Three Approaches to measuring National Income

National income measures the income generated by a country through the production activities that are carried out within a country during a specific period of time.

A circular flow of income and expenditure exists within an economy, where factor income is earned from the production of goods and services, and the income is spent on the purchase of produced goods. Thus, there are three alternative methods of computing national income. This includes:

• Income/Factor Income Method
• Expenditure Method

The value added method/ product method is also known as the output method or inventory method. In this method, the sum total of the gross value of the final goods and services in different sectors of the economy like industry, service, agriculture, etc. is acquired for the current year by determining the total production that was made during the specific time period. The value obtained is the gross domestic product. Thus, according to this method,

GDP= Total product of (industry + service + agriculture) sector

Symbolically, GDP= ∑ (P × Q)

Where,

P= Market price of goods and services

Q= Total volume of Output

Sometimes goods produced by one sector is further processed by another sector. These goods are termed as intermediate goods and are already included while determining the value of final goods.

So, in order to avoid the problem of double counting of value of goods, the product method if further categorized into two approaches:

The Final Goods Approach

In this method, only the value of final goods and services are computed while estimating GDP, regardless of any intermediate goods and their processing. This method takes into account only those goods and services that purchased and consumed by the final consumers in the economy.

In the value added method of measuring national income, the value of materials added by producers at each stage of production to produce the final good is considered. The difference between the value of output and inputs at each stage of production is the value added. Thus,

Value added= Value of output – Cost of intermediate goods

If the differences are added up for all production sectors in the economy, the value of GDP is computed. The table below clearly explains this method:

Producers Stage of Production Selling Price (Rs.) Cost Price (Rs.) Value Added (Rs.)
Farmer Wheat 60 0 60
Miller Flour 90 60 30
Total 250 150 100

Table 1: Estimation of National Income by Value Added Method

Income/Factor Income Method

Income method is also termed as factor income method or factor share method. Under this method, national income is measured as the total sum of the factor payments received during a certain time period.

The factors of production include land, labor, capital, and entrepreneurship. Individuals who provide these factor services get payment in the form of rent, wages/salaries, interest, and profit respectively. The total sum of income received by these individuals comprise the national income for a given period of time.

Besides these, there are professionals who employ their own labor and capital like advocates, doctors, barbers, CAs, etc. The income of these individuals are called mixed incomes and are also accounted for calculating the national income. However, income received in the form of transfer payments are not included.

Thus, according to this method,

GDP= Rent (Rental incomes on agricultural and non-agricultural properties)

+ Wages/Salaries (Wages and salaries earned by employees including supplements)

+ Interest (Net interest earned by individuals other than governmental bodies)

+ Undistributed Profit (Profits earned by businesses before payment of corporate taxes and liabilities)

+ Dividends

+ Direct taxes

+ Depreciation

Expenditure Method

The expenditure method measures the national income as the sum total of expenditures made by individuals on personal consumption, firms on private investments, and government authorities on government purchases.

Since incomes from production are earned as a result of expenditure made by other entities on the produced goods and services within the economy, the result of expenditure method should be same total as the product method. However, with an exception of avoiding intermediate expenditure in order to evade the problem of double counting, national income under expenditure method can be expressed as

GDP= C + I + G + (X – M)

Where, C= Consumption Expenditure (Expenditure on durable goods such as furniture, cars, and non-durable goods such as food)

I= Investment Expenditure (Private investment in capital goods or producer goods such as buildings, machinery, etc.)

G= Government Expenditure (Government expenses for maintaining law and order, developing pre-requisites of development, etc.)

(X-M)= Net Export (Difference between import and export)