Managerial Economics

MANAGERIAL ECONOMICS ME 601

PROJECT PAPER

STUDENT NAME: MARK MISOMALI

STUDENT ID: 24ELI-11765

INTAKE AND VENUE: EVENING 24, LILONGWE

LECTURER’S NAME: L.P. SOOLI

DATE SUBMITTED: MARCH 09, 2012

Table of ContentsIntroduction.................................................................................................................................................3

Background of the Project.......................................................................................................................3

Basic Concepts and Definitions....................................................................................................................4

Nominal and Real GDP........................................................................................................................4

Uses of National Income Statistics...............................................................................................................5

Income Distribution.....................................................................................................................................6

Measurement of National Income...............................................................................................................7

The Product (or Output) method.............................................................................................................7

The Income method................................................................................................................................7

The Expenditure method.........................................................................................................................7

Circular flow of Income...............................................................................................................................9

Problems of measuring National Income..................................................................................................10

Improving measurement of National Income............................................................................................12

Conclusion...............................................................................................................................................14

References..............................................................................................................................................15

THE CONCEPT OF NATIONAL INCOME

Introduction

According to J.M. Keynes, National Income is the monetary value of goods and services

produced in a country during a year. It includes those goods and services whose value

can be expressed in monetary terms. National Income refers to the monetary value of

economic activities in a country. The goods and services included are those that can

add value or contribute to the stock of the national capital. National income is an

important concept because it is the basis of measuring whether the economy is doing

well or poorly.

Background of the Project

Governments’ understanding of the country’s economic performance is vital for planning

and decision making. Governments use National Income figures to determine the level

of economic development, asses the level of supply and demand and decide on

production plans, understand how the income is distributed among the population,

formulate economic policies, know the composition of national income in various sectors

of the economy, measure the living standards of people, and many more.

This paper has been written to fulfill the requirements of Managerial Economics module

of an Executive MBA program with ESAMI. The paper will discuss the general concept

of National Income and outline how Governments can improve the measurements of

National Income especially to accommodate the activities of the informal sector.

Basic Concepts and Definitions

National Income is basically the income of a country for a particular period, usually a

year. Just as firms need to know how well they are doing, so does a country. The most

frequently used economic indicators when assessing status of economy are Gross

National Product (GNP) and Gross Domestic Product (GDP), which are explained

below.

Gross National Product

This is the total sum of final goods and services produced by people of a country in a

year. It includes income that nationals earn from abroad and exclude income that

foreigners earn in the country. GNP measures the capacity of the nationals to grow and

produce

Gross Domestic Product

This is a measure of the total market value of all final goods and services produced

within a country in a year. It includes income earned in the country by foreigners and

excludes income earned abroad by nationals. GDP is a measure of the capacity of the

economy.

Nominal and Real GDP

Nominal GDP is GDP evaluated at current market price. When there is inflation, nominal

GDP can rise when actually there is no corresponding upward movement in the goods

and services provided. To avoid this distortion, real GDP is used. Real GDP is GDP

evaluated at market price of some base year. To obtain the real GDP, the current GDP

is divided by a price index, also known as a deflator.

Uses of National Income Statistics

Indicator of standards of living

The GNP and GDP statistics are used to measure the living standards of the people in a

country. GNP/GDP per capita is calculated by dividing the GNP/GDP by the population

of the country. A higher figure indicates a higher standard of living and vice versa.

Comparison of the level of economic activities between countries

The GDP figure is usually used to compare economic status of different countries

Assessing sector contribution of the economy

National income figures are used to calculate the contribution from each sector of the

economy. This is very helpful to establish the relationship between the various sectors

of the economy

Assist Governments to manage the economy

The national income figures are used to view development overtime and are a basis to

compare output of the nation from year to year

To analyze distribution of income

Governments are interested to know how the wealth is distributed among various

groups of the population to assist in its planning for social services and taxation policies.

Income Distribution

The overall figure of National Income makes more sense when it is related to the

population size of the economy. The total National Income divided by the population

gives National Income per capita. This is an indication of the wealth and development of

a nation. In a real economy, wealth is not distributed fairly among the people or groups

of people. The per capita figure does not show the distribution of the income in the

economy. The Lorenz curve is used to show the distribution of income in the economy

and the degree of income inequality is measured through the Gini Coefficient. Below is

a diagram of the Lorenz curve for a given income distribution:-

Sample Income Distribution Table

Cumulative % Cumulative % of population of National Income15 3 20 525 8 C45 1760 2275 45100 100

A B

DIAGRAM OF THE LORENZ CURVE

Because income is not evenly distributed the Lorenz curve does not lie along the

diagonal. The area between the Lorenz curve and the diagonal line indicates the level of

income distribution. The further away the Lorenz curve is from the diagonal line the

greater the inequality of income distribution. The overall inequality in income is

calculated by dividing the area between the Lorenz curve and the diagonal by the area

of the triangle ABC.

Measurement of National Income

There are three methods of measuring National income: - product, income, and

expenditure approaches.

The Product (or Output) method

This method is based on the idea that the output of an economy is the sum of goods

and services produced by the various industries. This method approaches the National

income from the output side where the net value of production from the industry or

sector of economy is added together. The industries could be mining, agriculture,

fishing, construction etc. Since output from one industry can be used by another

industry, not all the outputs are measured but instead only the final products are

measured to avoid double counting

The Income method

This method is based on the idea that the income of producers is actually the market

value of their products since they are paid for what they have produced. This approach

looks at income as payment for the factors of production; rent for land, wages for labour,

profit for capital. This method is useful in giving indications of how income is distributed

among different income groups.

The Expenditure method

This is based on the idea that for every product sold, there is a buyer for the product. If

products are sold and bought within a country, then the sum of expenditures must equal

the value of goods and services produced. This approach calculates national income by

adding up all the expenditures made on goods and services. It looks at all types of

expenditures by households, private sector and public sector. These expenditures are

grouped under

Personal Consumption – expenditures by individual households denoted by “C”.

Private Expenditure – Investment by private business enterprises, denoted by “I”.

Government expenditure – Government purchases denoted by “G”.

Expenditure by foreigners – Exports minus imports (net exports) denoted by

“NX”.

Therefore GDP = C+I+G+NX

Circular flow of Income

From the preceding discussion, National Income can be viewed from three perspectives

of Income, output, and Expenditure. This implies that we can view national income as

total sum of income received, or total sum of goods and services produced, or total

expenditure on goods and services within a year. In a closed economy, where no

external forces exist, income must equal expenditure because every transaction has a

buyer and a seller, and therefore, expenditure by a buyer is income for a seller. Circular

flow of income is a diagrammatic representation of flow of income in an economy.

According to a two-sector economy, there are only two sectors of the economy;

households as buyers and firms as producers of goods and services. Below is a circular

flow of income in a two-sector economy:-

Spending

Revenue

Goods & services sold Goods & services bought

Inputs for Production Labour, Land Capital

Wages, Rent Income Profit

THE CIRCULAR-FLOW DIAGRAM

Market for Goods and Services

Market for Factors of Production

Households

Firms

Problems of measuring National Income

Reliability of statistics

National income figures come from what is recorded. Not all entities are capable of

keeping accurate records. Other transactions are poorly recorded or not recorded at all.

Problems of double counting

National Income includes only final goods and services. In some cases it is difficult to

determine which is a final good or service. Many times it depends on the use of such

services or goods

Non-monetary services

National Income only includes the goods and services with monetary value. There are

other equally economically valuable services such as child care, subsistence farming,

and services of a house wife which may not be included in the National accounts figure.

Informal trade

There are considerable volume of goods and services which occur through informal

trade. These are not included in the national income figures.

The informal sector is defined as that part of economy which is not taxed or monitored

by Governments. The regular data collection system of Governments does not cover

the informal sector. The informal sector is poorly organized, with unclear production

operations. The sector is mostly composed of units who deliberately avoid the

established systems of business dealings to avoid taxes, or persecution if they are

involved in illegal business.

Wages and salaries in kind

Some payments are made in kind for services and goods offered. Some goods are

exchanged for other goods in barter type of trading. It is difficult for the national income

to capture such kind of payments

Lack of common method of measurement

Different countries use different methods thereby making it difficult to have a fair

comparison of the performance of different countries

Figures may not always mean real economic growth

If there is a war in a country, defense expenses may lead to huge Government

expenditure thereby misleading users by giving a high national income figure.

The Government can easily manipulate the national income figures

In order to win donor confidence or in its own interest, Government can manipulate the

figures.

Improving measurement of National Income

Various stakeholders including investors and international donors rely to a great extent

on the national income figures to make economic or investment decisions. Quality of the

national income figures is therefore of paramount importance. Governments must

therefore find ways of overcoming the difficulties encountered in the measurement of

national income, including how to account for activities of the informal sector.

In this chapter I will discuss some of the ways Governments can implement in order to

improve the measurement of national income, especially to accommodate the activities

of the informal sector

Addressing problem of unemployment

Most people engage in informal business due to unavailability of proper employment. If

Government can address unemployment problems they can absorb some of these

people into decent and proper employment. Addressing the problem of unemployment

requires Governments to have clear employment policies in their national strategies.

Review fiscal policies

Some of the taxes and levies are just unreasonable to scare many businesses.

Governments should review its tax policy so that it is fair and reasonable. The review

should include an examination of processes and procedures which firms and individuals

are required to follow. Some requirements are just too cumbersome or too involving to

encourage businesses and individuals to evade the system.

Strengthen governance structures

Some of the informal sector business is encouraged by weak governance systems.

When Government has proper systems which are followed by its public servants, an

atmosphere of trust can be created between Government and informal sector and it will

be easy for the informal sector to abide by Government regulations including keeping of

proper records and submitting required regulatory reports and returns.

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Civic Education

Government should put in place sustainable civic and awareness programs to educate

the citizens. Citizens should appreciate that Government initiatives to provide social and

welfare services can be hampered if it does not have reliable national income figures to

determine the needs of the country.

Improve Government Data Collection system

Government should come up with a strategy to target the informal sector in its data

collection efforts. This may require training existing personnel or hiring new staff, and

acquiring modern data collection tools.

Integrating the informal sector

Government can explore ways of incorporating the informal sector into formal sector.

This may be challenging because not all informal sector business is legal and can be

integrated. The other challenge is getting information about the informal sector because

some of the transactions are invisible. All the same, a careful research into the informal

sector can provide opportunity for Government to consider integrating some of the

operations into formal sector.

Conclusion

National income is the best measure of the wealth of nations. Although, there are

challenges in measurement of national income, governments and other stakeholders

use national income figures as a basis for assessing and formulating policies about

economic development.

The increasing volume of trade in the informal sector cannot be ignored and makes it

imperative for governments to come up with strategies to accommodate the informal

sector in order to improve the measurement of national income.

References1. Harcourt College publishers, Measuring National Income

2. Wikipedia, Measures of National Income, February 12, 2012

Managerial Economics

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