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:

NDP_FC=

• Compensation of employees + operating surplus + mixed income

    of self- employed.

NNP_FC =

NDP_FC + 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:

GDP_MP=

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

NDP_MP = GDP_MP – Depreciation

NNP_MP = NDP_MP + NFIA

NNP_FC = NNP_MP – Net indirect tax.

Change in stocks = closing stock – opening stock

Capital formation =Fixed capital formation + change in stock

Net Export = Export – Import