Theories of Income Determination

Theories of Income Determination

1. Classical Theory of Income Determination

2. Keynes Theory of Income Determination

3. Saving-Investment Analysis and its effectiveness in Income Determination

1. Classical Theory of Income Determination

The Classical Theory of Income Determination is developed by Say. Therefore this theory is also known as Say’s Contribution in the determination of income in the economy. The classical theory of income determination assumes that there is always full employment of labor and other resources in the economy.

In fact full employment is considered to be normal situation and any departure from full employment is considered as abnormal. Even if at any time, there is not actual full employment the classical theory asserts that there is always a tendency towards full employment. The free play of economic forces itself brings about the fuller utilization of economic resources including labor. Any interference with the free play of market forces will fail to bring about full employment in the economy. Therefore the classical theory of income determination advocates that the government should not make any interference into the activities of the economic forces and if it is done full employment is achieved. The assumption that there is always full employment of resources is justified in the classical contribution which is popularly known as Say’s Law of Market. This law is in fact the fundamental of classical theory of income determination.

According to Say’s law, general overproduction and hence general unemployment are logical impossibilities. Say pointed out that overproduction and unemployment can’t be common occurrences by saying that “supply itself creates its own demand”. Say explains that the main source of Demand is the flow of factor income generated from the processes of production itself. Whenever any new productive process is initiated and a certain output results, the demand for the output is also simultaneously generated on account of the payment to the factors of production involved in the existing production process. Every output brought into existence injects an equivalent amount of purchasing power in circulation which ultimately leads to its sale so that there is no surplus output or overproduction.

It is observed that process of manufacture brings into being an equivalent amount of purchasing power in the form of wages, profits which would ultimately leads to its purchase. Hence, there can be no overproduction of any commodity at any time. This is the essence of Say’s Law. If general overproduction is impossible, there is no possibility of general unemployment. Therefore Say’s law assumes the non-existence of unemployment at any time. Full employment assumes by the classical economist is consistent with a certain amount of voluntary unemployment. Likewise, full employment of the classical contribution is also consistent with certain amount of fictional unemployment. The classical economist admits the existence of such unemployment in the full employment society.

But the classical economists are not prepared to admit the existence of involuntary unemployment. The classical economists do not believe that work is not available to the workers if they are willing to work. When they pointed out that in the society involuntary unemployment is existing the classical economists give the option that such unemployment is due to the interference by the government with the free working of the economic system. If the interference is stopped and the wages are allowed to go their own level, unemployment will disappear and everyone who is willing to work will get the job in the economy. Therefore the classical contribution believes that involuntary employment is due to the rigidity of the wage structure. If the wages are lowered sufficiently at the time of employment, all involuntary employment will disappear. The solution for unemployment according to classical economist, is to ensure the free working of the economic system by removing all interference whether by the trade unions or by the government.

The implication of the classical theory of income determination is that there is automatic adjustment of every element with the working of the economy. If the supply increases, the demand will also increase and these will be adjusted within supply and demand and therefore the government should not interfere with the working of economic system.

Another implication is that general over-production is possible. As production increases, the income of the concerned factors of production also increases and consequently new demand is created and increased stocks are sold in the market.

The other implication is that since general over-production is possible there will be no general unemployment. If there is some unemployment somewhere in the economy, it will automatically disappear in course of time.

The other implication is that employment of the unemployed resources will pay its own way. It is obvious that when unemployed resources are put towards they certainly help in increasing the volume of goods and services in the economy and as such, the size of national income increases and it becomes possible to give payment to the newly employed factors of production.

The final implication is that the economic system, according to Say, is automatic and works itself without any external forces. If there is some problem, the system has the capacity to remove the problem in due course of time and therefore the government should not interfere with the working of the economic system and allow the prices, wages and interest rate to be free to adjust them to the changing economic scenario.

2. Keynesian Theory of Income Determination

The first systematic theory of income determination is developed by Keynes and therefore it is known as Keynesian Theory of Income Determination.

This theory is also known as demand deficiency theory. This theory attributes unemployment to a lack of effective demand to a deficiency of outlay on consumption and on investment. Keynes measures the total output of the economy in terms of income and employment. The greater the output, the greater will be the employment and result in greater income. The net output depends upon the effective demand.

Effective demand has 2 components –

(i) consumption demand, and (ii) investment demand.

The consumption demand comprises the demand for consumer goods while the investment demand is for capital goods. It is the effective demand up to which the volume of employment and income depends. Since the employment is governed by effective demand it is clear that unemployment is due to lack of sufficient effective demand. If unemployment is to be removed, the solution is an increase in effective demand.

It is observed that as national income increases, national consumption does not increase in the same proportion as national income. There arises a gap between community income and community consumption. This gap, unless it is filled by an increase in investment accounts for the existence of unemployment. Therefore it is observed that in order to promote employment and income, effective demand must be increased by increase in investment in the economy.

Effective demand is determined by 2 factors, i.e., Aggregate Demand Function and Aggregate Supply Function. Just as in market analysis, price is determined by the market forces of supply and demand, likewise, in Keynesian theory; effective demand is determined by the forces of aggregate demand and aggregate supply.

Aggregate demand function is a schedule of a various amounts of money which the entrepreneur in the economy expects from the sale of their output at different levels of employment and income. It refers to the receipts which the entrepreneurs taken together expect from the sale of the output.

On the other hand aggregate supply function is a schedule of the various amount of money which an entrepreneur in an economy must receive from the sale of output at different levels of employment and income. Therefore aggregate supply function represents the cost whereas the aggregate demand function represents the receipts of the entrepreneur in the economy. Generally the cost must in no case be more than receipts. If at any particular level of employment and income entrepreneur finds that the receipts are less than the cost, they will stop production and refuse to give employment to that particular number of workers so long as the cost remains less than the receipts, the employment in an economy will go on increasing till both of them are equal. In no case the employers will give employment to the workers, if the costs are greater than the receipts.

Employment depends upon the effective demand and effective demand is governed by the aggregate demand function or receipts. Effective demand is the point where aggregate demand function and aggregate supply function are exactly balanced against each other, just as price is the point where supply and demand are exactly balance against each other.

In Keynesian theory of income determination, it is observed that Keynes has provided little attention to the parameter aggregate supply function and has devoted his entire attention to the parameter aggregate demand function. The reason is that Keynesian Economics is short term economics dealing only with short-term aspect. In the short term the aggregate supply function is assumed to be given as such. Keynes provides exclusive attention on the parameter aggregate demand function. Assuming aggregate supply function is to be given the essence of Keynesian Theory of Income Determination is that effective demand or employment or income is determined by aggregate demand function which depends on two parameters that is (a) consumption function or prosperity to consume, (b) investment function, i.e., inducement to investment. If employment is to be increased, expenditure both on consumption goods as well as investment goods must be increased. If the economy is facing unemployment the solution is to increase total spending by the economy on consumption goods and investment goods in order to increase employment and income. If on the other hand, the economy is facing with the problem of inflation, the solution is to cut down total spending by the economy on consumption goods and investment goods. Therefore it is concluded that Keynesian Theory of Income Determination is applied to both the situation, i.e., Deflation as well as Inflation in the economy.

3. Saving-Investment Analysis and its effectiveness in Income Determination

The saving analysis developed by Keynes is important contribution in the study of income determination. Keynes saving investment and functions are as important to income determination analysis as Marshall’s supply and demand curves to price analysis. In fact saving and investment functions are the foundation of Keynes theory of income determination. Equality between saving and investment is the most important condition of equilibrium. In Keynes theory of income determination, aggregate investment always equals aggregate savings and no level of national income can be sustained without this equality between saving and investments.

The equality between saving and investment has also been pointed out by classical economist. The classical economists held the view that saving and investment are always equal. But there are some differences between the classical concept and the Keynesian concept:

1.

The classical concept held the view that the equality between saving and investment was brought about by the rate of interest. If saving and investment are unequal at a particular time, they are brought into equilibrium by changes in the rate of interest. Therefore, for the classical concept the rate of interest is acting as the most important mechanism for equality between saving and investment. However Keynes held the view that equality between saving and investment is brought about not by the rate of interest but by changes in national income.

2.

The classical economists observe equality between saving and investment at a point of full employment. There was nothing important aspect about it because the classical economists assumed that the existence of full employment is the normal feature of the economy. But Keynes departed from the classical concept in holding the view that saving and investment are normally equal to each other at the point of less than full employment. Therefore Keynesian contribution is accepted as the contribution of under-employment equilibrium.

The equality between saving and investment can be observed in the following 2 methods:

(3.1) Method of Accounting Equality

(3.2) Method of Functional Equality

(3.1) Method of Accounting Equality:

This method is also known as method of logical identity. It does seems strange that saving and investment should be equal to each other despite the fact that the savers and the investors are two entirely different sets of persons and make their respective decisions to save and invest independently without reference to each other.

The employment of labor results in two things –

(i) It results in national output, and

(ii) It results in the creation of national income.

National output and national income are the same things and they are exactly equal to each other. National output comprises consumption goods and investment goods. National output is represented by ‘O’, consumption goods is represented by ‘C’ and investment goods is represented by ‘I’ and then the equilibrium becomes

O = C + I

Likewise, income is divided under 2 heads that is Consumption and Saving that is a part of the national income is spent on consumption while the rest is saved. National income is represented by ‘Y’, consumption is represented by ‘C’ and saving is represented by ‘S’ then the equilibrium becomes

Y = C + S

It is already known that

O = Y

And accordingly, the equilibrium is

C + S = C + I

And therefore ultimately we get,

S = I

The equality between saving and investment can be established in another way also. Since investment means the monetary outlet on goods and services other than consumption goods.

Therefore it is, NI – NC. Therefore we get,

I = Y – C

where,

I = investment

Y = income

C = consumption

On the other hand saving is equal to income minus consumption and therefore,

S = Y – C

therefore we finally get that,

S = I.

It is observed that the identity of saving and investment holds good at all levels of income.

The accounting equality between saving and investment is significant as it fully explains the error of composition. It clearly states that if all individuals try to save more, the aggregate saving will not increase. The reason is that if one individual saves more, then the other individual is saving less. One individual’s expenditure is another individual’s income. It means if the former spends less or saves more, the latter’s income is correspondingly reduced and the capacity to save is also reduced. Therefore the attempt of the economy to save more without affecting an increase in the total income will be definitely failure.

The accounting equality between saving and investment is not very effective. In the detailed analysis –

i) It provides us with no information about the causal factors that determine the levels of savings, investment, income and consumption in the economy.

ii) It provides us with no adjustment mechanism by which equality between saving and investment is brought about. Therefore this constitutes the static approach to the equality between saving and investment.

(3.2) Method of Functional Equality:

The functional equality method not only states the causal factors which determine income, consumption, saving and investment but it also gives idea on the actual process by which equality between saving and investment is brought about.

In the following diagram we observe how the equality between saving and investment takes place. SS is the saving curve and II is the investment curve. Both these curves increase with a corresponding increase in the level of national income. Both these curves intersect each other at point P. therefore OQ level of income is accepted as equilibrium income at this point. This is also known as unique level of national income or the equilibrium level of national income. At OQ1 level of income we observe that investment is R1Q1 but the saving is K1Q1. The investment exceeds saving. Therefore, the income will increase and having increased will stop at the point Q because at this point saving and investment are equal. At OQ level of income the saving is R2Q2 and investment is K2Q2 and therefore in this situation investment is less than saving. Therefore in this case the income will decline and having declined will revert to OQ level of income because at this point both saving and investment are equal. It is therefore clear that saving and investment are equal to each other only at the equilibrium income level and no other income level, exactly in the same manner in which demand and supply are equal only at the equilibrium price and nowhere else. Just as the price brings about equilibrium between demand and supply, in the same manner income brings about equality between saving and investment. According to Keynes, the economy will be in disequilibrium when either saving is in excess of investment or investment is in excess of saving. The economy will be in equilibrium when there is functional equality between saving and investment so that the national income is neither rising nor falling. It is pointed out that at the income level OQ in the following diagram the economy is no doubt in equilibrium because saving is PQ which is equal to the investment which is also PQ. This however doesn’t imply that OQ level of income is full employment equilibrium income. Saving and investment are no doubt equal to each other at OQ level of income, but it does not necessarily mean full employment in the economy. It only implies that saving and investment are equal to each other at less than full employment which is popularly known as under-employment equilibrium.

Diagram

Findings:

(i)                  P = equilibrium point where saving=investment

(ii)                 OQ = equilibrium income level determined from equilibrium point ‘P’

It is pointed that functional equality between saving and investment provides with a dynamic approach to the problem of income determination. It helps us to identify not only the causal factors between saving and investment, but also the actual process of adjustment between saving and investment. Therefore the functional equality method is definitely superior to the accounting equality method.

In this method the functional equality between saving and investment is brought about is actual practice. The equality between saving and investment is brought about by changes in national income. In fact, changes in income is the main parameter in this analysis. When investment increases, the business activity in the capital goods industry will increase. More individuals will get employment in capital goods industries and their level of income will also increase. They will spend more money on consumption goods. This will have the effect of improving the business activity in the consumption goods industry and therefore more employment will be generated in consumption goods industry. In this way there will be an all round increase in individuals’ income which will help them to save more and ultimately in this way saving will increase and increased saving will ultimately become equal to the increased investment.

The saving and investment analysis in income determination has generated two important concepts that is (1) consumption function or prosperity to consume, and (2) investment function or inducement to invest

(1) Consumption Function or Prosperity to Consume: The consumption function is an important determinant of effective demand of employment or income. The schedule of prosperity to consume expresses the relationship between total income and total consumption. Keynes contribution states that when aggregate income increases, consumption expenditure will also increase but by smaller amount. Therefore this results a gap between total income and total consumption. This gap is generating investment parameter. Therefore this gap can be filled by generating adequate amount of investment if the income is to be maintained. Therefore investment becomes essential if employment is to be increased. According to Keynes, it is the lack of investment which accounts for the existence of unemployment. The consumption function is more or less stable in the short run and it is fixed by the established habits of the individual in the economy. If it is desire to increase employment the actual determinant is the investment function parameter.

(2) Investment Function or Inducement to Invest: According to Keynes investment means an addition to real capital asset and it does not mean the purchase of existing capital asset. Investment, according to Keynes means real investment not financial investment. Investment according to Keynes depends on two parameters: (i) marginal efficiency of capital, and (ii) rate of interest.

An entrepreneur has to make a comparison between the two parameters. The entrepreneur observes to it that the marginal efficiency of capital is not in any way less than the rate of interest. The businessmen have to see that profit is coming from investment which is not less than the rate of interest. The marginal efficiency of capital is defined as the highest rate of return over cost emanating from an additional or marginal unit of a capital asset. The entrepreneur estimates the marginal efficiency of capital of an asset by taking two factors into account that is – (a) the supply price or cost of the asset, and (b) the expected income which is coming from the lifetime of the asset.

Therefore it is observed that the entrepreneur makes the estimate of the marginal efficiency of capital asset by taking its supply price and the prospective income to be generated from the asset.

The above analysis has explained in detail the effectiveness of saving and investment analysis as theory of income determination. Although the method of accounting equality is reflecting the effectiveness of saving and investment analysis, but the functional equality method is identifying not only the causal factors which determine income, consumption, saving and investment as well as the actual process by which equality between saving and investment is brought about in actual practice. Therefore it is concluded that the saving and investment analysis is important contribution in macroeconomics with regard to the analysis of income determination in the economy.

National Income or National Dividend

National Income is the aggregate money value of all goods and services produced in the economy in a particular financial year, account being taken of the deductions made due to wear and tear and depreciation of plants and machinery used in the production of goods and services. It is distributed among the factors of production in the form of rent, interest, wage and profit. National income is defined by different economist, i.e., Marshall, Pigou and Fisher.

Marshall’s Definition:

“The labour and capital of the economy acting upon its natural resources produced annually a certain net aggregate of the products, material and immaterial including services of all kinds. The term “net” is used in order to provide for using up raw products and half finished products and for the wearing out and depreciation of machinery and plants. Net income due to an account of foreign investment must be added. This is the true net national income of the economy which is known as National Dividend.”

Pigou’s Definition:

“The national dividend is that part of the objective income of the economy including income derived from foreign economy which can be measured in money.”

In this definition we get two components-

(1) Income earned by the residence on capital invested abroad has to be included in the measurement of the national income of the economy.

(2) Only that income can be included in the national income estimation of the economy which can be measured in terms of money. It means if there is any product or service, which has no money value it can’t be included in the national income measurement.

Fisher’s Definition:

While Marshall and Pigou have approached national income measurement from the product end, Fisher has approached the measurement of national income from the consumption end. According to Fisher “The National Dividend or National Income consists of services as received by the consumers in the economy, whether from their material environment or from their human environment.” Thus according to Fisher, the national income of the economy is determined not by its annual production, but by its annual consumption.

Fisher’s definition of national income appears to be better and more scientific definition than that of Marshall’s and Pigou’s, because Fisher has included in the national income measurement only the money value of the actual consumption of goods and services during the particular financial year.

METHODS OF MEASUREMENT OF NATIONAL INCOME

There are 3 methods of measuring national income of the economy and these are –

1. Census of Production Method

2. Census of Expenditure Method

3. Census of Income Method

1. Census of Production Method

According to this method of national income measurement, we find out the monetary value of the entire national output of the economy in a particular financial year. This includes all sources of output, agricultural output, industrial output, mineral output and forest output.

We evaluate the entire national output of the economy in a particular financial year and that constitutes the gross national product of the economy.
From this, we have to deduct the total depreciation undergone by the machinery and plants in the entire economy during that financial year. Since this constitutes an item of cost, the total depreciation has to be deducted from the gross national product in order to arise at the net domestic product at factor cost of the economy.
Into this Net Domestic Product we add net income coming into the economy from abroad, this constitutes The Net National Product or Net National Income at factor cost. Therefore we get –

(Gross National Product) – (Depreciation) = (Net Domestic Product at Factor Cost)

(Net Domestic Product at Factor Cost) + (Net Income from Abroad) = (Net National Product or Net National Income at Factor Cost)

While evaluating the national output of the economy, adequate care has to be taken to see that final goods and services are included in the national output in the economy otherwise there is a possibility for double entry which means certain items of output may be counted more than one in the national income measurement. This method is also known as national income by industrialization.
The main advantage of this method is that it indicates clearly the relative importance of the different sectors of the national economy by revealing their respective contribution to national income of the economy. But this method can be used only when correct and updated statistical data relating to the various sector of the economy are available.

2. Census of Expenditure Method

The gross national product can be observed as total expenditure of the nation on goods services produced during the year. Each unit of goods and services produced is matched by an expenditure on that unit. Most of the goods and services produced in the economy are purchased by the consumer but the unsold goods and services are regarded as having being purchased by the producers who hold them as stocks and inventories. The monetary value of the total national income is equal to the total national expenditure. The total national expenditure can be divided into the following 4 categories –

(1) Personal Consumption Expenditure – It includes the consumption expenditure made for both durable goods and non-durable goods in the economy during the financial year. This also includes expenditure on services, i.e., transport, education and postal services.

(2) Gross Domestic Private Investment – This item includes private investments in capital goods or producer goods such as buildings, machinery, plants, equipment etc. such goods are primarily purchased by business firms. Houses are also included in this category of expenditure because houses are so durable that they represent the capital goods.

(3) Government Purchases of Goods and Services – Government also purchases from the market different consumer goods, i.e., different types of stationery products as well as investment goods, i.e., machinery and equipment for public sector enterprises. In addition the government also purchases a number of different services in the economy.

(4) Net Foreign Investment – The entire production of the economy is sold within the economy. A part of it is exported to other countries. This part of production should be included in the gross national product of the economy. At the same time the economy imports some finished goods from abroad. The value of imports should be deducted from the value of exports. If the balance is positive, it should be added to the other items of expenditure. If it is negative, it should be subtracted from the aggregate of the other expenditure items. It is therefore clear that if the entire production of the economy is produced at market price, the amount so spent will represent the gross national product of the economy.

Therefore we have to add the above stated four categories of expenditures in order to estimate gross national product of the economy.

3. Census of Income Method

The expenditure incurred on purchasing goods and services produced in the economy during the financial year also becomes income of the various factors of production which are involved in the production of those goods and services. We can identify this factor income in the following categories –

(1) Wages and Salaries of the employees

(2) The Income of the non-company business

(3) Rental Income of the individual

(4) Corporate Profits

(5) Income from Interest

The 1^st category includes the wages and salaries received by employees during the financial year plus some supplements. These supplements are the contributions which the employers make to social securities and other provident fund and pension fund of the workers.

The 2^nd category includes the income earned by the individual proprietors partners and self employed persons.

The 3^rd category comprises rental income earned by the individual on agricultural properties and on non-agricultural properties.

The 4^th category include corporate profits earned by the business corporation before the payment of corporate profit taxes or the payment of dividends to the shareholders. Thus the corporate profits used in calculating the gross national product are equal to the aggregate of corporate profit taxes plus dividends paid to the shareholders plus undistributed corporate profits.

The 5^th category contains net interest earned by the individual from different sources other than different departments of the governments.

An aggregate of the above stated 5 categories of income will not be equal to the gross national product as measured by the census of expenditure method. The reason is that a part of the total expenditure incurred by the economy does not become available to the factors of production in the form of income. There are 2 such leakages – (i) indirect taxes levied by the government on goods and services, and (ii) depreciation of machinery, plants and buildings. The expenditures incurred by the households or the factors of production on goods and services include the indirect taxes levied by the government. The income from these indirect taxes goes to the government and is not available to the factors of production concerned. The payment on account of depreciation also does not become available to the factors of production in the form of income. Therefore, while estimating the gross national product by income method we have to add indirect taxes and depreciation charges to the factor incomes.

VARIOUS COMPONENTS OR CONCEPTS IN NATIONAL INCOME

1. GROSS NATIONAL INCOME or NET NATIONAL INCOME

The gross national income of gross national product is the fundamental accounting measure. It is known as National Income Aggregate. It is the nation’s total production of goods and services in a particular financial year evaluated in terms of Market Price of goods and services produced. It means the gross national product is the money value of the total national production in a particular financial year.

In estimating the gross national product, adequate care is taken into account in order to improve the money value of only the final goods and services produced in the economy in order to avoid double counting.

On the other hand the net national product is a better concept than gross national product because it gives proper consideration on the depreciation for machinery, equipment and buildings etc during the particular financial year. Therefore we get that Net National Product is equal to Gross National Product minus Depreciation on capital assets.

Net National Product = Gross National Product – Depreciation

It is observed that when we count Gross National Product, we don’t deduct the total depreciation of the fixed assets from the Gross Income, but at the time of calculating Net National Product, depreciation of the fixed assets is being deducted from the Gross Income. Therefore it is observed that the net national product concept gives the idea of the net increase in the total production of the economy and this concept is very effective in the analysis of the long run problem of maintaining an increase in the supply of physical capital of the economy. Therefore the net national product is highly useful concept for the study of development economics.

2. NATIONAL INCOME at MARKET PRICE and NATIONAL INCOME at FACTOR COST

Net national product is the net production of goods and services in the economy in a particular financial year. It is the,

(Net National Product) = (Gross National Product) – (Value of Capital Consumed or Depreciated during the year)

Net national product is known as National Income at Market Price.

National Income is also known as National Income at Factor Cost.

National income is the total of all income payments received by the factors of production in a particular financial year and it can be derived from the net national product in the following way:

(National Income) = (net national product) – (indirect taxes) + (subsidies)

It is observed that net national product or national income at market price is arrived at by subtracting depreciation from the gross national product. But it is also observed that the entire net national product is not available for distribution among the factors of production. The firms have to pay indirect taxes on their goods and services to the government. This aggregate of indirect taxes does not go to the factors of production. Consequently, indirect taxes have to be deducted from the net national product in order to find out National Income at Factor Cost. Sometimes the government also gives subsidies on the production of certain goods and services. The production cost of these goods and services are higher, but on account of subsidies they are sold to the market at prices lower than the actual cost of production. Therefore though these goods and services are sold at lower prices in the market, yet the factors of production are paid higher payment on account of subsidies. If we desire to find out the income of various factors of production, we will have to add the amount of governmental subsidies to the market value of net national product. The concept of national income at factor cost gives idea on the distribution of National Output. This concept indicates how a national output is being distributed among the various factors of production against their services in the economy and therefore this concept of national income is closely related to the concept of economic justice.

3. NET NATIONAL INCOME at FACTOR COST and NET DOMESTIC INCOME at FACTOR COST

When we deduct the total value of depreciation from the gross national product, we get net domestic product at factor cost but if we add net income coming to the economy from abroad to the net domestic product at factor cost, it becomes net national income at factor cost. Therefore we get,

(gross national product) – (total depreciation) = (net domestic product at factor cost)

(net domestic product at factor cost) + (net income coming from abroad) = (net national income at factor cost)

4. PERSONAL INCOME and DISPOSABLE PERSONAL INCOME

Personal income is that income which is actually received by the individuals in the economy in a particular financial year. The entire national income earned by the factors of production in one particular financial year is not available to them. Several deductions are made out of it. The corporate income taxes have to be pay out of corporate profits before they are distributed among the shareholders. Similarly a part of the corporate profit may be written by the corporation that is it may not be distributed among the shareholders. To that extent, the corporate profits available for distribution among the shareholders are reduced. Similarly, the workers have to make certain social security contributions out of their wages and salaries for provident fund and pension fund. To the extent of these deductions, the amount available to the workers is reduced. As against this, the government may give social security benefits like Unemployment Allowance and Pensionery Benefits. Such allowances are known as Transfer Payments. In order to derive personal income from national income we have to deduct from national income those amounts which are not available for the distribution among the different factors of production. At the same time, we have to add to national income the transfer payments made by the government to certain categories of employees. We therefore get,

(Personal Income) = (National Income) – (Corporate Income Taxes) – (Undistributed Corporate Profits) – (Social Security Contributions) + (Transfer Payments)

The concept of personal income helps us in estimating the potential power of the individuals in the economy. It also helps us to measure the welfare of the consumers in the economy. The limitation of this concept is that it does not fairly give us the actual amount of money that is available to the individual for spending and saving. In order to know this, we have to find out the disposable personal income of the individual. The entire amount of the personal income is not available for consumption purpose. A part of the personal income has to be paid by the individuals to the government in form of Personal Direct Tax. This part of the personal income which is left behind after personal direct taxes is known as Disposable Personal Income. In fact, it is the disposable personal income which is spent by the individual on consumption. Therefore we get,

(Disposable Personal Income) = (Personal Income) – (Personal Direct Taxes)

But it is not essential that entire disposable personal income is spend on consumption, because individuals spend a major portion of the disposable personal income on consumption, keeping some portion for saving. Therefore,

(Disposable Personal Income) = (Consumption) + (Saving)

By comparing disposable personal income with personal income, we can find out the money burden of Personal Direct Taxes and therefore we get that disposable personal income is a very useful concept in macroeconomics.

DIFFICULTIES IN THE MEASUREMENT OF NATIONAL INCOME

In measuring national income, we are facing certain difficulties which are as follows:

1. It has been observed that it is not always possible to improve certain categories of services performed by the individual in the national income measurement.

2. There is no authentic method in order to evaluate the raw materials, unfinished products, semi-finished products as well as finished products which are existing as inventories by the firms. Without a correct evaluation of these goods, we can’t arrive at reliable estimate of the national income of the economy.

3. The calculation of the total value of Depreciation and Replacement creates another difficult problem. At what rate depreciation will be calculated for different types of machinery, plants and buildings. There can’t be uniform rate for calculating the depreciation on all these fixed assets.

4. Another problem is related to the income earned by the foreign firms operating in the economy. The problem is whether this income be added to the economies gross national product or it should be treated as the income of the foreign economies to which the firms are belonging.

5. in the underdeveloped or developing country like India we observe that the available statistics are not only inadequate but also unreliable. Statistics pertaining to Indian Agriculture are not complete. We have no reliable estimate of production cost in Indian Agriculture. Similarly there are no reliable statistics for small scale and medium industries.

6. In the developing country like India, we observe that there is the existence of a large non-monetary market system. Therefore it is observed that a quite, substantial part of the agricultural output in the developing countries does not reach the market because either it is consumed in agricultural sector or it is exchanged for other goods and services in the agricultural sector.

7. The other problem in the developing countries is related to the small firms as these firms are not in a position to keep any account of their productive activities and therefore they can’t provide authentic information about the quality as well as the value of the product.

8. It is also observed that in the developing country there is little of operational specialization on the part of the individuals. Many individuals take up more than one activity in order to improve the standards of living. Therefore it becomes difficult to collect information about their income.

FACTORS DETERMINING NATIONAL INCOME

There are a number of factors which determine the size of the national income of the economy. It is on account of these factors that one economy is having a larger national income than the other economy. The main factors which influence volume of national income of the economy are as follows:

1. Quantity and Quality of Factors of Production: This factor is the most important factor which is influencing the national income of the economy. The quantity and quality of the factors of production are determining the volume of the national income. The quantity of labor has significant impact as it is important factor of production as well as it is consumer in the economy. The quality of the labor depends on intelligence, level of education, the adequate training which is given to the workers and these parameters influence the volume of industrial production. Capital is also very important parameter as it has having significant impact on improvement of productivity. The ability of the entrepneurs is another important parameter which is determining the volume of national income.

2. The Size of Technical Knowledge: Another parameter on determination of the national income is the state of technical knowledge in the economy. It is proved that an economy having low level of technical knowledge can’t generate higher national income. This justifies the introduction of new technologies into the existing production process.

3. Political Stability: It has been observed today that political stability is an essential requirement for maintaining production at the highest level. It has been proved that political instability is standing in the way of achieving higher economic development and therefore component is also playing important role in the determination of national income of the economy.

IMPORTANCE/SIGNIFICANCE OF NATIONAL INCOME MEASUREMENT

1.

Since the national income measurement represents the monetary measures of the volume of production in a particular financial year, this measurement gives us the idea of the aggregate production in the economy.

2.

An increasing national income is accepted as an indicator of economic development. Therefore a decreasing national income is an indicator of economic undevelopment.

3.

The national income measurement gives an idea of the rate of national income growth in the economy. Therefore in development economics, national income measurement is important contribution.

4.

The economic welfare is closely connected with the volume of national income. An increase in the national income of economy also implies an increase in the economic welfare.

5.

The national income measurement gives idea on the contribution of the different sectors of the economy to the gross national product of the economy. Therefore national income measurement indicates the comparative importance of the different sectors of the economy.

6.

The national income measurement also indicates how national income of the economy is distributed among the different sectors of the population in the economy. An increase in the share of labor that is increase in wage rate out of the national income is a clear indication that economic inequalities are being reduced.

7.

The national income measurement also gives idea on the volume of consumption, saving and investment in the economy. The level of consumption reflects the level of economic welfare, while level of saving and investment determine the nature of economic growth.

8.

By comparing national income measurement of different countries, we can compare their standard of livings and the level of economic welfare achieved by them.

9.

It is observed that national income estimate is a very important for the formulation of economic policy of the government. No government can formulate a correct, realistic and well balanced economic policy without having authentic national income estimate about the volume and distribution of national income in the economy.

10.

Economic planning is very important in the developed as well as in the developing economy. All countries, whether socialist country or capitalistic or mixed economy must take proper economic plan in order to accelerate the rate of economic growth. The formulation of economic plan is not possible without reliable estimates of national consumption, national saving and national investment. No economic plan can be formulated without adequate national income statistics. Therefore the working of the economic planning can be evaluated with the help of authentic national income estimate.