Macro Economics 1 BBA/ADC

NATIONAL INCOME

Question.1:

Define National Income. Discuss various concepts of National Income.

Answer:
National Income:
National Income is the total market value of all final goods and services produced in a country
during one year. All kinds of goods e.g. agricultural, industrial, minerals and all kinds of services e.g.
services of doctors, professors,engineers etc. are included in national income. The figure of national
income indicates the economic performance of a nation in monetary terms.
In the words of Alfred Marshall:
“Labour and capital of a country acting on its natural resources produce annually a
certain net aggregate of commodities, material and immaterial, including services of all kinds, which is
its national income.”
In modern terms the figure of national income can be reached by subtracting indirect taxes and adding
subsidies into NNP, where NNP is obtained by deducting depreciation from GNP.
i.e. NI = NNP - Indirect Taxes + Subsidies
and NNP = GNP - Depreciation
BASIC ECONOMIC INDICATORS: (Basic Concepts of National Income)
The national income concepts provide different perspectives on the income generated within an
economy and are used to assess the overall economic performance and standard of living of a country.
These may be:

i. GDP (Gross Domestic Product)

ii. GNP (Gross National Product)
iii. GNI (Gross National Income)
iv. NNP (Net National Product) (National Income at Market Price)
v. NI (National Income at Factor Cost)
vi. PI (Personal Income)
vii. DPI (Disposable Personal Income)

i. Gross Domestic Product:

The measure of the final value of all goods and services produced by the factors of
production, located within a nation’s borders regardless of the nationality of the producer, in a year
is called GDP. It represents the overall economic output of a country.
The formula for calculating GDP in its simplest form is:

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Macro Economics 2 BBA/ADC
GDP = C + I + G + (X - M)

Where C = Personal consumption expenditures of individuals on the purchase of goods and

services like food, clothing, house, etc.
I = Private investment which individuals spend from their savings on building, new
investment etc.
G = Expenditure of Govt. on goods and services like expenditure on salaries,allowances etc.
X - M = Net difference of Exports and Imports.

ii. Gross National Product:

GNP provides the foundation to see the real changes in NI or real output of the economy. It
represents the total value of all goods and services produced by the residents of a country, both
domestically and abroad,regardless of where the output is produced, during a specific time period.
Earning from people working in foreign countries and profits from foreign investment are also
included.

GNP = GDP + NFI

or
GNP = C + I + G + (X-M) + NFI

Where C = Personal consumption expenditures of individuals on the purchase of goods and services like
food, clothing, house, etc.
I = Private investment which individuals spend from their savings on building, new investment
etc.
G = Expenditure of Govt. on goods and services like expenditure on salaries,allowances etc.
X - M = Net difference of Exports and Imports.
NFI = Net Foreign Income
(i.e. net income earned by domestic residents from overseas investments minus
net income earned by foreign residents from domestic investments).

iii. Gross National Income:

It is similar to GNP in that it measures the total income earned by the residents of a
country, including both domestic and international sources. GNI includes the total income
generated from production within a country (GDP) as well as net income from abroad. However,
GNI also takes into account additional factors, such as international transfers, such as foreign aid
or remittances, and the compensation of employees working for foreign companies within the
country. GNI provides a broader measure of a country's income than GNP, as it considers all
sources of income, including those outside of the traditional production activities.

GNI = GDP + (EXFS - IMFS)

Wher
e GDP = Gross Domestic Product.
EXFS = Money flowing from foreign countries.
IMFS = Money flowing to foreign countries.

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Macro Economics 3 BBA/ADC
iv. Net National Product (National Income at Market Price):

Net National Product at Market Price is the net market value of all final goods and
services produced in a country during a year. But in the production of GNP, some capital goods
i.e. equipment, machinery etc. are used. These capital goods lose their value with the passage of
time.
A certain amount of money for wear and tear is set aside every year from the gross
annual income. This sum which is set aside for covering deterioration of the machinery is named
as depreciation allowance. Therefore to find the net value of output, we deduct depreciation from
GNP.
i.e. NNPat MP = GNP - Depreciation

v. National Income at Factor Cost:

Usually NI means the National Income at Factor Cost. In other words, the figure of
National Income is reached when we add up the the incomes of four factors of production say
rent, wage, interest and the normal profit.

Whereas NI at market price means the market value of all the goods and services
produced in a country over a specified time period say one year, after accounting for .

To equate the NI at factor cost and NI at market prices, we have to deduce the indirect
taxes from NNP at market prices and subsidies have to be added in it.
The equation of NI at market prices with the adjustment of Indirect taxes and subsidies is
expressed below:

NNPat MP =GNP - Dep

NI at FC = NNPat MP - Indirect Taxes + Subsidies

vi. Personal Income:

Personal Income is the total income received by the individuals of a country from all
resources before direct taxes in one year. PI is never equal to the NI because PI includes transfer
payments like Zakat, donation, scholarship, pension etc. whereas these items are not included in
NI. Few income items, which are only included in NI but are not paid to individuals are
undistributed corporate profit, corporate profit taxes and social security funds.

PI = NNP - Social Security - Corporate - Undistributed + Transfer Payments

Contributions Income Taxes Corporate Profits

vii. Disposable Personal income:

Disposable Personal Income is the amount which is actually at the disposal of households
to spend, as they like. It is the amount, which is left with the households after paying personal
taxes such as income tax, property tax, wealth tax etc. Thus:

DPI = PI - Direct Taxes

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Macro Economics 4 BBA/ADC
Per Capita Income:

The average income of the people of a country in a particular year is called Per Capita
Income. To find out PCI , the NI of a country is divided by the population of the country in that year.
NI

Total Population
PCI =

Nominal Income and Real Income:

Nominal Income is calculated at current prices prevailing in the period during which the
output is produced. It is not adjusted with subsequent changes in inflation rates.
Real Income is calculated at constant prices of some base year. It is inflation adjusted income.
Real NI is the true reflector of economic performance of an economy.

GNP Deflator / GDP Deflator:

It measures the average changes in price level of goods and services over a specific time
period with the help of the following formula:
Nominal GNP

Real GNP
GNP deflator = x 100

Nominal GDP
Similarly,

Real GDP
GDP deflator = x 100

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Macro Economics 5 BBA/ADC
Question.2:

Describe methods of measurement of National Income.

Answer:
MEASUREMENT OF NATIONAL INCOME:
The progress and prosperity of a nation is measured by NI. Measurement of NI is not an easy
task because income is produced at many sources by millions of people working in different fields like
shops, factories, offices and industries etc. Therefore exact measurement is not possible. We can only
have a good estimate of measuring NI of a country. For this purpose, three alternative approaches are
generally used.
1. Production or Output Method
2. Income Method
3. Expenditure Method
1. PRODUCTION OR OUTPUT METHOD: (NI at market price)
Production method is useful to know the relative importance of various sectors of the economy
by showing their respective contribution to the NI. According to this method, NI is measured in two
ways:
i-Final Product Approach
ii-Value Added Approach
i- Final Product Approach:
This product approach is used to find out the market value of all final goods and services
produced in a country during a year. The economy is divided into different sectors like agriculture,
manufacturing, mining, transport, commerce and services etc. The value of gross product from all the
sectors is added up.

Sectors Value(Rs.Billion)
Agriculture 30
Manufacturing 150
Mining 20
Transport 30
Commerce 20
Services 50
National Income 300

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Macro Economics 6 BBA/ADC
Thus we can say that
NNPat Market Price =GNP - Depreciation

NI at Factor Cost = NNPat Market Price - Indirect Taxes + Subsidies

ii- Value Added Approach:

This approach is used to measure NI in different phases of production in the circular flow. It
shows the contribution (value added) of each producing unit in the production process. It is calculated
as the difference between value of output and value of intermediate consumption.
Value Added = value of output - intermediate consumption
This is one of the ways to avoid double counting of goods and services. The following schedule
illustrates this method:

Stage of Production Value of output Value Added(Rs.)

or at each stage
SaleValue(Rs.)
Wheat 20 20
Flour 25 (25 - 20) = 5
Bread 40 (40 - 25) = 15
Total 85 = 40

Money value is added at each stage of production of all the sectors of economy. Sum of the values added
is equal to NI.
Precautions:
The following precautions should be adopted in this method.
1. Multiple counting should be avoided. The value of final goods and services should be added to
avoid multiple counting.
2. Indirect taxes are included in the prices of commodities but revenue from these goes to the Govt.
treasury and not to the factors of production. So it should be deducted from NI.
3. The values of Unpaid Services like services of house-wives, treatment of a doctor to his son are
not included in the estimation of NI.
4. Capital gains or losses are not included in NI as they do not show the current flow of goods and
services in the economy.
5. The value of Unsold Goods or the goods in process must be included in current output.

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Macro Economics 7 BBA/ADC
2. INCOME METHOD: (National Income at Factor Cost)
This method estimates NI from distribution side. The sum total of the incomes of all the persons
of a country during a year is called NI by income method. All the persons of a country can be either
Land or Labor or capital or Organization. So, all the renumerations received by the factors of production
during a year, are summed up. These renumerations are generally grouped as under:
i. Rent
Income earned by individuals for the use of their property such as land, houses etc.
ii. Wages
All types of payments to the labour force, salaries, allowances, reward of services of
doctors, engineers and teachers etc.
iii. Interest
All types of interest received by the people and firms during a year
iv. Normal Profit
Net corporate earnings of the firms, undistributed profits of the companies, corporate
taxes paid to the government.
NI at Factor Cost = (Rent, wages, Interest, Normal Profit)

Precautions:
The following precautions should be adopted in this method.
1. Transfer Payments such as zakat, pensions, gifts, scholarships etc. are not included in NI.
2. Illegal Earnings (smuggling, bribery etc.) are not included in NI.
3. Second Hand Sales should not be included included in measurement of NI.
4. Value of Increase in Properties due to increase in their price during a year should not
be included in NI.
5. Non-monetized Consumption and the corresponding productive activities go unrecorded in
measurement of NI.
3. EXPENDITURE METHOD:
National Income can also be estimated by adding up all the expenditures made on goods and
services by people and government during a year. These expenditures are as follows:
i- Personal Consumption Expenditures (C):

It includes all the expenditures that private individuals spend on the purchase of consumer goods
and services of daily routine.

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Macro Economics 8 BBA/ADC
ii- Government Expenditures (G):

It includes all the expenditures that the government of a country spends on the purchase of goods
and services e.g. expenditure on defence, administration, health, education etc.

iii- Gross Domestic Private Investment (I):

It includes all the expenditures by private business on replacement, renewals and new investment
etc.

iv- Net Foreign Investment + (X - M):

This type of expenditure is the net difference of exports and imports i.e. the difference of what
the foreign countries spend on goods and services of the national economy over and above what
the economy spends on the output of foreign countries.

The total of these expenditures comprise the GNP of a country during a

year. Thus GNP = C + I + G + (X-M) + NFI
Precautions:
The following precautions should be adopted in this method.
1. Avoid Over-Estimation. All the expenditures must be counted once.
2. Intermediate Expenditures must not be included in NI.
3. Expenditures on Used Goods of the firm should not be included in NI.
4. Expenditures on Old Shares are not included in NI.
5. Property Income from abroad should be included in NI.

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Macro Economics 9 BBA/ADC
Question.3:

Explain why an economy’s income must equal to its expenditure.

Answer:
Circular Flow Of Income and Expenditure in a Two Sector Economy:

Goods
Product Market Final

Households/ Firms/Business/
Consumer of Goods/ Owners of Inputs Producer of Goods/ Employers of Resources

Factor Market

, Labour

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Macro Economics 10 BBA/ADC
The movement of national income from households to firms and from firms to households in a circular
manner during a specific time period in an economy is called circular flow of national income.

Assumptions:
1. There are only two sectors in the economy i.e. households or consumers and business sector or
firms.
2. Neither the household nor firm save.
3. Govt. does not play any role.
4. There is no foreign trade. i.e. Closed Economy.

In the diagram, the upper portion shows the Product Market and the lower portion shows the
Factor Market. The outer loop of the upper portion shows that the firms supply goods and services to
the households and the inner loop of the upper portion shows the household expenditures on the goods
and services, which they pay to the firms.
The outer loop of the lower portion shows that the households provide inputs in the shape of land,
labour, capital and organization to the firms. For which they receive a reward or flow of income from
the firms which is shown by the inner loop of the lower portion of the circular flow.
The upper portion shows the flow of expenditures and the lower portion shows the flow of incomes. In
such case the expenditure of a person becomes the income of the other.

Firms expenditures become income of households and expenditures of households become

income of firms. Households provide factors of production to the firms. The firms produce goods and
services with the help of factors of production. Firms pay for services of factors of production that
becomes the income of households. The households spend that income for purchase of goods and
services produced by the firms. In this way the circular flow of NI is completed.
Two principles are involved in this process:

i- The flow of goods and services and the flow of money income move in opposite direction.

ii- The seller of goods receive the same amount of money spent by the buyers in the
business transactions.

Because every transaction has a buyer and a seller, so the total expenditure in the economy must
equal the total income in the economy.
The producers sell out their products to consumers. It is the representation of National Income in
the form of Production. On the other hand, the consumers spend all of their income on the consumption
of goods produced by the business sector. It is also the representation of national income in the form of
Expenditure.
Expenditures = Outputs = Incomes
The upper and lower loops of the circular flow diagram illustrate that the flow of expenditures
must be equal to the flow of income if there are no “Leakages”. The leakages may be:
i. Savings of households,

ii. Taxes paid to Govt. And

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Macro Economics 11 BBA/ADC
iii. Imports

Likewise “Injections” cause increase in national income. The injections may be:

i-Investment

ii-Government Spendings

iii-Exports

If the total of leakages are equal to that of injections then national income will remain stable.

Question.4:

Discuss the difficulties in measurement of National Income.

Answer:
DIFFICULTIES IN MEASUREMENT OF NATIONAL INCOME
National Income is the total market value of all final goods and services produced in a country during
one year. Following are the major problems in measuring the national income of a country.
1. Difficulty of Double Counting:
In the estimation of National Income, there is danger of double or multiple counting of cost of
commodities. It causes overestimation of national income. In order to avoid this problem, we must take
value of final goods and services only.
2. Lack of Reliable Data:
There is generally lack of adequate statistical data. Due to illiteracy, a large number of petty
producers have no idea of the quantity of their output and do not keep regular accounts. So exact data
does not reach to data collector. It adds to the difficulties in estimation of NI .
3. Lack of Trained Staff:
Collection, compilation and analysis of statistical data is highly technical exercise and it is
difficult to arrange sufficiently trained staff for it. Inefficient data collectors provide vague data causing
problem in the estimation of NI.
4. Existence of Non-Monetized Sector:
There is a large non-monetized sector in rural areas in which a large portion of production is
partly exchanged for the other goods and is partly kept for personal consumption. Such production and
consumption can not be calculated in NI.
5. No Occupational Classification:
Some people receive income by working in various capacities e.g. an individual may receive
income partly from business and partly from Govt. Job. It is difficult to know the total earning of such
person. It becomes a problem to count his income in any sector of production.

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Macro Economics 12 BBA/ADC
6. Illegal Income:
The huge underground economy of corruption, smuggling, gambling, drug trades etc. can not be
estimated and therefore, a major part of production is not included in NI. It creates problem in the exact
measurement of NI.
7. Value of Inventory Change:
All inventory changes whether negative or positive are included in NI. But valuation of
inventories is a difficult and subjective procedure. It causes over or under estimation of NI.
8. Calculation of Depreciation Cost:
To find NNP at market price, we deduct depreciation allowances. Other similar reserves and
expenditures such as replacement expenses etc. are to be charged to production. To calculate the correct
value of such expenditures is a difficult task because there is no fix standard for their calculation.
Therefore there are more chances of over estimation or underestimation of NI.
9. Difficulties of Expenditure Method:
Generally justice, administration and defence are treated as Consumption expenditure whereas
capital formation is treated as Investment expenditure. In some cases, it becomes difficult to decide
whether Govt. spending is Consumption expenditure or investment expenditure. The same case is in
personal spending. This misleads to estimation of NI.
10. Free Services:
The services without material gains like treatment of a doctor to his parents, tuition by a teacher
to his son etc. are not included in NI. It causes under estimation of NI.
11. Changing Price Level:
We observe fluctuations in price level due to which market value may change. It leads to
increase in money income even though production might have fallen. On the contrary, a fall in price
level shows decline in NI though production might have gone up. It causes over or under estimation of
NI.
12. Income of Foreign Firms:
The income earned by foreign firms poses a question of whether it is the part of NI of host
country or not. According to IMF such income belongs to the country in which production takes place,
however, profits by foreign branches are credited to their parent concern. It causes overestimation of NI.
Q: Define Transfer Payments.
Ans: The part of personal income which is not earned by the mental or physical efforts of the
individuals is called transfer payments.

Prof. Muhammad Ex-Principal GGC