Grade 11 Economics Note

National Income Accounting

Introduction

National Income Accounting is the systematic rendering of statements about the performance of an economy during a period of time. National Income Accounting is the process of measuring the national income of an economy over a period of time. It tells us about the economic health of a country over a period of time. It is very useful tool of measuring and comparing living standards as well as formulating economic policies. It shows the share of different sectors of an economy in the total income of the economy. It helps us to find the per capita income of the country. It is also an important indicator of economic development.

 

Definitions of National Income

Different economists have defined national income in their own ways. Here are some of the popular definitions given by the prominent economists.

 

Marshall's definition

According to Marshall, "The labor and capital of a country acting upon its natural resources produce annually a certain net aggregate of commodities, material and immaterial including services of all kinds. This is the net annual income or revenue of a country or the national dividend."

 

Pigou's definition

According to Pigou, "National income is that part of objective income of the community, including of course income derived from abroad which can be measured in money."

 

Fisher's definition  

According to Fisher, "The national dividend or income consists solely of services as received by ultimate consumers, whether from their material or from their human environments. Thus, a piano or an overcoat made for me this year is not a part of this year's income, but an addition to capital. Only the services rendered to me during this year by these things are income."

 

Simon Kuznets` definition

According to Simon Kuznets, "National income is the net output of commodities and services following during the year from the country's productive system in the hand of the ultimate consumers."

 

Concepts of National Income

National Incomes can be of different types. Incomes in an economy can be derived from many sources. Some types of income include something while others might exclude something out of the income stream. Hence, it is necessary to know about the various concepts of income, which are as follows:

 

Gross Domestic Product (GDP)

GDP is defined as the total market value of the final goods and services produced in an economy over a period of time, usually one year is known as the Gross Domestic Product. GDP is a monetary measure of national income. In order to calculate the GDP, the quantity of various goods and services are multiplied with their respective prices and added to come to a monetary figure.

                                              $GDP = p1x1 + p2x2 + ....pnxn = \mathop \sum \limits_{i = 1}^n pixi$

The above equation shows that for n number of goods and services produced in an economy over a period of one year, the GDP equals the summed up monetary value of all goods and services in the economy.

Gross National Product (GNP)

GNP is the total monetary value of the final goods and services in an economy over a period of time plus the net factor income from abroad. It includes only those goods, which are produced using domestic factors of production. In a time like this where factor mobility is not a surprising phenomenon, ordinary residents of a country work abroad and are paid for their services. Foreigners also render services in the domestic economy and are paid their share of contribution. Hence, GNP subtracts the income paid to the foreigners in the economy and adds the income earned from giving services of nationals in the foreign economy. The difference between income earned from abroad and income paid to foreigners is known as the net factor income from abroad.

Therefore, $GNP = GDP + net\: factor\: income\: from\: abroad$

 

Difference between GDP and GNP

Basis of distinction

GDP

GNP

Definition

It is the market value of the final goods and services produced in a country during a period of time.

It is the market value of final goods and services produced by the ordinary citizens of a country over a period of time.

Scope

It is a narrow concept.

GNP is a broader concept than GDP.

Main concern

It focuses on the value produced within a 'territory'. Here, territory is of importance.

It focuses on the value produced by the citizens of the country. The focus is on citizens, not boundary.

Inclusion of net factor income from abroad

It excludes the net factor income from abroad.

It includes the net factor income from abroad.

Frequent use

GDP is widely used for international comparisons than GNP.

GNP is less used in international comparisons than GDP.

Formula

   $GDP = \mathop \sum \limits_{i = 1}^n pixi$

                 $GNP = GDP + net\: factor\: income\: from\: abroad$

 

Net National Product (NNP)

There happens to be wear and tear of machineries and other fixed capital during the production process. This is also known as depreciation or consumption of fixed capital. NNP is the result of deduction of value of depreciation from the GNP. NNP allows for the deduction of depreciation, maintenance of fixed capital and gives the true value of goods and services after excluding such expenses.

                                                                                      $NNP = GNP - Depreciation$

 

National Income

National income is the total income accruing to all factors of production for the services rendered in the production process. The household sector provides factors of production in the form of land, labor, capital and organization in the production of goods and services. They are paid in the form of rent, wages and salaries, interest, profit, mixed income etc. for their contribution in the production of goods and services by supplying the factors of production. The steps which are followed to arrive at a figure of national income are as follows.

$GDP = $W+R+I+P+Depreciation +Net Indirect Taxes

GNP = GDP + Net factor income from abroad

NNP = GNP - Depreciation

NNP at factor cost = NNP - Indirect Taxes = National Income

 

                                                                                                    

 

 

One important thing to note in this regard is that some forms of income like transfer payments, capital gains, second hand sales and illegal incomes do not come under the purview of national income. This is because they are not earned from expenditures on currently produced goods and services. Transfer payments are not included in national income, because they simply function as the redistribution of wealth. They are not earned in exchange of goods and services. Capital gains are also mere claim on financial assets and do not represent expenditure on currently produced goods and services. Second hand sales do not fall under the national income, because nothing new is produced. It already must have come under past year's GDP. Illegal incomes form illegal activities like gambling, smuggling, robbery do not fall under national income because they do not increase the productive capacity of the economy.

 

Personal Income

The total income received by all individuals and households of a country from all possible sources before payment of direct taxes during a year is called personal income. There are time when income is received by a firm but not by the members of the firm. That is why there is a gap between national income and personal income. All of the corporate profits do not go to shareholders. A part of it is paid as tax and some portion of the corporate profit might be retained in the business. All of the wages and salary accruing to the workers might not be received. A portion of it is contributed for the provident fund, pension fund etc. Also, transfer payments accrue to the individuals as income and are hence included in personal income.

PI = National income - Undistributed corporate profits - Corporate taxes - social security contribution + transfer payments

 

Disposable Income

The income left for consumption after paying the direct taxes is known as disposable income. In other words, it is the income left for consumption available at people's disposal. However, not all of the disposable income is used for consumption.

Disposable income = Personal income - Direct taxes

 

Per Capita Income

Per Capita Income is the average income of the people of a country in a particular year. It is the income received by a single person of a country in that year.

Per Capita Income = National Income in a particular year ÷ Total population in that year

 

Measurement of National Income

The production of goods and services requires the use of resources which are in the hands of the household sector of an economy. Households are paid for their services in the production of goods and services which generates income for the household. This income stimulates demand for goods and services. The demand of goods and services from the household sector is satisfied by business firms in an economy. Hence, household sector spend on goods and services of the firms which acts as income to the firms. The income they get helps in further production of goods and services. Hence, there is a circular flow of income. Therefore, the national income of a country can be measured using three different approaches, i.e. production, income as well as expenditure method. These three methods are considered to end up giving the same figure because an income results into an equal expenditure which again acts as an income to the producers and the cycle goes on uninterrupted which is why these three approaches are believed to give the same figure of national income.

 

Product Method

Product method measures national income by summing up the market value of all the final goods and services produced in an economy during a certain period of time. Here, final goods are those goods which are in the market for consumption by the ultimate consumer. In this method, economy is divided into three sectors, primary sector (agriculture, forestry, fishing, mining), secondary sector (manufacturing, construction, electricity, gas, water supply) and tertiary sector (banking, transport, insurance, trade and commerce) etc. respectively. The money value of total product of each sector is calculated and summed up to find out GDP. The GDP so derived can be changed into GNP by adding Net factor income from abroad.

However, this method results in the problem of double counting. Double counting means certain items are calculated more than once while calculating national income. Avoiding the problem of double counting is difficult because the same product is used as an intermediate goods by a firm and as final goods by households. For example, flour is used as the intermediate good by biscuit industries where it is used as final product by households for making Chapattis.

In order to avoid the problem of double counting, value added method is used. A detailed description of these two methods are as follows:

Final Product Method

The final product method uses the market value of all the final goods and services to come to a GDP figure from which national income is deduced.

GDP = p1q1 + p2q2 + … + pnqn

GNP = GDP + Net Factor Income From Abroad

NN P =GNP - Depreciation

National Income = NNP - Indirect Taxes

 

Value Added Method

Unlike final product method, the value added method does not take the final market value of goods. In the process of production, there are many stages. Value Added Method only takes the added value in each stage of production and adds them all to come to a single GDP figure. This method is used to avoid the problem of double counting. Value addition means the addition of the value of raw materials and other inputs in the process of production. Net value added is the difference between the value of output and intermediate good. The following example will make the concept of value addition more clearer.

Stage of production

Value of Output

Cost of Intermediate Goods

Gross Value Added

Wheat

1000

200

800

Flour

1400

1000

400

Bread

2000

1400

600

Total

4400

2600

1800

 

The above table shows the different stages in the production of bread. There are three stages involved in the production of bread. The first stage is where a farmer produces wheat. The wheat thus produced goes to the mill and the resulting output is flour. The flour then goes further for processing to a factory from where the final product, bread is produced. Hence, in all the process value is added in the form of the raw material to produce something with more use. This addition in value can be measured in terms of market price of the product in various stages of production. The first stage of production in the production of bread starts with the production of wheat by a farmer. Let us suppose, his inputs cost 200 rupees. He sells his production to the mill for 1000 rupees. The mill processes the wheat to produce flour and sells his product for 1400 rupees to the baker. The baker produces bread and sells it in the market or to the final consumer for 2000 rupees. Here, there is value addition at every stage involved. The farmer buys inputs worth 200 rupees and sells the wheat for 1000 rupees. Here, the value addition is the difference between the intermediate good and the value of the final output that the farmer sells, i.e. 800 rupees. Likewise the value addition made by the mill is 400 rupees. Finally the value addition done by the baker is 600 rupees. Hence, the total value addition done by all three players in the production process of bread is 1800 rupees which is the value of the bread.

                               $Net\: value\: Addition = cost\: of\: final\: output - cost\: of\: intermediate\: good$

In an economy, if we sum up the value addition in the production of all goods and services, we get the GDP. We can find out the national income then from the GDP.

                                         $GDP = NV1 + NV2 +  \ldots  + NVn = \mathop \sum \limits_{i = 1}^n NVi$

GNP = GDP + Net Factor Income From Abroad

NNP = GNP - Depreciation

NI = NNP - Indirect Taxes

 

Income Method

The income approach of measuring national income considers all the payments made to the factors of production to arrive at a national income figure. Therefore, it is also called the factor payment method. The household sector provide factors of production like land, labor, capital and organization to produce goods and services. For this, they are paid in terms of rent, wages and salaries, interest and profits. If we sum up all these values we get the GDP of the country.

GDP = Rent + Wages and Salaries+Interest + Profits + Depreciation + Net indirect taxes

GNP = GDP + Net factor income from abroad

NNP = GNP - Depreciation

NI = NNP - Net Indirect Taxes

 

Expenditure Method

Factors of production are paid for their contribution in the production of goods and services. The income they get can be used in two ways that are consumption expenditure and investment expenditure. Also, the government spends in the economy. The domestic economy is also linked with the external sector through imports and exports. The difference between imports and exports is known as net exports. The expenditure method measures national income as the aggregate of all the final expenditure on gross domestic product at market price in an economy during an accounting year.

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

 

GNP = GDP + Net Factor Income From Abroad

NNP = GNP - Depreciation

NI = NNP - Net Indirect Taxes

where,

C= Private Consumption Expenditure

I= Private Investment Expenditure

G= Government Expenditure

X= Exports

M= Imports

 

Notes

While using expenditure method to measure national income, the following things should be kept on mind:

The expenditure on currently produced goods within the period under consideration should only be included. Previously produced goods should be excluded.

It must also exclude all the expenditures for the purchase of used assets.

Purchase of financial assets such as stocks and bonds must be excluded.

Transfer payments provided by governments must be excluded.

Expenditure on intermediate goods must also be excluded.

 

Difficulties in Measurement of National Income

Measuring national income is a very important task, because it acts as an indicator of the performance of an economy over a certain time period. It is useful in international comparisons as well as time series comparison of the same economy. However, there are many difficulties in the measurement of national income. Some of the major difficulties are as follows:

Double Counting: The problem of double counting occurs because; the same good is sold and resold many times in the stages of production. Moreover, it is very difficult to identify which good is final or intermediate. Based upon its use, the same good can sometimes act as final and sometimes as an intermediate good. Therefore, there is a chance of overestimation of national income as a result of double counting.

Method used in the calculation of depreciation: Calculating depreciation is a very baffling task. This is because different firms use different methods to calculate depreciation. There is no universal consensus on which method gives an accurate measurement of the exact wear and tear of fixed capital used in the production of goods and services. Moreover, there is also a debate whether depreciation should be deducted from the original cost or replacement cost of the fixed capital.

Non-marketed goods: All the goods do not come to the market. There are many household services, value addition to the raw materials in the form of cooking, cleaning, decorating, babysitting which do not come under the purview of national income. However, the same activities done elsewhere would have generated income.

Changes in price level: National income needs two variables for its calculation, price and quantity of different goods and services produced in a economy. However, the results can be confusing sometimes. National income may increase without an increase in production because of increase in price level.

Unreported illegal income: Illegal incomes earned through illegal activities like tax evasion, smuggling, bribery, gambling are not reported which underestimates national income.

 

Practical Difficulties in Measuring National Income in Developing Countries

There are certain difficulties in measuring national income in developing countries, which are unique to those countries. These kinds of difficulties are specific to those countries. Nepal is also a developing country and hence these unique problems are also relevant in our case. Hence, it is important to know about these problems. They are as follows.

Large non-monetized sector: Nepalese economy is an agriculture-dominated economy. In such economy, a considerable amount of agricultural produce does not come to the market place because the production is used for self-subsistence. Hence, there exists a large non-monetized sector, which makes the correct estimation of national income a tedious task.

Illiteracy: Most of the farmers do not keep record of their production due to illiteracy.

Lack of trained staff: There is a lack of adequate trained statistical staff for the purpose of measuring national income.

Narrow Mindset: The people in these countries are superstitious and hence reluctant to disclose their incomes. Moreover, people cannot disclose their actual income if it is earned through illegal sources.

Lack of occupational specialization: People depend on various income sources for continuing their livelihood and hence lack occupational specialization, which makes measuring national income a difficult task.

 


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