Unit 5: National Income

Table of Contents

National Income Concepts (GNP, GDP, NNP, NDP)

National Income is the total monetary value of all final goods and services produced in an economy during a given period (usually one year).

Key Conversion Rules:

  1. Gross vs. Net:
    • Gross = Total value produced.
    • Net = Total value minus Depreciation (wear and tear of capital).
    • Net = Gross - Depreciation
  2. Domestic vs. National:
    • Domestic = Produced *within the geographical territory* of a country (by anyone).
    • National = Produced *by normal residents (nationals)* of a country (anywhere in the world).
    • National = Domestic + Net Factor Income from Abroad (NFIA)
    • (NFIA = Factor income earned by residents from abroad - Factor income paid to non-residents)
  3. Market Price (MP) vs. Factor Cost (FC):
    • Market Price = What the consumer actually pays.
    • Factor Cost = What the producer actually receives.
    • MP = FC + Net Indirect Taxes (NIT)
    • FC = MP - Net Indirect Taxes (NIT)
    • (NIT = Indirect Taxes - Subsidies)

The Main Aggregates:

National Income (NI) is officially defined as Net National Product at Factor Cost (NNP_FC).
NI = NNP_FC = NNP_MP - Net Indirect Taxes (NIT)

Personal Income Concepts (Private, Personal, Per Capita)

Private Income

Private Income is the total income earned by the private sector (households and private firms) from all sources (both earned and unearned).

Private Income = (NI) - (Income from property/entrepreneurship accruing to Govt) - (Savings of Non-Departmental Enterprises) + (All Transfer Payments)

Personal Income (PI)

Personal Income is the income actually received by households and individuals from all sources *before* paying personal taxes.

PI = Private Income - Undistributed Corporate Profits - Corporate Taxes

(It is the income households get, so we must remove the profits that firms keep).

Personal Disposable Income (PDI)

Personal Disposable Income is the income households have left *after* paying personal direct taxes (like income tax). This is the income they can actually spend or save.

PDI = Personal Income - Personal Direct Taxes - Fines, Fees, etc. PDI = Consumption (C) + Saving (S)

Per Capita Income (PCI)

Per Capita Income is the average income per person in the country. It is a rough measure of the standard of living.

PCI = National Income (NNP_FC) / Total Population

Real and Nominal Personal Income

This concept applies to all income aggregates (GDP, GNP, Personal Income, etc.).

Nominal Income

Real Income

Real Income = (Nominal Income / Price Index) × 100

The Price Index used to convert nominal GDP to real GDP is called the GDP Deflator.

Methods of Measuring National Income

There are three main methods to measure National Income (GDP), which should all give the same result:

1. Product Method (or Value Added Method)

This method sums up the value added by all producing firms in the economy. Value added is the market value of a firm's output minus the value of intermediate goods it purchased.

Value Added = Value of Output - Intermediate Consumption GDP_MP = Sum of Gross Value Added by all firms in the economy
Exam Tip: This method is the best way to avoid the problem of double counting (counting the value of the same good multiple times, e.g., counting the wheat, the flour, *and* the bread).

2. Income Method

This method sums up all the factor incomes earned by the factors of production (land, labor, capital, entrepreneurship). This gives NDP_FC (Net Domestic Product at Factor Cost).

NDP_FC = Compensation of Employees + Operating Surplus + Mixed Income

To get to NI (NNP_FC) from here: NI = NDP_FC + NFIA

3. Expenditure Method

This method sums up all the final spending on goods and services in the economy. This gives GDP_MP.

GDP_MP = C + I + G + (X - M)

Difficulties in Measuring National Income

Calculating an accurate NI figure is extremely difficult due to several conceptual and practical problems:

  1. Problem of Double Counting: The risk of counting the value of intermediate goods multiple times. (Solved by the Value Added method).
  2. Non-Monetized Sector: In economies like India, many transactions are not in money (barter system) or are for self-consumption (e.g., a farmer growing food for his own family). This output is not counted.
  3. Non-Market Activities: GDP excludes a vast amount of valuable unpaid work.
    • Example: Services of a homemaker, DIY home repairs, volunteer work.
  4. The "Black" or Informal Economy: Illegal activities (e.g., smuggling) and legal but unreported income (to avoid taxes) are not included, leading to underestimation.
  5. Lack of Reliable Data: In many developing countries, data collection is poor, and records from small-scale producers are inaccurate or unavailable.
  6. Depreciation: Calculating the *true* value of depreciation (wear and tear) of capital is very difficult and often just an estimation.

National Income and Economic Welfare

Does a high or rising National Income (GDP) mean a high level of social welfare or well-being? Not necessarily. GDP is a flawed measure of welfare for many reasons:

Limitations of GDP as a measure of well-being:

  1. Distribution of Income: A high GDP could be concentrated in the hands of a few (high inequality), so the average person may not be better off. A high Per Capita Income can hide this.
  2. Composition of Output: GDP only measures *how much* is produced, not *what* is produced. A country that produces more weapons and a country that produces more schools could have the same GDP, but very different welfare levels.
  3. Externalities (Negative): GDP can *increase* due to harmful activities.
    • Example: A factory pollutes a river (which isn't subtracted from GDP). Then, the government spends money to clean it up (which is *added* to GDP). GDP rises, but welfare has clearly fallen.
  4. Leisure: GDP doesn't value leisure time. If everyone works 80 hours a week, GDP might soar, but well-being (welfare) would collapse.
  5. Non-Market Activities: As mentioned before, GDP excludes valuable unpaid work (housework, childcare, volunteering) that contributes greatly to welfare.

Conclusion: GDP is a good measure of economic production, but a poor measure of economic welfare.

Circular Flow of Income in Two Sector, Three Sector and Four Sector Economy

(This is a review and application of the concepts from Unit 4)

The Circular Flow of Income model shows how income and spending flow between different sectors of the economy. It demonstrates the identity that Total Leakages must equal Total Injections for the economy to be in equilibrium.

Equilibrium Conditions:

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