MEASUREMENT OF NATIONAL INCOME
National income is the total money value of goods and services produced by a country in a particular period of time. The duration of this period is usually one year.Measurement of National income can be made by taking three viewpoints, namely production viewpoint, income viewpoint, and expenditure viewpoint.
Based on these viewpoints, there are three different methods of estimating national income which are as follows:
Product method is also known as output method or value added method. In this method, we calculate the national income in terms of final goods and services produced in an economy during a particular period of time. The final goods are those which are either available to the consumers for consumption or become a part of national wealth in the form of investment.
Product method is that which estimates the national income by measuring the contribution of final output and services by each producing enterprise in the domestic territory of a country during a given accounting period.
STEPS INVOLVED IN PRODUCT METHOD
STEP I: Classification of Productive Enterprises
The first step in this method of measuring national income is the classification of enterprises. All the productive enterprises in the economy are classified into three main categories.
(i) Primary Sector – Primary sector refers to that sector of the economy which exploits natural resources to produce goods. Agriculture and allied activities like mining, quarrying, fishing, forestry etc. are included in this sector.
(ii) Secondary Sector – The manufacturing sector of the economy which transforms one physical good into another is included in the secondary sector.
(iii) Tertiary Sector – This includes banking, insurance, education, trade, commerce etc.
STEP II: Classification of Output
National output is classified into the following types:
(i) Consumer Goods – Consumer goods are those goods which help in the further production of consumer gods. These are also called are also called capital goods.
(ii) Producer Goods– Producer gods are those goods which help in the further production of consumer gods. These are also called capital gods.
(iii) Govt. Produced Goods– These include defence, police, education, health care, roads, railways, ports, dams etc.
(iv) Net Exports– Net exports refer to the value of goods and services exported to the rest of the world minus the value of goods & services imported during an accounting year.
STEP III: Measurement of Value of Output
(a) Value of output
Here output means final goods as well as intermediate goods. The value of all these goods can be estimated by multiplying the quantity of output of each producing unit with the market price. This is equal to the value of sales and the change in stock.
Value of output= Sales+ Change in stock
(b) Value of intermediate consumption
The goods and services used by the firms as inputs are known as intermediate consumption. To calculate the value of intermediate consumption, we have to multiply the intermediate goods with the prices paid by the enterprises to purchase these goods.
(C) Consumption of fixed capital
Consumption of fixed capital means depreciation. When goods are produced, there is wear and tear of machines leading to the loss of value of the capital assets.
Value of final output= Value of output- Value of intermediate goods
When we add the market value of final output in the primary sector, secondary sector and that of tertiary sector, we arrive at gross domestic product at market price.
GDP at Market Price = Market value of final output of primary sector + Market value of final output of tertiary sector + Market value of final output of tertiary sector.
STEP IV: CALCULATION OF NATIONAL INCOME
From gross domestic product at market prices. The national income is calculated by deducting depreciation and net indirect taxes and adding net factor income from abroad.
National Income (NNP at Factor Cost)= GDP at market prices-Depreciation+ Net Factor Income from Abroad- Net Indirect taxes.
PROBLEM OF DOUBLE COUNTING
Double counting means counting of the value of the same product (or expenditure) more than once.
According to product or output method of calculating national income, value of only final goods and services produced by all the production units of a country during a year should be counted. In other words, value of intermediate goods which enter into final goods (e.g., paper used in printing of books, raw cotton used in garments, wheat used in making bread, etc.) should not be taken into account.
But in actual practice, while taking value of final goods, value of intermediate goods also gets included because every producer treats the commodity he sells as final product irrespective of whether it is used as intermediate or final good. For instance, while taking value of final goods like cycles, the value of tyres, tubes, frames, bells, etc. (intermediate goods) used in manufacturing these cycles also gets included inadvertently
In this way certain items are counted more than once resulting in over-estimation of national product to the extent of the value of intermediate goods included. This is called the problem of double counting which means counting value of the same commodity more than once.
EXAMPLE: Presume that in an economy, there are only four production units (or firms) engaged in production of garments (ready-made clothes like shirts, pants, etc.).
Firm A produces raw cotton, assuming though unrealistically that it uses no intermediate inputs and sells it for Rs 1,000 to firm B. Firm B converts it into cotton yarn and sells it for Rs 1,500 to firm C. Firm C manufactures cotton cloth and sells it for Rs 2,200 to firm D. Firm D produces garments and sells them for Rs 3,500 to final consumers.
The total value of all these transactions or gross output is Rs 8,200 (= 1,000 + 1,500 + 2,200 4- 3,500) in which raw cotton has been counted four times, cotton yarn three times and cotton cloth two times. On the contrary, value of final goods (garments) which the economy has produced is t 3,500. Thus, while calculating national income, if we take into account Rs 8,200 (value of final as well as intermediate goods), it will be a case of double counting and duplication.
Actually only Rs 3,500 should be counted since the economy has produced final goods worth Rs 3,500 and not worth Rs 8,200. It is, therefore, essential that the element of double counting erupting in final product approach should be avoided. The problem of double counting is solved by Value added approach according to which chances of double counting are automatically eliminated.
How to avoid Double Counting
Theoretically, we may say that there may be two alternative ways of avoiding double counting, namely,
- Final product approach and
- Value added approach.
But in actual practice, double counting still occurs unintentionally in final product approach because every producer treats the product he sells as a final product though the same might have been used by the buyer as an intermediate product.
Therefore this problem is perfectly solved by value added method. According to this method, instead of taking value of final products, value added by each firm at each stage of production is included.
Clearly, value added by all the four firms is Rs 3,500 comprising Rs 1,000 by A + Rs 500 by B + Rs 700 by C + Rs 1,300 by D. There is no scope for double counting in this method. Thus, to avoid double counting, the value added method, also known as industry of origin method, is used in computation of national income. It is worth mentioning that total value added is equal to value of final product.
In the above example, total value added is Rs 3,500 and the value of final product (final garments sold to consumers) is also Rs 3,500.
Problems in Product Method:
The following problems arise in the computation of national income by product method:
1. Services of Housewives:
The estimation of the unpaid services of the housewife in the national income presents a serious difficulty. A housewife renders a number of useful services like preparation of meals, serving, tailoring, mending, washing, cleaning, bringing up children, etc.
She is not paid for them and her services are not including in national income. Such services performed by paid servants are included in national income. The national income is, therefore, underestimated by excluding the services of a housewife.
The reason for the exclusion of her services from national income is that the love and affection of a housewife in performing her domestic work cannot be measured in monetary terms. That is why when the owner of a firm marries his lady secretary, her services are not included in national income when she stops working as a secretary and becomes a housewife.
When a teacher teaches his own children, his work is also not included in national income. Similarly, there are a number of goods and services which are difficult to be assessed in money terms for the reason stated above, such as painting, singing, dancing, etc. as hobbies.
2. Intermediate and Final Goods:
The greatest difficulty in estimating national income by product method is the failure to distinguish properly between intermediate and final goods. There is always the possibility of including a good or service more than once, whereas only final goods are included in national income estimates. This leads to the problem of double counting which leads to the overestimation of national income.
3. Second-hand Goods and Assets:
Another problem arises with regard to the sale and purchase of second-hand goods and assets. We find that old scooters, cars, houses, machinery, etc. are transacted daily in the country. But they are not included in national income because they were counted in the national product in the year they were manufactured.
If they are included every time they are bought and sold, national income would increase many times. Similarly, the sale and purchase of old stocks, shares, and bonds of companies are not included in national income because they were included in national income when the companies were started for the first time. Now they are simply financial transactions and represent claims.
But the commission or fees charged by the brokers in the repurchase and resale of old shares, bonds, houses, cars or scooters, etc. are included in national income. For these are the payments they receive for their productive services during the year.
4. Illegal Activities:
Income earned through illegal activities like gambling, smuggling, illicit extraction of wine, etc. is not included in national income. Such activities have value and satisfy the wants of the people but they are not considered productive from the point of view of society. But in countries like Nepal and Monaco where gambling is legalised, it is included in national income. Similarly, horse-racing is a legal activity in England and is included in national income.
5. Consumers’ Service:
There are a number of persons in society who render services to consumers but they do not produce anything tangible. They are the actors, dancers, doctors, singers, teachers, musicians, lawyers, barbers, etc. The problem arises about the inclusion of their services in national income since they do not produce tangible commodities. But as they satisfy human wants and receive payments for their services, their services are included as final goods in estimating national income.
6. Capital Gains:
The problem also arises with regard to capital gains. Capital gains arise when a capital asset such as a house, some other property, stocks or shares, etc. is sold at higher price than was paid for it at the time of purchase. Capital gains are excluded from national income because these do not arise from current economic activities. Similarly, capital losses are not taken into account while estimating national income.
7. Inventory Changes:
All inventory changes (or changes in stocks) whether positive or negative are included in national income. The procedure is to take changes in physical units of inventories for the year valued at average current prices paid for them.
The value of changes in inventories may be positive or negative which is added or subtracted from the current production of the firm. Remember, it is the change in inventories and not total inventories for the year that are taken into account in national income estimates.
Depreciation is deducted from GNP in order to arrive at NNP. Thus depreciation lowers the national income. But the problem is of estimating the current depreciated value of, say, a machine, whose expected life is supposed to be thirty years. Firms calculate the depreciation value on the original cost of machines for their expected life. This does not solve the problem because the prices of machines change almost every year.
9. Price Changes:
National income by product method is measured by the value of final goods and services at current market prices. But prices do not remain stable. They rise or fall. When the price level rises, the national income also rises, though the national production might have fallen.
On the contrary, with the fall in the price level, the national income also falls, though the national production might have increased. So price changes do not adequately measure national income. To solve this problem, economists calculate the real national income at a constant price level by the consumer price index.
Income method, also known as factor income method, is used to calculate all income accrued to the basic factors of production used in producing national product. Traditionally, there are four factors of production, namely land, labor, capital, and organization. Accordingly there are four factor payments, namely rent, compensation of employees, interest, and profit. There is another category of factor payment called mixed income.
These factor payments are explained as follows:
Refers to the amount payable in cash or in kind by a tenant to the landlord for using land. In national income accounting, the term rent is restricted to land and not to other goods, such as machinery.
In addition to rent, royalty is also included in national income which is defined as the amount payable to landlord for granting the leasing rights of assets that can be extracted from land, for example, coal and natural gas.
(b) Compensation of Employees:
Refer to the remuneration paid to employees in exchange of services rendered by them for producing goods and services.
Compensation of employees is divided into two parts, which are as follows:
(i) Wages and salaries:
Include remuneration given in the form of cash to employees on a daily, weekly, or monthly basis. It includes allowances, such as conveyance allowance, bonuses, commissions, rent-free accommodation, loans on low interest rates, and medical and educational expenses.
(ii) Social security contribution:
Includes remuneration provided to employers in the form of social security schemes such as insurance, pensions, and provident fund.
Refers to the amount payable by the production unit for using the borrowed money. Generally, production units borrow for making investment and households borrow for meeting consumption expenditure.
In national income accounting, interest is restricted to the payment by production units. If production units use their own savings, then the interest is payable to them in the form of imputed interest.
This refers to the amount of money earned by the owner of a production unit for his/her entrepreneurial abilities. The profits are distributed by the production unit under three heads. First is by paying income tax, called corporate profit tax.
Second is by paying dividend to shareholder. Third is the retained earnings called undistributed profits. Thus, profit Is the sum total of corporate profit tax, dividend, and retained earnings.
(e) Mixed Income:
Refers to earnings from farming enterprises, sole proprietorships, and other professions, such as medical and legal practices. In these professions, owners themselves assume the role of an entrepreneur, financier, worker and landlords. Mixed income also takes into account the income of those individuals who earn from different sources, such as wages rents on own property, and interests on own money.
National Income= Rent + Wages + Interest + Profit + Mixed Income
STEPS INVOLVED IN INCOME METHOD:
These steps are as follows:
1. Classifying the production units into primary, secondary, and tertiary sectors.
2. Estimating Net Value Added of each sector. The sum total of the factor payments equals net value added.
3. The sum of value added of all the sectors is known as NDP at Factor Cost.
NVA = NDP at Factor Cost
4. Estimating NFIA and adding it to NDP at Factor Cost, which gives NNP at Fcator Cost (national income).
NDP at factor Cost + NFIA = National Income (NNP at Factor Cost)
The following are the precautions that should be taken into consideration while calculating national income using the income method:
a. Including the imputed value of factor services rendered by the owners of production units themselves. For example, if production units use their own savings for production, then the interest is payable to them in the form of imputed interest. This imputed interest should be added in the calculation of national income.
b. Avoiding the inclusion of transfer payments, such as gifts, donations and taxes.
c. Excluding the gains that arise from the sales of pre-owned goods. These gains are called capital gains.
d. Excluding the income arising from sale of financial assets, such as shares and debentures. This is not related to the production of goods and services. However, national income includes the value of services rendered by the agents in selling these financial assets.
Problems in Income Method
The following problems arise in the computation of National Income by income method:
1. Owner-occupied Houses:
A person who rents a house to another earns rental income, but if he occupies the house himself, will the services of the house-owner be included in national income. The services of the owner-occupied house are included in national income as if the owner sells to himself as a tenant its services.
For the purpose of national income accounts, the amount of imputed rent is estimated as the sum for which the owner-occupied house could have been rented. The imputed net rent is calculated as that portion of the amount that would have accrued to the house-owner after deducting all expenses.
2. Self-employed Persons:
Another problem arises with regard to the income of self-employed persons. In their case, it is very difficult to find out the different inputs provided by the owner himself. He might be contributing his capital, land, labour and his abilities in the business. But it is not possible to estimate the value of each factor input to production. So he gets a mixed income consisting of interest, rent, wage and profits for his factor services. This is included in national income.
3. Goods meant for Self-consumption:
In under-developed countries like India, farmers keep a large portion of food and other goods produced on the farm for self-consumption. The problem is whether that part of the produce which is not sold in the market can be included in national income or not. If the farmer were to sell his entire produce in the market, he will have to buy what he needs for self-consumption out of his money income. If, instead he keeps some produce for his self-consumption, it has money value which must be included in national income.
4. Wages and Salaries paid in Kind:
Another problem arises with regard to wages and salaries paid in kind to the employees in the form of free food, lodging, dress and other amenities. Payments in kind by employers are included in national income. This is because the employees would have received money income equal to the value of free food, lodging, etc. from the employer and spent the same in paying for food, lodging, etc.
FINAL EXPENDITURE METHOD
Final expenditure method, also known as final product method, is used to measure final expenditures incurred by production units for producing final goods and services within an economic territory during a given time period.
These expenditures are incurred on consumption and investment. This method is the opposite of the value-added method. This is because value-added method estimates national income from the sales side, whereas the expenditure method calculates national income from the purchase side.
Final expenditure of an economy is divided into consumption expenditure and investment expenditure, which are explained as follows:
(a) Consumption Expenditure: It includes the following:
(i) Private Final Consumption Expenditure:
It includes expenditure incurred by households and expenditure incurred by private non-profit institutions serving households. Households Final Consumption Expenditure is defined as expenditures, both actual and imputed, incurred by a country’s households on final goods and services for satisfying their wants. In addition to actual money expenditure, Households Final Consumption Expenditure includes imputed value of goods and services received without incurring money expenditure, for example, self-consumed output and gifts received in kind.
On the other hand, Private non-profit institutions serving households includes expenditure incurred by private charitable institutions, trade unions, and religious societies, which produce goods and services to be supplied to consumers either free or at token prices.
(ii) Government Final Consumption Expenditure (GFCE):
It includes expenditure that is incurred by government for providing free goods and services to citizens. It is equal to value of output minus sales (GFCE = Value of Output – Sales).
The value of output is calculated as:
Value of output generated by government = Compensation of government employees + purchases of commodities and services + consumption of fixed capital
Sales by government = Commodity Sales + Non- Commodity Sales
(b) Investment Expenditure:
Involves expenditure incurred on capital formation. This expenditure is known as Gross Domestic Capital Formation.
There are three components of Gross Domestic Capital Formation which are as follows:
(i) Acquisition of fixed capital assets:
Implies purchasing assets, such as building and machinery.
(ii) Change in stocks:
Involves making addition to the stock of raw materials, semi-finished goods, and finished goods.
(iii) Net acquisition of valuables:
Involves acquisition of valuables minus disposal of valuables. These valuables include precious stones, metals, and jewellery.
Gross Domestic Capital Formation becomes net when it is diminished by depreciation.
Net Domestic Capital Formation = Gross Domestic Capital Formation – depreciation
STEPS INVOLVED IN EXPENDITURE METHOD
These steps are as follows:
1. Classifying the production units into primary, secondary, and tertiary sectors.
2. Estimating the final expenditures on goods and services by industrial sectors. These expenditures are private final consumption expenditure, government final consumption expenditure and investment expenditure. The expenditure also includes net exports, which are equal to exports minus imports.
3. Taking the sum of the final expenditures which gives GDP at Market price.
4. Estimating the consumption of fixed capital and net indirect taxes to calculate NDPfc.
NDP at Factor Cost = GDP at Market Prices – Consumption of Fixed Capital- Net Indirect Taxes
5. Adding NFIA to get national income (NNPfc)
NDPfc +NFIA = NNPfc
The following are the precautions that should be taken into consideration while calculating national income using the final expenditure method:
a. Excluding the intermediate expenditure as it is already a part of final expenditure
b. Including the imputed expenditure incurred for producing goods for self-consumption
c. Excluding the expenditure incurred on transfer payments
d. Excluding expenditure incurred on financial assets, such as shares and debentures
e. Excluding the expenditure incurred on pre-owned goods
Problems in Expenditure Method:
The following problems arise in the calculation of national income by expenditure method:
(1) Government Services:
In calculating national income by, expenditure method, the problem of estimating government services arises. Government provides a number of services, such as police and military services, administrative and legal services. Should expenditure on government services be included in national income?
If they are final goods, then only they would be included in national income. On the other hand, if they are used as intermediate goods, meant for further production, they would not be included in national income. There are many divergent views on this issue.
One view is that if police, military, legal and administrative services protect the lives, property and liberty of the people, they are treated as final goods and hence form part of national income. If they help in the smooth functioning of the production process by maintaining peace and security, then they are like intermediate goods that do not enter into national income.
In reality, it is not possible to make a clear demarcation as to which service protects the people and which protects the productive process. Therefore, all such services are regarded as final goods and are included in national income.
(2) Transfer Payments:
There arises the problem of including transfer payments in national income. Government makes payments in the form of pensions, unemployment allowance, subsidies, interest on national debt, etc. These are government expenditures but they are not included in national income because they are paid without adding anything to the production process during the current year.
For instance, pensions and unemployment allowances are paid to individuals by the government without doing any productive work during the year. Subsidies tend to lower the market price of the commodities. Interest on national or public debt is also considered a transfer payment because it is paid by the government to individuals and firms on their past savings without any productive work.
(3) Durable-use Consumers’ Goods:
Durable-use consumers’ goods also pose a problem. Such durable-use consumers’ goods as scooters, cars, fans, TVs, furniture’s, etc. are bought in one year but they are used for a number of years. Should they be included under investment expenditure or consumption expenditure in national income estimates? The expenditure on them is regarded as final consumption expenditure because it is not possible to measure their used up value for the subsequent years.
But there is one exception. The expenditure on a new house is regarded as investment expenditure and not consumption expenditure. This is because the rental income or the imputed rent which the house-owner gets is for making investment on the new house. However, expenditure on a car by a household is consumption expenditure. But if he spends the amount for using it as a taxi, it is investment expenditure.
(4) Public Expenditure:
Government spends on police, military, administrative and legal services, parks, street lighting, irrigation, museums, education, public health, roads, canals, buildings, etc. The problem is to find out which expenditure is consumption expenditure and which investment expenditure is.
Expenses on education, museums, public health, police, parks, street lighting, civil and judicial administration are consumption expenditure. Expenses on roads, canals, buildings, etc. are investment expenditure. But expenses on defence equipment are treated as consumption expenditure because they are consumed during a war as they are destroyed or become obsolete. However, all such expenses including the salaries of armed personnel are included in national income.
DIFFICULTIES IN MEASUREMENT OF NATIONAL INCOME IN UNDER DEVELOPED COUNTRIES
The estimation of national income in any country is a very difficult task. But in under-developed countries like India, the difficulties are particularly great.
The chief among them are as follows:
(i) Lack of Reliable Statistics:
The most serious handicap is the inadequacy, non-availability and unreliability of statistics. Correct statistical information regarding agriculture and allied occupations is not available. There is also no information available regarding consumption, expenditure and savings of either rural or urban population. Besides, owing to regional diversities, statistics available about one region cannot be used for another region.
(ii) Absence of Proper Accounts:
Illiteracy of the people and the absence of the practice of keeping accounts is the next. In western countries, economic statistics are collected directly from individuals and enterprises. This is obviously not possible in India. Moreover, Indian people are by tradition suspicious and do not co-operate in the collection of data.
(iii) Inability to Estimate:
Besides, most of the Indian producers are not capable of working out the exact quantity and the value of their products. Thus, “an assessment of output, produced by self-employed agriculturists, small producers and owners of household enterprises in the un-organised sector, would require an element of guess work.”
(iv) Unorganized Production:
For the most part, production, both agricultural and industrial, is unorganized and scattered. Thus, it does not admit of easy calculation. This also applies to household crafts.
(v) Lack of proper Classification:
A major part of the Indian economy consists of household enterprises which perform simultaneously functions belonging to different occupational categories. Thus the usual industrial classification cannot be observed.
(vi) Lack of Uniform Basis:
Another difficulty is the absence of a uniform basis which could be used for evaluating commodities and services in terms of money. This is made more difficult by the fact that a considerable portion of the output in India does not come into the market at all; it is either consumed by the producers themselves or bartered for other commodities and services. The large unorganized and non-monetized sector of the Indian economy presents the great difficulty in national income calculations.
(vii) Lack of Common Denominator:
Lastly, there is the universal academic difficulty of reducing the numerous economic activities of millions of people to a common measurable denominator. For example, how to add together the services of a street sweeper and those of the Prime Minister?
IMPORTANCE OF NATIONAL INCOME ANALYSIS
The national income data have the following importance:
1. For the Economy:
National income data are of great importance for the economy of a country. These days the national income data are regarded as accounts of the economy, which are known as social accounts. These refer to net national income and net national expenditure, which ultimately equal each other.
Social accounts tell us how the aggregates of a nation’s income, output and product result from the income of different individuals, products of industries and transactions of international trade. Their main constituents are inter-related and each particular account can be used to verify the correctness of any other account.
2. National Policies:
National income data form the basis of national policies such as employment policy, because these figures enable us to know the direction in which the industrial output, investment and savings, etc. change, and proper measures can be adopted to bring the economy to the right path.
3. Economic Planning:
In the present age of planning, the national data are of great importance. For economic planning, it is essential that the data pertaining to a country’s gross income, output, saving and consumption from different sources should be available. Without these, planning is not possible.
4. Economic Models:
The economists propound short-run as well as long-run economic models or long-run investment models in which the national income data are very widely used.
The national income data are also made use of by the research scholars of economics. They make use of the various data of the country’s input, output, income, saving, consumption, investment, employment, etc., which are obtained from social accounts.
6. Per Capita Income:
National income data are significant for a country’s per capita income which reflects the economic welfare of the country. The higher the per capita income, the higher the economic welfare of the country.
7. Distribution of Income:
National income statistics enable us to know about the distribution of income in the country. From the data pertaining to wages, rent, interest and profits, we learn of the disparities in the incomes of different sections of the society. Similarly, the regional distribution of income is revealed.
It is only on the basis of these that the government can adopt measures to remove the inequalities in income distribution and to restore regional equilibrium. With a view to removing this personal and regional inequality, the decisions to levy more taxes and increase public expenditure also rest on national income statistics.