Methods of Calculating National Income: Perspectives & Discrepancies

Introduction

Calculating national income is essential for understanding the overall economic performance of a country. Various methods are employed to measure national income, each offering insights into different aspects of economic activity. These methods typically include the income approach, expenditure approach, and product approach. 

Each method provides valuable perspectives on economic output, consumption, and production, contributing to a comprehensive understanding of a nation’s economic health and performance.

Measurement of Aggregate Income: Expenditure, Product, and Income Methods

• Aggregate income can be measured through three methods: expenditure method, product method, and income method. 
• Refer to Figure to understand the GDP by three methods.
  • Expenditure Method: Calculates aggregate income by measuring the spending firms receive for final goods and services produced.
  • Product Method: Measures aggregate income by calculating the aggregate value of final goods and services produced by all firms.
  • Income Method: Calculates aggregate income by summing up all factor payments (wages, interest, profit, rent).

The Product or Value Added Method in Economic Production

• Product Method: 
  • It is used to calculate the aggregate annual value of goods and services produced in an economy. 
    • It involves summing up the value added by all the firms in the economy.
  • Example: The example involves two types of producers – wheat producers (farmers) and bread makers (bakers). 
    • In a year, farmers produce wheat with a total value of Rs 100, out of which they sell Rs 50 worth of wheat to bakers. 
    • The bakers use this wheat to produce bread with a value of Rs 200.

• Value Added: 
  • The term that is used to denote the net contribution made by a firm is called its value added.
  • Value added by a firm is calculated as the value of production minus the value of intermediate goods used (Refer Table). 
  • For the farmers, their value added is Rs 100 (the entire value of their wheat production). 
  • For the bakers, their value added is Rs 200 (bread production) minus Rs 50 (the value of wheat they bought from the farmers), which equals Rs 150.

Gross Value Added and Net Value Added

• Gross Value Added: If we include depreciation in value added then the measure of value added that we obtain is called Gross Value Added.
• Net Value Added: If we deduct the value of depreciation from gross value added we obtain Net Value Added. 
  • Unlike gross value added, net value added does not include wear and tear that capital has undergone. 
• Example: Let us say a firm produces Rs 100 worth of goods per year, Rs 20 is the value of intermediate goods used by it during the year and Rs 10 is the value of capital consumption. 
  • The gross value added of the firm will be Rs 100 – Rs 20 = Rs 80 per year. 
  • The net value added will be, Rs 100 – Rs 20 – Rs 10 = Rs 70 per year.

Expenditure Method: Calculating GDP from Demand-Side Perspective

• Demand-Side Approach: An alternative approach to calculating GDP is through the expenditure method, which focuses on the demand side of products. 
  • Example: The Rs 50 worth of wheat that the bakers buy from the farmers counts as intermediate goods, hence it does not fall under the category of final expenditure. 
    • Therefore the aggregate value of output of the economy is Rs 200 (final expenditure received by the baker) + Rs 50 (final expenditure received by the farmer) = Rs 250 per year.
• Determining Aggregate Output: In the example of the farmer-baker economy described earlier, the aggregate value of the output in the economy using the expenditure method is determined as follows: 
• Calculation of Final Expenditures: Calculate the final expenditures made by each firm. Final expenditure refers to spending, not for intermediate purposes.
  • Calculation of Total Revenues: Sum up the revenues earned by each firm from final consumption (C), investment (I), government spending (G), and exports (X). 
  • This is represented as RVi for each firm.
  • For the entire economy, calculate the aggregate final consumption expenditure (C), which includes spending on domestic firms but excludes spending on imported consumption goods (Cm).
  • Calculate the aggregate final investment expenditure (I), which includes spending on domestic firms but excludes spending on foreign investment goods (Im).
  • Determine the aggregate final government expenditure (G) for the economy, which includes spending on domestic firms but excludes spending on imports (Gm).
  • Calculate the aggregate exports (X) received by the economy from foreign buyers.
  • Subtract the aggregate imports expenditure (M), which includes spending on imports of consumption goods (Cm), imports of investment goods (Im), and government spending on imports (Gm).
• Expression of GDP Using the Expenditure Method: as GDP = C + I + G + X – M.
  • This equation provides a way to calculate GDP based on final expenditures on consumption, investment, government spending, exports, and imports. 
  • It is worth noting that investment expenditure (I) is often the most variable component in this calculation.

Income Method: Determining GDP through Factor Incomes Distribution

• The income method of calculating GDP focuses on the incomes received by all the factors of production, such as labor, capital, entrepreneurship, and land. It establishes a relationship between the sum of final expenditures in the economy and the incomes earned by households and factors of production.
• Here’s how the income method is applied:
  • Consider there are M households in the economy, and let Wi represent the wages and salaries received by the i-th household, Pi for gross profits, Ini for interest payments, and Ri for rents in a specific year.
  • GDP is calculated as the sum of these various income components:
    • GDP = Σ(Wi) + Σ(Pi) + Σ(Ini) + Σ(Ri). (The symbol Σ is a notation – it is used to denote summation.)
• The total income earned by all households is expressed as GDP.
• Distribution of Revenues: This method essentially states that the revenues earned by all firms in the economy should be distributed among the factors of production such as salaries, wages, profits, interest earnings, and rents.

Harmonizing GDP Calculation Methods and Managing Discrepancies

• These methods represent the relationship between production, expenditure, and income.
• When considering the income method along with the value-added method and expenditure method, they all provide different expressions of the same GDP variable. 
  • Theoretically, the income, expenditure, and production approaches to calculating GDP should yield identical results, but in practice, they often diverge due to differences in data sources.
• Discrepancies: In the statistical GDP data refer to the difference in national income under the production method and expenditure method.
• Reducing Discrepancies: The government is making efforts to minimise discrepancies in computation of the national income or GDP data by relying more on data available under e-governance programmes and corporate accounts.
  • According to Experts, Discrepancy occurs because, alongside the production figure, the government also compiles the expenditure estimate which is principally based on some rules of thumb.
  • This allocation does not completely explain the expenditure side accurately. The difference between the two estimates thus becomes the discrepancy,
  • The availability of timely data on government accounts and corporate accounts would narrow down the discrepancy.

Conclusion

• Various methods, including the income approach, expenditure approach, and production approach, provide different perspectives on economic activity. 
• While theoretically, these methods should yield identical results, discrepancies often arise due to differences in data sources and measurement techniques. 
• To reconcile these disparities, countries employ various methods, such as averaging income and expenditure estimates and calculating a statistical discrepancy representing the difference between these estimates. 
• Overall, Calculating national income is crucial for assessing a country’s economic performance and well-being and helps in policy-making decisions.