METHODS OF MEASUREMENT OF NATIONAL INCOME

National Income Accounting

National income accounting is concerned with the statistical classification of the

activities of human beings and institutions in ways, which help us, understand
operation of the economy as a whole. They are designed to present a meaningful
summary of the working of the economic system of a country. They also provide a
framework within which operations of the economy are recorded.

There are three methods of measuring the national income.

(i) Product Method
(ii) Income Method
(iii) Expenditure Method

Product Method

This method approaches national income from the output side. Economy is divided
into different sectors such as agriculture, industry, mining, manufacturing, transport,
commerce, communication and other services. Output from each of the sectors is
summed up to obtain the GNP. GNP is found by adding up the value of all final goods
and services produced by firms and agents during the year. All final goods must be
include, whether they are sold to consumers, government, abroad or to other firms.
GNP is found by adding up net values of all production that has taken place in these
different sectors.

In this computation only final products are include while all intermediate goods are
excluded so that double counting is eliminated. If double counting is not avoided, then
the value of GNP will be overstated. This method of estimating national income enables
us to trace the origin of national income.

To avoid double counting, we compute the Value-Added by all firms at different stages
of production. In this endeavor, we must count the price of any commodity only once.
This is done by making sure that only the value of final goods should be included. For
example, if cotton worth Ksh. 300 is produced and cloth produced is worth Ksh. 800 we
should consider the value of cloth only because it includes the value of cotton.

Example
Production of woolen coat involves three main stages:
A sheep farmer produces raw wool and sells to a mill for Kshs 300. This represents an
income of 300/- for the farmer Value Added = Ksh. 300. The mill uses the raw wool to
produce cloth which it sells to a coat factory for Ksh. 500. This represents income
(including profit) of Ksh. 200 and the Value Added = Ksh. 200. The coat factory
produces the coat and sells it for Ksh. 800. This includes Ksh. 500 to cover the cost of

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the cloth and 300 to pay for incomes, including profits. Therefore, the Value Added =
300/-. The total Value Added in this example is just equal to the value of final coat
which is 800/=. We use this amount in the computation of GNP.

The product method can be used where there exists a census of production for all goods
and services during the year. However, this is not the case in many countries where
only the figures are those of industrial production. This method is therefore not
sufficient to measure national income. It is only applied along with other methods.

Exercise
1. A farmer in Kiambu produces milk and sells it for Kshs. 12000--8,000 to Brookside Ltd; the firm
pasteurizes the milk and sells it to Tuskys supermarket for Kshs. 40,000-32,000. The supermarket
sells the milk directly to customers for Kshs.60000- 40,000. Calculate the value added by each
party. State the GDP in this simple economy?

2. The table below represents economic transactions for country XYZ in billions of shillings:

Total output Intermediate purchases

Agriculture 30 10
Manufacturing 70 45
Services 55 25

Required:
i) Calculate the Gross National Product of this economy using the value added approach. (3 marks)
ii) If depreciation and indirect taxes equal 8 billion and 7 billion shillings respectively, find the Net
Domestic Product both at Market prices and at factor cost. (4 marks)

c) Briefly explain the multiplier and accelerator principles. (3 marks)

(Total: 20 marks
Income Method

This method approaches national income from distribution side. It measures the
national income after it has been distributed and appear as income earned or received
by individuals of the country. Goods and services are produced by factors of
production which in return earn income. In aggregate, this creates income for the entire
economy.

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National Income is obtained by summing up income of all individuals and institutions
in the country. Incomes are in form of wages, salaries, interest, rent and profits as well
as incomes of self employed people like doctors, lawyers, professors, accountants etc. In
this method, we exclude all transfer payments as this represents nothing more than a
redistribution of income from agent to another. For example, tax payment is a transfer
from individuals to the government. Therefore including these transfers would result to
double counting.
GDP = Y = Wages + rent + interest + profits- transfer payments
a) The table below shows value of different economic transactions for a XYZ economy in
billions of US Dollars for the Government Financial Year ending 30th June 2013.
Economic Transaction US Dollars (Billion)

Wages and Salaries 45

Income from Rent 3

Net interest Income 4

Profits of Corporates 8

Indirect taxes 7

Subsidies 3

Depreciation 11

Net income from Abroad -5

From the table compute the following

i. Gross Domestic Product GDP (2 Marks)

ii. Gross National Product GNP ( 1 Marks)
iii. Net National Product NNP (1Marks)
iv. National Income at Factor Cost NY (2 Marks)
v. According to Revised GDP estimates for Kenya, Per Capita Income for Kenya for the year
ending 30th June 2013 was US dollar 606. If the population of XYZ Economy above was 50

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 million people. Between Kenya and XYZ, which country has a higher Per Capita Income?
2
Marks)
Is it true that citizen of XYZ Economy enjoys a higher standard of living than Kenya? Explain
your answer

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Class exercise
The table below represents estimated national income values for hypothetical economy X in millions of
shillings:

Gross National Product (at market prices) = 389.2

Depreciation allowance = 47.0
Indirect taxes less subsidies = 42.4
Business taxes = 11.4
Personal income taxes = 66.3
Government transfers = 59.3
Retained profits = 13.0

Based on the information provided, calculate the Net National Product at market price, the Net
National Income (at factor cost), Personal Income and the disposable income for this economy
(8 marks)

Expenditure Method

This method arrives at national income by adding all the expenditures made on goods
and services during a particular year in a country. Income can be spent on either
consumer goods or producer goods. National income is found by summing up all
consumption expenditures made by all individuals as well as by the government of a
country during a year. In this aggregation, net stock changes and work in progress are
computed as part of firms investment spending. National expenditure is the sum of
consumption of domestically produced goods, investment, government expenditure
and exports. To avoid double counting, only spending on final goods and services is
included in the computation.
GDP = C + I + G + (X - M), where

C = Consumption expenditure of Households

I = Gross Investment by firms
G = Government Expenditure
X-M = Value of Export-value of Import

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From the data below calculate the gross national product at factor cost:

Million(000)
Imports 42,000
Value of physical increase in stock 1,300-1800
Exports 43,000
Capital formation 25,000
Government expenditure 29,000
Consumer expenditure 84,000
Taxes on expenditure 20,000
Subsidies 3,000
Net property income from abroad 400

In general assuming
-that all the three measures are calculated accurately and that only final goods and
services are counted in the national product, incomes and expenditure figures.
-that any changes in unsold stocks are included in the national expenditure.
-that all incomes including profits but excluding transfer payments are counted in the
national income figures.

Then it must follow that all three measures will provide an identical figure for the
value of the country’s total output.

GNP = GNE = GNI or GDP = GDE = GNI

In principle, these three measures or aggregates simply represents different ways of

measuring the flow of output or income created in an economy over a period of time.

THE CIRCULAR FLOW OF INCOME.

GOVERNMENT

Transfer
Payments
Taxes Taxes
Government
Spending
Income
FIRMS HOUSEHOLDS

Consumption

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Investments Export Imports Savings
FOREIGN MARKET

The two main agents in the circular flow of incomes are the households and the firms.
Households are the owners of factors of production such as labour, land, capital and
entrepreneurship. These factors are sold to the firms in exchange of money (income) in
forms of wages, salaries, interest, rent, and profits. Incomes from the firms are received
by the households. That part of the income earned by households is not spend forms the
savings and can be used to for consumption or importation of goods at later date.
Savings becomes a leakage of income form the circular flow of income.

The firms use factors of production to produce many different types of goods and
services, which they sell to households in the economy. This is referred to as
consumption. The process yields income to the firms. We can therefore argue that
consumption enables firms to gain income

Output of the firm is also required by government and foreigners in form of

government spending and exports respectively. Besides consumption firms also sell
part of their output to government and foreign sector.

Firms also buy output of other firms such as machines to assist in the production
process. Transactions between firms are mainly on capital goods, which in this case is
referred to as the investment. Expenditure by firms for capital goods is an injection to
the circular flow of income.

Firms and households pay income to the government in form of taxes. This is mainly in
form of income tax and corporate tax respectively. The government also spends income
towards households in form of subsidies.

Households and firms import from abroad in form of consumer goods and capital
goods respectively. Importation creates income to the foreign sector.

Movement among all these agents in an economy form a circular structure and that is
why we refer to it as the circular flow of income.

Introduction of Financial Sector into Circular flow of Income

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DIFFICULTIES IN MEASUREMENT OF NATIONAL INCOME

There are certain difficulties, which we face while measuring the national income of any
country. They include:-

1. The treatment of the non-monetised transactions such as services of housewives

to members of their families and farm output consumed at home. This is not
included when national income is computed.

2. The treatment of the government expenditure in national income accounts. This

includes payments of government workers salaries. This regards the
administrative functions of government like justice administrative and defence.
They should be treated as giving rise to final consumption of such services by the
community as a whole, so that contribution of government activities will be
equal to the among of wages and salaries paid by the government. Capital
formation by the government should be treated as par capital formation by any
other enterprise.

3. Treatment of incomes arising out of activities of foreign firms in the country.

Income arising from such enterprises should be part of national income of that
country. However, this is not always the case. Capital formation by the
government should be treated as capital formation by any other enterprise.

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4. DEPRECIATION
When investment take place during the year, new capital is created ad it is
correct be included in the calculation of the value of total output. Some
investments however occur, however to replace capital which has worn out
during the year. Such a wearing out of capital is called depreciation or capital
consumption. Where no allowance for depreciation is made then the resulting
figure is called Gross Investment. Therefore, GNP, GNE and GNY minus
depreciation equals NNP, NNE, NNI. Depreciation figures are difficult to
estimate for any economy and with time Gross and Net components tend to be
the same.

5. Stock Appreciation
If the prices are rising even if there is no net physical addition to them, the
output value seems to be increasing. However, this aspect is not excluded in
during the computation of national income.

6. Market Prices or Factor Cost

When national expenditure is computed, it is measured initially in market prices
(Price multiplied by Quantity). Unfortunately, market prices are distorted by
indirect taxes and subsidies which either increases or decreases the market
prices. National income and national product are measured at factor cost, which
excludes indirect taxes and subsidies. To ensure that Gross National
Expenditure is the same as Gross National Income and Gross National Product,
it is necessary to convert market prices to factor cost by subtracting indirect taxes
and adding subsidies. Therefore NNE at market prices - Indirect Taxes +
Subsidies = NNE at factor cost. If this is not done, then an increase in indirect
taxes or reduction in subsidies would have an effect of overstating the total
output hence making it misleading.

7. Net Property Income from Abroad

Some of the output produced within the country is actually produced by firms
which are owned by overseas residents. Similarly some output produced
overseas is produced by firms owned by Kenyans residents. We need to take this
into account when we want to measure domestic output (GDP, GDE, and GDY).
Net income from abroad is equal to that income received by Kenya residents
from output by overseas firms minus that income paid to oversees residents from
productions of output by domestic firms. GDP, GDI and GDE + Net property
Income from Abroad = GNP, GNI and GNE respectively.

8. The “Black” Economy

Official statistics tend to under estimate the actual volume of economic activity
that occurs in a country. This is because of the operation of the so called “black”
or underground economy. Black economy represents transactions, which do not

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 pass through the formal market. Unrecorded economic transactions conducted
on a cash basis with a view of evading taxes also constitute black economy. The
borderline between the officially recorded economy and the black economy is not
always clear-cut, hence it becomes almost impossible to quantify the extent of the
black economy.

9. Double Counting
This would occur when say output is valued at every stage in the production
process. It is therefore important to note that valuation should be based on the
final product.

Developing countries Complications.

Developing countries further face some peculiar problems in computing their national
incomes besides those mentioned earlier. These include:-
1. Unavailability of data
2. Non monetised transactions (black Market)
3. Illetracy making most producers not to be aware of the quantity or value of their
output.
4. Occupational specialization is not complete due lack of differentiation in
economic functioning. An individual may receive income partly from farm
ownership, business and from services rendered. It therefore becomes difficult to
allocate income from different sources.

NATIONAL INCOME AS A MEASURE OF WELFARE

Economic Welfare

This is the general level of well being in a society, which depends on such factors as
quantity of goods and services available the distribution of income, the impact of
externalities and the composition of output. Since the National Income is a
measurement of the output of the final goods and services produced in the country
during a year, then a rise in national income between two or more different years
exhibits a rise in economic welfare. We need to convert national income figures into
real national income and then obtain real per capita income in order to make
comparisons.

Adjustments of Conversion

National income must be deflated by an appropriate price index to convert them into

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to real terms.

The figure must be divided by the population to convert it to per capita incomes.

Actual, potential and pseudo - improvements in economic welfare

Even if real output per capita rises, it is not necessarily true that actual economic
welfare will have improved. This brings in the idea of Actual, Potential and Pseudo
economic welfare. If changes in the distribution of income have also occurred, the
improvement may only be a potential one. This is where increases in real output per
capita often do leave some individuals or groups in society worse off.

An Actual Improvement

For actual improvement in welfare, then Pareto conditions must be satisfied. Pareto
conditions are fulfilled when it is not possible to make one consumer better off without
at the same time making any other consumer worse off. An increase in real output per
capita is actual improvement in economic welfare if no distributional changes can occur
to make any individuals or groups better off without making others worse off.

Pseudo Improvement
An increase in real income/output per capita may be apparent (or Pseudo), if in
addition to the rise, it is accompanied by negative externalities or is caused by increased
production of goods and services which are not for current consumption. For example,
negative externalities may be generated in an effort to increase national income. These
would include more hours of working, increased production of investment goods at the
expense of consumer goods, etc.

Pollution, congestion and less peasant working conditions are likely to arise as output
expands and these factors will tend to offset the positive effects of any increase in
average income. This kind of scenario is called pseudo improvement in economic
welfare.

Potential Improvement

This occurs when increase in real output per capita often leave some individuals or
group within society worse off than they were before the increase. For example,
discovery of oil (fuel) which boost the country’s output considerably, may reduce the
demand for some other source of fuel like coal. In such a case coal workers may then
loose their jobs and become worse off than they were before. This is what we call
potential improvement.

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