Basic Concepts of Macroeconomics/Classification

Basic Concepts of Macroeconomics The Classification of Economic System

Basic Concepts of Macroeconomics

What is Economics?
Economics is the Social Science that analyzes the production, distribution and consumption of goods and services. Broadly, Economics is a social science that studies human activities aimed at satisfying needs and wants. It encompasses production, distribution, trade and consumption of goods and services.

Economics is usually divided into two main branches:
Microeconomics – which examines the economic behavior of individual actors such as consumer, business, households etc. to understand how decisions are made in the face of scarcity and what effects they have on larger economy.
Macroeconomics – which studies the economy and its features like National Income, Employment, Poverty, Balance of Payments and Inflation.

What is Macroeconomics?
• Macroeconomics is a branch of economics which studies the economy as a whole. It deals with the performance, structure and behavior of economy at national or regional level.
• It studies about aggregated indicators such as GDP, Unemployment Rates and Price Indices to understand how the whole economy functions.
• It develops models that explain the relationship between such factors as National Income, Output, Consumption, Unemployment, Inflation, Savings, Investment, International Trade and International Finance.

Vital Process of an Economy
By Vital Process we mean process without which an economy cannot exist. There are three vital process of an economy:
1. Production
2. Consumption
3. Investment

A. Production

• In economy the word production includes not only the making of various goods but also the services. For all of us services are also as essential as the goods. In fact, some of the goods cannot be used unless the services are not provided such as Television or Radio cannot be used unless the services of artists or technicians are provided. Thus production includes the goods made and the services provided in an economy.
• There are some services which are provided by family members to themselves or to one another like cooking and washing clothes, cleaning the house, ironing clothes, polishing shoes and so on.
• Such services are also a part of production but when it comes to measurement of the value of these services, problems arise about getting the required data of the quantity and value of these services. As such, in practical estimates, these services are left out of production.
• Similarly, all leisure time, activities such as growing fruits, flowers and vegetables in garden are also excluded from production for the same reason.

B. Consumption
• It is defined as an activity concerned with using up of goods and services for direct satisfaction of wants. In other words, consumption is an act of satisfying one’s wants.
• Consumption also includes consumption of both goods and services. For Example: we consume food, clothes, furniture etc. We use services of tailors, barbers, washerman, repairers, tutors ect.
• Consumption activity takes place as soon as we buy these goods and services. In other words, by consumption we mean acquiring of goods and services for consumption.
• All purchases by households, with an exception of purchase of a house, are consumption purchases.

C. Investment
• Whatever is produced during a year is not generally acquired for consumption in that year and is kept for future use in order to acquire more monetary amount or benefits.
• Goods lying with production units as raw materials in the process of production to satisfy the demands are also investment which will bear the result in future.
• Investment in fixed capitals by production units like machines, equipments, vehicles, buildings etc. during the year which are also known as durable use goods. Such components are meant to production of goods which may or may not be used in the same year and are kept for future use are also known as investment.
• During a particular year the goods are exceeding the production because of investment in various levels.

Production, consumption and investment processes are interrelated in the following manner
• First, production is the source of consumption and investment. If there is no production there would be no consumption and investment. Given production, if there is more consumption less would be available for investment.
• Second, consumption provides motivation for production and investment. If there is no need for consumption, there is no need to invest and produce.
• Third, investment determines the level of production. The more we invest, the more we can produce.
• Fourth, saving is the major source of financing investment. More saving means more investment which in turn means more production leading to more consumption and investment.

There are two components responsible for the excess of goods (during a particular year)
1. Stock Investment: Addition to the stock of raw material, semi-finished goods and finished goods during a year is called stock investment or inventory investment. Such a stock at the beginning of the year is called opening stock and at the end of the year is known as closing stock.
– The excess of closing stock over the opening stock is called inventory investment.
– However, it is possible that during a particular year the production may be less than consumption. It implies that the closing stock is less than the opening stock. This is called negative investment or disinvestment.

2. Fixed Investment: Acquiring up of durable use producer goods by production units is called fixed investment such as adding new machines and equipments etc.
– Total investment equals the sum of inventory investment and fixed investment. The alternative name of investment is capital formation.

Consumption Expenditure and Saving
Wages, salaries, rents, interests and profits earned by an individual has two alternatives: Consumption Expenditure and Saving.

1. Consumption Expenditure: It’s a part of the income is spent on acquiring goods and services for satisfaction of wants.

2. Saving: The unspent part of income is called saving. Thus saving equals excess of income over expenditure. The saving is in the form of money.

3. Saving = Income – Consumption Expenditure

4. Why do people do save?
a. For emergency expenses on illness, old age or any other unexpected expenditure.
b. The main motive is to earn interest income by lending these savings. It gives them an additional source of income in future years.
c. Savings play an important role in production process. In fact saving is a major source of financing investment. Higher the savings more the possibility of investment. Investment means acquiring goods and services for production. Savings are used to acquire investment goods. So, saving is the foundation of investment.

Other Basic Terminologies
A. Final Goods
• The commodity produced by an enterprise is being sold out to the consumers. In the process the commodity goes under various transformations through productive processes into other goods before being sold to the consumers for Final Use. Such an item that is meant for final use and will not pass through any more stages of production or transformation is called a Final Good.
Why Final Good? Once sold to the consumer, it passes out of the active economic flow and will not undergo further transformation by the action of the ultimate purchaser. Thus, it is not in the nature of the good but in the economic nature of its use that a good becomes a final good.
For example: A car sold to a Consumer is a final good; the components such as tyres sold to the car manufacturer are not; they are intermediate goods used to make the final goods. The same tyres, if sold to a consumer, would be final goods.

Final goods are divided into two parts: Consumption Goods and Capital Goods
a) Consumption Goods
• Tangible goods that are produced and subsequently purchased for direct consumption to satisfy the current human needs or wants.
Example: Food, Clothing, Cigarettes, Pen, TV Set, and Radio etc.
• Similarly, services rendered to consumers by hotels, retailers, barbers etc. are Consumer Services as they satisfy the immediate needs of the consumers.
• Consumer Goods are divided into two categories: Durable Goods and Non-Durable Goods
Durable Goods: This can be used in consumption again and again over a considerable period of time. e.g., chair, car, fridge, shoes, TV set etc.
Non-Durable Goods: are like single use goods which are used up by consumers in a single act of consumption, e.g., milk, fruits, matches, cigarettes, coal, etc.

b) Capital Goods
• Capital goods are fixed assets of producers which are repeatedly used in production of other goods and services. Alternatively durable goods which are bought for producing other goods but not for meeting immediate needs of the consumer are called capital goods.
• These goods are of durable character.
For Example: tools, implements, machinery, plants, tractors, buildings, transformers, etc.
• Capital Goods are used for generating income by production units. While they make production of other goods possible, they themselves do not get transformed (or merged) in the production process. Capital Goods undergo wear and tear and need repairs or replacement over time.
• Capital Goods are the backbone of production processes as they aid and enable production to go on continuously.
• Capital goods are purchased by the business enterprises either for maintenance or addition to their capital stock so as to maintain or expand the flow of their production.

B. Intermediate Goods
• Goods that are used by a business in the production of other goods or services. It is also referred to as producer goods. Intermediate Goods are used to make Consumer Goods.
For Example: Timber and steel rods are intermediate products because they are sold by the timber merchant or the steel dealer to the builder who uses them to produce the final product – a house or a building.

C. Depreciation
• Almost everything we see around us has a useful life because it is being used up little by little every day or will become outdated as technology changes. This ‘using up’ is called depreciation.
• In other words, ‘The monetary value of an asset decreases over the time due to use, wear and tear or obsolescence. This decrease is measured as Depreciation.’
• When the value of asset(s) erodes completely the capital asset has to be either replaced or repaired. Expenses incurred for replacing and repairing are called depreciation expenditure.
Therefore, Gross Investment = Net Investment + Depreciation
• Net Investment will increase the production capacity and output of a nation, but not by depreciation expenditure. So we have, NNP = GNP – Depreciation.
• The governments of the economies decide and announce the rates by which assets depreciate and a list is published, which is used by the different sections of the economy to determine the real levels of depreciations in different assets.


Organizing Economy
An economic system of a nation is defined as a continuous process of setting up of institutional arrangements by which a nation can satisfy unlimited and multiple wants of its people to the maximum with the optimal allocation and utilization of its limited resources by taking its production, distribution and consumption decisions.
The nature of economic system can be described in terms of the system of consumption, production, distribution and exchange transaction. From the standpoint of these factors, the economic system can be broadly classified as

A. Capitalist Economy
• Economy where means of production are owned and controlled by individuals and private institutions with the objective of earning profits. The decisions regarding production, distribution and consumption are made by forces of demand and supply without much intervention by the state.
• USA, Canada, Mexico, Germany, Sweden, etc. are the examples of Capitalist Economy.

B. Socialist Economy
• Also known as State Economy where the means of production are owned and controlled by the state. Here, central planning plays an important role in the matters related with production, distribution and consumption.
• Denmark, Finland, Norway, New Zealand, etc. are the examples of Socialist Economy.

C. Mixed Economy
• It combines both capitalism and socialism. Here, means of production are owned and controlled by both the state as well as private players. The forces of demand and supply and central planning plays an equally important role in the matters related with production, distribution and consumption.
• Mixed economy has emerged as the dominant economic system in several countries like Australia, Iceland, United Kingdom, Japan, and Italy including India.

Sectors of the Economy
Any Economy includes contribution of different sectors like primary sector (mostly agriculture), Secondary sector (industrial) and tertiary sectors (services), large, medium, small and tiny sectors to the economy, and their linkages, integration with the world economy.
Human activities which generate income are known as economic activities. Economic activities under the three sectors are broadly grouped into primary, secondary, tertiary activities respectively. Also higher services under tertiary activities are again classified into Quaternary and Quinary activities.

A. Primary Sectors

• Also known as Agricultural Sectors which includes exploitation of Natural Resources such as land, water, vegetation, building materials and minerals.
• It thus includes hunting and gathering, pastoral activities, fishing, forestry, agriculture, mining and quarrying etc.
• People engaged in primary activities are called red-collar workers due to the outdoor nature of their work.

B. Secondary Sector

• Also known as Manufacturing Sector which adds value to the Natural Resources (obtained by Primary activity) by transforming raw materials into valuable products.
• Secondary activities, therefore, are concerned with manufacturing, processing and construction (infrastructure) industries.
• People engaged in secondary activities are called blue collar workers.

C. Tertiary Sector

• Also known as Service Sector which includes both production and exchange.
• The production involves the ‘provision’ of services that are ‘consumed. Exchange, involves trade, transport and communication facilities that are used to overcome distance.
• People involved in tertiary sector are known as White Collar Workers.

Tertiary Activities are further categorized as:
a) Quaternary Activities: It’s the knowledge sector which demands a separate classification.

Personnel working in office buildings, elementary schools and university classrooms, hospitals and doctors’ offices, theatres, accounting and brokerage firms all belong to this category of services.

b) Quinary Activities: Services that focus on the creation, re-arrangement and interpretation of new and existing ideas; data interpretation and the use and evaluation of new technologies.

Often referred to as ‘gold collar’ professions, they represent another subdivision of the tertiary sector representing special and highly paid skills of senior business executives, government officials, research scientists, financial and legal consultants, etc.
The highest levels of decision makers or policy makers perform quinary activities.

Sectors of Economy
A. Agrarian Economy

• Also known as Agronomics is an applied field of economics concerned with the application of economic theory in optimizing the production and distribution of food and fiber.
• It focused on maximizing the crop yield while maintaining a good soil ecosystem.
• It is centered upon the production, consumption, trade, and sale of agricultural commodities, including plants and livestock.
• In the field of environmental economics, agricultural economists have contributed in three main areas.
• Designing incentives to control environmental externalities (such as water pollution due to agricultural production),
• Estimating the value of non-market benefits from natural resources and environmental amenities (such as an appealing rural landscape), and
• The complex interrelationship between economic activities and environmental consequences.

B. Industrial Economy

• It is the study of firms, industries, and markets. It looks at firms of all sizes – from local corner shops to multinational giants such as Wal-Mart or Tesco. And it considers a whole range of industries, such as electricity generation, car production, and restaurants.
• Industrial Economics also gives insights into how firms organize their activities, as well as considering their motivation.
• One of the key issues in industrial economics is assessing whether a market is competitive. Competitive markets are normally good for consumers (although they might not always be feasible) so most industrial economics courses include analysis of how to measure the extent of competition in markets.

C. Service Economy

• It depends on selling services such as banking, transport, information technology and tourism etc.
• It refers to a financial concept that says that services are becoming more and more important in product offerings.
• The service economy in developing countries is mostly concentrated in financial services, hospitality, retail, health, human services, information technology and education.
• Products today have a higher service component than in previous decades. In the management literature this is referred to as the servitization of products or a product-service system.
• Virtually every product today has a service component to it. For Example: Manufacturers of computer hardware and software, as well as software application developers, now consider service to be an integral part of their product offering. These companies commonly promote their “solutions,” which consist of both products and services that cannot be separated.