6. Economics Notes 25

Elaborate Notes

Production Method for National Income Calculation

The Production Method, also known as the Output Method or Value-Added Method, is a fundamental approach to calculating a nation’s Gross Domestic Product (GDP). It measures the total value of all final goods and services produced within the domestic territory of a country during a specific period. This method has two primary approaches: the final product approach and the value-added approach.

• Gross Value Added (GVA): This is the core concept of the production method. GVA represents the value of output less the value of intermediate consumption. It measures the contribution to an economy of an individual producer, industry, or sector.

  • Formula: GVA = Value of Output - Intermediate Consumption
  • Value of Output: This is the market value of all goods and services produced during a period. It is calculated as: Value of Output = Sales + Change in Inventory (Stock). Change in Inventory is the difference between closing stock and opening stock.
  • Intermediate Consumption: This refers to the value of goods and services consumed as inputs by a process of production, excluding fixed assets whose consumption is recorded as consumption of fixed capital (depreciation). For instance, in car manufacturing, the cost of steel, tires, and paint constitutes intermediate consumption.

• Relationship between Factor Cost, Basic Prices, and Market Prices: These concepts are crucial for understanding the different stages of valuation. The System of National Accounts (SNA) 2008, adopted by India’s Central Statistics Office (CSO) in 2015, provides the framework for these definitions.

  • Factor Cost (FC): This represents the total cost incurred on the factors of production (land, labor, capital, entrepreneurship). It is the sum of wages, interest, profit, and rent (WIPR). It is the price from the producer’s perspective, excluding any taxes and including any subsidies related to production.
    • GVA at FC = Compensation of Employees (CE) + Operating Surplus (OS) + Mixed Income (MI)
  • Basic Prices (BP): This is the amount receivable by the producer from the purchaser, which includes production taxes and excludes production subsidies. It provides a more accurate picture of value added at the production level than factor cost.
    • GVA at Basic Prices = GVA at FC + (Production Taxes - Production Subsidies) or GVA at BP = GVA at FC + Net Production Taxes
  • Market Prices (MP): This is the final price paid by the consumer in the market. It includes both production and product taxes and excludes both production and product subsidies.
    • GDP at Market Prices = GVA at Basic Prices + (Product Taxes - Product Subsidies) or GDP at MP = GVA at BP + Net Product Taxes

• Production vs. Product Taxes and Subsidies:

  • Production Taxes/Subsidies: These are independent of the volume of production. They are paid or received concerning production itself.
    • Examples of Production Taxes: Land revenues, stamp duties, registration fees, professional taxes.
    • Examples of Production Subsidies: Subsidies to Railways, input subsidies to farmers, subsidies to village and small industries.
  • Product Taxes/Subsidies: These are levied or provided per unit of the good or service produced or sold.
    • Examples of Product Taxes: Goods and Services Tax (GST), customs duties, excise duties.
    • Examples of Product Subsidies: Food subsidies, fertilizer subsidies, interest subsidies to farmers.

• Approaches within the Production Method:

  • Final Product Approach: This method calculates national income by summing the market value of all final goods and services produced. The formula is GDP at MP = P*Q + P*S, where P is the market price, Q is the quantity of goods, and S is the quantity of services. The primary challenge is to avoid the “problem of double counting,” where the value of intermediate goods is counted multiple times.
  • Value-Added Approach: This is a more refined method that avoids double counting. It measures the contribution of each producing unit by summing the “value added” at each stage of production. Value added is the difference between the value of a firm’s output and the value of the inputs it has purchased from others.
    • Example: A farmer produces wheat worth ₹100. A miller buys the wheat, grinds it into flour worth ₹150 (value added = ₹50). A baker uses the flour to bake bread worth ₹250 (value added = ₹100). The total value added (₹100 + ₹50 + ₹100 = ₹250) is equal to the market price of the final product (bread), thus avoiding counting the value of wheat and flour multiple times.

• Steps in Calculation (Value-Added Method):

  1. Identification and Classification: All producing units in the domestic economy are identified and classified into three sectors: Primary (agriculture, mining, fishing), Secondary (manufacturing, construction, electricity), and Tertiary (services like banking, education, transport).
  2. Estimation of GVA: Gross Value Added (GVA) at basic prices is estimated for each sector by summing the GVA of all producing units within it.
  3. Calculation of GDP at MP: GDP at Market Prices = Sum of GVA at Basic Prices of all three sectors + Net Product Taxes.
  4. Derivation of Domestic Income (NDP at FC): Depreciation is subtracted from GDP at MP to get NDP at MP. Then, Net Indirect Taxes (Product + Production) are subtracted to arrive at Net Domestic Product at Factor Cost (NDP at FC).
  5. Derivation of National Income (NNP at FC): Net Factor Income from Abroad (NFIA) is added to Domestic Income (NNP at FC = NDP at FC + NFIA).

• Precautions in the Production Method:

  • Items Included:
    • Imputed Rent of Owner-Occupied Houses: The value of housing services provided by owner-occupied houses is included. This ensures that the total value of housing services in an economy is captured, regardless of whether a house is rented or owner-occupied, making national income data more comparable.
    • Production for Self-Consumption: The value of goods produced for own consumption (e.g., a farmer consuming part of their crop) is included as it represents a part of the total production.
  • Items Excluded:
    • Sale and Purchase of Second-Hand Goods: These are excluded because their value was already counted in the year of their original production. However, any commission or brokerage earned in facilitating the sale is a fresh service and is included.
    • Intermediate Goods: The value of intermediate goods is not included separately to avoid the problem of double counting. Only the value added at each stage is considered.
    • Financial Transactions: The sale of bonds, shares, or other financial assets is excluded as it represents a transfer of ownership or a claim on assets, not a contribution to the current flow of goods and services.

GVA at Basic Prices

In January 2015, the Central Statistics Office (CSO), under the Ministry of Statistics and Programme Implementation, revised the methodology for national accounts. This included shifting the headline measure of economic growth from GDP at factor cost to GVA at basic prices, and subsequently GDP at market prices. This move was based on the recommendations of the United Nations System of National Accounts (SNA) 2008 to align India’s practices with global standards.

• Rationale for the Shift: The concept of GVA at basic prices is internationally considered a more accurate measure of economic output. It reflects the value added by producers before the product reaches the market and is subjected to product-specific taxes and subsidies. It provides a clearer picture of sectoral contributions to the economy from the producer’s side.
• Formulation:
  • GVA at Basic Prices = GVA at Factor Cost + Production Taxes - Production Subsidies
  • GDP at Market Prices = GVA at Basic Prices + Product Taxes - Product Subsidies
• This distinction helps policymakers analyze the impact of fiscal policy (taxes and subsidies) on production versus consumption.

Expenditure Method for National Income Calculation

The Expenditure Method calculates national income by summing up all the final expenditures made on goods and services produced within a country’s domestic territory during an accounting year. The logic is that the total value of production must equal the total expenditure on that production.

• Formula: GDP at Market Prices = C + I + G + (X - M)

• Components of Final Expenditure:

  1. Private Final Consumption Expenditure (C): Expenditure by households and non-profit institutions serving households on final goods and services. This is the largest component of GDP in most economies.
  2. Government Final Consumption Expenditure (G): Expenditure by the government on providing services such as defense, law and order, and education, as well as consumption of goods. It does not include transfer payments.
  3. Gross Domestic Capital Formation (I): This is the expenditure on investment. It has two sub-components:
     • Gross Fixed Capital Formation (GFCF): Expenditure on fixed assets like machinery, buildings, and infrastructure by businesses, government, and households.
     • Inventory Investment (Change in Stocks): The net change in the stocks of raw materials, semi-finished goods, and finished goods held by producers (Closing Stock - Opening Stock).
  4. Net Exports (NX or X-M): This represents the difference between the value of a country’s exports (X) and imports (M). Exports are added as they are produced domestically, while imports are subtracted as they are produced abroad but consumed domestically.

• Precautions in the Expenditure Method:

  • Exclude Intermediate Expenditure: To avoid double counting, expenditure on all intermediate goods and services (e.g., raw materials purchased by a factory) is excluded.
  • Exclude Transfer Payments: Government expenditure on transfer payments like scholarships, unemployment allowances, and old-age pensions is excluded because these payments do not correspond to any production of goods or services in the current period.
  • Exclude Financial Asset Purchases: Expenditure on the purchase of second-hand goods, shares, and bonds is excluded as these are transfers of existing assets and do not represent spending on currently produced goods or services.

Personal Income and National Income

These concepts distinguish between the income earned by the nation as a whole and the income actually received by individuals or households.

• National Income (NI): Typically refers to Net National Product at Factor Cost (NNP at FC). It is the sum of all factor incomes (wages, rent, interest, profit) earned by the normal residents of a country.
• Personal Income (PI): This is the total income received by individuals and households from all sources before the payment of direct taxes. It includes both factor income and transfer payments.
  • Derivation: PI = NI - Undistributed Profits - Corporate Tax - Net Interest Paid by Households + Transfer Payments from Government and Abroad
  • Undistributed Profits and Corporate Tax: These are parts of company profits (which are in NI) but are not received by households, so they are subtracted.
  • Transfer Payments: These are received by households without providing any productive service (e.g., pensions, remittances) and are therefore added to NI to get PI.
• Personal Disposable Income (PDI): This is the income that remains with individuals after the deduction of direct taxes and other miscellaneous fees and fines. It is the income available for consumption and saving.
  • Formula: PDI = PI - Personal Direct Taxes - Miscellaneous Fees & Fines
• Per Capita Income (PCI): This is the average income earned per person in a given area over a specified year. It is a key indicator of the standard of living.
  • Formula: PCI = National Income / Total Population
  • Real vs. Nominal PCI: Nominal PCI is calculated at current prices, while Real PCI is adjusted for inflation, providing a more accurate measure of purchasing power over time.
  • International Comparison: For comparing PCI across countries, the Purchasing Power Parity (PPP) method is used. PPP compares the cost of a common basket of goods and services in different countries to create an exchange rate that equalizes their purchasing power. This provides a better comparison of living standards than market exchange rates. The World Bank’s International Comparison Program (ICP) is the primary source for PPP data.

Exchange Rate Concepts

• Nominal Exchange Rate (NER): This is the rate at which the currency of one country can be exchanged for the currency of another. It is the price of a foreign currency in terms of the domestic currency (e.g., ₹80/$1). NER is determined by the forces of demand and supply in the foreign exchange market.

• Purchasing Power Parity (PPP) Exchange Rate: This is a theoretical exchange rate that would equalize the purchasing power of two currencies. It is calculated by comparing the price of an identical basket of goods and services in two different countries.

  • Formula: PPP Exchange Rate = Price of goods basket in domestic currency / Price of same goods basket in foreign currency
  • Example: If a burger costs ₹140 in India and $2intheUS,thePPPexchangerateis₹140/$2 = ₹70 per dollar.

• Real Exchange Rate (RER): This measures the relative price of goods and services of two countries and is a key determinant of a country’s trade competitiveness. It is the nominal exchange rate adjusted for relative price levels.

  • Formula: RER = NER × (Foreign Price Level / Domestic Price Level)
  • Alternatively, RER = NER / PPP Exchange Rate
  • Interpretation and Trade Competitiveness:
    • If RER > 1: It implies that foreign goods are relatively more expensive than domestic goods. This makes domestic goods more competitive, encouraging exports and discouraging imports.
    • If RER < 1: It implies that domestic goods are relatively more expensive than foreign goods. This makes domestic goods uncompetitive, discouraging exports and encouraging imports.
    • If RER = 1: A state of purchasing power parity exists for the basket of goods.

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Prelims Pointers

• GVA Formula: Value of Output - Intermediate Consumption.
• Value of Output Formula: Sales + Change in Stock.
• GVA at Basic Prices: GVA at Factor Cost + (Production Taxes - Production Subsidies).
• GDP at Market Prices: GVA at Basic Prices + (Product Taxes - Product Subsidies).
• Production Taxes: Independent of production volume (e.g., Land Revenue, Stamp Duty).
• Product Taxes: Dependent on production volume (e.g., GST, Customs Duty).
• Expenditure Method Formula: GDP at MP = C + I + G + (X - M).
• Gross Domestic Capital Formation (I): Gross Fixed Capital Formation (GFCF) + Inventory Investment.
• 2015 Methodological Change: India’s CSO (now NSO) shifted the headline growth measure from GDP at factor cost to GVA at basic prices, in line with the SNA 2008 framework.
• Inclusions in National Income: Imputed rent of owner-occupied houses, production for self-consumption, broker’s commission on second-hand goods.
• Exclusions from National Income: Sale of second-hand goods, intermediate goods, transfer payments (e.g., pensions, scholarships), sale of financial assets (shares, bonds).
• Personal Income (PI): NI - Undistributed Profits - Corporate Tax - Net Interest Paid by Households + Transfer Payments.
• Personal Disposable Income (PDI): PI - Direct Taxes.
• Purchasing Power Parity (PPP): An exchange rate that equalizes the prices of a basket of goods between countries. Used for comparing standards of living.
• Real Exchange Rate (RER): NER / PPP Exchange Rate. It determines trade competitiveness.
• An RER > 1 indicates that a country’s exports are competitive.
• An RER < 1 indicates that a country’s imports are cheaper than domestic goods.

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Mains Insights

The Significance of the Shift to GVA at Basic Prices

1. Alignment with Global Standards: The shift from Factor Cost to Basic Prices in 2015 was a crucial step to align India’s national accounting with the internationally accepted System of National Accounts (SNA) 2008. This enhances the comparability and credibility of India’s economic data globally.
2. More Accurate Measure of Production: GVA at Basic Prices provides a more realistic measure of the value added by producers. It captures the effect of production-level taxes and subsidies which directly impact producers’ costs and revenues, unlike Factor Cost which ignores them.
3. Policy Formulation: By disaggregating taxes and subsidies into ‘production’ and ‘product’ based, policymakers can better analyze the structural aspects of the economy. It helps distinguish the impact of general production-related policies (e.g., land revenue policy) from product-specific policies (e.g., GST rates).
4. Historiographical Debate: The new series, with a revised base year (2011-12), initially showed higher growth rates than the old series. This sparked a significant debate among economists, including former policymakers like Dr. Arvind Subramanian, regarding the accuracy of the new methodology and the potential overestimation of growth, which had implications for assessing economic performance and policy effectiveness.

Analyzing the Economy through the Expenditure Method

The components of GDP via the expenditure method (C + I + G + Nx) serve as a dashboard for the economy’s health and structure:

• Consumption (C): A high share of ‘C’ indicates a consumption-driven economy. While strong consumer demand is positive, if it is largely fueled by debt rather than income growth, it can create vulnerabilities. Policies like income tax cuts or direct benefit transfers aim to boost ‘C’.
• Investment (I): The share of Gross Fixed Capital Formation (GFCF) is a critical indicator of the economy’s future productive capacity. A declining investment rate signals low business confidence and can hinder long-term growth. Government initiatives like the National Infrastructure Pipeline and Production Linked Incentive (PLI) schemes are aimed at reviving the ‘I’ component.
• Government Spending (G): In a downturn, Keynesian economics advocates for increased ‘G’ to stimulate demand. However, persistently high government spending, especially on non-capital items, can lead to high fiscal deficits, inflation, and the “crowding out” of private investment.
• Net Exports (Nx): A persistent trade deficit (negative Nx) can be a strain on a country’s foreign exchange reserves and indicates a lack of international competitiveness. Policies promoting ‘Make in India’ and export diversification aim to improve the Nx balance.

GDP and Its Limitations: A Critical Perspective

While GDP is the most widely used measure of economic activity, it has significant limitations as an indicator of overall societal well-being, a crucial perspective for GS Paper I (Society) and GS Paper III (Economy).

1. Distributional Blindness: GDP and Per Capita Income are averages that mask income and wealth inequality. A country can have high GDP growth while poverty and inequality worsen. This highlights the need for supplementary indicators like the Gini coefficient.
2. Exclusion of the Informal Economy: In developing countries like India, a large informal or unorganized sector exists, whose economic contribution is not fully or accurately captured in official GDP statistics, leading to an underestimation of economic activity.
3. Environmental Cost Ignored: The conventional GDP framework does not account for the depletion of natural resources or environmental degradation caused by economic activities. In fact, activities that harm the environment (e.g., over-fishing) and subsequent remedial measures (e.g., clean-up operations) both add to GDP. This has led to the advocacy for “Green GDP” or environmental accounting.
4. Non-Monetized and Non-Market Activities: The immense value of unpaid work, particularly care work performed by women in households, is not included in GDP calculations. Similarly, barter transactions and the voluntary sector are largely excluded.
5. Quality vs. Quantity: GDP measures the quantity of production but not necessarily the quality of life. It does not reflect factors like health outcomes, educational attainment, leisure time, or political freedom, which led to the development of broader indices like the Human Development Index (HDI).

PPP vs. Nominal Exchange Rate: Understanding India’s Global Position

• Two Pictures of the Economy: India’s GDP in nominal (NER) terms positions it as the world’s 5th largest economy (as of 2023-24). However, in PPP terms, India is the 3rd largest. This discrepancy is fundamental to understanding India’s economic reality.
• Why the Difference?: The difference arises because NER is determined by trade in internationally traded goods and capital flows, while PPP accounts for the prices of a wider basket of goods and services, including non-tradables (like haircuts, local transport) which are significantly cheaper in India.
• Relevance for Policy and Perception:
  • PPP: Better reflects the domestic purchasing power of the average citizen and the actual volume of goods and services produced. It is more suitable for comparing living standards and the domestic market size across countries.
  • NER: More relevant for assessing a country’s economic power in the global financial system, its ability to import goods, and its capacity to service external debt. The choice between the two metrics influences global perceptions of India’s economic might and its role in international forums.