ODWAR VINCENT-LIRA UNIVERSITY

TOPIC: Concepts of National Income:

1. Introduction:
The national income of a country in a year denotes the value expressed in
monetary terms, the net contribution of the factors of production in the country
and abroad. It is the current flow of net final goods and services expressed in
monetary terms, resulting from the production activities of the residents of a
country during the year.

National income accounting is the study of the methods of measuring the

aggregate output and aggregate income of an economy taking the nation’s
economic pulse. It helps define the relationship between an economy’s total
output and total income (Simon Kuznets - 1971 Nobel prize). National Income
Accounting represents the tools and methods by which economists and policy-
makers measure economic activity and economic growth over time.

The national income accounts are based on the idea that the amount of
economic activity that occurs during a period of time can be measured in terms
of the amount of output produced, excluding output used up in intermediate
stages of production, the incomes received by the producers of output and the
amount of spending by the ultimate purchasers of output

2. Definition of National Income

National income is the money value of the final goods and services produced in
a given period of a nation. J.M.Keynes, a famous economist defined
national income as the money value of all goods and services
produced in a country during a year". While family income reflects the
economic position of households, national income shows the economic
position of a nation.

According to Keynes, the basic objective of an economy is to achieve

economic progress. This is achieved by coordinating natural resources,
human resources, capital, technology etc. National income will help to
assess and compare the progress achieved by a country over a period
of time.
According to modern approach, National Income may be defined as the
aggregate factor income which arises from the current production of goods and
services by the nation’s economy. The nation’s economy refers to the factors of
production supplied by the normal residents of the national territory. Thus,
national income is defined as the money value of all final goods and services

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produced by a country during a period of one year. National income consists of

goods and services of different types.

According to Simon Kuznets,” It is the net output of commodities and services

flowing during the year from the country’s productive system in the hands of
ultimate consumers”

For Colin Clark, the national income for any period consists of the money value
of the goods and services becoming available for consumption during that
period, reckoned at their current selling prices, plus additions to capital
reckoned at the prices actually paid for the new capital goods, minus
depreciation and obsolescence of existing capital goods, and adding the net
accretion of, or deducing the net drawings upon stocks, also reckoned at current
prices”

Thus, there are three measures of national income of a country:(a) as the sum of
all incomes in cash and kind, accruing to factors of production in a given time
period;(b) as the sum of net outputs arising in several sectors of the nation’s
production; © as the sum of consumers’ expenditure, government expenditure
on goods and services and net expenditure on capital goods.

3. National Income Aggregates

There are various concepts of national income. These are explained

below one by one:

(a),The GNP so defined is identical to the concept of gross national income

GNI. Thus GNP = GNI. The difference between the two is only of procedural
nature. While GNP is estimated on the basis of product flows, the GNI is
estimated on the basis of money income flows.
(i) GNP is a flow concept: GNP represents a flow. It is a quantity of
goods produced per unit of time. It is the value of final goods and
services produced in a country during a given time period.

(ii) GNP measures final output: While calculating GNP, the market
value of only final goods and services produced in a year are added up.
Final goods are those goods which are purchased for final use in the
market.

(iii) GNP is output produced by the citizens of a country: Gross

national product is the final output of goods and services produced by
the citizens and businesses of a country during a given time period
which is usually a year. For example, the economic activity carried out
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by the USA citizens and businesses outside the country is counted in

GNP. While the income of the residents who are not USA citizens is
subtracted from GNP.

Components of Expenditures in GNP: For measuring GNP at market

price, the economists use Expenditure Approach. According to this
approach:
There are four categories of expenditures which are added together to
measure gross national product (GNP) at market price, (i) Consumption,
(ii) Investment (iii) Government expenditure and (iv) Net exports.

These four types of expenditures are now explained in brief:

(i) Consumption Expenditure (C): It includes all personal expenditure

incurred by the citizens of a country on durable and non-durable goods
in a period of one year.

(ii) Investment (I): It is the total expenditure incurred by firms or

households on capital goods.

(iii) Govt. expenditures (G): It includes all types of expenditure incurred

by Federal, Provincial, Local Councils on the purchases of goods and
services such as national defense, law and order, street lighting etc.

(iv) Net Exports (X - M): Net exports of goods and services are value of
exports minus the value of imports.

Numerically, GNP = C + I + G + (X - M)

Where:C = consumption, I = investment, G = Govt. expenditure and X -

M = Net exports
(b) Gross Domestic Product (GDP):
The broadest measure of aggregate economic activity, as well as the best-known
and most often used, is the gross domestic product, or GDP. GDP measures the
value of output produced within the domestic boundaries of a country. It
includes the output of the many foreign owned firms that are located in the
country, following the high levels of foreign direct investment in the country
but excludes incomes earned abroad by the nationals

The labor and capital of a country working on its natural resources

produce a certain aggregate of commodities, material and non-material
every year. In addition to this, there may be foreign firms producing

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goods in the various sectors of the economy like mining, electricity,

manufacturing etc.

The concept of GDP is similar to that of GNP with a significant procedural

difference. In case of GNP the income earned by the nationals in foreign
countries are added and incomes earned locally by the foreigners are deducted
from the market value of domestically produced goods and services. In case of
GDP, the process is contrary- incomes earned locally by foreigners are added
and incomes earned abroad by the national are deducted from the total value of
domestically produced goods and services

According to Shapiro:"GDP is defined as a flow variable, measuring the

quantity of final good and services produced" during a year".

(i) GDP at Current Prices. If the domestic product is estimated on the

basis of prevailing prices, it is called gross domestic product at
current prices.
(ii) GDP at Constant Prices. If GDP is measured on the basis of some
fixed price, that is price prevailing at a point of time or in some base
year it is known as GDP at constant prices or real gross domestic
product.
NB. When the GDP is measured in current prices, it is described in nominal
terms and when is expressed in terms of goods and services, it is real GDP.

Problems in Measuring GDP:

The main problems or pitfalls which are to be avoided in the
measurement of GDP are as under:

(i) Stress on final output. While calculating the gross domestic product
(GDP), the value of only those goods are added which have reached
their final stage of production and are available for consumption. The
primary or intermediate goods are not counted in GDP. For example,
table made of wood is the final product. The wood used in making the
table is a primary good. While calculating GDP, if we include the value of
wood as a separate item and the value of table separate, it will be a
case of double counting and this leads to inflated rise in GDP.

(ii) Value added method. Another way to avoid pitfall of double or

multiple counting is to calculate only the added value of a particular
commodity at its every stage of production. The result in both the cases
will be the same.

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Suppose the price of book which you are reading is $10. This includes
the cost of paper, printing and binding charges, etc., while estimating the
gross domestic product, there are two ways open to you. Either you
include the final price of the book at one time in gross domestic product
or you add up the added value at every stage in the process of the
production of the book. But you are not to count the value of a thing
more than once.

From the following example, the reader can easily understand as to how
the danger of double or multiple counting can be avoided.

Value Added at
Stage of Form of the Price at Each
Each Process
Production Product Stage ($)
($)

1st Jungle Wood 0.25 0.25

The price of wood

nd
2 after transporting 0.38 0.13
to the city

Paper
3rd 2.00 1.62
manufacturing

4th Printing of book 5.00 3.00

Binding and title,

5th 6.00 1.00
etc.

6th Sale price 10.00 4.00

$23.63 $10.00

From the above example, it is clear that if we add up the value of the
product at every stage of production, the total value of the book comes
to $23.63, while in fact it is priced al $10 only.

So we come to the conclusion that while adding the value of the book to
the gross national product, we should either include the final price of the
book which is $10 or we should add up the added value at each stage in
the process of production. But we are not to count the value of a
particular commodity more than once. If we do so, the gross product will

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be overestimated. The computation of GDP by this method is not

popular.

(iii) Non-Productive transactions are excluded from GDP. In order to

measure the economic well-being of a society in a year, the non-
productive transactions are excluded from the Gross Domestic Product.
There are two major types of non-productive transactions, namely:
(a) Purely financial transactions and (b) Second hand sales. Under
purely financial transaction (i) all public transfer payments which do not
add to the current flow of goods such as social security payments, relief
payments and (ii) all private financial transactions such as receipt of
money by a student from his father which make no contribution in
current production are all excluded from GDP. Similarly, the second
hand sales are excluded from GDP as they do not contribute to current
production in a year.

(iv) Other transactions. There are a few other transactions which are
not included in GDP. For example, persons working in their own houses
without any payment through the market. For example, a house wife
takes care of house and children. Since she is not paid, therefore, the
value added by her is not included in GDP.

Exclusion of output production abroad. GDP is the value of output

produced by factors of production located within a country. It excludes
the output produced abroad by domestically owned factors of
production.

Distinction between GDP and GNP:

Here it seems necessary to make a distinction between gross domestic
product (GDP) and gross national product (GNP). Gross domestic
product is the total market value of all final goods and services produced
by factors of production within a nation's border during a period of one
year. In other words GDP is a flow of production produced within the
country by domestically located resources in a year.

Gross national product (GNP) on the other hand, is the measure of all
final goods and services produced by the citizens within their own
country as well as outside the country during a period of one year. In
other words, GNP expresses the money value of flow of goods and
services produced within the country and the net income received from
abroad during a period of one year. Thus when we move from GDP to
GNP, we add factor income receipts from foreigners and subtract factor
income payments to foreigners.
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GDP therefore is = GNP - Net Foreign Income from Abroad

(c) Net National Product (NNP)/National Income:

"Net national Product or national income at market prices is the net

market money value of all the final goods and services produced in a
country during a year. It is found out by subtracting the amount of
depreciation of the existing capital in a year from the market value of all
final goods and services".

For a continuous flow of money payments, it is necessary that a certain

amount of money should be set aside from the gross national income for
meeting the necessary expenditure of wear and tear of all capital
equipment so that there should not be any deterioration in the capital
and it should remain intact. If we deduct depreciation allowance from
gross national product, we get Net National Product at current market
price.

NNP at Market Price = GNP at Market Price - Depreciation

Depreciation Allowance and Maintaining Capital Intact. Here a

question can be asked as to what we actually mean by depreciation
allowance and maintaining capital intact; (the words which we have used
in explaining NNP).

It is known to every one of us that when production is going on, the

value of capital equipment does not remain the same. A decrease in
value because of wear and tear through, use, rusting, accident or
through actions of elements, gradually take place in the building and
other equipment of business. A certain sum of money based on the
value of the capital equipment and its longevity is set aside every year
from the gross annual income so that when machinery is worn out, new
capital equipment can be set up from the sum thus accumulated. This
fund which is set aside for covering the wear and tear, deterioration and
obsolescence of the machinery is named as Depreciation Allowance.
We can make this concept more clear by taking a simple example.

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Example of NNP: Suppose, a person buys machinery for manufacturing

cloth for $10000 only. He expects that this machinery will last ten years
and after that period, it will be partially or completely worn out. He sets
a-side $1000 every year from the gross national income as a
depreciation reserve of the capital equipment.

After the expiry of ten years, he accumulates $10000 and with that
money he replaces the old capital equipment which has lived its useful
life and maintains capital intact. The sum of money, i.e., $1000 which he
annually deducts from the gross annual income, is known as
depreciation allowance.

It is often pointed out by economists that the calculation of depreciation

allowance every year is a difficult task.
Maintaining Capital Intact. By maintaining capital intact we do not
mean that capital equipment should remain the same. It should neither
increase nor decrease. This can only by possible in a static society. In a
progressive society, the total capital equipment of a country must
increase every year, otherwise the national income will be affected
adversely.
NNP therefore = GNP - Depreciation

(e) National Income at Factor Cost:

National income can be estimated in terms of either output or total
income. When national income is measured by adding together all
income payments made to the factors of production in a year, it is called
national income at factor cost. National income thus is the sum total of
all income payments made to the factors of production. In the words of
J. Sloman:

"National income (Nl) or national income at factor costs. This is the

aggregate earning of the four factors of production (land, labor, capital
and organization) which arise from the current production of goods and
services by the nations' economy".

Components of National Income at Factor Cost:

The main components of national income at factor cost are as follows:

The factor incomes are generally divided into four categories:

(i) Compensation to employees (ii) Interest (iii) rents and (iv) profits.

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(i) Compensation to employees: It is the largest component of national

income. It consists of wages and salaries paid by the firms to the
workers for their labor services.

(ii) Interest: Interest is the payment for the use of funds in a year. The
payment is made by private businesses to households who have lent
money to them.

(iii) Rent: Rent is all income earned by individuals for the use of their
real assets such as building, farms etc.

(iv) Profit: Profit is the amount which is left after compensation to

employees; rent and interest have been paid out. The sum of
compensation to .employees, interest, rent and profit is supposed to
equal national income at factor cost.

(f) Personal Income:

National income is the sum of factor income. In other words, it is the
income which individuals receive for doing productive work in the form of
wages, rent, interest and profits. Personal income, on the other hand,
includes all income which is actually received by all individuals in a year.
It includes income which is not directly earned but is received by
individuals.

For example, social security payments, welfare payments are received

by households but these are not elements of national income because
they are transfer payments.

In the same way, in national income accounting, individuals are

attributed income which they do not actually receive. For example,
undistributed profits, employees’ contribution for social security
corporate income taxes etc. are elements of national income but are not
received by individuals. Hence they are to be deducted from national
income to estimate the personal income.

Numerically PI = Nl + Transfer Payments - Corporate retained earnings,

income taxes, social security taxes

(g) Disposable Personal Income:

Disposable personal income is the amount which is actually at the
disposal of households to spend as they like. It is the amount which is
left with the households after paying personal taxes such as income tax,
property tax, national insurance contributions etc.

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Therefore DPI = PI - Personal Taxes

The concept of disposable personal income is very important for
studying the consumption and saving behavior of the individuals. It is the
amount which households can spend and save.

Disposable Income = Consumption + Saving (DI = C + S)

(h).Per Capita Income (PCI). This is the average annual income of the
people of a country. It is obtained by dividing national income by the
population.

4. Methods of Computing/Measuring National Income:

There are three methods of measuring national income of a country.

They yield the same result. These methods are:

(a) The Product Method.

(b) The Income Method.

(c) The Expenditure Method.

We now look at each of the three methods in turn.

(a) Product Method or Value Added Method:

Goods and services are counted in gross domestic product (GDP) at
their market values. The product approach defines a nation's gross
product as that market value of goods and services currently produced
within a nation during a one year period of time.

The product approach measuring national income involves adding up

the value of all the final goods and services produced in the country
during the year. Here we focus on various sectors of the economy and
add up all their production during the year. The main sectors whose
production value is added up are:(i) agriculture (ii) manufacturing (iii)
construction (iv) transport and communication (v) banking (vi)
administration and defense.

Precautions for Product Method or Value Added Method:

There are certain precautions which are to be taken to avoid

miscalculation of national income using this method. These in brief are:

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(i) Problem of double counting: When we add up the value of output

of various sectors, we should be careful to avoid double counting. This
pitfall can be avoided by either counting (he final value of the output or
by including the extra value that each firm adds to an item.

(ii) Value addition in particular year: While calculating national

income, the values of goods added in the particular 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. GDP thus includes only
those goods, and services that are newly produced within the current
period.

(iii) Stock appreciation: Stock appreciation, if any, must be deducted

from value added. This is necessary as there is no real increase in
output.

(iv) Production for self-consumption: The production of goods for

self-consumption should be counted while measuring national income. In
this method, the production of goods for self-consumption should be
valued at the prevailing market prices.

(b) Expenditure Method:

The expenditure approach; measures national income as total

spending on final goods and services produced within nation during an
year. The expenditure approach to measuring national income is to add
up all expenditures made for final goods and services at current market
prices by households, firms and government during a year. Total
aggregate final expenditure on final output thus is the sum of four broad
categories of expenditures:

(i) consumption (ii) investment (iii) government and (iv) Net export.

(i) Consumption expenditure (C): Consumption expenditure is the

largest component of national income. It includes expenditure on all
goods and services produced and sold to the final consumer during the
year.

(ii) Investment expenditure (I): Investment is the use of today's

resources to expand tomorrow's production or consumption. Investment
expenditure is expenditure incurred on by business firms on (a) new

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plants, (b) adding to the stock of inventories and (c) on newly

constructed houses.

(iii) Government expenditure (G): It is the second largest component

of national income. It includes all government expenditure on currently
produced goods and services but excludes transfer payments while
computing national income.

(iv) Net exports (X - M): Net exports are defined as total exports minus
total imports.
National income calculated from the expenditure side is the sum of final
consumption expenditure, expenditure by business on plants,
government spending and net exports.

Thus, NI = C + I +G + (X - M)

Precautions for Expenditure Method:

While estimating national income through expenditure method, the

following precautions should be taken:

(i) The expenditure on second hand goods should not be included as

they do not contribute to the current year's production of goods.

(ii) Similarly, expenditure on purchase of old shares and bonds is not

included as these also do not represent expenditure on currently
produced goods and services.

(iii) Expenditure on transfer payments by government such as

unemployment benefit, old age pensions, interest on public debt should
also not be included because no productive service is rendered in
exchange by recipients of these payments.

(c) Income Approach:

Income approach is another alternative way of computing national

income. This method seeks to measure national income at the phase of
distribution. In the production process of an economy, the factors of
production are engaged by the enterprises. They are paid money
incomes for their participation in the production. The payments received
by the factors and paid by the enterprises are wages, rent, interest and
profit. National income thus may be defined as the sum of wages, rent,
interest and profit received or occurred to the factors of production in lieu
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of their services in the production of goods. Briefly, national income is

the sum of all income, wages, rents, interest and profit paid to the four
factors of production. The four categories of payments are briefly
described below:

(i) Wages: It is the largest component of national income. It consists of

wages and salaries along with fringe benefits and unemployment
insurance.

(ii) Rents: Rents are the income from properly received by households.

(iii).Interest: Interest is the income private businesses pay to

households who have lent the business money.

(iv).Profits: Profits are normally divided into two categories (a) profits of
incorporated businesses and (b) profits of unincorporated businesses
(sole proprietorship, partnerships and producers cooperatives).

Precautions for Income Approach:

While estimating national income through income method, the following

precautions should be undertaken.

(i) Transfer payments such as gifts, donations, scholarships, indirect

taxes should not be included in the estimation of national income.

(ii) Illegal money earned through smuggling and gambling should not be
included.

{iii) Windfall gains such as prizes won, lotteries etc. is not be included in
the estimation of national income.

(iv) Receipts from the sale of financial assets such as shares, bonds
should not be included in measuring national income as they are not
related to generation of income in the current year production of goods.

5. Why Three Methods of Computing/Measuring National Income

are Equal:

The three approaches used for measuring national income give the
same result. The reason is the market value of goods and services

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produced in a given period by definition are 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 sellers’ receipts must equal
what the buyers spend. The sellers’ 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.

6. Circular Flow of National Income in a Two Sector Economy or

Circular Flow Model:

Definition of Circular Flow Model:

A simple circular flow model of the macroeconomics containing two

sectors (business and household) and two markets (product and factor)
that illustrate the continuous movement of the payments for goods and
services between producers and consumers. The payment flow between
the two sectors and two markets is conveniently divided into four
segments representing consumption expenditures, gross domestic
product, factor payments, and national income.

The modern economy is a monetary economy. In the modern economy,

money is used as a medium of exchange. While analyzing the circular
flow of income in a two sector model of the economy, we assume:

Assumptions of Circular Flow Model:

(i) There are only two sectors in the economy, household sector and
business sector.

(ii) The business sector (or the firms) hires factors of production owned
by the household sector and it is the sole producer of goods and
services in the economy.

(iii) The household sector (or the households) is the sole buyer of goods
and services. It spends its entire income on the goods and services
produced by the business sector. They are also suppliers of labor and
various factors of production.

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(iv).The business sector sells the entire output to households. It does not
store. There are, therefore, no inventories.
(v) There are no savings and investment in the economy.

(vi).The household sector receives income by selling or renting the

factors of production owned by it.

(vii) Government does not exist for all such practical purposes (No public
expenditures, no taxes, no subsidies, no social insurance contribution,
etc.).

(viii) The economy is closed one having no international trade relations.

In this hypothetical economy stated above, we explain the circular flow

of economic life.

Principles of Circular Flow of National Income:

In the simple circular flow of income and product, there are two
principles which are involved.

First. In the business transactions, the sellers of goods receive exactly

the same amount which the buyers spend on them.

Second. The goods and services flow in one direction and money
payment flow in the other direction.

Explanation of Circular Flow of National Income:

In a two sector economy, there are business firms which produce goods
and services. The other sector is households which supplies their factors
services to the firms and also buy goods and services produced by
them. The households supply the economic resources to the firms and
receive payments in terms of money. There is, thus, a flow of money
corresponding to the flow of economic resources. These money incomes
are spent by households on goods and services produced by the firms.
With this the money comes back to the firms. This circular flow of
income in fact is the mutual dependence of the two sectors of modern
economy.

Diagram of Circular Flow of Income:

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The circular flow of income in a two sector economy is explained with

the help of figure 23.1.

In this figure, it is shown that the economy consists of two sectors (1)
households and business. In the upper top of this figure, the resources
such as land, capital, labor and entrepreneurial ability flow from
households to business firms as indicated by the arrow mark. In
opposite direction to this, money flows from business firms to the
households as factors payments such as rent, wages, interest and profit.

In the lower pipe line, money flows from households to firms as

consumption expenditure made by the households on the goods and
services produced by the firms. The flow of goods and services is in
opposite direction from business firms to households. We, thus, find that
money flows from business firms to households as factor payments and
then it flows back from households to firms. Thus there is in fact a
circular flow of income. This circular flow of money or income continues
year after year. This Is how the economy functions.

7. Difficulties/Problems in the Measurement of National Income:

According to Kuznets, the measurement of national income is a

complicated problem and is faced with the following difficulties:

(i) Non-availability of statistical material: Some persons like

electricians, plumbers, etc., do some job in their spare time and receive
income. The state finds it very difficult to know the exact amount
received from such services. This income which, should have been

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added to the national income is not recorded due to {be lack of full
information of statistics material.

(ii) The danger of double counting: While computing the national

income, there is always the danger of double or multiple counting. If care
is not taken in estimating the income, the cost of the commodity is likely
to be counted twice or thrice and national income will be overestimated.

(iii) Non-marketed services: In estimating the national income, only

those services are included for which the payment is made. The unpaid
services, or non-marketed services are excluded from the national
income.

(iv).Difficulty in assessing the depreciation allowance: The

deduction of depreciation allowances, accidental damages, repair, and
replacement charges from the national income is not an easy task. It'
requires high degree of judgment to assess the depreciation allowance
and other charges.

(v) Housing: A person lives in a rented house. He pays $5000 per

month to the landlord. The income of the landlord is recorded in the
national income. Let us suppose that the tenant purchases the same
house from the landlord. Now the income of the owner occupant has
increased by $5000. Is it not justifiable to include this income in the
national income? Should or should not this income be recorded in the
national income is still a controversial question.

(vi).Transfer earnings: While measuring the national income, it should

be seen that transfer payments should not become a part of national
income. The payments made as relief allowance, pensions, etc. do not
contribute towards current production. So they should be excluded from
national income.

(vii) Self-consumed production: In developing countries, a significant

part of the output is not exchanged for money in the market. It is either
consumed directly by producers or bartered for other goods.This
unorganized and non-monetized sector makes calculation of national
income difficult.

(viii) Price level changes: National income is measured in money

terms. The measuring rod of-money itself does not remain stable. This
means that national income can change without any change in output.

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Problems of Measurement in Under Developed Countries:

The national income in under-developed countries like Pakistan,

Afghanistan, etc., cannot be accurately measured due to the following
reasons:

(i) Self-consumed-bartered consumption: Some of the transactions of

agricultural goods in the villages are done without the use of money. The
statisticians, therefore, cannot measure the exact amount of the
transactions for inclusion in the national income.

(ii) No systematic accounts maintained: Most of the producers do not

keep any record of the sale of the products in the market. This makes
the task of national income still more complicated.

(iii) No occupational classification: There is no occupational

specialization in the under-developed countries. People receive income
by working in various capacities. One person sometimes works as
carpenter and at another time as mason. The statisticians cannot
accurately measure the income of such persons.

(iv) Unreliable data: The statisticians themselves do not feel the

importance of figures which they collect They also do not take much
pains for getting the reliable data. The figures of national Income are,
therefore, not up-to-date in the under-developed countries.

8. Determinants of National Income or Factors Affecting the

National Income:

There are many determinants or factors which influence the size of

the national income. They, in brief, are as follows:

The stock of factors of production: One of the very important factors

which influences the size of the national income is the quality and
quantity of the country's stock of factors of production. The factors of
production are land, labor, capital and organization.
(i) Land: Land supplies man with gifts of nature. It provides him with
agricultural goods and. raw material for production. The production of
land depends upon fertility of the soil, latitude, climate and irrigation
system in the country. If the land is fertile and is not handicapped in any
way say by salinity, water logging, shortage of rainfall and adverse

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climate, the size of the national income will be quite large, if the quality
of land is poor, the size of the national income will be small.

(ii) Labor: The second factor of production, i.e., labor is by no means

less important. This can be judged from it that if land is not aided by
human labor, it cannot produce anything except the wild vegetation. The
size of the national income greatly depends upon the quality and
quantity of labor in the country. If the labor is efficient and its size is
consistent with the means of subsistence, the size of the national
income will be large and if the labor is underfed, under clothed and
under-housed unskilled, and has no ambition to rise, the size of the
national income will be small.

(iii) Capital: The volume of production is also very much influenced by

the quality and quantity of capital available in the country. Capital now-a-
days is considered to be the lifeblood of the modern industry. If the
capital consists of primitive tools, the size of the national income cannot
be large. But if modern types of plants are used for production, then they
can enhance the productive capacity of a country.

(iv) Enterprise: The size of the national income also greatly depends
upon the number and skill of the entrepreneurs. If the captains of the
industries are efficient, they will combine; the various factors of
production to the! Optimum proportion and so the volume of total
production will be quite large, if managerial skill is lacking in the country,
the size of the national income will be small.

(v) State of technical knowledge: State of technical knowledge is also

one of the very important factors which influence the size of the national
income. The methods of production now-a-days have become so much
roundabout that unless advance technical knowledge is available in the!
Country, they cannot be adopted. The roundabout methods of
production have considerably increased the production capacity of the
country. If the state of technical knowledge is poor in the country, the
size of the national income will be small, but if advance technical
knowledge is available, then the size of the national income will be large.

(vi) Political Stability: Political instability greatly hampers economic

progress. If there is political stability in the country, the production can
be maintained at the highest level. The size of the national income will
be large. In case of political instability, the production will be adversely
affected and so the size of the national income will be small.

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Gross Domestic Product (GDP) as a Measure of

Welfare/Growth/Development:

Gross Domestic product (GDP) is generally considered a best single

measure of the value of output produced in the economy. The
importance of GDP as a measure of good standard of living or welfare is
as under:

9. Importance of GDP:

(i) Study of economic growth: The GDP has not only a theoretic
importance but also practical importance. Harris is of the opinion that
the study of national income can be split up into two parts, one for the
Iong term analysis and the other for short term study. If GDP increases
over years, it shows that we are heading towards prosperity and if it is
stagnant or is falling, it indicates that the economy is declining.

(ii) Unequal distribution of wealth: The GDP throws light on the

earnings of the various factors of production and the total output of the
country. If the output is less and there is unequal distribution of wealth,
the economist can suggest measures to increase output and to bridge
the income gap between the rich and the poor.

(iii) Problems of inflation and deflation: The GDP statistics can help
the economists a lot in solving the problems of inflation in the country.
The national income figures throws light asto how much general price
level has increased or decreased, how much income people spend on
consumption goods and how much they save? Government can devise
measures of controlling inflation or deflation on the basis of these figures
of consumption, saving and investment in the country.

(iv) The share of government in economic progress: In a centrally

controlled economy, all the factors of production are awarded and are
fully controlled by the state. In a mixed economy, the state as well as the
people in cooperation with each other can take part in the economic
advancement of the country, GDP shows the role which state is playing
for the economic progress of the people.

(v) Comparison with developed countries of the world: The GDP

figures help us to know the economic position of the people of the
various countries. If the standard of living of the people in one country is
low, they can take measures to increase the standard of living of the
people.

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(vi) Estimate of the purchasing power: The importance of the GDP

can also be judged from the fact that it throws light in the purchasing
power of the people, their power to save and the ability lo pay taxes to
the government.

(vii) Guide to economic planning: The GDP figure is very helpful for
the government to frame short and long term economic policies
according to the prevailing conditions in the country.

(viii) Economy's structure: The GDP indicates the share of various

sectors to the economy. If in a particular sector, the share is less and it
is desired to be raised, then steps can be taken to increase it. GDP thus
gives us a clear idea about the structure of the economy.

(ix) Public Sector: GDP studies help us to know the relative roles of
public and private sector in the economy.

Is GDP a Good Indication of a Country's Standard of Living?

GDP no doubt is a good measure of the value of output produced by an

economy but it is not regarded as a good indicator of the welfare or
happiness of the citizens of its country. There are certain serious
problems in relying solely on national income statistics.

The main problems or flaws involved in the construction of GDP

are as under:

Problems of Measuring National Output:

(i) Non marketed items: GDP ignores transactions that do not take
place in organized markets. For example, the services performed in the
home such as cleaning, cooking, child care, painting of houses by the
residents themselves etc., go unrecorded. GDP statistics, thus,
understate the true level of production in the country.

(2) Ignores the underground economy: There are certain economic

activities that should have been included in the GDP account but they
are not shown up because the activity is either illegal or unreported. For
instance, a teacher doing tuition work at home but does not declare
income to evade taxes. The waiters and waitresses do not report all their
tips to avoid paying tax. The profits of illegal trade such as drugs sale
etc. also go unrecorded.

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(3) Human cost of productions: If GDP increases as a result of people

having to work for longer hours and in unhygienic conditions, its net
benefit will be less to the citizens of a country.

(4) GDP ignores externalities: When there is industrial growth in the

country, its side effects such as pollution of air, water etc., are not taken
into account.
( 5). Types of goods produced. National income can increase when a
country produces capital goods, which do not necessarily improve
welfare in the short run.
(6).Omission in measuring GDP. National income figures can be low
due to omission in measuring GNP e.g. due to large fraction of
subsistence sector, high non-monetary output etc.
(7).Income distribution.A country can have high National income
figures when income is in the hands of few people while the majority of
the population is suffering.
(8).Price structure. Figures of National income can be high because of
inflation and this does not mean that people are better off. Also a
commodity can be cheap in the country and therefore does not mean
people are worse off due to low figures of National income.
(9). Difference in tastes. Taste of people in a country differs because of
age, sex, education, tribal, cultural and religious differences. National
income figures can be high when commodities produced or imported in
the country do not fit the taste of the majority.
(10). Problem of unemployment. National income figure can increase
when there is unemployment in the country. This affects the welfare of
the people.
(11). National budget problems. National income figure can increase
but when the Government allocates expenditures on
commodities/ventures like purchase of firearms, paying foreign debts; it
does not improve on the welfare of its people.
(12). Remittances from abroad. Countries which earn their National
income abroad may raise their National Income figures but with little
effect on welfare of its nationals

Conclusion:

GDP statistics are a measure of output of a country and should be

primarily seen in this context. However, if a country's industrialists give a
high priority on a clean environmental, quality production and relaxed
way of life and still increase production, the GDP would be a good
measure of economic welfare of its citizens.

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Measurement of Gross Domestic Product (GDP) in Current Price

and Constant Price or Difference between Nominal GDP and Real
GDP:

Definition and Explanation of Nominal GDP:

The gross domestic product (GDP) is the total market value of all the
final goods and services produced within an economy in a given year.
When all the components of GDP are valued at their current prices in the
market, it is called nominal gross domestic product. Nominal GDP
measures national income ruling at the time and thus takes no account
of inflation.

In many applications of macroeconomics, the nominal GDP is not

considered a measure of growth and welfare. Why this is so as
explained by taking a simple example of two good economy and two
years.

Example:

Let us assume that an economy produces 100 pens and 50 books in the
year 2001. The price of one pen is $1 and that of the book is $2 in the
market. The total value of the goods produced is $200 in the year 2001.

(100 pens x $1 per pen) + (50 books x $2 per book)

(100) + (100) = $200

Suppose that in the year 2002, the production of the two goods, pens
and books remains the same, but their prices get doubled. The total
value of the goods then would be $400.

(100pens x $2) + (50 books x $4)

200 + 200 = $400

The nominal GDP in the year2001is $200 and is $400 in the year 2002.
The nominal GDP has increased by 100% even though the physical
production of goods has remained the same. So, if we use the nominal
GDP to measure growth of the economy, we will be misled into thinking
that production has grown. What all has really happened is a rise in the

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price level. The standard of living of the people will increase only if (i) the
economy produces larger quantity of goods than the previous year and
(ii) the goods are sold at normal prices in the market.

The economists while studying the changes in the economy need a

measure of output which shows an actual increase in production of
goods and it is not affected by changes in their prices. To get this
problem solved, the economist use a measure called Real GDP.

Definition and Explanation of Real GDP:

Real gross, domestic product (Real GDP)is the production of goods

and services valued at constant prices. It is also defined as GDP
adjusted for price changes. It is a measure of output that reflects actual
income in. production, separate and part from any price changes that
may have occurred in the economy during the year.

Example for Calculating Nominal GDP and Real GDP:

Let us take a simple example of a two good economy and of two years
to explain the concept of Real GDP. The table given below shows the
nominal GDP for two years 2001 and 2002.

Price and Quantity

Year Price of Pen Quantity Price of Book ($) Quantity Produced

($) Produced (books)
(Pens)
2001 1 100 2 50
2002 2 150 3 100

Calculating Nominal GDP:

2001 ($1 per pen x 100 pens) + ($2 per book x 50 books) = $200
2002 ($2 per pen x 150 pens) + ($3 per book x 100 books) = $600

Calculating Real GDP:

2001 ($1 per pen x 100 pens) + ($2 per book x 50 books) = $200

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2002 ($1 per pen x 150 pens) + ($2 per book x 100 books) = $350

We find that real GDP has increased from $200 in the year 2001 to $350
in the year 2002. This increase is due to increase in quantities of goods
produced because the prices are held fixed at base year levels. The real
GDP enables us to see how much real income has changed from one
year to another.

Measuring Price Changes Overtime:

We can measure the changes in prices of goods overtime by an index

called GDP Deflator.

Definition of GDP Deflator:

GDP deflator is a measure of the price level calculated as the ratio of

nominal GDP to real GDP times 100.

Formula For GDP Deflator:

GDP Deflator = Nominal GDP x 100

Real GDP 1

Calculating the GDP Deflator:

2001 $200/$200 x 100 = 100

2002 $600/$350 x 100 = 171

For the year 2002, the value of GDP deflator as worked out is $171 and
was 100 in the base year. This means that the price level has increased
by 71% from the base year.

Base Year:

The year from which a financial or economic index is first calculated. It is

normally set at an arbitrary level of 100. Any year can be chosen as a
base year, but it is generally desirable to use a fairly recent one. New,
more up to date base years are periodically introduced. An average
value for a number of years can also be used as a base year.

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