Methods to Measure National Income

National Income represents the total monetary value of all final goods and services produced in a country during a given period, usually one year. It is one of the most important macroeconomic indicators because it reflects the economic performance, growth level, and standard of living of people in a nation. Governments, planners, economists, and international organizations use national income estimates for planning, policy formulation, comparison between countries, and measuring economic development.

Economic activities in a country form a circular flow. Firms produce goods and services, households supply factors of production, incomes are earned, and these incomes are spent on consumption and investment. Because of this circular flow, national income can be measured from three viewpoints — production, income, and expenditure. These correspond to three methods:

• Production (Value Added) Method

• Income Method

• Expenditure Method

All three methods should theoretically give the same national income because the value of output equals the income earned and also equals the expenditure incurred.

1. Production Method (Value Added or Output Method)

The Production Method measures national income by calculating the total value of all final goods and services produced within the domestic territory of a country during an accounting year. This method is also known as the Output Method or Value Added Method.

Production refers to the creation of utility or addition of value to goods and services. In an economy, goods pass through various stages before reaching the final consumer. For example, wheat is produced by a farmer, sold to a flour mill, converted into flour, purchased by a bakery, and then sold as bread to consumers. Each stage adds value to the product.

If we simply add the value of output at every stage, the value of the same product will be counted multiple times. This is called double counting. To avoid this, economists calculate only the additional value created at each stage, known as value added.

Meaning of Value Added

Value added is the difference between the value of output produced by a firm and the value of intermediate goods used in production.

Value Added = Value of Output – Intermediate Consumption

Intermediate goods are those goods which are used up in the production process, such as raw materials, fuel, electricity, and semi-finished goods. Final goods are those purchased by consumers for final use.

Illustration Examples

Suppose a shirt passes through four stages:

Farmer sells cotton → ₹200
Textile mill sells cloth → ₹500
Garment factory sells shirt → ₹900
Retailer sells to consumer → ₹1200

If we add all values (200 + 500 + 900 + 1200), the total becomes ₹2800, which is incorrect because the same product is counted repeatedly.

Value added:

Farmer: 200
Mill: 500 − 200 = 300
Factory: 900 − 500 = 400
Retailer: 1200 − 900 = 300

Total Value Added = 200 + 300 + 400 + 300 = ₹1200

Thus, the real national income contribution is ₹1200 only.

Steps of the Production Method (Value Added Method)

Step 1. Classification of Production Sectors

The Income Method measures national income by adding all incomes earned by factors of production during a year. Production of goods and services generates income to individuals who contribute land, labour, capital, and entrepreneurship.

Whenever production takes place, income is generated. Firms pay wages to workers, rent to landowners, interest to capital providers, and profit to entrepreneurs. By adding all these factor payments, we can estimate national income.

Therefore, national income is the sum total of factor incomes earned by residents of a country.

Components of Factor Income

Factor income refers to the income earned by factors of production — land, labour, capital, and entrepreneurship — for their contribution to the production of goods and services. These incomes are included while calculating national income under the Income Method.

1. Wages and Salaries (Compensation of Employees)

Wages and salaries are payments made to workers for providing labour services in the production process. It includes regular wages, salaries, overtime payments, bonuses, commissions, allowances (house rent allowance, dearness allowance), and employer’s contribution to provident fund and social security schemes. Payments may be in cash or kind, such as free accommodation or meals. This is usually the largest component of factor income in most economies.

2. Rent

Rent is the income earned by the owner of land and buildings for allowing their use in production activities. It includes payments received for agricultural land, commercial buildings, shops, factories, and warehouses. Even when a person uses his own house, economists include an estimated value called imputed rent, because the house is providing a productive service. Rent represents the reward for the use of natural resources.

3. Interest

Interest is the payment made for the use of capital in the production process. When a firm borrows money to purchase machinery, raw materials, or equipment, it pays interest to the lender. Only productive interest is included in national income. Interest on loans taken for consumption purposes, like personal loans, is excluded. Interest reflects the reward to the supplier of capital for postponing present consumption.

4. Profit

Profit is the income earned by entrepreneurs for organizing production, taking risks, and managing business activities. It includes both distributed profits (dividends paid to shareholders) and undistributed profits (retained earnings kept in the business). Profit also includes corporate tax and depreciation reserves. Profit is considered the reward for risk-bearing, decision-making, and innovation in the production process.

5. Mixed Income of Self-Employed

Mixed income refers to earnings of self-employed individuals such as farmers, shopkeepers, doctors, lawyers, and small business owners. Their income cannot be separated into wages, rent, interest, and profit because they contribute labour, capital, and entrepreneurship themselves. Therefore, their total earnings are treated as mixed income. This component is particularly important in developing countries where self-employment is common.

Steps in the Income Method

The Income Method measures national income by adding all incomes earned by factors of production — labour, land, capital, and entrepreneurship — during an accounting year. The following steps are followed:

Step 1. Identify Producing Enterprises

First, all producing units and enterprises operating within the domestic territory are identified. These include farms, factories, shops, banks, transport companies, schools, hospitals, and service providers. Only those units engaged in productive economic activities are considered. Transfer agencies and purely financial institutions that do not produce goods or services directly are excluded from national income estimation.

Step 2. Estimate Compensation of Employees

The next step is to calculate total payments made to labour. This includes wages, salaries, overtime, bonuses, commissions, and allowances. Employer contributions to provident fund, pension schemes, and social security are also included. Payments in kind such as free housing, food, or transport facilities are added. This component is called compensation of employees and usually forms the largest share of national income.

Step 3. Calculate Rent Income

Rent earned by owners of land and buildings used for production is calculated. It includes payments received for agricultural land, factories, offices, and commercial property. Economists also include imputed rent of self-occupied houses because they provide housing services to owners. However, rent received from transfer activities or purely personal transactions is excluded.

Step 4. Estimate Interest Income

Interest paid on capital used in productive activities is included. Firms pay interest on loans taken for purchasing machinery, equipment, and working capital. Only productive interest is counted. Interest on public debt, personal loans for consumption, or savings accounts meant purely for transfer payments is excluded to avoid overestimation of national income.

Step 5. Calculate Profit

Profits earned by business enterprises are added next. This includes dividends distributed to shareholders, retained earnings kept within the firm, and corporate taxes paid to the government. Profit represents the reward to entrepreneurs for risk-bearing, innovation, and management of production. Losses, however, are deducted from total profits.

Step 6. Add Mixed Income of Self-Employed

Income of self-employed individuals such as farmers, shopkeepers, and professionals is calculated. Since their earnings cannot be separated into wages, rent, interest, and profit, their total earnings are treated as mixed income. This is especially important in developing economies where a large portion of the population works in small or family-owned businesses.

Step 7. Add Net Factor Income from Abroad (NFIA)

Finally, the difference between income earned by residents from abroad and income paid to foreign residents within the country is calculated. If residents earn more from abroad, it is added; if foreigners earn more domestically, it is deducted. After adding NFIA, we obtain Net National Product at Factor Cost (NNPfc), which represents National Income.

3. Expenditure Method (Final Expenditure Method)

The Expenditure Method measures national income by calculating the total expenditure on final goods and services during a year. Since one person’s expenditure becomes another person’s income, total spending equals total income.

All goods and services produced in an economy are ultimately purchased by someone — households, firms, government, or foreigners. Therefore, by adding total spending on final goods and services, we can estimate national income.

Components of Expenditure (Expenditure Method)

Under the Expenditure Method, national income is measured by adding the total expenditure made on final goods and services during an accounting year. Every product produced is ultimately purchased by someone — households, firms, government, or foreigners. The main components are as follows:

1. Private Final Consumption Expenditure (Consumption – C)

This refers to expenditure made by households on goods and services for satisfaction of wants. It includes spending on food, clothing, housing, electricity, transport, education, medical services, entertainment, and other daily necessities. Both durable goods (like furniture, vehicles, appliances) and non-durable goods (like food items) are included. However, purchase of old or second-hand goods is excluded because they are not part of current production.

2. Gross Domestic Capital Formation / Investment Expenditure (I)

Investment expenditure is spending by firms and producers on capital goods used for future production. It includes purchase of machinery, tools, equipment, factory buildings, and construction of new plants. It also includes change in inventories (stock of unsold goods, raw materials, and work-in-progress). This component increases the productive capacity of the economy and contributes to economic growth.

3. Government Final Consumption Expenditure (G)

Government expenditure includes spending by central, state, and local governments on public services. Examples include salaries of government employees, defense services, police administration, judiciary, education, public health, road construction, and maintenance of public infrastructure. Transfer payments like pensions, scholarships, and unemployment allowances are excluded because they do not involve current production of goods or services.

4. Net Exports (X − M)

Net exports represent the difference between exports and imports of goods and services.

• Exports (X): Goods and services sold to foreign countries. They add income to the domestic economy.

• Imports (M): Goods and services purchased from foreign countries. They reduce domestic income because production occurs abroad.

Net Exports = Exports − Imports

If exports exceed imports, it is a trade surplus; if imports exceed exports, it is a trade deficit.

Formula

GDP = C + I + G + (X−M)

Steps in the Expenditure Method

The Expenditure Method measures national income by adding all expenditures made on final goods and services during an accounting year. Since every expenditure becomes someone’s income, total spending in an economy equals total income. The following steps are followed:

Step 1. Estimate Private Final Consumption Expenditure (C)

First, calculate expenditure made by households on consumption goods and services. It includes spending on food, clothing, transport, education, medical care, electricity, and entertainment. Both durable and non-durable goods are counted. However, purchase of second-hand goods and financial assets like shares or bonds is excluded because they do not represent current production.

Step 2. Calculate Gross Domestic Capital Formation / Investment Expenditure (I)

Next, measure investment made by firms on capital goods. This includes purchase of machinery, tools, plant, factory buildings, and construction of new houses. Changes in inventories such as unsold stock, raw materials, and semi-finished goods are also included. Investment expenditure increases future production capacity and is an important indicator of economic growth.

Step 3. Estimate Government Final Consumption Expenditure (G)

Government spending on goods and services is calculated. It includes salaries of government employees, defense services, administration, education, public health, and infrastructure development. However, transfer payments such as pensions, scholarships, and unemployment benefits are excluded because they are not payments for current production.

Step 4. Calculate Net Exports (X − M)

Determine the difference between exports and imports of goods and services. Exports are added because they represent domestic production purchased by foreigners, while imports are subtracted since they are produced outside the country. The balance shows the contribution of the foreign sector to national income.

Step 5. Obtain Gross Domestic Product at Market Price (GDPmp)

Add consumption expenditure, investment expenditure, government expenditure, and net exports.

GDPmp = C + I + G + (X − M)

This gives the total market value of final goods and services produced within the domestic territory.

Step 6. Deduct Depreciation

Subtract depreciation (wear and tear of machinery and equipment) from GDP at market price. This gives Net Domestic Product (NDP), which represents net production created during the year.

Step 7. Adjust Net Factor Income from Abroad (NFIA) and Net Indirect Taxes

Finally, add net factor income from abroad to convert domestic product into national product and subtract net indirect taxes (indirect taxes minus subsidies) to convert market price into factor cost. The result obtained is Net National Product at Factor Cost (NNPfc), also called National Income.