Unit 1 Introduction to Business and Environment PDF

UNIT 1 INTRODUCTION TO BUSINESS AND ENVIRONMENT Objectives After reading this unit you should be able to: define what you mean by environment; explain the concept of business environment; describe the scope of business environment; and understand the basic c...

UNIT 1 INTRODUCTION TO BUSINESS AND ENVIRONMENT Objectives After reading this unit you should be able to: define what you mean by environment; explain the concept of business environment; describe the scope of business environment; and understand the basic concepts of macroeconomics. Structure 1.1 Introduction 1.2 Business and Environment 1.3 Basic Propositions 1.4 Nature and Scope of Business Environment 1.5 Types of Business Environment 1.6 Importance of Business Environment 1.7 Environmental Analysis 1.8 Basics of Macroeconomics 1.9 Summary 1.10 Key Words 1.11 Self-Assessment Questions 1.12 References/ Further Readings 1.1 INTRODUCTION You may have a variety of reasons for studying this course, but the main reason, we presume, is to become a successful manager. Your success or failure as a manager depends on a number of factors and these factors may not always be within your control; very often such factors constitute your work environment. These include your job, your department, your organisation, your nation and the world around you. After all, as a manager you do not function in a vacuum. You exist and operate within and not without, an environment. Therefore as a manager when you think, or take decisions, you cannot neglect the limitations of your environment. Just think for a while and then answer. Don’t you arrive at decisions 1 after examining the possible reactions from the environment in which you are placed ? Say, as a marketing manager, would you not study your market environment before launching a new product ? Or, as a finance manager, wouldn’t you study how the capital and money markets of the country are structured and organised before deciding on the sources and uses of your funds ? Or, as a personnel managers wouldn’t you care to find the rules and regulations laid down by the government on subjects like reservation before undertaking recruitment and selection of your required staff? When you have answered these questions, you will discover that all your answers are in the affirmative : “Yes, I would”. You can’t do without thinking about your environment. As a business manager, you have to constantly evaluate your business environment. This opening unit aims to set you thinking about three ideas. It aims to help you to: precisely define “environment”, classify your business environment on the basis of some criteria; identify some of the critical elements of environment of business;;and establish the nature of interaction between environment and business. In pursuing these aims and objectives, our focus will primarily be on the Indian environment of business. We shall try to identify, describe and analyse the Indian situation to understand its impact on our business. Our ultimate purpose is to train our business mangers to face the macro-level environment of business. As managers, wherever you are be it in the public or the private sector, you have to remain alive and alert to your environment so that you are successful in your day-to-day business operations. 1.2 BUSINESS AND ENVIRONMENT The term “environment” refers to the totality of all the factors which are external to and beyond the control of individual business enterprises and their managements. Environment furnishes the macro-context, the business firm is the micro-unit. The environmental factors are essentially the “givens” within which firms and their managements must operate. For example, the value system of society, the rules and regulations laid down by the Government, the monetary policies of the central bank, the institutional set up of the country, the ideological beliefs of the leaders, the attitude towards foreign capital and enterprise, etc., all constitute the environment system within which a business firm operates. These environmental factors are many in numbers and various in form. Some of these factors are 2 totally static, some are relatively static and some are very dynamic – they are changing every now and then. Some of these factors can be conceptualized and quantified, while other can be only referred to in qualitative terms. Thus, the environment of business is an extremely complex phenomenon. The environmental factors generally vary from country to country. The environment that is typical of India may not be found another countries like the USA the (former) USSR, the UK, and Japan. Similarly, the American/Soviet/British/Japanese environments may not be found in India. There may be some factors in common, but the order and intensity of the environmental factors do differ between nations. What to say of countries, the magnitude and direction of environmental factors differ over regions within a country, and over localities within a region. Thus, one may talk of local, regional, national (domestic) and international (foreign) environment of business. For example, the local custom of “coolie” labour, the climate of the northern region of Assam, the policies of the State and Central Governments in India and the size of the world market : all these factors together will have an important bearing on tea industry. The production, consumption and marketing of tea will be affected by environmental factors. The environment differs not only over space but also over time within a country. As such, we can talk of temporal patterns of environment, i.e., past, present and future environment. Future environment is the product of past and present environments. The Indian economy of tomorrow will be influenced by what the state of the economy is at present and what it was in the past. Sometimes the environment may be classified into market environment and non-market environment depending upon whether a business firm’s environment is influenced by market forces like demand, supply, number of other firms and the resulting price competition, or non-price competition, etc., or by non-market forces like Government laws, social traditions, etc. Finally, we may classify the environment into economic and non-economic. Non- economic environment refers to social, political, legal educational and cultural factors that affect business operations. Economic environment, on the other hand, is given shape and form by factors like the fiscal policy, the monetary policy, the industrial policy resolution, physical limits on output, the price and income trends, the nature of the economic system at work, the tempo of economic envelopment, the national economic plan, etc. The non- 3 economic environment has economic implications just the economic environment may have non-economic implications. Since the environment is the sum total of the history, geography, culture, sociology, politics and economic of a national, the interaction between economic and non-economic forces is bound to take place. Definition of Business Environment The word ‘Business Environment’ is defined by many authors in different ways. Few of the definitions are as follows: According to Keith Davis, “Business environment is the aggregate of all conditions, events and influences that surround and affect it”. According to Reinecke and Schoell, “the environment of a business consists of all those external things to which it is exposed and by which it may be influenced directly or indirectly”. According to Barry M. Richman and Melvgn Copen “Environment consists of factors that are largely if not totally, external and beyond the control of individual industrial enterprises and their management. These are essentially the ‘givers’ within which firms and their management must operate in a specific country and they vary, often greatly, from country to country”. According to William F. Glueck “Business environment is the process by which strategists monitor the economic, governmental, market, supplier, technological, geographic, and social settings to determine opportunities and threats to their firms”. All these definitions give a better understanding of the business environment. It can be concluded that a business environment is a combination of dynamic, complex, and uncontrollable external factors within which a business is to be operated. It is pertinent to scan all these forces. Hence, it is crucial to have a thorough understanding of the basic idea of the business environment and the nature of its different components. This interrelation assists the business organisation to reinforce its capabilities and efficiently allocate its resources. Business organisations interact and transact with the business environment. Therefore business organisation and business environment are directly related. Business environment influence the scope and direction of business activity. 4 Business can be seen as a specific activity e.g. a retail business in which a company is making use of the internet and social media for marketing of their products. For example, Flipkart is a specific form of business and is a private limited company. Business can also be seen as a broad activity like a business system as a whole where we may refer it as a market system or capitalism in which a whole range of activities including professional bodies, trade unions, consumer groups, regulatory agencies and government bodies are included. The environment may be classified into market environment and non-market environment depending upon whether a business firm’s environment is influenced by market forces like demand, supply, number of other firms and the resulting price competition, or non-price competition, etc., or by non-market forces like Government laws, social traditions, etc. In early 2015, Nestle’s famous product Maggi Noodles faced a setback in India when food inspectors claimed to have found it unsafe, as the amount of lead was more than its permissible limits. But Nestle tried its best to keep consumer trust by continuously interacting with them on social media platforms and ensuring that Maggi is safe and they are cooperating with the authorities. Later Maggi was temporarily banned in India and Nestle was asked by the Food Safety and Standards Authority of India (FSSAI) to recall its Noodles products from the market and destroy them. It hugely impacted their revenues and profits as Maggi was one of the most popular products in India. In the second half of 2015, fresh batch of Maggi was tested and it was allowed to sell again. But lead controversy adversely affected the trust of consumers and it took lots of promotional strategies to regain the lost revenue. It launched emotional campaign # Wemissyoutoo on all social media platforms to revive the bond between consumers and Maggi brand. It took them sometime to revive from the losses and gain pre ban market share. Activity 1 If you wish to set up an enterprise you must have a clear understanding of business environment. Identify an enterprise and study whether the business environment is conducive. ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 5 ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ ___________________________________________________________________________ 1.3 BASIC PROPOSITIONS As a prelude to the description and analysis of the business environment in any economy, you may examine the three basic propositions given below: 1. Business is an economic activity. 2. A business firm is an economic unit. 3. Business decision-making is an economic process. These propositions may be examined separately or jointly to justify the study of the environment of business in any country. Business is an economic activity An economic activity involves the task of adjusting the means (resources) to the ends (targets), or the ends to the means. An economic activity may assume different forms such as consumption, production, distribution, and exchange. The nature of business differs depending upon the form of economic activity being undertaken and organised. For example, manufacture is primarily concerned with production; the stock exchange. For example, manufacture is primarily concerned with production; the stock exchange business of Government is to run the administration. The Government may also own, control and mange public enterprises. The business of banks is to facilitate transactions with short-term and long-term ends. These examples can be easily multiplied. The point to be noted is that each business has a target to achieve, and for this purpose each business has some resources at its disposal. Sometimes the target has to be matched with the given resources, and sometimes the resources have to be matched with the given target, Either way, the task of business is to optimize the outcome of economic activities. A business firm is an economic unit A business firm is essentially a transformation unit. It transforms input into outputs of goods or services, or a combination of both. The nature of input requirements and the type of output flows are determined by the size, structure, location and efficiency of the business firm under consideration. Business firms may be of different sizes and forms. They may 6 undertake different types of activities such as mining, manufacture, farming, trading, transport, banking etc. The motivational objective underlying all these activities is the same viz., profit maximization in the long run. Profit is essentially “a surplus value”- the value of outputs in excess of the values of inputs or the surplus of revenue over the cost. A business firm undertakes the transformational process to generate this “surplus value”. The firm can grow further if the surplus value is productively invested. The firm, therefore, carefully plans the optimum allocation of resources (i.e., men, money, material, machines, time, energy, etc.) to get optimum production. The entire process of creating, mobilisation and utilisation of the surplus constitutes the economic activity of the business firm. Business decision-making is an economic process Decision-making involves making a choice from a set of alternative courses of action. Choice is at the root of all economic activity. The question of choice and evaluation arises because of the relative scarcity of resources. If the resources had not been scarce, an unlimited amount of ends could have been met. But the situation of resources constraint is very real. A business firm thinks seriously about the optimum allocation of resources because resources are limited in supply and most resources have alternative uses. The firm, therefore, intends to get the best out of given resources or to minimise the use of resources for achieving a specific target. In other words, when “input” is the constraining factor, the firm’s decision variable is the “output”. And when “output” is the constraining factor, the firm’s decision variable is the “input”. Whatever may be the decision variable, procurement or production, distribution or sale, input or output, decision-making is invariably the process of selecting the best available alternative. That is what makes it an economic pursuit. 1.4 NATURE AND SCOPE OF BUSINESS ENVIRONMENT Every organisation operates in a certain kind of environment. Each organisation has some opportunities and threats associated with various forces which may be external or internal in nature. Nature of Business Environment 1. Dynamic: Business environments such as internal and external business environments are highly flexible and keep on changing. For example, changing customer preferences, new competitors entering into the market, novel 7  technology, new marketing channels, new government policies and changing demography. 2. Uncertain: It is very difficult to pre assume with any degree of certainty about the factors influencing the business environment because they continue to fluctuate very quickly. 3. Complex: The business environment is complex as it is continuously exposed to uncertain challenges such as technological disruptions, global competition, leadership change, shifting economic, social, and regulatory conditions etc. It may be easy to scan the environment but its impact on business decisions will be difficult to estimate. It is very difficult for a firm to survive and prosper in such an uncertain environment. 4. Relativity: The business environment is associated with societal norms and local conditions and this is the reason, why the business environment varies from country to country, region to region which makes it more complex. 5. Interrelation: All the factors and forces of the business environment are related to each other. For instance, with the proclivity of youth towards western culture, the demand for fastfood is also rising. Take another example, change in political parties will result in changing monetary policy, fiscal policies, government rules, market conditions, technology, etc. Thus, all these factors are required to be scanned properly as these factors are interrelated to each other. Scope of Business Environment a) Internal and external environment: Internal environment means those factors that are within an organisation and influence the strength or weakness of the business. For example, superior raw material, inefficient human resources, etc. External environment means those factors which are beyond the control of the business and are outside the organisation. They provide opportunities and pose threats to business. For example, changing political and economic conditions, technological changes, etc. b) Micro-environment and macro-environment: Sometimes internal and external environment are interchangeably reffered as micro and macro environment respectively. Micro-environment affects the working of a particular business. It directly impacts business activities and incorporates customers, suppliers, market intermediaries, competitors, etc. These factors are controllable to some extent. Macro- 8  environment is the general environment that impacts the working of all businesses. It is uncontrollable and influences indirectly. Political conditions, economy, technology, etc., are part of the macro environment. For example, Technological advancement such as blockchain, Artificial Intelligence (AI) have changed the face of business operations. c) Controllable and uncontrollable environment: All those factors which are governed by business come under a controllable environment. Internal factors are also treated as controllable factors, such as money, men, materials, machines, etc. Uncontrollable factors are external and are beyond the control of business namely global, technological, legal and natural changes. For example, recent Corona pandemic is a major example of uncontrollable factor. The pandemic has hugely impacted the businesses and led to changes in strategies of operations. d) Specific and general environment: Specific environment refers to external forces that directly influence business enterprises’ decisions and actions and are directly pertinent for the achievement of organisational goals. The main forces that include the specific environment are customers, suppliers, competitors and pressure groups. General environment refers to the economic, politico-legal, socio-cultural, technological, demographic, and global conditions that influence organisations. These external forces or factors impact organisations indirectly and organisations must plan, organise, lead and control their activities by incorporating these factors. 9  1.5 TYPES OF BUSINESS ENVIRONMENT There are certain factors or forces internal and external to the organisation influencing the it in both positive and negative ways. These different components of the business environment have been explained below as shown in Figure 1. 1. Business Environment External Internal Environment Environment Micro Macro ‐ Value System Environment Environment ‐ Mission and Objectives ‐ Organisation ‐ Suppliers of ‐ Economic Structure Inputs ‐ Politico‐ legal ‐ Corporate Culture ‐ Customers ‐ Technological ‐ Human Resources ‐ Marketing ‐ Global or ‐ Physical Resouces Intermediaries International and Financial ‐ Competitors ‐ Socio‐cultural Capabilities ‐ Public ‐ Demographic ‐ Natural Figure 1.1: Components of Business Environment 1. Internal Environment This includes those factors or forces that exist within an organisation influencing the performance of an organisation. These factors are controllable in nature and organisations can attempt to change or modify these factors. Organisation’s resources like men, materials, money, and machines are part of the internal environment. The different internal factors are given below: 10  i. Values: The values are defined as ethical beliefs that guide the organisation in attaining its mission and objectives. These are formulated by top-level managers such as the board of directors. The extent to which these value systems are shared by all in the organisation is a significant factor leading to its success. ii. Mission and objectives: Mission reflects the overall purpose or reason for organisation’s existence. A mission guides and affects the decisions and economic activities of the organisation. Accordingly, an organisation can change or modify its mission and objectives. iii. Organisation structure: The organisational structure is the hierarchical relationship explaining roles, responsibilities and supervision. The structure of the board of directors, the professionalism of management, etc., are the part of the organisation structure and are significant forces affecting business decisions. For effective management and working of a business organisation and for prompt decision making, the structure of the organisation should be conducive. iv. Culture: Shared values and belief in an organisation determine its internal environment also known as corporate culture. Organisation having strict supervision and control reflects the lack of flexibility and unsatisfied employees. These sets of values assist the employees to understand what organisation stands for, what it considers, how it works. Cultural values of business, thus determine the direction of activities. v. Human resources: Human quality of a firm is an important factor of internal environment. Skills, qualities, capabilities, attitude, competencies and commitment of its employees, etc., contribute to the strengths and weaknesses of an organisation. Organisations may find it difficult to carry out modernisation and redesigning because of resistance by its employees. vi. Physical resources and financial capabilities: Physical resources, like machinery, plant and equipment facilities and financial capabilities of a firm decides its competitive strength which is the significant factor for examining its efficiency and unit cost of production. Moreover, research and development capabilities of a company decides its ability to innovate and thus increase the productivity of workers. 11 2. External Environment This includes those factors or forces that exist outside an organisation influencing the performance of an organisation. These external factors can be further classified into micro-environment and macro environment which are defined below. A. Micro-Environment: Those factors which have a direct impact on business. The different components under micro-environment are as follows: i. Suppliers of inputs: The suppliers of inputs are a significant constituent of the external micro environment of an organisation. Suppliers give raw materials and resources to the firm. A firm should have more than one supplier for efficient input inflows. ii. Customers: Customers are the buyers of the firm's products and services. Customers are an important part of the external micro-environment as a firm’s survival and growth are dependent on sales of a product or service. Thus, it is essential to keep the customers satisfied. iii. Marketing intermediaries: Intermediaries play an essential role in selling and distributing products to the final customers. Marketing intermediaries are an important link between a business firm and its ultimate customers. Retailers and wholesalers buy in bulk and sell business products and services to the ultimate consumer. iv. Competitors: Competitors are the rivalry in business influencing the business strategies of the organisation. For example, Zomato and Swiggy are major competitors in food delivery business and their strategies impact each other. v. Public: Public or groups, such as media groups, women’s associations, environmentalists, consumer protection groups, are significant factors in the external micro-environment. The public can be defined as any group affecting a company's ability to achieve its objectives. Recently People for the Ethical Treatment of Animals (PETA) India protested against Amul (dairy company) suggested them to produce vegan milk. 12 B. Macro Environment: These are the factors or conditions which are general to all businesses and are uncontrollable. Because of the uncontrollable nature of macro forces, a firm needs to adjust or adapt itself to these external forces. These factors are as follows: i. Economic environment: Economic environment refers to all those forces and factors which have an economic impact on businesses. It consists of the role of the private and public sector, monetary and fiscal policy, role of saving and investment, economic reforms, agriculture, industrial production, infrastructure, planning, basic economic philosophy, stages of economic development, trade cycles, national income, per capita income, money supply, international debt, etc. For example, an increase in Groos Domestic Product (GDP) will increase disposable income and thus further rise in demand for products. ii. Politico-legal environment: Politico-legal environment constitutes all the factors related to the activities of legislature, executive and judiciary which play a leading role in shaping, directing, developing and controlling business activities. For example, rules and regulations, framed by the government, like licensing policy, Skill India movement, Digital India, Swachha Bharat Abhiyan, polythene ban, etc., affect the business. Higher business growth can be achieved in a stable and dynamic politico-legal environment. iii. Technological environment: Technology is defined as the “Systematic application of scientific or other organised knowledge to particular tasks”. The technology incorporates both machines (hard technology) and ways of thinking (soft technology). These organized knowledge and innovation provide new methods of producing goods and services and latest ways of operating business. Recent technological changes such as the online sale of grocery items, online booking of air tickets, online payments, etc. have changed the business strategies. As technology is changing fast, organisations should keep a close look at these technological fluctuations for their adaptation in their business activities. iv. Global or international environment: The global environment includes all environmental factors having a global impact which is also important for shaping business activity. In the era of globalisation, the whole world is a market. Business analyses the international environment to cope up with the changes. 13  Principles and agreements of the World Trade Organisation (WTO), other international treaties and protocols such as crude oil prices are examples of the global environment. v. Socio-cultural environment: The socio-cultural environment reflects customs and values which influence business practices. People’s attitude towards work and wealth, lifestyle, ethical issues, religion, the role of family, marriage, education and also social responsiveness of business impact the business. For example, foreign brands like McDonalds were sensitive to Indian culture and avoided selling beef burgers in India. vi. Demographic environment: Demographic environment includes the composition and characteristics of the population. For example, Population size and growth, the life expectancy of the people, rural-urban distribution of population, the technological skills and educational levels of the labour force are part of the demographic environment. These forces also impact the organisations’ functioning. For example, many MNCs are targeting Indian youth because of the country’s demographic dividend. vii. Natural environment: Natural environment includes geographical and ecological resources like minerals and oil reserves, weather and climatic conditions, water and forest resources, and port facilities. These are very important for many business activities. For example, in places where climate conditions such as temperatures are high, demand for coolers and air conditioners will also be high. Similarly, demand for clothes and building materials is also conditioned upon weather and climatic conditions. Natural calamities such as floods, droughts, earthquakes, etc. greatly affect business activities. 1.6 IMPORTANCE OF BUSINESS ENVIRONMENT Business environment plays an important role in the functioning of organisations in the following ways: I. Enable the organisation to identify the business opportunities and achieving first-mover advantage: Many opportunities are provided by the business environment to the organisation. Scanning the business environment will help the organisation to attain the first-mover advantage. 14  II. Help the firms to identify the threats and early warning signals: The business Enterprises who can scan the business environment and obtain qualitative information on time will be able to get a warning signal to deal with negative policies and constraints of the business environment. III. Help in tapping and assembling resources: Resources such as raw material, capital, money, labour, etc., are the necessary inputs to the business organisation. All these inputs are obtained through the environment to the firms for carrying out their activities and also expect something in return. IV. Help in adjusting and adapting to rapid changes: Business environment scanning assists the firms to scan and understand the rapid changes in the environment and these changes are having important implications on business strategies. V. Assist in planning and policymaking: The major strategic plans and policies in the organisation are formulated based on the business environment because the policies and strategies have to be implemented in the presence of these environmental factors. VI. Help in performance improvement: Continuous scanning of business environments can improve their performance. By incorporating changes in the internal environment matching to external environment, business organisations can enhance and prosper their market share. 1.7 ENVIRONMENTAL ANALYSIS We know that all organisations perform within a framework of specific factors of business environment. These can be internal as well external. A proper environmental analysis of the business environment is very important. There are different steps involved in the environmental analysis of a business. These are: 1. Scanning the internal / external factors. 2. Grouping of the scanned factors. 3. Observation of internal factors. 4. Monitoring external factors. 5. Defining the variables for the analysis. 6. Identifying specific techniques for analysis. 15  7. Forecasting. 8. Strategy formulation. 9. Evaluation. In this section we will discuss SWOT analysis to familiarize ourselves with environmental analysis. SWOT analysis SWOT analysis is the business analysis process of examining both the internal and external environment of an organisation. Here, S, represents Strengths and W, represents Weaknesses. Both these terms are internal constituents of an organisation. While O, represents available Opportunities in the market and T, represents the possible Threats in the market. Both of these are the external constituents of the organisation (Figure 1.2). Environmental Internal External Analysis Analysis -Opportunities -Strengths -Threats -Weaknesses Figure 1.2: SWOT analysis Framework a. Strengths: It reflects the core competencies or capabilities of an organisation for which it can achieve strategic advantages over its competitors. Even if the organisation does not gain any advantages over its competitors, it indicates an organisation’s capacities in which the organisation is having affirmative aspects. For example, mobile payment platform PhonePe has the strength of easy user interface. b. Weaknesses: Weaknesses means those factors which prevent successful results within the organisations. These are exact opposites of Strengths. Strengths indicate 16  competitive advantages while weaknesses indicate the competitive disadvantages of an organisation. c. Opportunities: These are favourable circumstances present in the external environment, which should be grabbed by the organisation, to enhance its strengths to gain competitive advantage. An organisation strategist must be aware of the upcoming opportunity in the market so that it could grab them on time and could raise revenues and profits. d. Threats: The term ‘threat’ reflects exposing vulnerability to something which leads to adverse impact. In an external environment, if sudden or even gradual changes occur which are not in favour of the organisation, then these represent threats to the organisation. The SWOT analysis is a tool to evaluate the strengths, weaknesses, opportunities and threats of an organisation. Every organisation should do SWOT analysis very effectively to explore both internal and external factors of an organisation and accordingly business strategy should be formulated. Activity 2 1. Explain the need for environmental analysis. How can it enchance organisational effectiveness? ____________________________________________________________________ ____________________________________________________________________ ____________________________________________________________________ ____________________________________________________________________ ____________________________________________________________________ ____________________________________________________________________ ____________________________________________________________________ ____________________________________________________________________ 2. Select any company of your choice and explain the SWOT analysis of that company. _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ 17  _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ ____________________________________________________________________ 1.8 BASICS OF MACRO ECONOMICS Since business is an economic activity, a business firm an economic unit, and business decision-making an economic process, it is the economic environment of business which is the primary consideration in evaluating the business policies, business strategies and business tactics of a corporate entity in any national economy. Economic transactions are the lifeline of the business and in the preceding sections, you have learnt how the business environment is influenced by the economic policies and economic structure prevailing in the country. So, students of the business environment must have some understanding of the working of an economy, what are different sectors of the economy, how they interact with one another, how monetary and fiscal policies influence the economy and so on. In the following sections, we shall study about basics of macroeconomics. Macroeconomics is primarily the study of the behaviour and performance of the economy as a whole. The macroeconomic theories make use of macroeconomic models to explain and establish the relationship among different macroeconomic variables. Income determination, price level determination, investment, employment, product and money market equilibrium, exchange rate, the balance of payments, etc. are the main areas of macroeconomic theories. Macroeconomics also analyses the working and effects of major government policies like monetary and fiscal policies, on the economy. According to J.M.Culburtson ‘Macroeconomic theory is the theory of income, employment, price, and money’ According to Paul Samuelson ‘Macroeconomics is the study of the behaviour of the economy as a whole. It examines the overall level of a nation’s output, employment, prices, and foreign trade’ 18  Interaction of Business and Macroeconomics You must be wondering that we are students of Management then why should we worry about economics and especially macroeconomics. What is the relationship between the two? On the contrary, the understanding of macroeconomics, in particular, is of immense importance for the students of Management. Let us understand this interaction with the help of an example. Inflation is one of the prominent problems of macroeconomics. Inflation refers to the situation in which prices of goods and services rises continuously over a period of time. Inflation can affect both the consumer and producer depending upon the cause of inflation whether it is demand-pull or cost-push. If it is demand-pull or due to an increase in demand in relation to supply, then consumers are at a disadvantage. Cost-push or increase in the cost of production (for example increase in input cost) affects the supplier or producer. To alleviate the problem, the central bank of the country takes the help of the Monetary Policy. One of the instruments of the monetary policy is increasing the repo rates i.e. repo and reverse repo rate. This increase in repo rates leads to both increases in the cost of borrowing for business and a shortage of money supply in the system. These both affect the scale of production. So, producers and enterprises keep a close eye on every move of the government concerning any change in monetary policy and other policies. Some Important Concepts of Macroeconomics Let us understand some of the major concepts used in macroeconomics. Net National Product (NNP) at Factor Cost (NNPFC) is commonly known as National Income. The Gross National Product (GNP) or NNP can also be evaluated at factor cost. The basic cause of difference between the two concepts is that NNP arises because some of the allocations of market value do not go into the payments to the factors of production. Gross Domestic Product (GDP) GDP is defined “as the value of final goods and services produced within the borders of a country during a fiscal year”. It also includes income earned locally by foreigners and excludes income received by the nationals from abroad. GDP is calculated at two prices- market prices (i.e.current prices) and constant prices. 19 GDP at Market Price (GDPMP): GDP at market price is the total value of final goods and services produced within a year at current prices. GDP at Constant Prices: GDP at constant prices estimates GDP in reference to some base period. For example, if we estimate GDP for 2020-21, then it will give us GDPMPfor the fiscal year 2020-21. If we estimate GDP with reference to some base year say 2004-05, then it is GDP at constant prices or real GDP. The distinction between current and constant prices is important as GDP at current prices could grow very rapidly if prices are rising. This increase will not tell anything about the volume of production whether the total output is increasing or not. On the other hand, growth in GDP at constant prices indicates a rise in the total production/output of the country. To obtain GDP at a constant price, GDP at market price is divided by GDP deflator and multiplied by 100. GDP at constant prices is called real GDP. While calculating GDP at a constant price, the base period is always mentioned. Aggregate Demand and Aggregate Supply I. Aggregate Demand (AD):Aggregate Demand is one of the most important concepts in macroeconomics. In simple words, it means total demand for consumer and capital goods at a given price. C= Consumption; I = Investment; G = Government Expenditure; X = Exports; and M = Imports This equation encapsulates the gist of Aggregate Demand. In the two-sector model, there is an absence of G and (X-M) so the above equation becomes AD= C+I and investment is assumed to be constant. Ultimately aggregate demand function is largely dependent upon consumption expenditure or consumption function. II. Aggregate Supply (AS): The Aggregate Supply (AS) shows the amount of output firms plan to supply at different levels of prices or the total supply of goods and services in an economy. Since firms like to sell more output with increasing product prices, the AS has an upward sloping supply curve. The intersection of AD and AS determines the short-run equilibrium in the economy. 20  Multiplier or Investment Multiplier Investment multiplier is of much importance in macroeconomics. It is a ratio of change in income/national income to change in investment. m = investment multiplier; ΔY = change in national income ; ΔI = change in investment. Multiplier indicates that with one unit change in Investment how much national income will change. So, it indicates the level of investment required to achieve the desired level of national income. For example, if the value of m=2 and investment is increased by Rs 100 crore then with this increase in investment level the national income will increase by Rs 200 crore. The Four Macroeconomic Sectors Macroeconomics has primarily four sectors and the interplay and the interaction of these sectors give momentum to the economy. 1. Household Sector This sector covers all the individuals in the economy. The major function of this sector is to supply the factors of production to the different sectors. There are four factors of production i.e. land, labour, capital, and entrepreneur. The household sector is the ultimate consumer who consumes the goods and services that are manufactured by the firms and in return makes payments to the firms. This sector also provides the savings and supply finance to the firms. 2. Firms This sector comprises all the businesses, firms, and corporations. The major function of this sector is to manufacture goods and supply services for sale in the economy. They hire the factors of production and pay them factor payments namely rent, wages, interest, and profits. 21  3. Government Sector This sector involves the centre, state, and local governments of a country. The major function of this sector is the management and regulation of the economy. It is mostly done by its monetary and fiscal policy. Monetary policy is related to the regulation of the money supply in the economy. Fiscal policy is related to taxes, public expenditure, and public debt. Tax and non-tax sources are the major sources of revenue and revenue collected is spent on public health, services, infrastructure, etc. 4. The Foreign Sector This sector takes into account all the economic transactions with the rest of the world. The foreign sector primarily consists of export and imports of goods and services. When we sell domestically produced goods and services to other economies, these are called exports. Imports are items that the domestic country purchases from the outside world. Net Exports are exports minus imports. The Three Markets There are three major markets in an economy. These are 1) goods market, 2) factor market, and 3) financial market or money market. 1) Goods Market In this market, goods and services are exchanged among the different sectors. The goods and services produced by the firms/industry are consumed by households, the government, and the external sector. 2) Factor Market The factors of production are traded in this market. The factor services are demanded by the firms for the production of goods and services and these factors are paid in the form of rent, wages and profits. For example, labour is a factor of production and is owned by the household sector i.e. the workers. Workers offer their services and they are hired by firms, the government, and the foreign sector. In return for labour services, workers receive wages. This equilibrium of demand for labour and supply of labour is part of the factor market. Similar is the case for other factors of production. 22  3) Money Market In this market, equilibrium is attained between demand for and supply of money. Primarily money is provided in the form of savings by the household sector and is channelized by financial institutions like banks. Firms borrow from these financial institutions and equilibrium is attained in the money market. The government regulates the money market by its monetary policy. Circular Flow of Income and Expenditure The economic system can be viewed as the continuous flow of income and expenditure. It is this flow that determines the size of the national income and the overall worth of the economy. One of the major objectives of macroeconomics is income determination, so it is important to understand the circular flow of income and expenditure. This flow can be understood with the interaction of two sectors, three sectors, and four sectors. I. Two Sector Flow In the two-sector flow, we have two sectors namely households and firms. we have discussed the main characteristics of both these sectors in the previous paragraphs. The two sector flow is depicted in Figure 1.3. factors of production Saving Investment Households Firms Banks factor payments Figure 1.3 : Two Sector Flow Households supply factors of production viz land, labour, capital, and entrepreneurs to the firms. Firms in return make factor payments rent, wages, interest, and profits to the households. The flow from households to firms represents the real flow however the flow from firms to households is money flow as all payments are made in monetary form. The money flow from firms to households ultimately becomes the total income (Y) of the 23 households. Similarly, there is a flow of goods and services from firms to households. In return for goods and services, households make payments to the firms which is again money flow. This continuous real and money flow gives momentum to the economy. Financial intermediaries like banks channelise the savings from the households to the firms. The firms take the loans from the banks and other financial institutions. The primary ingredient of loan creation by banks is the savings from households. Households save their savings in the banks and then banks lend to firms. In this circular flows of income and expenditure, there are certain leakages /withdrawals and injections/additions. For example, savings by the households represent leakages from the system. Saving is that part of income that is not consumed. The amount of saving and the size of the circular flow are inversely related. More the savings less will be the size of circular flow and vice versa. On the other hand, additional spending by households from past savings or borrowings acts as an injection or addition to the circular flow. More the spending, bigger the size of circular flow. II. Three-Sector Model In the three-sector model apart from the above-mentioned model one more sector i.e. government sector enters into the circular flow. This model is depicted in Figure 1.4. Government Firms Households Figure 1.4 : Three Sector Model 24 Government affects the circular flow of income and expenditure through monetary and fiscal policy. In our model, we will only consider the fiscal policy effect i.e. taxation and government expenditure. Taxes both direct and indirect paid by both households and firms act as a withdrawal from the flow just like savings. Taxes reduce the disposal income of both households and firms which leads to a reduction in consumption and savings. On the other hand, government expenditure is like injection to the circular flow. Government expenditure gives more income into the hand of households that leads to an increase in consumption expenditure. Similarly, purchases of goods and services by the government from firms increase the income of the firms.Households also provide factors of production to the government and in return receive factor payments. III. Four-Sector Model Let us now learn about the four-sector model of the economy. This model includes households, firms, government, and the foreign sector.The four-sector economy has exports as inflows/injections in the national income whereas the imports are treated as leakages/ outflows from national income. Let us briefly discuss the export function and import function. i) Export Function The economic growth, economic development, and equitable distribution of income depend upon the export levels of a country. Exports are needed for maintaining foreign exchange reserves in an economy. Exports also play an important role in increasing the internal trade and economic stability of a country. The exports of a country depend upon several factors. Some are listed as follows: a. The prices of domestic goods in comparison to prices of similar goods in importing countries. b. Trade-policy and tariff policies of importing country c. Export subsidies d. Income elasticity for import goods in importing countries e. Level of imports by the domestic country Thus, while computing national income, exports is taken as an autonomous variable and represented by X. 25 ii) Import Function Imports represented by M, play an equally important role in the growth of an economy. Imports help strengthen the global presence of a country. The imports of a country depend upon the following factors: a. Import prices in relation to domestic prices b. Domestic tariffs c. Domestic trade policy d. Income elasticity of imports e. Income levels f. Export levels When the value of exports is more than the value of imports (i.e. X > M) we call it trade surplus. However, when the value of imports is more than the value of exports (i.e. M > X) it is called a trade deficit and represents an unfavourable situation for any economy. The four sector circular flow is shown in figure 1.5. Figure 1.5: Four Sector Flow Let us assume that Households only supply labour to the foreign sector and in return, they receive foreign remittances (money sent by a person residing abroad to their families in a 26 domestic country). Firms make payments for imports to the foreign sector and firms receive exports receipts. The foreign sector provides different taxes and tariffs to the government and the government in return formulates various schemes and policies which facilitates trade. If the trade balance is positive (i.e,. X > M) then circular flow increases as it increases the magnitudes of circular flows of income and expenditure. Activity 3 1. Visit the website of the Ministry of Statistics and Programme Implementation and find out the value of GDP at both current and constant prices for the last 5 years and notice the change in both the series. Also, find out the change in the base year for the calculation of GDP. _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ 2. Read the Economic Survey of India for the year 2021-22 and make the list of important exports and imports of India and also analyse the change which has taken place in the composition of both exports and imports. _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ _____________________________________________________________________ 27 1.9 SUMMARY The environment is a complex phenomenon. The term environment consists of several subsets, e.g., economic environment, socio-cultural environment, politico-legal environment, technological environment, etc. It thus represents the totality of all kinds of environments which have an impact on business. To a large extent, the environment is external to the firm. Business firms in general have little influence on external forces. Depending upon the nature and composition of several subsets of the environments, the business environment varies from country to country, and may even vary in the same country from one point of time to another. A number of problems are involved in the identification, description, explanation and prediction of environmental factors. The environmental factors are dynamic. It is difficult to conceptualise and/or quantify the proportion of change as well as the direction of change in environmental factors. Since the environment and the economic institutional framework affect business organisations, it is imperative on the part of the management to scan the environment before taking any decisions. The success of any business enterprise in a large measure, would depend upon the proper understanding of the business environment. Macroeconomics studies concepts like national income, nationwide employment, aggregate demand, aggregate supply etc. It deals with the aggregates of all quantities as opposed to microeconomics which deals with individual quantities. There are four macroeconomic sectors, viz the Household Sector, firm sector, government sector and foreign sector. The concept of aggregate demand and aggregate supply is the total demand and total supply of the entire economy. Further, the concept of investment multiplier is of much importance to analyse the effect of investment on the national income. 1.10 KEY WORDS Environment : The totality of all factors or forces affecting business and external to and often beyond the control or influence of individual business enterprises. The environment comprises several subsets, e.g., economic environment, socio-cultural environment, politico-legal environment, technigological environment, etc. 28 Internal Environment : Consists of factors existing within business organisations and which are controllable. External Environment: Refers to forces / factors outside an organisation and which are by and large byond the control. Economic Activity : Any activity undertaken with economic or financial motive or consideration. In the business context, it is the task of adjusting the means/resources to the needs/targets. Decision-Making : Making a choice from a set of alternative courses of action. Environmental Analysis: The process through which an organisation monitors and comprehends various environmental forces in order to identify the opportunities and threats. 1.11 SELF-ASSESSMENT QUESTIONS 1. Explain the concept and nature of business environment. 2. Distinguish between micro environment and macro environment. 3. What are the various elements of internal environment of business? 4. Explain the process of environmental analysis. 5. How environmental analysis can enhance organisational effectiveness? Discuss in detail. 1.12 REFERENCES/ FURTHER READINGS N. Gregory Mankiw. Macroeconomics, Worth Publishers, 7th edition, 2010. Justine Paul, Business Environment: Text and Cases ; Tata McGraw – Hill Publishing Company Ltd., New Delhi. Gupta C.B., Business Environment: Sultan Chand & Sons, New Delhi. 29 UNIT 2 ECONOMIC GROWTH AND DEVELOPMENT Objectives After reading this unit you should be able to: explain the concept of economic growth, economic development and some indicators of economic development; discuss the Harrod-Domar model, Solow model, Endogenous growth theory and major theories of under-development; familiraize with national income accounting, Gross Domestic Product (GDP), various concepts related to national income along with three major methods of estimating national income; and discuss Inflation and its effect on various aspects of the economy. Structure 2.1 Introduction 2.2 Theories of Economic Growth 2.3 National Income 2.4 Inflation 2.5 Summary 2.6 Key Words 2.7 Self - Assessment Questions 2.8 References/ Further Readings 2.1 INTRODUCTION Achieving a higher rate of economic growth is the objective of every nation around the world. It is because of economic growth that production, employment, income, saving and investment in the country increases. The standard of living improves and the people of the country prosper. But how can this objective be met? what are the major factors which contribute to achieving higher rate of economic growth? The various growth models and theories given by economists provide an answer to this problem. The economic literature is 1 full of many theories like classical, Marxist, neoclassical and many others who have tried to investigate the reasons behind underdevelopment and the possible solutions.However, in this unit, you will learn about few models like Harrod-Domar, Solow and endogenous growth theory along with some theories of underdevelopment.Harrod-Domar theory highlights the role of saving and investment in achieving higher economic growth, the Solow model talks about the importance of technology and capital accumulation whereas endogenous growth theory emphasises the role and importance of investment in human and physical capital. Having understood these theories in the next section you will read about national income, various concepts related to national income and various methods of estimating it. Further, in the last section, you will get yourself familiarise with the concept of inflation and how does it impact different sections of society. 2.2 THEORIES OF ECONOMIC GROWTH You all must have heard or read at one time or another that some countries of the world like USA, Germany, etc. are termed as developed countries. On the other hand, countries like India, China, etc. are classified as developing. Now you might be guessing how countries are labelled as developed, developing or underdeveloped and why is it so that some are developed and other underdeveloped. Well, the answer lies in the per capita income (PCY), Gross Domestic Product (GDP) and Gross National Income (GNI). Countries are classified into various categories of development and level of income based on a certain level of income threshold. These thresholds are defined by different world organisations like United Nations, World Bank, etc from time to time. Economic growth indicates an increase in the national income and total output of the country. The growingGDP, Gross National Income (GNI) and production capacity of the country are some of the indicators of the economic growth of a nation. Economic growth can be viewed as the material wellbeing of a country. On the other hand, economic development implies an upward trend in the real income of the country over a long period. According to Schumpeter economic development is a change in the stationary state of the economy. This change is erratic, spontaneous and discontinuous. It is a movement from one equilibrium point to another. It is a steady and gradual change that happens in long run and is a result of a general increase in the rate of savings and population. It also implies a per capita increase in the production of a country. Achieving a higher level of economic growth and economic 2 development are major planning goals of every nation. It is with a higher level of total output that the standard of living, productive capacity and overall efficiency of the nation increases. It is because of the increase in GDP that employment increases and more peoplefind jobs. With an increase in employment level, income level improves and the problems of poverty and deprivation can be eradicated. Purchasing Power Parity (PPP) One of the important curiosity among individuals/politicians/economists is to compare their country with another and then draw many conclusions as per their convenience. However, there is a well-developed methodology to do and it is called Purchasing Power Parity or PPP. PPP is used to make comparisons between economic growth and standard of living among nations. This task of international comparison is lead by World Bank through its statistical initiative known as International Comparison Program (ICP). ICP provides comparable price and volume measures of GDP and its expenditure aggregates among countries and publishes PPP of the world’s economies. PPP measures the purchasing power of the currency. It measures the total amount of goods and services that a single unit of a currency of one country can buy in another country. For example, if a pair of shoes cost Rs 1000 in India and if the same pair of shoes cost $50 in the USA then the exchange rate between the US dollar and Indian rupee is $1= Rs 20. It means $1 is equal to Rs 20. PPP is used to convert the cost of a basket of goods and services into common currency and in this process, the price difference is eliminated across countries. PPP equalises the purchasing power of currencies. It was important to discuss the PPP as data on various developed indicators is published using the PPP approach. Measurement of Economic Development Economists are interested in measuring economic development because it can help in ranking the countries and making meaningful comparisons. From time to time attempt has been made to measure economic development with some socio-economic indicators ranging from Social Development Index of United Nations Research Institute on Social Development, Physical Quality of Life Index (PQLI) of Morris D Morris to Human Development Index (HDI). In Modern times HDI is one most widely accepted index. Let us understand how does it work and rank countries. HDI is prepared by United Nations Development Program (UNDP) and was developed by economist Mahbub Ul Haq. It is a composite index made from 3 indicators measuring key dimensions of human development. These three indicators are life expectancy 3  (life expectancy index), expected years of schooling and mean years of schooling (education index) and a decent standard of living measured by GNI per capita (PPP $) (GNI Index). The top 5 countries in the HDI ranking of 2020 were Norway (1st), Ireland (2nd), Switzerland(3rd), Hong Kong and Iceland (both 4th) and in the same ranking, India stood at 131 ranks out of 189 countries. World Bank has prepared the list of countries based on income level. World Bank has divided countries into 4 categories namely low- income economies, lower-middle-income economies, upper-middle-income economies and high-income economies. The following table presents the summary of the World Bank classification for the 2021 fiscal year. Classification of Countries on the basis of Income Classification of Income Level (Gross Countries * Economies National Income per capita) Low-income of $1,035 or less in 2019 Afghanistan, Haiti, Somalia, Madagascar, Ethiopia Lower middle-income $1,036 and $4,045 India, Sri Lanka, Bangladesh, Bhutan, Myanmar, Pakistan Upper middle-income $4,046 and $12,535 China,Thailand, Cuba, Maldives, Tuvalu High-income $12,536 or more USA, UK, Finland, France, New Zealand, Germany, Norway, Gibraltar, Oman Source: World Bank *The list include only major countries for more details visit World Bank webiste In the preceding paragraph,we have discussed economic growth and economic development and its importance, now in the following section, we will discuss in short, some major theories of economic growth namely the Harrod-Domar model, Solow model, endogenous growth theory and major theories of underdevelopment. HARROD-DOMAR MODEL OF ECONOMIC GROWTH This model of economic growth was given by two economists namely Roy Harrod and EveseyDomar in the early 1950s. This model highlights the role of saving and investment in economic growth. According to this model,the growth rate in an economy is dependent upon two factors. One is the saving-income rate (S/Y) and the second, capital-output ratio (the 4 amount of capital required to produce a unit of output). The model is based on many assumptions like no government interference in the working of the market (Laissez-faire), full employment in the economy, closed economy, the law of constant returns to scale, neutral technical progress, etc. In this model, three growth rates are explained namely actual growth, warranted growth rate and natural growth rate. The actual growth rate is determined by the actual rate of saving and investment. It is expressed aschange in income divided by total income ( ). This growth rate is determined by the saving-income ratio and capital-output ratio and its relationship can be expressed in the following functional form. Or In above equation ,G = actual growth rate; C = capital-output ratio; or (I = investment) and s = saving-income rate ( For example, if the saving rate of an economy is 10 % and the capital-output ratio is 2, then the economy would grow at 5 % per annum. Warranted Growth Rate The warranted growth rate is also known as full capacity growth rate or potential growth rate. If the economy is making optimum use of its resources and working at full capacity then we can say that this is the warranted rate of growth or Gw. Natural Growth Rate This rate of growth an economy can achieve with the help of natural resources. Factors like capital equipment, technical knowledge, amount of fertile land, minerals and forest cover, etc. determine the natural growth rate of an economy. This is the upper limit or the ceiling beyond which we cannot go. It is denoted by Gn. Harrod-Domar model highlights that investment has a dual role to play. It increases income on one hand via multiplier process and on the other hand, it enhances the productive capacity 5 of the country. Further, lack of saving and deficiency of investment are major bottlenecks in the path of economic growth. So there is a need to mobilise domestic savings or create a domestic environment conducive for generating investment and achieving higher economic growth. SOLOW MODEL OF ECONOMIC GROWTH Solow model is also known as neoclassical growth theory and was propounded by Robert Solow of Massachusetts Institute of Technology in 1956, also awarded Nobel Prize for Economics in 1987. This model propounds that changes in population growth rate, rate of technological progress and saving rate bring about changes in the level of output. There are three basic propositions of neoclassical growth theory. First, the growth of output in the long- run steady state is determined by the rate of growth of the labour force and the rate of growth of labour productivity. Second, the level of per capita income (PCY) depends upon the rate of saving and investment to GDP. Third, there will be convergence in the income levels of different countries with certain assumptions related to labour force growth, savings,depreciation andproductivity growth. The major assumptions of the model are: I. The labour force grows at a constant exogenous rate II. Constant returns to scale III. Output is a function of capital and labour and both factors are subjected to diminishing productivity. IV. The elasticity of substitution is equal to 1. V. All of the saving is converted into investment i.e. no independent investment function. VI. Variable capital-output ratio. Production Function In the Solow model, the production function can be presented as (1) Where Y = Output; K = capital ; L = Labour and F is the functional relationship between output and inputs. The important property of the production function is that it exhibits 6 constant returns to scale. It implies that if inputs increase by 10% then the output will also increase by 10%. (2) In the above equation, is some positive number and in our preceding example the value of is 10 %. Now if you put = 1/L in equation 2, then or = (3) In the above equation, is output per worker and is capital per worker. Equation 3 also states that output per worker is a function that depends on the amount of capital per worker. The graphical representation of the production is given in the Figure 2.1. Figure 2.1: Production Function The slope of the production function in Figure 2.1 shows how much extra output per worker is produced from an extra unit of capital per worker. As we have stated in the assumption that diminishing return operates. It is because of this reason that the production function assumes a flat shape as the amount of capital per worker increases or k increases. Evolution of Capital and Steady-State In the above section, you have understood about production function and now you will examine how capital stock impacts economic growth. The change in the capital stock is affected by two forces investment and depreciation of capital. How much proportion of output will be allocated between consumption and investment is determined by saving rate S. At any particular level of k, the output is , investment is and consumption is given as. The higher the level of capital k, the greater the levels of output and 7 investment. Further, a constant function represents depreciation which takes place in capital stock every year. Solow model predicts that the saving rate is one of the key determinants of the steady-state capital stock. refers to labour productivity growth rate and labour force grows at the rate ‘n’ per year. The total capital stock will tend to grow when savings are greater than depreciation but capital per worker will grow when savings are greater than what is needed to equip new workers with the same amount of capital that was available with the existing workers. The Solow equation (given in equation 4) shows the growth of capital-labour ratio (k) depends on savings ( , depreciation( ) and labour force(nk). (4) In the Solow model, steady-state refers to a state in which output and capital per worker are no longer changing. To find a steady-state, let us assume = 0 then equation 4 will become: * (5) Figure 2.2: Equilibrium of capital per worker and output per worker. From equation 5 and Figure 2.2, we can see that k* is the level of capital per worker when the economy is in its steady state. The equilibrium which is attained in the above figure is the stable equilibrium and it highlights that saving per worker (sf(k*)) is just equal to k*, the amount of capital per worker needed to replace depreciating capital and nk* which needs to be added to labour force growth. In the steady-state, if k is higher or lower than equilibrium k*, the economy will return back to its original equilibrium value. As you can see from the diagram that if for some reason we are on the left of k* , then k < k* and (n+ ) k < sf(k) and in this scenario, >0, and because of this result k in the economy will grow and move toward equilibrium point k*. 8 In the above section, you must have understood the neo-classical model, further one of the major implication of this model is that there will be conditional convergence in the level of income of various economies. Endogenous Growth/ New Growth Theory The central idea of endogenous growth theory is that the economic growth of a nation is generated by the factors which are within the production process or endogenous like technological change or increasing returns to scale rather than exogenous factors. GNI growth is a natural consequence of long-run equilibrium. This conclusion is in contrast to the famous belief of the neo-classical theory. The major objective of this new growth theory is to explain differences in the growth rate observed by developed and underdeveloped countries. Further, the theory assumes increasing returns to scale in production function which implies that proportionate change in output will be more than proportionate change in inputs. Moreover, they have highlighted the role of externalities and further propagated that these externalities do impact the rate of return on capital investment. Externalities are the cost or benefits that originate from either production or consumption of a good or service. Heavy investment in human capital like providing training, imparting skill, etc generate external economies which mitigates the negative effect of diminishing returns, rather it leads to increasing returns to scale and a higher level of productivity. The simple equation explaining endogenous growth can be expressed as : Here Y refers to output or growth and A is the constant marginal productivity of capital i.e. K. Above type of production function is linear in nature. In the above equation, K, not only includes physical capital alone but human capital also. Endogenous growth theory propagates the important role of saving and human capital investment in achieving a higher level of growth. The higher the level of savings in the economy, the higher will be capital stock and national income. Similarly, this theory also explains that a higher level of the international flow of capital widens the inequality gap between developed and underdeveloped countries. According to theory, developing countries offer a higher rate of returns on investment which lures the capital flow towards these countries. But developing countries have much lower levels of complementary investment in human capital ( investment that supplements and support other 9 productive factors). These countries are marred by a lower level of investment in infrastructure, education, schooling, research and development. So, these countries are unable to fully utilise the benefits of international capital flows. Complementary investments create positive externalities and when these private and social benefits are realised, the government also contributes to efficient resource allocation. More and more public goods ( like roads, railways etc) are created by the government agencies. Similarly, the government can encourage private investment in knowledge-intensive industries like education, training, etc which leads to the creation of more and more human capital. These changes ultimately help in mitigating the drawback of diminishing returns. Endogenous growth theories suggest that government or public policy should work in the direction of expanding the budget and expenditures on the creation of human capital and promoting/creating a conducive environment that attracts foreign private investment in the fields like software development, information and technology, telecommunication, etc. Major Theories of Under-Development In the economic literature, there are a vast number of theories related to under-development. As discussing all of them are beyond the scope of this unit, we present the details about major theories of underdevelopment namely vicious circle of poverty, low-level equilibrium trap, critical minimum effort, big push and stages of economic growth. The Vicious Circle of Poverty Theory: This theory is associated with Prof Nurkse who propounded that the main reason for the backwardness of underdeveloped countries is the vicious circle of poverty. According to Prof Nurkse, the vicious circle of poverty is- “ circular constellation of forces tending to act and react in such a way as to keep a country in the state of poverty” Figure 2.3 illustrates how this circle works from both supply and demand side. From the supply side, low income, low rate of savings and investment, low rate of capital formation which leads to low productivity and production. From the demand side, low income leads to low consumption and demand for goods and services which creates less incentive for investment and production. Underdeveloped countries need to break this circle with the help of entrepreneurship and the labour force. 10  Figure 2. 3: Vicious Circle of Poverty Low Level of Equilibrium Trap Model: Richard Nelson (1956) gave this theory of low level of equilibrium trap in which he highlights that underdeveloped are trapped in a low level of income. He propounds that in UDCs there is low per capita income. It is because of poverty that individual's income levels are low which are the cause of low saving and investment rate and ultimately low national income. Accordingly, a quantum leap above minimum per capita income is required to above which people are able to raise the level of savings and this results in a higher level of national income and economic growth. Critical Minimum Effort Theory: The critical minimum effort theory is associated with economist Harvey Leibenstein. Leibenstein was of the opinion that underdeveloped countries were entrapped in the vicious cycle of poverty and to rise above this poverty trap a minimum level of investment or critical minimum effort is needed. This minimum level of investment is of paramount importance for raising per capita income and economic growth. According to the theory in every economy there are two forces : a) income depressing forces (or shocks) that lead to a fall in per capita income and b) income-generating forces (or stimulants). The main feature of underdeveloped economies is that income depressing forces are abundant and are one of the main reasons for their underdevelopment and to overcome these hurdles or to break the chain of underdevelopment a critical level of investment is needed. Theory of Big Push:Prof. Paul N. Rosenstein Rodan gave the theory of big push in 1943. According to the theory of big push, ‘bit by bit’ investment programme will not yield the 11 desired result in underdeveloped countries and they need huge and comprehensive investment package (big-push) to move from the stage of underdevelopment towards development. Citing an example of an aeroplane he says that an aeroplane needs some critical ground speed to take off and become airborne. Same for an economy a big push is needed to unshackle itself from chains of underdevelopment. He has identified three kinds of indivisibilities intending to specify the areas where big push needs to be applied namely indivisibilities in the production function, indivisibility of demand and indivisibility of savings. Indivisibilities in the production function may be due to inputs, output or processes and these lead to increasing returns. An important form of indivisibilities is the social overhead capital like infrastructure which area major obstacle to economic development and a large sum of investment is required to overcome this obstacle. Indivisibilities in demand requires that investment be made in many industries which could mutually support each other instead of just concentrating on a few for the purpose of complementary demand. Lastly, underdeveloped countries face a huge dearth of supply of savings due to low-income levels and this leads to low investment. Rostow’s Stages of Economic Growth: Rostow (1959) presented the 5 stages of economic growth which all countries must pass to become developed. The 5 stages are traditional society, precondition to take off, take off, drive to maturity and age of high mass consumption. Traditional society is predominant agrarian and production function is primitive with no scientific temper or perspective. In precondition to take off which is the transitional phase, ideas begin to germinate for economic progress and better lives for the present and future. Manufacturing began to develop along with agriculture and the establishment of institutions for mobilising savings and investment. Take off stage is marked by dynamic changes in society and a substantial increase in the standard of living. Take off stage requires the rate of investment which is the range of 5 to 10 % of GNP. Development of the manufacturing sector and the existence of social, political and institutional framework is another feature of the take-off stage. According to Rostow after 40 years of takeoff stage, there is a long interval. In this interval, diversification takes place in all sectors of the economy. Multiple industries are set up and the process of industrialisation is highly sophisticated and manufacturing of consumer durables picks up along with capital goods. A large investment is taken up in infrastructure both physical and social. In the age of high consumption, the industrial sector dominates the economy, people have a large amount of disposable income and the urbanisation process gain heavy momentum. 12 Activity 1 1. Discuss some of the features and limitations of Harrod-Domar Model of growth. __________________________________________________________________ __________________________________________________________________ __________________________________________________________________ __________________________________________________________________ __________________________________________________________________ __________________________________________________________________ 2. What are the various stages of economic growth as mentiond in Rostow Theory? In your opinion, Indian Economy is passing through which stage, support your answer with data and figures. __________________________________________________________________ __________________________________________________________________ __________________________________________________________________ __________________________________________________________________ __________________________________________________________________ __________________________________________________________________ __________________________________________________________________ 2.3 NATIONAL INCOME The health and wellbeing of an economy can be judged by the amount of total income that the citizens of the economy are earning. National Income accounts help us to understand the growth and trajectory of the economy. The figures of national income accounting (NIA) are used to make international comparisons. It shows how our country is doing (economically) in relation to other countries. The planning process of any country is heavily dependent on these numbers. The interrelationship between different players in the economy can be better understood in the light of these estimates. In the NIA, Gross Domestic Product (GDP) is one of the most essential components. The entire series of national income revolves around this component. Most importantly figures of national income are derived from the figures of GDP. So to understand national income it is essential to understand this component. GDP in the simplest sense is the market value of all 13 final goods and services which are produced by the residents of a country within the domestic territory of a country in a given period of time. Before we move further few points about GDP needs to be understood. First, it is the market value of final goods and services. Market value is reflected as market prices and market prices indeed represent the willingness to pay by the consumers. So, the value of goods and services are reflected by market prices. Second, it includes only the value of the final goods. It means that the intermediate goods are excluded when calculating GDP. It is because to avoid the problem of double counting. Third, goods and services produced by the residents of the country within the boundaries of the country are included. Fourth, it measures the value of production which takes place within the specific time period usually fiscal year or a quarter.GDP indeed measures total income and total expenditure in an economy. However, they both are the same because for an economy as a whole income must equal expenditure. Let us take an example. In every economic transaction, there are two parties namely buyer and seller so one person’s income is the other’s expenditure. For example, Mehta decorator and painters were given the order to paint the courtyard of Mr Verma and the deal was signed off with the contract of Rs 10,000 for doing this work. In this example, Mr Verma is a buyer of the service and Mehta decorator and painters is the seller. The company earns Rs 10,000 and Mr Verma spends Rs 10,000. In this example, the amount of Mr Verma expenditure is equal to Mehta decorator and painters income. So, whether you measure GDP from the Income side or expenditure side,it will rise by Rs 1000 in the above example. Different Concepts related to National Income Gross National Product or GNP: It is the market value of all final goods and services produced in the year alongwith net factor income from abroad (NFIA). NFIA is the difference between factor income received (like rent, interest and profit) from abroad and factor income paid abroad. GNP = GDP + NFIA Net National Product or NNP = It is the market value of all final goods and services produced by country citizens both domestically and internationally in a given period. NNP is indeed national income that is available to the economy for consumption and investment. NNP divided by total population gives per capita income. 14  NNP = GNP - Depreciation Net Domestic Product (NDP) = It refers to the economic output of the country adjusted for depreciation (or consumption of fixed capital). NDP = GDP - Depreciation Market Price (MP): When any measure of national income like NNP is calculated at a market price it includes the cost of production and also various taxes/subsidies which are imposed and provided by the government. Net Indirect tax isthe difference between indirect tax (like Goods and Services Tax or GST, Value-Added Tax or VAT)and subsidies. NNPMP = NNP + Net Indirect Taxes (NIT) Factor Price(FP): In contrast to market price, factor price excludes the effect of NIT. NNPFC = NNPMP - NIT Personal Income (PI): PI is the income which an individual or households receive from all the sources before paying taxes. It includes income from factor services like wages, rent and interest along with transfer payment, payments like pensions, social security benefits. The personal income includes transfer payment which is not included in national income. Disposable Income: It is income that is left with individuals after paying taxes and other compulsory payments to the government. It is the actual amount of money that is in the hands of the individual for consumption and other expenditures. Disposal Income = Personal Income – (taxes + fees+ fines) Different Approaches of Estimating National Income There are three approaches of measuring national income namely: Product Method or Value Added Method Income Method, and Expenditure Method There is one common thing about these three methods, the figures of GDP will be the same irrespective of any method which you use in estimating National Income. 15 Product Method or Value Added Method Under the value added method,GDP is calculated by the sum total of gross value added of all the firms in the economy. Value added by a single firm is obtained by the substracting value of intermediate goods from the value of output. Let us understand this with the help of an example. Suppose there are two producers in the economy, one producing cotton and the other producing cloth. To simplify, we assume that the cotton producer uses only one input i.e. human labour and he sells some proportion of cotton to the producer producing cloth. On the other hand, cloth producer also makes use of only one input i.e. cloth. The total value of cotton that the cotton producer has produced is Rs 500. Out of this Rs 500, cotton worth 450 was sold to the cloth producer. The cloth producer having used cotton worth Rs 450 produced cloth whose value was estimated to be Rs 1500. Based on the example cited above, what is the value of total production in the economy? If we were to simply add up the contribution of each producer then the value of total production would be Rs 500 (share of cotton producer) + Rs 1500 ( value of output created by cloth producer) will equal Rs 2000. However, this estimate is not correct. The value of output which the cotton producer has generated is indeed Rs 500 as he has not paid any amount for the use of intermediate goods (raw material). Though the same is not true for cloth producer. For calculating the net contribution of his, we need to subtract the value of intermediate good (i.e. cotton) which amounts to Rs 450 from his contribution. If we do not do this exercise then we commit the error called ‘double counting’ (counting the value of good more than once). In our case, Rs 450 worth of cotton will be counted twice. One, as part of total output produced by cotton producer and second as the value of input while producing cloth. So, the value added by the cloth producer will be Rs 1500 (value of output) – Rs 450 ( value of intermediate good) = Rs 1050. The aggregate value of production in the economy consisting of these two producers will be Rs 500 + Rs 1050 = Rs 1550. Here at this point, it is necessary to introduce you to the concept of depreciation also known as consumption of fixed capital. Capital goods like the plant, building etc, when used in the production process are subject to deterioration which is called depreciation. If we subtract the value of depreciation from the gross value we arrive at the new concept ‘Net value’. For instance, in the previous section you learnt about NDP. NDP= GDP – Depreciation And similarly, we can estimate the value of Net Value Added as Net Value Added = Gross Value Product – Depreciation 16 So if we add up the net value added of every good produced we arrive at national output. Income Method In the productionprocess, the producer makes use of factors of production namely land, labour, capital and entrepreneur. In return for their services rendered they receive rent, wages, interest and profit combinedly called factor payments. Under the income method, national income is measured by aggregating these factor incomes generated by different producing units within the domestic territory of the country in one fiscal year. The different components of the income method are the compensation of employees, rent, interest, profit and mixed-income. Wages and salaries paid in cash and kind and the contribution made by the employer to the social security scheme of employees are the major components of compensation of employees. Rent is the payment that accrues from ownership of land and building. Interest is the payment that