CBSE Class 12 Economics HOTs Economics Forms of Market and Price Determination Set 02

UNIT 1- National Income and related aggregates

Circular flow of income : Circular flow of income is how income generates in production process, then gets distributed among factors of production and ultimately gets disposed in the form of consumption expenditure on goods and service by households.

Phases of Circular flow of income

• 1. Generation phase – income is generated in production phase by firms.
• 2. Distribution phase - income distributed among factors of production and flows from firms to households.
• 3. Disposition phase – income is spent by households on goods and services and flows from households back to firms.

Stock variable: stock variable is a variable whose magnitude is measured at a particular point of time. It is not time dimensional. Examples are capital, wealth, fixed assets, distance, population, money supply etc.

Flow variable : flow variable is a variable whose magnitude is measured during a given period of time. It is time dimensional. Examples are income ,expenditure, export , import , GDP, production etc.

Question. Explain the phases of Circular flow of income.
Answer: The phases of circular flow of income are: (1) Generation phase where income is generated in the production phase by firms, (2) Distribution phase where income is distributed among factors of production and flows from firms to households, and (3) Disposition phase where income is spent by households on goods and services and flows from households back to firms.

Question. Write difference between stock and flow. Give examples.
Answer: Stock variable is measured at a particular point of time and is not time dimensional (e.g., wealth, capital). Flow variable is measured during a given period of time and is time dimensional (e.g., income, export).

Question. Identify stock and flow variable from the following and give reason.
a. Wealth
b. Investment
c. Income
d. Capital
e. Export
Answer: (a) Wealth is a stock because it's measured at a point in time. (b) Investment is a flow because it is measured over a period. (c) Income is a flow because it is earned over time. (d) Capital is a stock because it exists at a specific point in time. (e) Export is a flow because it occurs over a period of time.

Final goods – final goods are the goods which are purchased for consumption by consumer households and for investment by firms. E.g. milk purchased by consumer, machinery purchased by a firm etc. value of final goods is added in national income.

Intermediate goods – intermediate goods are the goods which are:
a. Purchased for resale purpose by a firm in the same year. And
b. Completely used up in the production process.
Examples are milk purchased by a dairy, wheat purchased to make biscuit by a factory etc.

Value of intermediate goods are not to be added to national income as these are included in the value of final goods. Adding value of intermediate goods in national income leads to problem of double counting and overestimates the national income.

Consumption/consumer goods – these are the goods which satisfy the wants of consumers directly. For example wheat, clothes , washing machine etc.

Capital goods- these are the final goods which help in the production of goods and services and have expected life time of more than one year. E.g tools and equipment , machinery purchased by firms etc.

Consumption of fixed capital (depreciation) : It is the fall in the value of fixed assets due to normal wear and tear and expected obsolescence. It can be calculated by dividing the value of fixed assets by its expected life in number of years.

Gross Investment – it is the addition to the stock of capital of an economy during a given period of time.

Net Investment – it is the net addition to the stock of capital of an economy during a given period of time.

Note : net investment = gross investment - Consumption of fixed capital (depreciation).

What domestic territory includes:

1. Political frontiers including territorial water and airspace.

2. Ships and aircrafts operated by residents between two or more countries.

3. Fishing vessels, oil and natural gas rigs, floating platforms operated by residents in the international water.

4. Embassies , consulates and military establishments of the country located abroad.

Normal resident : normal resident refer to an individual or institution who ordinarily resides in a country and whose centre of economic interest lies in that country.
*Citizens of other country who resides in India for more than one year becomes normal resident of India.

Factor income- income which is received by factors of production for rendering their services in the production process. Factor income is included in national income. Examples are rent ,wages, interest and profit.

Transfer income – income which is received without rendering productive services in return. It is not included in national income. Examples are old age pensions, scholarships e.t.c.

Question. Classify the following goods into final and intermediate goods with reason.
a. Wheat purchased by a flour mill.
b. Tractor purchased by a farmer.
c. Car purchased by a taxi driver.
d. Computer purchased by a school.
e. Goods unsold at the end of year.
Answer: (a) Intermediate good as it is used for further production. (b) Final good as it is an investment for the farmer. (c) Final good as it is an investment for the taxi driver. (d) Final good as it is an investment for the school. (e) Final good as it is treated as addition to inventory/investment.

Question. Write differences between transfer income and factor income. Give examples.
Answer: Factor income is earned by providing factor services (e.g., rent, wages) and is included in national income. Transfer income is received without providing any service (e.g., old age pensions, scholarships) and is not included in national income.

Question. Difference between gross investment and net investment is……………..
Answer: Consumption of fixed capital (depreciation).

Question. Which of the following are normal residents of India:
a. American visiting India for medical treatment.
b. Sri Lankan working in Indian company in India since 2017.
c. Tourist visiting India for one month.
Answer: (b) Sri Lankan working in Indian company in India since 2017 is a normal resident as they have resided for more than one year.

Question. Branch of Indian company in USA comes under domestic territory of …………………
Answer: USA

Question. Indian embassy in Afghanistan comes under domestic territory of …………………
Answer: India

National income(\( NNP_{FC} \)):-it is the sum total of factor incomes generated by the normal residents of a country within the domestic territory of that country and in rest of world during an accounting year. It includes NFIA.

Domestic income(\( NDP_{FC} \)):- it is the sum total of factor incomes generated within the domestic territory of a country by residents and non residents during an accounting year. It does not include NFIA.

Important concepts:

\( GDP_{MP} = GDP_{FC} + \text{INDIRECT TAXES} - \text{SUBSIDIES} \)

\( GNP_{MP} = GDP_{MP} + \text{NFIA} \)

\( NNP_{FC} = GDP_{MP} - \text{CONSUMPTION OF FIXED CAPITAL} + \text{NFIA} - \text{INDIRECT TAXES} + \text{SUBSIDIES} \)

\( \text{NFIA} = \text{FIFA} - \text{FITA} \)

\( \text{NET INDIRECT TAXES} = \text{INDIRECT TAXES} - \text{SUBSIDIES} \)

Question. Now calculate \( NNP_{FC} \) from the following.
\( GDP_{MP} = 1500 \)
GST (INDIRECT TAXES) = 150
SUBSIDIES = 50
NFIA = 100
DEPRECIATION = 200
Answer: \( NNP_{FC} = GDP_{MP} - \text{Depreciation} + \text{NFIA} - (\text{Indirect Taxes} - \text{Subsidies}) \)
\( NNP_{FC} = 1500 - 200 + 100 - (150 - 50) \)
\( NNP_{FC} = 1300 + 100 - 100 = 1300 \)

Items not to be included in national income and domestic income.( PRECAUTIONS)

• S – Second hand goods ‘sale and purchase( already counted in the NY of the year they were produced.)
• W- Wind fall gains like winning from lottery, horse race etc.(no contribution to flow of goods & services)
• I – Intermediate goods value.( already included in value of final goods.)
• F – financial transactions like sale& purchase of shares ,debentures(no contribution to flow of goods &services).
• T – Transfer income and payments (no contribution to flow of goods & services)

Besides production of services for self consumption is not included (difficult to measure market value)

But, production of goods for self consumption is included (as it contribute to current production)

Which of the following will be included in national income (give reasons)

Question. Commission and brokerage
Answer: ( yes, these are productive services)

Question. Construction of flyovers, hospitals ,school, building
Answer: ( yes, these are part of capital formation)

Question. Free meals, clothes , bonus , rent free house, medical facilities, retirement pension, salaries and wages in cash, to employees.
Answer: ( yes , as these are part of compensation of employees)

Question. Dividend / undistributed profit
Answer: ( yes ,as these are part of operating surplus ).

Question. Interest paid by firm to bank
Answer: ( yes, the interest has been paid on loan taken for productive purpose.

Question. Interest paid by individual to bank
Answer: (no ,the interest has been paid on loan taken for consumption purpose.

Question. Dividend received by Ram from a foreign company .
Answer: ( yes ,as it is a part of FIFA)

Question. Expenditure on advertisement/scientific research/entertainment allowance
Answer: ( no ,as these are intermediate expenditures.

Question. Salaries paid to Indian working in USA embassy in India
Answer: (Yes ,it is a part of FIFA)

Question. Dividend received by a foreigner from investment in Indian company
Answer: ( No, as it is FITA)

Question. Old age pension/scholarships/remittances/GST
Answer: ( no, as these are transfer income/payments)

Question. Expenditure by government on street light , free medicines & education
Answer: ( yes, as these are part of government final consumption expenditure)

Question. Purchase of truck to transport goods by a company
Answer: (Yes, it is a part of capital formation/investment expenditure)

Question. Payment of income tax
Answer: (No, as it is a compulsory transfer payment)

Question. Expenditure by government on providing free education
Answer: (Yes, part of government final consumption expenditure)

Question. Payment of fees to a lawyer engaged by a firm.
Answer: (No, it is an intermediate expenditure for the firm)

Which of the following will be included in domestic income (give reasons)

Question. Dividend received by Ram from a foreign company .
Answer: ( no, as it is not generated in the domestic territory of India)

Question. Salaries paid to Indian working in USA embassy in India
Answer: (no, as it is not generated in the domestic territory of India)

Question. Dividend received by a foreigner from investment in Indian company.
Answer: ( Yes, as it is generated in the domestic territory of India)

Question. Salaries paid to Japanese working in Indian embassy in Japan
Answer: (Yes ,as it is generated in the domestic territory of India)

Question. Domestic/household services performed by a woman may not be considered as an economic activity. Defend or refute the given statement with valid reason.
Answer: Defend. These services are not included because their market value is difficult to estimate and they are not rendered for a market price.

Question. Compensation to the victims of a cyclone is an example of a welfare measure taken by the government. State with valid reason, should it be included/not included in the estimation of national income of India.
Answer: It should not be included because it is a transfer payment, as no productive service is rendered in return.

REAL GDP (GDP AT CONSTANT PRICE) vs NOMINAL GDP (GDP AT CURRENT PRICE)

• Real GDP: GDP Measured at base year prices. Affected by change in quantity of physical output. Measures the true performance of growth of the Economy.
• Nominal GDP: GDP Measured at current year prices. Affected by both change in price and quantity of physical output. Not necessarily measures true performance of growth of the Economy.

\( \text{Real GDP} = (\text{Nominal GDP} \times 100 / \text{GDP Deflator}) \)

REAL NATIONAL INCOME vs NOMINAL NATIONAL INCOME

• Real National Income: National income Measured at base year prices. Affected by change in quantity of physical output. Measures the true performance of growth the Economy.
• Nominal National Income: National income Measured at current year prices. Affected by both change in price and quantity of physical output. Not necessarily measures true performance of growth of the Economy.

\( \text{Real National income} = (\text{Nominal National income} \times 100 / \text{price index}) \)

Question. What is the difference between Real GDP and Nominal GDP? Which one of these is a better indicator of growth of an economy?
Answer: Real GDP is measured at constant prices, while Nominal GDP is measured at current prices. Real GDP is a better indicator because it reflects the actual increase in physical output without being affected by price changes.

Question. To nullify the effect of change in price in national income ………………is used.
Answer: Price Index / GDP Deflator

Question. If value of GDP deflator is 120 and real GDP IS 24000 , then find the value of nominal GDP?
Answer: \( \text{Nominal GDP} = (\text{Real GDP} \times \text{GDP Deflator}) / 100 \)
\( \text{Nominal GDP} = (24000 \times 120) / 100 = 28800 \)

Question. Real GDP in 2019 is 500 and Nominal GDP in 2019 is 650, find GDP deflator.
Answer: \( \text{GDP Deflator} = (\text{Nominal GDP} / \text{Real GDP}) \times 100 \)
\( \text{GDP Deflator} = (650 / 500) \times 100 = 130 \)

GDP as a true indicator of welfare has following limitations:

• 1. Affected by changes price : Without any increase in real output GDP can increase due to increase in price.
• 2. Distribution of GDP : GDP does not ensure that goods and services are evenly distributed in an economy or not. If there are large number of poor people in country with high GDP how it can be said a true indicator of welfare of people.
• 3. Composition of GDP : if any increase in GDP is due to increase in the production of war, ammunition, liquor etc. then welfare of people may not increase.
• 4. Externalities : there are two types of externalities. (a)Positive externalities which results in benefit of people for which people don’t pay (e.g., parks). (b) Negative externalities which results in the harm of people cause by a firm (e.g., pollution).

Non monetary transactions : non monetary transactions like services of housewife, kitchen gardening are not included in the estimation of GDP, because their market value are difficult to estimate. But these transactions increase the welfare of people.

Question. Sale of private vehicles is increasing day by day. Analyse its impact on GDP and Welfare.
Answer: Increasing sale of private vehicles increases GDP as it adds to the final value of output. However, it may decrease welfare due to negative externalities like increased pollution and traffic congestion.

Question. In the determination of social welfare, what matters is the quantum of output rather than the composition of output. Defend or repute.
Answer: Refute. Composition of output matters significantly. An increase in output composed of harmful goods (e.g., weapons, liquor) does not increase social welfare as much as an increase in essential goods and services.

Question. State with valid reason, which of the following statement is true or false:
(a) GDP growth as an index of welfare loses its importance if there is deep economic divide in the economy.
(b) Real GDP may increase without any increase in the quantity of output in the economy.
Answer: (a) True, if the benefits of growth are concentrated in few hands, the welfare of the masses doesn't increase. (b) False, Real GDP only increases when there is an increase in the quantity of physical output as it is calculated at constant prices.