Methods of Calculating National Income

The Product or Value Added Method

Understanding the Concept

The product method, also called the value added method, measures national income by calculating the total annual value of goods and services produced in the economy. Instead of simply adding up the value of all outputs, this method focuses on the net contribution (value added) of each producer.

Example of Farmers and Bakers

Suppose there are only two producers in the economy: wheat farmers and bread bakers.

• Farmers produce wheat worth ₹100. Out of this, ₹50 worth of wheat is sold to bakers.
• Bakers use this ₹50 worth of wheat to produce bread worth ₹200.

If we just add outputs, it looks like total production is ₹100 (wheat) + ₹200 (bread) = ₹300. But this is wrong because the ₹50 worth of wheat is being counted twice: once as part of the farmer’s production and again as part of the bread’s value.

To avoid this double counting, we calculate value added:

• Farmers’ value added = ₹100 (since they used no intermediate goods).
• Bakers’ value added = ₹200 – ₹50 = ₹150.

Thus, the true value of output in the economy = ₹100 + ₹150 = ₹250.

Meaning of Value Added

The value added of a firm = Value of production – Value of intermediate goods used.

This value added is distributed as wages, rent, interest, and profit to the four factors of production.

Gross Value Added and Net Value Added

While calculating value added, we must also consider depreciation (wear and tear of machinery, buildings, etc.):

• Gross Value Added (GVA) = Value of output – Value of intermediate goods.
• Net Value Added (NVA) = GVA – Depreciation.

Example:

If a firm produces goods worth ₹100, uses intermediate goods worth ₹20, and incurs depreciation of ₹10:

• GVA = ₹100 – ₹20 = ₹80.
• NVA = ₹100 – ₹20 – ₹10 = ₹70.

Role of Inventories

A firm may not sell everything it produces. Some goods may remain unsold, or it may sell from stocks it already had. These unsold goods, semi-finished goods, or unused raw materials are called inventories.

• If inventories increase during a year, it is called accumulation.
• If inventories decrease, it is called decumulation.

Inventories are treated as a form of investment, since they add to the firm’s capital stock.

Example:

If a firm starts the year with stock worth ₹100, produces goods worth ₹1,000, and sells goods worth ₹800, then change in inventories = 1,000 – 800 = ₹200. Thus, inventories at year’s end = ₹100 + ₹200 = ₹300.

Planned and Unplanned Changes in Inventories

• Planned accumulation: The firm intentionally increases its stock. For example, a shirt factory wants to raise inventory from 100 shirts to 200 shirts, so it produces extra shirts beyond expected sales.
• Unplanned accumulation: Sales fall unexpectedly, leaving the firm with more unsold stock than planned.
• Unplanned decumulation: Sales rise unexpectedly, and the firm must sell from its existing stock to meet demand.

Expenditure Method

Basic Idea

The expenditure method calculates GDP from the demand side of the economy. Instead of looking at how much is produced (as in the product method), here we look at how much is spent on final goods and services.

• Final expenditure means spending that is not for intermediate use. For example, if bakers buy wheat worth ₹50 from farmers, that is intermediate expenditure and does not count. But when households buy bread worth ₹200 from bakers, it counts as final expenditure. Similarly, the wheat worth ₹50 that consumers buy directly from farmers is also final expenditure. So, in the farmer–baker example:
• GDP = ₹200 (bread bought by consumers) + ₹50 (wheat bought directly by consumers) = ₹250

Components of Final Expenditure

A firm’s revenue comes from four types of final expenditure:

1. Consumption Expenditure (C): This is the spending by households on goods and services like food, clothes, education, or medical services. Firms may also spend on small consumables (for example, tea, snacks for employees), but most of C comes from households.
2. Investment Expenditure (I): This is spending by firms on capital goods like machines, tools, and buildings. Unlike intermediate goods, investment goods remain with the firm and increase its productive capacity, so they are counted in GDP.
3. Government Expenditure (G): The government also buys final goods and services. This includes both consumption (for example, office supplies, vehicles) and investment (for example, highways, schools, defence equipment).
4. Exports (X): Goods and services sold to foreigners also count as final expenditure, because they are produced within the domestic economy.

Thus, revenue of a firm (RVi) can be written as:

RVi = Ci + Ii + Gi + Xi

Role of Imports

But not all expenditure adds to domestic GDP. Sometimes, part of consumption, investment, or government expenditure is spent on imports. Since imports are not produced domestically, they must be subtracted.

• C – Cm → Domestic consumption expenditure
• I – Im → Domestic investment expenditure
• G – Gm → Domestic government expenditure

Here Cm, Im, and Gm are the values of imports under each head.

So, the formula becomes:

GDP = C + I + G + X – M

Where,

• C = Consumption
• I = Investment
• G = Government expenditure
• X = Exports
• M = Imports

Income Method

• The income method calculates national income from the payment side. It considers the incomes paid to the primary factors of production—land, labour, capital, and entrepreneurship—for the services they render during a year. These payments take the form of rent, wages, interest, and profit. By adding up all such factor incomes generated by producing units within the domestic territory during an accounting year, we arrive at the measure of national income.
• The aggregate obtained in this way is called Domestic Income or Net Domestic Product at Factor Cost (NDPFC). When we add Net Factor Income from Abroad (NFIA) to this, we obtain National Income, also known as Net National Product at Factor Cost (NNPFC).
• It is important to note that under the income method, national income is measured at the stage when enterprises distribute their net value added as factor payments to the owners of land, labour, capital, and entrepreneurship.

Relation with Value Added Method

• The net value added by an enterprise is nothing but the combined result of the services provided by the factors of production. Since this value added is distributed as money income (rent, wages, interest, profit, etc.), the total income measured through the income method should equal the total measured through the value added method.

Steps in Estimating National Income by the Income Method

1. Identification of Enterprises:
2. List all enterprises engaged in production within the domestic economy that employ factors of production—land, labour, capital, and entrepreneurship.
3. Classification of Factor Payments:
4. Categorize factor incomes into appropriate groups such as:
   • Rent, wages, interest, and profit, or
   • Compensation of employees, operating surplus, and mixed income (particularly for self-employed persons where different incomes cannot be separated).
5. Estimation of Factor Payments:
6. Calculate the total amount of factor payments made by each enterprise.
7. Summation to Obtain Domestic Income:
8. Add up all factor payments made within the domestic territory. The result is Domestic Income (NDP at Factor Cost).
9. Adjustment for Net Factor Income from Abroad (NFIA):
10. Add the balance of factor incomes received from abroad minus those paid abroad. The resulting figure is the National Income (NNP at Factor Cost).

Inclusions and Exclusions

Included in National Income:

• Only factor incomes earned by rendering productive services.
• Imputed rent of owner-occupied houses.
• Value of production for self-consumption (e.g., farm produce kept by the farmer’s family).
• Commissions paid on the sale of second-hand goods (since they are payment for productive services).
• Direct taxes such as income tax and corporate tax (since they are paid out of current income).

Excluded from National Income:

• Transfer payments such as pensions, unemployment allowances, scholarships, and social security benefits, as these are not payments for productive services.
• Sale and purchase of second-hand goods (they do not represent current production).
• Sale proceeds of shares and bonds (financial transactions, not production).
• Services produced but not marketed, such as those of a housewife.
• Illegal incomes like smuggling or black-marketing, as well as windfall gains like lotteries.
• Wealth tax and gift tax, since they are paid out of past wealth, not current income.
• Indirect taxes like sales tax and excise duty, because they raise the market price of goods but are not factor incomes.