Winter Vacation Homework

Q. Define National Income and its various

concepts.

National Income:
The definitions of national income can be grouped
into two classes: One, the traditional definitions
advanced by Marshall, Pigou and Fisher; and two,
modern definitions.

The Marshallian Definition:

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.

Modern Definitions:
From the modern point of view, 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.

National Income Concepts

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

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.”
 1.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:

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

(ii) 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]

2.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:

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

(2) Gross private domestic investment in capital goods consisting of

fixed capital formation, residential construction and inventories of
finished and unfinished goods;
(3) Goods and services produced by the government; and

(4) 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.

In this concept of GNP, there are certain factors that have to be taken
into consideration: First, GNP is the measure of money, in which all
kinds of goods and services produced in a country during one year are
measured in terms of money at current prices and then added together.

3.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.

4.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.

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:

(i) Wages and salaries, (ii) rents, including imputed house rents, (iii)
interest, (iv) dividends, (v) undistributed corporate profits, including
surpluses of public undertakings, (vi) mixed incomes consisting of
profits of unincorporated firms, self- employed persons, partnerships,
etc., and (vii) 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.

5.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 income
 . Q. Write down merits and demerits of
Direct and Indirect tax
Direct Taxes:
Examples of direct taxation include income tax, corporation tax (on companies’
profits), capital gains tax (a tax on the profits of sales of certain assets), wealth tax
(which is a tax on ownership of property or wealth) and a capital transfer tax (a tax
on gifts to replace death duties). Direct taxes are mainly collected by the central
government.

Advantages:
(i) It is easy to determine the incidence of the tax – a person or institution who
actually pays and suffers the burden of tax.

(ii) Direct taxes tend to be progressive – people in the higher income group pay a
greater percentage than poorer people, e.g., income tax is graduated so that high
income earners pay a larger percentage; also a selective wealth tax would only
apply to those owning more than a certain level of wealth.

(iii) Direct taxes are easy to collect. Consider, for example, the PAYE system
which is used to collect income tax from most wage and salary earners.

(iv) Direct taxes are important to the government’s economic policy. If the
government is fighting inflation it can impose, for example, high levels of income
tax to restrict consumer demand. If the government is concerned about
unemployment it can reduce the levels of income tax to increase consumer demand
and increase production.
 Disadvantages:
(i) Direct taxation may be a disincentive to hard work. High rates of income tax,
for example, may discourage people from working overtime or trying to gain
promotion at work.

(ii) Direct taxation discourage savings because, after paying tax, individuals and
companies have less income available to save. This means that investment, which
relies on the level of savings, is low and this could cause less production and
employment.

(iii) This type of taxation encourages tax evasion – to avoid paying so much tax.

(iv) There is no element of choice about paying the tax – it is unavoidable.

Indirect taxes:

Examples of indirect taxation include customs duties, motor vehicles tax, excise
duty, octroi and sales tax. Indirect taxes are collected both by the central and state
governments but mainly by the central government.

Advantages:
(i) Indirect tax is fairly easy to collect.

(ii) It is easy to determine the incidence of an indirect tax.

(iii) The government can use it to discourage certain types of consumption. A high
rate of tax on tobacco can, for example, affect smoking habits.

(iv) Indirect taxation is a good way of raising revenue when levied on goods with
an inelastic demand, such as necessities.

(v) Tourists do not pay income tax. But they spend money on goods and services.
This adds to the tax revenue of the government.
 Disadvantages:

(i) Indirect taxes are regressive. A regressive tax is one which causes a poor person
to pay a higher percentage of his or her income as tax than a rich person. For
instance, the tax ingredient of the price of a new television set would be the same
for the poor and the rich person, but as a percentage of the poor person’s income, it
is far greater.

(ii) These taxes are not impartial. In recent years, certain groups of consumers have
complained that they are being heavily penalised by taxation, e.g., drinkers,
smokers and drivers.

(iii) Indirect taxes may contribute to inflation. The imposition of an indirect tax on
an item like petrol will increase its price. Since petrol is an essential input in a
large number of industries, this may set off an inflationary spiral. Moreover, trade
unions demand higher wages to maintain the real incomes of workers.

The advantages and disadvantages of two types are listed in

Table

So, the conclusion is that, in a good tax system there should be a proper balance between direct and
indirect taxes. The revenue will be optimum and loss of incentives minimum.
 Q; Explain in detail the Ricardian Theory of
Rent.
David Ricardo, an English classical economist, propounded a theory to
explain the origin and nature of economic rent. He defined rent
as “that portion of the produce of the earth which is paid to
the landlord for the use of the original and indestructible
powers of the soil.” In his theory, rent is nothing but the producer’s
surplus or differential gain and it is found in land only.

At the time of Ricardo land was primarily used for agriculture; now it
is mainly used for residences, offices and stores. But the most
important full of land is the same even today: the supply of land and
be increased by paying a higher price or its supply diminished by
offering a lower price.

Since land was not homogeneous, a surplus was earned on superior

land over the marginal land due to differences in fertility. This surplus
was called economic rent. According to Ricardo, “rent is that
portion of the produce of the earth which is paid to the
landlord for using the original and indestructible powers of
the soil.”

The Ricardian theory of differential rent is illustrated in Fig. 3. There

are three plots of land, A, B and C ranked by descending fertility or
increasing marginal cost (which –equals average costs). 
 Q: Explain the Quantity Theory of Money.
The quantity theory of money is a theory that variations in price relate to variations
in the money supply. The most common version, sometimes called the "neo-
quantity theory" or Fisherian theory, suggests there is a mechanical and fixed
proportional relationship between changes in the money supply and the general
price level. This popular, albeit controversial, formulation of the quantity theory of
money is based upon an equation by American economist Irving Fisher.

The Fisher equation is calculated as:

M×V=P×T
where:

M=money

V=velocity of money

P=average price level

T=volume of transactions in the economy
Generally speaking, the quantity theory of money assumes that increases in the
quantity of money tend to create inflation, and vice versa. For example, if the
Federal Reserve doubled the supply of money in the economy, the long-run prices
in the economy would tend to increase dramatically. This is because more money
circulating in an economy would equal more demand and spending by consumers,
driving prices north.

Q Q:Define Central Bank and its

function.
A Central Bank is an integral part of the financial and economic system. They
are usually owned by the government and given certain functions to fulfil.
These include printing money, operating monetary policy, the lender of last
resort and ensuring the stability of financial system. Examples of Central
Banks include

 Federal Reserve – US
 Bank of England – UK
 European Central Bank (ECB) – EU
 State Bank Of Pakistan

Functions of Central Bank

1. Issue money. The Central Bank will have responsibility for issuing notes and
coins and ensure people have faith in notes which are printed, e.g. protect
against forgery. Printing money is also an important responsibility
because printing too much can cause inflation.
2. Lender of Last Resort to Commercial banks. If banks get into liquidity
shortages then the Central Bank is able to lend the commercial bank sufficient
funds to avoid the bank running short. This is a very important function as it
helps maintain confidence in the banking system. If a bank ran out of money,
people would lose confidence and want to withdraw their money from the bank.
Having a lender of last resort means that we don’t expect a liquidity crisis with
our banks, therefore people have high confidence in keeping our savings in
banks. For example, the US Federal Reserve was created in 1907 after a bank
panic was averted by intervention from J.P.Morgan; this led to the creation of a
Central Bank who would have this function.
3. Lender of Last Resort to Government. Government borrowing is financed by
selling bonds on the open market. There may be some months where the
government fails to sell sufficient bonds and so has a shortfall. This would cause
panic amongst bond investors and they would be more likely to sell their
government bonds and demand higher interest rates. However, if the Bank of
England intervene and buy some government bonds then they can avoid these
 ‘liquidity shortages’. This gives bond investors more confidence and helps the
government to borrow at lower interest rates. A problem in the Eurozone in
2011, is that the ECB was not willing to act as lender of last resort – causing
higher bond yields.
4. Target low inflation. Many governments give the Central Bank a target for
inflation, e.g. the Bank of England has an inflation target of 2% +/- 1. See: Bank of
England inflation target. Low inflation helps to create greater economic stability
and preserves the value of money and savings.

Q: Differentiate Between Domestic

and International Trade.
International Trade

Trade that takes place in two and more countries is known as international trade.  No country is
perfect from the economic side. No man can produce his/her essential goods alone. Besides, no
country alone can produce essential goods. Many countries can get better facilities because of the
differences in geographical location, weather, rainy, natural resources, etc.

For example, Canada can produce wheat in a penalty manner and Bangladesh can produce jute in
a good manner. So, they can exchange these items between themselves. In this way, international
trade occurs between countries.

Domestic Trade

Trade that occurs inside a country is called domestic trade. Domestic trade takes place in many
divisions of a country. In short, trade that occurs inside the geographical area of the country
traditionally known as domestic trade. All region in a country does not equally produce all
goods.  But all people in all regions have equal rights to use their essential goods. For that
reason, the trading system is essential for exchanging goods between each other. One region
produces one good and exchange with other regions inside a country is typically known as
domestic trade.

Dif f erences betw een Domest i c trade and

I nt ernat i onal trade?
1. Field of trade:
domestic trade occurs inside a country, on the contrary, international trade occurs two or more
countries. The field of International trade is higher than the domestic trade

2. Differences in the dynamics of the material:

the raw material of production can move freely inside the country in case of domestic trade. But
in the case of international trade, the raw material of production can’t move freely between the
countries. Due to geographical location, language differences, social distance, transportation
cost, and overly government rules and regulations can hamper the free movement of the raw
material of the production.

3. Differences between natural resources:

there is no difference in characteristics of natural resources inside a country.but different
countries have different types of natural resources and there exist huge differences in their
characteristics.

For example, some countries are good in agricultural sectors and some are in industrial sectors.

4. Differences between the money and banking system:

same monetary policy and banking system exist inside a country. But different countries have
different rules and regulations in their banking and monetary systems. The foreign exchange rate
is essential for international trade. For that reason, international trade is more complex than
domestic trade.

THE
END
 Economics

nAme: syeda hadia

Hassan
ND
CLASS: 2 YEAR arts