CBSE Class 12 Economics - Measurement of National Income 


Measurement of National Income

National Income of a country can be measured by 3 different methods:

 1) VALUE ADDED METHOD METHOD

This method is used to measure national income in different levels of production in the circular flow. Every individual enterprise adds a certain value to the product when it purchases from some other firm as intermediate goods. When value-added by each and every firm is summed up, we get the value of national income.

i) Value Added

Value added is the difference between the value of goods as they leave a stage of production and the cost of the goods as they entered that stage.

Value-added = Value of output -Intermediate consumption

For Example -  Suppose a sweet shop owner buys milk worth ₹100 from the milkman. After processing the milk into sweets, he sold it for ₹250.

So, here the milk is intermediate consumption as it was used for making sweets.

The sweets which are sold off are output and termed as the value of output

The difference between this value of output and intermediate consumption is termed as ‘value-added’ value added by each producing enterprise is known as the Gross Value Added(GVAmp).

Sum total of all GVAmp of all producing enterprises within the domestic territory of a country during one year is equal to GDPmp.

∴ ΣGVAmp  =  GDPmp

ii) Imports are not separately included

If the value of intermediate consumption is given, then imports are not included separately as imports are already included in the value of intermediate consumption.

However, if domestic purchases are given ,then imports will also be included .

For Example:

Case 1: Intermediate Consumption =  ₹500

    Imports= ₹200

Here imports would not be included and the value of intermediate consumption is.  ₹500.

Case 2:  Purchase of Raw Material from domestic firm=.₹700

  Imports =₹300

Here, the value of intermediate consumption would be = Purchase of Raw material from +Imports domestic firm =700+300

 Intermediate consumption =₹1000

iii) Value of Output:  Value of output refers to the market value of all goods and services produced during a period of one year.

How to calculate the value of output:

  • When the entire output is used is sold in an accounting year then the value of output is equal to sales.
  • When the entire output is not sold in an accounting year then the value of output is calculated as follows:      

  Value of output = Sales + change in stock

[Change in stock=Closing stock-Opening stock]

Steps to Calculate National Income by Value Added Method

The following steps are to be followed in order to Calculate National Income

Step 1-  Identify and classify the production units:

 The first step is to identify all the producing units into the primary, secondary and tertiary sector.

Step 2- Estimate Gross Domestic Product at Market Price:

  Now gross value added to market price (GVAmp) of each sector calculated and the sum total of GVAmp of all sectors gives GDPmp i.e GDPmp= ΣGVA (of all sectors).

Step 3- Calculate Domestic Income (NDPFC)

Now, to calculate NDPFC from GDPmp, we need to subtract both depreciation as well as net indirect taxes i.e NDPFC = GDPmp – Depreciation – Net Indirect Taxes.

Step 4 – Calculate National Income (NNPFC)

For calculating NNPFC from NDPFC, NFIA is to be added  NNPFC= NDPFC +NFIA

     

 Precautions of value-added method

We need to take some precautions while calculating National Income using the value-added method.

1) Intermediate goods are not to be included in National Income  - If intermediate goods would be included in National Income it would lead to double counting as these are already included in final goods.

2) Sale and Purchase of Second Hand Goods are not included-Since these goods are already included in the year of manufacture, these are not included again.

However, any brokerage or commission earned or paid is to be included while calculation.

3) Production of services for self-consumption (Domestic Services) are not included: Domestic services like services of Housewife, kitchen gardening etc. are not included in national income as these services never entered market place and its difficult to find their market value.

4) Production of goods for self-consumption will be included - It’s not included in national income as they contribute to current output. Their value is to be estimated or imputed as they are not sold in the market.

5) Change in the stock of goods will be included -  Net increase in the stock of inventories will be included in national income as part of capital formation.

 

The problem of Double Counting:

  • Double Counting refers to the counting of output more than once while passing through various stages of production.
  • While calculating national income, the only value of final goods is to be included. The problem of double counting arises when the value of intermediate goods are also included along.

How to avoid Double Counting:

It can be avoided in two ways:

i) Final Output Method –  As per this method, the value of only the final output should be added to determine national income. For example, the value of sweets of Rs 250 sold to final customers should be taken in national income.

ii) Value- Added Method – The value-added in every stage of production is included under this method for calculation of National Income.

 

INCOME METHOD

We now turn to calculate GDP using the income approach, which looks at GDP in terms of who receives it as income rather than who produce it.

As per this method, all the incomes that accrue to factors of production by way of wages, profits rent, interest, etc are summed up to obtain the national income.

Components of Factor Income

The following are components of the Income Method. Sum of all the items given below is known as Domestic Income(NDPFC)

1. Compensation of Employees (COE) –

COE is the amount paid to employees by employers for rendering productive services. It includes all the benefits received by employees from employers. It includes the following-

i) Wages and Salaries in cash- It includes all the benefits which are in monetary terms like wages, Salaries, bonus, commission, etc.

ii) Wages and Salaries in kind- it includes all the benefits in non-monetary terms like free house, car, medical facilities, etc.

iii) Employer’s Contribution to social security schemas – it includes contribution by an employer for social security schemas for Example- provident fund, gratuity, etc.

2. Rent and royalty-

Rent: is income from ownership of land and building. It includes both the actual rent (rent of left out land) as well as imputed rent (rent of self - occupied factors).

Royalty: refers to income received from granting leasing right of sub-soil assets. For example – Royalty from leasing of Iron mine, Gold mine, etc.

3. Interest –

Interest refers to the amount received from lending funds to a production unit. It includes both actual interest and imputed interest. it includes interest on loans taken for productive services only. It does not include the following:

i) Interest paid by the government on National Debt.

ii) Interest paid by consumers as such interest is paid on loans taken for consumption purposes.

iii) Interest paid by one firm to another firm.

4. Profits –

Profits are excess of revenues over the expenditure of any corporation. It is a residual income. This profit earned by an entrepreneur can be used for 3 purposes:

i) Corporate Tax – it is a tax paid by a corporate to a government on total profits. it is also known as ‘Profit Tax’ and ‘Business Tax’.

ii) Dividend – it is divided part of profit given to share - holders. It is also known as distributed profits.

iii) Retained Earning – Out of total profit a part is distributed among shareholders and a part is retained in business in business, this is kept for future as Retained Earning. It is also known as undistributed profits, Saving of the  Private sector and Reserve and Surplus.

5. Mixed - Income –

It is income generated by people who are self - employed, for eg- Barber, farmers, etc or unincorporated enterprises like the  retail trader, small shopkeeper.

Mixed income arises from productive services of self - employed persons, whose income includes wages, rent, interest and profit and these elements cannot be separated from each other. For example – the income of a doctor running a clinic at his residence.


Steps of Income Method

The various steps involved in estimating national income by income method:-

Step-1 Identify and classify the production units.

All the producing units are classified in Primary, Secondary and tertiary sectors.

Step-2 Estimate the factor income paid by each sector.

Factor incomes paid by each factor are classified under

i) Compensation of Employees,

ii) Rent and Royalty

iii) Interest

iv) Profit and 

(v) Mixed income.

Step-3 Calculate Domestic Income (NDPFC)

When all factor incomes are summed up, we get domestic income (NDPFC)

i.e. NDPFC= Compensation of Employees + Rent and Royalty + interest +profit + mixed income of self-employed.

Step – 4 Calculating National income from Domestic income.

In the final step, we need to add NFIA to domestic income to get National Income.

National Income (NNPFC) = Domestic Income (NDPFC) + NFIA.

PRECAUTIONS OF INCOME METHOD

The following precautions need to be taken in order to calculate national income correctly.

1. Transfer Income – Transfer incomes are not included in National income as such incomes are not productive and there is no value addition.

2. Income from the sale of second-hand goods – Sale of second-hand goods are not included in national income as their sale are already recorded when these were first sold. However, commission, brokerage or any other income is to be recorded.

3. Income from the sale of shares, bonds and debentures are not included – Such items are not included in national income as they do not contribute to the current flow of goods and services. However, any brokerage or commission is to be included in national income.

4. Windfall gains- These are gains like on lottery, horse race, etc are not included as there is no productive activity.

5. The imputed value of services provided by owners of production unit be the included-  Imputed value of owner-occupied houses, interest on own capital, etc are included as it is a productive activity and add to flow of goods and services.

6. Payments out of past savings-  These Payments like death duties, gift tax, interest tax, etc are not included in national income as they are paid out of past savings and do not add to the current flow of goods and services.

EXPENDITURE METHOD

Under this method, we add up the total amount spent on all final goods and services, during a given period of time.

This method measures national income as the sum total of final expenditure incurred by households, business firms, governments, and foreigners.

This method is also known as ‘Income Disposable Method’.

Components of final Expenditure

The various components of final expenditure are as follows:

1. Private final consumption expenditure-

As the name suggests, it is the expenditure made by households and private non –profit sharing institutions on all type of consumer goods. it includes the following:

  • Household final consumption expenditure.
  • Private non-profit institutions serving household final consumption expenditure.
  • Expenditure made by normal residents abroad during any tour and travel.

However, any expenditure made by foreign tourists in the domestic market would be deducted.

2. Government Final Consumption Expenditure- 

It refers to expenditure made by the government on various administrative services like defense, law, and order, education, etc. it includes the following:

  • Intermediate consumption by government.
  • Compensation paid by the government.
  • Direct purchase from abroad for embassies and consulates located abroad.

However, it does not include the sale of goods and services produced by the general government.

3. Gross Domestic Capital Formation or Gross Investment-

It refers to the addition to the capital stock of the economy.

Following are components of GDCF:

  • Gross fixed capital formation: it refers to expenditure made on purchase to a fixed asset. It includes the following Gross business fixed investment - (expenditure on new plants, machinery, equipment, etc).

 

  • Gross Residential construction investment- (it includes expenditure on purchase of new houses by households).

 

  • Gross public investment – (expenditure on construction of flyovers, bridges, etc by the government).
  • Inventory Investment – it refers to the amount by which the firm’s inventories change during a period. it may include stock of raw material, semi-finished goods lying with producers.

It is calculated as the difference between closing stock and opening stock of the year.

Change in Inventories = closing stock-opening stock.

GDCF = Gross Fixed Capital Formation+ inventory Investment.                

4. Net Exports:

It refers to the difference between exports and imports of a country, during a period of one year. Instead of taking Imports and exports separately, the difference between the two is taken as it is turned as Net Exports.

Net Exports=Export – Import

Steps In Calculating Net Exports

Following steps are involved in the  calculation of national income by expenditure method:

Step-1. Identify the economic units incurring final expenditure-

All economic units which incur final expenditure within the domestic territory, are  classified under 4 groups

i) Households sector   ii) Govt. Sector

iii) Producing sector    iv) Rest of the world sector

Step-2. Classification of Final Expenditure –

Final expenditure by above economic units are estimated and classified under the following heads:

i) Private Final Consumption Expenditure (PFCE)

ii) Government Final Consumption Expenditure (GFCE)

iii) Gross Domestic Capital Formation (GDCF)

iv)Net Exports (X-M)

Sum of all of the above components gives GDP ie.

GDPMP = PFCE + GFCE + GDCF + (X-M)

Step-3. Calculate Domestic Income (NDPFC)

Now to calculated NDPFC from GDPMP we need to subtract depreciation and Net Indirect Taxes (NIT).

Step-4. Estimate net factor income from abroad to arrive at national income.

Finally, we add net factor income from abroad to NDPFC in order to get NNPFC (National Income).

Precautions of expenditure method

The following precautions are to be taken while using  the expenditure method:

1. Expenditure on intermediate goods will not be included in national income:

As intermediate goods are already included in the value of final expenditure, and if it is included again it will lead to double counting.

2. Transfer Payments are not included:

As these payments are not connected with any productive activity, these are not added while calculating national income.

3. Purchase of second - hand goods will not be included:

As the sale of second - hand goods are already included at the time when they were originally purchased. However, any brokerage or commission on such goods is included as it is the payment made for productive service.

4. Purchase of financial assets:

Transactions relating shares, debentures, bonds, etc are not included as they do not contribute to the current flow of goods and services. (Commission, brokerage on such transaction to be included)

5. Expenditure on own account production:

Production for self - consumption, imputed value of owner occupied house, free services from general government and private non-profit institutions serving households will be included in national income since these are productive services.

Treatments of different items in National Income

  • National Income includes income earned by a normal resident of a country as a reward for their productive services in the current year.

The following items are not included while calculating national income:

  • Transfer Income and payments like Pension, Scholarship, gifts, etc.
  • Compulsory Transfer Payments like interest tax, capital gain tax, etc.
  • Sale and purchase of financial assets.
  • Windfall gains like lotteries, gambling, etc.
  • Non - market transactions like kitchen gardening, etc.
  • Intermediate consumption expenditure like the purchase of raw material by a firm, vegetables purchased by a dairy shop, etc.
  • Sale or purchase of second- hand goods like sale/purchase of an old house, etc.
  • Capital loss like the destruction of a building by earthquake or flood etc.
  • Capital gains like profit due to increase in the price of land, building, shares, etc.
  • National debt interest or interest paid by households to commercial banks.

Following items are included while calculation of National Income:

  • Brokerage/Commission on sale/purchase of second- hand goods.
  • Services provided by the owners of production units like imputed rent of owner’s occupied house interest on own capital etc.
  • Capital Formation (Investment) like the purchase of machinery by a firm, construction of flyover, bridges, etc.
  • Payment of bonus, contribution to provident fund by employer etc.
  • Payment of bus fare by households, examination fees paid by students, payment of telephone bills, etc.
  • Profit earned by an Indian company from its branches abroad, wages received by Indian employee working abroad, etc.
  • Free services, (Dispensary, education) by government, government expenditure on street lighting.
  • Interest on the loan paid by commercial banks.

National Income at Current price and Constant price:

National Income at Current Price: It is the money value of final goods and services produced by normal residents of a country in a year, measured at prices of the current year.

It is also known as ‘Nominal National Income ’. For example – measuring India’s National Income of 2018-19 at prices of 2018-19 or measuring India’s National Income of 2017-18 at prices of 2017-18.

It does not show the true picture of the economic growth of a country as any increase in national income may be due to rise in price level without any change in physical output.

National Income at Constant Price: It is the money value of final goods and services produced by normal residents of a country in a year, measured at price of base - year. Base year is a normal year which is free from price fluctuations). Presently 2011-12 is taken as base year in India.

It is also known as ‘Real National Income’. It shows the true picture of the  economic growth of a country as  any increase in real national income is due to  the increase in output only.

Numerical Example - 

  1. National Income at current price and at constant price .

It can be seen that national income at current price is Rs22000 and at base price is Rs17000. The difference of Rs 5000 is not real. It does not give a true picture of economic growth as the increase is merely due to rise in prices.

 2) Conversion of National income at current price into constant price.

Conversion of national income at current into constant price can be done using price index.Price index is an index number which shows the change in price level between two different time periods.

Nominal GDP and Real GDP:

1. Nominal GDP or GDP at Current price – When GDP is estimated on the  basis of price of the same year, it is called Nominal GDP.

2. Real GDP or GDP at Constant price – When GDP is estimated on the basis of the price of base year, it is called real GDP.

GDP deflator (Price Index)

GDP Deflator is one measure of over all price level. It measures the average level of prices of all the goods and services that make up GDP.

Example:

If Nominal GDP is Rs 21000 Cr. and Real GDP is Rs 18000 Cr. Find GDP Deflator.

 GNP Deflator = ₹116.67

 

GDP and Welfare

We generally think that the increase in GDP is good. Increasing GDP is usually considered one of the Chief goals of government's  macro economics policy.

Because some serious problem arises when we try to use GDP as a measure of happiness or well-being, we now point out some of the limitations of GDP concept as a measure of welfare.

1. Distribution of GDP - GDP does not take into consideration the income distribution in an economy ie.gap between rich and poor.

It may be possible that a large part of goods and services are consumed by rich. So, the welfare of the people may not rise as much as the rise in GDP.

2. Change in P rice – If GDP is increasing due to increase in price rather than the  increase in production, then it will not be a reliable index of economic welfare.

3. Non - Monetary Exchange – GDP includes only those activities which are in direct monetary terms, so those activities like kitchen gardening which are non – monetary exchanges are not included in GDP due to non - availability of data. However, these activities contribute to economic welfare.

4. Externalities – Externalities refers to those harms or benefits for which a firm is not paid or penalised. It is of two types:

a) Positive Externalities – These are the activities which result in benefits to others is termed as positive externalities. For example – Gurudwaras provide free langar for everyone. It increases the welfare of society.

b) Negative Externalities – The activities which results in harm to others are termed as negative externalities. Smoking in public will make people smoke passively It reduces the  welfare through a  negitive effect on health.

GDP does not take these externalities into account.

5. Rate of Population Growth –  GDP also does not take into account the rate of growth of population i.e if GDP is increasing due to increase in population.  If the rate and growth of population are  greater than the rate and growth of GDP, then it will decrease per - availability of goods and services which would adversely affect economic welfare.

Private income =

  • Income from domestic productaccruing to private sector + Net factor income from abroad + All current transfer including national debt interest

 

  • National income – Income from domestic product accruing to government sector + transfer   income

 

  • Personal income + Corporate tax + undistributed profit

 

  • Private sector income + NFIA + All transfer income.

Personal Income =

  • Private income – Corporate tax – Undistributed profit

 

  • National income – Surplus of public sector – corporate tax –     Undistributed profit + All transfer income

 

  • Domestic income – Income from domestic product accruing to govt. sector – Corporate tax – Undistributed profit +NFIA + All type of transfer incomes.

Personal Disposable Income =

  • Personal Income – Personal taxes –Miscellaneous receipts of the govt.

Net National disposable income (NNDI) = 

  • NNPMP at + Net current transfer from rest of the world.

 

  • National income + Net indirect taxes + Net current transfer from ROW.

Gross national disposable income (GNDI) = 

  • GNP MP + Net Current transfer from ROI or

 

  • NNPFC + Net Current transfer from Row+ NIT + Dep

Formulae (Macro Economics)

  • Net product = Gross product – Depreciation

Net value added =

Gross value added – Depreciation

Net domestic capital formation =

Gross domestic capital formation – Depreciation.

Market price =

  • factor cost + Indirect tax – subsidies
  •  factor cost + Net Indirect taxes

 

NFIA =

  • Factor income earned from abroad by residents – Factor income of non- residents in domestic term.
  • National income = Domestic income + NFIA

Domestic income =

  • National Income – NFIA
  • Value of Output = Quantity of output     price

Value of Output =

  • Sales + Changes in stock

Value- added =

  • Value of output – Intermediate consumption.

Value-added Method:

  • Value of output = Output   Market Price (At MP)
  •  Sales + Change in Stock

Gross value added at MP=

  • Value of output – Intermediate consumption.

Net value added at MP =

Gross value added at MP – Depreciation

Net value added at FC =

Net value added at MP + NIT

 Income Method:

NDPFC=

  • Compensation of employees + operating surplus + mixed income

    of self- employed.

NNPFC =

NDPFC + NFIA

  • Compensation of employees = Wages and salaries in cash + wages and sales in kind + Employer’s contribution to social sector
  • Operating Surplus = Rent + Royalty + Interest + Profit

Profit = Corporate Tax + Undistributed profit + Dividends Retained earning +Saving of private corp sector.

Expenditure Method:

GDPMP=

Private final consumption expenditure + Government final consumption expenditure + Gross fixed capital formation+ Change in stock + Net exports.

NDPMP = GDPMP – Depreciation

NNPMP = NDPMP + NFIA

NNPFC = NNPMP – Net indirect tax.

Change in stocks = closing stock – opening stock

Capital formation =Fixed capital formation + change in stock

Net Export = Export – Import