Big picture
National income measures the total value of goods and services an economy produces in a year. It tells us how big the economy is, whether it is growing, and how incomes are earned and spent.
Three ideas run through the chapter. First, production creates income, and income is spent on production, so output, income and expenditure are three views of the same flow (the circular flow). Second, we must count only final goods, or we would count the same value many times. Third, we can adjust a basic aggregate (GDP at market price) by depreciation, net factor income from abroad and net indirect taxes to get the other aggregates. Numericals carry heavy marks, so practise each method.
Learning goals
Explain final and intermediate goods, consumption and capital goods, stocks and flows, gross and net investment, and depreciation.
Explain the circular flow of income in a two-sector economy.
Define domestic territory, normal residents and net factor income from abroad.
Derive GDP, GNP, NDP and NNP at market price and factor cost.
Calculate national income by the value added, income and expenditure methods, avoiding errors.
Distinguish real and nominal GDP and calculate the GDP deflator.
Explain why GDP is not a perfect index of welfare.
Core ideas
1. Basic concepts
Final and intermediate goods. A final good is bought for final use: consumption by households or investment by firms. An intermediate good is used up in producing other goods or is bought for resale in the same year. The same good can be either, depending on its use: milk bought by a household is final; milk bought by a sweet shop is intermediate.
Consumption goods and capital goods. Consumption goods satisfy wants directly (food, clothes). Capital goods are final goods used repeatedly in production and last for years (machines, buildings). They wear out gradually.
Stocks and flows. A stock is measured at a point of time (wealth, capital, money supply on 31 March). A flow is measured over a period of time (income, investment, consumption per year).
Investment and depreciation.
Gross investment = addition to the stock of capital, including replacement of worn-out capital.
Depreciation (consumption of fixed capital) = expected fall in the value of fixed capital due to normal wear and tear and obsolescence.
Net investment = Gross investment − Depreciation.
2. Circular flow of income
In a simple two-sector economy (households and firms, no government or foreign trade, no saving):
Households supply factor services (land, labour, capital, entrepreneurship) to firms.
Firms pay factor incomes (rent, wages, interest, profit) to households.
Households spend their income on goods and services produced by firms.
Firms receive this consumption expenditure as revenue.
So there are two flows in opposite directions: a real flow (factor services and goods) and a money flow (factor payments and consumption expenditure). Because every rupee of output becomes someone's income, and every rupee of income is spent on output:
Value of output = Factor income = Expenditure
This is why national income can be measured in three ways.
3. Domestic territory, residents and factor income from abroad
Domestic (economic) territory is the area within which persons, goods and capital circulate freely. It includes the political frontiers, territorial waters, ships and aircraft operated by residents between countries, fishing vessels and oil rigs operated by residents in international waters, and the country's embassies and military establishments abroad. It excludes foreign embassies and international organisations (like the UN offices) located in India.
A normal resident is a person or institution whose centre of economic interest lies in the country, usually living there for a year or more. Diplomats, foreign tourists and staff of international bodies are not normal residents of the country they are posted in.
Net factor income from abroad (NFIA) = Factor income earned by residents from abroad − Factor income earned by non-residents in the domestic territory.
Domestic product measures production within the domestic territory. National product measures production by normal residents, wherever it happens.
National product = Domestic product + NFIA
4. The aggregates
Market price and factor cost. Market price includes indirect taxes and excludes subsidies. Factor cost is what the factors of production receive.
Net indirect taxes (NIT) = Indirect taxes − Subsidies; Factor cost = Market price − NIT
The three adjustments
From | To | Adjustment |
|---|---|---|
Gross | Net | Subtract depreciation |
Domestic | National | Add NFIA |
Market price | Factor cost | Subtract net indirect taxes |
Worked example. GDP at market price = ₹1,000 crore; depreciation = ₹100 crore; NFIA = −₹20 crore; indirect taxes = ₹80 crore; subsidies = ₹10 crore (so NIT = ₹70 crore).
Aggregate | Calculation | ₹ crore |
|---|---|---|
GDPmp | Given | 1,000 |
NDPmp | 1,000 − 100 | 900 |
GNPmp | 1,000 + (−20) | 980 |
NNPmp | 980 − 100 | 880 |
GDPfc | 1,000 − 70 | 930 |
NDPfc | 900 − 70 | 830 |
NNPfc (National income) | 880 − 70 | 810 |
National income is NNP at factor cost: the total factor income earned by normal residents of a country in a year.
Other related aggregates: Gross value added (GVA) at basic prices is used in India's official estimates; GVA at basic prices + product taxes − product subsidies = GDP at market price.
5. Value added (product) method
Value added = Value of output − Intermediate consumption, where Value of output = Sales + Change in stock.
Example. A farmer grows wheat and sells it for ₹100 to a miller (no inputs bought). The miller makes flour and sells it for ₹250 to a baker. The baker sells bread worth ₹400 to consumers.
Producer | Value of output | Intermediate consumption | Value added |
|---|---|---|---|
Farmer | 100 | 0 | 100 |
Miller | 250 | 100 | 150 |
Baker | 400 | 250 | 150 |
Total | 750 | 400 |
The sum of value added (₹400) equals the value of the final good (bread, ₹400). Adding all outputs (₹750) would count wheat three times: this is the problem of double counting, which the value added method avoids.
Gross value added at market price by all producers = GDPmp. Adjust it to reach national income.
Precautions: exclude sale of second-hand goods (they were counted when first produced; only the broker's commission is included); include the imputed value of production for self-consumption (food grown and eaten by farmers) and imputed rent of owner-occupied houses; exclude services of housewives (no reliable market value).
6. Income method
National income is the sum of factor incomes earned within the domestic territory, adjusted for NFIA.
NDPfc = Compensation of employees + Operating surplus + Mixed income of self-employed
Compensation of employees = wages and salaries in cash and kind + employer's contribution to social security schemes.
Operating surplus = rent + royalty + interest + profit (profit = dividends + corporate tax + undistributed profits).
Mixed income = income of self-employed persons, where labour and capital incomes can't be separated.
Example. Compensation of employees ₹400 crore; rent ₹100 crore; interest ₹80 crore; profit ₹150 crore; mixed income ₹100 crore. NDPfc = 400 + 100 + 80 + 150 + 100 = ₹830 crore. With NFIA of −₹20 crore, NNPfc = ₹810 crore, matching the aggregates table.
Precautions: exclude transfer payments (old-age pensions, scholarships, gifts) since no service is rendered; exclude capital gains from sale of shares or property; exclude windfall gains (lottery wins); include imputed rent and the value of production for self-consumption.
7. Expenditure method
GDP at market price is the total final expenditure on goods and services produced in the domestic territory.
GDPmp = Private final consumption expenditure (C) + Government final consumption expenditure (G) + Gross domestic capital formation (I) + Net exports (X − M)
Gross domestic capital formation = Gross fixed capital formation + Change in stocks.
Example. C = ₹600 crore; G = ₹150 crore; gross fixed capital formation = ₹180 crore; change in stocks = ₹20 crore; exports = ₹120 crore; imports = ₹70 crore.
GDPmp = 600 + 150 + (180 + 20) + (120 − 70) = ₹1,000 crore, the starting figure of the aggregates table.
Precautions: exclude expenditure on intermediate goods (double counting); exclude transfer payments by government; exclude purchase of second-hand goods and financial assets (shares and bonds, which are only transfers of ownership).
8. Real and nominal GDP
Nominal GDP values output at current-year prices. It rises if either output or prices rise.
Real GDP values output at base-year (constant) prices. It rises only if output rises, so it is the better measure of growth.
GDP deflator = Nominal GDP ÷ Real GDP × 100
Example. Nominal GDP is ₹1,200 crore and real GDP is ₹1,000 crore. GDP deflator = 1,200 ÷ 1,000 × 100 = 120: prices have risen 20% since the base year.
9. GDP and welfare
Higher real GDP per head is often taken as a sign of higher welfare, but it is not a perfect index:
Distribution of GDP: if GDP rises but income becomes more unequal, many people may be no better off.
Non-monetary exchanges: services of housewives and barter in rural areas are not counted, so GDP understates actual activity.
Externalities: benefits or harms not paid for. A factory's pollution harms people (negative externality) but its output adds to GDP while the harm is not subtracted. A well-kept public garden benefits people (positive externality) but is not fully counted.
A reliable problem-solving routine
Identify which aggregate the question gives and which it wants.
Apply the three adjustments: depreciation (gross ↔ net), NFIA (domestic ↔ national), NIT (market price ↔ factor cost).
In the value added method, find value of output (sales + change in stock), subtract intermediate consumption, and then adjust.
In the income method, add compensation of employees, operating surplus and mixed income; leave out transfers, capital gains and windfalls.
In the expenditure method, add C, G, I and net exports; leave out intermediate goods, transfers and second-hand goods.
State the answer with its correct name (for example, "National income = NNPfc = ₹810 crore").
Connections that matter
Income and employment determination uses aggregate demand (C + I + G + X − M), which is the expenditure side here.
Government budget: taxes, subsidies and transfer payments explain the adjustments between market price and factor cost.
Balance of payments: exports, imports and factor income from abroad link national income with the rest of the world.
Common mistakes
Counting intermediate goods and causing double counting.
Adding NFIA to get domestic product. NFIA converts domestic to national.
Including transfer payments such as scholarships and pensions.
Treating NFIA as always positive. It is negative when non-residents earn more in India than residents earn abroad.
Using sales instead of value of output when stocks change.
Thinking a rise in nominal GDP means more output. It may only reflect higher prices.
Revision checklist
I can explain final and intermediate goods, stocks and flows, and depreciation.
I can explain the circular flow and why output, income and expenditure are equal.
I can derive all eight aggregates from GDPmp.
I can calculate national income by all three methods and list the precautions for each.
I can calculate the GDP deflator.
I can explain three limitations of GDP as a measure of welfare.