Pre Evaluation & Assessment Test ( Flashcard Quiz Game )
- The Flashcard Quiz contains questions that are based on this unit in the following tabs.
- Attempt this quiz and pay sufficient attention to each question and think for the probable answer.
- This exercise will give you a clear insight needed to approach the topics in this unit for a better understanding.
- Re-attempt this test after you finish reading the topics for a deep rooted interpretation of basic concepts.
- Happy Learning !!
Let us consider a simplified version of economy where there is –
- no government;
- no external trade;
- households do not save;
- households do not pay taxes to the government as there is no government.
There may fundamentally be four kinds of contributions that can be made during the production of goods and services –
- (a) contribution made by human labour, remuneration for which is called wage
- (b) contribution made by capital, remuneration for which is called interest
- (c) contribution made by entrepreneurship, remuneration of which is profit
- (d) contribution made by fixed natural resources (called ‘land’), remuneration for which is called rent.
In this simplified economy, there is only one way in which the households may dispose off their earnings – by spending their entire income on the goods and services produced by the domestic firms. The other channels of disposing their income are closed as we have assumed it’s a simple economy. In other words, factors of production use their remuneration to buy the goods and services which they assisted in producing.
The aggregate consumption by the households of the economy is equal to the aggregate expenditure on goods and services produced by the firms in the economy. The entire income of the economy, therefore, comes back to the producers in the form of sales revenue. There is no leakage from the system – there is no difference between the amount that the firms had distributed in the form of factor payments (which is the sum total of remuneration earned by the four factors of production) and the aggregate consumption expenditure that they receive as sales revenue.
In the next period the firms will once again produce goods and services and pay remuneration to the factors of production. These remunerations will once again be used to buy the goods and services. Hence year after year we can imagine the aggregate income of the economy going through the two sectors, firms and households, in a circular way.
When the income is being spent on the goods and services produced by the firms, it takes the form of aggregate expenditure received by the firms. Since the value of expenditure must be equal to the value of goods and services, we can equivalently measure the aggregate income by calculating the aggregate value of goods and services produced by the firms. When the aggregate revenue received by the firms is paid out to the factors of production it takes the form of aggregate income.
In the above figure –
- The uppermost arrow, going from the households to the firms, represents the spending the households undertake to buy goods and services produced by the firms. The second arrow going from the firms to the households is the counterpart of the arrow above. It stands for the goods and services which are flowing from the firms to the households. In other words, this flow is what the households are getting from the firms, for which they are making the expenditures. In short, the two arrows on the top represent the goods and services market – the arrow above represents the flow of payments for the goods and services, the arrow below represents the flow of goods and services.
- The two arrows at the bottom of the diagram similarly represent the factors of production market. The lower most arrow going from the households to the firms symbolises the services that the households are rendering to the firms. Using these services the firms are manufacturing the output. The arrow above this, going from the firms to the households, represents the payments made by the firms to the households for the services provided by the latter.
Since the same amount of money, representing the aggregate value of goods and services, is moving in a circular way, if we want to estimate the aggregate value of goods and services produced during a year we can measure the annual value of the flows at any of the dotted lines indicated in the diagram. We can measure the uppermost flow (at point A) by measuring the aggregate value of spending that the firms receive for the final goods and services which they produce.
This method will be called the expenditure method. If we measure the flow at B by measuring the aggregate value of final goods and services produced by all the firms, it will be called product method. At C, measuring the sum total of all factor payments will be called income method.
Observe that the aggregate spending of the economy must be equal to the aggregate income earned by the factors of production (the flows are equal at A and C).
Now let us suppose that at a particular period of time the households decide to spend more on the goods and services produced by the firms. For the time being let us ignore the question where they would find the money to finance that extra spending since they are already spending all of their income (they may have borrowed the money to finance the additional spending). Now if they spend more on the goods and services, the firms will produce more goods and services to meet this extra demand. Since they will produce more, the firms must also pay the factors of production extra remuneration. How much extra amount of money will the firms pay? The additional factor payments must be equal to the value of the additional goods and services that are being produced. Thus the households will eventually get the extra earnings required to support the initial additional spending that they had undertaken.
In other words, the households can decide to spend more – spend beyond their means. And in the end their income will rise exactly by the amount which is necessary to carry out the extra spending.
Putting it differently, an economy may decide to spend more than the present level of income. But by doing so, its income will eventually rise to a level consistent with the higher spending level.
This may seem a little paradoxical at first. But since income is moving in a circular fashion, it is not difficult to figure out that a rise in the flow at one point must eventually lead to a rise in the flow at all levels. This is one more example of how the functioning of a single economic agent (say, a household) may differ from the functioning of the economy as a whole. In the former the spending gets restricted by the individual income of a household. It can never happen that a single worker decides to spend more and this leads to an equivalent rise in her income.
The above mentioned sketchy illustration of an economy is admittedly a simplified one. Such a story which describes the functioning of an imaginary economy is called a macroeconomic model. It is clear that a model does not describe an actual economy in detail. For example, our model assumes that households do not save, there is no government, no trade with other countries. However models do not want to capture an economy in it’s every minute detail – their purpose is to highlight some essential features of the functioning of an economic system. But one has to be cautious not to simplify the matters in such a way that misrepresents the essential nature of the economy. The subject of economics is full of models. One task of an economist is to figure out which model is applicable to which real life situation.
If we change our simple model described above and introduce savings, will it change the principal conclusion that the aggregate estimate of the income of the economy will remain the same whether we decide to calculate it at A, B or C? It turns out that this conclusion does not change in a fundamental way. No matter how complicated an economic system may be, the annual production of goods and services estimated through each of the three methods is the same.
We have seen that the aggregate value of goods and services produced in an economy can be calculated by three methods. Lets now understand the detailed steps of these calculations at –
- The Product Or Value Added Method
- Income Method
- Expenditure Method
National income is a flow. This flow can be looked at from three different angles.. Hence, there are three different methods of measuring national income.
The production units produce goods and services. For this they employ four factors of productions viz, land, labour, Capital and entrepreneurship. These four factors of production jointly produce goods and services i.e. they add value to the existing goods. This value added i.e. net domestic product is distributed among the owners of four factors of production receive rent, compensation of employees, interest and profit for their contribution to the production of goods and services.
The incomes received by the owners of the factors of production are spent on the purchase of goods and services from the production units for the purpose of consumption and investment. In short, production generates income. Income is used for expenditure, and expenditure, in turn, leads to further production. There are three phases of circular flow of national income. So there are three methods of measuring national Income. They are –
(A) Output or value added method ; (B) Income method ; (C) Expenditure Method.
With the help of this method national income is estimated at production level. At production level national income is the value of final goods and services produced in a country within the domestic territory plus net factor income from rest of the world.
In this method following steps are involved –
First : all the producing enterprises in an economy are broadly classified into three industrial sectors according to their activities. These are – Primary, Secondary & Tertiary sectors.
- Primary sector consists of those producing units which are carried out by using natural resources. It includes productive activities like agriculture, forestry, fishing mining etc.
- Secondary sector includes those producing units which transform inputs into output for example – transformation of wood into a chair. It includes sub sectors like construction, manufacturing, electricity, gas and water supply.
- Tertiary sector produces services of all kinds such as banking, trade, transport etc. This is also known as service sector. This sector includes transportation, communication, banking services etc.
Second : Net value added of each producing unit of the economy is estimated from their gross value of output which is calculated by multiplying total volume of goods produced with their prices. After deducting the sum total of value of intermediate goods (IC), depreciation (Dep) and net indirect taxes (NIT) from value of output we get Net Value Added at Factor Cost ( NVAFC ) of the producing units.
Net Value added at Factor Cost ( NVAFC ) = Gross Value of output
By adding up net value added at factor cost (FC) of all the producing units of a sector we get net value added at FC of that particular sector. The sum total of net value added at FC of all the three sectors in the domestic territory of a country gives us Net Domestic Product at Factor Cost (NDPFC).
Third : Net National Product at factor cost is obtained by adding net factor income from ROW to net domestic product at factor cost.
If net factor income from ROW is negative, NDPFC will be greater than net national product at factor cost (National Income), and if it is positive national income will be greater than NDPFC.
Precautions : The following precautions are necessary while estimating national income by production method –
- (i) Production for self consumption : That output which is produced for self-consumption and whose value can be estimated, must be included in the estimates of production because it is a part of production of current year.
- (ii) Sale of second-hand goods : The sale of second-hand goods should not be included in national income because the value of these goods had already been included earlier.
- (iii) Commission paid to the broker for sale and purchase second-hand goods should be included because it is payment made for the services provided in the current year.
- (iv) Value of intermediate goods should not be included because it leads to double counting.
- (v) Services of house wife should not be included because it is very difficult to evaluate them.
In product method we calculate the aggregate annual value of goods and services produced (if a year is the unit of time). How to go about doing this? Do we add up the value of all goods and services produced by all the firms in an economy? The following Farmer-Baker example will help us to understand.
Let us suppose that there are only two kinds of producers in the economy. They are the wheat producers (or the farmers) and the bread makers (the bakers). The wheat producers grow wheat and they do not need any input other than human labour. They sell a part of the wheat to the bakers. The bakers do not need any other raw materials besides wheat to produce bread. Let us suppose that in a year the total value of wheat that the farmers have produced is ₹ 100. Out of this they have sold ₹ 50 worth of wheat to the bakers. The bakers have used this amount of wheat completely during the year and have produced ₹ 200 worth of bread. What is the value of total production in the economy? If we follow the simple way of aggregating the values of production of the sectors, we would add ₹ 200 (value of production of the bakers) to ₹ 100 (value of production of farmers). The result will be ₹ 300.
A little reflection will tell us that the value of aggregate production is not ₹ 300. The farmers had produced ₹ 100 worth of wheat for which it did not need assistance of any inputs. Therefore the entire ₹ 100 is rightfully the contribution of the farmers. But the same is not true for the bakers. The bakers had to buy ₹ 50 worth of wheat to produce their bread. The ₹ 200 worth of bread that they have produced is not entirely their own contribution. To calculate the net contribution of the bakers, we need to subtract the value of the wheat that they have bought from the farmers. If we do not do this we shall commit the mistake of ‘double counting’. This is because ₹ 50 worth of wheat will be counted twice. First it will be counted as part of the output produced by the farmers. Second time, it will be counted as the imputed value of wheat in the bread produced by the bakers.
Therefore, the net contribution made by the bakers is, ₹ 200 – ₹ 50 = ₹ 150. Hence, aggregate value of goods produced by this simple economy is ₹ 100 (net contribution by the farmers) + ₹ 150 (net contribution by the bakers) = ₹ 250.
The term that is used to denote the net contribution made by a firm is called its value added. We have seen that the raw materials that a firm buys from another firm which are completely used up in the process of production are called ‘intermediate goods’. Therefore the value added of a firm is, value of production of the firm – value of intermediate goods used by the firm.
The value added of a firm is distributed among its four factors of production, namely, labour, capital, entrepreneurship and land. Therefore wages, interest, profits and rents paid out by the firm must add up to the value added of the firm. Value added is a flow variable.
In the above example, we can think of the market prices of the goods being used to evaluate the different variables, and we can introduce more players in the chain of production in the example and make it more realistic and complicated. For example, the farmer may be using fertilisers or pesticides to produce wheat. The value of these inputs will have to be deducted from the value of output of wheat. Or the bakers may be selling the bread to a restaurant whose value added will have to be calculated by subtracting the value of intermediate goods (bread in this case).
The concept of depreciation, is also known as consumption of fixed capital. Since the capital which is used to carry out production undergoes wear and tear, the producer has to undertake replacement investments to keep the value of capital constant. The replacement investment is same as depreciation of capital.
- If we include depreciation in value added then the measure of value added that we obtain is called Gross Value Added.
- If we deduct the value of depreciation from gross value added we obtain Net Value Added.
Unlike gross value added, net value added does not include wear and tear that capital has undergone. For example, let us say a firm produces ₹ 100 worth of goods per year, ₹ 20 is the value of intermediate goods used by it during the year and ₹ 10 is the value of capital consumption. The gross value added of the firm will be, ₹ 100 – ₹ 20 = ₹ 80 per year. The net value added will be, ₹ 100 – ₹ 20 – ₹ 10 = ₹ 70 per year.
Note : while calculating the value added we are taking the value of production of firm. But a firm may be unable to sell all of its produce. In such a case it will have some unsold stock at the end of the year. Conversely, it may so happen that a firm had some initial unsold stock to begin with. During the year that follows it has produced very little. But it has met the demand in the market by selling from the stock it had at the beginning of the year.
How shall we treat these stocks which a firm may intentionally or unintentionally carry with itself? Also, a firm buys raw materials from other firms. The part of raw material which gets used up is categorised as an intermediate good. What happens to the part which does not get used up?
In economics, the stock of unsold finished goods, or semi-finished goods, or raw materials which a firm carries from one year to the next is called inventory. Inventory is a stock variable. It may have a value at the beginning of the year; it may have a higher value at the end of the year. In such a case inventories have increased (or accumulated). If the value of inventories is less at the end of the year compared to the beginning of the year, inventories have decreased (de-cumulated). We can therefore infer that the change of inventories of a firm during a year ≡ production of the firm during the year – sale of the firm during the year.
The sign ‘≡’ stands for identity. Unlike equality (‘=’), an identity always holds irrespective of what variables we have on the left hand and right hand sides of it. For example, we can write 2 + 2 ≡ 4, because this is always true. But we must write 2 × x = 4. This is because two times x equals to 4 for a particular value of x, (namely when x = 2) and not always. We cannot write 2 × x ≡ 4.
Observe that since production of the firm ≡ value added + intermediate goods used by the firm, we get, change of inventories of a firm during a year ≡ value added + intermediate goods used by the firm – sale of the firm during a year.
For example, let us suppose that a firm had an unsold stock worth of ₹ 100 at the beginning of a year. During the year it had produced ₹ 1,000 worth of goods and managed to sell ₹ 800 worth of goods. Therefore the ₹ 200 is the difference between production and sales. This ₹ 200 worth of goods is the change in inventories. This will add to the ₹ 100 worth of inventories the firm started with. Hence the inventories at the end of the year is, ₹ 100 + ₹ 200 = ₹ 300. Notice that change in inventories takes place over a period of time. Therefore it is a flow variable.
Inventories are treated as capital. Addition to the stock of capital of a firm is known as investment. Therefore change in the inventory of a firm is treated as investment. There can be three major categories of investment.
- First is the rise in the value of inventories of a firm over a year which is treated as investment expenditure undertaken by the firm.
- The second category of investment is the fixed business investment, which is defined as the addition to the machinery, factory buildings, and equipments employed by the firms.
- The last category of investment is the residential investment, which refers to the addition of housing facilities.
Change in inventories may be planned or unplanned. In case of an unexpected fall in sales, the firm will have unsold stock of goods which it had not anticipated. Hence there will be unplanned accumulation of inventories. In the opposite case where there is unexpected rise in the sales there will be unplanned de-cumulation of inventories.
This can be illustrated with the help of the following example. Suppose a firm manufactures shirts. It starts the year with an inventory of 100 shirts. During the coming year it expects to sell 1,000 shirts. Hence it produces 1,000 shirts, expecting to keep an inventory of 100 at the end of the year. However, during the year, the sales of shirts turn out to be unexpectedly low. The firm is able to sell only 600 shirts. This means that the firm is left with 400 unsold shirts. The firm ends the year with 400 + 100 = 500 shirts. The unexpected rise of inventories by 400 will be an example of unplanned accumulation of inventories. If, on the other hand, the sales had been more than 1,000 we would have unplanned de-cumulation of inventories. For example, if the sales had been 1,050, then not only the production of 1,000 shirts will be sold, the firm will have to sell 50 shirts out of the inventory. This 50 unexpected reduction in inventories is an example of unexpected de-cumulation of inventories.
What can be the examples of planned accumulation or de-cumulation of inventories? Suppose the firm wants to raise the inventories from 100 shirts to 200 shirts during the year. Expecting sales of 1,000 shirts during the year (as before), the firm produces 1000 + 100 = 1,100 shirts. If the sales are actually 1,000 shirts, then the firm indeed ends up with a rise of inventories. The new stock of inventories is 200 shirts, which was indeed planned by the firm. This rise is an example of planned accumulation of inventories. On the other hand if the firm had wanted to reduce the inventories from 100 to 25 (say), then it would produce 1000 – 75 = 925 shirts. This is because it plans to sell 75 shirts out of the inventory of 100 shirts it started with (so that the inventory at the end of the year becomes 100 – 75 = 25 shirts, which the firm wants). If the sales indeed turn out to be 1000 as expected by the firm, the firm will be left with the planned, reduced inventory of 25 shirts.
Taking cognizance of change of inventories we may write –
Gross value added of firm i –
GVAi ≡ Gross value of the output produced by the firm i (Qi)
– Value of intermediate goods used by the firm (Zi)
GVAi ≡ Value of sales by the firm (Vi)
+ Value of change in inventories (Ai)
– Value of intermediate goods used by the firm (Zi)
Second equation above has been derived by using: Change in inventories of a firm during a year ≡ Production of the firm during the year – Sale of the firm during the year.
It is worth noting that –
- the sales by the firm includes sales not only to domestic buyers but also to buyers abroad (the latter is termed as exports).
- all the above mentioned variables are flow variables. Generally these are measured on an annual basis. Hence they measure value of the flows per year.
Net value added of the firm i, NVAi ≡ GVAi – Depreciation of the firm i (Di)
If we sum the gross value added of all the firms of the economy in a year, we get a measure of the value of aggregate amount of goods and services produced by the economy in a year (just as we had done in the wheat-bread example). Such an estimate is called Gross Domestic Product (GDP). Thus GDP ≡ Sum total of gross value added of all the firms in the economy.
If there are N firms in the economy, each assigned with a serial number from 1 to N, then
≡ Sum total of the gross value added of all the firms in the economy
≡ GVA1 + GVA2 + · · · + GVAN
Thus, GVA stands for the sum total of gross value added of all the N firms. The net value added of the i-th firm (NVAi) is the gross value added minus the wear and tear of the capital employed by the firm.
Thus, NVAi ≡ GVAi – Di
Therefore, GVAi ≡ NVAi + Di
This is for the i-th firm. There are N such firms. Therefore the GDP of the entire economy, which is the sum total of the value added of all the N firms, will be the sum total of the net value added and depreciation of the N firms.
This implies that the gross domestic product of the economy is the sum total of the net value added and depreciation of all the firms of the economy. Summation of net value added of all firms is called Net Domestic Product (NDP).
Income method is used for measuring national income at distribution level. According to this method, national income is estimated by adding incomes earned by all the factors of production for their factor services during a year.
If includes the following steps –
First : Classify the production units into primary, secondary and tertiary sector. The classification is same as in value added method.
Second : Estimate the following factor incomes paid out by the production units in each industrial sector.
- (i) Compensation of employees
- (ii) Rent
- (iii) Interest
- (iv) Profit
- (v) Mixed income of self-employed
The sum total of the above factor incomes paid out is the same as net value added at factor cost by the industrial sectors.
Third : Take the sum of factor payments by all the industrial sectors to arrive at the net domestic product at factor cost. .
Last : Add net factor income from abroad to the net domestic product at factor cost to arrive at net national, product at factor cost.
Precautions : The following are some of the main precautions which must be taken while estimating national income by the income distribution method
- (a) While estimating compensation of employees all benefits accruing to the employees whether in cash or in kind must be included.
- (b) In estimating interest, the interest on only those loans should be included which are taken for production, The interest on loans taken to meet consumption expenditure is not included in national income as it is treated as transfer payment.
- (c) Gifts, donations, charities, taxes, fines, income from lotteries etc., are not factor incomes but transfer incomes. These should not be included in estimating national income.
- (d) Income from sale of second-hand goods should not be included as it is not the income received from the goods produced in the current year.
The sum of final expenditures in the economy must be equal to the incomes received by all the factors of production taken together (final expenditure is the spending on final goods, it does not include spending on intermediate goods). This follows from the simple idea that the revenues earned by all the firms put together must be distributed among the factors of production as salaries, wages, profits, interest earnings and rents.
Let there be M number of households in the economy. Let Wi be the wages and salaries received by the i-th household in a particular year. Similarly, Pi, Ini, Ri be the gross profits, interest payments and rents received by the i-th household in a particular year.
Therefore GDP is given by
It is to be noted that in above equation, I stands for sum total of both planned and unplanned investments undertaken by the firms.
It may be worth examining how the households dispose off their earnings. There are three major ways in which they may do so. Either they consume it, or they save it, or pay taxes with it (assuming that no aid or donation, ‘transfer payment’ in general, is being sent abroad, which is another way to spend their incomes).
Let S stand for the aggregate savings made by them and T be the sum total of taxes paid by them.
Therefore, GDP ≡ C + S + T
From above diagram, C + I + G + X – M ≡ C + S + T
Cancelling final consumption expenditure C from both sides we get I + G + X – M ≡ S + T
In other words (I – S) + (G – T) ≡ M – X
- G – T measures by what amount the government expenditure exceeds the tax revenue earned by it. This is referred to as budget deficit.
- M – X is known as the trade deficit – it measures the excess of import expenditure over the export revenue earned by the economy (M is the outflow from the country, X is the inflow into the country).
If there is no government, no foreign trade then G = T = M = X = 0. That is I ≡ S. This is simply an accounting identity.
Out of the GDP, a part is consumed and a part is saved (from the recipient side of the incomes). On the other hand, from the side of the firms, the aggregate final expenditure received by them (≡ GDP) must be equal to consumption expenditure and investment expenditure. The aggregate of incomes received by the households is equal to the expenditure received by the firms because the income method and expenditure method would give us the same figure of GDP. Since consumption expenditure cancels out from both sides, we are left with aggregate savings equal to the aggregate gross investment expenditure.
National income can also be measured at disposition phase with the help of expenditure method. It estimates national income by measuring final expenditure on gross domestic product at market price ( GDPMP).
Expenditure incurred on final goods is final expenditure. Final goods are those goods which are demanded for final consumption and investment. The demand for final consumption and investment is made by all the four sectors of the economy, namely, households, firms and the government and rest of the world.
The main steps involved in measuring national income by this method are –
First : Estimate the following expenditure incurred on the final products of all the sectors of the economy.
- (i) Private final consumption expenditure
- (ii) Government final consumption expenditure
- (iii) Gross Investment
- (iv) Net exports (exports – imports)
The sum total of all the above expenditures on final products of all the sectors of the economy gives us gross domestic product at market price ( GDPMP).
Second : Deduct consumption of fixed capital (Depreciation) and net indirect taxes from gross domestic product at market price ( GDPMP) to get net domestic product at factor cost ( NDPFC ).
NDPFC = GDPMP
– Consumption of fixed capital
– Net Indirect Tax (Indirect Taxes – Subsidies)
Third : Add net factor income from abroad to the net domestic product at factor cost ( NDPFC) to obtain net national product at factor cost ( NNPFC) which is the national income.
NNPFC = NDPFC
+ Net Factor Income from abroad (National Income)
Precautions : The main precautions required to be taken in estimating national income by expenditure method are –
- (i) Expenditure on intermediate products should not he included to avoid the problem of double counting.
- (ii) Expenditure on gifts, donations, taxes, scholarships etc. should not be included in National Income as these are transfer payments.
- (iii) Expenditure incurred on purchase of second-hand goods should not be included as the expenditure on these goods has already been included when bought for the first time.
- (iv) Expenditure on purchase of bonds and shares should not be included as these are financial transactions.
An alternative way to calculate the GDP is by looking at the demand side of the products. This method is referred to as the expenditure method.
In the Farmer-Baker example, the aggregate value of the output in the economy by expenditure method will be calculated in the following way.
- In this method we add the final expenditures that each firm makes. Final expenditure is that part of expenditure which is undertaken not for intermediate purposes. The ₹ 50 worth of wheat which the bakers buy from the farmers counts as intermediate goods, hence it does not fall under the category of final expenditure. Therefore the aggregate value of output of the economy is ₹ 200 (final expenditure received by the baker) + ₹ 50 (final expenditure received by the farmer) = ₹ 250 per year.
Firm i can make the final expenditure on the following accounts –
- (a) the final consumption expenditure on the goods and services produced by the firm. We shall denote this by Ci. We may note that mostly it is the households which undertake consumption expenditure. There may be exceptions when the firms buy consumables to treat their guests or for their employees.
- (b) the final investment expenditure, Ii, incurred by other firms on the capital goods produced by firm i.
Observe that unlike the expenditure on intermediate goods which is not included in the calculation of GDP, expenditure on investments is included. The reason is that investment goods remain with the firm, whereas intermediate goods are consumed in the process of production;
- (c) the expenditure that the government makes on the final goods and services produced by firm i. We shall denote this by Gi. We may point out that the final expenditure incurred by the government includes both the consumption and investment expenditure.
- (d) the export revenues that firm i earns by selling its goods and services abroad. This will be denoted by Xi .
Thus the sum total of the revenues that the firm i earns is given by –
RVi ≡ Sum total of final consumption, investment, government and exports expenditures received by the firm i
≡ Ci + Ii + Gi + Xi
If there are N firms then summing over N firms we get
- Say C be the aggregate final consumption expenditure of the entire economy.
- Say part of C is spent on imports of consumption goods. Let Cm denote expenditure on the imports of consumption goods.
- Therefore C – Cm denotes that part of aggregate final consumption expenditure that is spent on the domestic firms.
- ≡ Sum total of final consumption expenditures received by all the firms in the economy ≡ C – Cm
- Say I is the value of the aggregate final investment expenditure of the economy.
- Out of this I, say Im is spent on foreign investment goods.
- Thus I – Im stand for that part of aggregate final investment expenditure that is spent on domestic firms.
- ≡ Sum total of final investment expenditures received by all the firms in the economy ≡ I – Im
- Say G is the aggregate expenditure of the government of the economy.
- There say Gm is the part of G which is spent on imports.
- Then G – Gm stands for that part of aggregate final government expenditure that is spent on the domestic firms.
- ≡ Sum total of final government expenditures received by all the firms in the economy ≡ G – Gm
Gross Domestic Product measures the aggregate production of final goods and services taking place within the domestic economy during a year. But the whole of it may not accrue to the citizens of the country. For example, a citizen of India working in Saudi Arabia may be earning her wage and it will be included in the Saudi Arabian GDP. But legally speaking, she is an Indian. Is there a way to take into account the earnings made by Indians abroad or by the factors of production owned by Indians? When we try to do this, in order to maintain symmetry, we must deduct the earnings of the foreigners who are working within our domestic economy, or the payments to the factors of production owned by the foreigners. For example, the profits earned by the Korean-owned Hyundai car factory will have to be subtracted from the GDP of India.
The macroeconomic variable which takes into account such addition and subtraction is known as Gross National Product (GNP). It is, therefore, defined as follows
GNP ≡ GDP + Factor income earned by the domestic factors of production employed in the rest of the world – Factor income earned by the factors of production of the rest of the world employed in the domestic economy
Hence, GNP ≡ GDP + Net factor income from abroad
(Net factor income from abroad = Factor income earned by the domestic factors of production employed in the rest of the world – Factor income earned by the factors of production of the rest of the world employed in the domestic economy).
A part of the capital gets consumed during the year due to wear and tear. This wear and tear is called depreciation. Naturally, depreciation does not become part of anybody’s income. If we deduct depreciation from GNP the measure of aggregate income that we obtain is called Net National Product (NNP).
Thus, NNP ≡ GNP – Depreciation.
Note : All these variables are evaluated at market prices.
- Through the expression given above, we get the value of NNP evaluated at market prices. But market price includes indirect taxes. When indirect taxes are imposed on goods and services, their prices go up. Indirect taxes accrue to the government. We have to deduct them from NNP evaluated at market prices in order to calculate that part of NNP which actually accrues to the factors of production.
- Similarly, there may be subsidies granted by the government on the prices of some commodities (in India petrol is heavily taxed by the government, whereas cooking gas is subsidised). So we need to add subsidies to the NNP evaluated at market prices.
- The measure that we obtain by doing so (deduct indirect taxed & add subsidies) is called Net National Product at factor cost or National Income.
Thus, NNP at factor cost
≡ National Income (NI)
≡ NNP at market prices – ( Indirect taxes – Subsidies )
≡ NNP at market prices – Net indirect taxes
Net indirect taxes ≡ Indirect taxes – Subsidies
The part of NI which is received by households is called Personal Income (PI).
- First, let us note that out of NI, which is earned by the firms and government enterprises, a part of profit is not distributed among the factors of production. This is called Undistributed Profits (UP). We have to deduct UP from NI to arrive at PI, since UP does not accrue to the households.
- Similarly, Corporate Tax, which is imposed on the earnings made by the firms, will also have to be deducted from the NI, since it does not accrue to the households.
- On the other hand, the households do receive interest payments from private firms or the government on past loans advanced by them. And households may have to pay interests to the firms and the government as well, in case they had borrowed money from either. So we have to deduct the net interests paid by the households to the firms and government.
- The households receive transfer payments from government and firms (pensions, scholarship, prizes, for example) which have to be added to calculate the Personal Income of the households.
Thus, Personal income (PI) ≡ National Income (NI)
– Undistributed profits
– Net interest payments made by households
– Corporate tax
+ Transfer payments to the households from the government and firms.
However, even PI is not the income over which the households have complete say. They have to pay taxes from PI. If we deduct the Personal Tax Payments (income tax, for example) and Non-tax Payments (such as fines) from PI, we obtain what is known as the Personal Disposable Income (PDI).
Thus Personal Disposable Income (PDI) ≡ PI – Personal tax payments – Non-tax payments.
Personal Disposable Income is the part of the aggregate income which belongs to the households. They may decide to consume a part of it, and save the rest.
National Disposable Income and Private Income
Apart from these categories of aggregate macroeconomic variables, in India, a few other aggregate income categories are also used in National Income accounting
National Disposable Income = Net National Product at market prices
The idea behind National Disposable Income is that it gives an idea of what is the maximum amount of goods and services the domestic economy has at its disposal. Current transfers from the rest of the world include items such as gifts, aids, etc.
Private Income = Factor income from net domestic product accruing to the private sector
One implicit assumption in all the discussion around ‘National Income Accounting’ is that the prices of goods and services do not change. If prices change, then there may be difficulties in comparing GDPs.
If we measure the GDP of a country in two consecutive years and see that the figure for GDP of the latter year is twice that of the previous year, we may conclude that the volume of production of the country has doubled. But it is possible that only prices of all goods and services have doubled between the two years whereas the production has remained constant.
Therefore, in order to compare the GDP figures (and other macroeconomic variables) of different countries or to compare the GDP figures of the same country at different points of time, we cannot rely on GDPs evaluated at current market prices. For comparison we take the help of real GDP.
Real GDP is calculated in a way such that the goods and services are evaluated at some constant set of prices (or constant prices). Since these prices remain fixed, if the Real GDP changes we can be sure that it is the volume of production which is undergoing changes.
Nominal GDP, on the other hand, is simply the value of GDP at the current prevailing prices.
For example, suppose a country only produces bread. In the year 2000 it had produced 100 units of bread, price was Rs 10 per bread. GDP at current price was Rs 1,000. In 2001 the same country produced 110 units of bread at price Rs 15 per bread. Therefore nominal GDP in 2001 was Rs 1,650 (=110 × Rs 15). Real GDP in 2001 calculated at the price of the year 2000 (2000 will be called the base year) will be 110 × Rs 10 = Rs 1,100.
Notice that the ratio of nominal GDP to real GDP gives us an idea of how the prices have moved from the base year (the year whose prices are being used to calculate the real GDP) to the current year. In the calculation of real and nominal GDP of the current year, the volume of production is fixed. Therefore, if these measures differ it is only due to change in the price level between the base year and the current year. The ratio of nominal to real GDP is a well-known index of prices. This is called GDP Deflator.
Thus if GDP stands for nominal GDP and gdp stands for real GDP then,
GDP deflator = GDP / gdp
Sometimes the deflator is also denoted in percentage terms. In such a case
GDP deflator = (GDP / gdp) × 100 percent
In the previous example, the GDP deflator is 1,650 / 1,100 = 1.50 (in percentage terms this is 150 per cent). This implies that the price of bread produced in 2001 was 1.5 times the price in 2000. Which is true because price of bread has indeed gone up from Rs 10 to Rs 15. Like GDP deflator, we can have GNP deflator as well.
There is another way to measure change of prices in an economy which is known as the Consumer Price Index (CPI). This is the index of prices of a given basket of commodities which are bought by the representative consumer. CPI is generally expressed in percentage terms. We have two years under consideration – one is the base year, the other is the current year. We calculate the cost of purchase of a given basket of commodities in the base year. We also calculate the cost of purchase of the same basket in the current year. Then we express the latter as a percentage of the former. This gives us the Consumer Price Index of the current year vis-a-vis the base year.
For example let us take an economy which produces two goods, rice and cloth. A representative consumer buys 90 kg of rice and 5 pieces of cloth in a year. Suppose in the year 2000 the price of a kg of rice was Rs 10 and a piece of cloth was Rs 100. So the consumer had to spend a total sum of Rs 10 × 90 = Rs 900 on rice in 2000. Similarly, she spent Rs 100 × 5 = Rs 500 per year on cloth. Summation of the two items is, Rs 900 + Rs 500 = Rs 1,400.
Now suppose the prices of a kg of rice and a piece of cloth has gone up to Rs 15 and Rs 120 in the year 2005. To buy the same quantity of rice and clothes the representative will have to spend Rs 1,350 and Rs 600 respectively (calculated in a similar way as before). Their sum will be, Rs 1,350 + Rs 600 = Rs 1,950.
The CPI therefore will be (1,950 / 1,400) × 100 = 139.29 (approximately).
It is worth noting that many commodities have two sets of prices. One is the retail price which the consumer actually pays. The other is the wholesale price, the price at which goods are traded in bulk. These two may differ in value because of the margin kept by traders. Goods which are traded in bulk (such as raw materials or semi-finished goods) are not purchased by ordinary consumers. Like CPI, the index for wholesale prices is called Wholesale Price Index (WPI). In countries like USA it is referred to as Producer Price Index (PPI).
Notice CPI (and analogously WPI) may differ from GDP deflator because –
- The goods purchased by consumers do not represent all the goods which are produced in a country. GDP deflator takes into account all such goods and services.
- CPI includes prices of goods consumed by the representative consumer, hence it includes prices of imported goods. GDP deflator does not include prices of imported goods.
- The weights are constant in CPI – but they differ according to production level of each good in GDP deflator.
Can the GDP of a country be taken as an index of the welfare of the people of that country?
If a person has more income he or she can buy more goods and services and his or her material well-being improves. So it may seem reasonable to treat his or her income level as his or her level of well-being.
GDP is the sum total of value of goods and services created within the geographical boundary of a country in a particular year. It gets distributed among the people as incomes (except for retained earnings). So we may be tempted to treat higher level of GDP of a country as an index of greater well-being of the people of that country (to account for price changes, we may take the value of real GDP instead of nominal GDP).
But there are at least three reasons why this may not be correct –
- Distribution of GDP – how uniform is it : If the GDP of the country is rising, the welfare may not rise as a consequence. This is because the rise in GDP may be concentrated in the hands of very few individuals or firms. For the rest, the income may in fact have fallen. In such a case the welfare of the entire country cannot be said to have increased.
For example, suppose in year 2000, an imaginary country had 100 individuals each earning ₹ 10. Therefore the GDP of the country was ₹ 1,000 (by income method). In 2001, let us suppose the same country had 90 individuals earning ₹ 9 each, and the rest 10 individual earning ₹ 20 each. Suppose there had been no change in the prices of goods and services between these two periods. The GDP of the country in the year 2001 was 90 × (₹ 9) + 10 × (₹ 20) = ₹ 810 + ₹ 200 = ₹ 1,010. Observe that
compared to 2000, the GDP of the country in 2001 was higher by ₹ 10. But this has happened when 90 per cent of people of the country have seen a drop in their real income by 10 per cent (from ₹ 10 to ₹ 9), whereas only 10 per cent have benefited by a rise in their income by 100 per cent (from ₹ 10 to ₹ 20).
90 per cent of the people are worse off though the GDP of the country has gone up. If we relate welfare improvement in the country to the percentage of people who are better off, then surely GDP is not a good index.
- Non-monetary exchanges : Many activities in an economy are not evaluated in monetary terms. For example, the domestic services women perform at home are not paid for. The exchanges which take place in the informal sector without the help of money are called barter exchanges. In barter exchanges goods (or services) are directly exchanged against each other. But since money is not being used here, these exchanges are not registered as part of economic activity. In developing countries, where many remote regions are underdeveloped, these kinds of exchanges do take place, but they are generally not counted in the GDPs of these countries. This is a case of underestimation of GDP. Hence GDP calculated in the standard manner may not give us a clear indication of the productive activity and well-being of a country.
- Externalities : Externalities refer to the benefits (or harms) a firm or an individual causes to another for which they are not paid (or penalised). Externalities do not have any market in which they can be bought and sold.
For example, let us suppose there is an oil refinery which refines crude petroleum and sells it in the market. The output of the refinery is the amount of oil it refines. We can estimate the value added of the refinery by deducting the value of intermediate goods used by the refinery (crude oil in this case) from the value of its output. The value added of the refinery will be counted as part of the GDP of the economy. But in carrying out the production the refinery may also be polluting the nearby river. This may cause harm to the people who use the water of the river. Hence their utility will fall. Pollution may also kill fish or other organisms of the river on which fish survive. As a result the fishermen of the river may be losing their income and utility. Such harmful effects that the refinery is inflicting on others, for which it does not have to bear any cost, are called externalities. In this case, the GDP is not taking into account such negative externalities.
Therefore, if we take GDP as a measure of welfare of the economy we shall be overestimating the actual welfare. This was an example of negative externality. There can be cases of positive externalities as well. In such cases GDP will underestimate the actual welfare of the economy.
The sum of net value added by all the production units in the domestic territory is net domestic product of factor cost (NDPFC). All the income generated in a year is not received by consumer households.
- Income from property and entrepreneurship accruing to the departmental commercial enterprise of the government is retained by the government.
- Secondly non-departmental enterprises of the government save a part of their profits for future expansion. This too is not available for distribution.
If these two sums are deducted from NDPFC, we get income from domestic product or NDPFC accruing to private sector.
Income from domestic product accruing to private sector = NDPFC
– income from property and entrepreneurship accruing to government administration department savings of non-departmental enterprises
(i) Private income : Private income consists of factor incomes earned within the domestic territory and abroad by private enterprises and workers (factor owners in the private sector) and current transfer from government and the rest of the world.
Private income = Income from domestic product accruing to private sector
+ Net factor income from abroad
+ national debt interest
+ current transfers from government
+ other current transfers from the rest of the world (net)
(ii) Personal income : Personal income is defined as the current income of persons or households from all sources. We have to deduct undistributed profit and corporate tax payable by the enterprise from private income to arrive at personal income
Personal income = private income
– saving of private corporate sector (undistributed profit)
– corporation tax
(iii) Personal disposable income : The household cannot spend the entire personal income. Government takes away a part of it by way of income tax and other miscellaneous taxes such as education tax, fire tax, sanitation tax. These taxes have to be deducted from personal income to arrive at personal disposable income.
Personal disposable income = Personal income
– direct taxes paid by the households
– miscellaneous receipts of the government.
Personal disposable income is the income available to persons from all sources to dispose of as they choose.
National disposable income refers to the income which is available to the whole country for disposal.
It includes both earned income and transfer income (unearned income).
Net national disposable income = NNPMP
+ Net current transfers from rest of the world.
Net national disposable income = NNPFC
+ Net current transfer from rest of the world
Gross National Disposable income = GNPMP
+ Net current transfers from rest of the world.