National Income

FROM MICRO TO MACRO ECONOMICS

The microeconomic analysis of previous units was concerned with particular markets and the strategies of economic agents in these markets.  The focus was on the behaviour of the firm, the consumer, the worker, the determination of price in a competitive market, etc.

Macroeconomic analysis focuses on the performance of the economy as a whole, rather than the microeconomic features within it.  The level of production in the whole economy; the level of employment/unemployment in the economy; the average price level of the whole economy; trade between the economy and the rest of the world; these are all macroeconomic issues.  Because the focus is on the economy as a whole, the variables of interest are often aggregates of microeconomic variable.  For example, in microeconomics we might be concerned with consumers’ expenditure on a particular product whereas in macroeconomics, we might be concerned with total consumers’ expenditure in the economy.

Governments play a major role in modern economies.  The policies adopted by governments are often guided by macroeconomic analysis.  If, for no other reason, it is important that the analysis is reliable.

MEASURING ECONOMIC ACTIVITY

There are three related measures of economic activity for an economy:

• Gross Domestic Product (GDP)
• Gross National Product (GNP)
• Net National Product (or National Income)

GDP is the value, in money terms, of the total output of final goods and services produced in an economy over a period of (usually) one year.  Final goods include both consumer goods and capital goods.  There are three alternative methods of calculating this value, the income method, the output method and the expenditure method.

• The Output Approach: measures the sales value of the total output of final goods produced by firms.  (This gives you National Product, NP)
• for their use in producing the output (i.e. wages, profit and rent and interest). (This gives The Outcome Approach: adds up the total income received by the factors of production n you National Income, NI.)
• The Expenditure Approach: measures National Expenditure by calculating the total spending on final consumption goods and on investment.

Table 9.1 gives a simplified illustration of how these measurements are calculated.

 Producer Farms Mills Bakeries Retail Output Wheat Flour Bread Bread Value of Output (Gross) RWF100m RWF140m RWF180m RWF200m Value          Added          (Factor incomes) RWF100m RWF  40m RWF  40m RWF  20m

Table 9.1  Stages of Production

Table 9.1 illustrates hypothetical figures for stages of production, the final product being bread.  The farms supply the mills with wheat; the mills supply the bakeries with flour, the bakeries supply the retailer with bread which is then sold to the final consumer.

To simplify the analysis, it is assumed in Table 9.1 that there are no bought in inputs into the farms and therefore the RWF100m worth of wheat represents the net output of the farms.  The only bought in input for the mills is the RWF100m of wheat, for the bakeries the RWF140m of flour and for the retail trade the RWF180m of bread.

The value of final output for the whole process is the RWF200m worth of bread sold by the retail trade, and it is this figure we wish to add to the GDP of the economy.  The wheat, flour and wholesale bread are all intermediate products and care should be taken not to double count these items.  The value added at each stage is the difference between the value of output and the value of bought in inputs.  The value added can also be thought of as the gross earnings available to be paid as income (wages, profit, interest, rent) to the factors of production employed at that stage.

The three methods of measurement are all seeking to establish the contribution to GDP of RWF200m.  The expenditure method focuses on the RWF200m that is spent purchasing the bread; the income method focuses on the sum of the gross factor incomes generated in all sectors (RWF200m); the output method focuses on the sum of the value added of all sectors (RWF200m).

Because the three methods are merely different ways of measuring the same quantity the following identity must be true:

National Income = National Output = National Expenditure

In reality, national income accounting is not as straightforward as the above example suggests.  A modern economy is made up of many sectors with large, medium and small scale enterprises along with many self-employed traders.  Monitoring all this economic activity is a difficult task.  Furthermore, governments usually wish to measure economic activity so that the incomes earned can be taxed.  The requirement to pay tax on income can operate as a disincentive to declare income resulting in a black economy (undeclared economic activity).  Because of this, there may be a tendency for the official figures to understate the true level of economic activity.  The higher the rates of tax in a country, the larger the black economy is likely to be.

Various problems need to be avoided if an accurate measure of GDP is to be achieved:

Problems with National Income calculation

• With its estimation
•  With its use.

Estimation Problems

What Goods/Services to Include

General principle: take into account only those products which change hands for money but there are distortions which reduce its accuracy e.g.:

• Unpaid services (e.g. housewives duties, washing own car, etc.) are not included but the same services, when paid, for are.
• Many farmers consume part of their own produce with no money changing hands and many households live in their own houses, imputed value must be applied to these factors.
• Many durable goods give services over time but this is hard to calculate so they are included at the price they were bought at.
• There are many government services – healthcare, education, police and defence forces – provided ‘free’, these services are included at cost.
• Externalities are not measured or included (e.g. pollution).

The danger of double counting.

This can lead to incorrect estimates e.g.:

• Incomes such as social security are received without any contribution to production, These are TRANSFER PAYMENTS from the taxpayer to the welfare recipient and are therefore not included.
• The production of a final good includes a number of intermediate stages. It would be double-counting to include the value of the good in these preceding stages and then include it again in the value of the final good.

To avoid this problem;

*     only include the value of the final product.

• A rise in the value of stocks should not be counted as it does not represent any growth in real output.

The sources of information used may be inconsistently measured, subject to numerous revisions, change over time, differ between countries, e.g. income tax returns are likely to be underestimates.

The censuses of production, distribution, population, etc are taken infrequently so comparisons are hard.

Basically – statistics have many biases and inaccuracies built into them.

Problems with using national income

4 Main uses

( To describe the structure of the national economy (i.e. to measure the total wealth in the economy), to assist government planning.

But

Problem: Unless data is complete, Accurate and Up-to-date (which it rarely is) using NI as a policy guide may lead to perverse results (opposite of those aimed for).

(ii) To measure living standards (NI per capita)

Must adjust NI for the number of people in the economy (i.e. the number it must be shared between.

So only NI per capita (i.e. per head) is valid as a measure of living standards.

But

Problem:     Even the number of heads (capita) may be inaccurate.

Disparities in the distribution of income (the way income is shared out among the population) may mean that an average measure of NI gives a distorted picture of the economy.

Average living standards may be overestimated because “bads” are not costed in (i.e. negative), or underestimated because public sector activity is only included at cost and unpaid activities are not included at all.

• Comparisons over time (Change in NI per capita at constant prices)

These are only valid if the data have been collected/prepared on the same basis over time.

Problems: Changes in: income distribution, the price level (i.e. inflation), service-intensity, quality of goods, contribution of the public sector, share of investment, share of defence spending.

Can make comparisons over time inexact.

• Comparisons between countries

Much the same problems as for comparisons over time but also:

Exchange rates, different tastes and needs and different levels of development are problems.

• When using the expenditure method it is necessary to adjust for the value of imports and exports. Domestic expenditure will include expenditure on imports, while foreigners will be buying domestically produced goods or services that are exported.  The value of exports should be added to GDP while the value of imports should be subtracted.
• Another problem arises as a result of indirect taxes. If the bread in Table 9.1 was subject to 10% value added tax, consumers expenditure would be RWF220m but factor incomes would still be only RWF200m. The tax is a transfer payment to the government.  To calculate GDP at factor cost from GDP at market prices it is necessary to subtract indirect taxes and add any government subsidies to producers.

GDP and GNP

To get from GDP to GNP it is necessary to adjust for net factor incomes from abroad (NFIA).  Economic activity in one country can be generating income for residents of another country due to repatriated profits from foreign investment.  GDP measures the income generated in a particular country, no matter who has a claim to that income.  GNP measures the income being earned by the residents of a country irrespective of where the income is generated.

GNP = GDP + NFIA                                        (9.1)

Creditor countries (those accumulating net foreign assets) are net exporters of capital and consequently have positive NFIA.  For creditor countries GNP exceeds GDP.  Debtor countries (those accumulating net foreign liabilities) are net recipients of inward investment and consequently have negative NFIA with the result that GNP is less than GDP.

National Income

To get from Gross National Product to Net National Product (NNP), it is necessary to adjust for the depreciation of the national stock of capital.  Part of the capital stock will be used up in the production of goods and services.  NNP is calculated by subtracting an allowance for depreciation from GNP:

NNP = GNP – Depreciation

(9.2)

When Net National Product is calculated on a factor cost basis this figure is accepted as the National Income figure.

 A National Income Millions 2010 Personal consumption 85214 Public sector current expenditure 28503 Gross domestic fixed capital formation 25293 Change in stock -2264 Exports 145902 Imports -121037 Statistical discrepancy -1015 GDP at market price 160596 Net factor incomes from abroad -28363 GNP or GNY  at Market prices 132233 Subsidies 1719 Taxes -359 GNP/income  at factor cost 133592

GNP at factor cost less depreciation gives Net National Product at factor cost.

International comparisons:  The link below gives international comparisons of GNP per head.

http://data.worldbank.org/indicator/NY.GNP.PCAP.CD

Table 9.2

INTERPRETING THE FIGURES

National income figures are designed to measure the extent of economic activity in an economy.  The level of economic activity in turn determines the material living standards of the society.  The figures give an indication of how living standards in a particular country (1) are changing over time and (2) compare on an international scale.

It must be remembered that the figures are exclusively concerned with material living standards and say nothing about the quality of life in a country.  Living standards may be rising but some people may feel that the quality of life (however measured) is declining.

When measuring living standards the appropriate measure is per capita GNP which is arrived at by dividing GNP by the population:

GNP per capita = Gross National Product

Population

Living standards therefore depend not only on the income being earned by the members of a society (GNP) but also on the size of the population that the income must support.  If a country has a growing population, then GNP must be rising faster if living standards are to improve.

Real and Nominal Income

When comparing living standards over time, it is important to distinguish between real income and nominal income.  The distinction is important when there is inflation in an economy as the change in nominal income will exaggerate the change in living standards.  Table 9.3 gives hypothetical figures for an economy.

 Year 1993 1994 1995 GNP (RWFm) (current market prices) Price Index – Inflation GNP (RWFm) (constant prices) 30,000 100 30,000 33,000 105 31,429 36,300 112 32,411

Table 9.3  Real Income and National Income

The figures indicate that GNP (in nominal terms) has been growing at 10% p.a.  However, the inflation index indicates that prices have risen by 5% from 1993 to 1994 and by 12% overall from 1993 to 1995.  Nominal income is arrived at by multiplying output (quantities) by the prevailing prices, but if prices are rising, nominal GNP will tend to be rising whether or not real output is rising.  To get a measure of the change in real output it is necessary to express the GNP figures at constant prices by removing the effects of inflation.  The constant price figures are arrived at by deflating the market price figures with the appropriate GNP deflator which is 100/price index.  For example, the real GNP figure of 31,429 for 1994 is arrived at by multiplying 33,000 by 100/105.  It can be seen that the economy has expanded in real terms (constant prices) by 4.76% (93/94) and 3.12% (94/95).

Even if real per capita income is growing over time, it is important to be aware of certain facts:

• It is only an average and, therefore, says nothing about the distribution of income or changes in the distribution of income over time. In other words, growing per capita income is not incompatible with increasing poverty among some sections of society.
• It says nothing about the number of hours worked. Clearly it would be preferable if rising real income was achieved with a shorter working week rather than with a longer one.
• It fails to take account of any negative (or positive) externalities in production such as pollution
• It is a measure of output whether or not the output adds to welfare. If congestion on the roads means journeys are taking longer and more petrol is being consumed as a result, this will add to GNP while hardly improving welfare.
• It fails to include welfare increasing activities that do not involve market transactions. Unpaid domestic work and DIY activities are obvious examples.
International Comparisons

Special problems arise when making international comparisons of living standards.  Firstly, a common standard of measurement is required which means that the national incomes of different countries must be expressed in a common currency.  Secondly, if economies differ significantly in their structure, comparing GNP figures may not be comparing like with like.  Problems may arise if:

• exchange rates fail to reflect purchasing power parities and
• the scope of market transactions differ significantly between countries

To illustrate the first problem, we will use the following hypothetical figures for Rwanda and Kenya.

 GNP per capita Rwanda: RWF161,000 Kenya: KES 52,700 Exchange rate RWF7 = KES1

On the basis of this (convenient) exchange rate per capita income in Rwanda could be expressed as KES23,000 or the Kenyan figure could be expressed as RWF368,900.  Can we conclude that living standards are 129% higher in Kenya?  This conclusion is only valid if we assume that the purchasing power of RWF 7 in Rwanda is equivalent to the purchasing power of KES 1 in Kenya.  In other words, we need to assume that similar products have the same real prices in both countries.  In practice however, exchange rates can be extremely volatile, particularly in the short term.  We must conclude that prevailing exchange rates do not necessarily reflect purchasing power parities (Section 14C)

The second problem stems from the fact that national income accounting focuses on marketable production rather than production in general.  We have seen that unpaid domestic work and DIY activities are excluded from the figures.  But for less developed economies much of their economic activity may be of this kind due to the fact that market relationships are less developed.  Much of the economic activity, such as subsistence farming, takes place outside of market relationships.  International comparisons based on GNP figures have greater validity when comparing countries at similar stages of economic development and with similar accounting standards.

Because of the problems involved in international comparisons via GNP figures comparisons are often made in alternative ways.  The number of doctors per 1000 of population; pupil/teacher ratios in schools; the number of telephones or TVs per household, etc. can be used to make comparisons of living standards between countries.

Factors Affecting the Potential Size of the National Income (a) National Resources.

• Nature of the Labour force (% of population, skill).
• Amount of capital investment.
• Whether factors of production are combined efficiently.
• Innovation and technology.
• Political Stability.
• Availability of Foreign Loans.
• Terms of trade (i.e. amount of another country’s goods which can be got for home-grown goods).

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