National Income Accounting: The Measurement of Production, Income, and Expenditure

Differentiate among the three approaches to national income accounting.

The national income accounts are an accounting framework used in measur­ing current economic activity. Almost all countries have some form of official national income accounts.

The national income accounts are based on the idea that the amount of economic activity that occurs during a period of time can be measured in terms of

1. the amount of output produced, excluding output used up in intermediate stages of production (the product approach);

2. the incomes received by the producers of output (the income approach); and

3. the amount of spending by the ultimate purchasers of output (the expenditure approach).

Each approach gives a different perspective on the economy. However, the fundamental principle underlying national income accounting is that, except for problems such as incomplete or misreported data, all three approaches give identical measurements of the amount of current economic activity.

We can illustrate why these three approaches are equivalent by an exam­ple. Imagine an economy with only two businesses, called OrangeInc and JuiceInc. OrangeInc owns and operates orange groves. It sells some of its oranges directly to the public. It sells the rest of its oranges to JuiceInc, which produces and sells orange juice. The following table shows the transactions of each business during a year.

OrangeInc pays $15,000 per year in wages to workers to pick oranges, and it sells these oranges for $35,000 ($10,000 worth of oranges to households and $25,000 worth of oranges to JuiceInc).

JuiceInc buys $25,000 of oranges from OrangeInc and pays wages of $10,000 to workers to process the oranges into orange juice. It sells the orange juice for $40,000, so its profit before taxes is $5000 ($40,000 — $25,000 — $10,000). After paying taxes of $2000, its after-tax profit is $3000.

What is the total value, measured in dollars, of the economic activity gener­ated by these two businesses? The product approach, income approach, and expenditure approach are three different ways of arriving at the answer to this question; all yield the same answer.

1. The product approach measures economic activity by adding the market val­ues of goods and services produced, excluding any goods and services used up in intermediate stages of production. This approach makes use of the value-added concept. The value added of any producer is the value of its out­put minus the value of the inputs it purchases from other producers. The product approach computes economic activity by summing the value added by all producers.

In our example, OrangeInc produces output worth $35,000 and JuiceInc produces output worth $40,000. However, measuring overall economic activity by simply adding $35,000 and $40,000 would "double count" the $25,000 of oranges that JuiceInc purchased from OrangeInc and processed into juice. To avoid this double counting, we sum value added rather than output: Because JuiceInc processed oranges worth $25,000 into a product worth $40,000, JuiceInc's value added is $15,000 ($40,000 — $25,000).

In Touch with Data and Research

The National Income and Product Accounts in Malaysia

In Malaysia, the national income accounts are officially compiled, produced, and disseminated by the National Accounts Statistics Division in the Department of Statistics Malaysia (DOSM), which operates under the Prime Minister's Department.

Established in 1949 as the Bureau of Statistics, the DOSM produced statis­tics limited to only external trade and estate agriculture. However, since 1965, its functions have expanded to also include data on the economy and social areas. Currently, national accounts statistics are compiled quarterly and annually based on types of economic activity, while expenditure on GDP is compiled based on type of expenditure at current and constant prices. On the production side, the data is compiled based on industry, and on the expenditure side, based on the type of final consumption. The DOSM also compiles and produces other national accounts statistics such as national income, national income per capita, consump­tion, savings, and other economic variables.

In the past, most of the statistical data were disseminated in printed form. Since 1955, the DOSM has compiled and published national accounts statistics at current prices on an annual basis. The annual national income data are also available in the economic report published by the Ministry of Finance. This report is released in conjunction with the national budget in September every year. In addition, the Economic Planning Unit (EPU) of the Prime Minister's Department has a summary of GDP tables for annual series and quarterly series (from 2000). Reports are released two months after each quarter end and are available through the DOSM and Bank Negara Malaysia (BNM).

National income data is now also available and accessible online. The DOSM home page at www.statistics.gov.my provides access to current and historical data. Data on national income accounts are also disseminated through the web­sites of other agencies, such as the Malaysian National News Agency, EPU, and BNM, and through international statistical agency websites such as the United Nations Statistics Division and the ASEAN Secretariat.

OrangeInc doesn't use any inputs purchased from other businesses, so its value added equals its revenue of $35,000.

2. The income approach measures economic activity by adding all income received by producers of output, including wages received by workers and profits received by owners of firms. As you have seen, the (before-tax) profits of OrangeInc equal its revenues of $35,000 minus its wage costs of $15,000, or $20,000. The profits of JuiceInc equal its revenues of $40,000 minus the $25,000 the company paid to buy oranges and the $10,000 in wages paid to its employ­ees, or $5000. Adding the $20,000 profit of OrangeInc, the $5000 profit of JuiceInc, and the $25,000 in wage income received by the employees of the two companies, we get a total of $50,000, the same amount determined by the product approach.

In this calculation we added the before-tax incomes of workers and firm owners. Equivalently, we could have added the after-tax incomes of produc­ers of output and the taxes received by the government. Recall that, when taxes are subtracted, OrangeInc's after-tax profits are $15,000 and JuiceInc's after-tax profits are $3000. Adding the two firms' after-tax profits of $18,000, total wage income of $25,000 (we assumed that workers pay no taxes), and the $7000 in taxes received by the government, we again obtain $50,000 as the measure of economic activity

3. Finally, the expenditure approach measures activity by adding the amount spent by all ultimate users of output. In this example, households are ultimate users of oranges. JuiceInc is not an ultimate user of oranges because it sells the oranges (in processed, liquid form) to households. Thus ultimate users purchase $10,000 of oranges from OrangeInc and $40,000 of orange juice from JuiceInc for a total of $50,000, the same amount computed in both the product and the income approaches.^[9]

Why the Three Approaches Are Equivalent

That the product, income, and expenditure approaches all give the same answer is no accident. The logic of these three approaches is such that they must always give the same answer.

To see why, first observe that the market value of goods and services pro­duced in a given period is by definition equal to the amount that buyers must spend to purchase them. JuiceInc's orange juice has a market value of $40,000 only because that is what people are willing to spend to buy it. The market value of a good or service and the spending on that good or service are always the same, so the product approach (which measures market values) and the expendi­ture approach (which measures spending) must give the same measure of eco­nomic activity.^[10]

Next, observe that what the seller receives must equal what the buyers spend. The seller's receipts in turn equal the total income generated by the economic activity, including the incomes paid to workers and suppliers, taxes paid to the government, and profits (whatever is left over). Thus total expenditure must equal total income generated, implying that the expenditure and income approaches must also produce the same answer. Finally, as both product value and income equal expenditure, they also must be equal.

Because of the equivalence of the three approaches, over any specified time period

total production = total income = total expenditure, (2.1)

where production, income, and expenditure all are measured in the same units (for example, in dollars). Equation (2.1) is called the fundamental identity of national income accounting and forms the basis for national income accounting. (An identity is an equation that is true by definition.) In Section 2.2, we show how this fundamental identity is used in measuring current economic activity for the economy as a whole.

2.2