Accounting for acquisition of business

Introduction 

Business combination is the process under which two or more business organization or their net assets are brought under common control in a single business entity. Generally, companies doing similar types of business or involved in similar line of activities may go for business combination to get the economies of large scale production and to minimize the possibility of cut-throat competition. Business combinations result the growth. Other terms applied to business combinations are merger and acquisition. A "merger" refers to a situation where two or more than two companies of similar nature combine willingly while an "acquisition" or take over' refers to the situation where a  bigger company take over a smaller company. Business combination can take place either through amalgamation or through absorption.
Form of business combination
Amalgamation, absorption, reconstruction and holding company are the forms of business combination.

Amalgamation
When two or more companies carrying or similar business go into liquidation and a new company is formed to take over their business, it is called amalgamation. In other words, amalgamation refers to the formation of a new company by taking over the business of two or more existing companies doing similar types of business. In amalgamation, two or more companies are liquidated and a new company is formed to take over business of liquidating companies. The companies which go into liquidation are called or amalgamating or transferal companies where as the new company which is formed to take over the business of liquidating companies is called purchasing or amalgamated or transferred company. The main aim of amalgamation is to minimize the possibility of cut- throat competition and to advantages of large scale production.


Features of Amalgamation
Following are the main features of amalgamation:
1.    Two or more existing companies are liquidated.
2.    A new company is formed to take over the business of liquidating companies.
3.    The nature of business of existing companies is similar.
4.    Liquidating companies are called vendor companies and the new companies is called purchasing company.
5.    Generally, purchase consideration is discharged by issued of equity shares of purchasing company.
Absorption
Absorption is the process under which an existing large company purchases the business of another small company or companies doing similar business. In other words, when an existing company takes over the business of one or more existing companies carrying on similar business, it is called absorption. The company whose business is acquired is liquidating. But, no new company is formed. The company which take over the business is called absorbing or purchasing company and the company, the business of which is taken over is called absorbed or vendor company. The accounting record o absorption is similar to that of amalgamation.
Features of absorption
Following are the main features of absorption:
1.    One or more companies are liquidated.
2.    No new company is formed.
3.    The nature of business of both companies is similar.
4.    Generally, larger company purchases the business of similar company.
5.    The company which takes over the business of another company is called purchasing company and the company whose business is takes over is called Vendor Company.

Difference between amalgamation and absorption
Following are the difference between amalgamation and absorption:

Reconstruction
When a company is suffering loss for past several years and suffering from financial differences, it may go for reconstruction. In other words, when a company's balance sheet exhibits huge accumulated losses, functions and intangible assets or is financial difficulties or is over capitalized and them the process of reconstruction is restored. Reconstruction may be internal and external.
1.    External reconstruction
When a company is suffering losses for the past several years and facing financial crisis, the company can sell its business to another newly formed company. Actually, the new company is formed to take over the assets and liabilities of the old company. This recess is called external reconstructions. In other words, external reconstruction refers to the sale of the business of existing company to another company formed. The liquidated company is called 'vendor Company' and the new company is called 'purchasing company'. The accounting procedure of external reconstruction is similar to that of amalgamation and absorption. For example, if an existing company (welcome co.ltd.) goes in to liquidation to reconstruct externally and a new company (new company co. ltd) to take over the business of exiting company, it is called external reconstruction.
2.    Internal Reconstruction
Internal reconstruction refers to the internal re-organization of the financial structure of a company. It is also termed as re-organization which permits the existing company to be continued. Generally, share capital is reduced to write off the past accumulated losses of the company. The accounting procedure if internal reconstruction is distinct from teat of the amalgamation, absorption and external reconstruction.
Holding company
The creation of the relationship of holding and subsidiary companies is a form of combination. A company may acquire either the whole or the majority of the shares of another company so as to have a controlling interest in such a company or companies. The controlling company is known as the holding company and the so controlled company or the company whose shares have been acquired is known as subsidiary company and both together are known as the Group of Companies. Holding companies are able to nominate the majority of the directors of subsidiary company. The company gets such right which it purchases more than half share of another company. So, the holding company is one which control on or more other companies either by means of holding more the half in that company or companies or by having power to appoint the whole or majority of the directors of those companies. A companies controlled by holding company is known as a subsidiary company.
Advantages of Business Combination
Amalgamation or absorption result the merging of two or more companies into one and form a business combination the main objective of business combination is to eliminate cut throat completion and secure the advantage of large scale production. Following are the advantages of business combination i.e. amalgamation and absorption:
1.    Competition between and among the companies is eliminated.
2.    Amount of capital can be increased by companies companies.
3.    Establishment and management cost can be secured.
4.    Benefits of large scale productions can be secured.
5.    Operating cost can be reduced by avoiding duplication.
6.    Research and development facilities are increased.
7.    Monopoly in the market can be achieved.
8.    Bulk purchase of materials t reduced price is possible.
9.    Stability in the price of goods is maintained.

Disadvantages of Business Combination
Following are the major disadvantages of any form of business combination:
1.    It brings monopoly in the market, which may be harmful for the society.
2.    The identity of the company finishes.
3.    Goodwill of the old company becomes difficult.
4.    Management of the company becomes difficult.
5.    Business combination may result in over-capitalization.

Accounting procedures of Amalgamation, Absorption and external Reconstruction
In amalgamation, absorption and external reconstruction, Vendor Company is liquidated by transferring its assets and liabilities as per agreement with the purchasing company. In exchanges, it wills receive purchase consideration from the purchasing company. Thus, Vendor Company and purchasing company are the two parties involved in the process of amalgamation, absorption & external reconstruction. The accounting procedures involve the following:
a.    Calculating of purchase consideration.
b.    Closing entries in the book of Vendor Company.
c.    Opening entries in the books of purchasing company.

Purchase consideration (purchase price)
The price paid by Purchase Company to Vendor Company for taking over the business is termed as purchase price or consideration. It is determined by the mutual between Vendor Company and purchasing company. The calculation of purchase consideration is one of the important tasks in the process of amalgamation, absorption and external reconstruction. Generally, purchase price is discharged by issuing fully paid shares of purchasing company. It is computer by the following methods.

1.    Lump sum method
When a fixed amount is paid by purchasing company on behalf of purchase of business to Vendor Company, it is known as lump sum payment of purchase consideration. No calculation is required to calculate purchase consideration under this method. For example, Nepal Company limited purchase the business of International institute and agrees to pay Rs 9, 00,000 here, the amount of purchase consideration is equal to Rs 9, 00,000.
2.    Net payment method
Under this method, purchase consideration is computer by adding the various modes of payment made by Purchasing Company in the form of cash, debentures, preferences shares and equity shares. In other words, the purchase consideration is the sum of all payments made by purchasing company in the form of cash, debentures and shares. Under this method, purchase consideration is calculated as under:
3.    Net assets method/ Net worth method
Here, net assets mean the difference between assets taken over and liabilities taken over. Under this method, the purchase consideration is determined by adding the agreed value of assets taken over and there after deducting the agreed value of liabilities taken over the purchasing company. Net assets method is used to determine the amount of purchasing consideration when the full details of purchase consideration as per net payment method are not given. Under this method, amount of purchase consideration is determined as under:

Point to be considered in respect of assets of Vendor Company
•    Fictions assets like preliminary expenses, discount on shares, underwriting commission, discount or cost on issue of debentures, debit balance of profit and loss account etc should not be included in assets taken over,
•    Intangible assets such as patent, trademark, copyright etc. should be included in assets taken over.
•    The word "all assets" include cash in and balance at bank also.
•    If any asset is not taken over by purchasing company that should not be considered for purchase consideration.
•    The word "business" will always mean assets and external liabilities.
•    While computing purchase consideration, current market price of assets should be considered.
Points to be considered in respect of liabilities of Vendor Company
•    Liabilities taken over means only external liabilities.
•    Trade liabilities include creditors, bills payable and account payable only.
•    Liabilities taken over do not include accumulated profit and reserve.
•    Any fund or reserve created out of salary of staff is trade red as external liabilities.

4.    Intrinsic value of shares method
Under, this method, purchase consideration is calculated on the basis of intrinsic value of share of the two companies involved. Intrinsic value of share is calculated by dividing the net assets available for equity shareholders by existing number of equity shares. This value determines the ratio of exchange of the shares between the purchasing company and Vendor Company.

Intrinsic value per share= net assets/ no. of equity shares

Closing entries in the books of Vendor Company
The accounting books and balance sheet of Vendor Company are required to be closed after getting the process of liquidation. A liquidator is appointed on the liquidation of the company and he represents the vendor company with purchasing company. When the company goes for liquidation a realization account. Is operated for settlement of accounts. For following entries and passed to close the books of vendor company.
1.    For liabilities taken over by purchasing company
2.    For liabilities taken over by purchasing company.
3.    For sale of assets not taken over by purchasing company.
4.    For purchase consideration due from purchasing company.
5.    For receipt of purchase consideration
6.    For payment of external liabilities not taken over by purchasing company
7.    For amount due to debentures holder
8.    For amount due to debentures holders discharged
9.    For amount due to preference shareholders
10.    For amount due to preference shareholders discharged
11.    For transfer of share capital and accumulated profit and reserve to equity shareholder 
12.    For transfer factious fictitious assets to equity shareholder
13.    For transfer of gain on realization to equity shareholders'
14.    For amount due to equity shareholders discharged


Opening entries in the books of purchasing company
The purchasing company records the transactions by passing opening journal entries and preparing opening balance sheet in the case of amalgamation and absorption. The following are the accounting records maintain in the books of purchasing company.
1.    When business of vendor company purchased.
2.    When assets and liabilities are purchase or taken over at an agreed market value.
3.    When purchase price is discharged or paid off in cash or by issuing shares and debentures at a par, at a premium or at a discount.
4.    When liquidation expenses are paid by purchasing company
5.    When goodwill written off (if there is shared premium)
6.    When there is formation expense or preliminary expense.
7.    When fresh shares are issued to the public
Internal reconstruction
It is process of making financial strength sound internally by charging him financial elements. Under this case, the share capital and liabilities are required to be altered in a planned way. Internal reconstruction is also termed as re-organization which permits the exiting company to be continued.
Method of internal reconstruction
Internal reconstruction is the process of re-arranging he share capital and liabilities. It includes the following two methods:
1.    Reduction of share capital
2.    Alternation or re-arrangement of share capital

1.    Reduction of share capital
Capital reduction is the way of decreasing difference classes of share capital, as a result of large accumulated losses or an excess of funds without profitable use. Ordinary, reduction in capital is made to write of heavy accumulated loss, fictitious assets and intangible assets. Similarly, if the company has been suffering losses for the last many years and is required to bring profit earning position in future by eliminating loss balance, the capital is reduced.
Accounting records for reduction of share capital
1.    When paid-up share capital is reduced with reducing the liabilities on shares
2.    When there is any increase or profit on revaluation (appreciation) of fixed assets.
3.    When any liability is reduced.
4.    When balance of any reserve or fund transaction to capital reduction account.
5.    When functions assets, intangible assets and other assets are written off out of the balance of capital reduction.
6.    When reconstruction expenses is paid out of the balance of capital reduction.
7.    When balance of capital reduction is transferred to capital reserve.


2.    Re-arrangement of share capital
Re-arrangement of share capital of a company is another way of internal re-construction. This can be applied by many methods. The process of re-arrangement of share capital is known as alteration of share capital also. A company may, if so authorized by its articles, go for the following scheme for alternative in share capital:
a.    Increasing share capital be fresh issue of shares
b.    Consolidating or dividing share capital into shares of large amount than its existing shares or smaller amount.
c.    Converting fully paid up share capital into share stock.
d.    Subdividing its shares into share of smaller amount f par value by increasing number of shares.

Accounting records for alternation of share capital
a.    When old share capital is sub-divided into share
b.    When old share capital is consolidated into shares of large par value.
c.    When fresh are issued for cash.
d.    When shares of fully paid up are converted into share stock.

Define the term amalgamation with its features.
When two or more companies carrying on similar business go into liquidation and a new company is formed to take over their business. It is called amalgamation. The companies which go into liquidation are called vendor company or amalgamating or transfer companies where as the new company which is formed to take over the business of liquidation companies is called purchasing or amalgamate or transference company. The main aim of amalgamation is to minimize the possibility of cut threat competition and to secure the advantage of large scale production
Feature of amalgamation
Following are the main features of amalgamation:
1.    Two or more existing companies are liquidated.
2.    A new company is formed to take over the business of liquidating companies.
3.    The nature of business of existing companies is similar.
4.    Liquidating companies are called vendor companies and the new companies is called purchasing company.
5.    Generally, purchase consideration is discharged by issued of equity shares of purchasing company.

Concepts of National Income:

There are various concepts of national income. These are explained below one by one:

(1) Gross National Product (GNP).

(2) Net National Product (NNP)/National Income.

(3) Gross Domestic Product (GDP).

(4) National Income at Factor Cost.

(5) Personal Income.

(6) Disposable Personal Income.

(1) Gross National Product (GNP):

Gross National Product at Market Price:

Definition and Explanation of GNP:

The concept of gross national product (GNP) is comprehensive. It enables us to measure and analyze as to how much is the aggregate economic production of a country in a given period. The gross national product of a country (GNP) is defined as:

"The total money value of all final goods and services produced by the residents of a country in one year period".

In the words of W.C. Peterson:

"Gross national Product may be defined as the current market value of all final goods and services produced by the economy during an income period regardless of where the output is produced".

we should remember the following aspects about GNP.

(i) GNP is a flow concept: GNP represents a flow. It is a quantity produced per unit of time. It is the value of final goods and services I produced in a country during a given time period.

(ii) GNP measures final output: While calculating GNP, the market value of only final goods and services produced in a year are added up. Final goods are those goods which are purchased for final use in I the market.

(iii) GNP is output produced by the citizens of a country: Gross national product is the final output of goods and services produced by the citizens and businesses of a country during a given time period which is usually a year. For example, the economic activity carried out by the USA citizens and businesses outside the country is counted in GNP. While the income of the residents who are not USA citizens is subtracted from GNP.

Components of Expenditures in GNP:

For measuring GNP at market price, the economists use Expenditure Approach. According to this approach:

There are four categories of expenditures which are added together to measure gross national product (GNP) at market price, (i) Consumption, (ii) Investment (iii) Government expenditure and (iv) Net exports.

These four types of expenditures are now explained in brief:

(i) Consumption Expenditure (C): It includes all personal expenditure incurred by the citizens of a country on durable and non-durable goods in a period of one year.

(ii) Investment (I): It is the total expenditure incurred by firms or households on capital goods.

(iii) Govt. expenditures (G): It includes all types of expenditure incurred by Federal, Provincial, Local Councils on the purchases of goods and services such as national defense, law and order, street lighting etc.

(iv) Net Exports (X - M): Net exports of goods and services are value of exports minus the value of imports.

Formula For Gross Profit:

GNP = C + I + G + (X - M)

Where:

C = consumption, I = investment, G = Govt. expenditure and X - M = Net exports

(2) Net National Product (NNP)/National Income:

Definition and Explanation of NNP:

"Net national Product or national income at market prices is the net market money value of all the final goods and services produced in a country during a year. It is found out by subtracting the amount of depreciation of the existing capital in a year from the market value of all final goods and services".

For a continuous flow of money payments, it is necessary that a certain amount of money should be set aside from the gross national income for meeting the necessary expenditure of wear and tear of all capital equipment so that there should not be any deterioration in the capital and it should remain intact. If we deduct depreciation allowance from gross national product, we get Net National Product at current market price.

Formula For Net National Product/National Income:

NNP at Market Price = GNP at Market Price - Depreciation

Depreciation Allowance and Maintaining Capital Intact. Here a question can be asked as to what we actually mean by depreciation allowance and maintaining capital intact; (the words which we have used in explaining NNP).

It is known to every one of us that when production is going on, the value of capital equipments does not remain the same. A decrease in value because of wear and tear through, use, rusting, accident or through actions of elements, gradually take place in the building and other equipments of business. A certain sum of money based on the value of the capital equipment and its longevity is set aside every year from the gross annual income so that when machinery is worn out, a new capital equipment can be set up from the sum thus accumulated. This fund which is set aside for covering the wear and tear, deterioration and obsolescence of the machinery is named as Depreciation Allowance. We can make this concept more clear by taking a simple example.

Example of NNP:

Suppose, a person buys a machinery for manufacturing cloth for $10000 only. He expects that this machinery will last ten years and after that period, it will be partially or completely worn out. He sets aside $1000 every year from the gross national income as a depreciation reserve of the capital equipment.

After the expiry of ten years, he accumulates $10000 and with that money he replaces the old capital equipment which has lived its useful life and maintains capital intact. The sum of money, i.e., $1000 which he annually deducts from the gross annual income, is known as depreciation allowance.

It is often pointed out by economists that the calculation of depreciation allowance every year is a difficult task.

For example, a person expects the longevity of the capital equipment, say for ten years. There is a possibility that machinery may last longer or it may go out of use earlier. So they say what needed is an approximate decision regarding the' depreciation allowance. This decision should be based on high degree of judgment and guessing about the future.

Maintaining Capital Intact. By maintaining capital intact we do not mean that capital equipments should remain the same. It should neither increase nor decrease. This can only by possible in a static society. In a progressive society, the total capital equipment of a country must increase every year, otherwise the national income will be affected adversely.

In Economics, by the phrase 'maintaining capital intact' is meant to make good the physical deterioration which has taken place in the capital equipment while creating income during a given period. This can only be made by setting aside a certain amount of money every year from the annual gross income so that when the income creating equipment becomes obsolete, a new capital equipment may be created out. If the depreciation allowance is not set aside every year, the flow of income would not remain intact. It will decline gradually and the whole country will become poor.

NNP = GNP - Depreciation

(3) Gross Domestic Product (GDP):

Definition and Explanation of GDP:

It is a key concept in the national income. "Gross domestic product (GDP) is the total market value at current prices of all final goods and services produced within a year by the factors of production located within a country".

The labor and capital of a country working on its natural resources produce a certain aggregate of commodities, material and non-material every year. In addition to this, there may be foreign firms producing goods in the various sectors of the economy like mining, electricity, manufacturing etc.

If we add up the money value of all the final goods produced both by domestic and foreign owned factors annually in the country and valued at market prices, it wilt be called gross domestic product (GDP). Gross Domestic Product thus is the value of aggregate or total production of goods and services in a country in one year. This constitutes the Gross National Product, of a country. If we make a detailed list of all such commodities produced annually or measure the total goods produced during a year by weight or by volume, it will not give us any clear and concise impression about our total national output. So what generally done is that the money value of all final goods and service produced during a year at current market prices is added up. This total current market value of all final goods and services produced in an economy in one year period is called gross domestic product (GDP). In the words of Campbell:

"Gross Domestic Product is defined as the total value of all final goods and services produced in a country in one year".

According to Shapiro:

"GDP is defined as a flow variable, measuring the quantity of final good and services produced" during a year".

Problems in Measuring GDP:

The main problems or pitfalls which are to be avoided in the measurement of GDP are as under:

(i) Stress on final output. While calculating the gross domestic product (GDP), the value of only those goods are added which have reached their final stage of production and are available for consumption. The primary or intermediate goods are not counted in GDP. For example, table made of wood is the final product. The wood used in making the table is a primary good. While calculating GDP, if we include the value of wood as a separate item and the value of table separate, it will be a case of double counting and this leads to inflated rise in GDP.

(ii) Value added method. Another way to avoid pitfall of double or multiple counting is to calculate only the added value of a particular commodity at its every stage of production. The result in both the cases will be the same.

Suppose, the price of book which you are reading is $10. This includes the cost of paper, printing and binding charges, etc., While estimating the gross domestic product, there are two ways open to you. Either you include the final price of the book at one time in gross domestic product or you add up the added value at every stage in the process of the production of the book. But you are not to count the value of a thing more than once.

From the following example, the reader can easily understand as to how the danger of double or multiple counting can be avoided.

Stage of Production	Form of the Product	Price at Each Stage ($)	Value Added at Each Process ($)
1st	Jungle Wood	0.25	0.25
2nd	The price of wood after transporting to the city	0.38	0.13
3rd	Paper manufacturing	2.00	1.62
4th	Printing of book	5.00	3.00
5th	Binding and title, etc.	6.00	1.00
6th	Sale price	10.00	4.00
		$23.63	$10.00

From the above example, it is clear that if we add up the value of the product at every stage of production, the total value of the book comes to $23.63, while in fact it is priced al $10 only.

So we come to the conclusion that while adding the value of the book to the gross national product, we should either include the final price of the book which is $10 or we should add up the added value at each stage in the process of production. But we are not to count the value of a particular commodity more than once. If we do so, the gross product will be overestimated. The computation of GDP by this method is not popular.

(iii) Non-Productive transactions are excluded from GDP. In order to measure the economic well being of a society in a year, the non-productive transactions are excluded from the Gross Domestic Product. There are two major types of non-productive transactions, namely: (a) Purely financial transactions and (b) Second hand sales. Under purely financial transaction (i) all public transfer payments which do not add to the current flow of goods such as social security payments, relief payments and (ii) all private financial transactions such as receipt of money by a student from his father which make no contribution in current production are all excluded from GDP. Similarly, the second hand sales are excluded from GDP as they do not contribute to current production in a year.

(iv) Other transactions. There are a few other transactions which are not included in GDP. For example, persons working in their own houses without any payment through the market. For example, a house wife takes care of house and children. Since she is not paid, therefore, the value added by her is not included in GDP.

Exclusion of output production abroad. GDP is the value of output produced by factors of production located within a country. It excludes the output produced abroad by domestically owned factors of production.

Distinction Between GDP and GNP:

Here it seems necessary to make a distinction between gross domestic product (GDP) and gross national product (GNP). Gross domestic product is the total market value of all final goods and services produced by factors of production within a nation's border during a period of one years. In other words GDP is a flow of production produced within the country by domestically located resources in a year.

Gross national product (GNP) on the other hand, is the measure of all final goods and services produced by the citizens within their own country as well as outside the country during a period of one year. In other words, GNP expresses the money value of flow of goods and services produced within the country and the net income received from abroad during a period of one year. Thus when we move from GDP to GNP, we add factor income receipts from foreigners and subtract factor income payments to foreigners.

Formula For GDP:

GDP = GNP - Net Foreign Income From Abroad

(4) National Income at Factor Cost:

Definition and Explanation:

National income can be estimated in terms of either output or total income. When national income is measured by adding together all income payments made to the factors of production in a year, it is called national income at factor cost. National income thus is the sum total of all income payments made to the factors of production. In the words of J. Sloman:

"National income (Nl) or national income at factor cost is the aggregate earning of the four factors of production (land, labor, capital and organization) which arise from the current production of goods and services by the nations' economy".

Components of National Income at Factor Cost:

The main components of national income at factor cost are as follows:

The factor incomes are generally divided into four categories:

(i) Compensation to employees (ii) Interest (iii) rents and (iv) profits.

(i) Compensation to employees: It is the largest component of national income. It consists of wages and salaries paid by the firms to the workers for their labor services.

(ii) Interest: Interest is the payment for the use of funds in a year. The payment is made by private businesses to households who have lent money to them.

(iii) Rent: Rent is all income earned by individuals for the use of their real assets such as building, farms etc.

(iv) Profit: Profit is the amount which is left after compensation to employees, rent, interest have been paid out. The sum of compensation to .employees, interest, rent and profit is supposed to equal national income at factor cost.

(5) Personal Income:

Definition and Explanation:

National income is the sum of factor income. In other words, it is the income which individuals receive for doing productive work in the form of wages, rent, interest and profits. Personal income, on the other hand, includes all income which is actually received by all individuals in a year. It includes income which is not directly earned but is received by individuals.

For example, social security payments, welfare payments are received by households but these are not elements of national income because they are transfer payments.

In the same way, in national income accounting, individuals are attributed income which they do not actually receive. For example, undistributed profits, employees contribution for social security corporate income taxes etc. are elements of national income but are not received by individuals. Hence they are to be deducted from national income to estimate the personal income.

Formula For Personal Income:

PI = Nl + Transfer Payments - Corporate retained earnings, income taxes, social security taxes

(6) Disposable Personal Income:

Definition and Explanation:

Disposable personal income is the amount which is actually at the disposal of households to spend as they like. It is the amount which is left with the households after paying personal taxes such as income tax, property tax, national insurance contributions etc.

Formula For Disposable Personal Income:

Disposable personal income = Personal Income - Personal Taxes

DPI = PI - Personal Taxes

The concept of disposable personal income is very important for studying the consumption and saving behavior of the individuals. It is the amount which households can spend and save.

Disposable Income = Consumption + Saving

DI = C + S

Determination of Equilibrium National Income in a Two-Sector Economy!

1. Meaning of Equilibrium:

By equilibrium we mean the state of balance or state of no change. By equilibrium national income we refer to that level of national income which remains unchanged at a particular level.

At the equilibrium level of national income there is no tendency for income/output to rise or fall.

In the Keynesian two-sector economy there are only household and business sectors.

Government is absent and the economy is a closed one. In this simple economy, there are two elements of national income—consum­ption and investment, i.e., C + I. An economy is said to be in equilibrium when aggregate expenditure equals aggregate income or aggregate money value of all goods and services.

Aggregate demand is, thus, sum of consumption demand and investment demand. Since, in a two-sector economy, there are only two goods—consumption goods and investment goods—aggregate expenditure is, the sum of consumption and investment expenditures. Thus, aggregate demand (C + I) equals aggregate expenditure (C + I).

Alternatively, whenever aggregate income equals aggregate expenditure, leakages from and injections into the circular flow of income become equal to each other. In a two-sector economy, saving is the only source of withdrawal and investment is the only source of injection. Thus, an economy is said to be in equilibrium when saving (i.e., withdrawal) equals investment (i.e., injection).

The above argument, thus, suggests that there are two alternative approaches of national income determination. First approach slates that the equilibrium level of national income is determined by the equality of aggregate demand (or aggregate expenditure) and aggregate supply of output. In terms of a diagram, one can say that in a two-sector economy, the equilibrium level of national income is determined at that point where C + I line cuts the 45° line. This approach is, thus, known as income-expenditure approach or aggregate demand-supply approach.

Aggregate demand = money value of output (income)

or Y = C + I …(3.17)

Alternative approach states that, when injection (I) equals leakage (S) in a two-sector economy, equilibrium level of national income is determined. In terms of a diagram, when saving line and investment line intersect each other, equilibrium level of income is determined.

Leakage (saving) = injection (investment)

or S = I …(3.18)

Remember that these two approaches are alternative to each other.

2. Methods to Determine Equilibrium National Income:

Now these approaches will be explained in detail:

(i) First Method: Aggregate Income- Expenditure Approach:

In a two-sector Keynesian model, aggregate demand is composed of planned or desired consumption demand and planned investment demand. The total of planned expenditure (C + I) must be equal to the value of output or income for a simple economy to be in equilibrium. Or when the C + I line cuts the 45° line, an equilibrium level of income is determined. In other words, an equilibrium level of national income is determined at that point where aggregate demand (C + I) equals aggregate supply (i.e., the country’s aggregate output or national income).

To illustrate equilibrium national output graphically, we use Fig. 3.11 where we measure national income on the horizontal axis and aggregate demand or spending (C +1) on the vertical axis. The 45° line is purely a reference line; any point on this line is equidistant from both the horizontal and vertical axes. Aggregate spending (C + I) is equal to the value of income or output on this 45° line. For our exposition purposes, this line can be thought of as an aggregate supply curve, though it is not a ‘true’ aggregate supply curve.

With no government and foreign trade sectors, aggregate demand/expenditure is the sum of consumption demand and investment demand. In Fig. 3.11, CC’ is the planned consumption line. It shows the level of consumption for each level of income. Investment expenditure is assumed to be autonomous. To demonstrate this, investment line 1 has been drawn parallel to the horizontal axis.

By summing up the consumption and autonomous investment schedules one obtains aggregate demand schedule (C + I). The vertical distance between the CC’ line and the C + I line measures the volume of autonomous investment. Point E is the equilibrium point since C + I line cuts the 45° line at that point. Equilibrium level of income, thus determined, is OYE since it is the only level of income at which aggregate demand and aggregate value of output (or income) are equal to each other.

We can show that this equilibrium level of income is a stable one. This means that if the level of income is either more than or less than OYE then there will be a tendency for the level of income to move toward OYE. Otherwise, equilibrium is said to be unstable. Suppose, if income is OY, (< OYE), aggregate demand will exceed aggregate supply or aggregate output. Now there will be an excess demand for goods and services, resulting in an unplanned reduc­tion of inventories. (Remember that invento­ries are part of investment.) As inventories decline, business firms step up production.

Thus, output will continue to rise till OYE is achieved. Similarly, at OY, level of income, aggregate supply exceeds aggregate demand. This means an excess supply of goods and services. People are not willing to purchase all the goods that the nation has produced. Thus, there will be an unintended accumula­tion of inventories by producers. Firms will now be forced to cut back production. Output will continue to decline till OYE is attained. Only at OYE there is neither unplanned accu­mulation nor depletion of inventories. Thus, OYE is stable equilibrium national income.

To have a stable equilibrium of income one condition is needed—slope of the line C + I must be equal to the slope of the CC’ line. The slope of the consumption line CC’ is the MPC whose value must always be less than unity. Diagrammatically, this means that the C + I line must cut the 45° line from above. If C + I line cuts the 45° line from below then the value of MPC would be greater than unity and equilibrium income, thus, determined in this manner would be unstable.

(ii) Alternative Method: Saving-Investment Approach:

Total withdrawals from and injections into the circular flow determine equilibrium national income. In a two-sector economy, withdrawal comprises only saving while injection comprises only investment. Equilibrium national income is determined at that point when planned saving and planned investment are equal to each other. Diagram­matically, at the intersection of the saving and investment line, equilibrium national income is determined.

In Fig. 3.12, we measure national income on the horizontal axis and savings and investment on the vertical axis. SS’ is the planned saving curve which has a negative intercept in the sense that at low level of income since consumption exceeds income savings must be negative. As usual, I is the autonomous investment line drawn parallel to the horizontal axis. As SS’ curve cuts I at point E, equilibrium level of income is thus determined at OYE. In other words, planned saving and planned investment are equal only at the intersection of the two curves and, thus, equilibrium income is OYE. And this equilibrium income is a stable one.

To see whether OYE is a stable equilibrium income, we consider OY1 or OY2 level of income. If the deviation from OYE level of income gets corrected or if the equilibrium income OYE is attained after deviation, then equilibrium is said to be a stable one. At OY1 level of income, investment (injection) exceeds saving (leakage). Aggregate demand must exceed aggregate output. This will result in an unplanned reduction of inventories to meet excess demand. Consequently, output will rise until planned saving and planned investment are equal.

Similarly, at OY2 level of income, since saving exceeds investment, aggregate demand falls short of aggregate supply. Hence, an excess supply of commodities will appear leading to an unplanned accumulation of inventories. This will act as an incentive to cut back output. Output will continue to decline until point E is reached where OYEequilibrium level of national income is determined. Thus, OY£ is a stable equilibrium.

The condition for stability is that the saving curve must be positively sloped. MPS is the slope of the saving function. To have stability, the value of MPS must be positive but less than one. Remember that MPS is complementary to MPC. If MPC < 1, then MPS must be less than one since MPC + MPS = 1. Thus, the condition for stability in equilibrium income in both the approaches is the same, i.e., 0 < MPC < 1.

A Numerical Example on the Determination of Equilibrium National Income in. a two-sector economy:

Suppose, consumption (C) is given by the consumption function

C = 5 + 0.8Y

where Y is income.

Assume that investment is autonomous (I) and is given by

I = Rs. 10

With this information, we want to derive the equilibrium values of income, consumption, saving and investment.

Solution:

Equilibrium condition is Y = C + I, where C = a + bY and I = I. Putting the values of C and I, we obtain

Y = a + bY + I

or Y – bY = a + I

or Y (I – b) = a + I

Y = 1/1-b (a + I)

Here, Y is the equilibrium level of income. Substituting the consumption and investment equations into equation Y, we get 1

Y =1/1-0.8 (5 + 10) – Rs. 75

Thus, C = 5 + 0.8(75) = Rs. 65, and

S = Y-C = 75 – 65 = Rs. 10

I = Rs. 10

3. Equilibrium Income is not Necessa­rily Full Employment Income:

We have demonstrated how equilibrium level of national income in the Keynesian framework is determined. But this equilibrium income must not necessarily be full employment income (designated as YF in Figs. 3.11 and 3.12). Equilibrium income determined (OYE) is definitely less than full employment income (OYF). This means that aggregate demand (C + I) is inadequate to maintain full employment. At the full employment level, aggregate output becomes maximum.

But, in the Keynesian system, aggregate demand or aggregate spending creates an income level which is necessarily less than full employment income. This equilibrium income has been described by Keynes as ‘underemployment equilibrium’. To reach ‘full employment equilibrium’, Keynes prescribed a fiscal policy measure which aims at stepping up government expenditure and tax cuts.