National Income Accounting Lecture 3

Outline Measurement of national income Other measures of Income Value-Added Approach Factor Payments (or Income) Approach Other measures of Income GNP, NNP, National Income, Personal Income, Disposable income Nominal and real measures Limitations of the national income concept

Other Approaches to GDP The Value-Added Approach The Factor Payments/ Income Approach

The Value-Added Approach In the Expenditure approach, Count goods and services only when sold to final users In Value-added approach, Add up each firm’s contribution to a product as it is produced A firm’s contribution to a product is called its value added

The Value-Added Approach to GDP The revenue a firm receives minus the cost of the intermediate goods it buys GDP Sum of value added by all firms in the economy

Illustrating the Value-Added Approach Ghc2.25 (notebook paper) Ghc1.00 (Wood Chips) Ghc1.50 (raw paper) Ghc3.50 (Notebook paper) Ghc5.00 (Notebook paper) Lumber mill Paper mill Office Supplies Manufacturer Wholesaler Retailer Production of a ream of notebook paper: Ghc(1+ 0.5 + 0.75 + 1.25 + 1.50) = Ghc5

Another Illustration: Value Added Approach Suppose there are 5 stages in getting a suit manufactured and into the hands of a final consumer Stage of Production Sales Value of Materials or Product Value- Added Firm A, Sheep ranch 60 Firm B, wool processor 100 Firm C, suit manufacturer 125 40 Firm D, Clothing wholesaler 175 25 Firm E, retailer 250 50 Total Sales value 710 75 Value added (total income)

The Factor Payments/ Income Approach Payments to the owners of resources that are used in production GDP Calculation Sum of factor payments earned by all households in the economy

The Income Approach Domestic Income There are four (4) components Total income earned by residents and businesses in an economy There are four (4) components Employees compensation Rents Interests Profits

The Factor Payments Approach Compensation to employees Wages and salaries paid to individuals Fringe benefits Makes up a largest proportion of national income

The Factor Payments Approach Rents Income received by households from properties that they own Income received by firms from properties that they own form part of profits Rent component of GDP may be small if depreciation is high in a particular year

The Factor Payments Approach Interest The income that private businesses pay to households that have lent the business money e.g. purchase of stocks Interests paid to firms also show up in profits

The Factor Payments Approach Profits The amount that is left over after compensation to employees, rents and interest have been paid out

Other Approaches to GDP Why use more than one method to calculate GDP? Measurement errors

Problems With GDP Quality changes The underground economy Nonmarket production

Quality Changes Analysts record an increase in GDP only if there is an increase in the quantity of a good or service produced New pen that lasts four times longer than previous version should cost 4 times as much! GDP analysts record some quality changes (cars, computers); not all Reason: Budget constraints GDP underestimates the true growth in output from year to year

The Underground Economy Some production hidden from government Illegal (drugs, prostitution) Tax avoidance Underestimation of true production in economy

Non-Market Production Excluded Housecleaning Sewing Lawn mowing Child rearing Whenever non-market transactions become market transactions, GDP will rise, even though total production is the same Over last century, much production shifted from home to market Parenting to day care Home-cooked food to takeout Talking to a friend to therapy Neighbour watching your house to alarm system Real GDP increases although production has not Exaggerate growth in GDP over time

Other measures of national income

Gross vs. Net concepts Depreciation The decrease in the value of a capital good over time Wear and tear on economy’s stock of capital Examples?

GDP vs. NDP Gross Domestic Product (GDP) Net Domestic Product (NDP) Total output produced within a country Net Domestic Product (NDP) Total output produced within a country, minus depreciation

Market Price vs. Factor cost Recall expenditure = income assumption Prices paid by consumers revenue received by producers Why? Taxes and subsidies Taxes imply producer receives less than consumer pays Subsidies imply producers receive more than consumer pays

Market Price vs. Factor Cost To convert the value at factor cost to the value at market prices, we must: Add indirect taxes and subtract subsidies The expenditure approach values goods at market prices; the income approach values them at factor cost

Measures of Income More complete picture Gross National Product (GNP) Net National Product (NNP) National Income Personal Income Disposable Personal Income Largest to Smallest

Other measures of Income Gross National Product (GNP) Total output of goods and services produced by nationals Excludes production by foreigners within domestic economy; includes production by nationals in foreign country.

Other measures of income Net Factor income from abroad = Output by nationals abroad - Output by foreigners Ghana GNP = Ghana GDP + Net factor income from abroad Question (True/False) When a Nigerian businessman builds a factory in Ghana; his production is part of Ghana’s GDP, but not Ghana’s GNP. Why?

Other measures of Income Net National Product (NNP) Total production by a nation’s residents minus losses from depreciation National Income Total income earned by a nation’s residents. Differs from NNP by statistical discrepancy Market price vs. factor cost

Other measures of Income Personal Income Income received by households and businesses Excludes retained earnings Includes income from Transfer payments PI= NI – retained earnings + transfer payments

Other measures of Income Disposable Personal Income Income that households and businesses have left over after paying taxes = Personal income- personal taxes

Relationship between various measures of income

Real versus Nominal GDP Total spending rises from one year to the next Economy - producing a larger output of goods and services And/or goods and services are being sold at higher prices Nominal GDP Production of goods and services Valued at current prices

Real versus Nominal GDP Real GDP Production of goods and services Not affected by changes in prices From nominal GDP to real GDP….

Table 2 Real and Nominal GDP What is true about real GDP and nominal GDP in the base year?

Real vs. Nominal GDP Nominal GDP uses current prices to place a value on economy’s output Real GDP uses base-year prices to place a value on economy’s output

Real vs. Nominal GDP True/False If Nominal GDP is rising, real GDP must also be rising. Why?

GDP GDP – “the best single measure of the economic well-being of a society” Economy’s total income Economy’s total expenditure Larger GDP Good life, better healthcare Better educational systems Measure our ability to obtain many of the inputs into a worthwhile life

GDP GDP – not a perfect measure of well-being. Why not?

GDP Doesn’t include Nothing about distribution of income Leisure Value of almost all activity that takes place outside markets Chef, child care-taker, etc Quality of the environment Nothing about distribution of income

International differences: GDP & quality of life Rich countries - higher GDP per person Better Life expectancy Literacy Internet usage Poor countries - lower GDP per person Worse

GDP and the Quality of Life The table shows GDP per person and three other measures of the quality of life for twelve major countries.

International differences: GDP & quality of life Low GDP per person More infants with low birth weight Higher rates of infant mortality Higher rates of maternal mortality Higher rates of child malnutrition Less common access to safe drinking water Fewer school-age children are actually in school

International differences: GDP & quality of life Low GDP per person Fewer teachers per student Fewer televisions Fewer telephones Fewer paved roads Fewer households with electricity

Sample Questions What is nominal GDP for 2005 and 2010? Calculate real GDP for 2005 and 2010, using 2005 as the base year.

Sample Questions Consider an economy that produces only chocolate bars. In year 1, the quantity produced is 3 bars and the price is Ghc4. In year 2, the quantity produced is 4 bars and the price is Ghc5. In year 3, the quantity produced is 5 bars and the price is Ghc6. Year 1 is the base year. What is the nominal GDP for each of these years What is the real GDP for each of these years? What is the % growth rate of real GDP from year 1 to year 2?

Take-Home Exercise One day, Barry the Barber collects $400 for haircuts. Over this day, his equipment deteriorates in value by $50. Of the remaining $350, Barry sends $30 to the government in sales taxes, takes home $220 in wages, and retains $100 in his business to add new equipment in the future. From the $220 that Barry takes home, he pays $70 in income taxes. Based on this information, compute Barry’s contribution to the following measures of income: Gross domestic product Net national product National income Personal income Disposable personal income

Next Class The price level and inflation Measuring the rate of inflation The construction of the consumer price index (CPI)/retail price index (RPI) GDP deflator Unemployment Definition and Measurement