THE FUNCTIONING OF AN ECONOMY: BASIC CONCEPTS
This chapter defines the basic concepts of economics such as economic activity and circular flow of economic activity; and correlates it with consumption including an analysis of human wants. It describes Engel's law of family expenditure in the context of consumption, the concept of standard of living and the linkage between savings and investment in an economy.
WHAT IS AN ECONOMY?
An economy may be defined as a legal and institutional framework within which economic activity takes place. The Oxford English Dictionary defines economy “as the wealth and resources of a community, especially in terms of the production and consumption of goods and services”. In this chapter, we study all these parameters of India's economy and the significant concepts associated with the economy. A proper understanding of the actual meanings of these concepts when used in economics, as opposed to what these mean in common parlance, will help you get a clearer idea of the subject matter of economics.
We see around us people producing, consuming and exchanging their goods against money or other goods. A community at work might consist of miners, farmers, factory workers, shopkeepers, software engineers, artisans, drivers, teachers, doctors, chemists and clerks. Each of these groups is in some form of economic activity. An economic activity takes place to meet the economic requirements of the community—food, shelter, clothes and a host of other commodities. Activities of this type could be categorized as: (i) production of goods and services, (ii) exchange of goods and services, and (iii) consumption of goods and services.
WANTS: THE BASIS OF ALL ECONOMIC ACTIVITIES
The mainspring of all economic activities is human wants. A community with fewer wants does not have many economic activities, and is deemed backward in economic literature. Multiple and diverse wants lead to increasing economic activities, promoting greater economic prosperity. Therefore, it can be said that the main purpose of economic activity is the satisfaction of human wants. Where wants are relatively few, as in a primitive community, economic activities will be restricted to those needed to fulfil man's basic needs such as food and clothes. In a highly developed society, economic activity will be of a very high order, reflecting the many and varied wants of the population. One basic reason why countries such as India have remained poor for many centuries could be the tendencies of their people to be satisfied with what little they had and not overreach themselves to acquire too many worldly things. Their scriptures too glorified asceticism, self-contentment and self-denial. Obviously, their economies remained stagnant and underdeveloped.
CIRCULAR FLOW OF ECONOMIC ACTIVITY
The circular flow theory was first advanced by the early French economists known as the physiocrats. Francois Quesnay, a leading proponent of the physiocratic theory, wrote in 1758 that the flow of economic activity was a natural order which was self-sustaining in nature. Quesnay proposed that the flow had an inherent self-correcting mechanism and, therefore, did not need to be directed by the government. The circular flow creates a balance by automatically decreasing and increasing consumers’ spending levels and business investments, when needed. The underlying assumption of the circular flow of economic activity is the oft-quoted truism “what goes around comes around.” The flow commences with the spending habits of consumers that helps create the quantum of investments that businessmen make in resources to produce goods, which in turn has a bearing on the number of jobs that are created and the overall prosperity of the region. More jobs mean more incomes and increased spending. On the other hand, a fall in employment levels will leave less money with consumers who will spend less on goods and services produced by the business.
The phrase circular flow of income or circular flow of economic activities in economics refers to a simple economic model which explains the reciprocal circulation of income among producers and consumers.1 In such a model, the interdependent units of producer and consumer are called “firms” and “households” respectively and supply each other with factors of production with a view to facilitating the generation and flow of income. Firms offer consumers goods and services in exchange for consumer expenditure and “factors of production” from households.2
The circular flow of economic activity is facilitated through the market. To illustrate this further, the firms’ demand for factors of production process creates payments to the public. On the other hand, the peoples’ demand for goods and services creates payments to the firms and enables the sale of the products they produce.
So, the social acts of consumption and production are interlinked and cause clockwise and anticlockwise movements as shown in the Figs. 1.1–1.4. The process of production causes factor payments for those involved therein and generates goods and services as the outcome of the production process. The incomes thus produced create the capacity to purchase the final consumption goods, enabling their sale by business enterprises and fulfilling the basic object of their production. Likewise, capital goods, which are also produced in the production process, also enable their producers to earn incomes. Capital goods add to or maintain the capital stock of an economy making the production of other goods possible.
Whatever the form of economic organization, the fundamental processes of economic life consist of a circular flow among households, firms and the government. The household is the basic consuming unit in economic life. In more general terms, we would refer to it as a family unit. The firm, on the other hand, is the basic producing unit. It may be a provision store, a textile mill or a poultry farm. The most important characteristic of the firm is that it is a collection of resources brought together under the control and direction of an entrepreneur. This results in the production of goods.
The essence of the circular flow is the movement of factors (the services rendered by the factors or agents of production including land, labour, capital, and organization) from the households to the firms and the reverse movement of goods and services from the firms to the households.
Figure 1.1 illustrates the circular flow of economic activity in a barter economy where goods are exchanged against goods and services.
In a barter or moneyless economy, firms use the services of the factors to produce goods and services. In return, they will receive payments in kind, i.e., they will be paid in terms of the goods and services they helped to produce. But a household may receive payments in terms of goods such as shoes, a log of wood, bricks and the like, all of which they do not consume. This will create for them an enormous problem of exchange if they want to consume commodities other than what they produce.
In a barter economy, which is the direct exchange of goods and services, the following problems will arise without the use of money:
Figure 1.1 Real Flows of Economic Activity
- In a barter economy, if you have a particular quality of some good and require some quality of another good, you need to find someone with matching requirements, i.e. who wants what you have and has what you want. But more often, this double coincidence may be difficult to realize.
- In a barter economy, unlike in a money economy, there is neither a common standard of value nor a measure of value, which causes problems of exchange of two or more dissimilar commodities.
- In a barter economy, the producer has to wait until his produce is exchanged.
- In a barter economy, exchange is a single process whereas it is split into buying and selling in a money economy, which facilitates large and quicker transactions.
- In a barter economy, unlike a money economy, the producer cannot accumulate capital for future production.
- Where the goods are indivisible, as in the case of a boat or fridge, exchange of goods of diverse values cannot be carried out.
- A barter economy basically does not lend itself to fast growth as a money-based economy.
These problems of barter have necessitated the introduction of a monetary economy.
To solve the problems of exchange, all modern economies use money. Money acts as a go-between and helps the exchange of services of factors and products occurring between households and firms. In Fig. 1.2, we see (in the clockwise direction) firms making payments to households in terms of rents, wages, interests and profits for employing (as shown anticlockwise) services of factors of production from them. These payments, including profits, are costs to the firms.
Case 1.1 Barter is Back Again!
When Delhi housewife Lata Chauhan allowed a widow to live in her home in exchange for household work, she was simply trying to stretch a budget slashed by pay cuts and price rise. But in doing so, Chauhan had become part of a global trend towards barter, which is reviving the world's oldest form of payment—goods or services in lieu of cash.
Chauhan says she has a friend who doesn't pay the man who cleans her car but gives him her son's old clothes and notebooks instead. Yet another barters vegetables from the garden to compensate the gardener. Chauhan is part of the droves—homemakers, professionals, small traders and companies in India and abroad—who are holding on to precious cash reserves by doing business in kind. Ruby Agarwal, director of Mumbai firm Benefit Barter, says, “Companies are flooded with unsold goods because of low sales. Barter is a boon for them to reduce surplus stock.”
She says, “Many companies which were on the verge of collapse have survived.” But Anup Dutta, chief operating officer of Delhi company BBX India, says “barter is still just a fraction of Indian trade”. He says 30 per cent of the world business is barter; Indian barter is a mere 10–12 per cent of trade. America's Universal Barter Group claims that 65 per cent of the companies on the New York Stock Exchange are involved in barter. Is it any wonder the world is asking: Why buy when you can barter?
Source: Saira Kurup and Divya A, “Market Mantra: Barter When You Can't Buy,” Economic Times, 10 May, 2009. Reproduced with permission.
Figure 1.2 Money Flows of Economic Activity
Figure 1.2 illustrates the circular flow of economic activity in a monetized economy where goods and services are exchanged against money and vice versa.
However, the monetary income received from the sale of resources does not, as such, have real value. Consumers cannot use money directly. Households will want to obtain a share of what they have produced by spending their monetary incomes. Therefore, when they get their incomes, they spend them on goods and services of their choice. The clockwise flow of consumption expenditures and the counter-clockwise flow of goods and services, shown in the lower part of Fig. 1.2, reflect the exchange of income for products. From the firm’s viewpoint, the flow of consumption expenditures coming from households is receipts or revenue.
In a monetary economy, therefore, households as owners of factors sell them to firms and as consumers spend the monetary income received from there in buying goods and services, as shown in Figs. 1.2 and 1.3. Firms must buy these factors to produce goods and services; their finished products are then sold to households in exchange for consumption expenditures or, as firms view it, revenue. The net result is a counter-clockwise real flow of factor resources and finished goods and services and a clockwise monetary flow of income and consumption expenditures. These flows are simultaneous and recurring.
Figure 1.3 Circular Flows of Income and Expenditure
Governments—whether local, state or central—affect the circular flow by withdrawing income from it through taxes and injecting income into it by spending. If the government taxes firms, part of the money received by firms is not available to be passed on to the households. If the government taxes households, part of the money received by households is not available to be passed back to the firms. Of course, some of the tax revenue may find its way back to the circular flow if the government subsequently spends it on commodities purchased from firms or on factor services hired from the households. On the other hand, if the government does not spend the money but merely lets it accumulate as a reserve against some future-expected expenditure, it will remain outside the flow. Whatever subsequently happens to the money, the act of taxing withdraws funds from the circular flow of income.
While taxes imposed by governments represent withdrawals from the circular flow, when they spend them they represent injections. It creates income for a firm that does not arise out of the expenditure of households, and it creates income for households that do not arise from the productive activities of firms. If, for example, the government borrows money from banks and spends this money buying wheat from farms, the incomes of these farms will rise, as also the incomes of those households that work for the farms. Thus, this expenditure presents an injection into the circular flow.
Apart from the money flows shown in Figs. 1.2 and 1.3, there is another flow as illustrated in Fig. 1.4. It can be observed from the illustration that all the money income received by households is not spent by them on goods and services; a part of the income is saved and diverted to the capital markets. Firms, too, channel their savings to the capital market. The accumulated savings, drawn both from households and firms, are then borrowed by firms for investment purposes. Thus, the leakages from the circulation of money made by savings are being filled by investment spending by firms.
Now, the question arises as to how the flow of money can continue at a steady level so as to enable the production and subsequent purchase of the flow of a given volume of goods and services at constant prices. The answer to the question is that if the economy is to run a smooth course, it should be ensured that the inflow into the capital market (i.e., planned savings) is equal to the outflow from the capital market. If for any reason, there is a mismatch between the two, or say, the planned investment expenditure falls short of planned savings, there will be a fall in income, output and employment, leading to the contraction in the flow of money.
Figure 1.4 Circular Flows of Income with Savings
If the equality between planned savings and planned investment has not been maintained due to an increase in savings, it will lead to a fall in income due to fall in consumption and an increase in the stocks of goods in shops. Then, prices will tend to fall consequent to an increase in savings. The deficiency of demand will lead to the accumulation of stocks in shops causing retailers to cut down orders. Consequently, with smaller inventories, fewer amounts of goods will be produced. This, in turn, will lead to reduction in the demand for capital goods such as machinery, components and raw materials; as a result, the fixed investment will tend to fall. This will have a cumulative effect and will bring down the level of income, output and employment. Prices will also fall. Thus, the ultimate effect of either the fall in planned investment or the increase in planned savings is the same. The mismatch between the two will result in a fall in income, output, employment and prices, with the result that the flow of money will contract.
If we presume the contrary, wherein the equality between planned saving and planned investment is disturbed by an increase in investment demand, the result wil1 be an increase in income, output and employment. Consequently, the flow of money will expand. It is thus clear from the above analysis that only when the condition of equality between planned savings and investment is satisfied, the flow of money will continue at a steady level. However in a free-enterprise capitalist economy, wherein investment is made by enterprises and savings are mostly done by households and for different reasons, there is no guarantee that planned investment will be equal to planned savings and thus fluctuations in income, output and employment are inevitable. That is the reason why the circular flow of income does not continue at a steady level in a capitalist economy unless certain corrective and preventive steps are taken by the government to maintain stability in the economy.
This circular flow, sometimes known as the “wheel of wealth”, is common to all modern economies; it exists whether resources are privately or publicly owned and whether the decisions that produce the flow are made through a market mechanism or in the office of a central planning commission.
Most of the economic activities centre on the production of goods and services with the help of the factors of production such as land, labour, capital and organization. A country’s national income reflects its size of production. We will study the basics of production in the ensuing pages to have a clear understanding of its importance in a country’s economy and its business environment.
Production, in economics, means the process of creating wealth in the country in terms of goods and services. Indirectly, production can also be defined as creation or addition of utility as all goods and services have utility. A productive activity would therefore mean any activity, which creates value or adds utility to a commodity with a view to enhancing its value.
Creation of Utilities and Services
Production is realized by the addition of three types of utilities—form utility, time utility and place utility. When a carpenter produces a chair out of a piece of wood, he is creating form utility. When a seller stores up the grains after buying them cheap during harvest time in order to sell at a higher price at a later date, he is creating time utility. When a merchant buys apples in Kashmir where they are available cheap to sell in Bombay where they are costly, he is creating place utility. All these types of utilities are considered productive as they increase the value of the materials they started with originally. Production also includes services of all types such as transport and communications, insurance and banking, and trade and commerce. Thus, in economics, production would mean not only the production of goods but also services rendered by various professionals such as bankers, doctors, engineers, actors and teachers.
Production for Exchange
Production in economics is related to exchange. Any activity, which creates utility but is not meant for sale is not regarded as productive in economics. Work done for pleasure alone is not productive if no monetary benefit is derived from it. Domestic services, which are not paid for are not productive. Thus, production in economics refers to the creation of those goods and services that are valuable, scarce in relation to demand, and are marketable.
Consumers’ Goods and Producers’ Goods
Goods may be of two types: consumers’ goods and producers’ goods. Consumers’ goods are those goods, which satisfy the wants of consumers directly and finally without their having to wait in order to consume it. A soft drink, a chair, a notebook or a box of sweets are all examples of consumers’ goods. These consumers’ goods are also known as goods of the first order. Producers’ goods do not satisfy consumers’ wants directly and finally. They satisfy wants only indirectly by producing the consumers’ goods. For example, the machines that produce soft drink or the tools that are used to produce the chair, notebook, box of sweets etc. are producers’ goods. Hence, they are known as goods of the second order.
We have seen that production involves the creation of utilities. What does utility mean in economics?
When we consume food, we get satisfaction from it. This satisfaction can also be termed as utility. Thus, utility is the power or capacity of a commodity to satisfy a human want. Whenever we consume any commodity, we derive utility from it. As it gives us satisfaction, we are prepared to pay a price for it. We consume water, sunshine and air for which we may not pay any price. To the economist, everything that is wanted is useful, the fact that someone is prepared to buy and consume a commodity is a sufficient and necessary proof of its having utility.
Utility is not merely “usefulness”. A thing may not be useful but it still may possess utility. Poison may not be useful; in fact, it is harmful to human life. However, poison possesses utility because it has the capacity to satisfy a certain human want. As long as some people need it and are prepared to pay for it, it must be considered as a commodity that possesses utility. Likewise, opium and liquor are harmful to the human body but they do satisfy the want of some people in society. Obscene literature may be considered bad and immoral but some people are prepared to buy it. It, too, possesses utility.
Utility is a subjective concept. It varies from individual to individual. To a vegetarian, mutton will not have any utility. A cigarette does not give any satisfaction to a non-smoker; for him, it does not have any utility. However, mutton and cigarettes are still economic goods because they are scarce, marketable and carry a price, irrespective of the fact they do not have any utility for non-users.
Utility does not vary merely from individual to individual. It may also vary in the case of the same individual at different times and in different situations. Thus, woollen clothes would have less utility to a person in summer than in winter. A raincoat would have different utility to a person in rainy days from what it would have in warm days.
The term goods is defined in economics as anything that satisfies a human want. Goods may be classified as (i) free goods and economic goods, and (ii) consumption goods and capital goods.
Free Goods and Economic Goods
Free goods are those goods, which are gifts of nature. Such goods are available in abundance and people do not have to pay any price for them. Air and sunshine are examples of free goods. People residing near the river get water in abundance. Water to them is not scarce and, therefore, does not command a price.
Economic goods are those that: (a) have utility; (b) are scarce; and (c) can be bought and sold. Water, though a free good, is scarce in urban areas; so people have to pay a price to get it. Air is normally a free good but for a person climbing a mountain or for one working in a deep mine, it becomes scarce. A mountaineer or miner makes use of oxygen cylinders which have to be paid for. Almost all goods in the world fall short of human needs and so, they become economic goods. Economics is concerned with economic goods for, as we have seen earlier, economic activity comprises the utilization of scarce goods for the satisfaction of human wants.
Consumption Goods and Capital Goods
Consumption goods (also called goods of the first order) are those goods which people consume directly. Food, clothes, furniture, colour televisions and the like belong to this category. Some consumption goods are perishable—they do not last for long; for example, fish, meat, milk, fruits, vegetables, etc. Refrigeration can increase the life of such goods. Some consumption goods such as clothes, furniture and cars are non-perishable or durable goods. They give the consumers satisfaction for a long time.
Capital goods (also called producers’ goods or investment goods) do not satisfy consumers directly but are used by producers to produce consumption goods. Textile machinery represents capital goods but clothes are consumption goods. The instruments used by a carpenter are capital goods whereas chairs and tables are consumption goods. All raw materials such as coal, cotton, jute and sugarcane fall under this category. Consumers do not require them directly though producers need them. These goods are also called the goods of the second order.
Before classifying goods as either consumption or capital goods, we must consider who is using it and for what purpose. Consumers may consume sugarcane directly but when it is used in a sugar factory as raw material it becomes a capital good. And sugar itself becomes a capital good when a baker uses it for preparing sweetmeats.
We use the term value frequently in our day-to-day life. We often say, “Don’t attach any value to what he says.” However, in economics, the term is used in a different sense. Adam Smith says, “The word value has two different meanings and sometimes expresses the utility of some particular object and sometimes the power of purchasing other goods which the possession of the object conveys”3. In other words, value has been described in two ways: “use value” and “exchange value.”
Use value or value-in-use means utility, the power to satisfy human wants. Sometimes, a thing may have utility but it may not be scarce in relation to demand; for example, air, sunshine, water, etc. A thing which has value-in-exchange must have value-in-use too; however, a thing which has value-in-use need not have value-in-exchange. Value, in this sense, means that some other commodity or commodities can be obtained in exchange for it. If a piece of furniture can be exchanged for ten kilos of wheat, the value of a piece of furniture is equal to ten kilos of wheat. The value of a duster may be equivalent to ten chalks. This is the value-in-exchange of a duster. For a thing to have value in-exchange, it must have two characteristics: (i) it must have utility and (ii) it must be scarce.
We may express the value of any commodity either in terms of units of another commodity or in monetary units. When value is expressed in terms of money, it is called price. The price of a duster is one rupee; here the value of the duster is expressed in terms of money.
Wealth is another term in economics, which is to be used in a sense totally different from that of everyday usage. Wealth, in ordinary language, is used in the sense of money or property. Who is a wealthy man? One who has plenty of money, land, buildings and so on? However, in economics, the term has a different significance.
It must be mentioned at the outset that all economic goods constitute wealth. A person may have a small hut and a few utensils. Ordinarily, he will be regarded as a very poor man. But according to the economist, he possesses wealth. Anything with the following three characteristics constitutes wealth: (i) utility, (ii) scarcity and (iii) transferability.
- Utility: A commodity must have the capacity to satisfy a human want. A rotten egg may not have that capacity and so, it cannot be regarded as wealth. However, it may acquire utility in some countries during the time of election, when disgruntled voters may buy them to pelt the candidates with!
- Scarcity: All economic goods constitute wealth. In other words, free goods such as air and water are not to be regarded as wealth. Air possesses immense utility but, as it is in abundance, it is not wealth.
- Transferability: Personal qualities do not constitute wealth. A poet’s genius is not wealth. The artistic talent of a person may help him acquire wealth, but it is not wealth in itself. A commodity can be regarded as wealth only if it can be transferred from one person to another. S. P. Balasubramaniam’s melodious voice possesses great utility. Such a voice is certainly scarce, but can he transfer it to somebody else? Personal qualities such as health, intelligence and acting ability cannot be termed as wealth because they cannot be transferred. They cannot be separated from those who possess them. They are “sources” of wealth. Of course, making use of his fine voice, a singer can earn plenty of money.
All the three characteristics described above must be taken together. If either of these features is missing, the thing cannot be called wealth.
Wealth may not be always visible. It need not be a tangible object all the time. Non-material things may be regarded as wealth. The best example is the goodwill of a business—the name that a business has made in the market. Though intangible, it is still wealth. It has utility and scarcity. Besides, the goodwill of a firm can be transferred to another firm or can be sold with the equipment, buildings and so on. A doctor receives fees from his patient. A teacher gets a salary from his college. What they offer in return for money are their services. Those services are not visible but they still constitute wealth.
All money is wealth though all wealth is not money. Money is one form of wealth as it possesses all the characteristics of wealth.
We can classify wealth into three categories: (i) personal wealth, (ii) social or national wealth and (iii) universal wealth.
- Personal wealth: Personal wealth refers to all the material and non-material goods such as land, building and cash in the bank which an individual possesses. It is the wealth of a particular person. The goodwill of a business owned by an individual and the services offered by a person are examples of non-material personal wealth.
- Social or national wealth: Roads, public parks and museums are some examples of social wealth. Such wealth is not owned by any individual but it is held by public bodies (e.g., governments, municipalities, panchayats, etc.) on behalf of the community.
- Universal wealth: There are certain forms of wealth which are not owned by anyone but they confer the benefits on the whole universe. We may refer here to resources such as seas, rivers, lakes and mountains.
Strictly speaking, such classifications are rarely mutually exclusive. In other words, forms of wealth cannot be divided into water-tight compartments. When a person owns a factory, it becomes personal wealth. If his factory is closed down due to strikes by the workers, not only is it a loss to the owner but also a loss to the whole society. The gutting of timber depots in a fire deprives both the owners and the society of huge wealth.
Wealth and Welfare
The terms wealth and welfare come from an old English root meaning well-being. For the economist, welfare means the economic well-being of the individual and the community. To him, people in an economic system should achieve the maximum well-being.
When a person consumes goods and services, he derives satisfaction or welfare. A person fond of fish gets the maximum satisfaction by consuming it, and so on. Hence while reading James Hadley Chase satisfies some people, watching movies satisfies others equally. The consumption of goods and services gives us satisfaction. However, we must have wealth to secure goods and services. More wealth means more welfare. Wealth is the means to achieve welfare; wealth promotes welfare. Money enables people to buy goods and services and the latter help the people to increase their welfare. In general, increase in wealth leads to increase in welfare. However, an increase in wealth does not necessarily lead to an increase in welfare. There are many goods, which constitute wealth but may not increase the welfare of an individual. A pack of cigarettes, opium, pornographic literature—all of these are wealth. However, the consumption of such goods does not promote the welfare of consumers. The production of arms and ammunition, atom bombs and nuclear weapons increases the wealth of a community; but they are meant for destruction. They do not promote the welfare of the society. The construction of a new factory adds to the wealth of a community. It provides jobs for the unemployed people. However the new factory may emit noise and smoke, which is detrimental to the health of the people residing in the neighbourhood of the factory. Atomic plants may create the problem of radiation and pollution. We must also consider the manner by which wealth is created. If increase in wealth is the result of longer work hours or of the exertion of female and child labour in factories, it may lead to greater suffering instead of greater welfare.
There is also another aspect to this problem. How is the increased wealth distributed? If a large part of the increased wealth goes to rich persons such that the rich become richer and the poor become poorer, we cannot say that the increased wealth has promoted welfare. It is generally asserted that the transfer of wealth from the rich to the poor benefits the community at large. If the rich are deprived of a part of their wealth, they will certainly undergo some hardship. Their satisfaction will be reduced as a result of reduction in wealth. If this wealth is transferred to the poor, the latter’s welfare will undoubtedly increase. The satisfaction gained by the poor is much more than the loss in satisfaction suffered by the rich. When some part of the income of the rich is taken away, their consumption will not be adversely affected to any considerable extent. In the same way when the poor get additional income, their level of consumption will certainly go up. In short, wealth and welfare are intimately related. It must be remembered that increase in wealth does not automatically lead to increase in welfare. Every developing country, including India, tries to increase its welfare through greater production; but while doing so, a country tries to adopt policies that ensure that the increased wealth is not accompanied by the concentration of wealth in one section of the society alone. The welfare of a community will go up only if the increased wealth is properly distributed in the society.
Human wants are the starting points of all economic activities. When a man endeavours to satisfy his wants, he embarks on production. A consumer wants to consume certain goods, which drives its production initially and sustains it in the long run. The basic question is: What is consumption?
Consumption, in its broadest sense, means the use of economic goods and services to satisfy human wants. When a person consumes a mango, he makes use of that fruit to satisfy his want. In other words, he consumes the utility of that commodity. There is a difference between the consumption of a perishable commodity and a durable commodity. Perishable goods are single-use goods. Once these are consumed, they are destroyed. Durable goods last for a longer period. For example, the utility of a table that lasts for ten years is available to a consumer for ten years. We consume goods as well as services.
The goods and services satisfy the wants of a consumer and, obviously, he is willing to pay a price for them. The use of free goods and services does not come under consumption. We consume air and sunshine, but their use does not belong to consumption. In other words, the goods consumed should be economic goods—goods for which payment is necessary.
Human wants are the starting points of all economic activities in a society. Only those societies where their members have innumerable wants are able to build a prosperous economy as people try to earn as much as they can by engaging themselves in the production of goods and services, to satisfy their numerous and ever-increasing wants. If a society has fewer wants, it is not likely to build a prosperous economy. In the following analysis, you will learn more about the various facets of human wants.
In the primitive era, human wants were very few. Primitive man was content with some fruits and animal flesh, with leaves of trees to cover his body and a cave for shelter. As civilization developed, human wants increased. Look at your lunch, there is a variety of dishes you eat—rice, puris, pickles, chutney, curry and so many tasty things; look at your clothes, they are made of cotton, rayon, nylon, terylene and dacron. There are kurtas, pyjamas, maxis, minis, lungis and what not. A small hut will give you shelter, but wouldn’t happy with it. You would like to have a well-painted, well-decorated house with a sofa set, a home theatre, a refrigerator, a television, a mixer, a washing machine and so many other things. Think of primitive man and his simple needs! Look at modern man and his innumerable wants! As there is economic progress, our level of living goes up and with every increase in our level of living, wants also increase.
If wants are the basis for all economic activities, we must see how they arise. Wants originate mainly from three factors: (i) natural instincts, (ii) social obligation and (iii) advertisement and publicity.
- Natural instincts: When a child is born, it cries for milk. It needs some clothes to cover its body in the cold weather. It requires some shelter. These are the basic needs of a human being without which he cannot live. Man requires them in the natural course of his life. These wants are called biological—they are connected with our natural instincts.
- Social obligation: We are members of a society. We will have to behave as other members want us to behave. Rajan is an officer in a bank and draws a salary of INR 30,000. He belongs to the upper middle class. People expect him to reside in a decent well-furnished flat. So, Rajan would like to have such a flat. He feels that to reside in a one room-tenement by paying (say) INR 1000 is below his dignity. Some of our wants are based on social customs. Man is a social animal; he must observe the social customs regarding food, clothing and so on. His wants are always influenced by other peoples’ opinions and ideas. Social interactions might breed snobbery and develop costly habits in some people and these will add to their wants.
- Advertisement and publicity: This is the age of publicity. We see a lot of advertisements for goods of various types. There is an advertisement for a new brand of toothpaste and we would like to use it. Fashion shows are organized by certain textile mills, and women rush to purchase those new varieties of sarees. We decide to purchase a television set when we learn through advertisements in newspapers that the IPL cricket test match will be shown on television. The purpose of the publicity is to popularize newly invented products to create a demand for them. If you look carefully around yourself, you will observe that you purchase many goods only because you are attracted by the publicity for them. Our wants are continuously increasing, thanks to advertisements and sales gimmicks.
The goods and services that man wants are divided into different categories, viz. necessaries, comforts and luxuries.
- Necessaries: These are called the primary wants of a human being. Without necessaries, a man is not able to either live at all or live well. Without food, a man will die. Without clothes, he is not able to move in society. Without shelter, his life becomes miserable. Food, clothing and shelter are the biological needs of a man. These things are required for his very existence. These essential wants are called the necessaries for existence or necessaries for life.
In addition to the necessaries for existence, economists have maintained two other types of necessaries. These are: necessaries for efficiency and conventional necessaries.
There are certain things a man needs, which will enable him to raise his efficiency. With the help of those things, he will be able to perform his work more efficiently. A student can sit on the ground and study; but a chair and a table will certainly raise his efficiency. A busy officer will not lose his job if he does not have a mobile phone; but possession of one will certainly add to his efficiency. Such things are termed necessaries for efficiency.
Conventional necessaries arise out of the customs and conventions in society. As a social animal, a man has to observe certain modes of behaviour. A manager is expected to wear a suit; a woman residing in an ownership flat at a high end locality must have a dressing table loaded with expensive cosmetics! These are not strictly necessaries, but they are the result of social conventions.
- Comforts: There are so many things in the world, which make our life happier and comfortable. A sofa set in the living room, a geyser in the bathroom, a mixer in the kitchen, an air-conditioner in the bedroom will certainly make our life very comfortable. A colour television, a home theatre and the selected CDs of famous musicians add to our comforts. There is a slight distinction between necessaries for efficiency and comforts. An ordinary table and a chair are the necessaries for the efficiency of a student while an easy-chair gives him more comfort. Gas stove instead of primus stove will raise the efficiency of a housewife; but to get hot water for a bath, a geyser will be more convenient and comfortable.
- Luxuries: Luxuries are those goods which are very expensive. Rich people want to show off to others; in other words, there is the desire for distinction. For them, the luxuries add to their prestige and position in the society. Costly houses, air conditioners, diamond jewellery, expensive cars and lavish parties are examples of luxuries. The prices of these goods are very high; the benefit from them may not be so high. We visit an air-conditioned hotel where waiters are well-dressed, the furniture is luxurious and the lights are dim. We pay thirty rupees for a cup of coffee and several hundred rupees for the dinner. Here, the sacrifice by the way of expenditure is greater than the satisfaction derived from the commodities or services.
Necessaries are treated as primary wants whereas comforts and luxuries are generally regarded as secondary wants. We must bear in mind a few important points while discussing necessaries, comforts and luxuries. Shall we call a car a luxury? It all depends upon who uses it. If a clerk uses a car, it certainly is a luxury for him. But is it a luxury for a specialist doctor? No, it is not. He is an extremely busy man and for an emergency call, he has to attend a patient as quickly as possible. For him, a car becomes a necessary for efficiency. For the ministers and for top officials of the government too, a car is not a luxury.
We must also remember the income enjoyed by the person whose expenditure is being considered. For a poor man, a home theatre may be luxury but for a middle-class man, it is a conventional necessary. A car is not a luxury for a bank officer but for a peon, it is. An air conditioner in the house may be a luxury for a school teacher but for a businessman, it is necessary for efficiency. A necessity for one may be a luxury for another.
Certain goods which people used to regard as a luxury a few years ago have become necessaries now. Times are changing and so are human wants. A mobile phone which was regarded as a luxury few years back is considered as a necessity now. Many things which were once considered luxuries are slowly being treated as comforts and necessaries. A car, now a luxury for a majority of Indians, will certainly become a necessity within the next few years. A Nano, for instance, may replace scooters and motorbikes for many of our countrymen!
A human want is the starting point of all economic activities. Human wants possess many different characteristics. A number of theories of consumption are based upon the important features of human wants. Let us see the characteristics of human wants.
- Human wants are unlimited: When a child is born, it cries for milk. This is the beginning of its wants. The unending cycle of wants begins with birth and stops only when a man breathes his last. From birth to death, there is a continuous chain of wants in human life and except for an insane man or a sadhu living in a jungle everybody in this world is unsatisfied. Nobody will ever say, “I am a fully contended man. I no longer need anything in this world.” If somebody says this, do not believe him. He tells you a lie. If one has a cycle, he will crave for a scooter. If he gets it, he would like to have a car and if he owns an Indian car, he will be jealous of his neighbour who owns a foreign car! There is a continuous multiplication and expansion of human wants.
- Wants are satiable: Although wants, in their totality, are insatiable, any single want is satiable. For instance, Ram is thirsty and he gets two glasses of water; now his thirst is quenched, at least for the time being. John is hungry; he goes to a hotel and gets food. He feels satisfied. Individual wants are, therefore, satiable.
- Wants are recurrent: The trouble with human wants is that they can be satisfied only temporarily. John takes food when he is hungry and he is satisfied. After some time, he again becomes hungry. He is again in need of some food. Human wants are recurrent. They arise again and again. Every year, old clothes have to be thrown away and new clothes have to be bought. Had the wants not been recurrent, our life would have been happier—but unfortunately, they do recur.
- Some wants are complementary: If we want to have a cup of tea, we require water, sugar, tea leaves, milk and so on. A student wants both pen and ink. A want for a car also implies a want for petrol and that for a pair of shoes implies a want for the laces. Sometimes, two or more wants go together.
- Wants are competitive: Wants are competitive because there are many alternatives, which give more or less equal satisfaction to a person. Suppose Hari has fifty rupees in his pocket. He can buy two mangoes or purchase a magazine or visit a cinema show. There is, in a sense, competition among all these goods and services to satisfy him. Ultimately, he will have to show his preference. If he is very hungry, he will buy mangoes and forego the magazine and the cinema show.
- Many wants become habits: Habits are formed when people satisfy certain wants regularly. A casual smoker becomes a chain smoker. Once habits are formed, the casual want for such goods turns into almost a necessity. A chain smoker may be ready to forego a meal but if he does not get a cigarette for a long time he becomes restless.
- Wants change according to the time, place and person: Want is a subjective concept. Rama is a vegetarian, he does not eat meat. Possibly, he may develop a taste for it and then he starts deriving satisfaction from it. The same person wants different things at different times. I may enjoy a cold drink in summer but in winter I shall like to have a cup of hot coffee. A Punjabi goes on a tour to Chennai, stays there for a week and then relishes idli and sambhar for his breakfast. Wants never remain the same. Variety is the spice of life. Without it, life becomes monotonous.
Wants, effort and satisfaction comprise the cycle of human activity. Economist Lionel Robbins says, “Life is short and nature is niggardly.” People must continue their efforts to satisfy as many of their wants as possible. As long as they live in this dynamic world, human wants expand and multiply. A human brain is very fertile—it invents some new products and some new methods of production. Each invention leads to more wants. Wants are ever increasing. People are expected to work harder and get more income to satisfy these increasing wants. Unless they work hard, they will not be able to enjoy the fruits of economic progress and the fruits of growing civilization. The increasing wants are an incentive, which motivates the people to work hard. Production gets stepped up, economic activities flourish and nations prosper only because human wants keep multiplying at a rapid pace.
STANDARD OF LIVING
With reference to a person, a family, or a body of people, standard of living means the extent to which they can satisfy their wants. If a group of people can afford only the minimum amount of food, clothing and shelter, their standard of living is said to be low. If, on the other hand, these people are able to afford sumptuous food and costly clothing, live in well-furnished houses and enjoy other comforts and luxuries, then they enjoy a high standard of living.
The standard of living of a community is indicated by the nature of their consumption. It is a concept denoting the material well-being to which an individual or social group is accustomed. In other words, it is the aggregate of the level of necessaries, comforts and luxuries to which a community is accustomed. Both the quantity and the quality of goods consumed determine the standard of living. People, when habituated to a particular mode of living, don't want to lower it. Therefore, they will resist any rise in the price and try to get higher wages in order to neutralize the rise in the cost of living to maintain their standard of living. A person's standard of living tends to stabilize over a period of time. Lowering the standard of living is difficult for individuals and families. This becomes evident in times of economic upheaval such as the Great Depression of the 1920s and the more recent global financial meltdown during 2008-09.
There is a distinction between standard of life and standard of living. The former represents the values and virtues that govern one's life whereas the latter represents the necessaries, comforts and luxuries one gets used to get in one's life. Abraham Lincoln and Mahatma Gandhi had high standard of life but a poor standard of living.
Factors Affecting the Standard of Living
The standard of living is determined primarily by the level of income of a household. The higher the income, the higher is the standard of living. If a person is promoted, he will seek more comforts; his standard of living will go up. Similarly, if the national income of a country goes up, people will have, in general, a higher per capita income. The higher the per capita income, the larger the volume of goods and services people can buy. A poor country concentrates on improving the standard of living of its people. A country can achieve this goal successfully only if it is able to raise its national income. The standard of living depends not only upon the income but also on the use it is put to. For example, if a school teacher and a taxi driver have the same income, the teacher spends his income very carefully—on rent, provisions, milk, the education of his children, clothes and so on. After satisfying the most urgent needs of his family, he spends a few rupees, if possible, on entertainment. With systematic planning, he is able to maintain a decent standard of living with his meagre income. In contrast, a taxi driver who gets the same amount either gambles it away or spends it on liquor and cinema, making it impossible for him to purchase even the bare necessaries for his family. The wisdom with which people spend their income is, therefore, very important in determining the standard of living.
Apart from the size of national income, another important determinant of the standard of living is the manner in which the national income is distributed. People in developing countries are poor because the national income as an average per head is low. Wide differences in the standard of living of people in the same country are the result of unequal distribution of the national income. For instance, India has some of the world's richest billionaires and several thousands of millionaires who spend their enormous wealth in conspicuous consumption. In the same country, more than 42 per cent of the population lives on hardly 1. 25 dollars a day, according to the 2005 World Bank report illustrating the wide disparities in the standard of living in the country.4
The Standard of Living in India
Everybody knows that the standard of living of the vast majority of people in India is extremely low. The per capita annual income of India is one of the lowest in the world. It was only USD 950 in terms of per capita GNI for 2007 as against 46,040 for the USA and 37,670 for Japan.5 For most people, to get sufficient food twice a day is a luxury. About three-fourths of the people in India have one meal a day. Look at the pavement dwellers and the slum dwellers in Mumbai and Chennai. The huts become cold in the winter, hot in the summer and wet, even flooded, in the rainy season. Even then, millions of people reside in such slums. For many people, even such a shelter is not available. In the rural areas, people do not even get basic amenities such as clean water for drinking. When most people do not have the basic necessaries, it is easy to understand that comforts and luxuries are beyond their reach.
The main cause for this extremely low standard of living is the increasing rate of population growth. The per capita income can be stepped up either by raising the national income or by reducing the population or by both. (When we divide the total national income by population, we get the per capita income.) If population grows very rapidly and production increases very slowly, the increased population will nullify all the increase in the national income. That is exactly what is happening in India today. The population increases every year by almost 18.14 million whereas the growth in the national income does not match it.6 We have certainly made rapid progress in various fields of economic activities through economic planning but all our economic progress is being eaten up by the rapid growth of population. Unless all-out efforts are made to check the population growth, the standard of living of our people will not improve in the near future.
The problems of overpopulation and low economic growth cause a series of problems. The percentage of literacy in India is low. Consumption levels are miserably poor. As pointed out earlier, around 42 per cent of the Indian population lives below the poverty line on less than 2 USD a day. The low level of income of the average Indian manifests itself in his failure to secure a balanced diet, which in turn, causes low calorie intake and low level of consumption of protein. According to the National Sample Survey Organization's (NSSO) data of 2004–05, population reporting a calorie intake level of “less than 100%” of the norm of 2,700 kcal, formed 66 per cent of the total in rural areas and 70 per cent of the total in urban areas.7 Another health issue relates to the poor intake of protein. The NSSO data also reveals that the average daily intake of protein by the Indian population has come down from 60.2 to 57 grams in Indian villages between 1993–94 and 2004–05 and remained at around 57 grams in the urban area during the same period.8 In food consumption in India, cereals predominate whereas the diet in developed countries is rich as it contains a generous helping of fruits, fish, meat, butter and sugar. The per capita availability of milk in the country (245 gm per day) is lower than the world average (285 gm per day) despite the fact that India is the second largest producer of milk in the world.8 In the area of public health, the situation is still worse. For every 10,000 Indians, there is one doctor. In contrast, Australia has 249 doctors for every 10,000 people, Canada has 209, UK has 166 and USA has 548.9 According to the Planning Commission, the country has a shortfall of 600,000 doctors, 1 million nurses and 200,000 dental surgeons. This shortfall has led to a dismal patient–doctor ratio in the country. Most of the problems arising out of poverty, which is the root cause of low standard of living, can be addressed successfully only with the spread of education. According to World Bank indicators, nearly 60 per cent of the Indian mothers are malnourished and an equal percentage of children are severely undernourished. According to the Census of 2001, only 36 per cent of the households had access to safe drinking water, implying tap water. This results in developing less strength to fight diseases and is also partly responsible for the low level of efficiency of the Indian workers.10 With regards to housing, the situation is equally bad. As per the 2001 Census, only about 52 per cent of the households had permanent houses, whereas 30 per cent had only semi permanent houses and the rest only temporary dwellings. Another telling picture painted by the same Census was that 34.5 per cent of the households did not own any of the assets such as radio, transistor, television, telephone, bicycle, scooter and motor cycle or moped. People must get proper education. They must know how to spend their limited income carefully. That will help the vast majority of people to maintain a reasonable standard of living with the limited amount of income at their disposal.
ENGEL'S LAW OF FAMILY EXPENDITURE
We will now turn to an interesting economic law based on the consumption pattern and standard of living of the people. In 1857, Ernest Engel, the head of the Prussian Statistical Bureau, prepared family budgets of different types of people in Germany. A family budget gives the detailed income and expenditure of a family on various items during a month or a year. It included all sources of revenue and all items of expenditure (i.e., food, clothes, milk, education, entertainment, etc.) in a detailed manner. Engel selected three income groups in German society—working class, middle class and the well-to-do class. From his study of their family budgets, he derived certain important conclusions, which constitute “Engel's law of family expenditure.” His findings were as follows:
- As a person's income increases, the percentage expenditure on food and other necessaries decreases. In other words, as a person becomes richer, he spends a decreasing percentage of his income on food and other necessaries of life.
- As a person's income increases, the percentage expenditure on the items of comforts and luxuries also increases. This follows from the first law.
- A person's percentage expenditure on clothing is almost the same. Whatever be the level of income, his percentage expenditure on housing (i.e., rent), fuel and light too remains almost the same. Engel held that the percentage of a household's expenditure on food is a way of measuring the standard of living: the lower the income, the greater is the percentage spent on food.
While examining Engel's laws of family expenditure, we must remember that they refer to percentage expenditure and not to absolute expenditure. Whenever a person's income goes up, his absolute expenditure on food and other necessaries of life certainly increases. The fall is in the percentage expenditure only. For instance, when a person gets INR 1000 per month, he spends (suppose) INR 800 on food. This is 80 per cent of his expenditure. When he starts, let us suppose, getting INR 10,000 income per month, he undoubtedly spends more than INR 800 on food. Suppose he spends INR 2000 on food (he may consume better quality food). This constitutes just 20 per cent of his income. In the case of items of comfort and luxuries, not only the absolute expenditure but his percentage expenditure too increases.
Engel's law is a very important generalization about the nature of consumption. The law is only a statement of truism. People generally spend a smaller share of their budget on food as their income rises. This is because of the fact that food being a necessity, poor people spend most of their incomes on it to satisfy their hunger. As people get richer, they may spend on better quality of food which may cost them slightly more than earlier. That is to say, they may spend more quantitatively on food and other necessities but as a percentage of total income, there is a definite drop in the expenditure on these items. With more money still left, they spend it on comforts and luxuries. Engel's law is a universal law in the sense that in all countries, even now, it holds good. The law shows the general tendency of people and is true in all cases and in all countries.
SCALES OF PREFERENCES
Economics is a science that is centred on the problems of choice—how best to meet human wants with the limited resources, which have several uses. Economic theory assumes that in exercising this choice, man acts rationally with a view to attaining maximum satisfaction. Faced, therefore, with a choice between two things, a person will choose the one that will give him the greater amount of satisfaction. This clearly shows that he has a scale of preference, a kind of list of his unsatisfied wants arranged in order of satisfaction. A commodity near the top of the list would give him more satisfaction than the one which is lower on the list. People may not even be aware of their having scales of preferences, but they do act on them when they buy some things first and postpone the buying of other things when they have limited incomes. They are aware of the fact that some wants are more pressing than others. Whatever be the awareness of people in this regard we do assume in economic theory that everyone has a scale of preferences, as one person's scale will be quite different from another's. Each scale represents the preferences of an individual irrespective of ethical or moral considerations.
SAVINGS AND INVESTMENT
Saving is that part of one's income which is not spent but set aside either for future spending or for investing in property or securities. Saving is not to be confused with hoarding. It involves the productive use of the funds not spent on present consumption.
Saving is one of the determinants of income and employment. The total volume of saving depends on the size of income, its distribution, the capacity of the people to save and the rate of interest. Its economic importance lies in its relationship to investment. Saving is a necessary prerequisite of investment.
Investment has two related meanings:
(1) In economic theory, it is generally taken to mean the actual production of real capital goods. Thus, the construction of a railway and the erection of new factory buildings are examples of real capital investment.
(2) As a financial term, it refers to the purchase of stock exchange securities or Government securities or the deposits with banks or other financial institutions with the aim either of securing a regular income or the refund of a greater sum at some future date.
Classical economists assumed that saving and investment are equal at any point of time. However, in actual practice, this may not be so because saving is undertaken by one group of people and investment by another, and for different reasons. Those who save generally do so for meeting unforeseen contingencies; providing for some future purpose, such as for old age, education of children, starting of a business venture, or in the short term, to enable them to purchase expensive goods. More importantly, savers are gullible; their decisions to save can be easily swayed by false promises by persons and institutions who want their savings. Investors, on the other hand, invest for realizing profits, when they expect an equal or higher rate of profit than the prevailing rate at which they could secure investible fund. Investors are more professional and their investment decisions are based on more logical and professional considerations. Though there could be “leakages” between saving and investment, an economy should aim at stopping these. Equality of saving and investment are required because if saving exceeds investment, there will be less than full employment and if investment exceeds saving, there will be a rise in the level of prices. According to Keynes, saving and investment must always be equal because the amount of incomes generated by investment would provide an equivalent amount of saving. John Keynes demonstrated this equality between saving and investment as follows:
If we take the national income (Y) to be the total of all incomes derived from economic activity, personal income is either spent on consumer goods (C) or saved (S). Thus, Y = C + S. Hanson summarizes this equality of Keynesian saving–investment theory as follows:
Taking the national income, in real terms, as the total volume of production that comprises consumers’ and producers’ goods (real capital or investment):
As both saving and investment are equal to the difference between income and consumption, they must, therefore, be equal to one another. Therefore,
- Economic activities comprise the production, consumption, distribution and exchange of goods and services. Wants are the starting point of all economic activities. A circular flow is the exchange that takes place between households and firms. A circular flow represents these exchanges through the circulation of money between households and firms, through taxation and injecting money by government.
- Production means creation or addition of utilities to the existing matter. There are three types of utilities: form, time and place utilities.
- Production involves both goods and services. There are: (i) producers’ goods that are used to produce and (ii) consumers’ goods that are consumed directly. People produce on a large scale because they want to exchange the surplus over their consumption for other people's surpluses through money.
- Utility means the capacity of a commodity to satisfy a human want. Utility is not merely usefulness; it is a subjective concept. It varies from individual to individual. It also varies in the case of the same individual at different times and in different situations.
- An economic good means anything that has utility. Goods may be classified into free goods and economic goods. Free goods are gifts of nature; they are available in abundance and so do not command any price. Economic goods command a price and they have in addition to utility, scarcity in relation to demand and transferability. Economic goods are further subdivided into consumption goods and capital goods. Consumption goods are those goods, which people consume directly. Capital goods are demanded by the producers who with their help produce consumption goods.
- Value has been described in two ways: use value and exchange value. Free goods have use value but economic goods have exchange value as well.
- When value is expressed in terms of money, it is called price.
- Wealth has three essential characteristics: (i) utility, (ii) scarcity and (iii) transferability. There is a close relationship between wealth and welfare. Increase in wealth does not necessarily lead to increase in welfare. The types of wealth produced in a country and the manner in which increased wealth is distributed are most relevant in this concept.
- Consumption means the use of economic goods and services in the satisfaction of human wants. The beginning of economic activity is consumption. The quality and quantity of production will depend on the consumption pattern of the people. The consumer is said to be the king or the sovereign because production activities are undertaken to cater to the needs of the consumers.
- The study of consumption begins with that of human wants. Human wants originate mainly from: (i) natural instincts, (ii) social obligations and (iii) publicity.
- Wants are classified into necessaries, comforts and luxuries. Necessaries are further classified into: (i) necessaries for existence, (ii) necessaries for efficiency and (iii) conventional necessaries. Human wants possess a number of characteristics: (i) Wants are unlimited; (ii) Though wants in their totality are insatiable, each single want is satiable; (iii) Wants are recurrent; (iv) Some wants are complementary; (v) Wants are competitive; (vi) Wants develop into habits; (vii) Wants change according to the time, place and person. Wants are ever increasing. These, therefore, boost the productive activities in the economy.
- Standard of living of a community depends upon the nature of their consumption. It is the aggregate of the level of necessaries, comforts and luxuries to which a group of people is accustomed. It is determined by the level of income and the wisdom with which people spend their income. The standard of living of an average Indian is extremely low.
- Engel, the German economist, had formulated laws based on the consumption patterns of people. Engel's laws are universal laws and are as follows:
- As a person's income increases, the percentage expenditure on food and other necessaries decreases.
- As a person's income increases, the percentage expenditure on the items of comfort and luxuries also increases. Here Engel refers to the percentage expenditure and not to the absolute expenditure.
- Scales of preferences refer to the order of priorities an individual has, with the most urgent commodity at the top to be satisfied and others downward. Savings refer to the unspent part of income. It is not hoarding. Investment refers to the saving that is invested. Keynes says that equality between saving and investment is to be ensured to obtain full employment in the economy.
|capital goods||circular flow||consumers’ goods|
|consumption||economic activity||economic goods|
|Engel's laws||firms||free goods|
|households||human wants||natural instincts|
|social obligation||standard of living||transferability|
- Explain in your own words the circular flow of economic activity.
- Define goods. Distinguish clearly between (i) free goods and economic goods; and (ii) consumption goods and producers’ goods.
- Distinguish between value-in-use and value-in-exchange. What is price?
- What are the chief characteristics of wealth? How would you classify wealth? Does an increase in wealth necessarily lead to an increase in welfare?
- What is consumption? Why do we call the consumer a king?
- How do wants originate? Distinguish between comforts and luxuries.
- Classify human wants and state clearly the difference between the necessities for efficiency and comforts.
- Describe the important characteristics of human wants.
- Write a note on the standard of living. Why is the standard of living in India low?
- State and explain the Engel's Law of family expenditure.
- What do you understand by the scale of preference? Why is it important in economic theory?
- Define saving and investment. Why does Keynes argue that there should be equality between the two?
Bhaduri, Amit. Macroeconomics: The Dynamics of Commodity Production. New Delhi: Macmillian India Limited, 1990.
Mankiw, N. Gregory. Macroeconomics. New York: Macmillian Worth Publishers, 2000.
Stonier, Alfred William and Douglas C. Hague. A Textbook of Economic Theory. Fifth edition. New Delhi: Pearson Education, 2004.