Methods For Measuring National Income

Dr. A. K. Dash
IBS Hyderabad, IFHE University
National Income
National income is defined as the money value of all the final goods and services produced
within the domestic territory of a country during an accounting year plus net factor income
from abroad.

National income is the total income earned by a nation’s residents in the production of goods
and services during an accounting year.

National income is the income of the residence of a country

National income is the value of production by the normal residents of a country(within or

outside the domestic territory). Normal residents means the person who stays the domestic
territory within an accounting year.

National Income=Domestic Income +Net factor income from the rest of the World

is called as National income

-Depreciation=National income
National income depreciation is not included
Methods For Measuring National Income
Estimating national income is an indispensable task of the government.
However, estimating national income is an extremely complicated and
gigantic task. The reason is that the process of income generation in a
modern economy is extremely complex and, therefore, collecting
necessary data on sources and data availability problems. Economists
have, however, devised different methods of estimating national
income. The basic approach in measuring national income is to
measure the two kinds of flows generated by the economic activities of
the residents of the country. Given the product flows and two ways of
money flows, the economists have devised three methods of measuring
national income
(1) Value added method (output or production method) all value added
by each producer
(2) Income Method (all income generated) and
(3) Expenditure Method (all spending on final demand)
Any of the three methods can be adapted to measure the National income of a country
provided the required data is fully available. Where a single method can’t be adopted due to
non availability of required data or due to conceptual problems as to what should be and what
should not be included in national income accounting. Hence, a combination of the three
methods is used to measure GDP.
The national income identity is total output=Total income=Total expenditure

How it works?

Let’s assume that you called one daily labour to do your gardening work. The market value
of labour is Rs 500 per day. At the end of the day, the labour asked you to pay Rs. 1000 per
day. Will you pay Rs. 1000 per day?. The value of the work is Rs 500. If you want to pay less
than the market value, no labour will come to your house for work. Likewise, if any labour
will ask you to pay more than the market value, you will not pay. We can say the labour is
paid according to the output/value generated. Whatever money labour received will spend on
goods and services.
Hence Total output generated= Total Income=Total expenditure

The national income accounts are based on the simple fact that one person’s spending
is another person’s income.

Though there are 3 ways to measure national income, each of which theoretically
The Value Added Method
The Value added method is used to avoid the problem double counting.

Double counting means counting the value of a commodity more than once.

The problem of double counting arises because of the conceptual and practical
problem in determining whether a product is an intermediate product or a final
product.

At each stage of production, the product is transformed into a final product.

However, same final product is used as input in the next stage in the
production process of another commodity. Therefore, the value of the same
product is likely to be counted twice, or more than twice, in estimating the
national income.
The Value Added Method

For example, wheat is the final product for the farmer. But wheat is an
input(raw material) for a flour mill, say, MP Superior Atta. Wheat flour
is the final product for MP Superior Atta company. But wheat flour is
used by the bread manufacturer, Britania Bread Company, as raw
material. For Britannia , bread is the final product. But bread is an input
for Sandwich maker, the tasty food restraint. Now , if all these products –
wheat, wheat floor, bread and sandwich are treated as final products,
then the value of wheat is counted at four stages-wheat production, flour
production, bread production and sandwich production. This is called
double counting in the accounting sense.

Double counting results in an overestimation of national income.

Therefore, in order to avoid the problem of double counting, method
called the value added method is used to estimate the national income.
Methods of Measuring value Added

Product Value of Inputs Value of Final Output Gross Value Added

Wheat Nil 1000 1000
Flour 1000 1500 500
Bread Maker 1500 2000 500
Sandwich Maker 2000 3000 1000
Total 4500 7500 3000

Let’s assume farmer sold the wheat to the flour mill by charging Rs. 1000 per
quintal.
For flour mill, wheat is the intermediate product and the value is 1000 per quintal.
The flour mill processed it and sells to the bread manufacturer by charging Rs
1500. The bread manufacturer processed it and sold the same to sandwich maker
by charging Rs 2000

The gross value added in Sandwich production is estimated at Rs. 3000 per
quintal.
Income Method
The income approach refers to the aggregate income earned by all households, companies
and the government that operates within an economy over a given period of time.

Under the income approach, we calculate the income earned by all the factors of
production in an economy.

Factors of production are the inputs which are used to produce goods and services. Factor of
production as you know are Land, Labour, Capital and Entrepreneur. In the income approach,
we calculate income from each of these factor of production which includes the rent earned by
land, the wages and salary received by labour, the return on capital in the form of interest,
profits earned by entrepreneur. Sum of All these incomes constitutes national income.

The income approach states that all economic expenditures should equal the total income
generated by the production of all economic goods and services.

The income approach adds up earnings during a year by those who produce all that output. The
income approach sums income arising from that production.
(1) Compensation of employees
Compensation of employee is the income of workers (excluding self employed) .
Compensation of employee includes the followings (i) wages and salary in cash (ii)
compensation in kind (iii) employee contribution to social security.
(i)Wages and salary in Cash
a. Basic salary
b. Dearness allowances(DA)
c. Overtime allowances
d. HRA allowances
e. Bonus
f. Sick leave allowances
(ii) Compensation in kind
g. Free housing
h. Free Medical
i. Free uniform
j. Free Education
k. Free telephone bill
l. Conveyance facility
(iii) Employee contribution to the Social Security scheme
m. Pension fund
2. Proprietors income-proprietors income is the sum of the
nonincorporated self-employed. Proprietors income includes both
labour income and capital income. Because many self employed
people own some capital (eg. A farmers tractor or a dentist’s X-ray
machine).
3. Rental income of a person- This is income received from
property received by households. Rental income of a person, a small
item, is the income earned by individuals who own land that they
rent to others.
4. Royalty income: Some miscellaneous type of income, such as
royalty income paid to authors are included in the income method
5. Corporate profit: corporate profits are profits earned by the
corporations. As corporates are making profits, they used to pay
corporate tax, such as corporate income tax and pay dividend to the
share holder.
6. Net interest : net interest is interest earned by individuals from
business and foreign source minus interest paid by the individual.
Expenditure Method
The expenditure approach to measure national income is the
total amount spent on final goods and services that have been
produced in the economy during a specified period of time. The
expenditure approach adds up spending on all final goods
and services produced in the economy during a year. The
expenditure approach sums the spending on production. In
the expenditure approach we measure the different ways in which
this income is spent on goods and services. Four major categories of
spending are consumption expenditure by the household, investment
expenditure by the firm, government purchase on goods and services
and net exports of goods and services.
Y= C+I+G+NX …………..(1)
Y=GDP=Total production(output)
C=Consumption expenditure by the household
I=investment expenditure by the firms
G=Government purchase of goods and services(spending)
NX=Net exports of goods and services(Net exports is the diffidence between
value of exports and value of imports)
Equation (1) is called income–expenditure identity because it states that
income Y, equals to the total expenditure(C+I+G+NX)
Consumption: consumption is spending by domestic household on final
goods and services, including those produced abroad. It is the largest
component of expenditure, usually 2/3rd of US GDP. In India, private
consumption accounted approx. 58% of GDP. Consumption is typically
broken down into purchases of durable goods, nondurable goods and services.
Consumer durables: it represents long lived consumer items such as your
Car, TV, furniture, washing machine, table, AC etc.
Consumer non durable goods: it represents short lived items such as food,
clothing and fuel.
Services: such as education, health care and financial services, transportation
etc.
Investment: the purchase of new plants, new equipment's, new
buildings, and new residences, plus net addition to inventories.
The most important investment is physical capital, such as new
buildings and new machinery. Investment also includes new
residential constructions. Although investment fluctuates from
year on year, investment averaged about one-third of India’s
GDP during the last decade. More generally, investment consists of
spending on current production that is not used for current
consumption. A net increase to inventories also counts as
investment because it represents current production not used
for current consumption. Inventories are stock of goods in process,
such as computer parts, and stock of finished goods, such as new
computers awaiting sale.

Although investment includes purchasing a new residence, it excludes

purchase of financial assets such as stocks and bonds. In economics
purchasing stocks and bonds are not called investment. It simply the
transfer of ownership and not able to generate any output and
Government Purchases
Government purchase(spending):The third component is government
spending, which represents expenditures by state, local and central
government authorities for goods and services, investment on
infrastructure, education and health care investment and nondefense
spending such as purchase of tanks, guns etc.

Did this mean that every Rupee of government expenditure is included

in GDP?. Definitely not. GDP includes only government purchases, it
excludes spending on transfer payments. Transfer payments such as
unemployment allowances, old age pension, subsidy, mid day meals,
money donated to red cross etc.. These payments are important for
social purposes but are not purchases of current goods and services, and
therefore they are omitted from GDP as calculated in the expenditure
method.
Transfer Payments
Transfer payments are the payments made by people to the people, and by
people to the government without corresponding transfer of goods and
services. In other words, transfer payments refers to the flow of money
without a reverse flow of goods and services. For example, when a person gift
some money to a relative or friend, or to a poor person or a charitable
organization , without receiving anything in return, it is a transfer payments.
Gift to red cross society
 Unemployment allowances
 Scholarship
 Money received from a relative working in foreign country
 Old age pension
 Gift to red cross society
 When a father pays some money to their children
It is important to note that transfer payments are not taken into account while
counting the national income because such payments do not make any
addition to the total production nor do they add any additional value to the
society.
Net exports
 The final spending components, net exports, reflects international
trade in goods and services. Goods(merchandise trade) included
physical items such as spices, football, laptop etc. Services or so
called invisibles, include intangible items, such as tourism services,
banking services, internet services, doctor services etc.
 Foreign purchases of Indian goods and services are counted as
part of Indian GDP. But India’s purchase of foreign goods and
services are subtracted from India’s GDP. Net exports equals the
value of India’s exports of goods and services minus value of India’s
imports of goods and services. India’s imports have exceed India’s
exports nearly every year since 1950s, meaning India’s net exports
have been negative. Net exports the values of a country’s exports
minus the value of its imports.
Difficulties and problems associated with measuring
national income
There are many difficulties in measuring national income
(1) Non monetary transactions:
The first problem in national income accounting related to the treatment of non
monetary transactions such as the services of housewife's to the members of the
families. For example, if a man employees a maid servant for household work,
payment to her will appear in the national income. On the other hand, if that man
will marry that maid servant, then she will not paid and not added in national
income through her services performed remains the same as before.

2. Problem of double counting

The greatest difficulty of measuring national income arises because of the
possibility of double counting. The danger of double counting emerges as there
is no proper distinction between intermediate and final products. Flour is a final
product for a housewife but the same flour is used as a raw material for backer.
The flour as a good counted twice. To solve this difficulty only final goods and
services are taken into account, and that is rather a difficult task.
Only final goods and services are included in the national income accounting.
But it is very difficult to distinguish between final goods and services and
intermediate goods and services.
3. Sale of second hand goods
The trading of second hand commodities like Car, TV,
Washing machine etc cant not be counted for current year
national income as these products were included in the
national income when sold first time as new finish goods.
There will be duplication if counted once again.
4. Transfer payments:
Transfer payments are another difficulty for the
measurement of national income. Transfer payments like
pension, unemployment allowances, subsidy, Gift to red cross
society ,scholarship are not included in national income. These
earnings are a part of individual income and they are also a
part of government expenditure. To avoid these difficulties,
these incomes are deducted from national income. These
income are not producing any goods and services.
5. National income statistics takes no account of under
ground economy
The under ground economy consists of illegal and uncleared
transactions where the goods and services are themselves
illegal such as drugs, gambling, smuggling etc. Since, these
incomes are not included in the national income, the
national income seems to be less than the actual amount. By
leaving all these income, national income is calculated less
than the actual.
6. Price changes
The problem of changing prices is one of the major
problems of national income accounting. Due to price rises,
the value of national income for particular year appears to
increase even when the production is decreasing.
7. Data reliability
Purchasing Power parity(PPP)

If the basket cost $100 in the US and $200 in England,

then purchasing power parity exchange rate is 1:2
Example
Suppose Japan has a higher GDP percapita ($18) than the
US($16). It doesn’t necessarily mean that Japan is richer
than the US. Suppose one hotdog cost $6 in Japan and
same hot dog cost $2 in the US. Japanese can able to buy
3 hotdogs while the US can able to buy 8 hotdogs.
Therefore in terms of hotdogs US is richer. The US has
GDP(PPP) of $14 while Japan has a GDP(PPP) $12. The
exchange rate is 14:12 or 7:6.
Limitations of GDP: What GDP is not
1. Only market activity is included in GDP-Works done by
housewife and do it yourself is certainly contributes national well
being, but it is not included in GDP because it has no price tag.
 2. GDP statistics takes no account of “under ground economy”. This
includes not just criminal activities but also a great deal of legitmate
business activity that is counted in cash to escape the tax
 GDP place no value on leisure
 “Bads” as well as “goods” get counted in GDP
Items included and excluded in National income Calculation
Items Excluded
Items Included 1.Windfall gain/lottery income
1. Medical facility to government
2. Income from sale of old car
employees
2. Income of actors, singers, and artist 3. Gift to red cross
3. Bonus(it is a part of compensation of society(transfer payments)
employee 4. Gambling and smugglers
4. Interest received by households from income
commercial banks (factor income) 5. Transfer payments
5. Free meals to workers (wages in kind) 6. Expenditure by government
6. Undistributed profit(part of profit) on Scholarship
7. Payment of pension at the time of 7. Meals given to a beggar (it is
retirement expenditure and no productive
8. Purchase of a new car by households return)
9. Brokerage on sale of share
8. Expenditure on purchase of
10. Purchase of goods by foreigners from
share
India
11. Machine purchased by a factory 9. Compensation paid to
12. Purchased of goods by Indian residents accident victims ( not meant for
from abroad productive activities)
13. Water pump purchased by a farmer 10. Sales of new shares
14. School fees paid by students a part of 11. Interest payment on national
Double counting is a problem of national income
The fundamental identity of national income accounting
is Total output/production=Total income=Total
expenditure
Which of the following does not include GDP calculated
by the Income Method? -Income from capital gains
Index of industrial production(IIP) is used as a proxy of
GDP in absence of data and IIP represents manufacturing
sector.
Thank you