EEB PPT Chp 3 NI

Veena Keshav Pailwar copyright@Prentice Hall of India

1

Economic Environment of Business

Chapter 3

National Income: Measurement and

Environment Scanning

Veena Keshav PailwarProfessor

IMT Nagpur

Veena Keshav Pailwar copyright@Prentice-Hall of India

2

Chapter 3National Income: Measurement and Environment ScanningMain Points

• Process of generation of income/ output

• Different approaches of measuring total income

•Various aggregates measuring total output

•Equivalence of various aggregates

• Relationship between national and personal income

•Problems in the measurement of various aggregates

•Various uses of the concept of national income


3

National Income: Definition

National income is the money value of all- final goods and services produced in a county in a year’s time.

* Money Value* All Final Goods &

services* Given Country* Given period of time


4

Circular Flow of Income Simple Closed Economy

Assumptions: 1. Only two agents : Business Firms and Households

2. No Government; No interaction with other countries

Factor Markets

FirmsHouseholds

Product Markets

Factor Payment (Wage, Rent, Interest, Profit)

Revenue from sale of final goods and service

Expenditure on final goods and services

Factor Income (Wage, Rent, Interest, Profit)


5

In a state of equilibrium

Factor payments

= Wages + Interest + Rent + Profit

= Household Income

= Household Expenditure

= Value of Final Output

= National Income


6

Circular Flow of Income More Realistic Open Economy with Government

Factor Markets

FirmsHouseholds

Product Markets

Rest of the World

Government

Financial Markets

Leakages

Injections

Expenditure on final goods and services

Revenue from Sale of Final Goods and Service

Factor Payment (Wage, Rent, Interest, Profit)

Factor Income (Wage, Rent, Interest, Profit)

Saving Investment

Expenditure

ExportsImports

Taxes


7

Leakages

Shrinks the size of the Circular Flow of Income

Examples• Saving• Taxes• Imports


8

Injections

Expands the size of the Circular Flow of Income

Examples• Government Expenditure• Investment• Exports


9

Output/ Income Generated in an Economy

Output/ Income Produced in the

Domestic TerritoryGDP

Output/ Income Produced by the Normal Residents

GNP


10

Domestic Territory of a Country

Consists of • Territory lying within

the political frontiers (including territorial waters)

• Ships & Aircrafts operated by the residents between countries

• Embassies, govt. Offices, Consulates & Military Establishments of a country located abroad

Excludes• All foreign embassies

and offices of the International Organizations located in the country


11

Domestic Territory

Political Territory (India)

Foreign embassyOther govt offices

Political Territory (Other Countries)

Indian embassy

India’s GDP = Output produced within Indian Political Territory + Contribution by ships and aircraft + Output of Indian embassy – Output of foreign embassy


12

Approaches to Measurement of Aggregate Income

Expenditure Approach Value Added Approachor

Net Product Method

Incom e Approachor

Factor Incom e Method

Mea surem ent of N a tiona l Incom e


13

Investment: Various Concepts

Investm ent inP lant, Machinery

Building etc.

Gross Fixed Capital Form ation Change in Stock(Inventory)

Gross Dom estic Capital Form ation= Investm ent

= Production (Incom e) - Consum ption


14

Investment: Various Concepts

New assets produced dom estically

Im port of new assets

Net purchase of second hand assets from abroad

Gross Fixed Capital Form ation


15

GDP : Expenditure Approach1. Closed Economy with Govt.

Total Expenditure=

Private Consumption Expenditure (C)

+ Private Investment Expenditure ( Ip )

+ Government Consumption Expenditure (G )

+ Government Investment Expenditure (Ig)

= C + Ip +Ig + G = C + I+ G = GDP

Where I = Ip + Ig


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Total Expenditure=

Private Consumption Expenditure (C)

+ Investment Expenditure ( I )

+ Government Consumption Expenditure (G )

+ Exports (X)

- Imports (M)

= C + I + G +X - M

GDP : Expenditure Approach2. Open Economy with Govt. and Transaction

with Other Countries

Components of Expenditure


17


18

UEE 3.1 Drivers of GrowthExpenditure Components of the GDP

at current market pricesYear China India Pakistan Singapore Japan

Private Final Consumption1990 50.6 66.2 71.4 45.4 53.02000 46.2 63.7 75.4 41.9 56.22009 35.7 57.3 80.5 40.9 59.6

Government Final Consumption1990 14.1 11.7 15.1 9.5 13.32000 15.8 12.6 8.6 10.9 16.92009 13.0 12.3 8.1 11.5 19.7

Gross Domestic Capital Formation1990 36.1 26.0 18.9 35.1 32.72000 35.1 24.3 17.2 33.2 25.42009 47.7 35.0 19.0 27.2 20.4

Exports1990 19.0 7.1 14.8 177.4 10.42000 23.3 13.2 13.4 192.4 11.02009 3.8* 20.6 12.8 199.3 12.6

Imports1990 15.6 8.5 20.2 167.4 9.42000 20.9 14.2 14.7 179.6 9.52009 … 25.3 20.4 178.2 12.3

Discrepancy1990 -4.4 -2.4 … 0.0 …2000 0.5 0.3 … 1.1 …2009 -0.3 0.0 … -0.6 …

GDP at current mp (billion, in national currency1990 1867 5696.2 855.9 70390.6 4427812000 9922 21023.1 3826.1 162584.1 5029902009 34051 62311.7 12739.3 265057.9 474169

UEE 3.1 Drivers of Growth

The expenditure components help in understanding

•the ways in which the total GDP is used

•the sources of demand or drivers of growth


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Type of growth Type of problem

Consumption led growth Stagflation

Investment led growth Supply glut

Export led growth Higher sensitivity to external shocks

Country Type of growth pursued

China Investment and export led growth

India Consumption led growth: move towards investment and export led growth

Pakistan Consumption led growth

Singapore Export led growth

Japan Investment led growth, move towards more balanced growth


20

Factor Incom e M ethod

C om pensation of Em ployees = W ages

O perating Surp lus = R ent + Interest + P rofit

M ixed Incom e of Self Em ployed


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UEE 3.2 : Trends in the Components of Factor Income

• In India the factor income is composed of compensation of employees, operating surplus and mixed income of self employed

• Difficulty in distinguishing the wages from operating surplus in the case of mixed income of self employed: no clear trend in different components of income can be ascertained

• The share of organized sector in the total factor income is gradually increasing

• The share of compensation of employees which used to be the dominant component till 2005-06 in the organized sector has decelerated

• Changing composition of income in favour of operating surplus: Indicates growing inequalities in India

• Under a progressive taxation system growing inequalities indicate better revenue collection for the government


22

NDP at factor cost by Factor Incomesat current prices

Factor Income 1990-00 2004-05 2005-06 2006-07 2007-08 2008-09Compensation of Employees

All Sectors 37.4 34.6 34.1 32.7 34.1 34.2

Organized 24.2 22.2 22.0 20.7 21.6 21.7

Unorganized 13.2 12.4 12.0 12.0 12.6 12.6

Operating Surplus/ Mixed Income of Self Employed

All Sectors 62.6 65.4 65.9 67.3 65.9 65.8

Organized 16.3 18.8 19.9 21.9 20.8 21.5

Unorganized 46.3 46.6 46.1 45.3 45.0 44.2

NDP (at factor Cost)

All Sectors 100 100.0 100.0 100.0 100.0 100.0

Organized 40.5 41.0 41.9 42.7 42.4 43.2

Unorganized 59.5 59.0 58.1 57.3 57.6 56.8

NDP at factor Cost (Rs crore)

1605103 2646370 3032583 3516947 4051770 4653419


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Value Added Approach or Net Product Method

Estimation of Value Added

Value Added by the Firm =

Value of Final Output- Value of Intermediate Consumption

_________________________

Income Generated by the Firm = Factor Income

Σ Value Added by the Firms = Value Added in an economy


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Production of Bread in the EconomyAn Example

Factor Payment/ Income

Producers Output Input ValueAdded

Wage Rent Interest Profit Total

Farmer 100 - 100 60 10 5 25 100

Miller 200 100 100 40 5 15 40 100

Baker 350 200 150 65 15 20 50 150

Total 650 300 350 350

This example also illustrates

Computation of value added at each level of production

Equivalence of the three approaches: Expenditure Approach, Income Approach, Value Added Approach


25

UEE 3.3: Methods of Measuring Sectoral Output

Method Sectors

Production Approach(Value Added Method)

Agriculture & Allied ActivitiesForestry & LoggingFishing, Mining & QuarryingRegistered Manufacturing

Income Approach Unregistered ManufacturingGas, Electricity & Water SupplyBanking & InsuranceTransport, Communication & StorageReal Estate & Ownership of Dwellings Trade, Hotels & RestaurantsPublic Administration & DefenseOther Services

Expenditure Approach(Commodity Flow Method)

Construction


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Various Concepts of National Income

GDP at Market Price = GDP at Factor Cost + Indirect Taxes less Subsidies

GNP at Market Price = GNP at Factor Cost + Indirect Taxes less Subsidies

NDP at Market Price = NDP at Factor Cost + Indirect Taxes less Subsidies

NNP at Market Price =NNP at Factor Cost + Indirect Taxes less Subsidies


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Various Concepts of National Income

m a rket price

fa ctor cost

G ross D om estic P roduct

m a rket price

fa ctor cost

G ross N ational P roduct

m a rket price

fa ctor cost

N et D om estic P roduct

m a rket price

fa ctor cost

N et N ational P roduct


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Domestic Income = Total income (output) produced within the domestic territory of a country

Domestic Income Vs National Income

National Income = Total income (output) produced by the Normal Resident of a country


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Gross Vs. Net One of the important components of national output: output of investment goods However, capital stock depreciates over a period of time Part of the investment may just be replacing the wear and tear in the existing capital stock Therefore, the proper estimate of the national income is the one that takes care of depreciation

I = Gross Investment I – Depreciation (Consumption of Fixed Capital )

= Net Investment


30

GDP Vs NDPGross Product Vs Net Product

GDP = C + I + G + X- M

Where I = Gross Investment

GDP – Depreciation = C + (I – Depreciation) + G + X-M

= NDP = Net Domestic Product

= Wage + Rent + Interest + Profit

= Net Value Added

I - DepreciationNet Investment


31

GDP Vs GNP

GNP = GDP

+ Net Factor Income from abroad

Net Factor Incom e from ROW

Incom e Earned for Factor Servicesby

the Norm al Resident

Incom e Paid for Factor Servicesfrom

the ROW


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When the government does not Tax and Provide Subsidy

The prices faced by the consumers for different commodities are the same as the cost of producing commodities by the producers

Market Price Vs. Factor Cost

In the presence of Tax and Subsidy

The prices faced by the consumers are different than the total cost of production


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Existence of Indirect Tax: Increases the market price

Market Price > Cost of Production (Factor Cost)

Market Price = Factor Cost + Indirect Tax

Or Market Price – Indirect Tax = Factor Cost


Existence of Subsidy: Lowers the market price

Market Price < Cost of Production (Factor Cost)

Market Price + Subsidy = Factor Cost

Or Market Price = Factor Cost - Subsidy


34

Existence of Indirect Tax and Subsidy

Market Price Cost of Production (Factor Cost)

Market Price = Factor Cost + Indirect Tax - Subsidy

Or

Market Price – Net Indirect Tax = Factor Cost

Where Indirect Tax – Subsidy = Net

Indirect Tax



35

GDP at fc (estimated at the cost faced by producers)

Wage + Interest + Rent + Profit = C + I + G + X – M – Net Indirect Tax

GDP at fc Vs GDP at mp

GDP at mp (estimated at the price faced by consumers)

C+I +G + X-M = Wage + Interest + Rent + Profit + Net Indirect Tax

= Value Added + Net Indirect Taxes


36

GDP at fc = GDP at mp – Net Indirect Taxes

GDP at fc Vs GDP at mp

GDP at mp = GDP at fc + Net Indirect Taxes

Where Net Indirect Taxes

= Indirect Taxes - Subsidies


37

National Income

NI = NNP at fc

National Income = Net National Product at factor cost

Relationship among Eight Variants of National Product Aggregates


38

Depreciation

GNP fc

GNP mp

Net Income from Abroad

GDP fc

Net Indirect Taxes

NNP fc

NDP fc

GDP mp


Depreciation

Net Indirect Taxes

NNP mp

NDP mp


Net Indirect Taxes

Depreciation

Net Indirect Taxes

Depreciation



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Relationship between Various Concepts of National Income and Aggregate Personal Income

GNP mp

NNP mp

NNP fc

PI

(-)Corporate Taxes(-)Undistributed Profit(+)Transfer Payments

DPI

PO

(-)Depreciation

(-) Personal Savings

(-)Personal Income Taxes

(-)Indirect Taxes(+)Subsidies


40

Problems in the Measurement of National Income

• Exclusion of value of personal services rendered to oneself in the national product accounts

• Omitted market transactions

• Non-market activities and imputation

• Changes in the inventories and inventory valuation adjustment

• Final product- current & constant Rupees


41

Non Market Activities and Imputations

• Examples

• Farm production and consumption

• Services yielded by the owner occupied houses

• Wages paid in kind to farm workers


42

Non-Market Activities and Imputations

Difficulties in Imputations

• Valuation : at the cost of production or at market price

• Market price may vary if all the supply is marketed

• Quality of the retained output or payment in kind may vary

• Equivalent goods and services may not be available in the market:

e.g.: police and defence


43

Changes in Inventories & Inventory Valuation Adjustment

• Difficulties in Valuation

• Official Figures: value the inventories at average price

• Firms: value the inventories at the book value

• Difference: is adjusted as inventory valuation adjustment

• Helps in avoiding the overstating or understating the corporate profits and proprietor’s income and, therefore, national income


44

Inter-temporal and Inter-Spatial Comparison of National Income

• Change in Prices

• Changes in Taste

• Changes in Consumption Basket

• Changes in the Quality

• Emergence of New Goods and Services


45

Uses of National Income Estimates

• Measure of Economic Growth

• Indicator of Success or Failure of Planning

• Indicator of Structural Change

• Measure of Income Inequalities

• Indicator of the Pattern of Consumption and Investment

• Measure of International and Spatial Comparisons

• Measure of Business Cycles


46

Measure of Economic Growth

National Income at

Constant Prices

Indicates the economic growth of a country in

real terms


47

Indicator of Success or Failure of Planning

National Income at

Constant Prices

Achievements Vis a Vis the Targets: indicate the success of planning


48

Indicator of Structural ChangesSectors Activities Covered

Classification I

Primary Agriculture (cultivation of crops, livestock and animal husbandry); forestry, logging & fishing; mining & quarrying

Secondary Manufacturing; electricity, gas & water supply; construction

Tertiary Trade, transport & communication; Financial, real estate and business services; Community, social and personal services

Classification II

Agriculture Agriculture and allied (forestry, logging and fishing)

Industry Manufacturing; mining & quarrying; electricity, gas & water supply; construction

Services Trade, transport & communication; Financial, real estate and business services; Community, social and personal services


49

Indicator of Structural Changes

Sectors Characteristics

Primary • Many of the products of this sector are used as inputs in the secondary sector• Wealth creating sectors

Secondary • Most of the products are finished products consumed by the households or other business organizations• Wealth creating sectors

Tertiary • Consists of commodities which are intangibles - Consumer services: Tourism, health care and education - Producer services: Transport and Finance• Wealth consuming sector


50

Indicator of Structural ChangesDominant Sector/Stage of Development

Characteristics

Primary/AgricultureEarly Stage of Development

Value addition low: low growth rateLow level of income restricts the demand pattern: Major proportion of the income is spent on agriculture products

Secondary/IndustrySecond (Middle) Stage of Development

Significant transfer of resources from agriculture to industrial sectorValue addition higher than the first stage of developmentDemand pattern becomes more diversified: Demand for industrial products increasesCountries more open to trade & competition

Tertiary/ServicesHighest level of development

Value addition is the highest in servicesDisplaces unskilled labour: More employment opportunities for the skilled labour


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Indicator of Structural Changes

•Surpassing the middle stage of growth •Moving directly from an agrarian economy to a service oriented economy

Underdeveloped physical infrastructure and industrial sector

may constraint the sustainable growth

Phenomenon of Leapfrogging in Growth Process


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UEE 3.4: Structural Shift in the Indian Economy

Country Agriculture Industry Services

1980 1990 2000 2009 1980 1990 2000 2009 1980 1990 2000 2009

China 30.1 27.1 15.1 10.3 48.5 41.3 45.9 46.3 21.4 31.5 39.0 43.4

India 38.1 29.3 23.4 17.1 25.9 26.9 26.2 28.2 36.0 43.8 50.5 54.6

Indonesia 24.8 19.4 15.6 15.3 43.4 39.1 45.9 47.6 31.8 41.5 38.5 37.1

Korea 14.9 8.7 4.6 2.6 41.3 39.9 38.1 36.7 43.7 51.5 57.3 60.7

Malaysia … 15.0 8.3 9.3 … 41.5 46.8 43.4 … 43.5 44.9 47.3

Pakistan 29.6 26.0 25.9 21.6 25.0 25.2 23.3 24.3 45.5 48.8 50.7 54.2

Phillipines 25.1 21.9 15.8 14.8 38.8 34.5 32.3 30.2 36.1 43.6 52.0 55.0

Thailand 23.2 12.5 9.0 11.6 28.7 37.2 42.0 43.3 48.1 50.3 49.0 45.1


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• The sectoral composition of the GDP is changing in favour of services

• In line with the development experience of developed countries

• However, the share of industrial sector is particularly low: Signifies a phenomenon of leapfrogging


54


Leapfrogging made possible by

•Advances in communication technology

•A large supply of trained tnglish speaking personnel

•Reforms: especially in the financial sector

•Deregulation of the services sector

•Privatization

•Opening up of the economy to FDI


55


Mismatch between Income and Employment

Agriculture Sector

• The lowest share in the GDP

• The highest Share in employment

Disguised Unemployment


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Measure of Income Inequalities

Relationship between income inequalities and growth

Non-LinearHigher Inequalities: • Growth retarding in poor countries• Growth encouraging in advanced developed regionsHigh inequalities and high egalitarianism slows down the growth process


57

Measures of Income Inequalities

• Lorenz Curve

• Gini Coefficient

• Robin Hood Index

• Quantile Ratio


58


0 100 50

50

100

80

80

20

20

0’

a b

c

Cumulative Percentage of Population

Cumulative Percentage of Income

A

B

Lorenz Curve

Line of absolute equality

Lorenz curve

Lorenze Curve• Gives a broad picture of inequality• The closer the curve is to the 45 degree line the more equal the distribution of income is.


59


Gini Co-efficient (G)

G = Area Bounded by the 45 degree line and the Lorenz curve Entire area below the 45 degree line

= A / (A +B)

Range for G

0 ≤ G ≤ 1

G = 0 : Perfect equality in income distribution

G = 1 : Complete inequality in income distribution


60


Robin Hood Index ( R )

R = The value of the maximum vertical distance between the Lorenz curve and the 45 degree

line

Value of the index provides an estimate of the income that needs to be transferred

from the population above the mean to those below the mean


61


Quantile Ratio ( Q )

• Persons are ranked on the basis of income from the lowest to the highest• Divided into equally sized groups

Distribution of population • 5 equally sized groups: Quantile• 10 equally sized groups: Deciles• 100 equally sized groups: percentiles

First Quantile = First Two Deciles

= First 20 Percentiles

One quantile is compared with another to estimate the level of inequality, i.e.,

Q (P2)/ Q(P1) where P1 & P2 are percentile


62

Indicator of the Pattern of Consumption and Investment

The GDP measured using expenditure approach reveals Consumption Pattern

The changes in expenditure pattern reflects the changes in demand pattern

Business organizations can use this information to avoid the mismatch between demand and supply

Demand

Productive Capacity

Investment Expenditure

ConsumptionExpenditure

Supply in the long run


63

International and Spatial Comparisons

Problems in Inter Spatial Comparison

• NI of different countries expressed in different currencies

• Different countries experience different degrees of price levels

• Countries vary in terms of population size

Accounting for the Difference

Population Variation: Per Capita Income

Currency Variation: Use of Common Currency

Price Level Variation: Purchasing Power Parity


64

International and Spatial Comparisons

Purchasing Power Parity(PPP)

Process

Construct a common representative basket of goods and services

Collect the prices of commodities in the selected basket

Estimate un-weighted bilateral price ratios (parities)

Aggregate un-weighted parities using the expenditure data

Convert the GDP or per capita income into a common currency and the price level


65

International and Spatial ComparisonsPer Capita Income using PPP

An Illustration

Price Units Expenditure Price Ratio

Expenditure in Us $

A B A B A B $/Rs B

Food $ 50 Rs 300 80 100 $ 4000 Rs 30000 50/300 Rs30000x($50/300) = $ 5000

Cloth $ 100 Rs 500 60 40 $ 6000 Rs 20000 100/500 Rs20000x($100/500) = $ 4000

$10000 Rs 50000 = $ 9000

Comparing the expenditure in the two countries using US $ indicates that income in country A is 10 times more than income in country B

The expenditure in terms of PPP however indicates that the expenditure in country B is 90% of the expenditure in country A


66

UEE 3.6: Richest Nations in the World 2010

GDP Per Capita ($) GDP Per Capita (PPP) ($)

Country 2010 Rank Country 2010 Rank

Luxembourg 108,831.70 1 Qatar 88,558.83 1

Norway 84,443.63 2 Luxembourg 81,383.26 2

Qatar 76,167.85 3 Singapore 56,521.73 3

Switzerland 67,246.00 4 Norway 52,012.51 4

United Arab Emirates 59,716.85 5 Brunei Darussalam 48,891.67 5

Denmark 56,147.14 6 United Arab Emirates 48,820.86 6

Australia 55,589.55 7 United States 47,283.63 7

Sweden 48,874.61 8 Hong Kong SAR 45,736.27 8

United States 47,283.63 9 Switzerland 41,663.05 9

Netherlands 47,172.14 10 Netherlands 40,764.55 10MemoIndia 1,264.84 135 India 3,339.31 126


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No. of Years

Level of Economic Activity / Level of National Income

ATrough

PeakD

PeakB

CTrough

ETrough

One Business Cycle

Contraction Expansion

Business Cycles

o

Environment Scanning & National Income


68

Phases in Growth Cycles

No. of Years

Rate of growth of national income

Expansion Slowdown

RecoveryRecession

Recovery

DepressionA

B

D

E

C


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Growth Rate Cycles Vs Business Cycles

PeakA

B

JTrough

PeakH

D

Growth Rate CyclesGrowth Rate of Economic Activities

Level of Economic Activities

TroughC

F

I

Business Cycles

0

G

ContractionExpansion

Growth Rate Downturn

Recession Growth Rate upturn

Expansion

E

No. of Years

No. of Years


70

Measurement of Business Cycles

• Need high frequency data

• Need data on the variables which represent overall picture of an economy

• In the absence of high frequency data on national income movements in sectoral output data are taken as the representative

• For the countries dependent on industrial activities the IIP can be taken as the representative

• For primarily agrarian economies data on the agriculture GDP can be used for measuring business cycles


71

UEE 3.7: Global Economic Scenario: Expansion, Slowdown, Recession and Recovery

• Sustained global growth of 5% during 2004-07

• Outbreak of the US subprime crisis put a break on this high growth phase

• Mild Recession in some of the advanced economies in 2008; emerging economies continued to grow at robust rate– Failure of the major financial institutions in the USA

and other advanced economies resulted in a sharp decline in equity prices and disruption in the flow of trade finance and working capital


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World in severe recession in 2009

• Emerging markets were also hit hard by a steep drop in equity prices and disruptions in trade and capital flows

• Unprecedented slowdown of economic activities and trade world over

• Contraction in some of the advanced economies in 2009


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Global recovery in 2010

To overcome the crisis coordinated monetary and credit policies were pursued

• Conventional measures: lowering interest rate and reserve requirement

• Unconventional measures: purchases of private sector debt by the central banks

• Governments interventions: rolling out fiscal stimulus packages Impact of these measures• supported demand• Improved financial conditions• Lowered uncertainty• Bolstered confidence• Improved investment• World output registered impressive recovery

EEB PPT Chp 3 NI

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