Republic of the Philippines

SORSOGON STATE COLLEGE

Bulan Campus
Bulan, Sorsogon

SUBJECT DESCRIPTION: AE – ECO1: Managerial Economics

TOPICS: NATIONAL INCOME ANALYSIS AND ECONOMIC WELFARE

 Introduction to National Income

 Circular Flow of National Income
 Effect of Foreign Trade on Circular Income
 Importance of National Income Estimates
 Methods of Measurements of National Income
 Income Method or Factor Income in the Production Process
 Product Method or Value Added Production Process
 Final Expenditure Method
 Reconciling the Three Methods
 Choice of Methods
 Difficulties in the Measurement of National Income
 Economic Welfare of National Income

NAME: JASON B. IMPERIAL

COURSE / YEAR: Bachelor of Science in Accountancy - II

DATE: October 01, 2019

SCHEDULE: Tuesday (9:30 – 11:30) / Wednesday (10:30 – 11:30)

SUBJECT INSTRUCTOR: Marilyn N. Inocetes

INTRODUCTION TO NATIONAL INCOME

There is a great desire to measure the success, or performance of our economy.

Are we getting ‘bigger’ (and better) or ‘smaller’ (and worse) over time? The need to
evaluate the magnitude of our economic performance is important to planners and
policy-makers, who want to know how well the economy is performing so that they can
set goals and make policy recommendations. An accurate measurement of the
economy’s performance is also important to private businesses because failure to do
that can lead to wrong decision making. Stock traders are continuously checking
economic data — buying and selling in response to the latest economic statistics. The
object is to show how the national income of a country is measured. In that context we
shall refer to some conceptual and practical difficulties associated with the
measurement of national income. Various measures of national income and output
have been developed, the most important of which is gross domestic product (GDP).
We shall examine GDP and other indicators of national economic performance in
detail. The level of economic activity that is taking place in an economy is vitally
important because it determines the quantity of goods and services that will be
produced in the economy. This, in turn, gives an indication of the material well-being of
the people of a country. Every year, the Philippine economy produces a large number
(and a wide variety) of goods and services wheat, tomato, banana, apple, cars, shoes,
clothing, buildings, houses, medical services, legal services, banking service, electricity,
textbooks, etc. The more of these goods and services that the economy produces, the
more we will have available for consumption and the better off we will be. National
income accounts provide information on the pattern of economic activity. These
statistics explain various economic and social phenomena. These also help policy-
makers in formulating good economic policies both in government and in private
industry. This is why national income statistics are closely watched by businesses and
governments at all levels.

CIRCULAR FLOW OF NATIONAL INCOME

The circular flow of income is a neoclassical economic model depicting how

money flows through the economy. In its simplest version, the economy is modeled as
consisting only of households and firms. Money flows to workers in the form of wages
and money flows back to firms in exchange for products. In short, an economy is made
up of countless circular flows of income (or money).

Understanding Circular Flow of Income

Most, if not all, people go to work daily to earn a living. The money that is earned
is used to purchase goods and services from businesses such as food, clothes, rent,
basic commodities, entertainment services, health and wellness products, etc. The
income earned daily flows back to businesses continuously in a cycle known as the
circular flow of income.

Businesses and companies manufacture goods or provide services to consumers.

To increase sales and profits, these companies use factors of production—labor,
capital, and land—to run their operations and grow their businesses. In return for their
services, hired labor is given a wage or salary, known as income. The income received
is used by households and individuals to purchase the goods and services produced by
these businesses. The businesses use the proceeds from the sales to produce more
products and pay workers for their labor.

EFFECT OF FOREIGN TRADE IN CIRCULAR INCOME

The circular flow of income described above is the most simplistic illustration of
the interdependence of two sectors in the economy. However, actual money flows
through the economy are far more complicated. Economists have expanded on the
ideas of the circular flow of income model to better depict the complexity of modern
economies by including more sectors that affect money flow. These sectors can then
be conceptualized as the components of total nation income or output (GDP).

In addition to the household sector that engages in consumption spending (C)

and the business sector that produces the goods, two sectors that can also be included
in the circular flow of income include the government sector and the foreign sector.
The government injects money into the circle through government spending (G) on
things like welfare programs and infrastructure. Money is also added to the circular flow
through exports (X) which involves foreign entities purchasing goods from the economy.
Businesses that invest (I) money to purchase capital stocks contribute to the flow of
income in the economy.

Just as money is injected into the economy, money can also be withdrawn or
leaked through a number of activities. Taxes (T) imposed by the government reduce
the flow of income. Money that is used to pay foreign entities for goods and services
through imports (M) also constitutes a leakage. Finally, savings (S) of businesses which
could otherwise have been invested leads to a decrease in the circular flow of an
economy’s income.

By tracking the injections into and withdrawals from the circular flow of income,
the government can calculate its national income which is the wages and other forms
of income received by households for their services.
 The level of injections is the sum of government spending (G), exports (X) and
investments (I). The level of leakage or withdrawals is the sum of taxation (T), imports (M)
and savings (S). When G + X + I is greater than T + M + S, the level of national income
(GDP) will increase. On the other hand, when the amount of leakage is greater than
the amount injected into the circular flow, the national income will decrease. The
circular flow of income is said to be balanced when withdrawal equals injections.

IMPORTANCE OF NATIONAL INCOME ESTIMATES

National income is the aggregate output of the different sectors during a certain
time period. In other words it is the flow of goods and services produced in an economy
in a particular year thus the measurement of national income becomes important to
identify the economic growth or decline of a countries economic state. There are three
ways in measuring the national income of a country there are from the income side to
know a rough estimate of income that can be produced or is produced by a country in
a year or longer, the output side the determination of products that can be produced
by a country to help in the determination of its income within its normal range and the
expenditure side thus we can classify these perspectives into the following methods of
measurement of national income.

METHODS OF MEASUREMENT OF NATIONAL INCOME

1. Product Method

Under this method, we add the values of output produced or services rendered
by the different sectors of the economy during the year in order to calculate the
National Income.

In this method, we include only the value added by each firm in the production
process in the output figure.

Hence, we use the value-added method. The value-added output of all the
sectors of the economy is the GNP at factor cost.

However, this method is unscientific as it adds the value of only those goods and
services that are sold in the market or are available for sale in the market

2. Income Method

Under this method, we add all the incomes from employment and ownership of
assets before taxation received from all the production activities in an economy.

Thus, it is also the Factor Income method. We also need to add the undistributed
profits of the private sector and the trading surplus of the public sector corporations.
 However, we need to exclude items not arising from productive activities such as
sickness benefits, interest on the national debt, etc.

3. Expenditure Method

This method measures the total domestic expenditure of the economy. It consists
of two elements, viz. Consumption expenditure and Investment expenditure.

Consumption expenditure includes consumption expenditure of the household

sector on goods and services and consumption outlays of the business sector and
public authorities. Investment expenditure refers to the expenditure on the making of
fixed capital such as Plant and Machinery, buildings, etc.

INCOME METHOD OR FACTOR INCOME IN THE PRODUCTION PROCESS

Under this method, national income is measured as a flow of factor incomes.

There are generally four factors of production labor, capital, land and
entrepreneurship. Labor gets wages and salaries, capital gets interest, land gets rent
and entrepreneurship gets profit as their remuneration.

Besides, there are some self-employed persons who employ their own labor and
capital such as doctors, advocates, CAs, etc. Their income is called mixed income. The
sum-total of all these factor incomes is called NDP at factor costs. The people of a
country who produce GDP during a year receive incomes from their work. Thus GDP by
income method is the sum of all factor incomes: Wages and Salaries (compensation of
employees) + Rent + Interest + Profit. When GDP is measured on the basis of current
price, it is called GDP at current prices or nominal GDP. On the other hand, when GDP is
calculated on the basis of fixed prices in some year, it is called GDP at constant prices
or real GDP. Nominal GDP is the value of goods and services produced in a year and
measured in terms of rupees (money) at current (market) prices. In comparing one year
with another, we are faced with the problem that the rupee is not a stable measure of
purchasing power. GDP may rise a great deal in a year, not because the economy has
been growing rapidly but because of rise in prices (or inflation). On the contrary, GDP
may increase as a result of fall in prices in a year but actually it may be less as
compared to the last year. In both 5 cases, GDP does not show the real state of the
economy. To rectify the underestimation and overestimation of GDP, we need a
measure that adjusts for rising and falling prices.

PRODUCTION METHOD OR VALUE ADDED PRODUCTION PROCESS

This looks at national income from output side. By this method we measure value
of all that is produced in the domestic economy. It is broadly called Gross Domestic
Product. GDP is defined as gross market value of all the final goods and services
produced by all producing units located m the domestic economy in an accounting
year. It is estimated by multiplying the gross product with market prices. This gives us the
value of Gross Domestic Product at market price (GDPMP).

Symbolically:

GDPMP = P (Q) + P (S)

In which P = Market Price, Q = quantity of goods, S = quantity of services. Being

gross, it includes depreciation; being at MP, it includes net indirect taxes and being
domestic it includes production by all production units within domestic territory of a
country. Mind value of only final goods and services is included to avoid problem of
double counting. The term product refers to the value of output – value of intermediate
consumption. GDPMP is estimated by deducting value of intermediate consumption
from value of output. If depreciation and net indirect taxes are deducted from GOP MP,
we get NDPFC or what is known as Domestic Income. By adding to its net factor income
from abroad, we get NNPFC which is called national income. Estimates obtained by final
product approach (also called output method) are not much reliable due to two
reasons. Firstly it is difficult to get data regarding production, prices and costs. Secondly
it is difficult to distinguish between final and intermediate goods because every
producer treats the good sold by him as final good although the buyer might have
used it in production as an intermediate good. Consequently there is always the
possibility of double counting which means a commodity may be counted more than
once in estimating national income. To overcome the difficulty of double counting,
value added approach is used. According to this method, domestic income is first
calculated by totaling ‘net value added at FC by all the producing units during an
accounting year within the domestic territory. This total is called Net Domestic Product
at FC or Domestic Income. Then by adding net factor income from abroad to Domestic
Income (NDP at FC), we get National Income (NNP at FC). Mind, in value added
method, national income is measured at the stage of production (or addition of value).

FINAL EXPENDITURE METHOD

Expenditure method measures final expenditure on ‘Gross Domestic Product at

market price (GDP at MP) during a period of account. Since all domestically produced
goods and services are purchased for final use either by consumers for consumption or
by producers for investment, therefore, we take sum of final expenditure on
consumption and investment. This sum equals GDP at MP. Final expenditure is the
expenditure made on purchase of domestically produced goods and services for final
use, i.e., for consumption and investment. Under expenditure method national income
is calculated first by adding up all the items of final consumption expenditure and final
investment expenditure within the domestic economy The resulting total is called GDP
at MR By subtracting depreciation and net indirect taxes from GDP at MP and adding
to its net factor income from abroad, we get NNP at FC or national income. Thus, under
expenditure method, national income is measured at the point of actual expenditure.
Mind, income generated by factors of production in the production process is spent by
them on final goods. Final use of a commodity is either for consumption or for
investment and expenditure on them is called Final Consumption Expenditure and Final
Investment Expenditure, respectively By adding up all the items of final consumption
expenditure and final investment expenditure within the domestic economy, we get
the aggregate called GDP at MP.

RECONCILING THE THREE METHODS

DIFFICULTIES OF IN THE MEASUREMENT OF NATIONNAL INCOME

The following are the difficulties in estimating the National Income

Conceptual difficulties

Statistical difficulties

A. Conceptual difficulties

It is difficult to calculate the value of some of the items such as services rendered
for free and goods that are to be sold but are used for self-consumption. Sometimes, it
becomes difficult to make a clear distinction between primary, intermediate and final
goods. What price to choose to determine the monetary value of a National Product is
always a difficult question? Whether to include the income of the foreign companies in
the National Income or not because they emit a major part of their income outside
India?

B. Statistical difficulties

In case of changes in the price level, we need to use the Index numbers which
have their own inherent limitations.

Statistical figures are not always accurate as they are based on the sample
surveys. Also, all the data are not often available.

All the countries have different methods of estimating National Income. Thus, it is
not easily comparable.

ECONOMIC WELFARE OF NATIONAL INCOME

Before knowing the relation between economic welfare and national income, it
is essential to define economic welfare. Welfare is a state of the mind which reflects
human happiness and satisfaction. In actuality, welfare is a happy state of human
mind. Pigou regards individual welfare as the sum total of all satisfactions experienced
by an individual; and social welfare as the sum total of individual welfares. He divides
welfare into economic welfare and non-economic welfare. Economic welfare is that
part of social welfare which can directly or indirectly be measured in money. Pigou
attaches great importance to, economic welfare because welfare is a very wide term.
In his, words:
"The range of our enquiry becomes restricted to that part of social (general)
welfare that can be brought directly or indirectly into relation with the measuring rod of
money." On the contrary, non-economic welfare is that part of social, welfare which
cannot be measured in money, for instance moral welfare. When national income
increases, total welfare also increases and vice-versa. The effect of national income on
economic welfare can be studied in two ways:

I. Changes in size of national income and economic welfare

II. Change in the composition of national income and economic welfare
III. Changes in the distribution of national income and economic welfare.
(i) The change in the size of national income and economic welfare:

There is direct relationship between size of national income and economic welfare.
The changes in the size of national income and economic welfare may be positive or
negative. The positive change in the national income increases its volume, as a result
people consume more of goods and services, which. Leads in increase in the
economic welfare. Whereas the negative change in national income results in
reduction of its volume; People get lesser goods and services for consumption which
leads to decrease in economic welfare. But this relationship depends on a number of
factors.