Monday, 30 June 2014

Production Possibility Frontier, Opportunity Cost and Specialisation

Economics deals with the problem of optimizing the use of scarce resources to achieve the best possible returns out of them. To achieve the best possible results, it analyses various alternative methods of using the resources. During this study, we come across various terms like Production Possibility Frontier (PPF), Comparative Advantage, Opportunity Cost, Economic Efficiency, Specialization and Absolute Advantage etc.

Let us study these terms one-by-one.

Production Possibility Frontier (PPF)
Any country or region requires producing and providing a number of products and goods to meet the requirements of its people. But normally the resources of any given place or country do not allow it to produce all its requirements in abundance to meet all its requirements. Some items may be produced in larger quantities whereas some other items may be produced in lesser quantities and with higher costs. All this depends on the availability of resources and costs involved in turning those resources into end products.

For example, let us suppose two items are produced by a country, say steel and petroleum. Steel is easily produced in large quantities due to availability of vast reserves of iron ore. But petroleum is produced at comparatively lesser quantities and that too at high costs due to lesser resources and drilling problems at deep levels.

If the country has to produce both items, with the help of its other fixed resources remaining same like manpower, technology and working capital, it becomes necessary for the country to decide how much quantities of these products can be produced so that it may use the available resources to their optimum possible benefits.

Suppose the country in reference can invest equal amount of money on production of steel and petroleum products. Suppose it can produce 1 million MT of steel and half million kilo liters of petrol when equally invested. Now, if the steel production is surplus, the country may want to divert the investment in steel to petroleum products to meet shortage of petrol. Suppose cost of production per MT of steel is $800 and that of petrol $1000. So when diverting funds to producing petrol, you need additional $200 for each KL of extra petrol.

If you can reduce 5lac MT of steel, you will be able to produce another 4lac KL of petrol. Or, if you forego 2.5lac MT of steel, then you get 2lac KL petrol approximately.

If represented in a graph, the picture will be like this.

Category 1 is Steel and Category 2 is petrol.

Series 1 line shows that if the steel is produced 10 lac MT, Petrol production is 5 lac KL.
Series 2 line shows Steel production 5 lac MT and Petrol 9 lac KL.
Series 3 line shows Steel as 7.5 lac MT and Petrol as 7 lac KL.

All the three lines are intersecting at a point of 7.2 (approx) which may be the production possibility frontier for these two products. This is the best possible combination for producing the two goods economically by using the available resources to their optimal maximum advantage. That is, you can produce 7.2 LMT of steel and 7.2 LKL of petrol approximately to reach PPF.

This is when you are contemplating on only two products. But in actual there will be lot of goods being produced and making decisions will be much more tedious and requires much more prudence than a simple chart.

Thus Production Possibility Frontiers decide the production structure for any country or firms.

Comparative Advantage
Comparative advantage refers to the procedure of adapting to production of those goods and services which can be economically beneficial and feasible than other items both in terms of available resources and the cost factor. In this approach, you will be analysing the various factors related to production among available options. Any country or business can produce only certain goods and services beneficially with its available resources. If it indulges in producing all items, its economy will dwindle. In the above example of steel and petroleum, we can see that concentrating on steel production is more beneficial than producing both items. Petroleum or petrol can be more beneficially imported from other country where it is available cheaper by exchanging with steel than producing it at high costs domestically and wasting the resources. So it is comparatively advantageous to produce more steel in this case.

Opportunity Cost
By opportunity, it is meant that you are given an opportunity to select among two or more items for satisfying an immediate need with your available resources. For example, you have say Rs.1000/- with you and you are in need of shoes as well as a branded shirt. But when you enquire at the stores, you may realise that you can procure any one item only with your money. So you will have to decide which is more important for you and purchase that item and postpone the other item till next shopping. So here, if you are opting for the shoes by foregoing the shirt, it is the Opportunity Cost for shoes in this instance. The economists study these statistics and the driving reasons behind these decisions of consumers to setup guidelines for markets.

Economic Efficiency
Economic efficiency is a situation where the economy has attained its best results. If a country is able to produce all its requirements with its available resources without leaving any bad effects on the economy, it is said to have attained economic efficiency. It is a situation where the country is able to meet all the needs of its society and people at affordable costs and without any loss to the exchequer. This kind of efficiency is possible when the country is rich in all kinds of resources and technology, etc.

Specialization implies reaping the benefits of special skills in producing some goods more abundantly and cheaply than other countries. Normally any country or business cannot produce all goods and services equally and beneficially. It may produce some goods very beneficially and in abundance whereas for producing other goods or services it may have to put forth more resources and exertion while the quantity produced is much less. So it will be advantageous for that country to specialise on those goods and services which it can produce in more abundance and that too very easily and more cheaply. This is possible because it has vast resources and advanced technology for producing certain items. It can concentrate on those items only and reap the advantage of specialisation by producing more goods and export them to other countries from where it can import other requirements at cheaper rates than it could have produced. So specialisation improves trading relations between countries and boosts economy.

Absolute Advantage
Sometimes, a country may be so positioned that it will be rich in all kinds of resources and technology skills by default. In such cases, the country is said to be in absolute advantage as compared to others in production of any type of goods and services. It may be a rare case.

To sum up, normally, Economics of any country will be at benefit if it concentrates on some particular products and services with the use of PPF and Comparative Advantage and Specialization techniques. In this way, it can efficiently use its resources to their optimum benefits at comparatively low costs and sufficient stocks. It can export excess goods and services and import its other essential goods and services at affordable rates through trading. In this way they can improve their economy.

Friday, 13 June 2014

Notion of Scarcity and its effects on Economy

What is Scarcity?
Scarcity is a state of the economy where the available goods/ services and resources are unable to meet all the needs and requirements of public. It is a case of insufficiency. Requirements of people are more as compared to the available resources of the country or that particular economy. It is a condition of insufficient stock, insufficient production and insufficient availability of all resources including funds.

Factors contributing to Scarcity
  • It is geographically created or situated like that with low resources.
  • Lack of technology and mining facilities to unearth the resources and produce the end products.
  • Ever increasing population, with no corresponding improvement in production and services.
  • Impact of natural calamities destroying resources and produce.
  • Lack of efficient planning and management.
So you can see that scarcity of resources is both geographical and man-made. It is either natural element or weakness of that country and may be also due to chaos in administration.

How to tackle the problem of scarcity?

If the problem is due to natural elements such as destined by default to be poor in natural resources, then we may not be able to solve it easily. The available option is either to import raw materials and resources from other countries and produce finished goods in your country or to import finished goods directly from them. You may have to consider the cost factor also to be economical. If the cost of production on importing raw materials and turning them into finished goods is lower or equal to the cost of imported finished goods, then you can opt for importing raw materials and produce at your end as it has the benefit of giving employment to your workforce. If, on the other hand, you realize that cost of importing finished goods is much lower, then you should import the finished goods to tackle the situation.

In case of other than natural elements contributing to the scarce resources of a country, there should be many factors that need deep understanding and analysis before finding and formulating solutions.
  • In case of floods, rains and droughts contributing to destruction of stocks and resources, you must think over solutions to tackle the problem. Collecting the statistics of frequency and periodicity of these calamities can help you in formulating preventive measures like constructing dams and reservoirs, adapting techniques of rainwater harvesting and irrigation canals, water reservoirs and ponds to store water for off season usage, etc. These techniques can be of much help in solving the scarcity problem to some good extent.
  • If the problem is man-made like increasing population or congestion of population at some places, scarcity can be met out by controlling population or increasing the production and supply of goods by transportation and transhipment from other places.
  • Inefficiency in management and administration can be resolved through proper training programs and active participation of workers and management to remove bottlenecks.
  • Proper cost control study and analysis can reduce the fund problems which may contribute to scarcity if uncontrolled.
From the above, you are able to realise that the notion of scarcity is both natural and artificial. Artificial in the sense that it is created due to improper planning and administration and lack of knowledge. In some cases, scarcity may be intentionally created through corrupt methods to create black marketeering. 

But normally scarcity can be resolved through better planning and administration. Better planning is possible through a deep review of all the economic factors prevailing in the environments concerned and through formulating suitable principles and norms for application under particular conditions and situations.

Monday, 9 June 2014

Two branches of Economics: Macroeconomics and Microeconomics

There are two types of approaches in studying economics. Or you can say two branches of Economics. They are Macroeconomics and Microeconomics. Both these approaches are closely related and intertwined to each other. Let me explain in details-

Macroeconomics is the study of the whole country or world's economy. It mainly concentrates on government policies in dealing with the problem of allocation of scarce resources to achieve maximum production and development in economy. It deals with the country's available resources, the demands of the population, available technology and infrastructure, manpower and brainpower, available options to achieve goals, etc. It tries to project some policies and decisions for improving the economy based on the surveys and assumptions or conclusions arrived at through these studies and surveys.

For example take the example of power sector in India. Power is generated either utilising coal or water. Coal is becoming exhausted due to draining of coal fields since long periods. Now the reserves are found at very deep levels of coalfields and mining it is becoming very tedious job. Due to this coal prices have increased too much and power generation cost has also become very high. Coming to hydel power also we are facing the same problems. Water sources are drying up. Constructions of dams are also very problematic as people living at those places are strongly opposing the projects because of the fear of losing their livelihood and homes. Government has to tackle these things patiently and prudently. So all these matters are to be studied with great analysis and research to arrive at decisions.

The researches have lead to the utilisation of alternative sources of generating power like solar power. But solar power involves much investment and thereby cost of production is also very high at present.

Macroeconomics deals with all such problems. It studies all things very closely and carefully and advises the governing bodies in adapting to best possible solutions.

Now, coming to microeconomics, it is mainly related to the study of individuals or firms or companies in their reactions and habits under particular economic circumstances. Microeconomics watches and studies how an individual or company acts in making their choices among various wants and limited resources. It studies how a person under a particular level of income reacts to some changes in demands and supplies or changes in prices and income levels. It observes how he adjusts his wants and satisfies only certain wants and suppresses other wants. In other words, microeconomics studies to which needs he gives more preference by leaving behind the other needs. It also observes the degree of preference or the order of preference in which he satisfies his needs. If he gives more or most preference to particular wants, why he is giving that much degree of preference to that want over all others and what want he will satisfy next to it and so on. All these things are studied very minutely to understand consumer behaviour.

Microeconomics formulates some conclusions and laws according to this behaviour of individuals. It sets assumptions and predictions that at such and such level of income people will act like this and they will react to some changes in prices or supplies in such and such manner. These predictions will guide the marketing people in selling their products or manufacturing them according to the tastes and preferences of consumers.

In a nutshell

  • Economics, with the application of both these microeconomic and macroeconomic approaches, tries to solve all economic problems for improving the overall economy of the people.
  • It acts as an important tool in dealing with consumer behaviour and marketing behaviour. 
  • It helps in setting standards and guidelines to governments and markets in dealing with the problems of scarce resources and increasing demands. 
  • It tries to bridge the gap between production and demand and maintain a level of equilibrium as far as possible.

Thursday, 5 June 2014

What is Economics? A Review

Definition of Economics
Economics can be defined as the science of wealth and material welfare of society.
To be straightforward let us come direct to the point-
  • Economics is a scientific study of the allocation of scarce resources to their best uses.
  • To economise is to save or utilise for maximum possible satisfaction out of those scarce resources.
  • Economics is the study of wealth, material welfare of society and human behaviour related to these concepts of wealth and material welfare.
  • Wealth is not simply money. It refers to everything from natural resources to manufactured or produced products and material welfare is the allocation and distribution of these resources and wealth among society.

Need for Economics
Our world is full of resources. But, either they are scarce and insufficient to meet all our demands or we are unable to unearth them / produce them as much as to meet all our requirements. So our demands are always on higher side than the resources that are available to us at any point of time. So the need for economy arises.

If, we had been bestowed with abundance of resources that can last for ever, there would have been no need for economics. But the fact is that we are short of supply and so unable to satisfy all our demands. So, we are forced to undergo or cut short our needs to tally with the supply. So, we have to choose among our alternate multiple needs and try to satisfy the most urging needs first. Economics studies this behavioural pattern of people and sets guidelines to the economic system as a whole.

What does Economics do

Now the main objective of economics is to study this problem of scarce available resources and the always mounting needs of people to suggest some positive solution. For this purpose, the economists keep a continuous watch on the behavioural pattern of the consumers and public and after much exercises, arrive at some conclusions regarding projections of behavioural pattern of people under certain stimulated conditions. These conclusions are then, submitted to the government and the financial/ banking institutions for framing their economic policies.

For example, suppose a person with a certain income of Rs.50, 000 per month pays a monthly rent of Rs.10, 000, electricity bill of Rs.2, 000, internet/ phone bill Rs.1, 500, maintenance Rs.1, 500, housemaid payment Rs.2, 000, medicines Rs.5, 000, provisions Rs.5, 000, gas refil Rs.1, 000, milk Rs.2, 000, vegetables/ fruits Rs.1, 500, petrol Rs.10, 000, and invests Rs.5, 000 each month. So his total monthly expenses amounted to Rs.46,500. Now, he will be left with Rs.3, 500 only for other expenses. He may have to choose between buying a new set of new clothes or watching movie with friends or partying on week end with that balance amount. He can not meet all these from his balance income simultaneously. So he will think of buying clothes one month, watching movie in another month and weekly partying in yet another month. He will have to plan in this way and adjust his needs.

Economists watch this decision making of people in choosing among alternate options and under alternate circumstances and environments. They formulate some general laws based on this behavioural changes and project proper reform policies according to these surveys. They will see the effects of increase or decrease in supply and demand, and changes in the availability of funds in consumers' pockets, and effects of price changes on demand and supply, etc. All these factors are studied by stimulating some artificial conditions also for research purpose.

So, you must have now understood What is Economics and Why it is Important. Economics plays an important role in our daily life guiding all our monetary decisions according to the availability of resources and multiple needs.

Tuesday, 3 June 2014

How to differentiate accounting entries: Which Account to be Debited or Credited?

You must have understood the Double Entry System. Every transaction has two sides. One account to be debited and the other one to be credited. So when you make some, say 10 entries, there will be 10 debit entries and 10 credit entries. The total of Debits and the total of Credits will be tallying at any point of a time. If they do not tally, it means the entries are wrong and you will have to check each entry to verify that each Debit received a corresponding Credit.

Now coming to Debit and Credit, how to know which account should be debited or credited? If you would have gone through my previous articles, you could have realized one simple point. Can you locate it?

The simple rule is Debit all payments and Credit all receipts. Are you able to realize this point?

Let me clear this point through these simple steps:

DEBITS (Payments)

  • Assets: You are making payment and receiving some asset. Payment may be whole or in parts. But you are making payment. So, debit the Asset a/c like Land, Building, Plant & Machinery, Computer, etc. or advances a/c with the amount paid.
  • Purchases of Stock: Here also paying for stock items. So debit Stock a/c.
  • Expenses: Here you are paying for the travel and tour bills, stationery items, postage and courier charges, etc. So, Debit the relevant account heads.
  • Adhoc or Advances: Sometimes you pay an amount as advance for any job or contract for executing some work or supplies. Here, you will debit the advances a/c either in the party name or by the Work name.

CREDITS (Receipts)
  • Capital or Equity: Your business receives capital or share capital for starting and running of the business. So you Credit the Capital/ Equity a/c or Share Capital a/c.
  • Liabilities: You take loans for your business. Your business receives loan. So Credit Loan a/c.Say SBI loan a/c, ICICI loan a/c, IDBI loan a/c. etc. Further, your business receives money from customers against supplies. So Credit Customer a/c by his name. 
  • Income/Revenue: You sell items or provide services and in return, receive income for those services. So Credit the Sales a/c or other income against services a/c. Or if some interest is received on FDRs or Savings A/C, etc. Credit those income accounts.
So, from the above study, you are able to see that as a beginner of accounts, it is sufficient that you remember the basic fact to Debit all payments and Credit all Receipts.

Classification of Accounts into 5 major groups as per Accounting Equation Principle

According to a modern classification of accounts, ASSETS = Liabilities + Equity.

Based on this Accounting Equation principle, in a wider sense, all accounts have been classified into 5 main types of accounts.

This accounting equation principle assumes that whatever we spend, we spend it from the money invested by us in the business known as Capital/ Equity as well as from the loans taken by us known as Liabilities and the Income generated by us through the business. So, we spend from these three types of sources. Now, coming to the spending aspect, whatever we may be spending, we spend either for procuring Assets or for running the business through various expenses.

So, according to this notion, Assets + Expenses = Equity + Liabilities + Income

Naturally, the sum total of Assets + Expenses will be equal to the sum total of all Liabilities + Equity + Income. The excess of Expenses over Income becomes the Loss and the Excess of Income over Expenses becomes the Profit of the business during any year. So, ultimately, only the difference of the expenses or income gets added either in Assets or Liabilities. And the net effect is Assets = Equity + Liabilities.

But, you may ask how to treat the profit that I generate in my business or the loss if any?

If your business generates profit, it is an income and gets included in the Income group. Otherwise, if there is a loss, it is an expense for your business and so it gets included in the Expenses group. So, ultimately both sides tally. 

This classification into  5 basic types of accounts is derived from the concept of the Trial Balance also. In a Trial balance, you enter all debit balances in the left-hand side column and all credit balances in the right-hand side column. And if a trial balance does not tally, it means that some entry is wrong in your books. This is the inherent principle applied by the Accounting Equation in all books of accounting.

Now let us examine which type of accounts or what kind of elements does each group of accounts consist.

Equity or Capital is the money invested in the business. Any business requires some capital to start with. The businessman invests some money to establish and run the business. It is known as Capital. If it is a big company, it will have many promoters or shareholders in the business, who are allotted shares according to their shares. This is known as share capital or Equity. So accounts maintained under this group include Capital a/c or Proprietor Capital, ShareHolders' money a/c, Equity a/c and Preferential Share a/c, etc.

Liabilities are also a kind of investment in the business. For example, you may take some loan to run the business from Banks or Financial Institutions. This money is repayable to them in installments with interest. So it is a liability. Further, you may collect advances from customers for supplying goods or services to them. So it is a liability as you will have to supply to them the goods and services required by them. Another kind of liability is that you will be paying some accrued expenses due for the period up to March, but it is payable after 1st April. As on 31st March, it is a liability for the business. So all these are company's dues to outsiders. Accounts included under this group are naturally Customers a/c, Loan a/c, Interest payable a/c, Expenses Payable a/c, Bank Overdraft, etc.

Assets are of fixed or permanent nature and of current/ temporary nature. Any business owns Land, Building, Furniture, and Office Equipment like Computer, Calculator, Printer, etc. These are Fixed Assets as they run for some years. Current Assets are Cash Balance, Bank Balance, Stock-in-trade, Investments, Amounts Receivable etc. All these are assets to the company.

Any kind of income received by the business during a particular year is known as its income or revenue for the year. This income is generated through its transactions. So INCOME group includes accounts like Sales a/c, Interest received on Investments, Interest from Bank, Interest received from others like scrap sales, late payment or late supply interest, etc. Profit of the business during the year also is an income and comes under this group.

All expenses incurred for running the business during a particular year are grouped into this group. So this group consists expenditure heads like Stationary, Printing Charges/ Xerox Charges, Postage/ Courier charges, Tour Exp., Advertisement, Salaries & Allowances, etc. If there is any loss in running the business it also is an expenditure and comes under this group.

  • To sum up, there are five major groups or elements of accounts based on the Accounting Equation principle of Classification of Accounts.
  • Amounts invested in the business are treated as Equity/ Capital.
  • Amounts received from Financiers and other parties as advances against supplies and services are returnable, hence Liabilities of the business.
  • Cash and Bank Balances, Investments and Fixed Assets and other Stocks are all Assets of the company.
  • All incomes against business transactions for a particular year are INCOME/REVENUE of the business for that particular year including the profit of that year.
  • All expenses spent for running the business during a particular year are Expenses of the business including loss, if any, for that particular year. 

Sunday, 1 June 2014

Understanding the Three Major Types or Groups of Accounts: Real, Personal & Nominal Accounts

If you are dealing with accounts, you may be noticing different types and characteristics of accounts according to varied nature of dealings and degree of physical existence. Accounts are maintained for Building, land, machine, furniture, or in the names of persons like X, Y, Z or in the heads of various expenses and incomes like Food expenses, Tour expenses, Travelling expenses, or interest received from bank, interest paid to bank, Salary income or Salary expenses, etc.

Based upon this varied nature and characteristics of the accounts, all accounts have been classified into three major Groups of Accounts. This classification is known as the traditional classification of accounts.
  1. Real Accounts
  2. Personal Accounts
  3. Nominal Accounts
Let us examine each group deeply.
Real Accounts
There are two kinds of approaches to defining the Real Accounts.
  • According to one approach which goes directly on the meaning of the word "Real", real denotes to physical existence. So, all those accounts which represent physically existing goods or entities are known as Real Accounts. These include assets and stores accounts which we can feel and touch physically. So according to this explanation, Real accounts include assets like Land, Building, Furniture, Equipment, Roads, Tools and all physical stores items. 
  • The other perception of Real Accounts interprets the word "Real" as equal to permanence in nature. This definition is based on the periodicity of the account. So, this approach considers all Balance sheet items of a business entity as 'Real' because all balances in these Balance Sheets are carried over from one year to another year. So they are considered to be Permanent Accounts and hence grouped as "Real Accounts".So according to this interpretation, all balance sheet items of Assets, Liabilities, Capital are all grouped into Real Accounts.
Personal Accounts
Personal accounts refer to the accounts of Creditors and Debtors and the shareholders and partners, etc.
All these accounts are maintained in a certain person's name or a company name. 

But, if we adopt the definition of Real Accounts as permanently carried over accounts from one year to another year, then there will be a clash between Personal Accounts and Real accounts. If you are dealing with accounts, you might have noticed that most purchases and sales deal on credit basis. So there will always be balances outstanding in those accounts at the end of a particular year and need to be carried over to the next year as opening balances in their accounts.

Often, the same account can be grouped as Real and Personal also.

So, it is better to consider physical items as Real accounts and Name accounts as Personal accounts.

Nominal Accounts
All expenditure accounts and income accounts are grouped as Nominal Accounts. They are so called because they are maintained only during that particular year to know the impact of the transactions on business. The profit or loss of the business is calculated with the help of these accounts. And as soon as the objective is over, all these accounts will be closed in that year itself. Only the net amount of either profit or loss is carried forward to the next year. So these accounts are not permanent in nature. They are only nominal for the time being.