Component of National Income (Part - 1) - Macroeconomics | Macro Economics - B Com PDF Download

Components of National Income

Component # 1. Gross Domestic Product (GDP):

GDP is the total value of goods and services produced within the country during a year. This is calculated at market prices and is known as GDP at market prices. Dernberg defines GDP at market price as “the market value of the output of final goods and services produced in the domestic territory of a country during an accounting year.”

There are three different ways to measure GDP:

Product Method, Income Method and Expenditure Method. These three methods of calculating GDP yield the same result because National Product = National Income = National Expenditure.

a. The Product Method:

In this method, the value of all goods and services produced in different industries during the year is added up. This is also known as the Value Added Method to GDP or GDI at Factor Cost by Industry of Origin.

The following items are included in India in this: agriculture and allied services; mining; manufacturing, construction, electricity, gas and water supply; transport, communication and trade; banking and insurance, real estates and ownership of dwellings and business services; and public administration and defence and other services (or government services). In other words, it is the sum of Gross Value Added.

b. The Income Method:

The people of a country who produce GDP during a year receive incomes from their work. Thus GDP by income method is the sum of all factor incomes: Wages and Salaries (compensation of employees) + Rent + Interest + Profit.

c. Expenditure Method:

This method focuses on goods and services produced within the country during one year.

GDP by expenditure method includes:

(1) Consumer expenditure on services and durable and non-durable goods (C),

(2) Investment in fixed capital such as residential and non-residential building, machinery, and inventories (I),

(3) Government expenditure on final goods and services (G),

(4) Export of goods and services produced by people of the country (X),

(5) Less imports (M). That part of consumption, investment and government expenditure which is spent on imports is subtracted from GDP. Similarly, any imported component, such as raw material, which is used in the manufacture of export goods, is also excluded.

Thus GDP by expenditure method at market prices = C + I + G + (X – M), where (X – M) is net export which can be positive or negative.

Component # 2. GDP at Factor Cost:

GDP at factor cost is the sum of net value added by all producers within the country. Since the net value added gets distributed as income to the owners of factors of production, GDP is the sum of domestic factor incomes and fixed capital consumption (or depreciation).

Thus GDP at Factor Cost = Net value added + Depreciation.

GDP at factor cost includes:

(i) Compensation of Employees i.e., wages, salaries, etc.

(ii) Operating Surplus which is the business profit of both incorporated and unincorporated firms,

(iii) Mixed Income of Self- employed.

Conceptually, GDP at factor cost and GDP at market price must be identical. This is because the factor cost (payments to factors) of producing goods must equal the final value of goods and services at market prices. However, the market value of goods and services is different from the earnings of the factors of production.

In GDP at market price are included indirect taxes and are excluded subsidies by the government. Therefore, in order to arrive at GDP at factor cost, indirect taxes are subtracted and subsidies are added to GDP at market price.

Thus, GDP at Factor Cost = GDP at Market Price – Indirect Taxes + Subsidies.

Component # 3. Net Domestic Product (NDP):

NDP is the value of net output of the economy during the year. Some of the country’s capital equipment wears out or becomes obsolete each year during the production process. The value of this capital consumption is some percentage of gross investment which is deducted from GDP. Thus Net Domestic Product = GDP at Factor Cost – Depreciation.

Component # 4. Nominal and Real GDP:

When GDP is measured on the basis of current prices, it is called GDP at current prices or nominal GDP. On the other hand, when GDP is calculated on the basis of fixed prices in some year, it is called GDP at constant prices or real GDP.

Nominal GDP is the value of goods and services produced in a year and measured in terms of rupees (money) at current (market) prices. In comparing one year with another, we are faced with the problem that the rupee is not a stable measure of purchasing power. GDP may rise a great deal in a year, not because the economy has been growing rapidly but because of rise in prices (or inflation).

On the contrary, GDP may increase as a result of fall in prices in a year but actually it may be less as compared to the last year. In both the cases, GDP does not show the real state of the economy. To rectify the underestimation and overestimation of GDP, we need a measure that adjusts for rising and falling prices. This can be done by measuring GDP at constant prices which is called real GDP.

To find out the real GDP, a base year is chosen when the general price level is normal, i.e., it is neither too high nor too low. The prices are set to 100 (or 1) in the base year. Now the general price level of the year for which real GDP is to be calculated is related to the base year on the basis of the following formula which is called the deflator index:

Real GDP = GDP for the/Current Year × Base Year (=100)/Current Year Index. Suppose 1990-91 is the base year and GDP for 1999-2000 is Rs. 6, 00,000 crores and the price index for this year is 300.

Thus, Real GDP for 1999-2000 = Rs. 6, 00,000 × 100/300 = Rs. 2, 00,000 crores.

Component # 5. GDP Deflator:

GDP deflator is an index of price changes of goods and services included in GDP. It is a price index which is calculated by dividing the nominal GDP in a given year by the real GDP for the same year and multiplying it by 100. Thus,

GDP Deflator = Nominal (or Current Prices) GDP/Real (or Constant Prices) GDP x 100

For example, GDP Deflator in 1997-98 = 1426.7th. crores/1049.2th. crores at x 100= 135.9

1993 – 94 prices

It shows that at constant prices (1993-94), GDP in 1997-98 increased by 135.9% due to inflation (or rise in prices) from Rs. 1049.2 thousand crores in 1993-94 to Rs. 1426.7 thousand crores in 1997-98.

Component # 6. Gross National Product (GNP):

GNP is the total measure of the flow of goods and services at market value resulting from current production during a year in a country, including net income from abroad.

GNP includes four types of final goods and services:

(1) Consumers’ goods and services to satisfy the immediate wants of the people;

(2) Gross private domestic investment in capital goods consisting of fixed capital formation, residential construction and inventories of finished and unfinished goods;

(3) Goods and services produced by the government; and

(4) Net export of goods and services, i.e., the difference between value of exports and imports of goods and services, known as net income from abroad.

In this concept of GNP, there are certain factors that have to be taken into consideration.

First, GNP is the measure of money, in which all kinds of goods and services produced in a country during one year are measured in terms of money at current prices and then added together. But in this manner, due to an increase or decrease in the prices, the GNP shows a rise or decline, which may not be real.

To guard against erring on this account, a particular year (say for instance 1980) when prices are normal is taken as the base year and the GNP is adjusted in accordance with the index number for that year. This will be known as GNP at 1980 prices or at constant prices.

Second, in estimating GNP of the economy, the market price of only the final products should be taken into account. Many of the products pass through a number of stages before they are ultimately purchased by consumers.

If those products were counted at every stage, they would be included many a time in the national product. Consequently, the GNP would increase too much. To avoid double counting, therefore, only the final products and not the intermediary goods should be taken into account.

Third, goods and services rendered free of charge are not included in the GNP because it is not possible to have a correct estimate of their market prices. For example, the bringing up of a child by the mother, imparting instructions to his son by a teacher, recitals to his friends by a musician, etc.

Fourth the transactions which do not arise from the produce of current year or which do not contribute in any way to production are not included in the GNP. The sale and purchase of old goods; and of shares, bonds and assets of existing companies are not included in GNP because these do not make any addition to the national product, and the goods are simply transferred.

Likewise, the payments received under social security, e.g., unemployment insurance allowance, old age pension, and interest on public loans are also not included in GNP, because the recipients do not provide any service in lieu of them. But the depreciation of machines, plants and other capital goods is not deducted from GNP

Fifth the profits earned or losses incurred on account of changes in capital assets as a result of fluctuations in market prices are not included in the GNP if they are not responsible for current production or economic activity. For example, if the price of a house or a piece of land increases due to inflation, the profit earned by selling it will not be a part of GNP.

But if, during the current year, a portion of a house is constructed anew, the increase in the value of the house (after subtracting the cost of the newly constructed portion) will be included in the GNP. Similarly, variations in the value of assets, that can be ascertained beforehand and are insured against flood or fire, are not included in the GNP.

Last, the income earned through illegal activities is not included in the GNP. Although the goods sold in the black-market are priced and fulfil the needs of the people, but as they are not useful from the social point of view, the income received from their sale and purchase is always excluded from the GNP.

But there are two main reasons for this. One, it is not known whether these things were produced during the current year or the preceding years. Two, many of these goods are foreign made and smuggled and hence not included in the GNP.

Three Approaches to GNP:

After having studied the fundamental constituents of GNP, it is essential to know how it is estimated. Three approaches are employed for this purpose. One, the income method to GNP; two, the expenditure method to GNP; and three, the value added method to GNP Since gross income equals gross expenditure, GNP estimated by all these methods would be the same with appropriate adjustments.

a. Income Approaches to GNP:

The income approach to GNP consists of the remuneration paid in terms of money to the factors of production annually in a country.

Thus GNP is the sum total of the following items:

(i) Wages and Salaries:

Under this head fall all forms of wages and salaries earned through productive activities by workers and entrepreneurs. It includes all sums received or deposited during a year by way of all types of contributions like overtime, commission, provident fund, insurance, etc.

(ii) Rents:

Total rent includes the rents of land, shop, house, factory, etc. and the estimated rents of all such assets as are used by the owners themselves.

(iii) Interest:

Under interest comes the income by way of interest received by the individual of a country from different sources. To this is added, the estimated interest on that private capital which is invested and not borrowed by the businessman in his personal business. But the interest received on governmental loans has to be excluded, because it is a mere transfer of national income.

(iv) Dividends:

Dividends earned by the shareholders from companies are included in the GNP.

(v) Mixed incomes:

These include profits of unincorporated business, self-employed persons and partnerships. They form part of GNP.

(vi) Undistributed corporate profits:

Profits which are not distributed by companies and are retained by them are included in the GNP.

(vii) Mixed incomes:

These include profits of unincorporated business, self-employed persons and partnerships. They form part of GNP

(viii) Direct taxes:

Taxes levied on individuals, corporations and other businesses are included in the GNP.

(ix) Indirect taxes:

The government levies a number of indirect taxes, like excise duties and sales tax. These taxes are included in the prices of commodities. But revenue from these goes to the government treasury and not to the factors of production. Therefore, the income due to such taxes is added to the GNP.

(x) Depreciation:

Every corporation makes allowance for expenditure on wearing out and depreciation of machines, plants and other capital equipment. Since this sum also is not a part of the income received by the factors of production, it is, therefore, also included in the GNP.

(xi) Net income earned from Abroad:

This is the difference between the value of exports of goods and services and the value of imports of goods and services. If this difference is positive, then it is added to the GNP and if it is negative it is deducted from the GNP.

Thus GNP according to the Income Method = Wages and Salaries + Rents + Interest + Dividends + Undistributed Corporate Profits +Mixed Incomes +Direct Taxes+ Indirect Taxes+ Depreciation+ Net Income from abroad.

b. Expenditure approach to GNP:

From the expenditure view point, GNP is the sum total of expenditure incurred on goods and services during one year in a country.

It includes the following items:

(i) Private consumption expenditure:

It includes all types of expenditure on personal consumption by the individuals of a country. It comprises expenses on durable goods like watch, bicycle, radio, etc.; expenditure on single-use consumers’ goods like milk, bread, ghee, clothes etc., as also the expenditure incurred on services of all kinds like fees for school, doctor, lawyer and transport. All these are taken as final goods.

(ii) Gross domestic private investment:

Under this comes, the expenditure incurred by private enterprise on new investment and on replacement of old capital. It includes expenditure on house construction, factory- buildings, and all types of machinery, plants and capital equipment. In particular, the increase or decrease in the inventory is added to or subtracted from it.

The inventory includes produced but unsold manufactured and semi-manufactured goods during the year and the stocks of raw material, which have to be accounted for in GNP. It does not take into account the financial exchange of shares and stocks because their sale and purchase is not real investment. But depreciation is added.

(iii) Net foreign investment:

It means the difference between exports and imports of export surplus. Every country exports to or imports from certain foreign countries. The imported goods are not produced within the country and hence cannot be included in national income, but the exported goods are manufactured within the country. Therefore, the difference of value between exports (X) and imports (M), whether positive or negative, is included in the GNP.

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(iv) Government expenditure on goods and services:

The expenditure incurred by the government on goods and services is a part of the GNP. Central, State or Local governments spend a lot on their employees, police and army. To run the offices, the governments have also to spend on contingencies which include paper, pen, pencil and various types of stationery, cloth, furniture, cars, etc.

It also includes the expenditure on government enterprises. But expenditure on transfer payments is not added, because these payments are not in exchange for goods and services produced during the current year.

Thus GNP according to the Expenditure Method=Private Consumption Expenditure (C) + Gross Domestic Private Investment (1) + Net Foreign Investment (X – M) + Government Expenditure on Goods and Services (G) = C + I + (X – M) + G. As already pointed out above, GNP estimated by either the income or the expenditure method would work out to be the same, if all the items are correctly calculated.

c. Value added approach to GNP:

Another method of measuring GNP is by value added. In calculating GNP, the money value of final goods and services produced at current prices during a year is taken into account. This is one of the ways to avoid double counting.

But it is difficult to distinguish properly between a final product and an intermediate product. For instance, raw materials, semi-finished products, fuels and services, etc. are sold as inputs by one industry to the other. They may be final goods for one industry and intermediate for others.

So, to avoid duplication, the value of intermediate products used in manufacturing final products must be subtracted from the value of total output of each industry in the economy. Thus the difference between the value of material outputs and inputs at each stage of production is called the value added.

If all such differences are added up for all industries in the economy, we arrive at the GNP by value added. GNP by value added = Gross Value added + net income from abroad. Its calculation is shown in Table 1.

The Table is constructed on the supposition that the entire economy for purposes of total production consists of three sectors. They are agriculture, manufacturing, and others, consisting of the tertiary sector. Out of the value of total output of each sector is deducted the value of its intermediate purchases (or primary inputs) to arrive at the value added for the entire economy.

Thus the value of total output of the entire economy as per Table 1 is Rs 155 crores and the value of its primary inputs comes to Rs 80 crores. Thus the GNP by value added is Rs 75 crores (Rs 155minus Rs. 80 crores).

The total value added equals the value of gross national (domestic) product of the economy. Out of this value added, the major portion goes in the form of wages and salaries, rent, interest and profits, a small portion goes to the government as indirect taxes and the remaining amount is meant for depreciation. This is shown in Table 2.

Thus we find that the total gross value added of an economy equals the value of its gross domestic product. If depreciation is deducted from the gross value added, we have net value added which comes to Rs 67 crores (Rs 75 minus 8 crores). This is nothing but net domestic product at market prices.

Again, if indirect taxes (Rs 7 crores) are deducted from the net domestic product of Rs 67 crores, we get Rs 60 crores as the net value added at factor cost which is equivalent to net domestic product at factor cost. This is illustrated in Table 3.

This value added at factor cost is equal to the net domestic product at factor cost, as given by the total of items 1 to 4 of Table 46.2 (Rs 45 + 3 + 4 + 8 crores = Rs 60 crores). If we add net income received from abroad to the gross value added, this gives us gross national income. Suppose net income from abroad is Rs 5 crores. Then the gross national income is Rs 80 crores (Rs 75 crores + Rs 5 crores).

Its Importance:

The value added method for measuring national income is more realistic than the product and income methods because it avoids the problem of double counting by excluding the value of intermediate products. Thus this method establishes the importance of intermediate products in the national economy.

Second, by studying the national income accounts relating to value added, the contribution of each production sector to the value of the GNP can be found out.

For instance, it can tell us whether agriculture is contributing more or the share of manufacturing is falling, or of the tertiary sector is increasing in the current year as compared to some previous years. Third, this method is highly useful because “it provides a means of checking the GNP estimates obtained by summing the various types of commodity purchases.”

Its Difficulties:

However, difficulties arise in the calculation of value added in the case of certain public services like police, military, health, education, etc. Which cannot be estimated accurately in money terms? Similarly, it is difficult to estimate the contribution made to value added by profits earned on irrigation and power projects.