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1.4 I Production Method of Calculating National Income

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1.4 I Production Method of Calculating National Income 1.4 I Production Method of Calculating National Income In product method or value added method, we calculate the aggregate annual value of goods and services produced during a year. How to go about doing this? Do we add up the value of all goods and services produced by all the firms in an economy? The following example will help us to understand. Let us suppose that there are only two kinds of producers in the economy - wheat producers (or the farmers) and the bread makers (rhe bakers). The wheat producers grow wheat and they do not need any input other than human labour. They sell a part of the wheat to the bakers. The bakers do not need any other raw materials besides wheat to produce bread. Let us suppose that in a year the total value of wheat that the farmers have produced is ^100. Out of this they have sold ^50 worth of wheat to the bakers. The bakers have used this amount of wheat completely during the year and have produced ^200 worth of bread. What is the value of total production in the economy? If we follow the simple way of aggregating the values of production of the sectors, we would add ^200 (value of production of the bakers) to ^100 (value of production of farmers). The result will be ^300. A little reflection will tell us that the value of aggregate production is not ^300. The farmers had produced ^100 worth of wheat for which it did not need assistance of any inputs. Therefore, the entire ^100 is rightfully the contribution of the farmers. But the same is not true for the bakers. The bakers had to buy ^50 worth of wheat to produce their bread. The ^200 worth of bread that they have produced is not entirely their own contribution. To calculate the net contribution of the bakers, we need to subtract the value of the wheat that they have bought from the farmers. If we do not do this we shall commit the mistake of ‘double counting’. This is because ^50 worth of wheat will be counted twice. First, it will be counted as part of the output produced by the farmers. Second time, it will be counted as the imputed value of wheat in the bread produced by the bakers. Therefore, the net contribution made by the bakers is, ^200 —^50 = ^150. Hence, aggregate value of goods produced by this simple economy is ^100 (net contribution by the farmers) + ?150 (net contribution by the bakers) = ?250. The term that is used to denote the net contribution made by a firm is called its 'value added’. We know that rhe raw materials that a firm buys from another firm which are completely used up in rhe process of production are called ‘intermediate goods’. Therefore: Value added of a firm = Value of output produced by the firm — Cost of intermediate goods used The value added of a firm is distributed among its four factors of production, namely, labour, capital, entrepreneurship and land. Therefore wages, interest, profits and rents paid out by the firm must add up to the value added of the firm. Value added is a flow variable. We can represent the example given above in terms of the following Table. Farmer Baker Value of output 100 200 Intermediate consumption 0 50 Value added 100 200-50 =150 Problem of Double Counting The problem of double counting arises when the value of same goods and services are counted more than once while estimating national income. There are two approaches/methods to avoid the problem of double counting: (i) Take the value of final goods and services only ignoring all intermediate products. (ii) Take value added ar different stages in production process instead of total output. 30 Steps for calculation of national income by product method Step 1: Estimation of value of output produced by each firm in all the sectors of the economy during the year. Value of output is the market value of goods and services produced by a firm during an accounting year. Value of output = Output produced (in units) x Market price (a) If a firm had no initial unsold stock in the beginning of the year: Value of output produced = Sales + Value of unsold stock Note: Sales = Output sold (in units) x Market price Sales = Sale of goods and services to domestic buyers + Exports of goods and services. (b) If a firm had some unsold stock in the beginning of the year: Value of output = Sales + Net change in stock or, Value of output = Sales + Closing stock - Opening stock Example: Suppose that a firm had an unsold stock worth ?100 at the beginning of the year. During rhe year it produced ^1000 worth of goods by using raw materials and other inputs worth ?400 and managed to sell ^800 worth of goods. (i) Value of closing stock = Opening stock + Value of output produced — Sales = 100 + 1000-800 =^300 (ii) Change in stock = Closing stock - Opening stock = 300 - 100 = ?200 or, Change in stock = Value of output produced — Sales = 1000 — 800 = ?200 (iii) Value of output produced = Sales + Change in stock = 800 + 200 = ?1000 Step 2: Calculation of Value Added/Value Addition (VA) and Gross Domestic Product at market price (GDPmp) Vallie added/value addition is the difference between value of output and intermediate consumption. Value added = Value of output - Intermediate consumption Top Tip Intermediate consumption = Purchase of raw materials etc. + Imports of raw materials etc. J In our example of farmers and bakers, the Value Added by farmers and bakers are their Gross Value Added at market price (GVAmp). GVAmp of a firm = Value of output - Intermediate consumption Now, if we sum the GVAmp of all the firms in all the sectors of the economy, we get Gross Domestic Product at market price (GDPmp). GDPmp = Value of output of all the firms in the economy - Intermediate costs GDPmp is the money value of all final goods and services produced within the domestic territory of a country during an accounting year. All production done by the national residents or the non-residents in the domestic territory of the country gets included, regardless of whether that production is owned by a local company or a foreign entity. Everything is valued at market prices. Why is GDPmp called gross? GDPmp is final products valued at market price. This is what buyers pay. Bur this is not what production units actually receive. Our of what buyers pay, rhe production units have to make provision for depreciation and payment of indirect tax like excise, sales tax, etc. This explains why GDPmp is called 'gross'. It is called gross because no provision has been made for depreciation. However, if depreciation is deducted from rhe GDP it becomes Net Domestic Product (NDP). Naturally, depreciation does not become part of anybody’s income. Why is GDPmp called ‘at market price’ ? Out of what buyers pay, rhe production units have to make payments of indirect taxes, if any. Indirect taxes accrue to rhe government, and not to the production units. Payment of indirect taxes to the government is a transfer payment as no good or service is provided in return. Hence, indirect taxes are deducted from GDPmp to calculate what production units actually receive. Sometimes production units receive subsidy on production. This is in addition to the market price which production units receive from rhe buyers. Therefore, what production units actually receive is not rhe 'market- price' bur "market price — indirect tax + subsidies". Step 3: Calculation of Net Domestic Product at factor cost (NDPfc) If we make adjustment of depreciation, indirect taxes and subsidies in GDPmp, we get Net Domestic Product at Factor Cost (NDPfc). NDPfc = GDPmp — Depreciation - Indirect taxes + Subsidies or, NDPfc = GDPmp - Depreciation - Net indirect taxes or, NDPfc = GDPmp - Depreciation - Net product taxes - Net production taxes NDPfc is the income earned by the factors of production in the form of wages, profits, rent, interest, etc., within the domestic territory of a country. This is also called domestic income because this is rhe income generated in the production process within the domestic territory of the country. Step 4: Calculation of Net National Product at factor cost (NNPfc) or National Income (NI) Net National Product at factor cost (NNPfc) is the net domestic factor income added with the net factor income from abroad. In other words: National income (NNPfc) = NDPfc + NFIA or, NNPfc = GDPmp - Depreciation - Net indirect taxes + NFIA or, NNPfc = GDPmp - Depreciation - Net product taxes - Net production taxes + NFIA NNP at factor cost is the sum of income earned by all factors in the production in the form of wages, profits, rent and interest, etc., belonging to a country during a year. It is the National Product and is not bound by production in the national boundaries. 32 Other Basic National Income Aggregates 1. Net Domestic Product at Market Price (NDPmp) NDPmp = GDPmp - Depreciation This measure allows policy-makers to estimate how much rhe country has to spend just to maintain their current GDP. If the country is not able to replace the capital stock lost through depreciation, then GDP will fall. 2. Gross National Product at Market Price (GNPmp) GNPmp = GDPmp + Net factor income from abroad (NFIA) GNPmp is the value of all the final goods and services that are produced by the normal residents of India and is measured at the market prices, in a year. GNP refers to all the economic output produced by a nations normal residents, whether they are located within the national boundary or abroad. Everything is valued at the market prices.
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