National Income Essentials

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1. Sectors of an Economy Household Sector (Consumers) Firms (Producers) Government Sector (Government) External Sector (Rest of the world or abroad) 2. Circular Flow of Income Definition: It refers to the circular flow of income in the production process. Income is generated by households from firms, and they also spend their income in the form of consumption expenditure to firms. Phases: Generation Phase Distribution Phase Disposition Phase 3. Types of Flows Real Flow (Physical Flow) Flow of factor services from households to firms. Flow of goods and services from firms to households. Measures production volume and determines economic growth. Money Flow (Nominal Flow) Flow of money from firms to households (factor payments). Flow of money from households to firms (consumption expenditure). Measures the flow of money supply in the economy. 4. Stock vs. Flow Feature Stock Flow Meaning Variable measured at a particular point in time. Variable measured over a period of time. Time Dimension Not time-dimensional (e.g., as of 31st March). Time-dimensional (e.g., per year, per month). Nature Static concept. Dynamic concept. Examples Wealth, capital, population on a specific date, bank deposits, stock of water in a tank. Income, consumption, savings, production, GDP, investment, profit/loss, flow of water from a tank. 5. Classification of Goods Final Goods Goods finally produced and ready for use by their final users (consumers or producers). Consumer Final Goods: Used by consumers (e.g., clothes, food). Expenditure is called Final Consumption Expenditure. Producer Final Goods (Capital Goods): Used by producers for investment (e.g., plant and machinery). Expenditure is called Investment Expenditure. Expenditure on final goods = Consumption Exp. + Investment Exp. Included in National Income. Intermediate Goods Goods not yet ready for use by their final user; purchased by one firm from another. Used as raw materials or for resale. Examples: Wood for making chairs, shirts purchased for resale. Value is ultimately included in final goods; hence, not separately included in National Income to avoid double counting. Consumption/Consumer Goods Directly used for satisfaction of human wants. Final users: Consumers, Government, NGOs. Categories: Durable Goods: Last for several years (e.g., car). Semi-Durable Goods: Last for a limited period (e.g., clothes). Non-Durable Goods: Used up in a single act of consumption (e.g., food). Services: Non-material goods (e.g., doctor's visit). Capital Goods Used in the production process for several years and are of high value. Fixed assets of producers (e.g., plant and machinery). Note: Not all machines are capital goods (e.g., a sewing machine used by a tailor is capital, but one used by a housewife for personal use is a consumer durable). 6. Final Goods vs. Intermediate Goods Feature Final Goods Intermediate Goods Meaning Ready for use by final users. Not ready for use by final users; purchased for raw material or resale. Purpose Consumption or investment. Used in production process as raw material or for resale. Value Addition No value addition required. Value still needs to be added. National Income Included in both domestic and national income. Not included in domestic or national income. Production Boundary Have crossed the production boundary. Are within the production boundary. Example Milk purchased by household, machinery purchased for investment. Milk purchased by a biscuit company, milk purchased by a dairy shop for resale. 7. GDP Deflator and Real/Nominal GDP Real GDP GDP measured at base year prices. Inflation-adjusted GDP. True indicator of economic growth and welfare. Nominal GDP GDP measured at current year prices. Not adjusted for inflation. Not a true indicator of economic growth and welfare. GDP Deflator / Price Index Measures the change in the average level of prices of all goods and services that make up GDP. Formula: $ \text{Price index or GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100 $ 8. Depreciation vs. Capital Loss Feature Depreciation Capital Loss Meaning Fall in value of fixed assets due to normal wear and tear, passage of time, or expected obsolescence. Loss in value of fixed assets due to unforeseen obsolescence, natural calamities, thefts, accidents, etc. Provision for Loss Provision is made for replacement of assets as it is an expected loss. No such provision is made as it is an unexpected loss. Production Process Does not hamper the production process. Hampers the production process. 9. Domestic Territory and National Income Domestic Territory (Economic Territory) Area of economic activity that generates domestic income. Includes: Ships and aircrafts operated by residents between two or more countries. Fishing vessels, oil rigs, and floating platforms operated by residents in international waters. Embassies, consulates, and military establishments of the country located abroad. Does NOT include: Embassies and military establishments of a foreign country within India. International organizations (e.g., UNO, WHO) located within the geographical boundaries of a country. National Income Sum total of income of only the normal residents of a country. 10. GDP and Welfare - Exceptions Distribution of GDP: Unequal distribution can lead to lower welfare despite high GDP. Composition of GDP: High GDP due to production of harmful goods (e.g., weapons) may not increase welfare. Non-Monetary Exchanges (Barter System): Goods/services exchanged without money are not included in GDP, underestimating welfare. Externalities: Positive or negative impacts of economic activities not accounted for in market prices (e.g., pollution reduces welfare but isn't subtracted from GDP). 11. Precautions for National Income Estimation Production Method (Value Added Method) Value of sale and purchase of second-hand goods is not included (already accounted for). Commission earned on sale/purchase of second-hand goods is included (new service). Own-account production of goods for self-consumption is included (like market goods). Value of intermediate goods is not included (to avoid double counting). Change in stock (increase in stock) is included (part of capital formation). Services for self-consumption (e.g., housewife's services) are not included (difficult to estimate market value). To avoid double counting, use value added or value of final products only. Income Method Transfer earnings (pensions, scholarships, etc.) are not included (no value addition). Income from illegal activities (smuggling, gambling) is not included . Income from sale of second-hand goods is not included , but commission on their sale is included . Income from sale of financial assets (shares, bonds) is not included (no production of goods/services). Brokerage/commission on these is included . Imputed rent of owner-occupied houses is included . Expenditure Method Expenditure on intermediate goods and services is not included (to avoid double counting). Imputed expenditure on self-consumed or own-account produced output is included . Expenditure on transfer payments (gifts, subsidies) is not included (no goods/services in return). Expenditure on financial assets is not included , but brokerage/service charges are included . Expenditure on second-hand goods is not included , but commission/brokerage paid to intermediaries is included . 12. Components of Net Factor Income from Abroad (NFIA) Net compensation to employees. Net income from property and entrepreneurship (rental income, interest income, profits). Net retained earnings (part of profit after tax and dividend).