In this study session, our primary focus is to present to you the conceptual definition of national income accounting as well as familiarize you with the notion of circular flow of income. This idea is compelling as it will serve to propel you towards reading and understanding of the performance of the aggregate economy.
Tied to this, is the fact that to measure a nation’s output or income, we must begin by deciding on an economically meaningful concept of national income or national income accounting.
National income is defined as monetary value of all goods and services produced in a country during a particular period usually a year. In addition, you will be introduced to the concept of national income accounts, dwelling on the notion of measuring production of and income from production of economic goods – goods and services – which are relatively scarce and thus command a price in the marketplace, or would command a price if they were to pass through the marketplace.
Finally, you will be instructed on how much spending, income and output are being created in an economy over a period of time. National income measurement resulting in national income data gives us this information as you would have noted from the this post (Introduction to Macroeconomics).
However, there are a number of theoretical and practical issues that are encountered when one sets out to measure the economic activity of a nation. An understanding of these issues whilst important, one is hardly in position to tackle them until one understands the purposes for which the results are intended. You will therefore learn the purpose and difficulties of measuring national income.
National Income Defined
National income is a measure of the monetary value of the total flow of goods and services produced in an economy over a specified period of time, usually a year. It can be described as the flow of new wealth resulting from the productive use of the national capital stock and labor force. Being part of a continuous flow, national income is measured per time period, monthly, quarterly, or more usually yearly.
National income can be distinguished from national wealth and capital stock. National wealth comprises all the physical assets or things that have values, owned by the nation’s residents. The National capital stock is the part of national wealth capable of producing more wealth. It includes all the capital goods and raw materials owned by the country’s residents as well as social capital such as roads; . hospitals and schools.
However, it excludes consumer goods which are a part of national wealth but not national capital. All capital is wealth, but the reverse is untrue; not all wealth is capital. However, wealth and capital are examples of economic stocks and are thus distinguished from income which constitutes a flow.
What is National Income Accounting?
National income accounting is the science of measuring the aggregate output and income of an economy. It is based upon the principles of the circular flow of output and income.
The Circular Flow of Output and Income
The circular flow of income is the process of a flow of income from firms to households and a flow of expenditure from households to firms.
Two Sector Circular Flow of Output and Income:
The top half of the circular flow diagram highlights the flows of goods and services from businesses to households and the corresponding flow of money payments for these goods and services from households to businesses. The bottom half shows the flows of the factors of production from households to businesses and the reciprocal flow of factor payments (income) from the businesses to households.
Intermediate goods traded within the business sector do not enter the circular flow. Intermediate goods do not enter the circular flow because they remain within the business sector.
Final goods in the circular flow are those goods that do not require further processing and are purchased for final use (e.g. clothing by a consumer or a machine by a manufacturer).
Intermediate goods in the circular flow are those goods that: (1) require further processing during the year before they are ready for final use, (2) are purchased for modification before final use, or (3) will be resold during the year for a profit.
Note that certain goods could be either final or intermediate goods, depending on the purchaser’s use of the good. For example, the loaf of bread is a final good if purchased by a household for consumption; it is an intermediate good if purchased by a luncheonette, who will resell the bread in sandwich form. Similarly, a bag of flour is a final good when purchased by a household for family use but an intermediate good when purchased by a baker.
Measuring National Income
Three different methods can be used to measure national income or the flow of new wealth produced by an economy. They are:
The Product Method
The Product method involves adding up the value of all final goods and services produced by firms during the year. All intermediate goods are not included to avoid double counting. In effect, the product method entails summing then values-added by all firms at different stages of production.
To illustrate this, consider a simple example in which producing a woolen coat involves the following three stages of production:
• A sheep farmer produces raw wool and sells it to a mill for N10. This represents an income of N10 for the farmer. Value-added=N10
• The mill used the raw wool to produce cloth which it sells to a coat factory for N21. This represents income (including profit) of N11 for the mill – remember that N10 had to be paid for the raw wool. Value-added=N11.
• The coat factory produces the coat and sells it for N40. This includes N21 to cover the cost of the cloth and N19 to pay incomes, including profits. Value- added=N19.
• The total value-added in this example (N40) is just equal to the value of the final coat.
Please do note that, intermediate goods are components of final goods. If the value of both intermediate and final goods were included in the measurement of the value of final output, there would be a double counting of value and an overstatement of Gross National Product. Note also that Gross National Product measure does not measure the output of all final goods and services.
This is in regards to a number of productive activities that do not involve a market transaction (e.g. do-it-yourself home repairs, productive services of the housewife. etc). Since GNP includes only output that involves a market exchange, such productive activities are not included and their exclusion results in an understatement of the value of final output.
The Expenditure Method
The Expenditure method involves adding up all the spending on final goods and services produced by firms. Such an aggregate will only equal the value of total output if those goods which are produced but not sold are also included – this item, which is called ‘net changes in stocks and work in progress’, is normally counted as part of firms’ investment spending (which is logical since such goods are for future rather than current consumption).
National expenditure is then the sum of consumption of domestically produced goods, investment (including changes in stocks and work in progress), government expenditure and net exports. Notice that, as before, in order to avoid double counting, only spending on final goods and services is included.
The Income Method
It is because goods and services are produced by factors of production that income is created in an economy. The income method is another way of calculating the value of total output by adding up all the incomes (that is, wages, salaries, interest, rent and profits) of all factors of production, those producing intermediate goods as well as those producing final goods.
It is important in using this method to exclude all transfer payments, as these represent nothing more than a redistribution of income from tax payers to the transfer recipients; including them, therefore, would involve double-counting.
Please do note that, transfer payments are payments which are not made in return for some productive service. e.g., payments made by the state to needy individuals, which, in effect, transfer income from wealthier sector of the population to the poorer. Examples are old age pensions, unemployment benefit and widow’s’ pensions. They are
not payments in return for productive services, but rather represent income redistribution. Likewise, taxation is a transfer payment to the government as they do not arise from the production of new goods and services.
The above methods of measuring national income notwithstanding, it should be noted that all three methods lead to the Gross National Product, a measurement of the total value of goods produced before allowing for depreciation. GNP less depreciation allowance for capital resources used up during the process of production gives the Net National Product (NNP). Net National Product less net indirect taxes gives National Income.
Both GNP and NNP measure the total market value of all final goods and services produced in an economy during one-year period. Out of the three approaches; product and income approaches are the two principal approaches to measuring national income.
Calculation of Gross and Net National Income: Hypotheical Exam
Gross and Net National Product for XYZ Country, 1999, from the Product Side (In millions of Naira)
Agriculture, Forestry, Fishing – 11,802
Energy and Water supply – 48,360
Manufacturing – 171,104
Construction – 43,048
Transport, Communications – 51830
Distributive Trades – 97,926
Insurance, Banking, Finance and Business Service – 127,806
Ownership of Dwellings – 40,360
Public Administration, Defense – 49,760
Public Health, Education – 63,362
Other services – 44,732
Gross Domestic Product – 709,038
Statistical Discrepancy – -4,564
Gross Domestic Product (average estimate) – 704,474
Net Property Income from Abroad – 11,046
Gross National Product (average estimate) – 715,520
Depreciation – -96,476
Net National Product (average estimate) – 619,044