the multiplier and accelerator come into operation and the economy will move towards Q3 and the full employment ceiling CC. This is how the upswing of cyclical movement again starts.

Assumptions of Hicks Theory of Trade Cycle

The following assumptions were made to develop his theory of the trade cycle:

(i) In Hicksian analysis, a progressive economy is assumed in which autonomous investment is increasing at a regular rate, so that system is such which could remain in progressive equilibrium.

(ii) The saving and investment coefficients are such that an upward displacement from the equilibrium path will tend to cause a movement away from equilibrium, though this movement may be lagged.

(iii) There is no direct restraint upon upward expansion in the form of a scarcity of employable resources provided by the full employment ceiling i.e., it is impossible for the output to expand beyond full employment level.

(iv) Though there is no direct constraint on the contraction yet the transformation of accelerator in the downswing (i.e., disinvestment cannot exceed depreciation) provides an indirect constraint.

(v) There are fixed values of the multiplier and accelerator throughout the different phases of a cycle, i.e., consumption function and investment function are both assumed to be constant.

(vi) However, in Hicksian analysis both the multiplier and accelerator are treated with a lag. He treats multiplier as a lagged relation, so that consumption in period t is regarded as a function of income of the previous period t – 1 and not of current period t. He also uses accelerator with a time lag i.e., induced investment in present period also responds to output changes in the previous period.

Management Notes

Various Phases of Trade Cycle

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Trade Cycle, also known as the business cycle, refers to the recurring fluctuations in economic activity characterized by periods of expansion, peak, contraction, and trough. These cycles reflect the natural rhythm of economic growth and contraction within a market economy. During expansion phases, economic output, employment, and consumer spending increase, leading to prosperity. Peaks mark the highest point of economic activity. Contractions, or recessions, follow, characterized by decreased production, rising unemployment, and reduced consumer spending. Finally, troughs represent the lowest point of the cycle, before the economy begins to recover. Understanding trade cycles is crucial for policymakers, businesses, and investors to anticipate and manage the impacts of economic fluctuations on various sectors and stakeholders.

Four Phases of a Trade cycle are:

  1. Prosperity phase: Expansion or the upswing.
  2. Recessionary phase: A turn from prosperity to depression (or upper turning point).
  3. Depressionary phase: Contraction or downswing.
  4. Revival or recovery phase: The turn from depression to prosperity (or lower turning point).

The above four phases of a trade cycle are shown in Fig. 1. These phases are recurrent and follow a regular sequence.

Phases of a Trade Cycle

1. Expansion Phase:

The expansion phase marks the beginning of the trade cycle. It is characterized by increasing economic activity across various sectors of the economy. During this phase, several key indicators typically show positive trends:

  • Gross Domestic Product (GDP) Growth:

GDP, which measures the total value of goods and services produced within a country’s borders, tends to rise during the expansion phase. Increased production, consumer spending, and investment contribute to this growth.

  • Employment:

As economic activity expands, businesses experience rising demand for goods and services. This often leads to increased hiring to meet the growing demand, resulting in lower unemployment rates.

  • Consumer Spending:

Consumers tend to have more disposable income during periods of economic expansion, leading to increased spending on goods and services. This increased consumer demand further fuels economic growth.

  • Business Investment:

Businesses are more likely to invest in capital goods, such as machinery and equipment, during the expansion phase. Higher confidence in future economic prospects encourages firms to expand their productive capacity to meet growing demand.

  • Stock Market Performance:

Stock prices typically rise during the expansion phase as investors anticipate higher corporate profits and economic growth. Bull markets, characterized by rising stock prices, are common during this phase.

2. Peak Phase:

The peak phase represents the highest point of economic activity within the trade cycle. It is characterized by several key features:

  • Full Capacity Utilization:

During the peak phase, resources such as labor and capital are fully utilized as demand for goods and services reaches its highest levels. Production may be operating at or near maximum capacity.

  • Inflationary Pressures:

As demand outstrips supply during the peak phase, prices tend to rise, leading to inflationary pressures. This can be reflected in higher consumer prices, wage growth, and increased production costs.

  • Tight Labor Market:

With low unemployment rates and high demand for labor, competition for workers intensifies during the peak phase. This can lead to wage increases and labor shortages in certain industries.

  • Business Confidence:

Businesses may become increasingly optimistic about future economic prospects during the peak phase, leading to higher levels of investment and expansion plans.

  • Stock Market Volatility:

While stock prices may continue to rise during the peak phase, volatility often increases as investors become more cautious about the sustainability of economic growth.

3. Contraction Phase:

Following the peak phase, the economy enters the contraction phase, also known as a recession or downturn. This phase is characterized by declining economic activity and several negative trends:

  • GDP Contraction:

Economic output, as measured by GDP, begins to decline during the contraction phase as demand for goods and services weakens. This can be driven by factors such as reduced consumer spending, declining investment, and falling exports.

  • Rising Unemployment:

As businesses cut back on production and investment in response to weakening demand, unemployment rates tend to rise. Layoffs and hiring freezes become more common as companies adjust to the downturn.

  • Decreased Consumer Spending:

Consumer confidence often declines during the contraction phase, leading to reduced spending on discretionary goods and services. Consumers may prioritize essential purchases and cut back on non-essential items.

  • Declining Business Investment:

Businesses become more cautious about investing in new capital projects and expansion plans during the contraction phase. Uncertainty about future economic conditions and weak demand can lead to a decrease in business investment.

  • Stock Market Decline:

Stock prices typically fall during the contraction phase as investors react to negative economic news and uncertainty about future earnings prospects. Bear markets, characterized by falling stock prices, are common during recessions.

4. Trough Phase:

The trough phase represents the lowest point of the trade cycle and marks the end of the contraction phase. While economic conditions remain challenging, there are signs of stabilization and the beginning of recovery:

  • Stabilization of Economic Indicators:

Economic indicators such as GDP, employment, and consumer spending may stabilize or show signs of improvement during the trough phase. The rate of decline in economic activity begins to slow down.

  • Policy Responses:

Governments and central banks often implement monetary and fiscal policies to stimulate economic growth during the trough phase. These may include interest rate cuts, fiscal stimulus measures, and efforts to restore confidence in the financial system.

  • Inventory Rebuilding:

Businesses may start to rebuild inventories during the trough phase in anticipation of future demand. This can contribute to a gradual increase in production and economic activity.

  • Bottoming Out of Stock Market:

While stock prices may still be volatile during the trough phase, there may be signs that the market is bottoming out as investors anticipate a recovery in corporate earnings and economic growth.

  • Early Signs of Recovery:

Some sectors of the economy may begin to show signs of improvement during the trough phase, signaling the start of the recovery process. These early indicators can include increased consumer confidence, rising business investment, and stabilization in housing markets.

Management Notes

Trade Cycle: Introduction and Theories of Trade Cycle

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Trade Cycle refers to fluctuations in economic activities specially in employment, output and income, prices, profits etc. It has been defined differently by different economists. According to Mitchell, “Business cycles are of fluctuations in the economic activities of organized communities. The adjective ‘business’ restricts the concept of fluctuations in activities which are systematically conducted on commercial basis.

Features of a Trade Cycle

  • A business cycle is synchronic. When cyclical fluctuations start in one sector it spreads to other sectors.
  • In a trade cycle, a period of prosperity is followed by a period of depression. Hence trade cycle is a wave like movement.
  • Business cycle is recurrent and rhythmic; prosperity is followed by depression and vice versa.
  • Trade cycle is cumulative and self-reinforcing. Each phase feeds on itself and creates further movement in the same direction.
  • Trade cycle is asymmetrical. The prosperity phase is slow and gradual and the phase of depression is rapid.
  • The business cycle is not periodical. Some trade cycles last for three or four years, while others last for six or eight or even more years.
  • The impact of a trade cycle is differential. It affects different industries in different ways.
  • Trade cycle is international in character. Through international trade, booms and depressions in one country are passed to other countries.

Theories of Trade Cycle

Many theories have been put forward from time to time to explain the phenomenon of trade cycles. These theories can be classified into non-monetary and monetary theories.

Non-Monetary Theories of Trade Cycle

(a) Sunspot Theory or Climatic Theory

It is the oldest theory of trade cycle. It is associated with W.S.Jevons and later on developed by H.C.Moore. According to this theory, the spot that appears on the sun influences the climatic conditions. When the spot appears, it will affect rainfall and hence agricultural crops.

When there is crop failure, that will result in depression. On the other hand, if the spot did not appear on the sun, rainfall is good leading to prosperity. Thus, the variations in climate are so regular that depression is followed by prosperity.

However, this theory is not accepted today. Trade cycle is a complex phenomenon and it cannot be associated with climatic conditions. If this theory is correct, then industrialised countries should be free from cyclical fluctuations. But it is the advanced, industrialised countries which are affected by trade cycles.

(b) Psychological Theory

This theory was developed by A.C. Pigou. He emphasized the role of psychological factor in the generation of trade cycles. According to Pigou, the main cause for trade cycle is optimism and pessimism among business people and bankers. During the period of good trade, entrepreneurs become optimistic which would lead to increase in production.

The feeling of optimism is spread to other. Hence investments are increased beyond limits and there is over production, which results in losses. Entrepreneurs become pessimistic and reduce their investment and production. Thus, fluctuations are due to optimism leading to prosperity and pessimism resulting depression.

Though there is an element of truth in this theory, this theory is unable to explain the occurrence of boom and starting of revival. Further this theory fails to explain the periodicity of trade cycle.

(c) Overinvestment Theory

Arthur Spiethoff and D.H. Robertson have developed the over investment theory. It is based on Say’s law of markets. It believes that over production in one sector leads to over production in other sectors. Suppose, there is over production and excess supply in one sector, that will result in fall in price and income of the people employed in that sector. Fall in income will lead to a decline in demand for goods and services produced by other sectors. This will create over production in other sectors.

Spiethoff has pointed out that over investment is the cause for trade cycle. Over investment is due to indivisibility of investment and excess supply of bank credit. He gives the example of a railway company which lays down one more track to avoid traffic congestion. But this may result in excess capacity because the additional traffic may not be sufficient to utilise the second track fully.

Over investment and overproduction are encouraged by monetary factors. If the banking system places more money in the hands of entrepreneurs, prices will increase. The rise in prices may induce the entrepreneurs to increase their investments leading to over-investment. Thus Prof. Robertson has successfully combined real and monetary factors to explain business cycle.

This theory is realistic in the sense that it considers over investment as the cause of trade cycle. But it has failed to explain revival.

(d) Over-Saving or Under Consumption Theory

This theory is the oldest explanation of the cyclical fluctuations. This theory has been formulated by Malthus, Marx and Hobson. According to this theory, depression is due to over-saving. In the modern society, there is great inequalities of income. Rich people have large income but their marginal propensity to consume is less.

Hence they save and invest which results in an increase in the volume of goods. This causes a general glut in the market. At the same time, as majority of the people are poor, they have low propensity to consume. Therefore, consumption will not increase. Increase in the supply of goods and decline in the demand create under consumption and hence over production.

This theory is not free from criticism. This theory explains only the turning point from prosperity to depression. It does not say anything about recovery. This theory assumes that the amount saved would be automatically invested. But this is not true. It pays too much attention on saving and too little on others.

(e) Keynes’ Theory of Trade Cycles

Keynes doesn’t develop a complete and pure theory of trade cycles. According to Keynes, effective demand is composed of consumption and investment expenditure. It is effective demand which determines the level of income and employment.

Therefore, changes in total expenditure i.e., consumption and investment expenditures, affect effective demand and this will bring about fluctuation in economic activity. Keynes believes that consumption expenditure is stable and it is the fluctuation in investment expenditure which is responsible for changes in output, income and employment.

Investment depends on rate of interest and marginal efficiency of capital. Since rate of interest is more or less stable, marginal efficiency of capital determines investment. Marginal efficiency of capital depends on two factors – prospective yield and supply price of the capital asset. An increase in MEC will create more employment, output and income leading to prosperity. On the other hand, a decline in MEC leads to unemployment and fall in income and output. It results in depression.

During the period of expansion businessmen are optimistic. MEC is rapidly increasing and rate of interest is sticky. So entrepreneurs undertake new investment. The process of expansion goes on till the boom is reached. As the process of expansion continues, cost of production increases, due to scarcity of factors of production. This will lead to a fall in MEC. Further, price of the product falls due to abundant supply leading to a decline in profits.

This leads to depression. As time passes, existing machinery becomes worn out and has to be replaced. Surplus stocks of goods are exhausted. As there is a fall in price of raw-materials and equipment, costs fall. Wages also go down. MEC increases leading to recovery. Keynes states that, “Trade cycle can be described and analyzed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest”.

The merit of Keynes’ theory lies in explaining the turning points-the lower and upper turning points of a trade cycle. The earlier economists considered the changes in the amount of credit given by banking system to be responsible for cyclical fluctuations. But for Keynes, the change in consumption function with its effect on MEC is responsible for trade cycle. Keynes, thus, has given a satisfactory explanation of the turning points of the trade cycle, “Keynes consumption function filled a serious gap and corrected a serious error in the previous theory of the business cycle”.

Critics have pointed out the weakness of Keynes’ theory. Firstly, according to Keynes the main cause for trade cycle is the fluctuations in MEC. But the term marginal efficiency of capital is vague. MEC depends on the expectations of the entrepreneur about future. In this sense, it is similar to that of Pigou’s psychological theory. He has ignored real factors.

Secondly, Keynes assumes that rate of interest is stable. But rate of interest does play an important role in decision making process of entrepreneurs.

Thirdly, Keynes does not explain periodicity of trade cycle. In a period of recession and depression, according to Keynes, rate of interest should be high due to strong liquidity preference. But, during this period, rate of interest is very low. Similarly during boom, rate of interest should be low because of weak liquidity preference; but actually the rate of interest is high.

(f) Schumpeter’s Innovation Theory

Joseph A. Schumpeter has developed innovation theory of trade cycles. An innovation includes the discovery of a new product, opening of a new market, reorganization of an industry and development of a new method of production. These innovations may reduce the cost of production and may shift the demand curve. Thus innovations may bring about changes in economic conditions.

Suppose, at the full employment level, an innovation in the form of a new product has been introduced. Innovation is financed by bank loans. As there is full employment already, factors of production have to be withdrawn from others to manufacture the new product. Hence, due to competition for factors of production costs may go up, leading to an increase in price.

When the new product becomes successful, other entrepreneurs will also produce similar products. This will result in cumulative expansion and prosperity. When the innovation is adopted by many, supernormal profits will be competed away. Firms incurring losses will go out of business. Employment, output and income fall resulting in depression.

Schumpeter’s theory has been criticised on the following grounds.

Firstly, Schumpter’s theory is based on two assumptions viz., full employment and that innovation is being financed by banks. But full employment is an unrealistic assumption, as no country in the world has achieved full employment. Further innovation is usually financed by the promoters and not by banks. Secondly, innovation is not the only cause of business cycle. There are many other causes which have not been analysed by Schumpter.

Monetary Theories of Trade Cycles

(a) Over-Investment Theory

Prof. Von Hayek in his books on “Monetary Theory and Trade Cycle” and “Prices and Production” has developed a theory of trade cycle. He has distinguished between equilibrium or natural rate of interest and market rate of interest. Market rate of interest is one at which demand for and supply of money are equal.

Equilibrium rate of interest is one at which savings are equal to investment. If both equilibrium rate of interest and market rate of interest are equal, there will be stability in the economy. If equilibrium rate of interest is higher than market rate of interest there will be prosperity and vice versa.

For instance, if the market rate of interest is lower than equilibrium rate of interest due to increase in money supply, investment will go up. The demand for capital goods will increase leading to a rise in price of these goods. As a result, there will be a diversion of resources from consumption goods industries to capital goods industries. Employment and income of the factors of production in capital goods industries will increase.

This will increase the demand for consumption goods. There will be competition for factors of production between capital goods and consumption good industries. Factor prices go up. Cost of production increases. At this time, banks will decide to reduce credit expansion. This will lead to rise in market rate of interest above the equilibrium rate of interest. Investment will fall; production declines leading to depression.

Hayek’s theory has certain weaknesses:-

  • It is not easy to transfer resources from capital goods industries to consumer goods industries and vice versa.
  • This theory does not explain all the phases of trade cycle.
  • It gives too much importance to rate of interest in determining investment. It has neglected other factors determining investment.
  • Hayek has suggested that the volume of money supply should be kept neutral to solve the problem of cyclical fluctuations. But this concept of neutrality of money is based on old quantity theory of money which has lost its validity.

(b) Hawtrey’s Monetary Theory

Prof. Hawtrey considers trade cycle to be a purely monetary phenomenon. According to him non-monetary factors like wars, strike, floods, drought may cause only temporary depression. Hawtrey believes that expansion and contraction of money are the basic causes of trade cycle. Money supply changes due to changes in rates of interest.

When rate of interest is reduced by banks, entrepreneurs will borrow more and invest. This causes an increase in money supply and rise in price leading to expansion. On the other hand, an increase in the rate of interest will lead to reduction in borrowing, investment, prices and business activity and hence depression.

Hawtrey believes that trade cycle is nothing but small scale replica of inflation and deflation. An increase in money supply will lead to boom and vice versa, a decrease in money supply will result in depression.

Banks will give more loans to traders and merchants by lowering the rate of interest. Merchants place more orders which induce the entrepreneurs to increase production by employing more labourers. This results in increase in employment and income leading to an increase in demand for goods. Thus the phase of expansion starts.

Business expands; factors of production are fully employed; price increases further, resulting in boom conditions. At this time, the banks call off loans from the borrowers. In order to repay the loans, the borrowers sell their stocks. This sudden disposal of goods leads to fall in prices and liquidation of marginal firms. Banks will further contract credit.

Thus the period of contraction starts making the producers reduce their output. The process of contraction becomes cumulative leading to depression. When the economy is at the level of depression, banks have excess reserves. Therefore, banks will lend at a low rate of interest which makes the entrepreneurs to borrow more. Thus revival starts, becomes cumulative and leads to boom.

Hawtrey’s theory has been criticised on many grounds

  • Hawtrey’s theory is considered to be an incomplete theory as it does not take into account the non-monetary factors which cause trade cycles.
  • It is wrong to say that banks alone cause business cycle. Credit expansion and contraction do not lead to boom and depression. But they are accentuated by bank credit.
  • The theory exaggerates the importance of bank credit as a means of financing development. In recent years, all firms resort to plough back of profits for expansion.
  • Mere contraction of bank credit will not lead to depression if marginal efficiency of capital is high. Businessmen will undertake investment in-spite of high rate of interest if they feel that the future prospects are bright.
  • Rate of interest does not determine the level of borrowing and investment. A high rate of interest will not prevent the people to borrow. Therefore, it may be stated that banking system cannot originate a trade cycle. Expansion and contraction of credit may be a supplementary cause but not the main and sole cause of trade cycle.
Management Notes

Difficulties in Measuring National Income

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There are many conceptual and statistical problems involved in measuring national income by the income method, product method, and expenditure method.

We discuss them separately in the light of the three methods:

  1. Problems in Income Method

The following problems arise in the computation of National Income by income method:

(i) Owner-occupied Houses

A person who rents a house to another earns rental income, but if he occupies the house himself, will the services of the house-owner be included in national income. The services of the owner-occupied house are included in national income as if the owner sells to himself as a tenant its services.

For the purpose of national income accounts, the amount of imputed rent is estimated as the sum for which the owner-occupied house could have been rented. The imputed net rent is calculated as that portion of the amount that would have accrued to the house-owner after deducting all expenses.

(ii) Self-employed Persons

Another problem arises with regard to the income of self-employed persons. In their case, it is very difficult to find out the different inputs provided by the owner himself. He might be contributing his capital, land, labour and his abilities in the business. But it is not possible to estimate the value of each factor input to production. So he gets a mixed income consisting of interest, rent, wage and profits for his factor services. This is included in national income.

(iii) Goods meant for Self-consumption

In under-developed countries like India, farmers keep a large portion of food and other goods produced on the farm for self-consumption. The problem is whether that part of the produce which is not sold in the market can be included in national income or not. If the farmer were to sell his entire produce in the market, he will have to buy what he needs for self-consumption out of his money income. If, instead he keeps some produce for his self-consumption, it has money value which must be included in national income.

(iv) Wages and Salaries paid in Kind

Another problem arises with regard to wages and salaries paid in kind to the employees in the form of free food, lodging, dress and other amenities. Payments in kind by employers are included in national income. This is because the employees would have received money income equal to the value of free food, lodging, etc. from the employer and spent the same in paying for food, lodging, etc.

2. Problems in Product Method

The following problems arise in the computation of national income by product method:

(i) Services of Housewives

The estimation of the unpaid services of the housewife in the national income presents a serious difficulty. A housewife renders a number of useful services like preparation of meals, serving, tailoring, mending, washing, cleaning, bringing up children, etc.

She is not paid for them and her services are not including in national income. Such services performed by paid servants are included in national income. The national income is, therefore, underestimated by excluding the services of a housewife.

The reason for the exclusion of her services from national income is that the love and affection of a housewife in performing her domestic work cannot be measured in monetary terms. That is why when the owner of a firm marries his lady secretary, her services are not included in national income when she stops working as a secretary and becomes a housewife.

When a teacher teaches his own children, his work is also not included in national income. Similarly, there are a number of goods and services which are difficult to be assessed in money terms for the reason stated above, such as painting, singing, dancing, etc. as hobbies.

(ii) Intermediate and Final Goods

The greatest difficulty in estimating national income by product method is the failure to distinguish properly between intermediate and final goods. There is always the possibility of including a good or service more than once, whereas only final goods are included in national income estimates. This leads to the problem of double counting which leads to the overestimation of national income.

(iii) Second-hand Goods and Assets

Another problem arises with regard to the sale and purchase of second-hand goods and assets. We find that old scooters, cars, houses, machinery, etc. are transacted daily in the country. But they are not included in national income because they were counted in the national product in the year they were manufactured.

If they are included every time they are bought and sold, national income would increase many times. Similarly, the sale and purchase of old stocks, shares, and bonds of companies are not included in national income because they were included in national income when the companies were started for the first time. Now they are simply financial transactions and represent claims.

But the commission or fees charged by the brokers in the repurchase and resale of old shares, bonds, houses, cars or scooters, etc. are included in national income. For these are the payments they receive for their productive services during the year.

(iv) Illegal Activities

Income earned through illegal activities like gambling, smuggling, illicit extraction of wine, etc. is not included in national income. Such activities have value and satisfy the wants of the people but they are not considered productive from the point of view of society. But in countries like Nepal and Monaco where gambling is legalised, it is included in national income. Similarly, horse-racing is a legal activity in England and is included in national income.

(v) Consumers’ Service

There are a number of persons in society who render services to consumers but they do not produce anything tangible. They are the actors, dancers, doctors, singers, teachers, musicians, lawyers, barbers, etc. The problem arises about the inclusion of their services in national income since they do not produce tangible commodities. But as they satisfy human wants and receive payments for their services, their services are included as final goods in estimating national income.

(vi) Capital Gains

The problem also arises with regard to capital gains. Capital gains arise when a capital asset such as a house, some other property, stocks or shares, etc. is sold at higher price than was paid for it at the time of purchase. Capital gains are excluded from national income because these do not arise from current economic activities. Similarly, capital losses are not taken into account while estimating national income.

(vii) Inventory Changes

All inventory changes (or changes in stocks) whether positive or negative are included in national income. The procedure is to take changes in physical units of inventories for the year valued at average current prices paid for them.

The value of changes in inventories may be positive or negative which is added or subtracted from the current production of the firm. Remember, it is the change in inventories and not total inventories for the year that are taken into account in national income estimates.

(viii) Depreciation

Depreciation is deducted from GNP in order to arrive at NNP. Thus depreciation lowers the national income. But the problem is of estimating the current depreciated value of, say, a machine, whose expected life is supposed to be thirty years. Firms calculate the depreciation value on the original cost of machines for their expected life. This does not solve the problem because the prices of machines change almost every year.

(ix) Price Changes

National income by product method is measured by the value of final goods and services at current market prices. But prices do not remain stable. They rise or fall. When the price level rises, the national income also rises, though the national production might have fallen.

On the contrary, with the fall in the price level, the national income also falls, though the national production might have increased. So price changes do not adequately measure national income. To solve this problem, economists calculate the real national income at a constant price level by the consumer price index.

3. Problems in Expenditure Method

The following problems arise in the calculation of national income by expenditure method:

(i) Government Services

In calculating national income by, expenditure method, the problem of estimating government services arises. Government provides a number of services, such as police and military services, administrative and legal services. Should expenditure on government services be included in national income?

If they are final goods, then only they would be included in national income. On the other hand, if they are used as intermediate goods, meant for further production, they would not be included in national income. There are many divergent views on this issue.

One view is that if police, military, legal and administrative services protect the lives, property and liberty of the people, they are treated as final goods and hence form part of national income. If they help in the smooth functioning of the production process by maintaining peace and security, then they are like intermediate goods that do not enter into national income.

In reality, it is not possible to make a clear demarcation as to which service protects the people and which protects the productive process. Therefore, all such services are regarded as final goods and are included in national income.

(ii) Transfer Payments

There arises the problem of including transfer payments in national income. Government makes payments in the form of pensions, unemployment allowance, subsidies, interest on national debt, etc. These are government expenditures but they are not included in national income because they are paid without adding anything to the production process during the current year.

For instance, pensions and unemployment allowances are paid to individuals by the government without doing any productive work during the year. Subsidies tend to lower the market price of the commodities. Interest on national or public debt is also considered a transfer payment because it is paid by the government to individuals and firms on their past savings without any productive work.

(iii) Durable-use Consumers’ Goods

Durable-use consumers’ goods also pose a problem. Such durable-use consumers’ goods as scooters, cars, fans, TVs, furniture’s, etc. are bought in one year but they are used for a number of years. Should they be included under investment expenditure or consumption expenditure in national income estimates? The expenditure on them is regarded as final consumption expenditure because it is not possible to measure their used up value for the subsequent years.

But there is one exception. The expenditure on a new house is regarded as investment expenditure and not consumption expenditure. This is because the rental income or the imputed rent which the house-owner gets is for making investment on the new house. However, expenditure on a car by a household is consumption expenditure. But if he spends the amount for using it as a taxi, it is investment expenditure.

(iv) Public Expenditure

Government spends on police, military, administrative and legal services, parks, street lighting, irrigation, museums, education, public health, roads, canals, buildings, etc. The problem is to find out which expenditure is consumption expenditure and which investment expenditure is.

Expenses on education, museums, public health, police, parks, street lighting, civil and judicial administration are consumption expenditure. Expenses on roads, canals, buildings, etc. are investment expenditure. But expenses on defence equipment are treated as consumption expenditure because they are consumed during a war as they are destroyed or become obsolete. However, all such expenses including the salaries of armed personnel are included in national income.

Management Notes

Various Methods of Measurement of National Income

indiafreenotesby indiafreenotes0

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

Methods of Measurement of National Income

There are four methods of measuring national income. Which method is to be used depends on the availability of data in a country and the purpose in hand.

  1. Product Method

According to this method, the total value of final goods and services produced in a country during a year is calculated at market prices. To find out the GNP, the data of all productive activities, such as agricultural products, wood received from forests, minerals received from mines, commodities produced by industries, the contributions to production made by transport, communications, insurance companies, lawyers, doctors, teachers, etc. are collected and assessed at market prices. Only the final goods and services are included and the intermediary goods and services are left out.

  1. Income Method

According to this method, the net income payments received by all citizens of a country in a particular year are added up, i.e., net incomes that accrue to all factors of production by way of net rents, net wages, net interest and net profits are all added together but incomes received in the form of transfer payments are not included in it. The data pertaining to income are obtained from different sources, for instance, from income tax department in respect of high income groups and in case of workers from their wage bills.

  1. Expenditure Method

According to this method, the total expenditure incurred by the society in a particular year is added together and includes personal consumption expenditure, net domestic investment, government expenditure on goods and services, and net foreign investment. This concept is based on the assumption that national income equals national expenditure

  1. Value Added Method

Another method of measuring national income is the value added by industries. The difference between the value of material outputs and inputs at each stage of production is the value added. If all such differences are added up for all industries in the economy, we arrive at the gross domestic product.

Limitations in Measuring National Income

There are many conceptual and statistical problems involved in measuring national income by the income method, product method, and expenditure method.

  1. Problems in Income Method

The following problems arise in the computation of National Income by income method:

(i) Owner-occupied Houses

A person who rents a house to another earns rental income, but if he occupies the house himself, will the services of the house-owner be included in national income. The services of the owner-occupied house are included in national income as if the owner sells to himself as a tenant its services.

For the purpose of national income accounts, the amount of imputed rent is estimated as the sum for which the owner-occupied house could have been rented. The imputed net rent is calculated as that portion of the amount that would have accrued to the house-owner after deducting all expenses.

(ii) Self-employed Persons

Another problem arises with regard to the income of self-employed persons. In their case, it is very difficult to find out the different inputs provided by the owner himself. He might be contributing his capital, land, labour and his abilities in the business. But it is not possible to estimate the value of each factor input to production. So he gets a mixed income consisting of interest, rent, wage and profits for his factor services. This is included in national income.

(iii) Goods meant for Self-consumption

In under-developed countries like India, farmers keep a large portion of food and other goods produced on the farm for self-consumption. The problem is whether that part of the produce which is not sold in the market can be included in national income or not. If the farmer were to sell his entire produce in the market, he will have to buy what he needs for self-consumption out of his money income. If, instead he keeps some produce for his self-consumption, it has money value which must be included in national income.

(iv) Wages and Salaries paid in Kind

Another problem arises with regard to wages and salaries paid in kind to the employees in the form of free food, lodging, dress and other amenities. Payments in kind by employers are included in national income. This is because the employees would have received money income equal to the value of free food, lodging, etc. from the employer and spent the same in paying for food, lodging, etc.

2. Problems in Product Method

The following problems arise in the computation of national income by product method:

(i) Services of Housewives

The estimation of the unpaid services of the housewife in the national income presents a serious difficulty. A housewife renders a number of useful services like preparation of meals, serving, tailoring, mending, washing, cleaning, bringing up children, etc.

She is not paid for them and her services are not including in national income. Such services performed by paid servants are included in national income. The national income is, therefore, underestimated by excluding the services of a housewife.

The reason for the exclusion of her services from national income is that the love and affection of a housewife in performing her domestic work cannot be measured in monetary terms. That is why when the owner of a firm marries his lady secretary, her services are not included in national income when she stops working as a secretary and becomes a housewife.

When a teacher teaches his own children, his work is also not included in national income. Similarly, there are a number of goods and services which are difficult to be assessed in money terms for the reason stated above, such as painting, singing, dancing, etc. as hobbies.

(ii) Intermediate and Final Goods

The greatest difficulty in estimating national income by product method is the failure to distinguish properly between intermediate and final goods. There is always the possibility of including a good or service more than once, whereas only final goods are included in national income estimates. This leads to the problem of double counting which leads to the overestimation of national income.

(iii) Second-hand Goods and Assets

Another problem arises with regard to the sale and purchase of second-hand goods and assets. We find that old scooters, cars, houses, machinery, etc. are transacted daily in the country. But they are not included in national income because they were counted in the national product in the year they were manufactured.

If they are included every time they are bought and sold, national income would increase many times. Similarly, the sale and purchase of old stocks, shares, and bonds of companies are not included in national income because they were included in national income when the companies were started for the first time. Now they are simply financial transactions and represent claims.

But the commission or fees charged by the brokers in the repurchase and resale of old shares, bonds, houses, cars or scooters, etc. are included in national income. For these are the payments they receive for their productive services during the year.

(iv) Illegal Activities

Income earned through illegal activities like gambling, smuggling, illicit extraction of wine, etc. is not included in national income. Such activities have value and satisfy the wants of the people but they are not considered productive from the point of view of society. But in countries like Nepal and Monaco where gambling is legalised, it is included in national income. Similarly, horse-racing is a legal activity in England and is included in national income.

(v) Consumers’ Service

There are a number of persons in society who render services to consumers but they do not produce anything tangible. They are the actors, dancers, doctors, singers, teachers, musicians, lawyers, barbers, etc. The problem arises about the inclusion of their services in national income since they do not produce tangible commodities. But as they satisfy human wants and receive payments for their services, their services are included as final goods in estimating national income.

(vi) Capital Gains

The problem also arises with regard to capital gains. Capital gains arise when a capital asset such as a house, some other property, stocks or shares, etc. is sold at higher price than was paid for it at the time of purchase. Capital gains are excluded from national income because these do not arise from current economic activities. Similarly, capital losses are not taken into account while estimating national income.

(vii) Inventory Changes

All inventory changes (or changes in stocks) whether positive or negative are included in national income. The procedure is to take changes in physical units of inventories for the year valued at average current prices paid for them.

The value of changes in inventories may be positive or negative which is added or subtracted from the current production of the firm. Remember, it is the change in inventories and not total inventories for the year that are taken into account in national income estimates.

(viii) Depreciation

Depreciation is deducted from GNP in order to arrive at NNP. Thus depreciation lowers the national income. But the problem is of estimating the current depreciated value of, say, a machine, whose expected life is supposed to be thirty years. Firms calculate the depreciation value on the original cost of machines for their expected life. This does not solve the problem because the prices of machines change almost every year.

(ix) Price Changes

National income by product method is measured by the value of final goods and services at current market prices. But prices do not remain stable. They rise or fall. When the price level rises, the national income also rises, though the national production might have fallen.

On the contrary, with the fall in the price level, the national income also falls, though the national production might have increased. So price changes do not adequately measure national income. To solve this problem, economists calculate the real national income at a constant price level by the consumer price index.

3. Problems in Expenditure Method

The following problems arise in the calculation of national income by expenditure method:

(i) Government Services

In calculating national income by, expenditure method, the problem of estimating government services arises. Government provides a number of services, such as police and military services, administrative and legal services. Should expenditure on government services be included in national income?

If they are final goods, then only they would be included in national income. On the other hand, if they are used as intermediate goods, meant for further production, they would not be included in national income. There are many divergent views on this issue.

One view is that if police, military, legal and administrative services protect the lives, property and liberty of the people, they are treated as final goods and hence form part of national income. If they help in the smooth functioning of the production process by maintaining peace and security, then they are like intermediate goods that do not enter into national income.

In reality, it is not possible to make a clear demarcation as to which service protects the people and which protects the productive process. Therefore, all such services are regarded as final goods and are included in national income.

(ii) Transfer Payments

There arises the problem of including transfer payments in national income. Government makes payments in the form of pensions, unemployment allowance, subsidies, interest on national debt, etc. These are government expenditures but they are not included in national income because they are paid without adding anything to the production process during the current year.

For instance, pensions and unemployment allowances are paid to individuals by the government without doing any productive work during the year. Subsidies tend to lower the market price of the commodities. Interest on national or public debt is also considered a transfer payment because it is paid by the government to individuals and firms on their past savings without any productive work.

(iii) Durable-use Consumers’ Goods

Durable-use consumers’ goods also pose a problem. Such durable-use consumers’ goods as scooters, cars, fans, TVs, furniture’s, etc. are bought in one year but they are used for a number of years. Should they be included under investment expenditure or consumption expenditure in national income estimates? The expenditure on them is regarded as final consumption expenditure because it is not possible to measure their used up value for the subsequent years.

But there is one exception. The expenditure on a new house is regarded as investment expenditure and not consumption expenditure. This is because the rental income or the imputed rent which the house-owner gets is for making investment on the new house. However, expenditure on a car by a household is consumption expenditure. But if he spends the amount for using it as a taxi, it is investment expenditure.

(iv) Public Expenditure

Government spends on police, military, administrative and legal services, parks, street lighting, irrigation, museums, education, public health, roads, canals, buildings, etc. The problem is to find out which expenditure is consumption expenditure and which investment expenditure is.

Expenses on education, museums, public health, police, parks, street lighting, civil and judicial administration are consumption expenditure. Expenses on roads, canals, buildings, etc. are investment expenditure. But expenses on defence equipment are treated as consumption expenditure because they are consumed during a war as they are destroyed or become obsolete. However, all such expenses including the salaries of armed personnel are included in national income.

Management Notes

National Income, Meaning, Methods, expenditure method, income received approach, Production Method, Value added or Net product method

indiafreenotesby indiafreenotes0

National Income refers to the total monetary value of all final goods and services produced by the residents of a country during a specific accounting year. It includes income earned from both domestic and foreign sources, but only by citizens or institutions of the country. National income is a critical indicator of the economic performance of a nation and reflects the overall economic health and living standards of its population.

Economists often define national income as the net national product at factor cost (NNPfc). It is calculated by subtracting depreciation and indirect taxes from the Gross Domestic Product (GDP) and adding subsidies. It encompasses all forms of income—wages, rent, interest, and profit—earned by factors of production (land, labor, capital, and entrepreneurship).

According to Marshall: “The labour and capital of a country acting on its natural resources produce annually a certain net aggregate of commodities, material and immaterial including services of all kinds. This is the true net annual income or revenue of the country or national dividend.” In this definition, the word ‘net’ refers to deductions from the gross national income in respect of depreciation and wearing out of machines. And to this, must be added income from abroad.

Simon Kuznets has defined national income as “the net output of commodities and services flowing during the year from the country’s productive system in the hands of the ultimate consumers.”

On the other hand, in one of the reports of United Nations, national income has been defined on the basis of the systems of estimating national income, as net national product, as addition to the shares of different factors, and as net national expenditure in a country in a year’s time. In practice, while estimating national income, any of these three definitions may be adopted, because the same national income would be derived, if different items were correctly included in the estimate.

Methods of Estimating National Income:

National Income is a measure of the economic performance of a nation. It can be estimated using three primary methods: Production Method, Income Method, and Expenditure Method. All three aim to calculate the same value from different angles—output, income, and spending.

1. Expenditure Method of Estimating National Income

The Expenditure Method measures national income by calculating the total expenditure incurred on final goods and services produced within the domestic territory of a country during an accounting year. It reflects the demand side of the economy and is commonly used to calculate Gross Domestic Product (GDP) at market prices.

Components of Expenditure Method:

The formula is:

GDP (MP) = C + I + G + (X−M)

Where:

  • C – Private Final Consumption Expenditure: Spending by households on goods and services (e.g., food, clothing, education, etc.).
  • I – Gross Domestic Capital Formation (Investment Expenditure): Includes investment in fixed capital (machinery, buildings) and inventory accumulation by businesses.
  • G – Government Final Consumption Expenditure: Spending by the government on goods and services such as defense, education, and health.
  • X – Exports of Goods and Services: Goods and services sold to foreigners.
  • M – Imports of Goods and Services: Goods and services bought from foreign countries. It is subtracted because it’s not part of domestic production.

Steps to Calculate National Income using Expenditure Method:

Step 1: Calculate Final Consumption Expenditure

This is the first and largest component of national expenditure. It includes the total amount spent by households and government on final goods and services.

  • Private Final Consumption Expenditure (PFCE): It covers all spending by households on goods like food, clothing, healthcare, and services like education and entertainment.
  • Government Final Consumption Expenditure (GFCE): This includes all spending by the government on goods and services such as salaries of public servants, defense services, and public health.

Only final expenditures are counted to avoid double counting. Intermediate consumption is excluded.

Step 2: Measure Gross Domestic Capital Formation (Investment Expenditure)

This includes all investments made by businesses and the government in the production process.

  • Gross Fixed Capital Formation: Investments in buildings, machinery, vehicles, and infrastructure.
  • Change in Inventories: Any change in stock of raw materials, semi-finished, and finished goods held by firms.

Together, these reflect the value added to the capital stock of the economy.

Step 3: Calculate Net Exports (Exports – Imports)

Net exports reflect the value of foreign trade in the economy.

  • Exports (X): Goods and services produced domestically and sold abroad.
  • Imports (M): Goods and services produced abroad and purchased domestically.

To ensure only domestic production is accounted for, imports are subtracted from exports. The result is:

Net Exports=X−M

If exports exceed imports, net exports will be positive and add to national income. If imports exceed exports, net exports will be negative and reduce national income.

Step 4: Add All the Components to Get GDP at Market Prices (GDPMP)

Now that we have all three key components—consumption (C), investment (I), and net exports (X – M)—along with government expenditure (G), we calculate GDP at Market Prices:

GDP at M.P =C+I+G+(X−M)

Where:

  • C = Private Final Consumption
  • I = Investment
  • G = Government Final Consumption
  • X = Exports
  • M = Imports

This represents the total market value of all final goods and services produced within the domestic territory during the year.

Step 5: Deduct Net Indirect Taxes to Get GDP at Factor Cost (GDPFC)

GDP at market prices includes indirect taxes like GST and excise duties, which are not part of factor incomes. We deduct Net Indirect Taxes (NIT) to convert GDPMP into GDP at Factor Cost (GDPFC).

Step 6: Add Net Factor Income from Abroad (NFIA) to Get National Income

The final step involves adjusting for international income flows. We add Net Factor Income from Abroad (NFIA) to GDP at factor cost to get National Income or Net National Product at Factor Cost (NNPFC).

2. Income Received Approach (Income Method)

The Income Method of estimating national income focuses on calculating the total income earned by the factors of production (land, labor, capital, and entrepreneurship) in the production of goods and services within a country during an accounting year. It emphasizes the distribution side of national income rather than the production or expenditure side.

Basic Principle of Income Received Approach:

National income is the sum of all factor incomes earned in the form of:

  • Wages (for labor)
  • Rent (for land)
  • Interest (for capital)
  • Profits (for entrepreneurship)
  • Mixed incomes (for self-employed individuals)

Components of the Income Method:

The national income using the income method includes the following key components:

1. Compensation of Employees (Wages and Salaries)

  • Includes all forms of remuneration paid to labor.
  • Covers wages, salaries, bonuses, pensions, and employer’s contributions to social security.

2. Rent

  • Income earned from the use of land or property.
  • Includes actual rent and imputed rent of owner-occupied houses.

3. Interest

  • Income earned by capital as a factor of production.
  • Includes interest on loans used for production, but excludes interest on government bonds (transfer payment).

4. Profits

Income earned by entrepreneurs for taking business risks.

Includes:

  • Dividends,
  • Undistributed profits,
  • Corporate taxes.

5. Mixed Income of Self-employed

    • Many self-employed individuals perform multiple roles—capital owner, laborer, and entrepreneur—so their income is termed as “mixed income.”

6. Net Factor Income from Abroad (NFIA)

This is the difference between income earned by residents from abroad and income earned by foreigners in the domestic territory.

Formula for National Income (NNP at Factor Cost)

National Income =Wages + Rent + Interest + Profits + Mixed Income + NFIA

Steps to Estimate National Income by Income Method

Step 1. Identify all productive enterprises and institutions in the economy.

Step 2. Classify factor incomes paid by these entities—wages, rent, interest, profit, and mixed income.

Step 3. Exclude all non-production-related incomes such as:

  • Transfer payments (pensions, subsidies),
  • Windfall gains (lottery, capital gains),
  • Illegal incomes (black money),
  • Intermediate incomes.

Step 4. Add Net Factor Income from Abroad to include international income flows.

Step 5. The resulting figure is the Net National Product at Factor Cost (NNPFC)—which represents national income.

Advantages of Income Method:

  • Gives a clear understanding of income distribution among different sectors.

  • Useful for tax policy, wage regulation, and economic planning.

  • Helps in identifying the contribution of labor, capital, and entrepreneurship in GDP.

Limitations of Income Method:

  • Requires accurate and detailed income data, which is often difficult to collect.

  • Mixed income can be hard to classify accurately.

  • Incomes earned in the informal sector may be underreported or unrecorded.

3. Production Method of Estimating National Income

The Production Method, also called the Output Method or Value-Added Method, measures national income by calculating the total value of goods and services produced in the economy over a given period, usually one year. It is based on the principle of value addition at each stage of production.

Basic Principle of Production Method of Estimating National Income

This method calculates national income as the sum total of net value added at each stage in the production process across all sectors of the economy. The approach avoids double counting by subtracting the value of intermediate goods used during production.

Steps in the Production Method:

Step 1: Identify and Classify Productive Sectors

The economy is divided into three main sectors:

  • Primary Sector – Agriculture, forestry, fishing, mining.

  • Secondary Sector – Manufacturing, construction.

  • Tertiary Sector – Services like banking, transport, communication, education, health.

All productive enterprises in these sectors are included.

Step 2: Calculate Gross Value of Output (GVO)

For each enterprise or sector, calculate the total market value of output (goods and services) produced during the year:

GVO = Quantity of output × Market Price

Step 3: Subtract Intermediate Consumption to Find Gross Value Added (GVA)

To avoid double counting, subtract the value of intermediate goods and services used in production:

GVA = Gross Value of Output (GVO) − Intermediate Consumption

This step yields the Net Value Added by each firm or sector.

Step 4: Sum Up the GVA of All Sectors

Add the GVA from all sectors and industries to find the Gross Domestic Product at Market Price (GDPMP):

Step 5: Deduct Net Indirect Taxes to Find GDP at Factor Cost

GDPMP includes indirect taxes (like GST) and excludes subsidies. To arrive at GDP at Factor Cost (GDPFC):

GDP = GDP − Net Indirect Taxes

Where:

  • Net Indirect Taxes = Indirect Taxes – Subsidies

Step 6: Add Net Factor Income from Abroad to Find National Income

To convert Domestic Product into National Product, add Net Factor Income from Abroad (NFIA):

NNP = GDP + NFIA

This gives the Net National Product at Factor Cost, which is National Income.

Precautions While Using Production Method:

  • Avoid Double Counting: Only the value added at each stage should be considered, not the total value of output.

  • Exclude Non-productive Activities: Transfer payments, illegal activities, or purely financial transactions should not be included.

  • Consider Only Final Goods: Intermediate goods should be subtracted to ensure accuracy.

  • Include Imputed Values: Include estimated values like rent of owner-occupied houses and goods produced for self-consumption.

Advantages of Production Method:

  • Directly measures productive capacity and sectoral contribution.

  • Useful for identifying which sectors drive economic growth.

  • Helps in analyzing industrial structure and development.

Limitations of Production Method:

  • Difficult to get accurate data, especially from unorganized or informal sectors.

  • Challenges in estimating self-consumed goods or home-produced services.

  • Excludes non-market transactions which may be economically significant.

4. Value Added or Net Product Method

The Value Added Method, also known as the Net Product Method or Production Method, estimates national income by measuring the net contribution of each producing unit or sector in the economy. It is called the “value added” method because it focuses on the additional value created at each stage of the production process.

Steps in Calculating National Income Using the Value Added Method:

Step 1. Classification of Sectors

The economy is divided into three production sectors:

  • Primary Sector: Agriculture, fishing, mining, etc.
  • Secondary Sector: Manufacturing, construction, etc.
  • Tertiary Sector: Services like banking, trade, transport, etc.

Each sector contributes a portion of the total national income.

Step 2. Estimate Gross Value of Output (GVO)

For each enterprise or sector, compute the value of total production:

Gross Value of Output = Quantity Produced × Price

Step 3. Deduct Intermediate Consumption

Intermediate goods used in production are subtracted to find Gross Value Added (GVA):

GVA=Gross Value of Output−Intermediate Consumption

Step 4. Add Gross Value Added Across Sectors

Total Gross Value Added (GVA) from all sectors gives Gross Domestic Product at Market Price (GDPMP).

Step 5. Adjust for Taxes and Subsidies

To derive Gross Domestic Product at Factor Cost (GDPFC):

GDPFC=GDPMP−Net Indirect Taxes

Where:

Net Indirect Taxes = Indirect Taxes – Subsidies

Step 6. Add Net Factor Income from Abroad (NFIA)

To convert domestic product into national product, we add:

National Income (NNPFC) = GDP + Net Factor Income from Abroad

This yields the Net National Product at Factor Cost, which is the national income.

Advantages of Value Added Method:

  • Prevents double counting by focusing on net contributions.
  • Helps determine sector-wise contributions to the economy.
  • Useful for productivity analysis.

Precautions in Using This Method:

  • Include only productive activities (exclude transfers, illegal income).
  • Use imputed values where actual data isn’t available (e.g., rent of owner-occupied houses).
  • Exclude the value of intermediate goods.
  • Accurate data collection is essential, especially from informal sectors.

Concepts of National Income

There are a number of concepts pertaining to national income and methods of measurement relating to them.

(i) Gross National Product (GNP)

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

GNP includes four types of final goods and services:

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

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

Goods and services produced by the government; and

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

(ii) Gross Domestic Product (GDP)

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

(iii) Nominal and Real GDP

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

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

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

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

(iv) GDP Deflator

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

(v) GDP at Factor Cost

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

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

GDP at factor cost includes:

Compensation of employees i.e., wages, salaries, etc.

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

Mixed Income of Self- employed

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

In GDP at market price are included indirect taxes and are excluded subsidies by the government. Therefore, in order to arrive at GDP at factor cost, indirect taxes are subtracted and subsidies are added to GDP at market price.

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

(vi) Net Domestic Product (NDP)

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

(vii) GNP at Factor Cost

GNP at factor cost is the sum of the money value of the income produced by and accruing to the various factors of production in one year in a country. It includes all items mentioned above under income method to GNP less indirect taxes.

GNP at market prices always includes indirect taxes levied by the government on goods which raise their prices. But GNP at factor cost is the income which the factors of production receive in return for their services alone. It is the cost of production.

Thus GNP at market prices is always higher than GNP at factor cost. Therefore, in order to arrive at GNP at factor cost, we deduct indirect taxes from GNP at market prices. Again, it often happens that the cost of production of a commodity to the producer is higher than a price of a similar commodity in the market.

In order to protect such producers, the government helps them by granting monetary help in the form of a subsidy equal to the difference between the market price and the cost of production of the commodity. As a result, the price of the commodity to the producer is reduced and equals the market price of similar commodity.

For example if the market price of rice is Rs. 3 per kg but it costs the producers in certain areas Rs. 3.50. The government gives a subsidy of 50 paisa per kg to them in order to meet their cost of production. Thus in order to arrive at GNP at factor cost, subsidies are added to GNP at market prices.

GNP at Factor Cost = GNP at Market Prices – Indirect Taxes + Subsidies.

(viii) GNP at Market Prices

When we multiply the total output produced in one year by their market prices prevalent during that year in a country, we get the Gross National Product at market prices. Thus GNP at market prices means the gross value of final goods and services produced annually in a country plus net income from abroad. It includes the gross value of output of all items from (1) to (4) mentioned under GNP. GNP at Market Prices = GDP at Market Prices + Net Income from Abroad.

(xi) Net National Product (NNP)

NNP includes the value of total output of consumption goods and investment goods. But the process of production uses up a certain amount of fixed capital. Some fixed equipment wears out, its other components are damaged or destroyed, and still others are rendered obsolete through technological changes.

All this process is termed depreciation or capital consumption allowance. In order to arrive at NNP, we deduct depreciation from GNP. The word ‘net’ refers to the exclusion of that part of total output which represents depreciation. So NNP = GNP—Depreciation.

(x) NNP at Factor Cost

Net National Product at factor cost is the net output evaluated at factor prices. It includes income earned by factors of production through participation in the production process such as wages and salaries, rents, profits, etc. It is also called National Income. This measure differs from NNP at market prices in that indirect taxes are deducted and subsidies are added to NNP at market prices in order to arrive at NNP at factor cost. Thus

NNP at Factor Cost = NNP at Market Prices – Indirect taxes+ Subsidies

= GNP at Market Prices – Depreciation – Indirect taxes + Subsidies.

= National Income.

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

(xi) NNP at Market Prices

Net National Product at market prices is the net value of final goods and services evaluated at market prices in the course of one year in a country. If we deduct depreciation from GNP at market prices, we get NNP at market prices. So NNP at Market Prices = GNP at Market Prices—Depreciation.

(xii) Domestic Income

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

Domestic income includes:

  • Wages and salaries
  • Rents, including imputed house rents
  • Interest
  • Dividends
  • Undistributed corporate profits, including surpluses of public undertakings
  • Mixed incomes consisting of profits of unincorporated firms, self- employed persons, partnerships, etc., and
  • Direct taxes

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

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

(xiii) Personal Income

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

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

But business and government transfer payments, and transfer payments from abroad in the form of gifts and remittances, windfall gains, and interest on public debt which are a source of income for individuals are added to national income. Thus Personal Income = National Income – Undistributed Corporate Profits – Profit Taxes – Social Security Contribution + Transfer Payments + Interest on Public Debt.

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

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

 (xiv) Private Income

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

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

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

(xv) Disposable Income

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

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

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

Thus Disposable Income = National Income – Business Savings – Indirect Taxes + Subsidies – Direct Taxes on Persons – Direct Taxes on Business – Social Security Payments + Transfer Payments + Net Income from abroad.

(xvi) Per Capita Income

The average income of the people of a country in a particular year is called Per Capita Income for that year. This concept also refers to the measurement of income at current prices and at constant prices. For instance, in order to find out the per capita income for 2001, at current prices, the national income of a country is divided by the population of the country in that year.

(xvii) Real Income

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

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

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

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

Suppose 1990-91 is the base year and the national income for 1999-2000 is Rs. 20,000 crores and the index number for this year is 250. Hence, Real National Income for 1999-2000 will be = 20000 x 100/250 = Rs. 8000 crores. This is also known as national income at constant prices.

Management Notes

Degrees of Price Discrimination

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Price discrimination means charging different prices from different customers or for different units of the same product. In the words of Joan Robinson: “The act of selling the same article, produced under single control at different prices to different buyers is known as price discrimination.” Price discrimination is possible when the monopolist sells in different markets in such a way that it is not possible to transfer any unit of the commodity from the cheap market to the dearer market.

Degrees of price discrimination

Prof. Pigou in his Economics of Welfare describes three degrees of discriminating power which a monopolist may wield. The type of discrimination discussed above is called discrimination of the third degree. We explain below discrimination of the first degree and the second degree.

Discrimination of the First Degree (1st) or Perfect Discrimination

Discrimination of the first degree occurs when a monopolist charges “a different price against all the different units of commodity in. such wise that the price exacted for each was equal to the demand price for it and no consumer’s surplus was left to the buyers.”

Joan Robinson calls it perfect discrimi­nation when the monopolist sells each unit of the product at a separate price. Such discrimination is possible only when consumers are sold the units for which they are prepared to pay the highest price and thus they are not left with any consumer’s surplus.

For perfect price discrimination, two conditions are required

(1) To keep the buyers separate from each other, and

(2) To deal with each buyer on a take-it-or-leave-it basis. When the discriminator of first degree is able to deal with his customers on the above basis, he can transfer the whole of consumers’ surplus to himself. Consider Figure 1. Where DD1 is the demand curve faced by the monopolist. Each buyer is assumed as a price-taker. Suppose the discriminating monopolist sells four units of his product at four different prices:

OQ1 unit at OP1price, Q1Q2 unit at OP2 price, Q2Q3 unit at OP3 price and Q3Q4 unit at OP4 price. The total revenue (or price) obtained by him would be OQ4 AD. This area is the maximum expenditure that the consumers are willing to incur to buy all four units of the product under the first-degree discriminator’s all-or-nothing offer. But with no price discrimination under simple monopoly, the monopolist would sell all four units at the uniform price OP4 and thus obtain the total revenue of OQ4AP4.

This area represents the total expenditure that consumers would actually pay for the four units. Thus the difference between what Quantity the consumers were willing to pay (OQ4 AD) under Fig. 1 the take-it-or-leave-it offer of the first degree discrimi­nator and what they actually pay (OQ4AP4) to the simple monopolist, is consumers’ surplus. This is equal to the area of the triangle DAP4.

Thus under the first-degree price discrimination, the entire consumers’ surplus is pocketed by the monopolist when he charges a separate price for each unit of the product. Price discrimination of the first degree is rare and is to be found in such rare products as diamonds, jewels, precious stones, etc. But a monopolist must have full knowledge of the demand curve faced by him and he should know the maximum price that the consumers are willing to pay for each unit of the product he wants to sell.

Discrimination of the Second Degree (2nd) or Multi-part Pricing

In discrimination of the second degree, the monopolist divides the consumers in different slabs or groups or blocks and charges different prices for different slabs of the same product. Since the earlier units of the product have more utility for the consumers than the later ones, the monopolist charges a higher price for the former units and reduces the price for the later units in the respective slabs.

Such discrimination is only possible if the demand of each consumer below a certain maximum price is perfectly inelastic. Electric supply companies in developed countries practice discrimination of the second degree when they charge a high rate for the first slab of kilowatts of electricity consumed. As more electricity is used, the rate falls with subsequent slabs.

Figure 2 illustrates the second degree discrimination, where DD1is the demand curve for electric­ity on the part of domestic consumers in a town. CP3 represents the cost of generating electricity, so that the electricity company charges M1P1 rate per kw. up to OM1 units. For consuming the next M1 to М2 units, the rate is lowered to M2P2. The lowest rate charged is M3P3 for M2 to M3 units. M3P3 is, however, the lowest rate which will be charged even if a con­sumer consumes more than M3 units of electricity.

If the electricity company were to charge only one rate throughout, say M3P3the total revenue would not be maximized. It would be OCP3 M3But by charg­ing different rates for different unit slabs, it gets the total revenue equal to OM3 x P1M1 + OM2 x P2M2 + OM3x P3M3 Thus the second degree discriminator would take away a part of consumers’ surplus covered by the rectangles ABEP1and BCFP2 .The shaded area in three triangles DAP1 Р1ЕР2, and P2FP3 still remains with consumers as their surplus.

The second degree price discrimination is practised by telephone companies, railways, companies supplying water, electricity and gas in developed countries where these services are available in plenty. But it is not found in developing countries like India where such services are scarce.

The differences between the first and second degree price discrimination may be noted. In the first degree discrimination, the monopolist charges a different price for each different unit of the prod­uct. But in second degree discrimination, a number of units in one slab (or group or block) are sold at the lowest price and as the slabs increase, the prices charged by the monopolist are lowered. In the case of the former the monopolist takes away the whole of consumers’ surplus. But in the latter case, the monopolist takes away only a portion of the consumers’ surplus and the other portion is left with the buyer.

Conditions under which Price Discrimination is Possible

Price discrimination is possible under following conditions:

  1. Nature of Commodity

In the first place it is said that price discrimination is possible when the nature of the commodity or service is such that there is no possibility of transference from one market to the other.

That is, the goods sold in the cheaper market cannot be resold in the dearer market; otherwise the monopolist’s purpose will be defeated.

  1. Distance of Two Markets

Price discrimination is possible when the two markets or markets are separated by large distance or tariff barriers, so that it is not possible to transfer goods from a cheaper market to dearer markets. For instance, a monopolist may sell the same product at a higher price in Bombay and lower price in Meerut.

  1. Ignorance of the Consumers

Price discrimination is possible when the consumers are ignorant about price discrimination, they are not aware that in one part of the market prices are lower than in the other part. Thus, he purchases in dearer market, than in cheaper market since he is ignorant of the prices that are prevailing in different markets.

  1. Government Regulation

Price discrimination occurs when the government rules and regulations permit. For instance, according to rules, electricity rates are fixed at higher level for industrial purposes and lower for domestic uses. Similarly, railways charge by law higher fares from first class passengers than from the second class passengers. Hence, price discrimination is possible because of legal sanction.

  1. Geographical Discrimination

Price discrimination may be possible on account of geographical situations. The monopolist may discriminate between home and foreign buyers by selling at lower price in the foreign market than in the domestic market. Geographical discrimination is possible because no unit of the commodity sold in one market can be transferred to another.

  1. Difference in Elasticity of Demand

A commodity may have different elasticity of demand in different markets. Thus, the market of a commodity can be separated on the basis of its elasticity of demand.

Hence, a monopolist can charge different prices in different markets classified on the basis of elasticity of demand, low price is charged where demand is more elastic and high price in the market with the less elastic demand or inelastic demand.

  1. Artificial Difference between Goods

A monopolist may create artificial differences by presenting the same commodity under different names and labels, one for the rich and snobbish buyers and the other for the ordinary customers. For instance, a biscuit manufacturer may wrap small quantity of the biscuits, give it separate name and charge a higher price. Thus, he may charge different price for substantially the same product. He may charge Rs. 2/- for 100 gram wrapped biscuits and Rs. 1.50 for unwrapped biscuits.

Management Notes

Price Discrimination under Monopoly and Necessary Condition

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Price discrimination is a selling strategy that charges customers different prices for the same product or service, based on what the seller thinks they can get the customer to agree to. In pure price discrimination, the seller charges each customer the maximum price he or she will pay. In more common forms of price discrimination, the seller places customers in groups based on certain attributes and charges each group a different price.

Price discrimination is most valuable when the profit that is earned as a result of separating the markets is greater than the profit that is earned as a result of keeping the markets combined. Whether price discrimination works and for how long the various groups are willing to pay different prices for the same product depends on the relative elasticities of demand in the sub-markets. Consumers in a relatively inelastic submarket pay a higher price, while those in a relatively elastic sub-market pay a lower price.

[Important: Price discrimination charges customers different prices for the same products based on a bias toward groups of people with certain characteristics—such as educators versus the general public, domestic users versus international users, or adults versus senior citizens.]

With price discrimination, the company looking to make the sales identifies different market segments, such as domestic and industrial users, with different price elasticities. Markets must be kept separate by time, physical distance, and nature of use.

For example, Microsoft Office Schools edition is available for a lower price to educational institutions than to other users. The markets cannot overlap so that consumers who purchase at a lower price in the elastic sub-market could resell at a higher price in the inelastic sub-market. The company must also have monopoly power to make price discrimination more effective.

Price Discrimination under Monopoly

In monopoly, there is a single seller of a product called monopolist. The monopolist has control over pricing, demand, and supply decisions, thus, sets prices in a way, so that maximum profit can be earned.

The monopolist often charges different prices from different consumers for the same product. This practice of charging different prices for identical product is called price discrimination.

According to Robinson, “Price discrimination is charging different prices for the same product or same price for the differentiated product.”

According to Stigler, “Price discrimination is the sale of various products at prices which are not proportional to their marginal costs.

In the words of Dooley, “Discriminatory monopoly means charging different rates from different customers for the same good or service.”

According to J.S. Bains, “Price discrimination refers strictly to the practice by a seller to charging different prices from different buyers for the same good.”

Necessary Conditions for Price Discrimination

Price discrimination implies charging different prices for identical goods.

It is possible under the following conditions:

(i) Existence of Monopoly

Implies that a supplier can discriminate prices only when there is monopoly. The degree of the price discrimination depends upon the degree of monopoly in the market.

(ii) Separate Market

Implies that there must be two or more markets that can be easily separated for discriminating prices. The buyer of one market cannot move to another market and goods sold in one market cannot be resold in another market.

(iii) No Contact between Buyers

Refers to one of the most important conditions for price discrimination. A supplier can discriminate prices if there is no contact between buyers of different markets. If buyers in one market come to know that prices charged in another market are lower, they will prefer to buy it in other market and sell in own market. The monopolists should be able to separate markets and avoid reselling in these markets.

(iv) Different Elasticity of Demand

Implies that the elasticity of demand in the markets should differ from each other. In markets with high elasticity of demand, low price will be charged, whereas in markets with low elasticity of demand, high prices will be charged. Price discrimination fails in case of markets having same elasticity- of demand.

Types of Price Discrimination

Price discrimination is a common pricing strategy’ used by a monopolist having discretionary pricing power. This strategy is practiced by the monopolist to gain market advantage or to capture market position.

  1. Personal

Refers to price discrimination when different prices are charged from different individuals. The different prices are charged according to the level of income of consumers as well as their willingness to purchase a product. For example, a doctor charges different fees from poor and rich patients.

  1. Geographical

Refers to price discrimination when the monopolist charges different prices at different places for the same product. This type of discrimination is also called dumping.

  1. On the basis of use

Occurs when different prices are charged according to the use of a product. For instance, an electricity supply board charges lower rates for domestic consumption of electricity and higher rates for commercial consumption.

Conditions for Price Discrimination

Price discrimination is possible under the following conditions:

  • The seller must have some control over the supply of his product. Such monopoly power is necessary to discriminate the price.
  • The seller should be able to divide the market into at least two sub-markets (or more).
  • The price-elasticity of the product must be different in different markets. Therefore, the monopolist can set a high price for those buyers whose price-elasticity of demand for the product is less than 1. In simple words, even if the seller increases the price, such buyers do not reduce the purchase volume.
  • Buyers from the low-priced market should not be able to sell the product to buyers from the high-priced market.

Hence, we can conclude that a monopolist who employs price discrimination, charges a higher price from the market with inelastic demand. On the other hand, the market which is more responsive is charged less.

Difference between price discrimination and product differentiation

  • Charging different prices for similar goods is not pure price discrimination
  • Product differentiation gives a supplier greater control over price and the potential to charge consumers a premium price arising from differences in the quality or performance of a product
Management Notes

Pricing Theory: Pricing Under Different Market Conditions (Perfect Competition, Imperfect Competition and Monopoly)

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The theory of price is an economic theory whereby the price for any specific good or service is based on the relationship between supply and demand. The theory of price posits that the point at which the benefit gained from those who demand the entity meets the seller’s marginal costs is the most optimal market price for the good or service.

The theory of price, or price theory, is a microeconomic principle that uses the concept of supply and demand to determine the appropriate price point for a good or service. The goal is to achieve the equilibrium where the quantity of the goods or services provided match the demand of the corresponding market and its ability to acquire the good or service. The concept allows for price adjustments as market conditions change.

For example, suppose that market forces determine that a widget costs $5. A widget buyer is, therefore, willing to forgo the utility in $5 to possess the widget, and the widget seller perceives that $5 is a fair price for the widget. This simple theory of determining prices is one of the core principles underlying economic theory.

Pricing under different market conditions

  1. Perfect Competition

A perfectly competitive market is one in which the number of buyers and sellers is very large, all engaged in buying and selling a homogeneous product without any artificial restrictions and possessing perfect knowledge of market at a time. In the words of A. Koutsoyiannis, “Perfect competition is a market structure characterised by a complete absence of rivalry among the individual firms.” According to R.G. Lipsey, “Perfect competition is a market structure in which all firms in an industry are price- takers and in which there is freedom of entry into, and exit from, industry.”

Characteristics of Perfect Competition

The following are the conditions for the existence of perfect competition:

(a) Large Number of Buyers and Sellers

The first condition is that the number of buyers and sellers must be so large that none of them individually is in a position to influence the price and output of the industry as a whole. The demand of individual buyer relative to the total demand is so small that he cannot influence the price of the product by his individual action.

Similarly, the supply of an individual seller is so small a fraction of the total output that he cannot influence the price of the product by his action alone. In other words, the individual seller is unable to influence the price of the product by increasing or decreasing its supply.

Rather, he adjusts his supply to the price of the product. He is “output adjuster”. Thus no buyer or seller can alter the price by his individual action. He has to accept the price for the product as fixed for the whole industry. He is a “price taker”.

(b) Freedom of Entry or Exit of Firms

The next condition is that the firms should be free to enter or leave the industry. It implies that whenever the industry is earning excess profits, attracted by these profits some new firms enter the industry. In case of loss being sustained by the industry, some firms leave it.

(c) Homogeneous Product

Each firm produces and sells a homogeneous product so that no buyer has any preference for the product of any individual seller over others. This is only possible if units of the same product produced by different sellers are perfect substitutes. In other words, the cross elasticity of the products of sellers is infinite.

No seller has an independent price policy. Commodi­ties like salt, wheat, cotton and coal are homogeneous in nature. He cannot raise the price of his product. If he does so, his customers would leave him and buy the product from other sellers at the ruling lower price.

The above two conditions between themselves make the average revenue curve of the individual seller or firm perfectly elastic, horizontal to the X-axis. It means that a firm can sell more or less at the ruling market price but cannot influence the price as the product is homogeneous and the number of sellers very large.

(d) Absence of Artificial Restrictions

The next condition is that there is complete openness in buying and selling of goods. Sellers are free to sell their goods to any buyers and the buyers are free to buy from any sellers. In other words, there is no discrimination on the part of buyers or sellers.

Moreover, prices are liable to change freely in response to demand-supply conditions. There are no efforts on the part of the producers, the government and other agencies to control the supply, demand or price of the products. The movement of prices is unfettered.

(e) Profit Maximization Goal

Every firm has only one goal of maximizing its profits.

(f) Perfect Mobility of Goods and Factors

Another requirement of perfect competition is the perfect mobility of goods and factors between industries. Goods are free to move to those places where they can fetch the highest price. Factors can also move from a low-paid to a high-paid industry.

(g) Perfect Knowledge of Market Conditions

This condition implies a close contact between buyers and sellers. Buyers and sellers possess complete knowledge about the prices at which goods are being bought and sold, and of the prices at which others are prepared to buy and sell. They have also perfect knowledge of the place where the transactions are being carried on. Such perfect knowledge of market conditions forces the sellers to sell their product at the prevailing market price and the buyers to buy at that price.

(h) Absence of Transport Costs

Another condition is that there are no transport costs in carry­ing of product from one place to another. This condition is essential for the existence of perfect compe­tition which requires that a commodity must have the same price everywhere at any time. If transport costs are added to the price of the product, even a homogeneous commodity will have different prices depending upon transport costs from the place of supply.

(i) Absence of Selling Costs

Under perfect competition, the costs of advertising, sales-promotion, etc. do not arise because all firms produce a homogeneous product.

Perfect Competition vs Pure Competition

Perfect competition is often distinguished from pure competition, but they differ only in degree. The first five conditions relate to pure competition while the remaining four conditions are also required for the existence of perfect competition. According to Chamberlin, pure competition means, competi­tion unalloyed with monopoly elements,” whereas perfect competition involves perfection in many other respects than in the absence of monopoly.” The practical importance of perfect competition is not much in the present times for few markets are perfectly competitive except those for staple food products and raw materials. That is why, Chamberlin says that perfect competition is a rare phenomenon.”

Though the real world does not fulfill the conditions of perfect competition, yet perfect competi­tion is studied for the simple reason that it helps us in understanding the working of an economy, where competitive behaviour leads to the best allocation of resources and the most efficient organization of production. A hypothetical model of a perfectly competitive industry provides the basis for appraising the actual working of economic institutions and organizations in any economy.

  1. Imperfect Competition

Imperfect competition exists whenever a market, hypothetical or real, violates the abstract tenets of neoclassical pure or perfect competition. The contemporary theory of imperfect versus perfect competition stems from the Cambridge tradition of post-classical economic thought.

Characteristics of Imperfect competition

(i) Large number of Sellers and Buyers

There are large numbers of sellers in the market. All these firms are small sized. It means that each firm produces or sells such an insignificant portion of the total output or sale that it cannot influence the market price by its individual action. No firm can affect the sales of any other firm either by increasing or reducing its output; so there is no reaction from other firms. Every firm acts independently without bothering about the reactions of its rivals. There are a large number of buyers and none of them can affect price by his individual action.

(ii) Product Differentiation

Another important characteristic is product differentiation. The product of each seller may be similar to, but not identical with the product of other sellers in the industry. For example, a packet of Verka butter may be similar in kind to another packet of Vita butter, but because of the idea that there are differences, real or imaginary, in the quality of these two products, each buyer may have a definite preference for the one rather than for the other. As a result, each firm will have a group of buyers who prefer, for one reason or another, the product of that particular firm.

(iii) Selling Costs

Another important characteristic of the monopolistic competition is existence of selling costs. Since there is product differentiation and products are close substitutes, selling costs are important to persuade buyers to change their preferences, so as to raise their demand for a given article. Under monopolistic competition, advertisement is not only persuasive but also informatory because a large number of firms are operating in the market and buyer’s knowledge about the market is not perfect.

(iv) Free Entry and exit of Firms

Firms under monopolistic competition are free to join and leave the industry at any time they like to. The implication of this characteristic is that by entering freely into the market, the firms can produce close substitutes and increase the supply of commodity in the market. Similarly, the firm commands such a meager amount of resources that in the event of losses, they may easily quit the market.

(v) Price makers

In the monopolistic competitive market, each firm is a price-maker as it can determine the price of its own brand of the product.

(vi) Blend of Competition and Monopoly

In this market, each firm has a monopoly power over its product as it would not lose all customers if it raises the price as its product is not perfect substitute of other brands. At the same time, there is an element of competition because the consumers treat the different firms’ products as close substitutes. Hence, if a firm raises the price of its brand, it would lose some customers to other brands.

  1. Monopoly Market

Monopoly is a market situation in which there is only one seller of a product with barriers to entry of others. The product has no close substitutes. The cross elasticity of demand with every other product is very low. This means that no other firms produce a similar product. According to D. Salvatore, “Monopoly is the form of market organization in which there is a single firm selling a commodity for which there are no close substitutes.” Thus the monopoly firm is itself an industry and the monopolist faces the industry demand curve.

The demand curve for his product is, therefore, relatively stable and slopes downward to the right, given the tastes, and incomes of his customers. It means that more of the product can be sold at a lower price than at a higher price. He is a price-maker who can set the price to his maximum advantage.

However, it does not mean that he can set both price and output. He can do either of the two things. His price is determined by his demand curve, once he selects his output level. Or, once he sets the price for his product, his output is determined by what consumers will take at that price. In any situation, the ultimate aim of the monopolist is to have maximum profits.

Characteristics of Monopoly

The main features of monopoly are as follows:

  • Under monopoly, there is one producer or seller of a particular product and there is no differ­ence between a firm and an industry. Under monopoly a firm itself is an industry.
  • A monopoly may be individual proprietorship or partnership or joint stock company or a co­operative society or a government company.
  • A monopolist has full control on the supply of a product. Hence, the elasticity of demand for a monopolist’s product is zero.
  • There is no close substitute of a monopolist’s product in the market. Hence, under monopoly, the cross elasticity of demand for a monopoly product with some other good is very low.
  • There are restrictions on the entry of other firms in the area of monopoly product.
  • A monopolist can influence the price of a product. He is a price-maker, not a price-taker.
  • Pure monopoly is not found in the real world.
  • Monopolist cannot determine both the price and quantity of a product simultaneously.
  • Monopolist’s demand curve slopes downwards to the right. That is why, a monopolist can increase his sales only by decreasing the price of his product and thereby maximize his profit. The marginal revenue curve of a monopolist is below the average revenue curve and it falls faster than the average revenue curve. This is because a monopolist has to cut down the price of his product to sell an additional unit.
Management Notes

Market Structure, Meaning, Elements, Factors influencing Market Structure

indiafreenotesby indiafreenotes0

Market structure refers to the organizational and competitive characteristics of a market that influence the behavior and performance of the firms operating within it. It defines how businesses interact with each other, how prices are determined, and how easily new firms can enter or exit the market.

Elements or Determinants of Market Structure:

  • Number of Buyers and Sellers

The number of buyers and sellers in a market determines the degree of competition and price influence. In a perfectly competitive market, numerous sellers exist, none of which can individually influence price. In contrast, a monopoly has a single seller with complete price control. An oligopoly features a few dominant firms, often engaging in strategic pricing and product decisions. The greater the number of sellers, the more competitive the market becomes, leading to better choices and prices for consumers. On the buyer side, the presence of many buyers ensures demand diversity and minimizes buyer influence. If a few large buyers dominate (monopsony), they may exert significant control over prices and terms. Thus, the balance of buyers and sellers shapes the market’s competitive nature.

  • Nature of the Product

The type of product offered—whether homogeneous or differentiated—significantly influences market structure. In perfect competition, products are identical (e.g., wheat, salt), leaving firms with no control over pricing. In monopolistic competition, products are similar but differentiated by branding, quality, or features (e.g., clothing brands), allowing some pricing power. In oligopoly, products may be either homogeneous (e.g., cement) or differentiated (e.g., automobiles), and product features become strategic tools for competition. In a monopoly, the firm offers a unique product with no close substitutes, granting it full pricing authority. Product nature affects customer loyalty, elasticity of demand, and marketing strategies. The greater the product differentiation, the more power a firm has to set prices and influence consumer choices.

  • Degree of Price Control

Price control refers to the extent to which a firm can influence the price of its product. In perfect competition, firms are price takers—they accept market-determined prices due to intense competition and identical products. In monopolistic competition, firms have limited pricing power due to brand loyalty and differentiation. In oligopolies, firms have considerable price control, but often follow price leadership or engage in collusive pricing to avoid price wars. A monopolist, on the other hand, is a price maker, setting prices to maximize profits, although constrained by consumer demand and potential regulation. The degree of price control depends on factors like product uniqueness, market entry barriers, and consumer sensitivity. Understanding price control helps assess market power and the potential for consumer exploitation or competitive pricing.

  • Entry and Exit Barriers

Ease of market entry and exit is a key element of market structure, affecting the level of competition and innovation. In perfect competition, there are no barriers, allowing new firms to enter freely and keep profits in check. In monopolistic competition, entry is relatively easy, though branding may pose minor challenges. In oligopoly, high entry barriers such as heavy capital investment, economies of scale, and control over distribution prevent new competitors from entering. In a monopoly, barriers are the highest, often due to patents, government licenses, or ownership of key resources. These barriers protect existing firms from competition, allowing them to maintain profits and influence. Lower entry and exit barriers promote market dynamism, while higher barriers can lead to reduced competition, higher prices, and consumer disadvantage.

Factors influencing Market Structure:

  • Number of Firms in the Market

The number of firms determines the level of competition in a market. A large number of firms typically results in a competitive structure like perfect or monopolistic competition, where no single firm dominates. Fewer firms may lead to oligopoly or monopoly, where market power is concentrated. The higher the number of firms, the less control each has over pricing and supply. This factor directly affects how freely new businesses can enter the market, influence prices, and affect consumer choices, shaping the overall structure and nature of business rivalry.

  • Nature of the Product

The similarity or differentiation of products significantly impacts market structure. Homogeneous products, such as grains or steel, lead to perfect competition, where firms compete solely on price. Differentiated products, like branded clothing or electronics, result in monopolistic competition or oligopoly, where firms gain some price control through branding and features. A unique product with no substitutes, as seen in a monopoly, gives complete pricing power to the firm. The more distinct the product, the higher the potential for firms to establish loyal customer bases and exercise market influence.

  • Control Over Prices

The degree of control firms have over pricing determines their influence in the market. In perfect competition, firms are price takers—they cannot alter prices due to intense rivalry. In monopoly, a firm is a price maker, controlling prices due to a lack of substitutes. Oligopolistic firms have considerable price-setting power but often avoid price wars through collusion or tacit agreements. Price control is shaped by product uniqueness, brand value, and the availability of alternatives. More price control indicates less competition and a more concentrated market structure.

  • Barriers to Entry and Exit

Barriers affect how easily new firms can enter or leave a market. Low barriers promote competition, as seen in perfect and monopolistic competition. High barriers, like legal restrictions, high startup costs, and access to technology, protect established firms in oligopolies and monopolies, reducing competition. These barriers determine market dynamics, profitability, and innovation levels. The ease or difficulty of entering the market shapes the competitive intensity, and hence, the overall market structure. Exit barriers, such as long-term contracts or sunk costs, also influence firms’ decisions and market fluidity.

  • Economies of Scale

When firms grow large enough to lower average costs through mass production, they experience economies of scale. This factor influences market structure by favoring oligopolies and monopolies, where large firms dominate due to cost advantages. Smaller firms find it difficult to compete, leading to a concentrated market. The presence of economies of scale raises entry barriers, discouraging new entrants and reducing competition. Industries like telecom, aviation, and energy often display this trait. This factor strengthens the position of existing firms and shapes the strategic behavior in the industry.

  • Level of Innovation and Technology

High levels of innovation and advanced technology can significantly affect market structure. In tech-driven industries, early adopters often gain a temporary monopoly due to patents, proprietary processes, or first-mover advantages. Rapid innovation can reduce entry barriers if technology is widely accessible, but may also create new barriers when it involves complex, capital-intensive processes. Innovation leads to product differentiation, changing competitive dynamics and often shifting markets from monopolistic to oligopolistic forms. It influences firm growth, pricing strategies, and the overall shape of market competition.

  • Government Policies and Regulations

Government intervention through licensing, tariffs, price controls, and antitrust laws significantly influences market structure. Policies that encourage free trade and deregulation promote competition, while those granting monopoly rights or subsidies can limit it. Regulatory frameworks may either lower or raise entry barriers, depending on their objectives. For instance, strict patent laws can create monopolies, while competition laws may break up large firms. These rules impact pricing, market access, and competitive fairness, playing a crucial role in shaping the structure and efficiency of different markets.

The features of market structures are shown in Table 1.

Important features of market structure:

  • Number and Size of Buyers and Sellers

The number and relative size of buyers and sellers directly influence the nature of competition in a market. In perfect competition, there are many small buyers and sellers, so no single entity can influence the price. In contrast, monopoly features one large seller dominating the entire market. Oligopoly has few large sellers, while monopolistic competition has many sellers offering differentiated products. The balance of power between buyers and sellers determines price-setting behavior, market entry, and overall market dynamics.

  • Nature of the Product

Products can be homogeneous (identical) or differentiated. Homogeneous goods (e.g., wheat, sugar) are typical of perfect competition, where consumers have no preference between suppliers. Differentiated products (e.g., smartphones, clothing) are associated with monopolistic competition or oligopoly, where branding and features give firms some pricing power. In monopoly, the product is unique with no close substitutes. The product’s nature shapes consumer choice, pricing strategy, and firm competitiveness, making it a key feature in defining the structure of a market.

  • Degree of Price Control

Price control refers to how much influence firms have over the price of their products. In perfect competition, firms are price takers, accepting market-determined prices. In contrast, monopolies are price makers, having full control due to lack of substitutes. Oligopolies have partial control and often avoid price wars through mutual understanding. Monopolistic competitors can influence prices slightly due to product differentiation. The ability to control prices affects profitability, strategic planning, and the level of consumer surplus in different market structures.

  • Entry and Exit Conditions

The ease with which firms can enter or exit the market impacts the level of competition. Free entry and exit, seen in perfect and monopolistic competition, keeps profits normal in the long run. High entry barriers in monopoly and oligopoly markets, such as large capital requirements, patents, and government regulations, protect existing firms from new competitors. These conditions influence firm behavior, investment decisions, and the long-term structure of the industry. Exit barriers also matter, including sunk costs and contractual obligations.

  • Flow of Information

Market transparency, or the availability of information, significantly impacts decision-making. In perfect competition, information is perfect and freely available to all participants, ensuring rational decisions and uniform prices. In monopoly, oligopoly, or monopolistic competition, information may be asymmetric—some firms have better access to market data, customer preferences, or production techniques. Information asymmetry leads to inefficiencies, mispricing, and poor resource allocation. The better the information flow, the more efficient and competitive the market structure becomes.

  • Interdependence Among Firms

In oligopoly, firms are highly interdependent; the actions of one firm significantly impact others. For example, a price cut by one may trigger retaliatory pricing. In monopoly and perfect competition, interdependence is minimal—monopolies face no rivals, and perfect competitors are too small to affect market outcomes. Monopolistic competition lies in between, with firms competing based on product features. This interdependence influences strategic behavior, including pricing, advertising, and innovation, and it makes game theory and collusion relevant in oligopolistic settings.

  • Government Regulation and Legal Framework

Government rules and policies shape the nature and behavior of market structures. Antitrust laws, price controls, trade regulations, and licensing influence how freely firms can operate, compete, or dominate. Monopolies may be state-sanctioned, while competitive markets are supported by policies promoting transparency and consumer rights. Legal restrictions may also create barriers to entry, affecting the long-term dynamics of the industry. In regulated markets, government action balances business interests with consumer welfare, playing a crucial role in defining market behavior and structure.

  • Profit Margins and Cost Efficiency

The structure of a market significantly impacts potential profit margins and cost structures. Perfect competition leads to minimal profit margins due to intense competition and price pressure. In contrast, monopolies enjoy higher profit margins due to price-setting power and absence of competition. Oligopolistic firms also enjoy significant profits through collusion or differentiated services. Monopolistic competitors rely on brand value to maintain margins. Additionally, cost efficiency varies—larger firms may benefit from economies of scale, leading to lower average costs and higher profitability in certain structures.

Types of market structure:

1. Perfect Competition

Perfect competition is an idealized market structure where a large number of small firms sell identical products. No single firm can influence the price, making them price takers. The product is homogeneous, and all buyers and sellers have perfect knowledge. Entry and exit are completely free, and there is no government intervention. Examples include agricultural markets like wheat or rice, where products are uniform and pricing is dictated by market forces. Long-run profits tend toward normal, and efficiency is maximized.

2. Monopoly

A monopoly exists when a single firm dominates the entire market with no close substitutes for its product. The firm is a price maker, meaning it has full control over the price. High entry barriers such as patents, licenses, large capital requirements, or government protection prevent other firms from entering. Consumers have limited choices, and the monopolist maximizes profit by producing where marginal cost equals marginal revenue. Examples include utilities like electricity and water supply in many regions.

3. Monopolistic Competition

This structure features many sellers offering similar but differentiated products. Firms have some price-setting power due to brand identity, quality, packaging, or advertising. Entry and exit are relatively easy, and information is fairly well distributed among buyers and sellers. This market is common in retail sectors like clothing, restaurants, or consumer electronics, where consumers perceive differences in brands even if the underlying product is similar. Firms compete on both price and non-price factors like style, location, and service.

4. Oligopoly

In an oligopoly, a few large firms dominate the market. Products may be homogeneous (e.g., steel, cement) or differentiated (e.g., cars, smartphones). Firms are interdependent and often respond to each other’s actions—especially regarding pricing and output. Barriers to entry are high, which keeps competition limited. Pricing may be rigid due to fear of price wars. Strategic planning and collusion (formal or informal) are common. Real-world examples include the airline industry, telecom sector, and automobile manufacturing.

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