National Income: Various concepts of national income

National income refers to the total income of the nation in a particular period of time. National income data reveals the aggregate economic performance of the economy as a whole. National income – represents a receipts total, expenditure total and the total value of production. Since one person’s income is another person’s expenditure and each commodity is bought and sold at its market prices, a
national income accounting is based on the fundamental three fold identity: (i) The value received equals, (ii) The value paid equals, and (iii) The value of goods and services given in exchange.

Hence, National income = National expenditure = National Product

Marshall, Pigou & Fisher, has defined the traditional definitions of national income. According to Marshall, national income is, “The labor and capital of country acting on its natural resources produce annually a certain net aggregate of commodities, material and immaterial including services of all kinds. This is the true net annual income or revenue of the country or national dividend.” Pigou’s definition of national income includes that income which can be measured in terms of money. According to Pigou, “National income is that part of objective income of the community, including of course income derived from abroad, which can be measured in money.” Fisher defined on the consumption basis. According to Fisher, “The national dividend or income consists solely of services as received by ultimate consumers, whether from their material or from their human environment. Thus, a piano, or an overcoat made for me this year income, but an addition to the capital. Only the services rendered to me during this year by these things are income.” This definition of national income is better than Marshall and Pigou because it is near to the concept of economic welfare.

Simon Kuznets and Samuelson have given the modern definitions of national income. According to Simon Kuznets, “National income is the net output of the commodities and services flowing during the year from the country’s productive system in the hand of the ultimate consumers.” In the words of Prof. P. A. Samuelson, “National income or product is the final figure you arrive at when you apply the measuring rode of money to its land, labor and capital resources.” Modern economists view national income as a flow of output, income and expenditure. When the firms produce goods, the factors of production are paid income in the form of wages, profits, interest, rents, etc. Households on consumption goods spend a part of these income receipts and other part is saved. The producers for investment spending mobilize the savings. Thus, there is circular flow of production, income and expenditure. 

Hence, Total output = Total income = Total expenditure.

Various concepts of National Income

In modern times, a number of concept have come to be associated with the study of national income and social accounting which have made the study of national income broad based and comprehensive. The main concepts of national income are explained below:

i) Gross Domestic Product (GDP): It is a measure of the total flow of final goods and services produced within a country over a specified time period, generally one year. It can be obtained by valuing output of goods and services at market prices and the summing that up. It includes final consumption and investment goods but it excluded intermediate product because they are already implicit in the prices of final products. In short GDP can be listed as:
  • GDP is expressed in money terms; it is the money value of final total goods and services produced within the country during a period of time. The value of final goods and services is calculated at the current market price; hence it is called GDP at market price.
  • GDP includes only those goods and services which have market value and which are brought in the market for sale.
  • GDP does not include depreciation of capital goods and services during the course of production as well as transfer payment and capital gains are not included under GDP.
Hence, GDP = Total agriculture product + Total industrial product + Total product of tertiary sector. By sing expenditure method, it can be shown as:

GDP = C + I + G

Where, GDP = Gross Domestic Product

C = Consumption Expenditure

I = Investment Expenditure and

G = Government Expenditure

ii) Gross National Product (GNP): Gross National Product is the total measure of the flow of final goods and services at market value produced during the year in a nation plus net foreign incomes. GNP is a broader concept than GDP. The net foreign income is the difference between the factor income earned by our residents from foreign countries and the factor income earned by the foreigners from native country.

Hence, GNP = GDP + Net foreign income

Or, GNP = C + I + G + (X – M)

Where, C = Consumption expenditure

I = Investment expenditure

G = Government expenditure

X = Total export earnings

M = Total imports expenses, and

X – M = Net income from abroad

iii) Net National Product (NNP): In the production process, certain amount of fixed capital is used up. This is called depreciation of fixed capital or consumption of fixed capital. By deducting the value of depreciation from the value of GNP in a year, we get another measure of output called Net National Product.

Hence, NNP = GNP – Depreciation

Further, NNP at market price = GNP at market price – Depreciation

iv) National Income (NI): National income is called national income at factor cost because the national income is calculated on the basis of the remuneration of factors of production. Since National Income is the result of the joint efforts of factors of production, it is distributed among the factors. The owners of labor, land, capital and entrepreneurs receive wage, rent, interest and profit respectively. Hence, national income is the sum of income received by factors of production. In other words, national income can be expressed as, 

National Income (NI) = Net National Product + Subsidies – Indirect taxes

Or, NI = NNP + S – IT

Where, NNP = Net National Product, S = Subsidies and IT = Indirect taxes

v) Personal Income (PI): Personal income is the sum of all income actually received by all individuals or households during a given year. However, all income earned by a person does not constitute personal income. It only refers to the income received by the individuals.

Hence, Personal Income (PI) = National income – Corporate income taxes – Undistributed profits – Social security contribution + Transfer payments.

vi) Disposable Income (DI): The entire amount received by the individuals and households are not available for consumption expenditure because some part of the personal income should be paid to the government in the form of direct tax (income tax). Hence, the income remained after paying direct taxes from personal income is called disposable income.

Hence, Disposable Income (DI) = Personal Income (PI) – Direct taxes.

The total disposable income is not spent on consumption. Some part is saved. Thus,

DI = C + S

Where, C = Consumption expenditure and S = Saving

vii) Per Capita Income: Per capita income of a country usually refers to the average earning or income of individuals in a particular year. It is obtained by dividing the national income of the country by the total population.

Hence, Per capita income = National Income/Total Population

Hence, per capita income of the people is useful to compare people’s standard of living in different countries.

Calculation of GDP, GNP, NNP, NI, PI and PDI
($ in million)
1. Gross Domestic Product (GDP)440
Net Factor income from aborad+ 41
2. Gross National Product (GNP)481
Depreciation- 20
3. Net National Product (NNP)461
Net indirect taxes (indirect taxes - subsidies)- 6
National Income(NI)455
Corporate profit taxes, undistributed profits, and valuation adjustment- 2
Social security contribution- 3
Transfer payments to persons+ 6
Personal interest income+ 2
5. Personal Income (PI)458
Personal taxes (direct taxes)- 111
6. Personal Disposable Income (PDI)347

The concept of Super Multiplier Theory

The multiplier that emerges from macroeconomic model in which is both induced consumption and induced investment is called the super-multiplier. The value of the super-multiplier is necessarily greater than the simple multiplier. It is believed that H.R. Hicks first used the term ‘super-multiplier’ in explaining his business cycle theory.

The concept of super-multiplier develops from the point that increase in autonomous investment originates the increase in income. The initial increase in income will give rise to induced investment via the marginal propensity to invest (MPI). The increase in income/output indicates a condition of growing economic activities. So, the business community takes the increase in income as a positive incentive to increase further investment. The increase in income will also affect consumption via marginal propensity to consume (MPC). Induced investment and induced consumption produce further increases in income, and these increases in income still induce/motivate more investment and more consumption spending, and this process continues until a new equilibrium is established.

The super-multiplier is derived by using the consumption and investment function along with national income accounting identity. In formulating the models it is assumed that the economy is operating below full employment level (which means there are unemployed resource of production in the economy), general price level in the economy is more or less constant, effect of interest rate on investment demand as well as on consumption is neutral/unbiased, the economy is simple two sector closed economy.

Aggregate expenditure/demand (AE or AD) is the sum of households’ expenditure on the goods and services (C) and business sectors’ investment expenditure (I). This relationship is mathematically written as

AE = C + I …………………………. (i)

Macroeconomic equilibrium needs that aggregate expenditure/demand should be equal to the total value of income (Y).

Therefore, Y = AE ……………….. (ii)

By combining equations (i) and (ii), we get

Y = C + I ………………………….. (iii)

Equation (iii) is a national income accounting identity (unique condition hold true by definition). It simply tells that total income in equilibrium is equal to the sum of household consumption expenditure and business investment expenditure. In other words, represents macroeconomic equilibrium condition when aggregate demand/expenditure (C+I) is equal to the value of aggregate supply/income (Y).

Household consumption expenditure totally depends upon the level of current income (Y). Consumption is linearly dependent upon income. Keynes in explaining his consumption-affecting factors is insignificant. So, the relation of consumption (C) with income (Y) is algebraically expressed as

C = Ca + bY (0 < b < 1) ……………………. (iv)

Where, Ca is autonomous consumption, b is marginal propensity to consume (MPC) and Y is income level, it is the disposable income or after-tax income (income left after the payment of tax). We have been assuming a simple two sector private economy where there is no government tax, so Y is both national income and disposable income.

Autonomous consumption is independent of the level of income, it is the minimum level of consumption to be made to keep one’s life alive even if the current level of income earning is zero; Ca is the intercept term of the consumption function which represents the effect of all factors other than current income on consumption. Marginal propensity to consume (MPC) or ‘b’ in equation (iv) is the coefficient of Y, and it measures the change in consumption resulting from some change in the level of income. MPC is expressed as a ratio of the change in consumption to the change in income. So, 

MPC = (Change in consumption)/(Change in income) = ∆C/∆Y

In equation (iv) the restriction/limitation on the MPC is that it is positive but less than one (0 < b < 1). This is fully justified by Keynes’ Fundamental Psychological Law of Consumption according to which human beings have a tendency of increasing consumption with the increase in income but not by as much as the increase in income. This means that consumption expenditure increases with the increase in income but all the increases in income is not spent in consumption. The relation of consumption to income is geometrically shown in figure.
Keynesian Consumption Function
The consumption function slopes upward indicating that consumption rises with the rise in income. In the equation “C = Ca + bY”, the term ‘b’ or MPC also measures the slope of the consumption function. Every point on the consumption line represents a combination of the value of Y and C, and hence the ratio of C and Y is a measure of the average propensity to consume (APC = C/Y). Along the consumption increases with the increase in income but by less than the increase in income; some part of the increase in income goes for saving.

Total investment (I) is made of the sum of autonomous investment (Ia) and induced investment. Autonomous investment is not influenced by the change in income but induced investment is totally dependent upon the level of income. Then the investment equation is algebraically written as

I = Ia + βY (0 < β < 1) ………………………. (v)

Where β (Greek small letter beta) is the marginal propensity to invest (MPI); it measures the change in investment with the change in income/output (i.e. MPI = ∆C/∆Y = β). The restriction on the MPI is that it is also positive but less than zero. The increase in induced investment due to the change in income is normally less than the increase in income.

The investment concepts used in deriving the super-multiplier is shown in figure:
Autonomous, Induced and Total Investment
Autonomous investment is constant at some value (equal to Ia in the example) and totally unresponsive to income; the autonomous investment line is parallel to the horizontal income axis; it tells us that autonomous investment remains fixed for a particular period of time whatever may be the level of income. On the other hand, the induced investment line (βY) starts from the origin and is fully dependent upon income level. If income level is zero, induced investment is also zero, and as income rises induced investment also rises. As, total investment is the sum of autonomous and induced investments (I = Ia + βY), the total investment line (I) starts from above the origin with some positive value equal to the autonomous investment (Ia).

In order to derive the value of super-multiplier, we first of all find the equilibrium level of income. For this, we substitute equations (iv) and (v) into equation (iii) which gives:

Y = Ca + bY + Ia + βY

Or, Y –bY – βY = Ca + Ia (collecting Y terms in one side)

Or, Y (1 – b – β) = C0 + Ia

Then the equilibrium level of income (Ye) is

Ye = (Ca + Ia)/(1 – b – β) ………………………. (vi)

Now let us suppose that there is some increase in autonomous investment equal to ‘∆Ia’. This increase in autonomous investment will bring increase in the equilibrium level of income/output by some amount ∆Y. Then the new equilibrium is

Ye + ∆Y = (Ca + Ia + ∆Ia)/(1 – b – β) ……………………. (vii)

Then subtracting equation (vii) from equation (vi), 

Ye + ∆Y – Ye = (Ca + Ia + ∆Ia)/ (1 – b – β) - (Ca + Ia)/ (1 – b – β)

Simplifying,

∆Y = (Ca + Ia + ∆Ia – Ca – Ia)/ (1 – b – β)

Finally, we get,

∆Y = ∆Ia/(1 – b – β)

That is, ∆Y/∆Ia = 1/(1 – b – β)

= 1/{1 – ( b + β)}

= 1/1 – (MPC+MPI) ………………… (viii)

The right hand expression “= 1/{1 – ( b + β)} = 1/1 – (MPC+MPI)” in equation (viii) is what is called the super-multiplier. The restriction in the super-multiplier is that the sum of marginal propensity to consume (MPC = b) and marginal propensity to invest (MPI = β) is not greater than one, that is b + β = MPC + MPI ≠ 1. If b + β > 1 (i.e., MPC + MPI > 1) the value of the super-multiplier will be negative which would mean that increase in investment reduces income/output and this is nonsensical/ illogical in economic explanation because increase in investment is assumed to increase income. If b + β = 0 (MPC + MPI = 0), the value of the super-multiplier will be one which would mean that the increase in equilibrium income is exactly equal to the increase in investment; and if b + β = 1 (MPC + MPI = 1) the value of the super-multiplier tends to infinity (it becomes very large), this would mean that the increase in autonomous investment brings very large increase in the equilibrium level of income, and increased investment is highly productive.

We can now make a comparison of the simple and super-multipliers. The multiplier that emerges in a model where investment includes only the autonomous investment and no induced investment is called simple investment multiplier

∆Y/∆Ia = 1/1 – b = 1/1 – MPC

By comparison, it is obvious that as long as the marginal propensity to invest is positive (i.e., MPI > 0), the super-multiplier is greater than the simple multiplier because an initial rise in income created by a rise in autonomous investment leads to both induced consumption spending and induced investment spending and for this reason the overall rise in income will be greater than if only consumption spending had responded to the rise in income. Symbolically, we can write this as

1/{1 – (MPC + MPI)} > 1/(1 – MPC)

Or, Using the symbols of the equation, 1/{1 – (b + β)} > 1/(1 – b)

We can check this by taking some hypothetical values for MPC and MPI. Suppose MPC = 0.60 and MPI = 0.20. Then,

1/ {1 – (MPC + MPI)} = 1/{1 – (0.60 + 0.20)} = 1/1-0.80 = 1/0.20 = 5

And, 1/(1 – MPC) = 1/(1 – 0.60) = 1/0.40 = 2.5

It is obvious that 5 > 2.5 or super-multiplier is greater than simple multiplier. This would mean that the combined effect of autonomous and induced investment on the rise/increase in income (output) is more powerful than the effect of autonomous investment alone.

The Theory of Acceleration

The multiplier and accelerator are not rivals but parallel concepts. While the multiplier shows the effect of investment on consumption (and employment), the accelerator shows the effect of a change in consumption on investment. According to Hayek, “Since the production of any given amount of final output usually requires an amount of capital several times larger than the output produced with it during any short period (say a year) any increase to final demand will give rise to an additional demand for capital goods several times larger than the new final demand.”
The principle of acceleration states that if demand for consumption goods rises, there will be an increase in the demand for the product. The accelerator therefore makes the level of investment a function of the rate of change in consumption. In other words, the accelerator measures the changes in investment goods industries as a result of changes in consumption goods industries.

The idea underlying the accelerator is not so much one or ever-rising demand as of a functional relationship between the demand for consumption goods and the demand for the machines, which make them. The acceleration coefficient is the ratio between the induced investments to a net change in consumption expenditure.

Symbolically α = ∆I/∆C where α stands for acceleration coefficient; ∆I denotes the net changes in investment outlays, and ∆C denotes the net change in consumption outlays.

Suppose an expenditure of 10$ billion on consumption goods leads to an investment of 20$ billion in investment industries, and then the accelerator is 2. It could be one or even less than that. In actual practice, however, increased expenditures on consumption goods always lead in increased expenditures on capital goods. Hence accelerator is usually more than zero. Where a good deal of capital equipment is needed per unit of output, acceleration coefficient is positive and more than unity.

Sometimes, the production of increased consumer goods does not lead to an increase in the capital equipment producing these goods. The existing machinery also wears out on account of the constant use, with the result than the increased demand for consumer goods cannot be met. In the absence of induced investment and the acceleration effects, the increase demand of consumption goods leveled off and the accelerator, which measures the effects of induced investment as a result of changes in consumption, did not seem to work during these years.

The actual basis of the acceleration principle is the knowledge that the fluctuations in output and employment in investment goods industries are greater than in consumption goods industries. Acceleration has greater applicability to the industrial sector of the economy and as such it seeks to analyze the problem as to why fluctuations in employment in the capital goods industries are more violent than those in the consumption goods industries. There would be no acceleration effects in an economy that used no capital goods. Hence, acceleration principle has been widely used to explain fluctuations in economic activity, especially in the investment goods industries.

Thus, the acceleration principles hold that investment demand in dependent on increases in output, because such increases put pressures on firms to expand their stocks of capital goods. In this theory, investment occurs to enlarge the stock of capital because more capital is needed to produce more output. Firms may be able to produce more output with existing capital through more intensive use, but there is, at any time, a particular ratio of capital to output that firms consider optimum. At any time, there is a particular ratio that is the desired ratio for the economy as a whole over time, this ratio will changes as the mix or output changes. In order to reduce the complication it is assumed that this ratio remains unchanged or constant over time. With K representing the capital stock, Y the level of output and W the capital output ratio, we have 

K = W Y

K (the desired stock of capital) will change over successive time periods only with changes in output (Y). Denoting a particular time period by t, preceding time periods are t – 1 and t – 2 and future of subsequent time periods are t + 1 and t + 2. Assume that in the preceding period (t – 1) the desired capital stock was enough to produce the level of output of the period t – 1. That is

Kt-1 = W Yt-1

Its output rises from Yt-1 to Yt, the desired capital stock would also rise from Kt-1 to Kt that is:

Kt = WYt

This increase in the desired stock of capital is Kt – Kt-1

To get this increase in capital stock, additional net investment is needed – this net increase in net investment expenditure is equal to the change in capital stock, that is,

It = Kt – kt-1 ………………………. (i) 

Where, It is not investment in period t. By substituting WYt for Kt and WYt-1 for Kt-1, we get

It = WYt – WYt-1 = W(Yt – Yt-1) …………………………….. (ii)

This equation simply means that investment during a particular time period (t) depends on the changes in output from ‘t-1’ to t multiplied by capital output ratio (W). If Yt > Yt-1, the equation shows that there is positive and investment during the period ‘t’. If, however, we want to show gross rather than net investment, all that it needed is to add replacement investment to both sides of the equation. This replacement investment is taken to be equal to depreciation and in shown by Dt, we have thus;

It + Dt = W (Yt – Yt-1) + Dt

The sum of It and Dt cannot be less than zero. If Ig represents gross investment in period t. We have, 

Igt = W (YtYt-1) + Dt …………………………. (iii)

Investment will respond to changes in the level of output shown by the equation only if certain assumption are satisfied, the most important being the absence of excess capacity, if Xt shows the excess capacity at the beginning of the period t, we may rewrite equation (iii) as;

Igt = W (YtYt-1) + DtXt

Whatever the level of gross investment might otherwise be in t, it will be reduced by the amount of Xt. It’s the value of W(Yt – Yt-1) + Dt happened to be equal to an less than Xt then Igt would be zero, the minimum possible for gross investment in plant equipment.

Limitations and Assumptions

The acceleration value may be considerably reduced as account of some practical limitations and assumptions:
  1. No excess capacity: If there is already excess capacity in the consumer goods sector, a rise in demand for consumer goods will not lead to any induced investment or acceleration effects, because the increased demand may be met from the existing capital and machinery without producing additional capital goods. This will be a case of zero gross investment and is the typical case during the initial period of recovery phase of the trade cycle.
  2. Surplus capacity: The operation of the principle depends upon the presumption that there in surplus capacity in the investment goods industries. If it were not so and no excess capacity existed in machine making industries, an increase in the derived demand for machines could not result in an increased supply of machines. Hence, the principle of acceleration depends upon very tough conditions that there shall be excess capacity in one industry (investment industry) but no excess capacity in other (consumer goods industries).
  3. Capital output ratio: It is based on the assumption that there is a constant ratio of the output of consumer goods and capital equipment needed for their production. In reality thus ratio is not constant. Apart from the inventions and improvements in the technique of production, existing capital equipment may be worked more intensively. The capital output ratio also varies in different phases of the business cycle and does not remain constant.
  4. Nature of demand: An increase in the demand for consumption goods must be more or less permanent in nature to have acceleration effects. A purely temporary increase in the demand for consumer goods will not lead to any addition in the capital goods. Durable capital goods are expensive and no producer will order capital goods that increases in demand in short level. This also shows that the acceleration is not based on merely technological factors but also no profit expectation.
  5. Availability of resources: The working of acceleration principle is further impaired by the availability of resources and the ability of the machine making industry to produce more machines. In order that the increased demand for capital goods is followed by an increase in the production, there must be enough unemployed factors available for employment in the capital goods industries. This is possible only when there is widespread unemployment in the economy.
  6. Elastic credit supply: The elastic supply of money and credit is another factor, which helps, in the smooth working of the acceleration principle. Whenever there is induced investment as a result of induced consumption, enough money and credit should be forthcoming for investment in investment goods industries. A scarcity of money and credit will raise the rate of interest and will make investment financed by borrowed funds easier. It is, therefore, essential that the rate of interest not be allowed to rise and that there is enough credit to allow for the acceleration effects to flow.

Price level is the consequent of change in income

According to the saving-investment theory, price level is he consequent of the change in income than quantity of money.

At the equilibrium level of income, S = I or Y = C + I, the output and the price level in the economy tend to be stable. But saving and investment decisions are made by diverse groups of people and with different motives. Thus, there is every possibility of saving-investment disequilibrium taking place in the economy. Sometimes, investment may exceed saving and sometimes saving may exceed investment. This disequilibrium in saving and investment causes changes in output and prices.

i) Investment Exceeding Saving

Let us assume saving investment equilibrium and also assume that the investment expenditure increases in the economy without an equal reduction in the consumption expenditure. This is a case of an excess of investment over saving. This excess of investment over saving may be possible by an expansion of money through credit creation by commercial banks or by the dis-hoarding of wealth by the people. This excessive investment increases the money income of the consumers due to increase employment resulting from increased investment. The consumers in turn spend more on consumer goods. It raises the prices of the consumer goods and the profits of the producers manufacturing consumer goods. They tend to increase their investment in anticipation of still higher profits. This cumulative process of expanding investment continues.

During depression, as a result of the expansion of investment employment of idle resources and money income for the people will increase. There will be some increase in prices but it will not be a steep rise because of a simultaneous increase in output. Once full employment is reached, the prices will rise in proportion to the rise in money supply.

But the saving-investment disequilibrium will not last long. When income rises as result of investment exceeding saving, saving being a function of income also starts rising. This reduces the gap between investment and saving and once again saving-investment equality is attained. This new equilibrium is at higher levels of income, output, employment and prices.
Investment Exceeding Saving
In figure, original saving-investment equilibrium is at E where investment curve (II) intersects the saving curve (SS). The equilibrium level of income is OY. As a result of increase in investment, the investment curve shifts upward to IT which intersects the saving curved at the new equilibrium point E1. OY1 is the new and higher equilibrium level of income.

ii) Saving Exceeding Investment

The excess of saving over investment may arise in two ways:

i) As pointed by Keynes, saving function remaining unchanged, the excess of saving over investment is the result of a sudden fall in the marginal efficiency of capital unaccompanied by proportional fall in the rate of interest. This generally happens during the boom period of the trade cycle. The excessive saving results in a decline in the expenditure on consumer and investment goods. The demand and the prices of the consumer goods fall. The actual profits of the producers fall short of the expected profits. Consequently, they reduce the employment, output and income. But, when income falls, saving being a function of income, also falls. This reduces the gap between saving and investment and new saving investment equilibrium is reached at lower levels of output and prices.
Saving Exceeding Investment
In figure, original saving-investment equilibrium is at point E with an income of OY. Excess of saving over investment is depicted by a shift in investment curve form II and I’I’. The new equilibrium is at point E1 with a reduced income of OY1.

ii) Investment function remaining unchanged, the excess of saving over investment is the result of an upward shift of saving function. In this case too, the new equilibrium will be at a lower level of income and prices. In figure (B), the original saving-investment equilibrium is at point E with an income of OY. Excess of saving over investment is represented by a shift in saving curve from SS to S’S’. Then now equilibrium is established at point E1 with a reduced income of OY1. Thus, whenever saving exceeds investment, it initiates a process of cumulative decline in income prices and economic activity. It is in this sense that Keynes regarded saving as a private virtue but a public vice.

According to Keynes, saving function remains more or less stable in the short period. Hence, the business fluctuations in the economy are largely due to investment. An increase in investment leads to a rise in income, output, employment and prices and a decrease in investment causes a fall in the income, output, employment and prices.

In summary, saving investment theory of money, it is the inequality between saving and investment that causes price fluctuations (or the changes in the value of money) through changes in the level of income:
  1. If saving and investment are in equilibrium (S = I), the price level will tend to be stable.
  2. If investment exceeds saving, the price level will rise.
  3. If saving exceeds investment, the price level will fall. Thus, contrary to the quantity theory of money, the income theory of money emphasizes those fluctuations in the price level are due to the changes in income rather than in the quantity of money.

The dispute between Monetarism and Keynesianism

A large part of modern monetary economics is characterized as having two views, the monetarist and the Keynesian or fiscalist. The conflicting views on the mechanism as to how money supply affects the general economic activities or income level. Some theorists put the emphasis on a direct relation between the money supply and expenditure. Some economists argue that it is by changing financial conditions particularly the rates of interest, volumes of lending and borrowing that influence of money supply on economic activities can be judged. According to the former school, an increase in the money supply means that some money holders will have excess money balance in their asset portfolios. In the process of restoring equilibrium these balances will be converted into the real goods and services either directly or through the inter mediation of financial institutions. The pressure of demand for
more goods and services will stimulate output and encourage price rises until the value of the output has risen in proportion to the increase in the money supply. Monetary school gives no special emphasis on the rates of interest on the financial assets.

The other school points out that the increase in the money supply will affect cost and the availability of the credit. The superiority of monetary over Keynesian models has not been demonstrated. However, monetary factors are not unimportant; there is no reason to reject the view that changes in the interest rate or the availability of credit. Advocates to monetary approach have not yet shown that the changes in money supply have a reliable and predictable effect on expenditure, even the directions of causation between the money supply and income is at issue.

The most interesting event or a very long time in the real economics has been challenged by a new school of thought called ‘Monetarists’ led by its leader Milton Friedman of Chicago University. A debate continues to exist between one group, which places major stress on fiscal policy as the primary engine of growth and economic stabilizer, and a second group, which feels that money, and therefore monetary policy is the most important primary factor in growth and economic stability.

Monetarism refers to the followers of Milton Friedman who hold that ‘Only money matters’ and as such monetary policy is a more potent instrument than fiscal policy in economic stabilization. Keynesianism refers to the followers of Keynes who believe that ‘Money does not matter’, for economic stabilization, fiscal policy is a more powerful instrument than monetary policy. The difference between Monetarism and Keynesianism can be analyzed as follows:

Theoretical Differences

The monetarists emphasize the role of money in explaining short changes in national income. Friedman and Schwartz have shown that changes in the money supply cause changes in national income. The monetarists believe that all recessions and depressions are caused by severe contraction of money and credit, and booms and inflation by excessive increases in the money supply.

The Keynesians reject the monetarist view that changes in national income are caused solely by changes in money supply. They hold that changes in national income cause changes in the supply of money. The moderate Keynesians still believe such as monetarists that hyperinflation is caused by excessive money supply. On the other hand, the extreme Keynesians hold that non-monetary factors such as investment cause depressions and booms.

Monetarist View

As pointed by the monetarists, the money supply is the ‘dominant though not exclusive’ determinant of both the level of output and prices in the short-run, and of the level of prices in the long run. The long run level of output is not influenced by the money supply. It is dependent on such real factors as technology and the quantity and quality of productive resources. Although factors other than the money supply affect the level of output, employment and prices in the short-run, yet their effects are subordinate to that of the money supply.

A change in the money supply will inevitably affect the price level and output in the short run. But, in the long run, the effect of change in the money supply will be entirely on the price level because the economy is near full employment in that time period and the increase in national income will consist mainly of higher prices. Hence changes in the money supply affect national income directly. This is due to the assumption that the velocity of circulation of money is stable.

The monetarists hold that he rate of interest plays no part in determining the demand for money. The demand for money is the transactions demand for money, which is determined by the level of income. The monetarists believed that the money supply is also not influenced by interest rates. This insensitiveness of both demands for and supply of money is based on the quantity of money. The simplest quantity equation is MV = PQ, where M is the quantity of money, V is its velocity, Q is the number of physical transactions, and P is the price level. Taking PQ = Y, where Y is the national income, the quantity equation becomes MV = Y. As V remains constant, changes in M cause changes in Y.

The monetarist is based on the belief that money is a god substitute for all types of assets such as securities, houses, durable consumer goods etc. Prof. Friedman findings show a ‘stable money demand function’, which implies the demand for money is a stable function of peoples’ income. In other words, the amount of money that the people want to hold is related in a fixed way to their income. If the central bank increases the money supply, it affects interest rates on these different ways:

i) There is the liquidity effect, which causes a very short run reduction in the interest rates. As a result, people will sell securities and their holdings of money will increase. Therefore, there will spend their excess money balances on financial assets on durable consumer goods. This increase in aggregate expenditure on assets and goods will tend to raise output, employment and income. It is called output effect, which will tend to a rise in interest rates because of the rise in output and demand for money resulting from the liquidity effect.

ii) There is the price expectations effect, which occurs due to the expectations of lenders that inflation will continue. They will demand higher interest rates in order to cover the expected inflation rate.

Thus, with the short run liquidity effect bringing a downward pressure on interest rates and both the output and price expectations effects bringing an upward pressure on them, the combined effect will be an increase in interest rates. It will, in turn, discourage investment, and reduce output and employment.

Keynesian View

The Keynesian hold just the opposite views to monetarists about the demand for and supply of money and the aggregate expenditure. Both the demand for and supply of money are highly interest elastic while the aggregate expenditure is not.

They consider the supply of money to be fixed in the short run by monetary authorities. The demand for money also called the liquidity preference is the desire to hold cash. There are three motives on the part of the people to hold cash: transactions, precautionary and speculative demand for money. Money held for transactions and precautionary motives is a function of the level of income, and for the speculative motive, it is a function of the interest rate.

To the Keynesians, it is expected about changes in both prices or in the market rate of interest that determine the speculative demand for money. The speculative demand for money is a decreasing function of the rate of interest. The higher the rate of interest, the lower the speculative demand for money, and vice-versa. But at a very low interest rate, the speculative demand for money becomes perfectly elastic.

On the whole, given the level of nation income, the demand for money is a decreasing function of the interest rate. The Keynesians believe that money and financial assets to be goods substitutes for each other. They are highly liquid and yield interest. So, even small changes in interest rates lead to substitution between money and financial assets. A small fall in the interest rate will mean a rise in the price of securities, which will induce people to sell securities and hold more money. The reverse will be case in the event of a small rise in the rate of interest. Thus, the demand for money is highly interest-elastic under Keynesianism.

The Keynesians believe in the existence of unemployment equilibrium. This implies that an increase in money supply can bring about permanent increases in the level of output. The ultimate influence of money supply on the price level depends upon its influence on aggregate demand and the elasticity of the aggregate output.

The Keynesian chain of causation between changes in the quantity of money and in prices is an indirect one through the rate of interest. So when the quantity of money is increased, its first impact is on the rate of interest which tends to fall. Given the marginal efficiency of capital, a fall in the rate of interest will increase the volume of investment. The increased investment will raise effective demand through the multiplier effect thereby increasing income, output and employment. Since the supply of factors of production is perfectly elastic in a situation of unemployment, wage and non-wage factors are available at constant rate of remuneration. There being constant returns to scale, prices do not rise with the increase in output so long as there is any unemployment. Under the circumstances, output and employment will increase in the same proportion as the quantity of money.

But ‘once full employment is reached, output ceases to respond at all to changes in the supply of money and so in effective demand. The elasticity of supply of output in response to change in the supply, which is infinite as long as there was unemployment, falls to zero. The entire effect of changes in the supply of money is exerted on prices, which rise in exact proportion with the increase in effective demand’. Thus, so long as there is unemployment, output will be no change in prices; and when there is full employment, prices will change in the same proportion as the quantity of money.

In the Keynesian transmission mechanism, changes in the money supply affect aggregate expenditure and national income indirectly by changes in interest rate. Suppose the money is increased, it lowers the interest rate which, in turn, increases investment and expenditure thereby supply are transmitted into the level of income: for example, an increase in the money supply causes people to spend their excess holdings of money on financial assets. This means, an increase in the demand for such assets and a rise in their prices. Rise in the prices of assets (securities), brings down the interest rates which, in turn, increase aggregate expenditure, investment and hence income. Thus, according to the Keynesian view, a change in the money supply can only affect aggregate spending and national income first through changes in interest rates, and then only if the aggregate spending is sensitive to interest rate changes.

Policy Differences

Another point of differences between the monetarists and the Keynesians is over the policy prescriptions. According to the monetarists, monetary policy has a greater influence on economic activity than fiscal policy, and fiscal policy is important only making changes in the money supply. On the other hand, the Keynesians emphasize the importance of both fiscal and monetary policy in influencing the economy but they attach more importance to the former than to the later. First, we study the monetarist view on monetary and fiscal policy and then the Keynesian view.

Monetarist View

The monetarists hold that changes in the money supply have a direct influence on aggregate expenditure and thus on income. It can be analyzed an expansionary monetary policy followed by monetarists. To begin, suppose the central bank purchased securities in the open market. It raises the price of securities and lowers the rate of interest. People will, therefore, start selling securities and hold more money. People spend their excess money balances on financial assets and durable consumer goods. Other attracted by low interest rates borrow from banks for expenditure on houses, durable consumer goods, plants and equipment, etc. The forces tend to increase aggregate expenditure and income.

Keynesian View

In contrast to the monetarists, the Keynesians regard monetary policy relatively less effective because of the relative interest inelasticity of aggregate expenditure. In the expansionary monetary policy, the central bank purchases securities in the open market. As a result, the price of securities rises and the interest rate falls. People will therefore, start selling securities in order to hold more money. As the demand for money is highly interest elastic in the Keynesian system, even a small fall in the rate of interest will induce people to sell securities and hold more money.

The controversy between Keynesianism and monetarism can be list out as follows:
Differences
Monetarists
Keynesians
(i) Role of MoneyOnly money matters. In other words, only changes in money supply influence the level of nominal income.Money does not matter. In other words, a change in money supply will not change nominal income; it will simply increase the idle cash balance for speculative motive.
(ii) Rate of InterestMoney supply alone should be watched closely because a change in money supply changes aggregates demand directly and not through interest rates.Interest rates are important but the money supply is not. Interest rates affect planned investment and thus national output.
(iii) Monetary PolicyUse monetary policy rule for stabilization.Monetary policy is seldom appropriate.
(iv) Fiscal PolicyFiscal policy is absolutely ineffective because it has no effect on nominal aggregate demand.Fiscal policy is powerful tool, as compared to monetary policy.
(v) Relationship between Money Supply and Price LevelThere is direct and proportional relation between money supply and price level. So, MV = PQThere will be some relationship between price level and money supply through investment and return but not directly proportional relation.
(vi) Economic GrowthMoney supply, demand of money and interest rate can play major role for sustainable economic growth.Government intervention promotes the economic activities because at that condition private sectors are not invested. So, government should promote economic activities.
Similarly, the monetarists advocated that the role of central bank is important whereas Keynesians believed that demand for resources, factor employment, and increase in income then effective demand which increase investment.

Operating Controls

Operating controls are government’s regulations or standards that limit undesirable behavior by compelling certain actions while prohibiting others. Regulation through operating control, that is, control through government directive is an important and growing form of regulation. These regulations are designed to limit or control socially undesirable activities of firms. This tool
of regulation is one of the most popular methods of correcting market failure due to negative externalities. Through these means the government will protect and advance that public interest in health, safety and security, the quality of the environment, and the social and economic well-being of people.

Government sets the rule of game for the operation of private sector business activities. The legal framework sets the legal status of business enterprises, ensures the rights of private ownership, and allows the making and enforcement/implementation of contracts. Government also establishes the legal “rules of the game” governing/administering the relationships of businesses, resource suppliers, and consumers with one another. Units of government can judge/referee economic relationships, try to find foul/dishonest play, and exercise authority in imposing appropriate penalties.

Forms of Operating Control

Operating controls may be in various forms:
i) Control over environmental pollution: Environmental pollution is a negative externality created by private business firms involved in production activities. Government uses its different tools to correct the negative externality. For example, government sets limit for automobile emissions, fuel efficiency, and safety standards to control environmental pollution. The government of Nepal, for example, has introduced Nepal Vehicle Mass Emission Standards 1999 (2056 B.S.) to control pollution created by vehicles. The role of the Environmental Protection Agency (EPA) of the US Federal Government is to control pollution.

ii) Control on food products: Firms involved in the production and sales of food products, drugs, and other substance could harm consumers by producing and/or supplying low-quality or substandard items. So it is essential to regulate such production activities. Government regulates such activities through food and drug acts. The act designed by the government to control the quality of Food forces the private business to maintain the standard mentioned in the act.

For example, The Pure Food and Drug Act of 1906 in the US sets rules of conduct governing producers in their relationships with consumers. It prohibits the sale of adulterated and misbranded foods and drugs, requires net weights and ingredients of products to be specified on their containers, establishes quality standards which must be stated on labels of packaged foods and prohibits deceiving claims on patent-medicine labels. These measures are designed to prevent false activities by producers and to increase the public’s confidence in the integrity of the market system.

iii) Industrial work conditions: Government controls the working environment of a factory by using labor laws and health regulation including the provisions relating noise levels, noxious gases and chemicals, and safety standards. For example, The Occupational Safety and Health Administration (OSHA) agency of the US Federal government requires that employers inform workers about risks and mandates firms to reduce risks.

iv) Wage and price control: Government also regulates wage through minimum wage law and price is also regulate to control inflation. Wage and price control policy of the government limits the freedom of the firm to determine wage and price.

v) Control in the operation of financial institutions: Government attempts to control the loan advancing activities of commercial banks by setting the minimum required reserved ratio (RRR) under which every commercial bank is required to keep certain percent of the deposit in cash. Banks cannot advance loan by undermining that RRR.

vi) Control in transportation: Government also regulates the operation of airplanes and vehicles. For example, the government fixes the limit of the weight of luggage/baggage in airplanes, (normally up to 15 kg it is free, and beyond that passengers have to pay additional charges), prohibition on carrying passengers on the top part of passenger buses, the Federal Aviation Administration (FAA) of the US sets standards for airline safety whereas The National Highway and Traffic Safety Administration (NHTSA) monitors risks and sets standards for automobiles and highways.

Cost and Benefits of Operating Controls

The question of who pays for such regulation is seldom answered by simply referring to the point of tax collection or point of the incidence of tax burden. This economic cost of regulation is often transferred to consumers or suppliers, as determined by the relative price elasticities of the demand and supply functions.

We can discuss the benefits of much operating controls in terms of information and risk. We know that there are externalities associated with information and risk. If every person who flew on an airplane had to have it checked for safety, the costs would be huge. It is much cheaper to have an agency like the Federal Aviation Administration (FAA) checks for airline safety. When the FAA sees a way to make a change in safety requirements that will reduce risk and thereby save lives, it has the authority to require that the airlines make these changes. Similarly, it would be costly for each consumer to check the accuracy of all advertising claims, or to test the efficacy of a new drug. By giving the Food and Drug Administration (FDA) of the US Federal government the responsibility for testing new drugs, the public saves considerably on time and effort.

To be sure, without the government, private organizations would probably keep going to provide testing and information about products. Consumers Union is one such organization, and many industries in the US economy have private watchdog organizations. But because of information externalities, the private actions would probably fall short of the efficient level.

The benefits from providing information about risks must be considered in light of the costs. The FDA might hold back a new drug for testing to reduce risks, but his is costly to the people whose lives could be saved if the drug were approved. The building code requirements for a construction site might raise the cost of construction significantly. Frequently, these costs are not visible. No one knows that an illness might have been prevented with a new drug, but everyone knows when a faulty new drug causes severe illness or death.

The actions of the FDA, Occupational Safety and Health Administration (OSHA), and other agencies of the US Federal government involved in social regulation are frequently criticized because of the costs they impose on firms and consumers. Very angry letters and critical editorials about the costs are common. It is very difficult to estimate the costs, but some economists have tried. It has been reported that the cost estimate of implementing the operating control measures in the US economy ranges from around 3 to 5 percent of GDP per year for all programs. On the other side, the programs are popular, and they clearly do reduce risks and provide information.

Ultimately, the degree of government intervention will be decided in the give and take of the political process. But careful cost-benefit analysis on a program-by-program basis, as urged by many economists, would help in the decisions-making process.

Subsidies

Subsidy is a financial incentive by the government to the consumers and/ or producers. According to P. A. Samuelson and William D. Nordhaus, “A payment by a government to a firm or household that provides or consumers a commodity”.

A subsidy can be used to support businesses that might otherwise fail, or to keep prices below what they would be in a free market or to encourage activities that would otherwise not take place. For producers/suppliers ‘subsidy’ is the financial support/grant generally by the government to private firms (which may be called investment grants) and to state-owned firms (covering losses).

Types of Subsidies

There are many forms of subsidies given out by the government, including welfare payments, farm subsidies, housing loans, and student loans. For example, if a domestic industry, like farming, is struggling to survive in a highly competitive international industry with low prices, a government may give cash subsidies to farms so that they can sell their product at the low market price but still achieve financial gain.

Subsidies provided by the government are classified on different bases for example on the basis of the recipients of the subsidy (e.g., consumer or producer) or on the basis of the source of the funds (government, consumer, general tax revenues, etc). In economics, one of the most important ways to classify subsidies is the mean/ way of distributing the subsidy. We briefly introduce the major forms of government subsidies as follows:
i) Direct subsidies: Direct subsidies involve a direct cash transfer to the recipient by the government, for example an unemployed person or an agricultural corporation. These are the most simple, and perhaps the least frequently used forms of government subsidy. During the 19th century, as the American frontier (boarder line) was moving westward, the federal government gave extensive grants of land and construction funds to the railroads. In the 20th century, governments in Europe, North America, and Japan give direct payments for ship construction and some forms of public transportation.

ii) Indirect subsidies: Indirect subsidy is a broad term that would cover any form of subsidy that does not involve a direct transfer. These are the most widespread, if less visible, forms of support/aid provided by the government to private enterprise and other institutions. Indirect subsidies may take such forms as favorable tax policies, loans, import quotas, and price supports. For example, if the Government of Nepal persuades India or China to limit their new chocolates exports to Nepal, Nepalese chocolates industry would benefit.

iii) Tax subsidy: A tax that is below its optimal level generates a “tax subsidy.” Under this form of subsidy, the recipients get the benefits through the tax system, usually through the income tax, profit tax, or consumption tax systems. Examples may include tax deductions for workers in certain industries, accelerated depreciation for certain industries or types of equipment or exemption/omission from consumption tax (sales tax or value added tax).

Subsidies provided through tax breaks are described as “corporate welfare.” A tax break is a reduction in the normal rate of a particular class of taxes targeted towards an individual or group of companies. Bigger tax breaks are provided to larger companies which are planning to open a new factory (e.g., shop) around a location. Locations provide these tax breaks because they often feel that the benefits of job creation will more than the decline in tax revenues. Governments of all levels may do this to encourage employment in under-developed areas. Tax subsidies are given as a protection to smaller producers to help them compete with larger companies, to help correct international trade imbalances, to support industry believed important to national security, and to help industry compete with other countries, and these are common practice throughout the world.

However, there is debate/dispute on whether such subsidy should also apply to firms that create excessive social cost in the form of environmental degradation and public health costs. The most effective way of compensating for the problems as traditional economic theory suggests is to internalize the cost (by regulations, or other means).

iv) Labor subsidies: A labor subsidy is any form of subsidy provided by the government to pay for labor costs. Examples may include labor subsidies and tax deductions for workers in industries, such as the film and/or television industries. Wage subsidies provide a financial incentive to eligible/authorized employers when considering the employment of job seekers with disability or with other barriers to employment. Wage subsidies are payments made to employers to help cover the costs of paying wages at least for short run. They also aim to increase the competitiveness of job seekers, including those with disability. During economic recession government provide labor subsidies to employers.

v) Production subsidies: Governments in certain case (for example to encourage the development of a particular industry) may provide direct production subsidies – cash payments for production of a given good or service. Normally, production subsidies are easily identifiable, such as minimum price policies. Indirect production subsidies may be less easy to identify, such as infrastructure subsidies.

vi) Perverse subsidies: Famous environmental economist Norman Myers has argued on “perverse subsidies”. The term “perverse” can be applied to a subsidy by its opponents if they believe that it encourages adverse/undesirable actions with social costs. Possible examples, suggested by Norman Myers are German subsidies on coal mining and American petrol (gasoline) subsidies.

vii) Infrastructure subsidies: Infrastructures subsidies may be used to refer to a form of indirect production subsidy. The provision of infrastructure (at public expense) may effectively be useful for only a limited group of potential users, such as construction of roads at government expense for a single logging company. The implication is that those users or industries benefit disproportionately from the provision of that infrastructure, at the expense of taxpayers.

In some cases, the government may need to improve the public transport by subsidizing those transportation agencies that provide the public services so that the services can be affordable for everyone. This is the best way of helping different groups of disabled and low income families in the society.

viii) Export subsidies: Various taxes or other subsidy measures may be used to promote exports of favored – industries. In other cases, tax measures may be used to ensure that export subsidies are justified as a means of compensating for the subsidies or protections provided by a foreign state to its own producers.

ix) Trade protection: Measures used to limit imports from other countries may form/represent another type of hidden subsidy. The economic argument is that consumers of a given product are forced to pay higher prices for a given good than they would pay without the trade barrier; the protected industry has effectively received a subsidy. Such measures include import quotas, import tariffs, import bans, and others.

x) Consumption subsidies: Customers would pay only market prices for goods and services if economic competitions were totally unhindered/unhampered and all markets were free and unregulated. Competition would serve/work to keep prices low and quality high. But this situation rarely exists because of a wide range of government policies that affect the selling prices and the quantities of most items produced and offered for sale.

The provision of public goods (e.g., health and education services through consumption subsidies is an example of a type of subsidy recognized/identified as ‘efficient’ by economics. In some cases, consumption subsidies may be targeted at a specific group of users, such as large utilities, residential home-owners, and others.

xi) Purchasing subsidies: Government everywhere is relatively large consumers of various goods and services. Subsidies may occur in this process by choice of the products consumed, the producer, the nature of the product itself, and by other means, including payment of higher-than-market prices for goods purchased.

xii) Subsidies due to the effect of debt guarantees: Another form of subsidy is due to the practice of a government guaranteeing a lender payment if a particular borrower defaults (fails to pay). For example, this occurs in the United States, in certain airline industry loans, in most student loans, in small business administration loans, and in mortgage (home equity) backed bonds. A government guarantee of payment lowers the risk of the loan for a lender, and since interest rates are mainly based on risk, the interest rate for the borrower lowers as well.

xiii) Price subsidy: Price subsidy is a form of government intervention resulting in a deviation/discrepancy of an actual price facing consumers and producers from a specified “optimal/appropriate” benchmark price level. Government price are common/widespread in developed, emerging, and low-income countries. They reflect public choices in favor of certain economic outcomes and/or efforts to overcome market failures. For example, almost all governments subsidize the costs of education and health services for the mass of their populations. Food and energy subsidies are relatively large in many emerging and low-income countries. Many governments subsidize the cost of transport. Agricultural subsidies are relatively large in number of developed countries. Other common subsidies include those for utilities, public services, and pharmaceutical products.

Externalities in the Economy

Externalities are pervasive and significant phenomena in modern societies. The term externalities refer to the economic effects which occur from the production or the use of goods to other parties or economic units. It is said that public goods and externalities are not un-related. In other words, public goods and externalities are related. Externalities may affect a large number of people in a uniform manner, in which case the externality is essentially a public good (or public “bad”).

For example, education increases the skills and general welfare of the person being educated and may in addition, make the person better citizen. That is, the person’s behavior in political process may be more wise and informed, and an informed may make better political decisions. Since, such decisions affect every one, the education of each person produces an external benefit that accrues to the
members of the community and the nation in which person reside. This external benefit is a public good that is jointly produced along with the private goods (marketable skills) resulting from education.

Similarly, air pollution generated by an iron mill’s smoke and the exhaust of automobiles are public bads that are produced jointly with private goods (iron mills and private transportation). Again, the railways using a lot of coal in firing steam locomotives put the residential and other areas near the railway loco sheds to a lot of suffering on account of the smoke nuisance. These are the cost to the society but not to the individual undertaking.

In the above examples, public goods, i.e., benefits and public bads that are produced with private goods are known as externalities. These are the cost to the society but not the individual undertaking. This causes of divergence between private cost (internal cost) and social marginal cost or external cost of benefit, of the good in question. Market takes into account internal costs and not the social marginal cost or external cost (or benefit) of the good in question. Consumer’s reveal their preferences for the benefits which are wholly internalized (rival) but not for the external benefits, i.e., purification of air (non-rival). Thus, market fail to achieve efficient allocation of resources when externalities are present.

To be more clear, let the production of a commodity, say iron generates air pollution that adversely affects the welfare of the people in the surrounding community. The cost of iron, thus, have two components: (i) the cost of the labor, machines, iron ore, coal and other inputs directly required to produce the iron; and (ii) the costs borne by the members of the community in the form of air pollution damages. Market takes into account first component of the above costs but not the second. This is the cause of divergence between private cost (internal cost) and the social marginal cost (external bads). Hence, markets fail to achieve efficient allocation of resources when externalities, i.e., external costs or benefits are present.

Thus, externalities can take many forms. For example, external benefits from education: children gain from having educated parents; society benefits in so far as education reduces crime, social un-rest, unemployment and welfare costs; society benefits from an educational system that inculcates acceptable social values, improves communication and strengthen democratic institutions, on the (external bads) side are many forms of pollution and other disseminates such as congestion and noise etc.

i) Externalities in the form of external benefits: Problems of social good-type arise not only in the budgetary context but also wherever private consumption or production activities generate external benefits. Suppose, for instance, that A derives benefits being inoculated against polio but this also benefits others, since the number of potential carriers and hence the danger of infection, is reduced. Similarly, by getting educated, A not only derives personal benefits but also makes it possible for others to enjoy association with a more educated community. Since, large number of other consumers may be affected, market does not work and a budgetary process is needed to secure preference revelation. But budgetary intervention in this case will not involve full budgetary provision: rather, it will take the form of subsidy to private purchases.

ii) Externalities in the form of external costs or bads: Let us now consider a case of a commodity which generates external costs or bads. Suppose, the production of iron generates air pollution that adversely affects the welfare of the people in the surrounding community. The cost of iron, thus, has two components: (i) the cost of the labor, machines, iron ore, coal and other inputs directly required to produce the iron, and (ii) the costs borne by member of community in the form of air pollution damages. However, the second component of cost is not taken into account by the market. In fact, private activities, whether in production or consumption frequently give rise to external costs which are not accounted for by the market. Hence, public (Government) intervention is needed to get this part of the cost to be internalized.

iii) Efficiency and equity problems: In the first place, failure to account for external costs leads to an over supply of production question (i.e., here iron) and an under supply of the benefits (i.e., clean air) which are reduced by pollution. This is the efficiency problem. If the damage cost of pollution were internalized, resource use would become more efficient. The price of iron would be higher, less iron would be produced and the air quality would be improved.

Second, the existence of pollution poses distributional or equity problems. Through, the loss of environmental quality, consumers of air are forced to subsidize consumers of iron, much as they would if a tax were imposed on them (consumers of air) and transferred to the latter (i.e., consumers of iron). Moreover, the incidence of pollution damage may fall with different weight upon low income and high income families, and this affects the distribution of real income. The same goes for the cost of pollution prevention and the net gains to be derived there from.

iv) Efficient solution: It should, however, be noted that air is a public property, it is a social good. The principle of exclusion does not apply. Hence, market fail to take into account external costs or the damages caused by air pollution. The benefits of this good are shared by all those who are damaged by pollution.