Methods of measuring national income
Introduction
Measures
of national income and output are used in economics to estimate the
value of
goods and services produced in the economy. They use a system of
national
accounts or national accounting developed by Prof Simon Smith Kuznets
a Russian
American economist and statistician in the 1960s. Some of the more
common
measures are Gross Domestic Product [GDP], Gross National Product
[GNP], and
Net National Income [NNI].
According
to Ruggles and Ruggles, “National income accounting focuses attention
on the
total output of the economy in terms of the final goods that are
produced and
the income and other payments generated by such production”.
As
per “National income statistics sources and methods”, National income
may be
measured in three ways
1]
As a sum of values of the produce of various industries.
2]
As a sum of incomes derived from the economic activity.
3]
As a sum of expenditures on consumption and investment.
There
exists a triple income identity between output income and expenditure
ie
National
output = National income = National expenditure.
Goods
and services produced can be
considered in two ways
Type of goods and
services produced
Sectors in which goods and services
are produced
1]
Output / census / inventory / product method of measuring national
income.
A]
Final goods method
- The output method
considers the total aggregate money value of final goods and services
produced
in the economy in a given period of time usually a year.
The
goods and services produced in the economy may be considered in two
ways.
a]
Type of goods produced. Goods produced in the economy are
i]
Consumer goods – Consumer goods are those goods which have a direct
demand and
yield a direct satisfaction to the consumer. They are the output in
the process
of production. The total money value of consumer goods produced in the
economy
is denoted by “C”.
ii]
Investment goods – Investment goods are the inputs in the process of
production. They yield an indirect satisfaction to the consumer and
therefore
have a derived demand. They are productive and hence increase
production. The
total money value of investment goods produced in the economy is
denoted by “I”.
iii]
Services – Services of various kinds include the services of
professionals like
doctors, lawyers, teachers, architects, consultants etc; banking,
insurance,
trade transport and communication, etc. All these are intangible.
Services also
includes Government services and therefore by “G”.
b]
Sectors in which goods and services are produced are
i]
Primary sector – Primary sector consists of all productive activities
in which
the role of nature is primary. These activities include agriculture,
forestry,
fishery, cattle breeding, horticulture, dairy farming, mining etc.
Since
agriculture is the most popular and dominant activity in this sector,
it is
popularly known as “Agricultural sector” and denoted by “A”
ii]
Secondary sector – Secondary sector consists of all those productive
activities
in which the role of nature is secondary. This sector is dominated by
the role
of manmade instruments of production and includes tiny, mini, village,
khadi,
handicraft, small scale, medium scale, large scale; agro based etc
industries
as well as construction activities. It is popularly known as
“Industrial
sector” and denoted by “I”
iii]
Tertiary sector – Tertiary sector consists of services of all kinds
which help
in the development of the primary and secondary sectors. This sector
includes
services of professionals; banking, insurance, trade transport and
communication, irrigation and power generation, education training and
research
facilities, marketing and credit facilities etc and government
services. All
these are intangible. It is popularly known as “Service sector”. The
dominant
activity in this sector is government services, therefore by it is
denoted by “G”.
A
part of the total production of the country is exported for which the
country
receives payment from other countries. This is denoted by “X”.
A nation
also imports goods and services from other countries for which it has
to make
payments. This is denoted by “M”.
While
calculating national income the difference between exports and imports
is
considered.
This
difference may be positive (when value of exports is more than
imports), zero
(when value of exports is equal to imports), or negative (when value
of exports
is less than imports).
Therefore
GDP (mp) =
C+I+G+(X-M)
OR GDP (mp) = A+I+G+(X-M)
Besides
domestic production a country may receive payments from enterprises
owned and
investments made etc by citizens abroad. This is denoted by “R”.
Similarly a
country may makes payments for enterprises owned and investments made
etc by
foreign nationals in the country. This is denoted by “P”.
Therefore
GNP (mp) = GDP (mp) +(R-P).
GNP
(mp) = C+I+G+(X-M)
+(R-P).
OR GNP (mp) = A+I+G+(X-M) +(R-P).
There
is a wear and tear of fixed capital assets in the process of
production. This
leads to loss in the value of the asset. Idleness of an asset,
outdated assets
and loss in the value of capital may also occur in the value of
capital due to
fire floods and other calamities. This is known as depreciation and
defined as
“wear and tear of capital”. To arrive at net or exact or actual value,
loss in
the value of capital assets has to be deducted from the gross value.
Therefore
NNP
(mp) = GNP (mp) – D
NNP
(mp) = C+I+G+(X-M) +(R-P) – D.
OR NNP (mp) = A+I+G+(X-M) +(R-P) – D.
Calculation
at market price does not give us the exact value of productive
activity in the
country and therefore it is necessary to calculate national income at
factor
cost ie the cost borne by the producer which is the same as the income
received
by the factors of production. For this it is necessary to consider
“indirect
taxes” and “subsidies”.
The
market price of goods and services is inclusive of indirect taxes
which are
transferred by the producers from the consumers to the government. Due
to this
the factors of production receive a reward less than the market price.
Therefore while calculating national income the value of indirect
taxes has to
be deducted.
The
market price of goods and services does not include the value of
subsidies,
which are transferred by the producers from the government to the
consumers.
Due to this the factors of production receive a reward more than the
market
price. Therefore while calculating national income the value of
subsidies has
to be added.
Therefore
NI = NI (fc) = NNP (fc) = NNP (mp)-IT+S.
NNP
(fc) = C+I+G+(X-M) +(R-P) – D-IT+S.
OR
NNP
(fc) = A+I+G+(X-M) +(R-P) – D-IT+S
This
is the true national income of the nation.
B]
Value added method of measuring national income.
Value added method is also known as Production method.
In order to
avoid double counting, value -added approach is used.
This method is used to measure national income at the
different
phases of the process of production of each enterprise during a year.
In fact
this method measures the contribution of each enterprise in the flow
of goods
and services in the economy.
According to this approach value- added in each stage
of
production process is taken separately and added to get the final
value of the
commodity.
Meaning of value added
i) Value added is “the
increase in the value of goods or
services as a result of the production process”
ii) Value added = value of production – value of intermediate
goods
iii)
Value added is
“the difference between the cost of materials purchased by a firm and
the price
for which it sells those goods that were purchased by that firm”.
iv) Value added is the difference between the value of
final
outputs and inputs at each stage of production
The same approach can be used to estimate national
income from the three main wealth-generating sectors of the economy
(a) Primary (agricultural) sector
(b) Secondary (industrial) sector and
(c) Tertiary (service sector.
For computing national income, the values added
bythe
above three sectors at each stage is worked out. The value of output
at each
enterprise is found by multiplying the physical output with the market
prices
of the goods produced.
This measure of GDP adds together the value of output produced by
each of the productive sectors in the economy using the concept of
value added.
The same approach is also used to calculate net income
contributed
to national income from international trade.
Thus GNP is obtained as the sum total of the values
added in all
the different stages of production process, till the final output
reaches the consumer,
to meet their final demand.
While considering this approach we should deduct
indirect taxes
and include subsidies.
Whether we adopt the final goods method or the
value-added method,
if proper adjustments are made, the result will be the same.
This can be explained with the help of the following
examples
Examples
1]
i)
Say
you buy a pizza from Dominos at a price of Rs 325. This is the retail
price
and will count as consumption.
The
pizza
has many ingredients at different stages of the supply chain – for
example tomato growers, dough, mushroom farmers and also the value
created by
Dominos as they put the pizza together and deliver to the consumer.
ii)
Some
products have a low value-added, for example cheap tee-shirts that you
might find in a supermarket for little more than Rs 100.
These
are
low cost, high volume, low priced products.
iii)
Other
goods and services are such that lots of value can be added as we move
from sourcing the raw materials through to the final product. Examples
include
designer jewellery, perfumes, meals in expensive restaurants and
sports cars.
And also the increasingly lucrative computer games industry.
2]
|
Firm |
Sale |
To |
Price |
Value added |
|
A |
Produces & sells raw materials |
Firm B |
Rs 2000 |
Rs 2000 |
|
B |
Manufactures & sells finished product |
Firm C |
Rs 4000 |
Rs 2000 |
|
C |
Sells finished product to |
Households |
Rs 5000 |
Rs 1000 |
|
TOTAL |
Rs 5000 |
|||
What is total ‘GDP’ here?
Rs 2000+ Rs 4000+ Rs 5000 = Rs 11000? Definitely no! This would be
double counting.
You should consider only the value added ie Rs 2000+ Rs 2000+ Rs
1000= Rs 5000.
OR only the value of the final product sold to households ie Rs
5000.
3]
|
Producer/seller |
Produces & sells |
@ Rs |
Value (Original/Added) |
|
|
Farmer |
(100 kg)Wheat |
2000 |
2000 |
Original value |
|
Flour mill owner |
flour |
2500 |
500 |
value added |
|
Baker |
breads, cookies and biscuits |
3500 |
1000 |
value added |
|
TOTAL |
3500 |
|
||
What is total ‘GDP’ here?
Rs 2000+ Rs 2500+ Rs 3500 = Rs 8000? Definitely no! This would be
double counting.
You should consider only the value added ie Rs 2000+ Rs 500+ Rs
1000= Rs 3500.
OR only the value of the final product sold to households ie Rs
3500.
Not all of the wheat goes into Baker’s oven. Some of it will go in
making beer, some in a normal household for making roti and so on.
One has to track the value added in each different line.
4] We use
seed to
produce wheat, wheat to produce flour, and flour to produce bread. In
order to
produce Rs 5000 worth of bread (the final product). For this we
need Rs
3500 worth of flour, which require Rs 2500 worth of wheat, which require
Rs
1000 worth of seed.
The value
added in
each process is illustrated below:
|
Product |
@ |
Value added = |
|
Seed |
Rs1000 |
1000 – |
|
Wheat |
Rs 2500 |
2500 – |
|
Flour |
Rs 3500 |
3500 – |
|
Bread (Final product) |
Rs 5000 |
5000 – |
|
TOTAL |
Rs 5000 |
|
The sum of
value
added is the value of the final product, bread in the above example.
Therefore,
value added approach is the same as counting only the value of the final
products.
To avoid double counting, either
the value of final
output or the sum of value added should be taken in the estimation of
GNP.
Precautions
1. Danger of double counting
:-
We can avoid from this danger by the following ways :
i) We should add up the value of those goods which have reached to the
final
shape and are available for consumption, ie consider only the value of
final
goods and services.
ii) Value of intermediate goods: Value of intermediate
goods is ignored while calculating in the national income.
(iii) Second method is that we
should calculate only the added value of a particular commodity at every
stage.
2. Production for self
consumption-
The production of goods for
self
consumption should be should be valued at the prevailing market prices..
As
part of the production, though has been by the producer, but it has been
produced. This value is estimated by guess work.eg self consumption by
farmers.
Similarly imputed rental value
of
the self-occupied house is included in the national income.
3. Indirect taxes and
subsidies
Indirect taxes included in the
market prices are to be deducted and subsidies given by the government
on
certain products should be added for accurate measurement of national
income.
4. Changes in price level
While evaluating output,
changes in
the price level between different years must be taken into account.
5. Value of exports and
imports
Value of exports should be
added
and value of imports should be deducted.
6. Depreciation allowances :-
The depreciation allowance, for depreciation of capital assets should be
deducted
Similarly stock appreciation,
if
any, must be deducted from value added.
This is necessary as there is
no
real increase in output
(7)
Sale price of second-hand
goods:
Sale
price of second-hand assets should be ignored as it is not a part of
current
production. Their values were included in the year when they were
produced.
(8)
Value
addition in particular year: While
calculating
national income, the values of goods added in the current year in
question are added up. The values which had previously been added to the
stocks
of raw material and goods have to be ignored
The output method is widely
used in
developing countries. However, it is less reliable because of the margin
of
error.
In India, this method is
applied to
agriculture, mining and manufacturers including handicrafts. But it is
not
applied for transport, commerce and communication sectors in India.
B]
Value added method of measuring national income.
2]
Income method of measuring national income.
Income
method of calculating national income
This
method
is also known as factor cost method. This method approaches
national income from the distribution side.
Under
this method the national income is also estimated by summing up the
income that
accrues to the factors of production provided by the national
residents [owned by that nation] in a
particular year. It is the total income
generated through production of
goods and services.
The
data pertaining to income are obtained from various sources like from
income
tax returns, reports, books of accounts as well as estimates for small
incomes.
According
to Dr. Bowley and Robertson, incomes of both categories of people –
paying
taxes and not paying taxes are added to obtain national income.
This
method of calculating national income is quite complex. Specially in
the
developing countries where most of the people are not directly covered
by
direct taxation
Under
this method, national income is measured as a flow of factor incomes.
The
various factors of production are classified in four broad categories.
1]
Land
land gets rent and royalty
[R]
Rent
is income received from property received by households.
Royalties
from patents, copyrights, assets, intellectual
property
rights
and extractable natural resources. as well as
imputed rents are included.
[Imputed rent - .if your employer gives you a place to
live as part
of your employment...that is actually like him giving you an
additional amount
of salary. This is a form of payment/income even though the value of
it isn't
specified in your salary. In these cases, for tax purposes, the value
you
receive as income is "imputed" and determined (and must be reported
by the employer or you) as income anyway
Difficulty - Imputed rents disappear from
measures
of
national income and output,
unless figures are added to take them into account.The
governmentloses
the opportunity totaxthe transaction. Sometimes governments have attempted to
tax the
imputed rent, but this tends to be unpopular].
2]
Labour,
Labour gets wages and salaries [W]
Salaries,
wages, and fringe benefits such as health and travel and other
benefits.
3]
Capital,
capital gets interest and dividends [I]
Income
received by households through the lending of their money to
corporations and
business firms.
4]
Entrepreneurship.
entrepreneurship gets profit as their
remuneration. [P]
Profit
is the amount firms
have left after paying their rent,
interest on debt, and employee compensation.
5]
Besides, there are some self-employed persons who employ their own
labour and
capital such as doctors, advocates, CAs, etc. Their income is called
mixed
income.
Under
this
method, national income is obtained by adding the incomes such as
rent,
wages, interest and profit received by all persons in the country
during a
year. In practice, the income figures are obtainable mostly from
income tax
returns, books of accounts and published accounts. To this, net income
from
foreign trade and net investment from abroad should be added. Thus,
National
Income
= Rent + Wages + Interest
+ profit + Mixed
Income
+ (X-M) + (R-P)
Precautions
1] All
transfer
income/payments which do not represent earnings from productive services
such
as pension, old age pensions, scholarship, gifts, donations, charity,
unemployment doles, lottery prize, etc. should be ignored as they are
not
earned by participating in the current production, these are unilateral
payments.
Windfall
gains like
income from prizes won, lottery etc are not included in the estimation
of
national income.
Private
transfers of money from one
individual to another should also be ignored.
2] All
unpaid
services like services of a housewife, teacher teaching his/her own
child,
doctor treating his/her own family etc should be ignored.
3] Any income from sale of
second
hand like cars, houses etc should be ignored as it is not a part of
current
production. Their values were included in the year when they were
produced.
4] Receipts from sale of
financial
assets such as shares and bonds (all capital gains or loss eg resale of
property) etc should be ignored, as they they are not related to
generation of
income in the current year production of goods.
5]
Direct
tax
revenue of the government should be ignored as it is only transfer of
income.
For example
i) Income
tax on
personal income is a part of compensation of employees. This should not
be
separately included in the national income.
ii) Death duty, wealth-tax, capital gains tax etc. are
paid out of
past saving and assets. These are not related to current flows of
goods and
services; therefore, they are not the part of national income.
iii)
Indirect
taxes are a transfer from the consumer to the government, through the
producers
and therefore should be ignored while estimating national income.
6]
Undistributed
profits
of companies, income from government property and profits of public
enterprises such as water supply etc should be included.
7]
Imputed
value
of production kept for self consumption and imputed rent of owner
occupied houses should be included.
8]
Income that is not registered with the
Revenue
department is not included (note here the effects of the Black or
shadow
economy where goods, services and money are exchanged but the value
of these
transactions is hidden from the authorities and therefore does not
show up in
the official statistics! This also includes illegal income like income of gamblers, smugglers, thieves etc.)
In
India,
the national income committee of the central statistical organisation,
uses this method for adding the net income arising from trade,
transport,
public administration, professional and liberal arts, domestic
services.
Due
to
lack of popularity of personal accounting practices, this method
cannot be
fully used or practiced. This method is used only for some minor
sectors. None
of these methods alone will give a more correct figure.
In
India,
a combination of both product method and income method is used to
estimate national income
3]
Expenditure method of measuring national income.
Expenditure
method of measuring national income
It is also called the
consumption
method of calculating national income. Income is either spent on
consumption or
saved. Hence national income is the addition of total consumption and
total
consumption and total savings. For using this method, we need data
related to
income and saving of the consumers.
Generally reliable data of saving and consumption are not
easily available.
Therefore, expenditure method is generally not used for estimating
national
income. [In India a combination of production method and income method
and
income method is used for estimating national income].
The
expenditure
approach is basically an output accounting method. It shows the total amount of expenditure taking
place in the economyit focuses on finding the total
output of a nation
by finding the total amount of money spent. This is acceptable,
because like
income, the total value of all goods is equal to the total amount of
money
spent on goods.
In
this
method, all expenses are counted. In this
method,
national income is measured as a flow of expenditureExpenses
are
incurred by:-
(i)
Household/private
consumption expenditure: – it includes household consumption
and expenditure by non profit organizations. Expenditure on durables
(including
durables of more than one year like TV and furniture) are included.
Rent on
self occupied house is also counted. Further agriculture produced and
consumed
for self, interest on self employed capital is also included. This is
denoted
by “C”
(ii)
Domestic
investment (or capital formation), i.e. expenditure on immoveable
goods, and increase (or accumulation) in stock. It includes buildings,
road,
bridges transport equipment, machinery etc. This denoted by “I”.
(iii)
Government
Consumption, i.e. expenditure made by government, e.g. expenditure
to sustain law and justice, health etc. Transfer payments are not
included.
This is denoted by “G”.
(iv)Net exports
(Export-Import).
X: Exports of Goods and
Services
M: Imports of Goods and
Services
The basic formula for domestic
output takes all the
different areas in which money is spent within the region, and then
combines
them to find the total output.
GDP = C + I + G + [X
– M]
Precautions
1]
Expenditure on all intermediate goods and services should be ignored,
in order
to avoid double counting.
2]
Expenditure on the purchase of second hand goods should be ignored as
it is not
incurred on current year’s production of goods.
3] Expenditure by the
government on
transfer payments like pensions, old age pensions, scholarships,
unemployment
allowances interest on public debt etc should be ignored, because no
productive
service is rendered in exchange by recipients of these payments.
4]
Expenditure on purchase of financial assets, such as shares, bonds
debentures
etc should not be included, as such transactions do not represent expenditure on the current
flow of goods and services.
5]
Indirect taxes should be deducted from the market price.
6]
Expenditure on final goods and services should be included.
7]
Subsidies should be included.
8] The depreciation allowance should be deducted while
calculating
national income.
9] Property income from abroad should be included in the
national
income
Out
of these methods the output method and income method are extensively
used. In
advanced countries like USA and UK the income method is popular.
Expenditure
method is rarely used by any country because of practical
difficulties.
In
India, the Central Statistical Organisation [CSO] adopts a combination
of
output and income method to estimate national income of India.
Why three approaches are
equal
The three approaches used for
measuring national income give the same result. The reason is the market
value
of goods and services produced in a given period, by definition, is
equal to
the amount that buyers must spend to purchase them. So the product
approach
which measures market value of goods and services produced and the
expenditure
approach which measures spending should give the same measure of
economic
activity.
Now as regards the income
approach,
the seller’s receipts must equal what the buyers’ spend. The seller’s
receipts
in turn equal the total income generated by the economic activity. Thus,
total
expenditure must equal total income generated implying that the
expenditure and
income approach must also produce the same result.
National
income estimates in India
In
India both the income and output methods are used by the Central
Statistical
Organisation [CSO].
Output
method is used for calculating the share of the primary sector eg
agriculture,
forestry, fishing, mining etc.
Income
method is used in the organized secondary and the service sectors. The
data is obtained
from the National Sample Survey’s reports, official publications,
departmental
records and annual reports of the Reserve Bank of India etc.
Expenditure
method is used only for calculating the domestic production of
commodities used
in the construction sector. The approach is called commodity flow
approach.