Methods of calculating national income

The essentials

National income can be measured in three ways, which give the same answer because they look at the same flow from different points of the circular flow.

Value added (product) method: for each producing unit, value added = value of output − intermediate consumption. Adding the value added of all units avoids double counting, the mistake of counting the value of intermediate goods more than once. GDP equals the sum of gross value added of all firms (plus net indirect taxes when measured at market price).

Expenditure method: GDP at market price = private final consumption expenditure + government final consumption expenditure + gross investment (fixed capital formation + change in stock) + net exports (exports − imports). Only spending on final goods is counted.

Income method: add the factor incomes generated in production: compensation of employees + rent + interest + profit + mixed income of the self-employed. This gives domestic income (NDP at factor cost).

Key points

• Value of output = sales + change in stock.
• Included: imputed rent of owner-occupied houses, own-account production of goods, compensation in kind.
• Excluded: transfer payments (pensions, scholarships), sale of second-hand goods (only the dealer's commission counts), purchase of shares and bonds, interest on loans taken for consumption, windfall gains.
• Domestic services of a homemaker are excluded because they are not marketed.

Exam tips

In numericals, first decide which method the data fit. In the value added method always subtract intermediate consumption; in the expenditure method use only final expenditure.

Common mistakes

• Adding the full value of each stage of production (double counting).
• Including transfer payments in income.