Welcome to National Income!

Hey everyone! Ready to dive into one of the biggest topics in macroeconomics? This chapter is all about National Income. Think of it like a country's annual report card. It tells us how well the economy is performing.

We'll learn how economists measure a country's total production and income using tools like GDP. This is super important because it helps governments make decisions, lets us compare our economy with others, and gives us a clue about our standard of living. Don't worry if it sounds complicated; we'll break it all down step-by-step with simple examples!


Part 1: Gross Domestic Product (GDP) - The Big Picture

The Official Definition

Let's start with the big one: Gross Domestic Product (GDP). It's the most common way to measure an economy's size.

The formal definition is: The total market value of all final goods and services produced within a country during a specific period of time.

Let's break that down:

  • Total market value: We use prices (in HKD, for example) to add up all the different things produced, from bubble tea to banking services. Everything is measured in the same unit: money.
  • Final goods and services: This is super important! We only count the final product, not the parts that go into it. This is to avoid counting the same thing twice. (More on this next!)
  • Produced: GDP measures new production. A transaction involving a used car or a second-hand phone doesn't count in GDP because nothing new was created.
  • Within a country: GDP measures all production that happens inside a country's geographical borders, no matter who owns the company. This is based on the concept of Resident Producing Units (RPUs) - any individual, household, or company that produces goods/services within the country's territory. For example, the value of iPhones assembled in China is part of China's GDP, even though Apple is an American company.
  • Specific period of time: GDP is usually measured for a quarter (3 months) or a year.

Why "Final" Goods and Services? Avoiding Double Counting

Imagine a bakery sells a birthday cake for $200. To make that cake, they bought flour for $20 and sugar for $10. If we counted the value of the flour ($20), the sugar ($10), AND the final cake ($200), our total would be $230. But the value of the flour and sugar is already included in the cake's price! This is called double counting, and it would make GDP seem much bigger than it really is.

To avoid this, we can use the Value-Added Approach.

Step-by-Step Example: From Wheat to a Sandwich

Let's see how value is added at each stage of production. Value added is the market value of a firm's output minus the value of the intermediate goods it purchased from other firms.

  1. A farmer grows wheat and sells it to a miller for $3. (Value added by farmer = $3)
  2. The miller grinds the wheat into flour and sells it to a bakery for $8. (Value added by miller = $8 - $3 = $5)
  3. The bakery uses the flour to bake bread and sells it to a cafe for $15. (Value added by bakery = $15 - $8 = $7)
  4. The cafe makes a sandwich with the bread and sells it to you for $25. (Value added by cafe = $25 - $15 = $10)

The total contribution to GDP is the sum of the value added at each stage: $3 + $5 + $7 + $10 = $25. Notice this is exactly the price of the final good (the sandwich)!

Included vs. Excluded: The "Do's and Don'ts" of GDP

Getting this right is a common exam question! Here's a quick guide:

What's INCLUDED in GDP:
  • Newly produced goods and services: A new car, a haircut, a doctor's visit, a newly built apartment.
  • Services from existing assets: For example, the estimated rental value that homeowners get from living in their own homes (this is called imputed rent).
What's EXCLUDED from GDP:
  • Second-hand goods: Selling your old textbook. The transaction happens, but nothing new is produced.
  • Purely financial transactions: Buying stocks or bonds. This is just a transfer of ownership of a financial asset.
  • Transfer payments: Money from the government where no good or service is produced in return. Examples: Comprehensive Social Security Assistance (CSSA) or elderly allowances.
  • Non-marketed activities: Work that isn't paid for. Examples: A parent cooking dinner for their family, washing their own car, or volunteering. These activities have value, but it's too hard to measure.
  • Illegal activities: The "underground economy".

Quick Review: Common Mistakes to Avoid

- Mistake: Including the sale of a 5-year-old apartment in GDP.
Correction: Only the value of newly constructed properties is included. The commission earned by the property agent on the sale, however, IS included because it's a payment for a newly provided service.

- Mistake: Including government transfer payments in GDP.
Correction: Only government spending on goods and services (like building a bridge or paying a civil servant's salary) is included. Transfer payments are not.


Part 2: Three Angles, One Number - The Approaches to GDP

The Circular Flow of Income

How can we have three different ways to measure GDP? Imagine a very simple economy with just two groups: households and firms. Households buy goods and services from firms (expenditure), and in return, firms pay households for their labour and other resources (income). This creates a loop.

This simple model shows us a fundamental idea: the total value of what is produced must equal the total amount spent to buy it, which must also equal the total income earned from producing it.

Production = Expenditure = Income

This is why we have three approaches to calculate GDP!

Method 1: The Expenditure Approach (The Most Important One!)

This method calculates GDP by adding up all the spending on final goods and services in an economy. It's the most common formula you'll see.

Here's the magic formula:

$$GDP \equiv C + I + G + NX$$

Let's remember it with this mnemonic: "Consumers Invest in Government and Net eXports".

C = Private Consumption Expenditure

This is the biggest component of GDP. It's the total spending by households on goods (like food, clothes, phones) and services (like MTR rides, movies, tuition).

I = Gross Investment Expenditure

This is spending to create new capital that will produce more goods and services in the future. It includes:

  • Firms buying new machinery and equipment.
  • Construction of new buildings (factories, offices, residential apartments).
  • Changes in inventories (unsold goods). If a company produces 100 cars but only sells 90, the 10 unsold cars are counted as inventory investment.
G = Government Consumption Expenditure

This is spending by the government on goods and services. Examples: building new roads and hospitals, paying the salaries of police officers and teachers, buying new equipment for government departments.
Remember, this does NOT include transfer payments!

NX = Net Exports (Exports - Imports)

Exports (X) are goods and services produced in Hong Kong but sold to foreigners. They are part of our production, so we add them.

Imports (M) are goods and services produced abroad but bought by people in Hong Kong. This spending is already counted in C, I, or G, but since it wasn't produced here, we must subtract it.

So, Net Exports (NX) = Exports (X) - Imports (M).

Method 2: The Production (Value-Added) Approach

As we saw with the sandwich example, this approach sums up the value added by all the different industries in the economy (e.g., finance, tourism, construction). In Hong Kong, this is often called "GDP by economic activity".

Method 3: The Income Approach

This approach adds up all the income earned from producing goods and services. This includes wages for workers, rent for landowners, interest for capital owners, and profits for entrepreneurs. The syllabus says you do NOT need to know the detailed components of this approach, just that it exists and gives the same result as the other two!


Key Takeaway

No matter which of the three methods you use—expenditure, production, or income—you should get the same final GDP figure. They are just different ways of looking at the same economic activity.


Part 3: Real vs. Nominal - Is the Economy *Really* Growing?

If Hong Kong's GDP was $2 trillion last year and $2.2 trillion this year, did the economy grow by 10%? Not necessarily! What if all that increase was just because prices went up (inflation)? This is where we need to distinguish between Nominal and Real GDP.

Nominal GDP: The Price Tag Value

Nominal GDP measures the value of production using the prices from the current year (current market prices). It's a simple calculation, but it can be misleading because it includes changes in both production and prices.

Example: If HK only produces 100 cups of milk tea at $20 each in 2023, Nominal GDP is $2,000. If in 2024, it still produces 100 cups but the price rises to $22, Nominal GDP becomes $2,200. It looks like growth, but we haven't actually produced more milk tea!

Real GDP: The "Stuff" Value

Real GDP measures the value of production using the prices from a fixed base year (constant market prices). This is a much better measure of economic growth because it removes the effect of price changes and tells us if the actual quantity of goods and services has changed.

Example: Using 2023 as the base year (price = $20), the Real GDP in 2024 would still be 100 cups x $20 = $2,000. This shows there was zero real growth, which is the true picture.

Did you know? A note on Chain Volume Measures

The Census and Statistics Department in Hong Kong now uses a more advanced method called chain volume measures to calculate real GDP. It's a bit complex, but its goal is to provide a more accurate picture of real economic growth over time. You just need to know the term and its purpose; you are NOT expected to grasp the calculation method.

GDP at Market Prices vs. Factor Cost

There's one final adjustment we can make.

  • GDP at market prices is what we've been talking about—it's the value calculated using the prices you pay in stores, which often include indirect taxes (like tobacco duty).
  • GDP at factor cost measures what producers actually receive after indirect taxes are paid to the government and subsidies are received from the government.

The relationship is simple:

GDP at Factor Cost = GDP at Market Prices - Indirect Taxes + Subsidies

Example: A movie ticket costs $120 (market price). If this includes a $10 entertainment tax, the cinema only receives $110. The $110 is the factor cost.


Part 4: Beyond GDP - Other Key Stats

Per Capita GDP: Slicing the Pie

Total GDP tells us the size of the whole economic pie. But to get an idea of the standard of living, we need to know how big each person's slice is. That's Per Capita GDP.

Per Capita GDP = Total GDP / Total Population

It represents the average income per person. A country might have a huge total GDP, but if it also has a massive population, the per capita GDP might be quite low.

GDP Growth Rate: How Fast Are We Going?

This measures the percentage change in GDP from one period to the next. We are usually most interested in the Real GDP growth rate because it shows the true change in output.

Formula: $$Growth \ Rate = \frac{(GDP_{current \ year} - GDP_{previous \ year})}{GDP_{previous \ year}} \times 100\%$$

Gross National Income (GNI): Bringing the Money Home

GDP is about where production happens. But what about who earns the income?

Gross National Income (GNI) measures the total income earned by a country's residents, regardless of where they earned it.

The formula is:

GNI = GDP + Net External Primary Income Flows

Net External Primary Income Flows is just a formal name for (Income earned by residents from abroad) - (Income earned by non-residents in the domestic economy).

  • Example 1 (Inflow): A Hong Kong resident owns an apartment in London and receives rent. This income is part of the UK's GDP but Hong Kong's GNI.
  • Example 2 (Outflow): A Japanese executive works in Hong Kong for a year and sends part of her salary back to Japan. Her salary contributes to Hong Kong's GDP, but it is subtracted when calculating Hong Kong's GNI.

Think of it like this: GDP is about production within a place, GNI is about income of the people from that place.


Part 5: Is GDP Everything? Uses and Limitations

GDP and other national income statistics are incredibly useful, but they don't tell the whole story. It's crucial to understand both their strengths and weaknesses.

Why We Use National Income Statistics

  • To measure the overall performance and growth of an economy.
  • To help the government make informed policy decisions (e.g., on taxes or spending).
  • To compare the standard of living between different countries.
  • To track changes in the economy over time.

The Hidden Story: What GDP Doesn't Tell Us

GDP is a good measure of production, but it's an imperfect measure of well-being or welfare. Here's what it misses:

  • Income Distribution: Per capita GDP is an average. A country could have very high per capita GDP but also have extreme inequality, with a few super-rich people and many poor people.
  • Composition of Output: A HK$100 million increase in GDP is treated the same whether it comes from building a new school or building more weapons. The impact on social welfare is very different.
  • Non-marketed Production: All the valuable work done for free, like cooking, cleaning, childcare at home, and volunteering, is not counted.
  • The Unreported Economy: "Underground" or illegal activities are not recorded, so GDP is likely underestimated.
  • Changes in Leisure Time: If everyone starts working longer hours, GDP might go up, but people's well-being might go down due to less free time. GDP doesn't capture this trade-off.
  • Negative Externalities: GDP doesn't subtract the "bads" that can come with production, like pollution, noise, and traffic congestion. A factory might add to GDP, but the pollution it creates could harm people's health.

Problems with International Comparisons

Comparing the GDP of two countries is tricky because of:

  • Different currencies: We need to convert them using exchange rates, which can fluctuate.
  • Different price levels: A dollar might buy you more in Thailand than in Hong Kong.
  • Different statistical methods and data accuracy.
  • Different sizes of the unreported economy.

Key Takeaway

National income statistics like GDP are essential tools for understanding the economy. They give us a powerful snapshot of our economic production. However, always remember that they are not a perfect measure of happiness or overall well-being. A high GDP is good, but it's not the only thing that matters for a good society.