Chapter 8: National Income

National Income is a measure of the money value of goods and services becoming available to a nation from economic activities. It can also be defined as the total money value of all final goods and services produced by the nationals of a country during some specific period of time – usually a year – and to the total of all incomes earned over the same period of time by the nationals.

Concepts of National Income

  • Gross Domestic Product: The money value of all goods and services produced within the country but excluding net income from abroad.
  • Gross National Product: The sum of the values of all final goods and services produced by the nationals or citizens of a country during the year, both within and outside the country.
  • Net National Product: The money value of the total volume of production (that is, the gross national product) after allowance has been made for depreciation (capital consumption allowance). NNP=GNP-D
  • Nominal Gross National Product: The value, at current market prices, of all final goods and services produced within some period by a nation without any deduction for depreciation of capital goods.
  • Real Gross National Product: This is the national output valued in constant prices during some base year or nominal GNP corrected for inflation. An inflational deduction called stock appropriation is done.
  • Net national income: This is the income received from productive activities after subtracting indirect taxes and adding subsidies i.e. NNI=national income at factor cost-indirect taxes + subsidies.
  • Personal income: this is the sum of all incomes received by the residents of a country during a excludes undistributed profits, corporation taxes and social security contributions e.g. the NSSF but it includes transfer payments i.e.

Personal income = NNI – undistributed profits – corporation taxes – social security            contributions + transfer payments.

  • Disposable personal income: this is the income that an individual /resident of a country receives after paying direct taxes to the government e.g. income tax
  • Per capita income: Refers to national income divided by the population of that particular country.

Approaches to Measuring National Income

The compilation of national income statistics is a very laborious task.  The total wealth of a nation has to be added up and there are millions of nationals.  Moreover, in order to double check and triple check the statistics, the national income statistician has to work out the figures out in three different ways, each way being based on a different aspect.  The three aspects are:

  • The National Output: The creation of wealth by the nation’s industries. This is valued at factor cost, so it must be the same as b) below.
  • The National Income: The incomes of all the citizens
  • The National Expenditure: because whatever we receive we spend, or lend to the banks to invest it, so that the addition of all the expenditure should come to the same as the other two figures. Put in its simplest form we can express this as an identity

The output/product/value added/net output method of measuring national income

In this method value of output of all the firms in the economy is added together to arrive at national income figure. To aid in this the economy is divided into different productive sectors eg farming, fishing, mining etc.  It is a useful method where a census of production of the economy is required. It is important that only the value added at each stage of production or by each firm is counted in order to avoid double counting. The term value added of the firm may be defined as the difference between the total value at each stage and the value of the previous stage. For example:  Consider a case of wheat bread production shown below:

Farmer 100,000 100,000
Miller 150,000 50,000
Bakers 180,000 30,000
Retailers large/wholesalers 190,000 10,000
Retailers 200,000 10,000
Total 820,000 200,000

To avoid double counting we use value added only or the other approach is to add the final product only. Imports if and only if included in the total output should be excluded and exports if excluded should be included.

The figure obtained is further adjusted by adding net factor income from abroad. This is the most direct method of calculating national income.

Adjustments to be made

  • Stock appreciation – subtracted.
  • Residual errors – subtracted.
  • Net factor income from abroad – added if positive and subtracted if negative.
  • Depreciation

Income Method

Income method approach is from the distribution side. In this approach national income is got by adding together all the rewards earned by all factors of production for a given period. We include only those particular income flows that originate with the production of goods and services whose total we seek to estimate.

Only then will the total income flows equal the total of the goods and services. In an economy income is earned as follows

  • Land receives rent (R)
  • Labour receives wages (w)
  • Capital receives interest (r)
  • Enterprenuer receives profit (π)

So that Y = R + W + r + π, however the following also should be taken into account:

  • Retained earnings – (re) that part of profit retained by firms should be taken into account
  • Subsistence income (sy) – this occurs in a case where income is not paid but services are rendered eg services of housewives, self-provided services etc.

The following should be excluded:

  • Transferred payment (tp) – Payment made without satisfying ‘Quid Pro Quo’ criteria ie income for which the recipient provides no good or service.
  • We should exclude income received from people who sell building, automobiles or things produced in a previous period, because what they receive in payment is ‘not income’ in the sense of something generated in the cause of producing the output of the current period (py)
  • Anything for which neither a good or a service is supplied in exchange and for which there is therefore no corresponding for example receipts of people who sell bonds and debentures (S)

Therefore National Income will be expressed as follows:

Y = R + W + r + Re + π + Sy – tp – Py – S

Y = C + S + T + Rpf

Expenditure Method

In this approach we add together all types of spending on finished goods and services in an economy.  It involves counting each unit produced at the time of purchase and valuing it at the actual purchase price.  If we add up total expenditure on goods and services, we will have (subject to a number of qualifications).  The total we seek and also a total in which each unit of output is valued at what appears to be the best available indicator of the value of that unit to the society i.e. the price actually paid for it.

Different types of spending in an economy are identified and added together:

  • Personal consumption expenditure (C) Spending in food items, services, durable goods by households.
  • Private domestic investment (Gross) (I): This includes all purchases of machinery, tools and equipment, all construction whether residential as commercial and changes in inventory.

Inventory changes as investments are produced and not sold or sold when not produced in the present period.  If at the end of the year firms have more stock on the shelves than at the end of the year it means that the economy has produced more than it has consumed. Therefore positive changes should be added when GNP is determined. For inventory decline we subtract from GNP since GNP is a measure of the current year’s output and we must omit anything produced in past or previous years. A fall in inventory means that the economy consumed more than it produced in a given year, thus consuming previous year’s production.

  • The Government (G) All government spending on final goods and services should be included but exclude spending on transferred payments as well as subsidies.
  • Exports and Imports Spending by foreigners on goods and services produced in a country should be included. Export is symbolized by (X), Imports is spending on foreign goods and services produced in other countries. It is symbolized by (M).

Net export (Xn) is the amount by which foreign spending on our goods and services exceed the amount of spending on goods and services exceed the amount of spending on goods and services produced by foreigners.

Therefore, GNP = C + I + G + X – M; also measures aggregate demand of an economy.

Exclusions from Expenditure

The desired total measures the amount of output produced by an economy in a specified period of time. Thus it must clearly indicate only expenditures on the purchase of goods and services produced in that period. The exclusions include:

  • Any part of billions of shillings spent during that period on goods produced in earlier periods. All expenditures of this kind merely reflect changes in the ownership of pre-existing output.  As such they are not part of the total of expenditure that measures the values of total output.
  • It must exclude all expenditures of things that are neither goods nor services and therefore do not reflect production at all either current or past. For example spending on stocks and bonds. There is no production or output of goods and services corresponding to expenditure on mere pieces of paper.
  • All expenditure by central and local government for which the government does not receive a good or services in exchange e.g. transfer of payments.
  • Spending on intermediate products so as to avoid double counting

Difficulties in Measuring National Income

National Income Accounting is beset with several difficulties. These are:

  • Making decisions on what goods and services to include: Although the general principle is to take into account only those products which change hands for money, the application of this principle involves some arbitrary decisions and distortions. For example, unpaid services such as those performed by a housewife are not included but the same services if provided by a paid housekeeper imputed value is usually assigned to this income. Many durable consumer goods render services over a period of time. It would be impossible to estimate this value and hence these goods are included when they are first bought and subsequent services ignored.  Furthermore, there are a number of governmental services such as medical care and education, which are provided either ‘free’ or for a small charge. The solution is that all unpaid services are excluded.
  • Danger of Double Counting: The problem of double counting arises because of the interrelationships between industries and sectors. Thus we find that the output of one sector is the input of another. If the values of the outputs of all the sectors were added, some would be added more than once, giving an erroneously large figure of national income. This may be avoided either by only including the value of the final product or alternatively by summing the values added at each stage which will give the same result. Some incomes such as social security benefits are received without any corresponding contribution to production. These are transfer payments from the taxpayer to the recipient and are not included. Taxes and subsidies on goods will distort the true value of goods. To give the correct figure, the former should not be counted as an increase in national income for it does not represent any growth in real output.
  • Inadequate Information: The sources from which information is obtained are not designed specifically to enable national income to be calculated.
    • It is easy to value the goods that are sold in market but those which aren’t sold in market have no price attached to them.
    • Activities that are considered illegal e.g. making illicit brews are also not included when measuring national output although they involve exchange of money.
    • The value to put on goods that have been kept as stock becomes has to decide whether to use the cost of goods /the price to be paid for them. Price is different from cost of similar goods being produced due to a rise /fall in the production costs.
    • Prices of some resources keep fluctuating in markets
    • It is difficult to measure the cost of wear and tear or depreciation of equipment in order to arrive at net national income

Factors Affecting the Size/Level of National Income

The size of a nation’s income depends upon the quantity and quality of the factor endowments at its disposal. A nation will be rich if its endowments of natural resources are large, its people are skilled, and it has a useful accumulation of capital assets.  The following points are of interest:

  • Natural Resources: These include the minerals of the earth; the timber, shrubs and pasturage available; the agricultural potential (fertile soil,  regular  rainfall, temperature or tropical climate); the fauna and flora; the fish; the energy resources, including oil, gas, hydro-electric, geothermal, wind and wave power
  • Human Resources (labour supply): A country is likely to prosper if it has a large population; literate and numerate sophisticated and knowledgeable about wealth creating processes.  It should be well educated and skilled, with a nice mixture of theory and practice.  It should show enterprise, being inventive, energetic and determined in the pursuit of a better standard of living.
  • Capital Resources: A nation must create and then conserve capital resources.  This includes not only tools, plant and machinery, factories, mines, domestic dwellings, schools, colleges, etc., but a widespread infrastructure of roads, railways, airports and ports. Transport creates the utility of space. It makes remote resources accessible and turns high cost goods into low-cost goods by opening up remote areas and bringing them into production. A country that uses modern equipment eg tractors in ploughing would be able to produce more than a county using simple jembes.
  • Self-sufficiency: A nation cannot enjoy a large national income if its citizens are not mainly self-supporting.  If the majority of the enterprises are foreign – owned there will be a withdrawal of wealth in the form of profits or goods transferred to the investing nation.
  • Political Stability: the government that maintains conducive political atmosphere may attract both local and foreign investors who in turn contribute to increasing size of national income. In order to plan and execute production plans, firms require a stable political environment.
  • Level of technology: this refers to the techniques in production of goods and services determining quality and quantity of goods and services provided. The higher the level of technology used in production process, the higher its output and hence higher national income
  • Entrepreneurship: availability of entrepreneurs who have the ability to organise the factors of production will have a bearing on county’s national income.
  • Land: a country with abundant resources is likely to have a high national income relative to a country without.
  • The quantity and quality of factors of production.

Uses of National Income Statistics

  • We need national income statistics to measure the size of the “National cake’ of goods and services available for competing uses of private consumers, government, capital formation and exports (less imports).
  • National Income statistics are also used in comparing the standard of living of a country over time and the standards of living between countries.
  • National Income Statistics assists in investment decisions and this is possible because the data from this statistics may show the sectors which are declining and those growing. Investors would save in growing sectors to save him/her time and cost of conducting market research.
  • If National Income Statistics are disaggregated it would enable us to assess the relative importance of the various sectors in the economy. This is done by considering the contribution of the various sectors to Gross National Product over time. Such information is crucial for planning purposes for it reveals to planners where constraints to economic development lie. It therefore becomes possible to design a development strategy that eventually would overcome these problems. This central contribution could be in the form of employment or the production of goods and services.
  • By assessing exports and imports as a percentage of Gross national Product i.e. using national statistics, it is possible to determine the extent to which a country depends on external trade.
  • Provides a breakdown of consumer expenditure, government expenditure, levels of investment and total taxes paid to the government. This helps the government to plan for development activities using taxes collected e.g. social amenities provision helps government when making policies regarding investment.
  • To provide information on the relative sizes of the various sectors of the economy and their contribution e.g. agriculture and manufacturing. This will be determined by the share of each sector in relation to total national output.
  • Provide information on performance of the economy over a given period of time and this forms a basis of comparison between different periods.
  • Provide information which is used in making economic policies, preparing annual budgets and preparing development plans.
  • This statistics provide information on the distribution of income which helps the government to address income disparities e.g. through subsidies and tax relief.
  • D.P is a measure of economic growth. If G.D.P goes up it indicates that the economy is growing.
  • Provides information on the types of factor incomes within the economy and this can be an indicator of shrinking/growing sectors of the economy.
  • Used as a measure of standard of living of people in a country.
  • Assists in comparing standards of living, although this method has a number of drawbacks i.e. different currencies are used and conversion may be tedious, definition of goods and services used in computing national income may also differ in different countries, disparity in income distribution and different needs and taste of citizens.

Per Capita Income/GNP

National Income is meant the value of outputs produced within a year.  Income per capita is simply the National Income divided by the population of the country in a year.

Income Per Capita = National Income/Population

It shows the standard of living a country can afford for its people.  The level of income per capita is determined by the size of a country’s population. The higher is the rate of growth of population, the lower is the rate of growth of income per capita.

Per capita income is a theoretical rather than a factual concept.  It shows what the share of each individual’s National Income would be if all citizens were treated as equal.  In a real world situation there exists considerable inequality in the distribution of income especially in the third world countries.

National Income and Standards of Living

Standard of living refers to the quantity of goods and services enjoyed by a person. These goods may be provided publicly, such as in the case of health care or education or they may be acquired by direct purchase. It also includes the less easily quantifiable aspects of living such as terms and conditions of employment and general living environment.

National Income figures can be used to measure the standard of living at a particular point of time and over time. This is done by working out the per capita income of the country. By per capita income we mean: the value of goods and services received by the average man. Per capita income is obtained by dividing the National Income by the Total population. If the per capita income is high, it can be deduced that the standard of living is high.

Problems of Using Per Capita Income to Compare Standard of Living over Time

  • The composition of output may change. E.g. more defense-related goods may be produced and less spent on social services, more producer goods may be made and less consumer goods, and there may be a surplus of exports over imports representing investment overseas. Standards of living depend on the quantity of consumer goods enjoyed.
  • Over time prices will change. The index of retail prices may be used to express the GNP in real terms but there are well known problems in the use of such methods.
  • National Income may grow but this says nothing about the distribution of that income. A small group may be much better off. Other groups may have a static standard of living or be worse off.
  • Any increase in GNP per capita may be accompanied by a decline in the general quality of life. Working conditions may have deteriorated. The environment may have suffered from various forms of pollution. These non-monetary aspects are not taken into account in the estimates of the GNP.
  • Finally the national income increases when people pay for services which they previously carried out themselves. If a housewife takes an office job and pays someone to do her housework, national income will increase to the extent of both persons’ wages. Similarly a reduction in national income would occur if a man painted his house rather than paying a professional painter to do the same. Changes of the above type mean that changes in the GNP per capita will only imperfectly reflect changes in the standard of living.

Per Capita Income and International Comparisons

Per capita income figures can also be used to compare the standards of living of different countries. Thus if the per capita income of one country is higher than that of another country, the living standard in the first country can be said to be higher. Such comparisons are made by aid giving international agencies like the United Nations and they indicate the relevant aid requirements of different countries.

But there are major problems in using real income per head (per capita income) to measure the standard of living in different countries. First there is the whole set of statistical problems and, secondly, there are a number of difficult conceptual problems or problems of interpretation.

Limitations of National Income as a Measure of Welfare

  • Inaccurate estimates of population: The first statistical problem in calculating income per head particularly in less developed countries is that we do not have very accurate population figures with which to divide total income.
  • Specific items which are difficult to estimate: Another data problem, as already mentioned, is that data for depreciation and for net factor income from abroad are generally unreliable.  Hence although we should prefer figures for “the’ national income, we are likely to fall back on GDP, which is much less meaningful figure for measuring income per head.  Inventory investment and work-in progress are also difficult items to calculate.
  • Non-marketed subsistence output and output of government: some output like subsistence farming and output of government are not sold in the market. These are measured by taking the cost of the inputs.  In one country, however, salary of doctors for instance, might be higher and their quality low compared to another country. Although the medical wage bill will be high, the “real consumption” of medical care in the former might be lower. Since “public consumption” is an important element in national income, this could affect comparisons considerably. Also in making international comparisons it is assumed that the complied national income figures of the countries being compared are equally accurate. This is not necessarily the case. If, for example, in one country there is a large subsistence sector, a lot of estimates have to be made for self-provided commodities. The national figures of such a country will, therefore, be less accurate than those of a country whose economy is largely monetary or cash economy.
  • Different degrees of income distribution: large population may be contributing a small proportion of national output while a few contribute a higher percentage. The many people who share only a small proportion will have a low standard of living.
  • Different Types of Production: If one country devotes a large proportion of its resources in producing non-consumer goods e.g. military hardware, its per capita income may be higher than that of another country producing largely consumer goods, but the standard of living of its people will not necessarily be higher.
  • Different forms of Published National Income figures: The per capita income figures used in international comparisons are calculated using the published figures of national income and population by each country. For meaningful comparisons, both sets of national income figures should be in the same form i.e. both in real terms or both in money terms, the latter may give higher per capita income figures due to inflation, and thus give the wrong picture of a higher living standard. On the other hand, if both sets are in money terms the countries being compared should have the same level of inflation. In practice, this is not necessarily the case.
  • Exchange Rates: Every country records its national income figures in its own currency. To make international comparisons, therefore, the national income figures of different countries must have been converted into one uniform currency. Using the official exchange rates does this. Strictly speaking, these apply to internationally traded commodities, which normally form a small proportion of the national production.  The difficulty is that these values may not be equivalent in terms of the goods they buy in their respective commodities i.e. the purchasing power of the currencies may not be the same as those reflected in the exchange rate.
  • Difference in Price Structures: Differences in the relative prices of different kinds of goods, due to differences in their availability, mean that people can increase their welfare if they are willing to alter their consumption in the direction of cheaper goods. The people in poor countries probably are not nearly as badly off as national income statistics would suggest, because the basic foodstuffs, which form an important part of their total consumption, are actually priced very low.
  • Income in relation to Effort: increased gross national output may have resulted from an increase in the number of hours worked. G.N.P is a measure of production and consumption not necessarily indicating an improvement in people’s welfare. The citizens may be working in unhealthy conditions and leisure time denial thus G.N.P does not take into account people’s welfare.
  • Differences in size: A problem which is both conceptual and statistical is due to the transport factor. If two countries are of different sizes, the large country may devote a large proportion of its resources in developing transport and communication facilities to connect the different parts of the country. This will be reflected in its national income, but the standard of living of its people will not necessarily be higher than that of smaller country, which does not need these facilities to the same extent.
  • Differences in Taste: Another formidable difficulty is that tastes are not the same in all countries. Also in different countries the society and the culture may be completely different thus complicating comparisons of material welfare in two countries. Expensive tastes are to some extent artificial and their absence in poor countries need not mean a corresponding lack of welfare. Tastes also differ as regards the emphasis on leisure as against the employment of the fruit of labour:
  • Different climatic zones: If one country is in a cold climate, it will devote a substantial proportion of its resources to providing warming facilities, e.g. warm clothing and central heating. These will be reflected in its national income, but this does not necessarily mean that its people are better off than those in a country with a warm climate.
  • Income per head as index of economic welfare: We cannot measure material welfare on an arithmetic scale in the same way as we measure real income per head. For instance, if per capita income increases, material welfare will increase; but we cannot say by how much it has increased, and certainly that it has increased in proportion.
  • It does not take into consideration the effects of production activities on environment eg environmental degradation and pollution.
  • It just measures economic growth as opposed to economic development
  • Quality of Life: National income figures do not reflect the quality of life. An increase in national income may be the result of linger working houses, inferior working condition, increase in housewives (which means less comfort). Generally national income has no provision for leisure time.