National income: the circular flow and the three approaches
National income can be measured by output, income or expenditure. All three give the same total, because one person's spending is another person's income.
The circular flow of income (two-sector economy)
- back to Households
Money flows this way round; real goods and factor services flow the opposite way. In a four-sector economy, leakages (saving, taxes, imports) leave the flow and injections (investment, government spending, exports) enter it. Income is stable when leakages = injections.
The three approaches
| Approach | What is added | Main caution |
|---|---|---|
| Output (value added) | Value added at each stage of production, across agriculture, industry and services | Count only value added, not total sales, to avoid double counting |
| Income | Wages and salaries + rent + interest + profit (incomes of factors) | Exclude transfer payments such as pensions and welfare benefits |
| Expenditure | C + I + G + (X − M): spending on final goods and services | Exclude second-hand goods, financial transactions and intermediate goods |
Worked example 1: value added and double counting
A grower sells green tea leaf to a factory for Rs. 200. The factory sells made tea to a packer for Rs. 500. The packer sells packets to a retailer for Rs. 800. The retailer sells them to consumers for Rs. 1,000. Find the value added and the contribution to GDP.
- Grower's value added = 200 − 0 = Rs. 200.
- Factory: 500 − 200 = Rs. 300. Packer: 800 − 500 = Rs. 300. Retailer: 1,000 − 800 = Rs. 200.
- Total value added = 200 + 300 + 300 + 200 = Rs. 1,000, the price of the final product.
- Adding all sales (200 + 500 + 800 + 1,000 = Rs. 2,500) would count the leaf several times: double counting.
Contribution to GDP = Rs. 1,000 (sum of values added = final sale value), not Rs. 2,500.
Worked example 2: from GDP to national income
An economy's data (Rs. billion, illustrative): consumption 6,000; investment 1,500; government spending 1,200; exports 2,000; imports 2,400; net factor income from abroad −200; depreciation 600; indirect taxes 900; subsidies 100. Find GDP, GNP, NNP at market prices and national income. Then check with incomes: wages 4,000, rent 500, interest 700, profit 1,500. Finally find real GDP if the GDP deflator is 125.
- GDP = C + I + G + (X − M) = 6,000 + 1,500 + 1,200 + (2,000 − 2,400) = 8,700 − 400 = 8,300.
- GNP = GDP + net factor income from abroad = 8,300 + (−200) = 8,100.
- NNP at market prices = GNP − depreciation = 8,100 − 600 = 7,500.
- National income (NNP at factor cost) = NNP at market prices − indirect taxes + subsidies = 7,500 − 900 + 100 = 6,700.
- Income approach check: 4,000 + 500 + 700 + 1,500 = 6,700. ✓
- Real GDP = nominal GDP ÷ deflator × 100 = 8,300 ÷ 125 × 100 = 6,640.
GDP 8,300; GNP 8,100; NNP at market prices 7,500; national income 6,700 (matching the income approach); real GDP 6,640.
Difficulties in measuring national income
- Double counting of intermediate goods if total sales are added instead of value added.
- The informal sector: small traders, home-based work and casual labour often go unrecorded.
- Non-market work, such as cooking and caring at home, is left out.
- Self-consumed output, such as vegetables a farm family grows for itself, must be estimated.
- Transfer payments, second-hand sales and share purchases must be excluded.
- Depreciation is hard to estimate, and prices change, so nominal figures must be adjusted to real terms.
Uses and limits
National income figures are used to measure economic growth, compare living standards (using real GDP per capita), plan government policy and guide business investment. In Sri Lanka, official GDP estimates are published by the Department of Census and Statistics, and the CBSL uses them in its analysis. But GDP is not the same as welfare: it ignores income distribution, leisure, the quality of goods and environmental damage.
A tea packet shows the output approach at work: the grower, the factory, the exporter or packer and the retailer each add value. Companies such as Dilmah or other branded tea packers aim to capture more value added inside Sri Lanka by exporting packed, branded tea rather than bulk tea.
Short answer: “Distinguish GDP from GNP.” GDP is the value of final output produced within the country; GNP adds net factor income from abroad (income earned abroad by residents minus income paid to foreigners).
Structured question: “From given data, calculate GDP, GNP, NNP and national income at factor cost.” GDP = C + I + G + (X − M); add net factor income for GNP; subtract depreciation for NNP; subtract indirect taxes and add subsidies for national income.
Essay: “Explain the three methods of measuring national income and the difficulties involved.” Draw the circular flow, explain output, income and expenditure approaches with what to include and exclude, work a short example, and list measurement problems such as double counting and the informal sector.
Output = Income = Expenditure. Down the ladder: GDP → (+ net factor income) GNP → (− depreciation) NNP → (− indirect taxes + subsidies) National income.