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Lesson Explainer: National Income Economics

In this explainer, we will learn how to identify the gross national income (GNI) and the gross domestic product (GDP) as measures of national income and how to characterize three different methods to measure them.

In economics, it is useful to have a concrete way to measure the size of a nation’s economy; different indicators are used in this respect including national income and the GDP. If we can measure the national income in a consistent way, we can use these statistics to compare the sizes of the economies of different nations, to understand the trend in economic growth, or to compare the standards of living between different countries. The structure of national income is quite complex, so it would be beneficial for us to represent the broader picture in simple terms first.

Let us start by considering a simplified economic model operated by two individuals: Nader the farmer and Samar the chef (hereinafter referred to as an island economy). Nader owns a farm where he harvests wheat, eggs, and meat, and Samar owns a kitchen where she can cook using these ingredients. One day after the harvest, Nader sells a portion of wheat, eggs, and meat to Samar for $10. Samar buys these ingredients and cooks a delicious dish with them, which she sells to Nader for $15. These economic activities are represented in the following diagram, which is known as the circular flow diagram.

Both Nader and Samar are participating in the process of production. Using his land resources (the farm) as well as his own labor, Nader produced wheat, eggs, and meat, which were sold to Samar. The wheat, eggs, and meat harvested by Nader are examples of intermediate goods and services because they are inputs for another production process. Samar uses these goods to produce a dish, which is purchased and consumed by Nader. The cooked dish is an example of final goods and services, since it has reached the end user, that is, the individual who will consume the final goods and services to satisfy their needs.

When calculating the value of the total economic activity, it might be tempting to add together the $10 that Nader charged Samar for the ingredients and the $15 that Samar charged Nader for the final meal. However, that would be double counting, which inflates the total figure. The $15 that Samar charged for the meal includes the $10 that Nader charged her for the ingredients, so this is a fair measure of the total value of the transactions.

In general, we do not consider the value of intermediate goods and services when measuring the size of an economy because their values are included in the value of the final goods and services. In other words, the total size of economic activities is given by the price of the final goods. This means that the size of the island economy is measured by the price of the cooked dish ($15), which is the final good.

While a nation’s economy is much more complex than island economy, we can also measure national income by the prices of final goods and services produced by the economy. GNI and GDP are two of the most widely used statistics that measure national income in this way.

Definition: GNI and GDP as Measures of National Income

Gross national income (GNI) measures the total income earned by a country’s nationals who are working either domestically or abroad within a given period.

Gross domestic product (GDP) measures the total income earned by (alternatively, the total market value of the final goods and services produced by) the individuals living within a nation’s physical and political borders within a given period.

Generally, the period of measurement for GDP and GNI is one year, and this period of measurement is called the fiscal year for the nation. The beginning and the ending of a fiscal year may not align with the calendar year, and its definition can vary from nation to nation. In order to unify the unit of these statistics internationally, both GDP and GNI are measured in the international monetary unit, which is the US dollar.

The distinction between these two measures lies in which goods and services are counted as a part of national income. To count toward the GDP, the goods or services must be produced within the nation’s borders regardless of who produces them. On the other hand, the GNI measures the national income by considering goods and services produced by the citizens, regardless of where they are produced. This means that GNI includes the wages of its citizens working abroad, while it excludes the goods and services produced by noncitizens, even if they are produced within the national borders. Both GNI and GDP are widely used measures of the national income.

We can use GDP or GNI to quantify a nation’s economic growth. Economic growth refers to an increase in a nation’s production of goods and services. For instance, if a nation’s GDP in 2000 and 2020 is $2 billion and $3 billion, respectively, this tells us that the total income of individuals working within the nation’s borders has increased by 50%. However, this does not necessarily mean that the output of this economy’s production has increased by 50%, since it is possible that the nation’s economy has produced the same amount of goods and services while the market prices of these goods and services have increased by 50%. In order to see whether the nation’s production level has increased, we should also consider the national income relative to the prices of goods and services during the given period. This leads to the following measures of national income.

Definition: Nominal and Real Measures of National Income

A nominal, or money, measure of national income considers the market value of the final goods and services produced in terms of the current year’s prices.

A real measure of national income considers what the value of the final goods and services would be during a certain year, which is called a reference year or base year.

In other words, real measures of national income consider the purchasing power due to the nation’s production relative to a reference point, while nominal measures only consider the current market value. Purchasing power refers to the amount of certain goods and services we can purchase using a given amount of money in an economy. For instance, if the prices of goods and services increased by 50% in 2020 compared to 2000, the amount of goods and services we could purchase with $3 billion in 2020 would be the same as what we could purchase with $2 billion in 2000. Hence, the nominal GDP of $3 billion in 2020 is equal to the real measure of the nominal GDP of $2 billion in 2000 because they have the same purchasing power. In this case, the real GDP of this nation has remained the same between 2000 and 2020, indicating that no economic growth has taken place over the 20-year period.

On the other hand, if the prices of goods and services remained the same in 2020 compared to 2000, the increase in the nation’s nominal GDP from $2 billion to $3 billion would indicate the equivalent increase in the true purchasing power due to the nation’s production. The real GDP in 2020 relative to 2000 would be $3 billion in this case, which is 50% larger than the real GDP in 2000 (which was $2 billion). This means that this nation’s economy has grown by 50% over the 20-year period. Hence, an increase in the real GDP is an indication of economic growth, and the increase in the general price level tends to adversely affect the purchasing power of money.

In the first example, we will consider the relationship between GDP and economic growth.

Example 1: Understanding the Relationship between GDP and Economic Growth

Which of the following is true about the relationship between GDP and economic growth?

  1. Decreasing prices of goods and services indicate economic growth.
  2. An increase in real GDP indicates economic growth.
  3. An increase in nominal GDP indicates economic growth.
  4. Rising prices of goods and services indicate economic growth.
  5. GDP is not an appropriate measure of economic growth.

Answer

Recall that GDP is a measure of national income, that is, the size of a nation’s economy, which represents the total income earned by the individuals living within a nation’s physical and political borders within a given period. We also recall that the measures of national income are divided into the nominal measure (the current market value of final goods and services) and the real measure (the equivalent purchasing power of national income in a reference point economy).

Economic growth refers to an increase in the nation’s production of goods and services from year to year. Let us consider which of the given options is a true statement about GDP and economic growth.

  1. Decreasing prices of goods and services do not tell us anything about the change in output of a nation’s production. This means that they are not an indicator of economic growth, so this is not a true statement about the relationship between GDP and economic growth.
  2. An increase in real GDP indicates that the purchasing power of national income has increased compared to a past year. This means that the nation’s economy produced more goods and services compared to the past, which indicates economic growth. Hence, this is a true statement.
  3. An increase in nominal GDP indicates that the total market value of final goods and services has increased over time. While this may be due to increased production, it can also be due to the rising prices of goods and services. It is possible that the increase in nominal GDP is entirely due to higher prices in the market place rather than more goods and services being produced. Hence, this is not a true statement about the relationship between GDP and economic growth.
  4. Rising prices of goods and services do not indicate an increased output of a nation’s production. Hence, this is not a true statement about the relationship between GDP and economic growth.
  5. GDP measures the output of a nation’s production in monetary units. Since economic growth refers to an increase in the output of production, GDP is a good measure of economic growth. In order to adjust for the fluctuation of market value, we need to consider the real measure rather than the nominal measure of GDP. Hence, this is not a true statement about the relationship between GDP and economic growth.

Option B, which gives an increase in real GDP as an indicator of economic growth, is a true statement.

So far, we have discussed how GDP and GNI are used as measures of the size of a nation’s economy. Let us turn our focus to the three different approaches used to establish these measures: output approach, income approach, and expenditure approach. To better understand how these different approaches can lead to an equivalent measure of national income, we will return to the island economy introduced earlier, which is operated by Nader and Samar.

The output approach, or the product approach, represents the national income by considering the market value of goods and services produced in the economy. When using the output approach, we should take care not to count the value of the same product twice. In this island economy, Nader produces wheat, eggs, and meat, while Samar consumes these resources to produce the cooked dish. The market value of the output of Nader’s production is $10, while the market value of the output of Samar’s production is $15. However, if we add up both of these prices, we would be counting the output of Nader’s production twice, since this value is included in the value of the cooked dish.

One way to solve this problem is simply to count the value of the final good, which is the cooked dish. While this simplified approach works for the island economy, it can be much trickier to calculate in a larger economy. For instance, consider a factory that builds cars using parts that are produced in a different country. The final market value of cars produced by that factory includes the market value of the car parts, which is not a constituent of the national income.

To overcome this hindrance, it is beneficial to break down the production process into smaller stages and consider the value added from each stage. The value added approach considers the difference in the market value of goods before and after each production stage. In the island economy, the value added from Nader’s production stage is $10, since he has farmed these goods from the factors of production he owns. Since Samar uses the resources that are worth $10 to produce the cooked dish, which is worth $15, the value added from Samar’s production stage is given by marketvalueofthecookeddishmarketvalueoftheingredients=$15$10=$5.

Hence, the total value added from all stages of production in this island economy is given by valueaddedbyNadervalueaddedbySamar+=$10+$5=$15.

We note that the value added approach leads to the same total as the market value of the final goods. This approach has the added benefit of breaking down each stage of production, which allows us to exclude production stages that occur outside the nation’s economy. According to this approach, we can define the national product, which refers to the total productive contribution of the different projects in a certain economy during the fiscal year.

Let us consider the income approach, which measures national income by considering the total amount of income earned as a compensation for the different factors of production in the economy. Recall the circular flow diagram of our island economy.

In the island economy, Nader earned $10 from selling his goods to Samar. On the other hand, Samar received $15 for her cooked dish, but $10 of the payment was spent on the ingredients, which means that she earned $5 from her good. Based on the income approach, the island’s income is given by NadersincomeSamarsincome+=$10+$5=$15, which gives the same value as the output approach. While this model of island economy gives a simplistic view of the income approach, this is not how economists view this approach.

To understand an economist’s view of the income approach, we need to consider a different model of the national economy involving two participants: a household and a firm. In economics, a household is a group of one or more individuals who own the factors of production, and a firm is an organization that produces new goods and services by employing the factors of production owned by the households. Hence, we can think of households and firms to be two different types of economic entities where households supply all factors of production for the firms in the economy as well as being the owners of the firms. We can draw the following circular flow diagram.

This diagram certainly resembles that of the island economy, but the main difference is that the firms in this circular flow diagram are not individuals, but they are owned by the households. Hence, the firms do not have their own income, and any profit made by the firms would go to their owners, who belong to households.

In order to make an explicit analogy between the island economy and this model, we should consider both Nader and Samar to be members of a household (or two households), while the firm in this economy is the restaurant producing the cooked dish. Nader provides land factors, in the form of ingredients, and Samar provides a labor factor. Furthermore, we need to assume that the restaurant is owned by the households.

At the top of the diagram, goods and services produced by the firm are transferred to the household in exchange for the financial compensation called consumer spending. Consumer spending represents the market value of final goods and services, since the household is considered to be the end user of the goods and services. Using the output approach, we can measure the size of a nation’s economy by considering the monetary value of consumer spending, if all of the factors of production involved in the production of the goods and services originated from the nation’s economy.

At the bottom of the diagram, the financial compensation received by households providing factors of production are called factor payments, or factor incomes. Recall that there are three types of factors of production: land, labor, and capital. Payments received for providing any of these resources are factor payments. We can categorize factor payments into rent, wage, interest, and profit. While these are commonly used terms in English, in the context of factor payments, rent, wage, and interest refer to the payments received for providing land, labor, and capital resources respectively. On the other hand, profit is a factor payment for entrepreneurship, which is the utilization of the three factors of production for the production of goods and services. Some references consider entrepreneurship as the fourth factor of production.

Let us demonstrate these terms in the context of the island economy, where Nader and Samar form the households and the restaurant is a firm owned by the households. To complete this picture, we need to add the financial compensation for Samar’s labor factor of production. Say that Samar is paid $3 for her labor by the firm. Then, the profit made by the firm is given by priceofthecookeddishcostoftheingredientscostofthelabor=$15$10$3=$15.

Since the households are the owners of this firm, the profit of $2 is given to them as a factor payment for entrepreneurship. Adding to the factor payments of $10 for Nader’s ingredients and $3 for Samar’s labor, the total income of the households is given by factorpaymentfortheingredientsfactorpaymentforlaborfactorpaymentforprot++=$10+$3+$2=$15.

The factor payments add up to $15 in the island economy, which is the size of this economy according to the income approach. We note that this is the same value as what we obtained using the output approach. The difference between the output and income approaches lies in the position in the circular flow diagram where we measure the economy. In the following diagram, we can see where the output approach and the income approach measure the economy of the island.

Economists view the income approach to calculating national income as measuring the total market value of factors of production offered by the households during the production process. In other words, the constituents of national income according to the income approach are rent, wage, interest, and profit, which are the factor payments.

When considering the income approach to calculating national income, we should be careful to exclude payments that are not related to the production of new goods and services. Transfer payments are payments that are not made in return (or exchange) for the production of new goods and services. In general, transfer payments refer to the government payments to certain individuals with the objective of achieving equity. They are called transfer payments since the government transfers its revenue from taxes, fines, and fees to make these payments. For instance, a government may provide payments to disabled individuals who have difficulty finding work. Since such payments do not directly lead to the production of new goods or services, they are considered to be transfer payments.

Also, the income approach to calculating national income excludes capital gains, which is the increased income of an individual due to the appreciation (i.e., increased value) of this individual’s physical or financial assets. For instance, if a person sells a house at a higher price than the original purchase price, the income generated by such a sale is considered capital gains, and it does not count toward the national income when using the income approach.

In our next example, we will identify examples of transfer payments.

Example 2: Understanding Transfer Payments

Which of the following are not an example of transfer payments?

  1. Unemployment payments
  2. Subsidies for farmers
  3. Food stamps
  4. Housing subsidies

Answer

Recall that transfer payments are financial transactions that do not lead to production of new goods or services. In general, transfer payments are payments that are not made in return (or exchange) for the production of new goods and services. Hence, we need to identify which of the listed options will lead to the production of new goods and services.

  1. Unemployment payments are payments made by the government to aid individuals who are not currently employed. These payments are made to achieve equity in the society, and they do not lead to production of new goods or services. Hence, this is an example of transfer payments.
  2. Subsidies are grants from the government intended for specific groups. In this instance, the subsidy is intended for farmers. A subsidy for farmers would be made on the condition that the capital is used specifically to pay for farming costs. Since these payments will aid in the production of farmed goods, this is not an example of transfer payments.
  3. Food stamps are indirect payments made by the government to aid individuals in poverty in purchasing food. These payments are not made in return (or exchange) for the production of new goods and services but they are intended to achieve equity in the society. Hence, this is an example of transfer payments.
  4. Housing subsidies are generally intended to aid individuals in poverty in obtaining a place to live. This subsidy exists to achieve equity in a society; It is not made in return (or exchange) for the production of new goods and services. Hence, this is an example of transfer payments.

Option B, subsidies for farmers, is not an example of transfer payments.

Now that we understand how to measure national income using the output approach and the income approach, let us consider another approach to measuring national income. The expenditure approach measures national income by considering the expenses incurred in the economy. Let us begin by considering the simpler version of the island economy from earlier.

In this economy, we could say that $10 is the expense incurred by Samar to purchase the ingredients, and $15 is the expense incurred by Nader to purchase the cooked dish. However, this creates a problem, similar to the one in the output approach, of double counting the expense of the ingredients. In order to accurately account for the total expenditure in this economy, we need to exclude the cost of the ingredients. To put this in economic terms, recall that the circulating capital is a capital resource that is consumed after one usage. Hence, the expenditure approach to calculating national income excludes a firm’s expenditure on circulating capital. Hence, in the island economy, only Nader’s expense for purchasing the cooked dish, which is a final good, is considered in the expenditure approach.

We can highlight the distinction between the three approaches by noting where in the circular flow diagram we are evaluating the national income. Using the output approach, we can measure the size of the economy to be $15 from the point of view of the firm (restaurant) producing the final good. Using the income approach, we can measure the economy to be $15 by summing up all factor payments involved in the production process. Finally, using the expenditure approach, we obtain the expenditure of $15 from Nader, the end user of this good.

The following diagram summarizes these approaches to measuring national income within the circular diagram of the island economy.

This distinction is very important, because it necessitates that we include all participants of the economy who have incurred expenditure. When considering the income approach, we defined a household and a firm to be two participants of a national economy. To fully account for national income using the expenditure approach, we need to also consider the government as a participant. In the expenditure approach, we can define the components of national income as consumer spending, government expenditure, investment, and net exports, whose total gives the value of the GDP using this approach. Let us discuss what is included in each of these components.

Consumer spending, which is the largest component of GDP in the expenditure approach, represents the market value of final goods and services that are purchased by its consumers, or the households. The households’ consumption of purchased goods and services to satisfy their needs is called private consumption. In other words, consumer spending is the expenditure of the households for private consumption. For technical reasons, consumers’ purchases of new houses do not belong to this category of expenditure, while the expenditure on existing houses such as rent and utility payments is considered to be consumer spending.

A difficulty in measuring consumption is caused by the distinction between durable and nondurable goods. Nondurable goods either are immediately consumed after one usage or have short life spans (three years or less). For instance, an apple is a nondurable good since it is consumed when an individual eats it. On the other hand, durable goods can stand repeated usage over a long period (three years or more). For instance, cars or televisions typically have a long life span, so there is a large gap between the time of purchasing and the time of consumption for durable goods. To overcome this discrepancy, consumption is measured when the goods are purchased, rather than when they are consumed.

Government spending is the expenditure incurred by the government to produce goods and services that benefit the society as a whole, rather than individuals. The satisfaction of needs from such goods and services is called public consumption. Examples of government spending are government-funded healthcare, a public education system, and subsidies to farmers.

In the context of the expenditure approach to measuring national income, investment refers to expenses incurred by a firm or the private sector to obtain fixed capital in order to add to the country’s productive capacities in the future. Recall that fixed capital is a capital resource, such as factory machinery, that can be used more than once in the production process. While circulating capital, like the ingredients for a cooked dish, does not count in the expenditure approach, the cost for purchasing fixed capital such as factory machinery does. Additionally, purchases of inventory items, that will be used in the future count as investment. Through investments, the economy allocates a part of its present expenses in order to accumulate fixed capital, which leads to an increased productive capacity in the future. While purchases of new houses are technically expenditures of households, they belong in the investment category.

Lastly, net exports refer to the difference between the values of exported and imported goods and services. When the value of net exports is positive, it means that the total market value of exports is greater than that of imports, which is called trade surplus. The opposite scenario, when the value of net exports is negative, is called trade deficit.

Using the expenditure approach, the national income is given by consumerspendinggovernmentspendinginvestmentnetexports+++.

In this expression, the first two terms, consumer and government spending, are called consumption, while the last two terms, investment and net exports, are called saving. In other words, saving represents the part of the national income that is not spent on the consumption of goods and services. This simplifies the expression for national income in the expenditure approach to be nationalincomeconsumptionsaving=+.

In the next example, we will identify the constituents of national income using the expenditure approach.

Example 3: Measuring GNI using the Expenditure Approach

Which of the following should not be included when measuring GNI using the expenditure approach?

  1. The cost of purchasing a new car
  2. The value of exported goods
  3. The cost of purchasing machinery in a factory
  4. The cost of raw materials used to produce goods
  5. Government expenditure for constructing a bridge

Answer

Recall that GNI, or gross national income, measures the total income earned by a country’s nationals who are working either domestically or abroad within a given period. GNI can be measured using the output, income, or expenditure approaches. In particular, the expenditure approach measures GNI by considering the expenses incurred by households, firms, and governments in the economy. We also recall that the expenditure approach divides GNI into consumer spending, government spending, investment, and net exports.

Let us examine each option to determine whether they should count toward GNI using the expenditure approach.

  1. The cost of purchasing a new car is an example of consumer spending, since it is the cost incurred by a consumer to satisfy their needs. Consumer spending is a component of GNI in the expenditure approach.
  2. Recall that net exports is a category of GNI in the expenditure approach, which represents the difference in the total values of exported and imported goods and services. Hence, the value of exported goods is included in the net exports category of the expenditure approach to calculating GNI.
  3. Recall that investment is an expenditure provided to obtain fixed capital that can be used multiple times in the production process. Hence, the cost of purchasing machinery, which is a fixed capital, is an example of investment, which is a category of GNI in the expenditure approach.
  4. Raw material is circulating capital that is consumed after the production of one good or service. Recall that the expenditure incurred by circulating capital is not included in GNI because it would lead to the double counting of its value. This cost is already reflected in the market value of the final good. Hence, raw material is not included in the computation of GNI.
  5. Government expenditure to construct a bridge is an example of an expense incurred by the government for public consumption. This is an example of government spending, which is a category of GNI under the expenditure approach.

Option D, the cost of raw materials, should not be included when calculating GNI using the expenditure approach.

In the next question, we will compare different approaches to calculating GNI.

Example 4: Understanding Different Measures of GNI

Which of the following methods measures GNI by considering the value added?

  1. Income
  2. Cash
  3. Output
  4. Expenditure

Answer

Recall that GNI, or gross national income, measures the total income earned by a country’s nationals who are working either domestically or abroad within a given period. Output, income, and expenditure approaches are three different approaches to calculating GNI. Let us consider their definitions.

  • The output approach measures the national income by considering the market value of final goods and services produced in the economy.
  • The income approach measures the national income by considering the total amount of money earned by individuals in the economy by participating in the production process.
  • The expenditure measures the national income by considering the expenses incurred by the households, firms, and governments in the economy.

In particular, recall that the output approach, or the product approach, represents GNI by considering the market value of goods and services produced in the economy.

When using the output approach to compute a nation’s GNI, we need to break down the production into smaller stages, which is achieved by using the value-added approach. The value added from a production stage is the difference in market value between the inputs and outputs of the stage of production. For instance, if a factory manufactures a good valued at $100 by using $70 worth of materials, then the value added by the factory’s production stage is $100$70=$30.

The value-added process is used when calculating a nation’s GNI in order to exclude the production stages that are not due to the citizens. If the parts are manufactured by foreign nationals, we can simply exclude the value added by that specific stage of production.

Hence, option C, output approach, measures GNI by considering the value added.

We mentioned that the measures of national income can be used to measure economic growth. Another usage of these statistics is to compare the standards of living in different countries. While we can use GDP to compare standards of living, there are a few precautions we should take when doing so. Firstly, GDP only gives financial measures of a nation’s economy. So, any comparison made using GDP will only be relevant from a financial perspective. Other qualitative aspects of standards of living cannot be captured purely by considering the GDP of a country.

We also need to be aware that market values of goods and services can widely vary between different countries. In order to make an accurate comparison of standards of living in different countries, we need to consider the true purchasing power of the national income rather than simply considering the market value of goods and services in the respective countries. Hence, the real measure of national income should be used rather than the nominal measure.

Lastly, the size of a nation’s economy can vary depending on its population. Comparing the sheer size of the economic output of a large country such as China to a country with a much smaller population would not be useful in comparing their standards of living. In this case, the levels of GDP will not be a fair comparison in regard to the level of production per individual in each country. If we are interested in making economic comparisons of standards of living using GDP, we need to compute the average income of individuals in the country. This leads to the following measure.

Definition: Per Capita Measures of National Income

The per capita measure of national income represents the total national income averaged over the number of individuals in the nation. This is given by percapitanationalincomenationalincomeduringagivenperiodpopulationofthenationduringtheperiod=.

For instance, if a country with a population of 10 million individuals has nominal GDP of $20 billion in a certain year, the per capita nominal GDP is given by $2000000000010000000=$2000/.individualsindividual

This means that, on average, an individual in that nation has produced goods and services with a total market value of $2‎ ‎000. Hence, per capita GDP or GNI is a good indicator that can be used to compare the financial aspects involved in standards of living in different countries. A larger per capita income indicates a larger average income. As always, when making comparisons between nations, we should use the real values, rather than the nominal values, so that we make a like-for-like comparison of spending powers.

In our final example, we will compare standards of living in different countries using GDP.

Example 5: GDP and Standards of Living

Country A with a population of 20 million has a nominal GDP of 500 billion dollars, and country B with a population of 1 million has a nominal GDP of 100 billion dollars. Assuming that the prices of goods and services in these countries are similar, what can we conclude about the standards of living in these two countries?

  1. Country A has higher standards of living than country B because it has a higher real GDP.
  2. Country A has higher standards of living than country B because it has a higher nominal GDP.
  3. Country B has higher standards of living than country A because it has a higher real GDP per capita.
  4. Country B has higher standards of living than country A because it has a higher nominal GDP per capita.

Answer

Recall that GDP measures the total income earned by the individuals living within a nation’s physical and political borders within a given period. We also recall that the nominal measure of GDP considers the current market value of the final goods and services, while the real measure considers the equivalent purchasing power of the GDP in a reference point economy.

Since we are given the nominal GDP of the two countries, we need to first convert these statistics into the corresponding real measures. To find the real GDP of the two countries, we will need to choose a reference point economy and compare their prices of goods and services. However, since we are given that the prices of goods and services in these two countries are similar, we can assume that the true purchasing power of $1 in both countries is the same. Using one of these two countries as the reference point economy, we can effectively say that the real GDP of countries A and B are, respectively, $500 billion and $100 billion.

We also need to consider a nation’s population when comparing standards of living. Recall that per capita measures of national income represent the average income of an individual due to their participation in the production process. This can be computed by percapitarealGDPrealGDPpopulationofthenation=.

Let us compute the per capita real GDP of these two nations. For country A, we have realGDPofcountryApopulationofcountryAindividualsindividual=$500000000000$20000000=$25000/.

Hence, the per capita real GDP of country A is $25‎ ‎000/individual. This means that the average purchasing power of an individual due to the income earned during this year is $25‎ ‎000. Let us now consider this statistic for country B: realGDPofcountryBpopulationofcountryBindividualsindividual=$100000000000$1000000=$100000/.

Hence, the per capita real GDP of country B is $100‎ ‎000/individual. This means that the average purchasing power of an individual in country B is 4 times higher than that of an individual in country A, which indicates higher standards of living, financially, for country B.

Options C and D both correctly state that country B has higher standards of living than country A. However, the reason given in option D is not accurate in general, since standard of living comparisons should use the real GDP per capita figures since they represent the true purchasing power of the income.

Hence, option C, which states that country B has higher standards of living due to per capita real GDP is correct.

Let us finish by recapping a few important concepts from this explainer.

Key Points

  • National income can be measured by the total market value of the final goods and services produced by a nation’s economy.
    • Gross national income (GNI) measures the total income earned by a country’s nationals who are working either domestically or abroad within a given period.
    • Gross domestic product (GDP) measures the total income earned by the individuals living within a nation’s physical and political borders within a given period.
  • The nominal, or money, measure of national income considers the current market value of the final goods and services produced in a nation in a given period. The real measure considers the purchasing power of the national income in a certain year, called a reference year.
  • An increase in a nation’s real GDP/GNI is an indicator of economic growth.
  • There are three approaches to calculating national income.
    • The output approach measures the national income by considering the market value of the final goods and services produced in the economy. To exclude components of production from foreign economies, we use the value added approach when using the output approach.
    • The income approach measures national income by considering the total amount of money earned by individuals in the economy by participating in the production process. In the income approach, the components of national income are called factor payments, which are rent, wages, interest, and profit. Transfer payments and capital gains are excluded in the income approach.
    • The expenditure approach measures national income by considering the expenses incurred by the households, firms, and governments in the economy. In the expenditure approach, the components of national income are consumer and government expenditure (consumption), as well as investment and net exports (saving). This leads to nationalincomeconsumptionsaving=+.
  • The per capita measure of national income represents the total national income averaged over the number of individuals in the nation. This is given by percapitanationalincomenationalincomeduringagivenperiodpopulationofthenationduringtheperiod=.
  • Per capita real GDP can be used to make a comparison of economic standards of living in different countries.

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