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Tuesday, August 25, 2009

National Income and its Concepts

Tuesday, August 25, 2009 - 4 Comments

Professor Marshall defines National Income as “Sum of all the physical goods produced and services provided by utilizing the natural resources of the country with the help of labour and capital. In addition to this net income from abroad is also included. Accordingly National Income is the summation of all the goods produced and services provided and the net income from abroad.” Apparently Marshallian definition seems to be very simple and comprehensive, but it has some practical shortcomings (1) statistically it is difficult to estimate accurately about the produced goods and services. (2) There may be the possibility of double and multiple counting (3) certain portion of produced goods is kept for personal consumption. Because of such shortcomings Pigou defined National Income as “Only those goods and services will be included in National Income which are sold against money” but Pigou’s definition is not acceptable for those countries where there is limited use of money and many a goods are traded under barter system, Professor J. M Keynes has used three methods or approaches to define National Income.

1. The sum of all expenditures which are made on consumption and investment goods is known as National Income. This method is known as Expenditure method.

2. The sum of incomes of all the factors of production engaged in production process is also known as National Income. This method is known as National Income at Factor Prices Method.

3. If we subs tract the cost production from total output produced in the economy we will get National Income.

According to present ideas National Income may be defined as the aggregate factor income which arises from the current production of goods and services by the nation’s economy.

CONCEPTS OF NATIONAL INCOME:

There are five concepts of National Income which are discussed below.

1. Gross National Product (GNP): Gross National Product (GNP) is defined as the total market value of all final goods and services produced in a year. It is a measure of the current output of economic activity in the economy.

Two things must be noted in regard to Gross National Product.

(i) It measures the market value of the annual output. In other words GNP is a momentary measure. There is no other way of adding up the different sorts of goods and services produced in a year except with their money prices. But in order to know accurately the changes in physical output, the figure for Gross National Product (GNP) is adjusted for price changes by comparing to a base year as we do when we prepare index numbers.

(ii) For calculating Gross National Product (GNP) accurately, all goods and services produced in any given year must be counted once, but not more than once. Most of the goods go through a services of production stages before reaching, market. As a result, parts or components of many goods are bought and sold many times. Hence to avoid counting several times the parts of goods that are sold and resold, gross national product only includes the market value of final goods and ignores transactions involving intermediate goods.

2. Net National Product (NNP): The second important concept of National Income is that of Net National Product (NNP). In the production of gross national product of a year, we consume or use up some capital i.e. equipment, machinery etc. The capital goods, like machinery, wear out or depreciate in value as a result of its consumption or use in the production process. This consumption of fixed capital or fall in value of capital duets wear and tear is called depreciation. When charges for depreciation are deducted from gross national product, we get net national product. It means the market value of all final goods and services after providing for depreciation. There fore it is called “national income at market prices.” Thus

Net National Product = Gross National Product – Depreciation

3. National Income at Factor cost or National Income: National Income at Factor cost means the sum of all incomes earned by resources suppliers for their contribution of land, labour, capital and entreprenial ability which go into the year’s net production or in other words society in terms of economic resources to produce net output. It is rarely the national income at factor cost for which we sue the term National Income.

The Net National Product (NNP) is summation of market values of all the goods produced and services provided in a country in a year. But NNP does not show what actually has been earned by countryman during a year. In NNP the business taxes are also included. Such taxes do not represent the incomes of the people. Accordingly to know National Income (N.I) we will have to subtract the indirect taxes and add subsidies in NNP. It is shown as

NI = NNP – IT + S

Here IT shows indirect taxes while S is for subsidies.

4. Personal Income (P.I): Personal Income is the sum of all incomes actually received by all individuals or households during a given year. National Income, that is income received, must be different for the simple reason that some income which earned as social security, contributions, corporate income taxes and undistributed corporate profits is not actually received by households and conversely some income which is received as transfer payments is not currently earned. Accordingly if we include transfer payments and subtract undistributed profits etc. from National Income we get Personal Income (P.I). It is as

PI = NI + R + PT – UP

Here PT is taxes on profits, R is transfer payment, and UP is undistributed profits.

5. Disposable Personal Income (D.P.I): After a good part of personal income is paid to government in the form of personal taxes like income tax, personal property tax etc. What remains of personal income is called disposable income.

If personal taxes are subtracted from personal income we get Disposable Personal Income (DPI). It is as

DPI = PI – TP = C + S

Here TP is personal taxes.

6. Gross Domestic Product (GDP): Gross Domestic Product (GDP) is the total market value at current prices of all final goods and services produced within a year by factors of production located within country.

If we subtract the income earned through foreign services we get GDP. It is as

GDP = GNP – FI

Here FI is Foreign Income.

Circular Flow of Income

National Income can be measured either by income or expenditure or output approach. The statistical data will remain the same in all cases. Aggregate output is the result of the cooperation and coordination among the factors of production land, labour capital and organization which is remitted back to then in the form of their remuneration rent, wages, interest and profit. The income is spend on the purchase of consumer goods and a part of that is saved which is invested on the capital goods and investment helps in the production of consumer goods which are purchased and consumed by the same factors into market. Thus income slops no where. It rather takes the circular flow. We will discuss circular flow of National Income in two sector and three sector economies.

CIRCULAR FLOW OF NATIONAL INCOME IN TWO SECTOR ECONOMY

The circular flow is based upon two principles:

1. As a result of each economic transaction the seller gets how much is spent by the buyer.

2. If goods and services have a flow towards a particular direction, the money has also a flow towards other directions.

In the two sectors economy what so ever is produced by producer is sold out to the consumers, while consumers spend all of their earnings on the consumption of the goods produced by producers. The consumer or household provide services of four factors to the producers. Against such services, the factors of production get remunerations.

In following figure we have assumed an economy where there are households and firms. The flows in the upper part of the figure represent goods market. Here the firms provide final goods to the consumers. While household makes the payments to the producers of such goods and services in the form of money. While the flows in the lower part of the figure represent factor markets. Here the households provide services of factors of production to the firms.

What so even the factors earn against their services, its summation represents National Income. The summation of goods produced also represents National Income. Again the total expenditure made by household also represents National Income.

Thus we find that National Income is a flow moves from household to firms and from firms to household. The such movement of income is given the name of irregular flow of National Income.

CIRCULAR FLOW OF NATIONAL INCOME IN THREE SECTOR ECONOMY

Three sector Economy consists of consumers, producers and government. In the presence of government, there will be government purchases. Hence in product market, government expenditures will also be included. In such situation, the national output will consists of monetary value of final consumption, final investment goods and final government purchases. For the production of three above mentioned goods and services, the factors of production have to be employed. Then three rises the resource or factors market. Against such factors of production the wages, rent, profit and interest have to be period. The summation of such factor payments is known as National Income at factor cost. Here the size of National Income will be greater than two sector economy. In three sector economy households and firms pay tax to the government. The consumers make the savings which create financial market. The firms get the loans from this financial market and make investment of produce capital goods. More over government also gets loans from money market. The amount collected through taxes and gotten through financial market is spent by the government on government purchases. All this shows that National Income moves like a circular flow from consumers to producers vice versa. However on such economy there are government expenditures which also generate GNP.

Gross National Product (GNP)

The Gross Nation Product (GNP) is the summation of all those finally produced goods and services which the labour and capital like factors of production have produced by utilizing all the resources of the country in a year. If we represent such all aggregate output in the form of money e get GNP.

If we define GNP from market prices print of view then “GNP is the market value of all the goods and services produced in a country in a year.”

The GNP is a flow variable, because it represents the amount of goods and services produced during some particular period of time i.e. a year. If we represent the produced goods and services by Q1, Q2, Q3, Q4………. And their prices by P1, P2, P3, P4,……….. then GNP of a country will be as

GNP=P1Q1+ P2Q2+ P3Q3+ P4Q4+……………PnQn

But the measure of GNP by this method we have to make the following cases.

1. To ensure GNP the value of final goods will be included while the value of intermediate goods or those goods which are used for preparation of final goods will not be included. Because if it is done the value of a good will be counted twice. In this situation National Income will be over estimated. Therefore either the price of final good be included or the value added method be adopted.

2. In the measurement of GNP the non-productive transactions will not be included. It is told that the productive transactions consist of final purchase of newly produced goods. In our economic life most of the transaction is of non productive nature. It is as:-

(i) The sale and purchase of old shares and securities:- If any body sells or purchases the old securities no economic activity comes into being- just transfer of ownership. These to measure GNP such like transactions will not be included.

(ii) The Government Transfer Payments:- If government makes the payments to the people etc without their services-they are known as transfer payments as the case of payments of social security, unemployment allowances, pensions or scholarships to the students. All such payments will not be included in National Income.

(iii) The Private Transfer Payments:- In addition to government transfer payments there are private transfer payments. Such payment consists of dowry, charity, Zakat and pocket money etc. all such payments are not included in GNP because they have not been paid against any productive service etc.

(iv) The Sale of used goods:- If any person sells his second hand car, T.V or Fridge etc such transactions will not be included in current production. It is so because their value in GNP has already been included. If their value is re included the national income statistics will be misleading.

National Income

Professor Marshall defines National Income as “Sum of all the physical goods produced and services provided by utilizing the natural resources of the country with the help of labour and capital. In addition to this the net income from abroad is also included. Accordingly, the National Income is the summation of all the goods produced and services is the summation of all the goods produced services provided and the net income from abroad.”

According to present ideas, National Income may be defined as the aggregate factor income i.e. earning of labour and property which arises from the current production of goods and services by nation’s economy.

Professor Keynes has used three methods or approaches to define National Income.

1. The sum of all expenditures which are made on consumption and investment goods is known as National Income. Such definition of National Income, on the one side, considers total output of the economy as National Income. While on the other side the total expenditures are accorded as National Income, this method of defining National Income is known as Income-Expenditure Method of National Income.

2. The sum of incomes of all the factors of production engaged in production process is also known as National Income. This method is define National Income is known as National Income at factor Prices Method.

3. If we subtract the cost of production from the total output produced in the economy we will get National Income. This method to define National Income is known as subtraction of costs of production from aggregate output method.

After Keynesian thinking, post Keynesian economists defined National Income in a better way. They say that National Income is like three flows which flow at the same time. These flows are (1) Income (2) Outputs (3) Expenditures.

It is explained as “When goods and services are produced in the economy, the factors of production (who produce the goods and services) will get the payments. Then the factors will spend these incomes on consumption and investment goods” All this denotes that (1) The summation of produced goods and services represents National Income (2) The summation of all incomes earned by the factors represents National Income (3) Summation of all expenditures made by the factors of the production is also known as National Income.

Macro Economics Problems

Macro economics deals mainly with the problems of employment or unemployment, rising prices or inflation and economic growth etc. We highlight these problems.

1. PROBLEM OF UNEMPLOYMENT: The classical economists believed in full employment i.e. all the resources of economy are fully employed in accordance with their capabilities. The labour force in the economy is fully employed hence there is no possibility of unemployment in the country. The classical economists presented as well as proved their theory of full employment with the help of goods market, labour market, money market and credit market. According to them market forces operate in such a way that full employment is restored automatically. But such utopia of full employment could not exist for ever. J. M Keynes rejected this philosophy of full employment in 1936 by wiring book “General Theory”. According to him equilibrium of level of national income may beat full employment, at above full employment and at below full employment. Thus according to Keynes capitalist economy may even experience unemployment. To remove unemployment Keynes suggested for state intervention. He stressed upon printing of new money and enhancing the job opportunities by introducing Public Works Programmers. This means that unemployment according to Keynes can be removed with the help of deficit budgets on the part of government.

Unemployment is not the issue just concerned with the poor countries it has also hit the developed countries except some rich countries. The macro economists are trying very hard to put unemployment to an end. Now the question rises, how unemployment is defined, nowadays, how it can be removed etc. In very simple words, “Unemployment represents that ratio of labour force which fails to get employment.” The surveys which have been conducted regarding unemployment in US defined an unemployed person as “An unemployed person is one who is not working and (1) he has made a lot of efforts to get employment during the last four weeks (2) after the removal from job he is excepting to be called back for job (3) or he is hoping to get the job during coming four weeks. It is told that any person wishes to work and fails to get job, such employment on the contrary if a person deliberately does not want to work such unemployment. The economists do not care for such employment. The real issue is to remove that unemployment which is involuntary. The Keynes thinks such employment due to market imperfections. As if wages are rigid down ward and wages are increased more than increase in prices due to the pressure of trade unions, the producers increase their profits or the supply of certain raw materials decreased at world level-all such may leap to increase the costs, of production. It will decrease aggregate supply. Hence the unemployment may rise. According to A. W Phillips the fall in unemployment is possible only at the expense of rise in prices. While Milton fried man and his followers think that there always exists a natural rate of unemployment in the economy, and the fiscal and monetary policies can not alter the level of such unemployment. The Keynesian and New classical economists are also of this opinion that in long run the level of unemployment can not be decreased from its natural level. Despite differences in thinking and observations the economists have the consensus that problem of unemployment must be removed.

2. PROBLEM OF INFLATION: During 1930’s the phenomenon of unemployment got a lot attraction. Hence most of policy experts presented their ideas to remove unemployment. As a government intervention was legitimized against the traditional Laisseze-fair of the classical economists. The government expenditure went on increasing to enhance employment, to provide social security, and to provide better social and economic services etc. The state intervention encouraged the growth of public sector and pubic spendings. In this situation the normal budgets of the governments were inadequate. So the governments had to restore the deficit financing. This state of affairs led to enhance aggregate demand in the economy. The increased demand for goods and services due to population growth also encouraged aggregate demand. The ruthless craze to get economic superiority and remove unemployment the industrialization was also considered something necessary. In this way, the investment expenditure also increased. Thus during 1950 to 1970, the greater increases in public spendings, private spendings and investment spendings greatly pushed the aggregate demand in the economy. With this the phenomenon of Demand Pull Inflation was observed. In this first half of 1970’s consequent upon certain supply. Shocks like oil crisis etc. the aggregate supplies declined-unable to match the rising demand. In this way costs of production and prices increased along with reduced production and employment. As a result a situation of inflation coupled with unemployment was observed in the world-which was given the name of “Cost-push Inflation”. During 1970’s and even till the present lime phenomenon of rising inflation and rising unemployment is commonly observed throughout the world. Meanwhile in the economic literature a bitter reality was identified known as “Phillips curve” - a curve which shows a trade-off between inflation and unemployment. It means that if any economy wants to reduce the level of unemployment, it will have to accept the rise n price level. Thus we find that most macroeconomists at present deal with the problems of unemployment and inflation. To remove these problems or attain economic stabilization “Fiscal and Monetary Policies” are advocated.

3. PROBLEM OF GROWTH: In the late 50’s and in the early 60’s the problem of growth got a lot off attraction. It means that poor and developing countries of the world wish to attain rise in their real national and per capita world incomes. Again the development countries of the world who have attained greater rise in their national and per capita incomes wish to maintain and change in technology. It means that this economists that what should be the level of rise in investment that mature economies could maintain their attained levels of income and employment without inflation and deflation. Such a state of affairs will result in the faller utilization of change in labour force, change in capital accumulation and change in level of income.

Now a days macro economics deals with the problem of growth- a situation for above the full employment. It is reminded that full employment and growth are not synonyms. Full employment means the maximization of output and employment in the presence of existing resources while economic growth is attached with potential increase in output and employment in the presence of increase in capital, increase in labour force, increase in natural resources and technological change. Full employment corresponds to the existing production frontier of economy while economic growth has the effect of shifting the production frontier of economy outward.

Difference between Micro Economics and Macro Economics

The study of economics is divided by the modern economics into two parts viz Micro economics and Macro economics.

An economic system may be looked at as a whole or in terms of its innumerable decision making units such as consuming units e.g. individual consumers and house holds producing units e.g. firms, farms, business and mining concerns, individual factors or production e.g. labourers, land owners, capitalists extrepreneurs and individual industries e.g. cotton textiles, iron and steel, fry making. When we are analysing the problems of economy as a whole it is macro-economic study. While an analysis of the behaviour of any particular decision making unit, such as a firm and industry a consumer, constitutes micro economics.

Micro economics is also called “Price Theory” and Macro Economics is called “Income Theory”. Price theory explains the composition or allocation of total production. Why more of something is produced than other. Income theory explains the level of total production and why the level rises and falls.

It may be emphasised that neither of the two approaches outlined above can alone adequately helps in analysing the working of the economic system. What is true of the parts may not be true of the whole and what is true of the whole may not apply to parts. It is very necessary to integrate the two approaches, if we wish to get correct solutions of our main economic problems. As, if a country is making progress from collective point of view while some sectors like energy are facing crises. Again the whole country may be in the clutches of recession but the electronics industry may be growing. In such like situation we can not depend upon neither entirely on macro nor on micro economics. Micro eventually generates macro. The total output and employment of economy depends upon the production and employment of the firm and industries. The aggregate consumption of the economy depends upon the consumption behaviour of individuals. The price theory in micro economics is aimed at optimal allocation of resources, while macro economics wishes to utilize the resources of economy fully. As Professor Ackly Gardener’s words “it is difficult to draw a line between micro economic theory and macro economic theory; the real general theory of economy will consist both the branches. Such theory will explain the individual behaviour, individual outputs, individual incomes and individual prices. While the summation of individual results will provide us such aggregates which would be dealing with macro economics.”

Objectives and Instruments of Macro Economics

The major instruments of macro economic policy are described as under.

1. Fiscal Policy: Fiscal Policy denotes the used of laxes and government expenditure. Government expenditures come in two distinct forms. First there are government purchases. These comprise spending on goods and services. Purchases of tanks, construction of roads, salaries for jubges and so forth. In addition there are government transfer payments which boost the incomes of targeted groups such as elderly or unemployed. Government spending determines the relative size of the public and private sector that is how much of our GDP is consumed collectively rather than privatively. From a macro economic perspective, government expenditures also affect the over all level of spending in the economy and thereby influence the level of GDP.

The other part of fiscal policy laxation affects the overall economy in two ways. To begin o with taxes affect people’s incomes. By leaving house holds with more or less disposable or speudrble income taxes tend to affect the amount people spend on goods and services as well as the amount of private savings. Private consumption and saving have important effects on investment and output in the short and long run.

In addition taxes affect the prices of goods and factors of production and there by affect incentives and behaviour. For example during the period. 1962 to 1986 the USA employed an investment tax credit which was a sebrte to business that bought capital goods, as a way of stimulation investment and boosting economic growth. Many provisions of the laxe code have and important impact on economic activity through their effect on the incentive to work and to save.

2. Monetary Policy: The second major instrument of macro economic policy is monetary policy which the government conducts through managing the nation’s money, credit and banking system. Money consists of the means of exchange or method or payment. Today people use currency to pay their bills. By eughying in central-banks operations, the federal reserves can regulate the amount of money available to the economy.

How does such a minor thing as the money supply have such a large impact on macro economic activity? By changing the money supply, the federal reserve can influence many financial and economic variables, such as interest rates and reduced investment which in turn cruse a decline in GDP and lower inflation. If the central bank is faced with a business down turn, it can increase the money supply and lower the interest rate to stimulate economic activity.

The exact nature of monetary policy is one of the most important areas of macro economics. A policy of light money in the USA raised interest rates showed economic growth and raised. Unemployment in the period 1979to1982. Then from 1982 to 2000, careful monetary maurfeuent by the Federal Reserve supported the longest economy expansion in American history. Over the last deade monetary policy has become the major weapon used by the US government to fight the business cycle.

Some Basic Concepts used in Macro Economics

The following are some of basic instrument and concepts which are used in macro economic analysis. These concepts help to understand macro economic problems clearly and easily.

1. Stock and Flow: A stock is a quantity measurable at a particular point of time. It has no time dimension. For example national capital is a stock because it refers to the nation’s capital at a particular point of time. Similarly wealth of nation is stock.

Flow is a quantity that can be measured over a specified period of time, say a year, capital formation in the economy is a flow.

2. Ratio Variables: Such variables express functional relationship between income and saving or income and consumption are known ratio variables. The ratio between saving and income is known as average propensity to save (APS). Symbolically it is expressed as S/Y where S is saving and Y is income and the ratio between consumption and income is known as average propensity to consume (APC). Symbolically it is expressed as C/Y where C is consumption and Y is income.

3. Independent and Dependent variables: Some economic variables are independent and some are dependent. For example income is an independent variable while consumption is a dependent variable and as such one can say that consumption is a function of income. Symbolically we can express this functional relationship as C = F (Y) where C is consumptions F is function and Y is income. This functional relationship shows that consumption is a function income as income increases, consumption also increases though less than the increase in income.

4. Equilibrium: Equilibrium refers to a state of balance between two variables. We can define a state of equilibrium as situation in which the effective demand for every good and every factor of production is exactly equal to the supply of it. When equilibrium is achieved there is no tendency to change from it. So it can be said that equilibrium is the best situation.

5. Ex-ante and Ex-post: This basic concept is used in saving and investment. Ex-ante means, what we plan or anticipate to do and Ex-post means what we have actually achieved or done. For example, economists classifying saving and investment into two parts.

(i) Ex-ante saving and investment i-e what they plan to save and invest.

(ii) Ex-post saving and in investment i-e what they actually save and invest.

Our plans to save and invest depend upon many independent variables like income, prices, future out look etc. so saving may or may not be equal to investment.

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