National Income Project

PROJECT ON NATIONAL INCOME

Submitted to:

Submitted by:

Professor Meenu Sehjpal

Yash Ajmani

UILS, PU, Chd.

BA LLB(1st sem) Rollno.-117

ACKNOWLEDGEMENT This acknowledgement is intended to be thanks giving gesture to all those people who have been involved directly or indirectly with my dissertation work. First and foremost, I express my special thanks with gratitude and great respect to my valuable teacher Professor Meenu sehjpal for her keen interest in my case study, fruitful suggestions and valuable guidance. I am also thankful to her for her great patience apart from invaluable guidance. Her wisdom, patience and humor helped me and guided me through all the difficulties to the end. I was truly fortunate to have Professor Meenu Sehjpal as my teacher. I would like to thank my family continous support that kept my spirit up during the endeavor.

CONTENTS 1. INTRODUCTION

2. DIFFERENT PHASES OF CIRCULAR FLOW i.

PHASE OF PRODUCTION

ii.

PHASE OF DISTRIBUTION OF INCOME

iii.

PHASE OF EXPENDITURE OF INCOME

3. DIFFERENT METHODS OF CIRCULAR FLOW a. PRODUCT METHOD b. INCOME METHOD c. EXPENDITURE METHOD 4. BIBLIOGRAPHY

1) INTRODUCTION National Income is the total amount of goods and services produced within some "boundary. " The boundary is usually defined by geography or citizenship, and may also restrict the goods and services that are counted. A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region, including gross domestic product (GDP), gross

national product (GNP), net national income (NNI), and adjusted national income (NNI* adjusted for natural resource depletion). All of the measures are especially concerned with counting the total amount of goods and services produced within some boundary. The boundary is usually defined by geography or citizenship, and may also restrict the goods and services that are counted. For instance, some measures count only goods and services that are exchanged for money, excluding bartered goods, while other measures may attempt to include bartered goods by imputing monetary values to them. Arriving at a figure for the total production of goods and services in a large region like a country entails a large amount of data-collection and calculation. Although some attempts were made to estimate national incomes as long ago as the 17th century, the systematic keeping of national accounts, of which these figures are a part, only began in the 1930s, in the United States and some European countries. The impetus for that major statistical effort was the Great Depression and the rise of Keynesian economics, which prescribed a greater role for the government in managing an economy, and made it necessary for governments to obtain accurate information so that their interventions into the economy could proceed as well-informed as possible.

2) Three Different Phases of Circular Flow Indicating Three Different Methods of Calculating National Income As it is assumed that the flow of income is circular. The circularity of income never stops because it is linked with the circularity of production. And circularity of production never stops because it is linked with the circularity of consumption, which never stops. A deeper insight into the circular flow of income reveals that this process passes through three different phases, viz. 1. Phase of Production, 2. Phase of Distribution of Income, 3. Phase of Expenditure of Income. In phase 1, the producing sector is themselves engaged in the production of goods and services. The firms purchases factors of production from the households and organize these factors to produce goods and services. Production leads to creation of utility as raw materials are converted

in useful things. Utility creation is also called value addition. This is measured as the difference between the market value of output and the market value of non-factor inputs. This is equal to the market value of final goods and services produced in the economy during the period of an accounting year. This is what is called Domestic Product. In phase 2, value added is distributed among those who have contributed to the process of value addition. Logically, the entire value added is distributed among the owners of the factors of production by the way of rent, interest, profit and compensation of employees. These are the factor payments from the view point of the firms, and factor incomes from the viewpoint of the households. The sum total of these factor incomes is called Domestic Income. In phase 3 the households spend their entire income on the purchase of final goods and services. Accordingly, domestic income is converted into the expenditure on the purchase of final goods and services produced in an economy during a financial year. Since domestic income = domestic product and since entire domestic income is spent on the purchase of final goods and services produced during the year, this emerges an obvious conclusion that domestic product =domestic income= expenditure on domestic product and is called triple identity. The triple identity suggests that domestic or national income can be looked at from three different angles: (i) as the sum total of all value added by producing units in the economy. (ii) as the sum total of factor incomes generated in the economy during the period of an accounting year. (iii) as the sum total of expenditure on the final goods and services produced in the economy during an accounting year. These different angles of looking at the domestic/ national income correspond to three different phases of the circular flow of income. Thus, the circular flow of income model suggests three different methods of estimating domestic/national income: (i) Product method (ii) Income method (iii) Expenditure method.

I.

PRODUCT METHOD

Product method and value added method are synonyms of each other. This method measures national income in terms of value addition by each producing enterprise in the economy during an accounting year. The concept of value addition says that value added is the difference between value of output of an enterprise and the value of its intermediate consumption.  Value added = Value of output – Intermediate consumption.  Value of output refers to the market value of goods produced by a firm during an accounting year. If the entire output is sold during the year, value of output = sales.  If some output remains unsold, it is added to the firm’s inventory stock. It is expressed as change in stock during the year.  Value of output = Sales + Stock  Stock = Closing stock- Opening stock  Intermediate consumption refers to value of non-factor inputs. Basically, it includes the value of raw materials used in the process of production. GDPMP = Gross value added by all the producing enterprises within the domestic territory of a country during the period of one year. Having estimated GDPMP, we find out the NNPFC by this way: o NNPFC = GDPMP – Depreciation – Net Indirect taxes + Net factor income from abroad

Precautions regarding product method Following are some important precautions regarding product method: 1) Value of sale and purchase of second hand goods is not included in value added. Because, value of second hand goods is already accounted for during the year they were produced. 2) Commission earned on account of the sale and purchase of second hand goods is included in the estimation of value added. Because, commission is a reward for the service rendered. 3) Own account production of goods of the producing units is taken into account while estimating value added. Because, these goods are like those produced for the market. They are simply not sold owing to their need by the producers themselves.

4) Value of intermediate goods is not included in the estimation of value added. Because, value of intermediate goods is reflected in the value of final goods. 5) Imputed value of production for self-consumption is taken into account. Because, these goods are like those produced for the market. They are not sold dimply because of their need by the producers themselves. 6) Imputed rent on the owner occupied house is also taken into account. Because, all houses have rental value, no matter these are self-occupied or tented out. 7) Services for self-consumption are not considered while estimating value added. Simply because, it is difficult to estimate their market value. 8) The value added in the government sector is equal to compensation of employees only. It is because the data regarding rent and interest are not available for this sector and profit just does not exist because all that is produced is meant for collective consumption, not for sale in market.

II.

INCOME METHOD It is also called Distributed share method or factor payment method. Accordingly, national income is measured in terms of factor payments to the owners of factors of production during an accounting year. o Factor Incomes refers to income earned by a person as a reward rendering his factor service. It may be in the form of wage/salary for his labour, rent for his land, interest for his capital or profit for his entrepreneurship. The factor incomes are those which are

earned, any unearned income will not be included in factor incomes.  Classification of Factor incomes  Compensation of Employees  Wages and salaries in cash: it refers to cash paid to the employees by the employers 

as a reward for the work done during the period of an accounting year. Payments in kind: it refers to benefits in kind given to the employees by the



employers. Employers’ contribution to social security: it refers to such payments as provident



fund by the employers on the behalf of the employees. Pension on Retirement: it only refers to the pension-payments as a part of the

‘Service-Contract’ between the employer and the employees.  Operating Surplus: it refers to income from property and entrepreneurship.  Rent

 

Interest Profit  Dividends: this part of profit is distributed among the shareholders, also called 

distributed profit. Corporate Profit Tax: the part of profit which is paid to the government by the



way of ‘profit tax’. Undistributed Profit: the part of profit which is retained by the firms for future

use, also known as ‘corporate savings’ or ‘retained earnings’.  Royalty  Mixed Income refers to the income of the self-employed persons using their own land, labour, capital and entrepreneurship for producing goods and services. These incomes are a mixture of wages, rent, interest, profit, i.e. why known as mixed incomes. The sum total of factor incomes generated within the domestic territory of a country is called NDPFC (Net Domestic Product at Factor Cost). o NDPFC = Compensation of Employees + Operating Surplus + Mixed Income o NNPFC = NDPFC + Net factor income from abroad Precautions regarding income method Following are the precautions regarding income method: 1) Transfer earning like old age pensions, are not to be included in the national income. Because, corresponding to transfer payments, there is no value addition in the economy. However, retirement pensions are to be included in national income. 2) Income from illegal activities like theft and gambling etc., is not to be included in national income. 3) Commissions paid on sale and purchase of second hand goods are to be included in national income as these are a reward for rendering factor services. 4) Brokerage on sale/purchase of shares and bonds is to be included in national income. Because this is a reward for factor services. 5) Income in terms of windfall gains should not be included as there is no value addition corresponding to windfall gains. Likewise, income in the form of capital gains is not to be treated as factor income 6) Imputed rent of owner occupied houses is to be treated along with rent as a component of factor incomes.

7) Corresponding to production for self-consumption, there should be generation of income in the economy. It should be taken account of. 8) Corporate tax, dividends and undistributed profits are all the components of corporate profits. Once profit is included in all the estimation of national income, any of these components should not separately added. 9) Income tax is paid out of compensation of employees. It should not be separately added in the estimation of national income. 10) Wages and salaries in cash and kind-as well as social security contribution by the employers on the behalf of employees are all components of compensation of employees. Any of these components should not be separately added once compensation of employees is included in the estimation of national income.

III.

EXPENDITURE METHOD According to this method, national income is measured in the terms of expenditure on the purchase of final goods and services produced in an economy during an accounting year. Since final expenditure comprises of Consumption and Investment, it is also known as

Consumption and Investment method.  Classification of Final Expenditure Final expenditure = C + I + G + (X-M)  Private final consumption Expenditure refers to expenditure on final goods and services by the individual households and non-private institutions serving society. It includes:  Consumer services.  Consumer non-durable goods.  Consumer durable goods.  Investment Expenditure refers to expenditure on purchase of final goods by the producers. It is further classified as under:  Fixed Investment is the expenditure incurred by the producers on the purchase of fixed assets like plants and machinery. It is often classified as (i) Business fixed investment, (ii) Fixed investment by the households, and (iii) Public fixed investment.  Inventory Investment: it refers to the change in stock during the year.  Net Exports (X-M) Net exports refers to the difference between exports and imports during an accounting year.

Sum total of expenditure on the domestically produced goods and services during an accounting year is called GDPMP (Gross Domestic Product at Market Price). o Private final consumption expenditure +government final consumption expenditure +business fixed investment +government fixed investment +investment on residential construction +inventory investment (= stock=closing stock-opening stock) +net exports(X-M) =GDPMP (Note: Gross domestic fixed investment is also called gross domestic fixed capital formation as investment implies capital formation or adding to the stock of the capital) GDPMP is converted into NNPFC (national income) in terms of the following equation: o NNPFC=GDPMP –DEPRECIATION-N.I.T+NFYA Precautions regarding expenditure method The following precautions are to be taken while using expenditure method; 1) Only final expenditure is to be taken into account to avoid error of double counting. Final expenditure is to be interpreted as expenditure on the final goods and services. Expenditure on the intermediate goods and services must be avoided. 2) Expenditure on the second hand goods is not to be included because value of second hand goods has already taken into the account during the year of the production. 3) Expenditure on shares and bonds is not to be included in total expenditure, as these are mere paper claims and are not related to the production of final goods and services. Such 4)

expenditures do not cause any value addition. Expenditure on transfer payment by the government is not included, because transfer

payments do not cause any value addition in the economy. 5) Imputed value of expenditure on goods produced for self-consumption should be taken into account, as these goods are reflected in the estimation of GDP. Also, imputed rent on owner occupied houses should be taken into account.

Factors causing increase in National Income The prosperity of any country depends upon the large size of national income. While the size of national income depends on the following factors: 1.) Natural resources Natural resources are those which are God gifted like land, minerals, rivers, mountains and climate. If any country is rich in natural resources, its national income will be greater. So the national income volume depends upon the natural resources. 2.) Man made sources Roads, Canals, Buildings, Railway, factories are manmade sources and are in large number then the size of national income will be greater. 3.) Capital Capital is considered the life blood for the modern economy. The volume of production depends upon the quality and quantity of capital available in the country. "Poor country is poor because it is poor." Under developed countries per capita income is low because there is deficiency of capital. 4.) Human resources National income also depends upon the human resources. If natural resources are available but a country is under populated then the size of national income will be small. If the labour is skilled, educated and efficient then the size of national income will be large. 5.) State of technology If there is a lack of technology in any country, the size of national income will be small. On the other hand, if advance technology is available in any country then its size of national income will be large. 6.) Entrepreneurial ability If this ability is available in large number in any country, then the size of national income

will be large. If any country is lacking this ability the size of national income will be small. 7.) Political stability If there is a political stability in the country, the production can be maintained at the highest level and the size of national income will be large. The production is adversely affected by the political unrest. 8.) Spirit of work If the people are patriotic and they want to develop their country then they will perform their duties honestly, and efficiently. In this way they will increase the national income. 9.) Division of labour and specialization If the scale of production is large then division of labour and specialization process will start which is very useful in increasing the production of the country.

BIBLIOGRAPHY 1) H.L AHUJA 2) T.R JAIN AND V.K OHRI 3) Branson W.H (2002), Macroeconomic Theory and policy ,AITBS, Delhi 2nd Edition

4) http://www.economicsonline.co.uk/Managing_the_economy/National_income.html 5) http://en.wikipedia.org/wiki/Measures_of_national_income_and_output 6) http://en.wikipedia.org/wiki/Gross_national_income