BUSINESS ECONOMICS – UNIT-4 - NOTES
National Income - Meaning
National Income defines a country's wealth. This income depicts the value of
goods and services which are produced by an economy. This gives effect to the net
result of all the economic activities performed in the country.
National income is the sum total of the value of all the goods and services
manufactured by the residents of the country, in a year, within its domestic
boundaries. It is the net amount of income of the citizens by production in a year.
Traditional Definition of National Income
According to Marshall: “The labor and capital (factors of production) of a country
acting on its natural resources produce annually a certain net aggregate of
commodities, material and immaterial including services of all kinds. This is the
true net annual income or revenue of the country or national dividend.”
Significance of National Income
(a) A comprehensive summary of the economic activity:
National income estimates give us detailed data relating to a country’s production,
savings, investment, capital formation and various other economic activi-ties in a
particular year. All these data give us a comprehensive picture of the economic
activities of the people during that year.
(b) Assessment of the relative importance and progress of the different sectors:
The national income data relating to the sources of national income give us an idea
of the relative importance of the different sectors (namely, agriculture, industry,
trade and commerce, services, etc.) in the economy of the country.
(c) Indispensable to government for framing policies and programmes
The government of a country is to frame its economic policies and pro-grammes on
the basis of the estimates of the different components of national income. The
importance of these estimates has increased consider-ably in developing countries
in framing their future development plans.
(d) The pivot of economic planning:
National income estimates constitute the pivot of economic planning as the entire
machinery of planning is based on “an appraisal of existing resources and an
accurate diagnosis of deficiencies” furnished by the national income estimates.
These estimates enable the government to determine the allocation of the country’s
resources on the different heads of development.
(e) Input-output analysis:
National Income data are also very useful for studying, as done by Prof. W. W.
Leontief, the structure of the economy through the input-output analysis.
(f) Measurement of inflationary and deflationary gaps:
Modern econo-mists take the help of the national income data for measuring the
inflation-ary or deflationary gaps found at any time in a country.
(g) Social accounting and the framing of the budget:
National income figures serve as the background of ‘Social Accounting’ and the
government’s annual budgets are also framed in the context of the country’s
national income estimates.
(h) Measuring the rate of growth and the per capita income:
The annual rate of increase in national income is considered to be the rate of
economic growth of a country. Moreover, the per capita income of the people of a
country is also calculated dividing the national income by the total popula-tion of a
country in a particular year.
(i) Comparison of living conditions:
The national income data are also very useful for comparing the overall economic
conditions, especially living conditions of the people of the different countries and
at different times.
Different Concepts of National income:
Gross Domestic Product
Gross Domestic Product, abbreviated as GDP, is the aggregate value of goods and
services produced in a country. GDP is calculated over regular time intervals, such
as a quarter or a year. GDP as an economic indicator is used worldwide to measure
the growth of countries economy. It is quantitative in nature.
Goods are valued at their market prices, so:
All goods measured in the same units (e.g., dollars in the U.S.)
Things without exact market value are excluded.
It is the total value of final goods and/ or services produced in the boundary of a
country in one financial year (01st April to 31st March)
Production done by foreign nationals in an economy is calculated in GDP if it is
done within the geographical boundary.
It is calculated at market price and is defined as GDP at market prices.
Different elements of the GDP are:
Wages and salaries
Interest
Rent
Undistributed profits
Depreciation
Mixed-income
Direct taxes
Dividend
GPD is used by businesses and economists to determine the economic performance
of the economy as a whole. A rising GDP is an indicator that the economy is
expanding and the people are spending their money, which shows an economy that
is growing stronger.
High GDP also helps investors in taking better investment decisions.
The concept of GDP was developed by an American economist named Simon
Kuznets in 1934 and is thereafter recognized as the gold standard for determining
the measure of a country’s economic growth since the Bretton Wood Conference
held in 1944.
Formula for Calculating GDP
The formula for calculating GDP is
Y = C + I + G + (X − M)
Where
Y= Gross Domestic Product
C = Consumption
I = Investment
G = Government spending
X = Exports
M = Imports
Methods of GDP Calculation
There are three different approaches for calculating GDP which is used by
economists. All these approaches produce the same results, theoretically.
Output Approach
Income Approach
Expenditure Approach
Output Approach : The Output approach, commonly known as production
approach is the market value of all the goods that are produced within the country.
The formula for calculating GDP by output approach is
GDP = GDP at market price – depreciation + NFIA (net factor income from
abroad) – net indirect taxes.
Income Approach : The Income approach of GDP calculation is based on the total
output of a nation with the total factor income received by residents or citizens of a
nation.
The formula for calculating GDP by income approach is
GDP = Compensation of employees + Rental & royalty income + Business cash
flow + Net interest
The compensation of employees is the total payments made to all the labourers and
employees.
Rent is earned by the businesses on the land, and profits are made by the business
from the sales of goods and services.
Interest is earned on the capital invested by the company.
Expenditure approach: The Expenditure approach calculates the GDP by
calculating the sum of all the services and goods produced in an economy.
The GDP can be calculated with the following formulae
Y = C + I + G + (X − M)
Where
Y= Gross Domestic Product
C = Consumption
I = Investment
G = Government spending
X = Exports
M = Imports
The components are described in brief here
Consumption is denoted by C. It stands for all the private spending, which includes
services, nondurable and durable goods.
Government expenditure is denoted by G and it includes employee salaries,
construction of roads and railways, airports, schools and expenditures in the
military.
Investment denoted by I, refers to all the investments which are spent on housing
and equipment.
Net exports is denoted by (X-M) which is the difference between total imports and
exports.
Types of GDP
1. Nominal GDP : Nominal GDP, also known as nominal gross domestic product
is the value of all the final goods and services at current market prices, or in other
words, it is GDP calculated at the current market prices.
Nominal GDP takes into account these factors such as inflation, price changes,
changing interest rates and money supply, at the time of determining GDP.
2. Real GDP : Real GDP is said to be the value of all goods and services
determined in an economy after taking into account the rate of inflation.
In other words, it is the inflation adjusted value of goods and services produced in
an economy in a year, therefore it is also known as inflation adjusted gross
domestic product.
Real GDP in addition to inflation also takes into account the deflation. Real GDP is
therefore a more accurate measure of the economy than the other measures, such as
Nominal GDP (which measures total output based on the prices).
Importance of GDP
GDP is regarded as the most important of the indicators that are used by
economists all over the world for determining the growth of an economy. It takes
into account the total production of the country during a year.
It serves as a major factor that is used for determining the development of the
economy and a very important parameter for estimating the performance of an
economy.
Limitations of GDP
GDP does not include non-market transactions.
It fails to indicate whether the growth of a nation is sustainable.
It fails to take into account the impact on human health and environment that may
arise as externalities from the production or consumption of the output.
Countries with the highest GDP
The following is the list of top 5 countries based on GDP
USA
China
Japan
Germany
India
Gross national product (GNP)
It refers to the total value of all the goods and services produced by the residents
and businesses of a country, irrespective of the location of production.
GNP takes into account the investments made by the businesses and residents of
the country, living both inside and outside the country. It also takes into account
the value of the products produced by the industries of the domestic origin.
GNP does not take into consideration the incomes earned by the foreign nationals
in the country or any products produced by a foreign company in the
manufacturing units in the country.
For calculating GNP, only the final goods and services are considered.
Intermediate goods are avoided as it leads to double counting.
To calculate the GNP for a nation, the following factors are considered:
Consumption expenditure
Investment
Government expenditure
Net exports (Total exports minus total imports)
Net income (Income earned by residents in foreign countries minus income earned
by foreigners in the country)
The mathematical formula for calculating GNP is expressed as follows:
Y=C+I+G+X+Z
Or
GNP = Consumption expenditure + Investment + Government expenditure + Net
exports + Net income
GNP considers the manufacturing of goods like equipment, machinery, agricultural
products, vehicles as well as some services like consulting, education, and health
care.
The cost of providing the services is not calculated separately as it is included in
the price of the final products.
Importance of GNP
GNP is considered as an important economic indicator by economists. It is used by
them for finding solutions to the economic issues such as poverty and inflation.
When income is calculated on the basis of per person irrespective of the location,
GNP becomes a much more reliable factor than GDP.
The information obtained from GNP is used for analysing the BoP (Balance of
Payments). In some countries or unions, such as the European Union, economists
use GNI or gross national income.
Drawbacks of GNP
The foreign exchange rate fluctuates. Therefore, it impacts the calculation.
It does not help in determining whether an economy is actually growing or
shrinking.
The GDP and GNP differences can be understood from the following points.
Parameters GNP GDP
The gross national product
The gross domestic product
amounts to the valuation of such
amounts to the valuation of
services and goods produced by
such services and goods which
a citizen of a country without
Concept are produced within the
any constraint on geographical
geographical confines of a
boundaries. It is computed
country. It is computed within
within a particular financial
a particular financial year.
year.
Gross domestic product is only
Gross national product is for for measuring the domestic
Purpose measuring all production by the production within the
country’s nationals geographical boundaries of a
country.
The production made by the The production made only on
Focus country’s citizens irrespective of the domestic front of a
the boundary country
Measurement of the contribution
What it seeks Measurement of the strength
of its citizens towards its
to measure of the economy of a country
economy
Measuring Production is measured on an Production is measured only
productivity international scale on a domestic scale
Services and goods which are
Services and goods which are
produced outside the domestic
produced by foreigners residing
Exclusion economy of a country is
within the country is excluded
excluded from the gross
from the gross national product
domestic product
What Is Net Domestic Product (NDP)?
Net domestic product (NDP) is an annual measure of the economic output of a
nation that is calculated by subtracting depreciation from gross domestic product
(GDP).
Net domestic product (NDP) is an annual measure of the economic output of a
nation that is adjusted to account for depreciation.
It is calculated by subtracting depreciation from the gross domestic product (GDP).
NDP, along with GDP, gross national income (GNI), disposable income, and
personal income, is one of the key gauges of economic growth that is reported on a
quarterly basis by the Bureau of Economic Analysis (BEA).
An increase in NDP would indicate growing economic health, while a decrease
would indicate economic stagnation.
How Net Domestic Product (NDP) Works
NDP accounts for capital that has been consumed over the year in the form of
housing, vehicle, or machinery deterioration. The depreciation accounted for is
often referred to as capital consumption allowance and represents the amount
needed to replace those depreciated assets.
NDP=GDP−Depreciation.
Distinguish between NNP and NDP.
NNP NDP
NNP = GNP – Depreciation NDP = GDP – Depreciation
It is equal to the product of per Currencies and the depreciation of
capita income and population. assets are taken into account.
It cannot be used for comparison
It gives the accurate total value of
across the world due to different
goods and services by a country.
rates of depreciation.
NNP is the National Income of an
It will always be lower than GDP.
economy.
The difference between NDP and
It is closely related to the concept
GDP indicates the obsoleteness of
of Gross National Product (GNP).
capital goods.
The narrowing of the gap between
It indicates the total production of NDP and GDP indicates that the
a country. capital stock position in the country
is improving.
Net national product(NNP)
NNP is the market value of all the finished goods and services that are produced by
citizens of a nation, living domestically and internationally during a year.
Net national product is also referred to as the value that is obtained by subtracting
depreciation from the gross national product (GNP).
Net national product considers all the goods, products and services that are
manufactured by the country’s citizens, irrespective of their location, or in other
words, net national product considers products that are produced domestically and
also from overseas.
NNP is one of the important metrics for determining the actual growth of a nation.
It measures how much the country is able to consume in a given period of time.
When the net national product (NNP) of a country declines or falls, then the
businesses consider moving to industries that are deemed to be recession-proof.
In case there is a rise in net national product, then the businesses shift their focus
on industries that are consumer led, such as travel and sales in order to generate
more sales
The depreciation that is calculated refers to the wear and tear of the capital assets
and the depreciation of human capital is observed when there is workforce
turnover.
The extent of workforce turnover helps in understanding the resources that will be
required to be spent by the companies in order to find new employees.
The net national product can be calculated by the following formula
NNP = GNP – Depreciation
Personal Income (PI): Is the total money income received by individuals and
households of a country from all possible sources before direct taxes. Therefore,
personal income can be expressed as follows:
PI=NI-Corporate Income Taxes-Undistributed Corporate Profits-
Social Security Contribution +Transfer Payments.
Disposable Income (DI) : It is the income left with the individuals after the
payment of direct taxes from personal income. It is the actual income left for
disposal or that can be spent for consumption by individuals.
Thus, it can be expressed as:
DI=PI-Direct Taxes
Per Capita Income (PCI): It is calculated by dividing the national income of the
country by the total population of a country.
Thus, PCI=Total National Income/Total National Population
Difficulties in calculation of national income
The Central Statistical Office (CSO) is the official agency that estimates the
national income of India. The assessment of national income is a tough job that is
challenged by practical and ideational issues.
1. Lack of reliable statistical data creates difficulty in estimating national income.
2. Services of housewives are not included in national income.
3. Ignorance and illiteracy of the people create problems in collecting statistical
data.
4. The practical difficulty in assessing the money value of services impede the
correct estimation of national income.
Measurement of National Income
There are three methods to calculate National Income:
1. Income Method
2. Product/ Value Added Method
3. Expenditure Method
● Income Method
In this National Income is measured as flow of income.
We can calculate NI as:
Net National Income = Compensation of Employees+ Operating surplus
mixed (w +R +P +I) + Net income + Net factor income from abroad.
Where,
W = Wages and salaries
R = Rental Income
P = Profit
I = Mixed Income
● Product/ Value Added Method
In this National Income is measured as flow of goods and services.
We can calculate NI as:
NATIONAL INCOME = G.N.P – COST OF CAPITAL – DEPRECIATION –
INDIRECT TAXES
● Expenditure Method
In this National Income is measured as flow of expenditure.
We can calculate NI through Expenditure method as:
National Income=National Product=National Expenditure. Major Difficulties in
the Measurement of National Income
Major difficulties in the measurement of national income.
1. Prevalence of Non-Monetized Transactions:
There are certain transactions in India in which a considerable part of output does
not come into the market at all.
Agriculture in which a major part of output is consumed at the farm level itself.
The national income statistician, therefore, has to face the problem of finding a
suitable measure for this part of output.
2. Illiteracy:
The majority of people in India are illiterate and they do not keep any accounts
about the production and sales of their products. Under the circumstances the
estimates of production and earned incomes are simply guess work.
3. Occupational Specialisation is Still Incomplete and Lacking:
There is the lack of occupational specialisation in our country which makes the
calculation of national income by product method difficult. Besides the crop,
farmers are also engaged is supplementary occupations like—dairying, poultry,
cloth-making etc. But income from such productive activities is not included in the
national income estimates.
4. Lack of Availability of Adequate Statistical Data:
Adequate and correct produc-tion and cost data are not available in our country.
For estimating national income data on unearned incomes and on persons
employed in the service are not available. Moreover data on consumption and
investment expenditures of the rural and urban population are not available for the
estimation of national income. Moreover, there is no machinery for the collection
of data in the country.
5. Value of Inventory Changes.
The value of all inventory changes (i.e., changes in stock etc.) which may be either
positive or negative are added or subtracted from the current production of the
firm. Remember, if in the change in inventories and not total inventories for the
year that are taken into account in national income estimates.
The Calculation of Depreciation:
The calculation of depreciation on capital consumption presents another
formidable difficulty. There are no accepted standard rates of depreciation
applicable to the various categories of machine. Unless from the gross national
income correct deductions are made for depreciation the estimate of net national
income is bound to go wrong.
7. Difficulty of Avoiding the Double Counting System:
The very important difficulty which a calculator has to face in measurement is the
difficulty of avoiding double counting.
Example: The value of bread sold is inclusive of the value of the flour, the
manufacturing, the packaging, and transport. If we added the cost of transport once
again to the final value of bread, the error of double-counting has been committed.
8. Difficulty of Expenditure Method:
The application of expenditure method in the calculation of national income has
become a difficult task and it is full of difficulties. Because in this method it is
difficult to estimate all personal as well as investment expenditures.
Circular flow of Income
Types of Flow
There are two types of flow within the model, i.e. Real flow and Money flow:
Real Flow: It is the mobilization of resources and commodities in the
economy. For example, factors of production, goods and services.
Money flow: It depicts the movement of money between households and
firms. For example, factor payments and consumption expenditure.
Two-Sector Model
This model shows the circular flow of income in a simple economy. It
consists of two sectors, i.e. households and firms. The domestic sector
provides the factors of production to the firms like:
● Land
● Labour
● Capital
● Enterprise
The firms use these resources in the production of goods and services. The
household spends its total income on the consumption of goods and
services. On the other hand, firms make factor payments like:
● Wages
● Rent
● Interest
● Profits, etc.
Assumptions of a two-sector model
1. The firms recruit factors of production from the domestic sector.
2. The households consume goods and services produced by firms.
3. There are no savings and investments.
4. There are no borrowings among the households.
5. Complete absence of foreign trade.
6. No role of government.
Three-Sector Model
The Three-sector Model includes government along
with domestic and corporate sectors. It plays a crucial role in maintaining
balance in the economy.
Government acts both as a producer and consumer for households
and firms. As it receives money in the form of direct and indirect taxes.
Whereas, spends money by giving subsidies, services and investments in
construction projects.
The flow of income between government and different sectors is as follows:
● Household and Government
The government take factors of production (army, administration, etc.)
from the household. On the other hand, makes factor payments
(salary, pensions, scholarships, etc.) to them. Also, the households
pay direct taxes to the government.
● Firms and Government
The government purchases goods and services of the firms. Also,
provide subsidies to them. Firms pay corporate taxes to the
government.
● Financial Market and Government
The government invests excess money into financial markets. It also
borrows money from the market to pay off its expenses.
Therefore, in the three-sector model, the equilibrium is obtained when
C+S+T=C+I+G
Where,
C is consumption
S is savings
T is taxes
I is investments
G is government expenditure
Four-Sector Model
The Four-sector model shows the flow of income in an open economy. It
consists of economic activities between the three sectors with the
foreign sector/rest of the world. The trading involves imports and exports
with foreign countries.
In an open economy, imports and exports affect the national income.
Assumptions of a four-sector model
1. Only exports and imports of goods & services are taking place.
2. The domestic sector exports only human resources and receives
foreign remittances.
The flow of income between foreign and different sectors is as follows:
● Household and Foreign Sector
The household provides human resources and pays for imports to the
foreign sector. They receive factor payments and transfer payments
from the foreign sector.
● Firms and Foreign Sector
The firm exports goods and services to the foreign sector. In return,
they receive payments for the exports.
● Government and Foreign Sector
The government export and import goods and services to/from the
foreign sector. It receives payments for exports and makes payments
for imports. Also, it receives payment through duties and taxes during
foreign trade.
● Financial Market and Foreign Sector
The foreign sector invests and borrows money from the financial
market. For example, Foreign Direct Investment (FDI).
There can be three possibilities:
1. Exports > Imports
● Increment in National Income
● The outflow of Goods and services
● Inflow of money
● Injection in the flow of income
2. Imports > Exports
● Decrease in National Income
● Outflow of money
● The inflow of goods and services
● Leakage in the flow of income
3. Imports = Exports
● A balanced flow of income
Therefore in the Four-sector model, the equilibrium is obtained when
Y = C + I + G + (X-M)
Where,
Y is Income
C is Consumption Expenditure
I is Investment Expenditure
G is Government Expenditure
X-M is Net Exports
Principles of Circular Flow Model
In the exchange process, the amount purchased should be equal to the amount spent.
The mobilization of goods and services should be in one direction. The receipts from them should be in
the opposite direction.
The real and money flow are opposites, which causes a circular flow.
The income flow from sectors should always show receipts and payments.
Importance of Circular Flow Model
1. It is a measure of National Income.
2. Gives an idea about the injection or leakage in the flow of money.
3. It shows the interdependence of economic sectors and their
activities.
4. Represents the overall health of the economy.
5. The model helps to detect causes and remedies for the imbalance in
the economy.
Limitations of Circular Flow Model
●
● Assumptions: These models are based on assumptions. It does
not provide a clear picture of the economic equations.
● Non-Monetary Transactions: Non-monetary transactions are
excluded from the model.
● Dynamic Environment: The dynamic environment leads to
continuous changes in the economy.
● Natural Disasters: Natural disasters cause huge damage to the
country’s economy. But, the decrease in money flow due to
disasters is not considered.
