Economics Notes on National Income

By Ajeet Kumar, MA Economics

This is a concise notes on national income  useful for Economics students. It provides the basis to solve the problems of national income accounting.

National income refers to the money value of all final goods and services produced by the normal residents of a country while working within or outside the domestic territory of a country in an accounting year. It includes net factor income from abroad.

The above definition is based on product method. In this method, the money value of goods and services are calculated by multiplying their quantities with their respective prices. In short, Y=PG+PS where G and S stand for amount of goods and services respectively and P being their prices.

Factor income:  Factor income refers to the income earned by different factors of production as reward for their contribution in production. It is an earning concept (exchange/give-and-get concept).

Transfer income: It refers to income received without doing any economic activity.

Transfer payment: Transfer payment refers to the payment which is made to some one without ones contribution in economic activity. One party’s income is another’s expenditure.

Inputs: Inputs are the resources which are used in production process.

Primary inputs: Primary inputs are those inputs which renders services in the production activities without being merged into the output. They are also known as factors of production. Factors of production are land, labor, capital, and entrepreneurship. In income method, the rewards of these factors of production i.e. rent, wage, interest, and profit are added together to estimate national income.

Secondary inputs: Secondary inputs are those inputs which are used in the production process and they are transformed into output as its parts. Examples are: seeds, fertilizers, insecticides, water, etc.

Primary factors of production: Land and labor are known as Primary factors of production.

Secondary factors of production: Capital and entrepreneurship are known as secondary factors of production since they are derived from primary factors of production in a sense. Karl Marx said: - capital is congealed labor and entrepreneur is a variety of labor.

Income method: In income method, the national income is defined as the sum total of factor incomes accruing to the normal residents of a country for their productive services rendered during an accounting year. In other words, the sum total of income generated from work and property of the normal residents in an accounting year refers to the national income. Wages and profits arise out of work and rent and interest from property. Income method is also known as Factor Payment Method or Distributed Share Method.

Analytical sectors of an economy: (1) Household sector, (2) Firm sector, (3) Government sector, and (4) External sector/The rest-of-world sector.

Household sector: Household sector provides the factor services like land, labor, capital, and entrepreneurship to the producing sector. The household sector is the consuming sector in an economy.

Firm sector: Firm sector receives the factor services like land, labor, capital, and entrepreneurship from the Household sector.  Firm sector is the producing sector in an economy.

Government sector: Government sector is the producing and consuming sector in an economy.

Real flow: Real flow refers to the flow of goods and services from the firm sector to household sector and flow of factor services from household sector to firm sector.

Money flow: Money flow refers to the flow of factor payment from firm sector to household sector and flow of expenditure on goods and services from household sector to firm sector.

Circular flow of income refers to the real flow and money flow in an economy that take place in circular fashion.

Three phases of Circular flow of income: (1) Production phase, (2) Distribution phase, (3) Disposition phase. Production generates income, income leads to expenditure and expenditure, in turn, leads to further production. Here, expenditure is about final one. Final expenditure is on consumption and investment.

Value added: Value added refers to the difference between total value of output and the value of inputs used to produce it. Value added= value of output – value of intermediate consumption.

Injection: Injection refers to the addition of income in the economy (or circular flow of income). For examples: investment, exports, subsidies etc. Injection leads to rise in the level of national income.

Leakage: Leakage refers to the decrease of income in the economy (or circular flow of income). For examples: savings, imports, taxes, etc. Leakage leads to fall in the level of national income.

Closed economy: An economy which is isolated from the rest of world in economic affairs is called closed economy. Such economy does hardly exist in real world. This situation is also known as autarky.

Open economy: An economy which deals with the rest of world in economic affairs is called open economy. In simple words, exports and imports are the economic activity that makes an economy open.

Final goods: Final goods are the goods which are neither for resale nor for further processing in the production process. They are used by the consumers for consumption and by producers for investment. They are finished goods.

Intermediate goods are those goods and services which are used by the producers to produce other (final) goods and services. They are excluded form national income because their value is already included in value of final products. In other words, in order to avoid problem of double counting, the values of intermediate products are excluded from national income.

Final goods Vs. Intermediate goods: Sugarcane is used in the production of sugar. So sugarcane can be treated as Intermediate good but there is no hard-and-fast rule to decide a given good as intermediate or final. In the above example, if the sugarcane is used by a household instead of a sugar mill the sugarcane will be treated as final good. Thus, water tight compartmentalization of goods as intermediate or final is wrong. In some cases, however, we can clearly decide whether a given good is intermediate one or final. For example, the spare parts of motorcycles or cars are intermediate goods. Intermediate goods are those goods which are used up in the production process.

Flow variable: A flow variable is one which is measured over a period of time. National income is a flow concept because it is measured over a period of time, usually one year.

Examples of flow variables: income, savings, depreciation, imports, exports, interest, profit, rent, wages, salaries, change in stocks, lending, borrowings, demand for goods and services, supply of goods and services, etc.

Stock variable: A stock variable is one which is measured at a point of time.

Examples of stock variables: money supply, wealth, inventories, opening stock, closing stock, population etc.

Self services: Domestic (self) services like cooking of food and washing of clothes by the housewife, shaving by someone oneself, etc. are not included in national income. Interestingly for this reason, the British economist A.C. Pigou once said - when a person marries his maid then he reduces the national income because after marriage her services are not recognized as economic activities. Such services are not included because, firstly, they are not rendered for market and secondly, their valuation is difficult.

Second-hand goods: The sales and purchases of second hand goods are excluded from national income because they are not newly produced goods in the current accounting year. However, the commission or brokerage earned by the broker on such transactions is added since they are the current flow of service in the economy.

Bonds: The Sales and purchases of financial assets like bonds, shares etc , both old and new, are excluded form national income since their transitions do not directly involve current production.

Illegal is forbidden: The income earned from illegal activities (e.g. black marketing, smuggling) is excluded from national income because such activities are not recognized by the law of country (although they are theoretically economic activities, by definition). Conventionally, illegal activities are not considered as economic activities.

Windfall gains: Windfall gains do not result from economic activities. Since they are not reward for any productive activity, so they are excluded from national income Example of windfall gain is income from lottery. Since such income is merely transfer of money from one party to another and it does not lead to production, so windfall gain is excluded from national income. Windfall gains do not lead to rise or fall in national income.

Transfer income: Transfer income or payments such as old age pensions, unemployment allowances, scholarship to students, relief to the victims of accidents, flood, or earthquakes etc. are not included in national income because these payments are not reward for any productive activity. It is, therefore, a receipt concept. Transfer payments are also called unilateral payments (uni=one, lateral=side).

Domestic territory: Domestic territory (also called economic territory) is more than the political frontier/boundary of a country. It includes the following apart from the political boundary:

(1) territorial waters, (2) ships and vessels owned and operated by the residents between two or more countries, (3) the country’s companies engaged in extraction in foreign countries where she has exclusive rights of operation, (4) fishing vessels, oil and natural gas rigs and floating platforms operated by the normal residents of the country in the international waters (5) embassies, consulates and military establishments of the country located rest of the world.

Caution: The international organizations like WHO, IMF, UNICEF, etc. which branches are located in the political boundary of the country are excluded from domestic territory.

Normal Resident: A normal resident is defined as a person (or institution) who ordinarily resides (usually for more than one year) in a country and whose centre of economic interest lies in that country. The concept of normal resident is different from that of a citizen. The citizen of a country derives all the political rights and other privileges given in the constitution of the country.

Examples of Normal Resident : (1) an American engineer living in India for more than one year is a normal resident of India but an American student living in India for more than one year is not a normal resident of India, (2) the international bodies like WHO, UNICEF, etc. are not normal residents, (3) local people working in the foreign embassies located in the country are the normal residents of the country but the foreign embassies in themselves are not part of the domestic territory of the country.

National income at current price:  National income calculated at the prevailing prices of the goods and services is called national income at current prices. It does not reflect the true economic growth or performance of an economy. To overcome from this problem, the national income is calculated at the prices of goods and services of the base year. The national income at current prices can increase without rise of the flow of goods and services in the economy, if the prices of the goods and services increase. It is affected either by change in the quantities of goods and services or their prices.

National income at constant prices (also called real national income) refers to the money value of all goods and services measured at base year prices produced by the normal residents of a country during an accounting year. The real national income can increase only when the flow of goods and services rise in the economy. Thus, it is affected only by change in the quantities of goods and services.

Base year:  The base year is the year which is characterized by economic stability and absence of great shock of business cycle, war, political stability etc.The base year is chosen to measure and compare various statistical indices such as consumer price index, wholesale price index, etc.

National income at current prices	National income at constant prices
1. National income calculated at the prevailing prices of the goods and services is called national income at current price.	1. National income at constant prices refers to the money value of all goods and services measured at base year prices produced by the normal residents of a country during an accounting year.
2. The national income at current price can increase without rise of the flow of goods and services in the economy, if the prices of the goods and services increase.	2. The real national income can increase only when the flow of goods and services rise in the economy.
3. It is affected either by change in the quantities of goods and services or their prices.	3. It is affected only by change in the quantities of goods and services.
4. It does not reflect the economic growth or performance of an economy.	4. It reflects the economic growth or performance of an economy.
5. They are not comparable over different periods.	5.They are comparable over different periods

Remember:

Net indirect taxes mean indirect taxes minus subsidies. i.e. NITs = IT – S.

Gross – Net = Depreciation.

MP = FC + NITs where MP = market price, FC = factor cost, NIT = net indirect taxes

National = Domestic + NFIA.

Value of output = value added + intermediate consumption.

Real GNP/nominal GNP = base year price index/current year price index

The term ‘gross’ includes the depreciation cost; depreciation is also called consumption of fixed capital.

The imputed value of some goods for example, rent of self occupied houses, production for self consumption are included in national income.

Capital gains, transfer income, and income from illegal activities etc are not included in national income.

Employer’s contributions to social security schemes such as PF (Provident Fund), LIC (Life Insurance Corporation), casualty insurance etc are included in compensation of employees.

Undistributed profit is also known as savings of private corporate sector.

Profit tax is also known as corporate or corporation tax.

Conventionally, NFIA is allocated to private sector and not to public sector because the major contribution in NFIA is made by the private sector rather than by the government sector.

National income means NNP at FC and Domestic income means NDP at FC.

Dividend is that part of the firm’s profit which is distributed among the share holders of the firm. A part of total profit is received by the government as profit tax and the remaining is used by the firm to develop the business.

Depreciation: Depreciation is normal wear and tear of fixed assets and their expected /anticipated/foreseen obsolescence. The depreciation causes fall in the value of assets. (Alas! every thing depreciates)

Capital loss: capital loss refers to the loss of value of assets due to some unforeseen factors/natural calamities like war, flood, theft, fire, etc. it is not included in national income. For example, destruction of some building and machinery during earthquake is assumed to not affect the national income (directly). (We cannot control every thing)

Gross Domestic Product(GDP)	Gross National Product(GNP)
1. It refers to the money value of all final goods and services produced within the domestic territory of a country.	1. It refers to the money value of all final goods and services produced by the normal residents of a country.
2. It is a territorial concept. It focuses on the domestic territory of the economy.	2. It is a national concept. It focuses on the normal residents of the economy.
3. GDP= PG +PS	3. GNP= GDP + NFIA
4. GDP is more than GNP if NFIA is negative.	4. GNP is more than GDP if NFIA is positive.

Net Domestic Product (NDP) can be defined as the net value of final goods and services produced by its residents and non-residents within the domestic territory of a country in a year.

Net Domestic Product(NDP)	Net National Product(NNP)
1. It refers to the market value of all final goods and services produced within the domestic territory of a country in a year.	1. It refers to the market value of all final goods and services produced by the normal residents of a country in a year.
2. It is a territorial concept. It focuses on the domestic territory of the economy.	2. It is a national concept. It focuses on the normal residents of the economy.
3. NDP= GDP – Depreciation.	3. NNP= GNP – Depreciation.
Or, NDP= NNP -  NFIA	Or, NNP= NDP + NFIA

Compensation of employees includes 1) wages and salaries 2) employer’s contribution to social security schemes and 3) retirement pension or private pension.

Wages and salaries include dearness allowances, sick leave allowance, leave travel concessions etc.However, reimbursement of business expenses incurred by the employees on behalf of their employers are excluded from it. Such expenses, in fact, form part of intermediate consumption of the business enterprises. Wages is all about payment for physical work and salary for white collar job (mental work). 

Compensation in kind: Value of interest foregone on loans to employees is treated as compensation in kind. Free housing, free medical facilities to the family members of the employee, free uniforms, free rent accommodation to employee, free education to the children of the employees, conveyance facilities, free ration to defence personnel etc are examples of compensation in kind.

Note: Employees’ contribution to social security schemes is not included in the national income since it is already included in wages and salaries. Also, compensation to injured worker, and travel allowance pertain to business promotion are not included

Pension: its type- Retirement pension also called private pension is included since it is a sort of deferred wage payment. Old age pension, however, is excluded since it is a transfer payment.

Operating surplus is defined as the excess of value added by the enterprises over and above the sum of domestic compensation of employees, net indirect taxes, and consumption of fixed capital. Operating surplus is the sum total of the income from property and (income from) entrepreneurship.

Income from property includes 1) Rent 2) Interest 3) Royalty.

The imputed rent is included in case of owner occupied houses.

Which kind of interest is included? The interest payments made on the loans raised for productive purposes are included in national income but the loans raised by the government for consumption such as flood control, welfare work etc  are excluded from national income. (Ask yourself: is the loan raised productive?)

Interest on national debt is excluded from the national income on this ground/assumption that the borrowing is used for the sake of welfare work rather than for production.

Royalty:  Royalty is the payment made for the use of natural resources (e.g. rights of mining) and for granting the rights of using patents, copyrights and trademarks etc. royalty is the price paid for the use of mineral deposits, patents, copyrights, and trademarks etc.

Income from entrepreneurship is known as profit. A part of the profit is distributed among the share holders and out of the rest a part is kept as undistributed profit and other is given to the government as corporation taxes. Corporation tax is the tax imposed by the government on the profit of the company.

Mixed income of self employed includes wage income as well as non-wage income such as rent, interest, profit. The self employed may be persons such as farmers, small businessmen, doctors, lawyers etc. In developed countries the mixed income of self employed is not shown separately. But in India, CSO (Central Statistical Organization) mentions it as a separate component of domestic factor income.

Factor income from abroad: It refers to the income received to the normal residents of a country from the rest of world in form of wages and salaries, rent, interest, and profit. The wages and salaries arise when the normal residents of the country are temporarily out of the country to earn. For example, a worker employed in a company abroad (say, Iraq) for less than a year sends money to his family. This money income will be treated as factor income from abroad. But if his stay is for more than a year then the person will be treated as a normal resident of Iraq and hence his income will be excluded from the national income of India. His income will be included in the national income of Iraq. Similarly, salary received by an Indian employee in a foreign embassy located in India is included in national income of India.

Factor income paid abroad: It refers to the income paid to the non- normal residents of the rest of world in form of wages and salaries, rent, interest, and profit. The wages and salaries are paid to the non-normal residents when they are temporarily in the country to earn. For example, consultancy fee paid to a foreign expert. It leads to decrease in national income.

Net Factor income from abroad (NFIA): It is the difference between factor incomes from abroad and factor income paid abroad. The NFIA is classified as (1) Net Compensation of employees (2) Net Income from Property and Entrepreneurship and (3) Net Retained Earnings of Resident Companies Abroad.

NDPatFC: NDPatFC is the sum of (1) Income from net domestic product accruing to private sector and (2) Income from net domestic product accruing to public sector. Note that the domestic income is all about the factor income generated in the domestic territory of a country.

Income from net domestic product accruing to private sector is that part of NDPatFC generated in form of compensation of employees, operating surplus and mixed income which is accrued to the private sector. In other words, by excluding the Income from net domestic product accruing to public sector from the NDPatFC, we get Income from net domestic product accruing to private sector. (Note: it is factor income.)

Income from net domestic product accruing to public sector is also called surplus of public sector. This is the sum of (1) income from property and entrepreneurship to government administrative department and (2) savings of non-departmental government enterprises. (Note: it is factor income.)

Private income is the total income as factor income and current transfers accruing to the private sector from the government and the rest of the world.

Private income has the following components:

(1)    Income from net domestic product accruing to private sector,

(2)    Net Factor income from abroad (NFIA),

(3)    Current transfers: (a) current transfer from the government in form of gifts, donations and subsidies. (b) Net current transfers from the rest of the world .The net current transfers from the rest of the world is the difference between current transfers received from other countries and the current transfers paid to other countries.

Current transfers are the payments which are made from the current income of the payer and added to the current income of the recipient for consumption expenditure. Current transfer may be voluntary or forced. 

Voluntary transfer payments: The examples of voluntary current transfers are gifts, donations, scholarship etc.

Forced or compulsory current transfer payments: Forced or compulsory current transfer may be in form of income tax, wealth tax, excise duty, sales tax etc.

 Private income = Income from net domestic product accruing to private sector + current transfer from the government + Net current transfers from the rest of the world + Interest on national debt +NFIA

Alternative Formula:

Private income = NDPatFC - Income from net domestic product accruing to public sector

+ Current transfer from the government + Net current transfers from the rest of the world + Interest on national debt +NFIA.

National income	Private income
1. National income includes only factor payments.	1. Private income includes factor income as well as transfer income.
2. It refers to factor income received to all sectors of the economy.	2. It refers to all types of income received by households and private enterprises.
3. It is the income of normal residents of the country.	3. It refers to the income only of private sector.
4. Interest on national debt is not included in it.	4. Interest on national debt is included in it.

Personal income: Personal income is the sum total of the incomes received by the households of an economy. It includes factor income as well as transfer income of the households. Since private sector includes households and private enterprises, so by deducting corporation taxes, undistributed profit, and net retained earnings of the foreign companies from private income, we get personal income.

Personal income = Private income - corporation taxes - , undistributed profits - net retained earnings of the foreign companies.

Alternative Formula:

Personal income = National income - Income from domestic product accruing to public sector - corporation taxes - undistributed profits - net retained earnings of the foreign companies + transfer income. (Note: Retained earnings of the foreign companies are excluded since they are already included in NFIA.).

Income from domestic product accruing to private sector	Private income
1. It includes only factor income.	1. It includes factor income as well as transfer income.
2. It is a domestic concept. So NFIA is not included in it.	2. It is a national concept. So NFIA is included in it.
3. Interest on national debt is not included in it.	3. Interest on national debt is included in it.
Private income	Personal income
1.It is a broader concept	1. It is a narrower concept.
2. It includes total income of household and firm sectors.	2. It includes total income of only household sector.
3.It includes corporation taxes, undistributed profit etc.	3. It does not include them.

National income	Personal income
1. It is an earning concept.	1. It is a receipt concept.
2. It also includes earning of public sector.	2. It excludes earning of public sector.
3. Interest on national debt is excluded.	3. Interest on national debt is included in it.
4.It includes corporation taxes, undistributed profit etc.	4.It does not include corporation taxes, undistributed profit etc.

Personal disposable income is that part of personal income which is either spent on consumption or saved by the households. It is the income which is available to the households to dispose. In other words, it is the income retained by the households after deducting direct taxes and miscellaneous receipts of the government from the personal income.

National disposable income is the income available to a country to dispose. It is the national income at market price including net current transfers from the rest of the world. Therefore, NDI = NNPatMP + Net current transfers from the rest of the world. The National disposable income can be more or less than national income because it includes the net current transfers from the rest of the world.

Personal disposable income	National disposable income
1. It is the income at the disposal of households to spend or save.	1. It is the income at the disposal of nation to spend or save.
2. It excludes indirect taxes.	2. It includes indirect taxes.
3. PDI = NNPatFC - Income from domestic product accruing to public sector + all current transfers.	3. NDI = NNPatFC + Net indirect taxes + Net current transfers from the rest of the world.

Gross National disposable income = Net National disposable income + depreciation.

Measurement of national income is possible in three different ways: (1) Product method (2) Income method and (3) Expenditure method.

Product method is also called net output method or industry of origin method or value added method. The calculation of national income by final output method gives rise to problem of double counting. Because of this problem, there is overestimation of the national income.

The counting of the value of commodity more than one in the process of measurement of national income is termed as problem of double counting.

The problem of double counting arises because of problem in establishing a commodity as final good. Each producer considers his product as final one.

Expenditure method is also known as income disposal method (sometimes also called consumption and investment method). In this method, the final expenditures on various items in a year   by all sectors of the economy are aggregated.

Categorization of final expenditure: The final expenditures are usually categorized into following components:

(1)    private final consumption expenditure,

(2)    government final consumption expenditure,

(3)    gross fixed capital formation,

(4)    change in stocks/inventories,

(5)    net acquisition of valuables,

(6)    Net exports.

Capital: Man-made means of further production is called capital. The stock of capital in an economy changes over time.

Capital formation: The net addition of capital sock in an economy is called capital formation. Capital formation is also known as investment.

Gross Domestic Capital Formation (GDCF) is the sum of following components:

(1)    Gross Domestic Fixed Capital Formation (GDFCF),

(2)    change in stocks/inventories,

(3)    net acquisition of valuables

Change in stocks refers to closing stock minus opening stock

Private final consumption expenditure includes the following:

(1) Purchases of currently produced goods and services in the domestic market by resident households are included but the expenses by foreigners/nonresidents are excluded.

(2) Imputed rent of owner-occupied houses is included.

(3) Purchases of houses are treated as investment, not as consumption.etc.

Unsold stock left with the firms is treated as purchased by them. This is why change in stock is treated as final investment expenditure.

Investment expenditure: The expenditure on construction of residential building, business fixed investment, public investment, and inventory investment in an economy.

 Public investment: Construction of roads, canals, schools, hospitals, etc. are examples of public investment.

Business fixed investment: The amount of money spent on newly produced capital goods by business units refers to business fixed investment.

Inventory investment refers to the currently produced goods which are not included in the current sale of final output.

Net export is considered as a part of domestic product. It is also called net foreign investment because positive net export leads to rise in productivity of the economy. If the net import is x then net export is (-) x. GDP = C + I + G + X – M.

Expenditure on second hand goods, intermediate goods, transfer payments, shares and bonds are excluded.

The choice of method of estimating national income is determined by a number of factors such as structure of economy, availability of data, kind of human activity etc. In traditional/undeveloped economy income method is not useful because the data regarding the income of various sectors such as agriculture sector, service sector are not available. Also these sectors play crucial role/ contribution in generation of national income. So, reliance on income method in these countries will underestimate the national income.