How to Measure National Income ? (3 Methods) | Macroeconomics

National Income is a flow concept, which is measured over a period of time.

This flow may take place in the following three methods: 1. Product Method or Value-Added Method 2. Income Method/Factor Payments Method 3. Expenditure Method.

It is important to note that since there are three different approaches to the study of National Income, the components of each of these flows differ from each other. But all the three methods give identical results. The choice of a method depends upon a number of factors.

1. Product Method or Value-Added Method:

This is the method under which we use final value of output produced by various enterprises (or firms). Alternatively, the sum total of the corresponding value addition made by each producing unit at respective levels of production may also provide the same results. Product method is also known by different names such as Net Output Method, Industrial-Origin Method, Flow-of-Product Method, etc.

Thus, the product method measures domestic income as the sum total of net final value of output produced or net value added by all the producing units in an economy during a year.

This method measures the domestic income by estimating the contribution of each producing enterprise in the domestic territory of the country in an accounting year.

Let us first clarify the meaning of three most important terms to be used here in this method, viz., value of output, intermediate consumption goods and value addition.

A. Value of Output:

It is the estimated value of the output produced by the producing units. By definition, Value of Output is the market value of all the goods and services produced during an accounting year including change in stock and production for self-consumption, i.e.,

Value of Output = Sales + Change in Stock + Production for self-consumption

Sales = Price × Quantity,

Change in Stock = Closing Stock – Opening Stock

Production for self-consumption = Imputed value of the output used by the producer (if not given specifically, this variable is presumed to be non-existent/zero).

Also, Sales = domestic sales + exports

We must understand and remember that only final value of output is included in national income and not the value of output at respective stages.

B. Intermediate Consumption/Goods:

These are those goods which are used to produce other goods and they always move from one stage of production to another stage of production. The value of such goods is also called ‘value of secondary inputs’. Most importantly, these intermediate goods lose their identity in the production process.

C. Value Added:

It refers to the excess of value of output produced over the value of intermediate goods employed in the production process, i.e, Value Added = Value of Output – Intermediate Consumption.

VA = VO – IC

Domestic Product (NDP_FC) is the sum total of the net value added by different producing units of an economy which is equal to the net value of final goods and services produced by that economy.

Three vital steps are involved in estimation of the national income by the value added methods which are as follows:

(i) Identification and classification of productive units (firms).

(ii) Classification of output.

(iii) Measurement of output.

(i) First Step:

It involves the identification and classification of firms (productive enterprises/units).

The various enterprises are grouped in three sectors:

(a) The primary sector of an economy which consists of those production units which produce commodities by exploiting nature, i.e., agriculture and allied activities,

(b) The secondary sector which consists of those production units which generate utility by transforming the shape of existing commodities, i.e., manufacturing, construction, etc., and

(c) The tertiary sector which consists of those production units which create utility by shifting the place or time of consumption of a commodity, i.e., various types of services.

Example:

A primary sector producer (farmer) produces wheat, which is converted into flour or further into bread, sandwiches, etc., by another set of producers (secondary sector), and a transport company (tertiary sector) enables transportation of the commodity from the place of production to the place of consumption.

(ii) Second Step:

It involves classification of output into three major categories, i.e., consumer goods, producer/capital goods and production of goods and services by the government, thereby estimating Gross Value Added at market price.

(iii) Third Step:

It involves measurement of national income, as follows:

NNP _FC = Gross Value of Output at MP – Intermediate Consumption – Depreciation – Net Indirect Taxes + Net factor income from abroad

NNP_FC = GVO_MP – IC – Depreciation – NIT + NFIFA

The estimation of net value added at factor cost by each enterprise involves the following steps:

1. The estimation of value of gross output by each enterprise is multiplied by the market price or this can also be calculated by adding the sales and change in stock. Cost of intermediate goods and services is included in the value of gross output.

2. From this gross value of output we deduct the value of intermediate goods, such as raw materials, fuel, coal, electricity and semi-finished goods, to arrive at the Gross Value Added at market price. It is called gross because it is estimated without deducting depreciation. We need to deduct intermediate consumption from the value of gross output to avoid double counting.

3. From this Gross Value Added at market price, we deduct depreciation, net indirect taxes and add net factor income from abroad to arrive at the value of National Income.

The following flow chart can help us in computation of national income by this method while taking up the numerical problems:

Price × Quantity = Sales (Domestic Sales + Exports)

GVO_MP = (Sales + Closing Stock – Opening Stock)

= (Sales + Change in Stock)

GVA_MP = GVO_MP (of Primary, Secondary and Tertiary sector) – Intermediate Consumption (Domestic Purchases + Imports)

NVA _MP = GVA_MP – Depreciation

NVA_FC = NVA _MP – Net Indirect Taxes

NNP_FC = NVA_FC +NFIFA

Also, GDP _MP = Sum of GVA_MP by all the sectors within the domestic territory.

Therefore, NVA_MP = NDP _MP and

NVA_FC = NDP_FC

Classic Example of Value Added Method:

Let us clarify this method using a classic (farm to firm to consumer) example often quoted to understand the value added method.

Say, a farmer produces sugar cane and sells it to the sugar mill which converts it to sugar and sells it to the retailers who eventually sell it to the consumers.

In the above example, for the sake of simplicity and convenience, we are presuming that the farmer is not spending any amount on the inputs, etc., to produce the output. He is producing sugar cane of worth Rs.3,00,000 which he sells to the sugar mill, thereby adding a value of Rs.3,00,000.

The sugar mill owner sells the output to various retailers for Rs.7,00,000 and in the process he adds value of Rs.4,00,000. Eventually the retailer sells the product to the consumers for Rs.9,00,000 and adding value worth Rs.2,00,000. Here, the gross value added is Rs.9,00,000 (= Rs.3,00,000 + Rs.4,00,000 + Rs.2,00,000).

Problem of Double Counting:

The single major problem faced under the product method is that of double counting. It refers to the addition of values more than once during the process of estimating value of output.

For every producer, his product is a final product but not so for a national income accountant.

For a farmer, the process of production ends immediately after he has harvested his crop (of say sugar cane). But we know that sugar cane is not the final product. It may serve as a raw material to produce sugar by the sugar mill.

Sugar, too, is not a final product till it reaches the end consumers passing through the hands of the retailers. The output of sugar includes the value of all other inputs. If we were to include the value of all intermediate inputs and sugar in the total domestic product, we would be overstating it simply because of multiple counting of different intermediate goods and final products.

As in the above example, it would be highly unfair to say that the value of the goods and services produced in the economy is Rs.19,00,000. Conversely, we must deduct the combined values of intermediate cost (worth Rs.10,00,000) to arrive at the actual value addition of Rs.9,00,000.

There are two alternative approaches to estimate national income by this method, without facing the problem of double counting:

1. Final Value Approach:

As per this approach, to arrive at the value of net value added at factor cost, we need to include only the value of the final products, i.e., those goods which go for final consumption, i.e., we need not include the value of intermediate goods. In the above example, by taking the final value of Rs.9,00,000 we can sort out the issue of the double counting.

2. Value Added Approach:

Alternatively, we can find out the net value added at factor cost corresponding to different stages of production of a commodity. The sum of net value added in the economy will give us the estimate of domestic factor income in the economy. As in the above example, we have taken it as Rs.19,00,000 – Rs.10,00,000 = Rs.9,00,000.

Precautions under the Value Added Method:

1. Goods and services that are sold in the market with a view to earn profits are included along with the goods and services not sold in the market but that are supplied free or at a nominal rate (e.g., free lunch to school children or employees in a company).

2. Own-use production or own-account production goods. It also includes own-account production of fixed assets by government, business enterprises and households.

3. Imputed rent of owner-occupied houses, etc., are also included.

4. Any illegal activities (smuggling, hoarding, black marketing, gambling, betting, etc.) are always excluded from the ambit of the national income estimation as per the production method.

5. Domestic services provided by a housewife (and other family members) are definitely economic in nature but still we exclude them from production as for these services their values cannot be estimated with accuracy as their valuation is very difficult.

6. Any value of intermediate consumption is not included, so as to avoid the problem of double counting.

7. Any second-hand sale is never included as the goods are not contributing to the current flow of production. However, any brokerage/commission paid to any broker/dealer must be included for their productive services rendered during the sale process of the second-hand goods.

8. Any sale of bonds/shares, etc., are excluded for the estimation of national income as they are merely financial paper claims that does not contribute directly to the current flow of goods and services.

9. Any gifts/donations from rest of the world should not be included as it is a transfer income received by the economy/person and not an earned income.

Some Practical Difficulties in estimation of National Income by the Product Method:

1. It is difficult to decide whether the money value of goods and services be measured at the manufacturer’s cost, wholesaler’s price or at retailer’s price.

2. It is difficult to determine the value of goods which do not reach the market and are retained for self-consumption. Owner-occupied buildings and goods retained for self-consumption create problems in the estimation of their market value.

3. It is not always possible to draw a clear-cut line of demarcation between the intermediate goods and the final goods. Whether a commodity is an intermediate good or a final good depends upon its usage. Milk is a final good for a household, but an intermediate good for the tea vendor.

4. In case the value of a capital good rises or falls due to changes in market conditions, it becomes difficult to estimate the depreciation. It is for this reason that the concept of gross national product is preferred to the net national product.

5. It is still a matter of dispute whether services should be included in national income or not.

6. Reliable and accurate data are not available about production in the unorganised and unincorporated enterprises.

2. Income Method/Factor Payments Method:

Four factors and four sectors play a vital role in determining the national income of a country. As per the Income Method, national income is measured from the viewpoint of payments made to the four crucial factors of production, i.e., land, labour, capital and entrepreneurship in the form of wages (compensation of employees), rent, interest and profit (income from property and entrepreneurship) for their productive services during an accounting year.

National income under this method is the result of the sum of payments made by all the producing enterprises to various factors of production operating in the domestic territory of the economy (resulting into domestic income) and net factor income from abroad (NFIFA).

This method is also known as distributed income method on the basis of the factor income distribution by the producing units to the factors of production in the following three major categories:

1. Income from Work/Compensation of Employees (COE)

2. Income from Property and Entrepreneurship/Operating Surplus (OS)

3. Mixed Income of Self-employed (MISE)

Net Domestic Factor Income at Factor Cost (NDP_FC) – (i) + (ii) + (iii)

1. Income from Work or Compensation of Employees (COE):

People sell their physical and mental labour and skill to firms with a motive of earning their livelihood. Producing units produce output using these skills and labour and pay them compensation for their efforts. This is defined as the compensation of employees or income from work.

This basically includes the following components:

(a) Payments made by producers in the form of wages and salaries in cash or kind. Wages and salaries in cash are the periodical payments made by the firms to households for their productive services to the production process. It may be covered under headings like basic salary, dearness allowance, bonus, etc.

Wages and salaries in kind include various facilities like medical facilities, food/uniform provided by the employer, concessional education to the wards of the employees, etc.

(b) Social security contributions by the employers on behalf of their employees like the contribution made by the employers towards provident fund or mediclaim policies or insurance premium for the employees, etc., and

(c) Retirement pensions are like deferred/delayed wages of the employees who worked for the organisation till their superannuation. These are related to factor services rendered by the recipients prior to their retirement, therefore, these are included in the estimation of national income.

To avoid any confusion, we must remember that old-age pensions are unilateral payments or transfer payments and, therefore, are not included in the estimation of national income.

2. Operating Surplus:

Operating surplus is defined as the total income earned by firms during the production process from property and enterprises in the form of rent, interest and profit. In brief, operating surplus is the income from property and entrepreneurship.

Symbolically, OS = Income from Property + Income from Entrepreneurship

Income from property includes rent, interest and royalty, while income from entrepreneurship includes profit.

Thus,

OS = (Rent + Interest + Royalty + Profit)

a. Rent and Royalties:

Rent is the reward/reparation paid by the tenants of land, building and physical properties to the owners of these resources for productive purposes. Similarly, royalties are the amount paid by the leaseholders/tenants to the owners/leasers of sub-soil assets.

b. Interest:

Households and firms often borrow funds for one purpose or the other ranging from productive investment purposes to meeting some consumption expenditure purposes. They have to pay interest on the funds they have borrowed. However, for the purpose of constructing the national income accounts, only the interest paid for investment purposes is taken into consideration or into the ambit of the ‘factor payments’. Even the value of imputed interest is included in the national income account.

Thus, interest income does not include:

i. Interest paid by Government on public debt.

ii. Interest paid by consumers as such interest is paid on loans taken for consumption purposes.

iii. Interest paid by one firm to another firm as it is already in the profit of the firms which pays it.

c. Profit:

It is the reward which the owner of the firm/entrepreneur gets. Firms desire to earn and maximise their profits as it is the main motivating factor behind running a business.

There are three components of profit:

i. Corporate Tax (also called Corporation Tax):

It is a tax paid by an enterprise to the government.

ii. Undistributed Profit:

It is the profit retained by an enterprise for capacity expansion, modernisation, technological up-gradation, etc.

iii. Dividend:

It is a payment made to the shareholders of an enterprise. Dividend paid by one firm to another is not included as it is already included in the profit of the firm which pays it.

Alternative Definition:

Alternatively, operating surplus can be defined as the gross output at producer’s value less the sum of intermediate consumption, compensation of employees, consumption of fixed capital and net indirect taxes.

Either of the above two formulations of operating surplus will give us the same result.

In brief:

Operating Surplus = GVO_MP – Intermediate Consumption – COE – Depreciation – NIT

Or

= Rent + Interest + Royalty + Profit.

3. Mixed Income of Self-Employed (MISE):

It is the most peculiar component of the national income estimation by the income method. Mixed income of self-employed can be defined as income on own account of workers and profits and dividends of unincorporated enterprises.

It is partly labour and partly capital income. Individuals in their capacities as producers and also as suppliers of factor services earn mixed income. In mixed income, income from farms and other agricultural enterprises, income from sole proprietorship and professional earnings are included. NDP_FC (Domestic factor income) includes mixed income of the self- employed.

Sometimes, it becomes difficult to distinguish clearly between the wage and non-wage or property income generated by an individual running a business activity. In such a case, the ‘gross/total earnings’ have to be taken as a single amount to represent this which is called ‘mixed income of self-employed’.

For example, if a doctor (general physician) is using two rooms of his house to run his clinic, he himself is the ‘labour’ and ‘entrepreneur’ who has employed his own capital, thus, his gross earnings in the form of consultation fees cannot be bifurcated into rent, wages, interest and profits. Therefore, it is taken in the same combined form under the heading of mixed income of self-employed.

Similar examples can be quoted with reference to individuals running boutiques, small coaching-centres, etc., from their own premises. In case of sole proprietorship, it is difficult to distinguish between the wage income and the property income. In those enterprises in which it is difficult to distinguish between wage income and property income, the net value added at factor cost is equal to the mixed income of the self-employed.

In underdeveloped countries such as India, the households (who also act as producing units) do not maintain proper income accounts. The concept of mixed income of the self-employed was introduced in national accounting to sort out such problems.

Mixed Income of Self-Employed = Income on Own Account of Workers + Profits and Dividends of Unincorporated Enterprises.

Distinction between Operating Surplus and Mixed Income of Self-Employed:

The main points of distinction between operating surplus and mixed income of self-employed are:

1. Operating surplus is the income from property and entrepreneurship, while mixed income is the income from work, property and entrepreneurship.

2. Operating surplus accrues to corporate and semi-corporate enterprises, while mixed income is available to the self-employed households.

3. Operating surplus includes rent, interest and profit, while mixed income includes rent, interest, profit and compensation of employees.

Steps of estimating National Income by Income Method:

1. First Step:

It involves the identification and classification of firms (productive enterprises/units). This step is same as has been explained in product method.

2. Second Step:

It involves classification of factor incomes into two categories:

(a) Domestic factor incomes:

Domestic factor incomes consist of:

i. Income from work or compensation of employees,

ii. Operating surplus, and

iii. Mixed income of the self-employed.

(b) Net Factor Income from Abroad:

3. Third Step:

It involves estimation of national income.

For this purpose we proceed as follows:

i. Income paid out by each producing enterprise can be measured by multiplying the number of units of each input employed by the income paid to each unit. The result will be the income generated by each enterprise.

ii. Income generated by all the enterprises in a particular sector can be found out by adding the incomes paid out by each enterprise.

iii. By adding the incomes paid out by all the industrial sectors, we get net domestic income or net domestic product at factor cost (NDP_FC).

From net domestic product at factor cost (NDP_FC), we can derive the values of net national product at factor cost as follows:

NNP_FC = NDP_FC + NFIFA

= COE + OS + MISE + NFIFA

To sum up, income is generated during the production process. The income so generated by all the producing units within the domestic territory of a country is called domestic factor income.

The domestic factor income comprises of:

a. Wage income (compensation of employees),

b. Non-wage income or property income (operating surplus) and

c. Mixed income of the self-employed.

Net Factor Income from Abroad:

Net factor income from abroad is defined as income attributable to factor services rendered by the normal residents of a country to the rest of the world less factor services rendered to them by the rest of the world.

There are three major components of NFIFA that are as follows:

(i) Net Compensation of Employees:

It is the difference between the compensation of employees received by the nationals/residents of a country from ROW and similar payments made to the ROW.

The net compensation of employees is positive if COE received from abroad is greater than COE paid to abroad, and vice versa. In the former case, national income will be more than domestic income {NNP_FC > NDP_FC}, while in the latter one, national income will be less than domestic income {NNP_FC < NDP_FC}.

(ii) Net Operating Surplus (Net Income from Property and Entrepreneurship):

Just as we include the net COE, we also include the net Operating Surplus/net earnings from property and entrepreneurship.

Earnings on this account by the Indian nationals abroad are added, whereas those by the foreign nationals in India are to be deducted. Domestic factor income will increase if the payments made to the rest of the world by way of rent, interest, profits and dividends are less than the payments received on these counts abroad and vice versa.

(iii) Net Retained Earnings of Resident Companies Abroad:

The net retained earnings of resident companies abroad refer to the difference between the retained earnings of resident companies located abroad and the retained earnings of foreign companies located in the domestic territory of other countries.

Precautions in the Estimation of Factor Income:

In order to have correct estimates of national income based on income method, the following precautions must be taken:

1. Income from the sales proceeds of second-hand goods should be excluded as it is not contributing to the current flow of income. However, the commission charged by the broker on such transactions should be included in the national income.

2. Any domestic service provided by any family member out of sheer love and affection or care for the family should not be taken up.

3. Any type of illegal incomes, e.g., the income of smugglers, black-marketers, etc., should be excluded. However, to the extent that incomes generated from such transactions may be used in legal transactions, these should be included. Also, such incomes are included if the transaction is made with mutual agreement between parties.

4. Windfall gains, such as income from lotteries, should not be included as they are not earned incomes.

5. Imputed rent of self-occupied accommodation should be included and should be estimated on the prevailing rent of similar property.

6. Any Transfer payments like scholarship, pocket money, old age pension, gifts should be excluded from the estimation of national income as they are not earned rather just received.

7. Corporation tax is a part of profit earned by enterprises. It should not be separately included in the national income. Also it must be noted that the income tax of the salaried individuals is a part of the compensation of employees and, therefore, it should not be taken up separately.

8. As Wealth Tax, Death Duties, Gift Tax are paid out of current income (or past savings), these should not be included in the national income.

9. Value of production for self-consumption should be included and estimated on the prevailing market price of the product.

10. Capital gains refer to income from sale of second-hand goods and financial assets. Any income arising from such transactions is not a factor income as these transactions are not productive transactions and do not add to the current flow of goods and services in the economy.

Difficulties in Estimation of National Income by Income Method are as Follows:

1. It is difficult to estimate mixed income of self-employed due to lack of reliable information. Mixed incomes are earned by the unincorporated sector and it is difficult to get reliable information from such unorganised sector.

2. Interest on national debt is not included in national income as per the national income convention on the assumption that government borrowings are used for consumption (unproductive) purposes. However, some economists object to this since a part of the government borrowing is used for productive purposes.

3. Incomes received are generally calculated from income tax returns of the households and firms. Therefore, income method is of limited use in underdeveloped countries because a very small part of the income earners are taxpayers in these countries.

However, income method of estimating national income is a very useful method because it provides information about distribution of national income among various factor categories like share of wages and profits, etc., in national income.

3. Expenditure Method:

Expenditure Method of estimating national income takes into account various heads under which an economy spends the amount it receives/earns from different sources. Total final expenditure, both consumption and investment together by all the sectors, i.e., household, firms, government and net export to the rest of the world, represents the gross domestic product at market price (GDP_MP) of the economy. It is also called Flow-of-Expenditure Method, Consumption and Investment Method, Income Disposal Method, etc. Expenditure Method measures national income at the disposition stage, i.e., the disposition of final products.

Expenditure Method measures the final expenditure on gross domestic product at market prices during a year.

This method measures the expenditure on GDP_MP during a year.

This method works on the basic- most identity of macroeconomics:

Y = GDP = C + I + G + (X – M)

Where; C = Consumption Expenditure (Households + Firms)

I = Investments/Capital Formation (Households + Firms + Government)

G = Consumption Expenditure (Government)

(X – M) = Net Exports (Excess of Exports to ROW over Imports from ROW)

We will discuss these components in detail in the coming sections.

The various steps involved in the use of expenditure method are briefly summarised as follows:

(i) First Step:

It involves identification of economic units incurring final expenditure. Different economic units are – Household sector, Firms/Producer sector, Government sector and Rest of the world sector.

(ii) Second Step:

It involves classification of final expenditure into the following categories:

A. Final Consumption Expenditure:

(i) Private final consumption expenditure (PFCE).

(ii) Government final consumption expenditure (GFCE).

B. Final Investment Expenditure:

(i) Gross domestic fixed capital formation (GDF_XCF).

(ii) Changes in stocks (Δs).

(iii) Net acquisition of valuables.

C. Net Exports (X – M)

(iii) Third Step:

It involves the measurement of final expenditure which represents the GDP_MP as the sum of private final consumption expenditure (PFCE), government final consumption expenditure (GFCE), gross domestic fixed capital formation (GDF_XCF), changes in stocks (Δs) and net exports (X – M).

Thereafter, we can arrive at the value of national income by adding NFIFA and deducting depreciation and net indirect taxes.

NNP_FC = GDP_MP – Depreciation – NIT + NFIFA

NNP_FC = PFCE + GFCE + GDF_XCF + Δs + (X – M) – Depreciation – NIT + NFIFA

Let us have a detailed discussion on various components of final expenditure which are measured as follows:

A. Private Final Consumption Expenditure (PFCE):

Private final consumption expenditure is incurred by:

(a) The consumer households, and

(b) Private non-profit institutions serving households.

Only resident households are included and non-resident households are avoided from inclusion in this category as they are beyond the formulation of the domestic territory of the economy.

PFCE is incurred by households on new durable and non-durable goods and services, including own-account production of goods and services, deducting their net sales of second­hand goods.

Private final consumption expenditure by households is estimated by combining the following items:

PFCE by households includes the following:

a. Expenditure on new durable and non-durable goods and services

b. Imputed gross rent of owner-occupied buildings

c. Food-grains and other items produced for final consumption

d. Benefits like wages and salaries, rent-free accommodation, non-durable goods and services received in kind

e. Net value of gifts received in kind

f. Direct purchase of households abroad

g. (Deduct) Net sale of second-hand goods

h. (Deduct) Sale of scraps and wastes.

PFCE by non-profit institutions includes the following:

a. Expenditure on the purchase of goods and services

b. Compensation of employees

c. Net value of gifts in kind received from the government, production enterprises and the rest of the world

d. (Deduct) Net sale of second-hand goods

e. (Deduct) Sale of scraps and wastes.

B. Government Final Consumption Expenditure (GFCE):

Final consumption expenditure of the government is the net current expenditure on goods and services, incurred in providing services of government administrative departments.

It is estimated by considering the items as follows:

a. Expenditure on intermediate consumption by the government

b. Expenditure on compensation of employees (i.e., wages and salaries in cash and kind)

c. Consumption of fixed capital (Depreciation)

d. Expenditure on direct purchase of goods and services abroad

e. (Deduct) Receipts from sale of goods and services by the government.

C. Gross Domestic Capital Formation and Net Domestic Capital Formation:

This category of expenditure deals with the investment expenditure made by households, firms and the government in the domestic territory of the economy. We have already studied that ‘investments’ can be further bifurcated into ‘fixed investments’ and ‘change in inventories’. Therefore, gross domestic capital formation (GDCF) is defined as the sum of gross domestic fixed capital formation (GDF_XCF), changes in stock in a year (ΔS) and the net acquisition of valuables (NAV) (i.e., value of acquisition less value of disposals) by enterprises, government and households.

Symbolically,

GDCF = GDF_XCF + ΔS + NAV.

Net domestic capital formation (NDCF) is equal to the difference of gross domestic capital formation (GDCF) and depreciation/current replacement cost (CRC).

Symbolically,

NDCF = GDCF – Depreciation.

(i) Gross Domestic Fixed Capital Formation:

As per the definition, it is the sum total of all the fixed assets purchased/prepared in the domestic territory of the country along with imports of such assets from abroad and imputed value of assets for the own account production.

Thus, GDF_XCF includes:

a. Purchase of new assets in the domestic market

b. Import of new assets

c. Own-account production of new assets

d. Purchase of new houses by consumer households

e. Net purchase of second-hand physical assets from abroad.

(ii) Change in Stock:

Stock, here, means the value of goods lying unsold with the seller/producer of the goods. As per the definition, the term Change in inventories/stock is the difference between the closing stock and opening stock during an accounting year.

It is important to understand that the term inventory/stock includes stock of:

a. Raw materials,

b. Work-in-progress or semi-finished goods, and

c. Finished products held by the sellers/producers.

(iii) Net Acquisition of Valuables:

It is another important category (although often ignored) of items which must be taken care of while estimating GDF_XCF. Net acquisition of valuables is the difference between the ‘acquisitions’ and ‘disposal’ of valuable items by households, firms and the government.

It is estimated as follows:

NAV = Value of acquisition of valuables – Value of disposal of valuables

(iv) Current Replacement Cost:

It is known by different names such as consumption of fixed capital, depreciation, or capital consumption. It includes loss of value due to normal wear and tear and expected obsolescence.

An alternative way of classifying or presenting the concept of Gross Domestic Capital Formation is to present it as:

(a) Gross Fixed Investments:

Gross Fixed Investments is the expenditure incurred on fixed capital assets by the households, firms or the government in the economy.

They are further classified into:

(i) Business Fixed Investments (BFI) deal with the fixed investments expenditure made by firms on factory building and premises, additions to machinery, tools and equipment with an aim of increasing their productive capital.

(ii) Residential Construction Investments (RCI) are defined as the fixed investments expenditure made by the households on the net additions made to their fixed residential/housing facilities.

(iii) Public Investments (PI)) refer to the fixed nature of capital formation/investments made by the government in the direction of ensuring general welfare by constructing new hospitals, schools, dams, bridges, roads, etc.

(b) Inventory Investments:

Stock, here, means the value of goods lying unsold with the seller/producer of the goods. As per the definition, the term change in inventories/stock is the difference between the closing stock and opening stock during an accounting year.

It is important to understand that the term inventory/stock includes stock of:

i. Raw materials,

ii. Work-in-progress or semi-finished goods, and

iii. Finished products held by the sellers/producers.

D. Net Exports (X-M):

It is the excess of exports of goods and services over the imports of the goods and services by the economy. The rationale behind inclusion of exports in the expenditure method is that it is the expenditure made by non-residents on the goods and services produced in the economy. Therefore, it is an expenditure on domestic product. We must remember that receipts of exports are different from the ‘factor income from abroad’.

Also, imports are an expenditure made by the residents on the goods produced abroad beyond the domestic territory of the economy. Another important point worth mentioning here is that some value of imports is always included in private final consumption expenditure, government final consumption expenditure and gross domestic capital formation. Thus, to eliminate any sort of repetition of such item we may safely deduct the value of such items under the heading of imports.

Distinction between Net Factor Income from Abroad and Net Exports:

Net Exports:

Net export is the difference between the exports of a country to the rest of the world and imports from the rest of the world.

The exports and imports of a country include both visible items (food products, raw materials, engineering goods, leather garments, handicrafts, chemicals, etc.) and invisible items (banking, insurance, shipping facilities, services of experts and technocrats, etc.).

Net export is a part of domestic income.

Net Factor Income from Abroad:

Net factor income from abroad is different from net exports in the sense that the factor income from abroad such as compensation of employees, rent, interest, profit, etc., is different from services included in net exports.

National income estimates, besides net factor income from abroad, should also include net exports.

Thus, according to the expenditure method:

GDP_MP = PFCE + GFCE + GDF_XCF + ΔS + (X – M).

From the estimates of GDP_MP, we can estimate NNP_FC as follows:

NNP_FC = GDP_MP – Depreciation + NFIFA – NIT.

Precautions to be taken while using Expenditure Method:

The following precautions are to be taken while using the expenditure method:

a. Expenditure on second-hand goods is not to be included in the final consumption expenditure. However, any payment on account of brokerage/commission to facilitate the sale of second-hand goods must be included due to the productive nature of the service provided by the broker/dealer.

b. To avoid any issue relating to the double counting of value goods, only ‘final expenditure’ is to be taken into account and not the intermediate consumption expenditure.

c. Gross investment is included in total expenditure. Gross investment includes replacement cost/depreciation.

d. Imputed value of goods and services must be taken into account.

e. Expenditure on acquisition of finance capital (bonds, shares, etc.) is not to be included as they are mere paper claims.

f. Government expenditure on old-age pensions, scholarships, unemployment allowance, etc., is not to be included.

Difficulties in Expenditure Method:

Some of the principal difficulties in the measurement of national income through the expenditure method are:

(i) Consumer Durables:

There are different opinions regarding consumer durables like T.V., refrigerator, washing machine, etc. The question that arises is that should expenditure on these items by the household be treated as consumption expenditure or investment expenditure? Conventionally, such expenditure is treated as consumption expenditure. Thus, if a refrigerator is bought by a household, it is consumption expenditure. But if the same refrigerator is bought by the producer, it is investment expenditure.

(ii) Nature of Government Expenditure:

There are difficulties regarding the nature of government expenditure as well. Here also, it becomes difficult to distinguish between consumption expenditure and investment expenditure. For example, expenditure incurred by the government on roads, bridges, etc., is taken as investment expenditure. On the other hand, expenditure incurred on education, health, etc., is taken as consumption expenditure.

(iii) Interest on National Debt:

It is controversial whether interest on national debt should be included in government expenditure or not. Different economists carry different opinions on the matter.

(iv) Inadequate Statistics:

It is very difficult to get data on consumption expenditure of the households and investment expenditure of the producers, particularly in the unorganised sector.

(v) Change in Stock:

There are frequent changes in production process. Accordingly, there are frequent changes in inventories of the producers. It is difficult to have a correct picture of the change in stock for the calculation of national income.

The following table shows Reconciliation of the three Methods: