BUSINESS STUDIES

FORM 3 CHAPTER 5
NATIONAL INCOME
Topic objectives
a)
b)
c)
d)
Definition of terms as used in national income
a) National income/national output/national product
(i) Refers to the total value of goods and services produced in a given
country over a given period of time, usually one year.
(ii) Refers to the total income receive by the owners of the factors of
production in a given country over a given period of time, usually one
year.
b) Gross Domestic Product
(i) Refers to the total money value of all goods and services produced in a
country over a given period of time irrespective of who is producing it.
c) Net Domestic Product
(i) It is the gross domestic product less depreciation, the value of capital
consumed in production process.
d) Gross National Product
(i) Refers to the total monetary value of all goods and services produced
by citizens of a given country irrespective of whether they are
producing it in their country or other countries.
e) Net National Product
(i) It is the gross national product less depreciation, loss in value of capital
used in production process.
f) Depreciation
(i) Loss in value of capital used in production process
(ii) Allowance made for wear and tear of equipment and machines used in
the process of production
Per capita income
(i) National income attributed to one person/per heard income.
(ii) Average income per head year in a given country represented by
national income divided by the total population.
Per capita income= National income
Total population
Disposable Personal Income
(i) It is the income available for consumption by individuals or a resident of
a country after paying direct taxes to the government such as income tax.
Personal income
The sum of all income receive by a resident of a country during a given year
excluding undistributed profits, corporate taxes and national security service fund.
Transfer payments
Payment for goods and services which have been received and which are excluded
when computing national income.

The circular flow of national income in a simple two sector closed economy
KCSE 2009PP2Q4b: Using a well labeled diagram, explain the circular flow of
income in a simple two sectors close economy.
(10 marks)

Individual/Citizens/Households/People

Firms/industry/business/produces
Explanation
(i) Arrow 1: Provision of factors of production by households to firms i.e.
land, labour, capital and entrepreneurship.
(ii) Arrow 2: Payments for the rewards of factors of production i.e.
Rent, rates and royalty for land, salary, wages, commission and fees for
labour interest for capital and profit for entrepreneurship.
(iii) Arrow 3: Expenditure on goods and services produced by firms/firms buy
goods and services produced by firms.
(iv) Arrow 4: Firms/industries sell goods and services they produce to
households/individuals/people
For the above circular flow to hold/to be true, six assumptions should be made

Assumptions associated with the circular flow of income in a simple two sectors
closed economy
KCSE 2019PP1Q6b: Outline five assumptions associated with the circular flow
of income in a two sector economy. (10 marks)
(i) That there are only two sectors/players in the economy: households and
firms.
(ii) There is no government intervention/interference/ regulation in form of
taxes/subsidies/licensing.
(iii) That household spend all their income/revenue to buy all goods and
services produced by firms without making any savings, hence no surplus.
(iv) That firms spend all their revenue to pay the rewards of factors of
production hence no room for expansion/savings by firms.
(v) That the economy is closed i.e. no foreign trade/international trade in
imports and exports.
(vi) That there is no injection of income or additional investments as the
economy has fixed amount of income/money in circulation.
(vii) That all output produced by firms is purchased by households hence no
surplus.
Ways in which household contribute to the national income of a country
KCSE 2011PP1Q20: Outline four ways in which household contribute to the
national income of a country
(i) Through consumption of goods and services
(ii) Through provision of land
(iii) Through provision of labour
(iv) Through provision of capital
(v) Through provision of entrepreneurship
(vi) Through payment of taxes
Ways in which firms contribute to the national income of a country
i) Through payment of taxes.
ii) Thro payment of salaries/wages/commission/fees for labour.
iii) Though payment of profit for entrepreneurship.
iv) Through paying interest for capital.
v) Through payment of rent/royalties and rates for land.
vi) Through selling of goods and services for households.

KCSE 2014PP1Q14/KCSE 2016PP1Q18:

The following diagram represent the circular flow of income in a two sectors closed
economy.

Households

a b

Firms

Identify two factors represented by each of the following arrows labeled a and b

Arrow a:
(i) Payment for rewards of the factors of production
(ii) Sale of goods and services by firms to households
Arrow b:
(i) Provision of factors of production: land, labour, capital and
entrepreneurship
(ii) Purchase/expenditure on goods and services by households from firms

KCSE 2013PP1Q6:
The participants in a two sector economy are households and firms. Identify the
relevant participant in each of the statements below. (4 marks)
(i) Payment for goods and services Households
(ii) Sale of factors of production Households
(iii) Payment for the factors of production Firms
(iv) Selling of goods and services Firms
Leakages and injections/withdrawals in an economy

Injections
(i) These are factors that increase income in the circular flow
(ii) These are factors that bring in resources into the circular flow in an
economy.
(iii) These are resources that increase or expand the volume of the circular
flow of national income

Examples of injections: GEI

(i) Government expenditure e.g. salary and wages payed to households
(ii) Exports which are income earned from other countries
(iii) Investment which are additional resources into an economy.
Leakages/Withdrawals
(i) These are factors that reduce/contract the volume of income and
resources out for the circular flow of income.
Examples of leakages/withdrawals
(i) Savings by households-income not consumed but kept for future use
(ii) Taxes which reduce amount of income available for spending
(iii) Imports which takes resources from the domestic economy through
payment to foreigners.

Ways through which leakages of national income may happen in a four

sector economy. (4 marks)

KCSE 2020PP1Q22: State four ways through which leakages of national

income may happen in a four sector economy. (4 marks)
(i) Savings by households
(ii) Government taxes on citizens and firms
(iii) Payment for imports
(iv) Transfer payments by the government
(v) Foreign aid/grants by the government
(vi) Retained profits by firms
Injections Households Leakages
a)
b)
c)

Firms

Factors that affect the circular flow of national income

(i) Savings which refers to income not consumed by households but set
aside for future use.
(ii) Government taxes and expenditure which comprises of leakages and
injections respectively.
(iii) Investments which refers to an injection that add resources into the
economy/circular flow.
(iv) Foreign trade which involve export into the circular flow and import
from the circular flow.
Equilibrium national income
Refers to a situation where there is no tendency to change in national income as total
injection is equal to total withdrawals
In equilibrium national income:
Government Expenditure + Exports+ Investments=Savings +Taxes +Imports
Points to note:
a) G: Government Expenditure
b) X: Exports
c) I: Investments
d) S: Savings
e) T: Taxes
f) M: Imports
g) Y: National Income
Therefore: Equilibrium national income
Y:=G+X+I=S+T+M
Approaches used in measuring national income
(i) Expenditure approach
(ii) Income approach
(iii) Value added approach/output approach
The expenditure approach as used in measuring national income
Here, national income is arrived at by adding together expenditure on all final goods
and services produced in an economy.
We add:
a) Expenditure on consumer goods by the general public C
b) Expenditure on investments/capital goods I
c) Expenditure by the government G
d) Expenditure on net exports X-M
Net exports is arrived at by total exports X less total imports M
Recall that national income is denoted by Y

Therefore, National Income Y=Consumer Expenditure C + Government expenditure

G+ Expenditure on investments I+ Net Exports X-M
That is to say: Y=C+G+I+(X-M)
Question
The formulae Y=C+G+I+(X-M) is used to measure national income by the
expenditure approach. State what is represented by each of the initials below.
(3 marks)
(i) Y= National income
(ii) C= Consumer expenditure
(iii) G= Government expenditure
(iv) X= Exports
(v) M= Imports
(vi) X-M Net Exports

Problems associated with expenditure approach

(i) Inaccurate records of expenditure in the private sectors e.g. expenditure by
Kenyan citizens abroad.
(ii) Difficulty to estimate expenditure on subsistence production due to lack of
records in the sectors.
(iii) Difficulty in differentiating between final and intermediate expenditures.
(iv) Double counting problem where some items are counted twice thus
untrue/inaccurate/unreliable.
(v) Fluctuating exchange rates especially in valuation of exports and imports.
Income approach
Here national income is arrive at by adding together all incomes received by different
individuals who contribute to production of goods and services. We add the four
rewards of the factors of production.
KCSE 2017PP1Q
Highlight four items that would be included in the measurement of national income
using the income approach.
(i) Personal income by households in form of salaries and wages.
(ii) Public income from government investments in parastatals.
(iii) Undistributed profits/retained earnings.
(iv) Dividend paid out to the owners of forms.
(v) Interest paid for the use of capital.
(vi) Rent paid for the use of land
Therefore national income calculated by the income approach
=All Personal Income + Public Income + Undistributed Profits/Retained Earnings +
Dividends + Interest + Rent

Transfer payments
These are payment for which no goods or services have been received ie income
received without corresponding output in the economy.

Example of transfer payments

(i) Grants
(ii) Student pocket money
(iii) National insurance and social security benefits
Problems associate with the income approach in the measurement of national
income
(i) Difficulty to compute proportional income constituted by transfer
payments
(ii) Inadequate data as companies falsify their income date to evade tax
(iii) Price fluctuation making it difficult to determine national income due
to inflation.
(iv) Problem of handling illegal income and unrecorded economic activities
from drug trafficking, commercial sex world, poaching and corruption
(v) Difficulty of obtaining real value of income of people working abroad
(vi) Double counting problem as it is difficult to distinguish between
payment for factors and transfer payments
(vii) Existence of a large subsistence sectors in which money is not used due
to underestimation of the true vale of goods and services.
(viii)
 Reasons for disparity bin income distribution
(i) Difference in individual and personal talents
(ii) Inheritance where some inherit more income from their parents
(iii) Limited access to education
(iv) Disparity in natural resource endowment e.g. land
(v) Nepotism and tribalism used to secure jobs
(vi) Acquisition of income through illegal means like drug trafficking,
prostitution, violence and robbery

Output/value added approach

Here national income is arrived at by adding together the value of all the final goods
and services produced by firms during the year. We add up all the values added to
the final product at each state of production.

Problems associated with the output/value added approach

KCSE 2010PP2Q5B: Discuss five problems that a country may face when
measuring her national income using the output approach. (10 marks)

KCSE 2012PP1Q16: Outline four problems that may be faced when measuring
national income using output approach. (10 marks)
KCSE 2017PP2Q5B: Explain five demerits of the output approach in
measuring national income. (10 marks)
(i) Double counting problem as it is difficult to distinguish between
intermediate and finished goods.
(ii) Lack of qualified personnel to be used to value/measure output and collect
data
(iii) Problem of valuing government output/services since they are subsidized
and not paid for.
(iv) Difficulty to determine the value for depreciation due to failure to record
accurate value of capital goods/fixed assets.
(v) Inadequate finance/capital/technology/equipment which limit
computation of data.
(vi) Difficulty to determine goods and services to include and exclude like the
input of households for services paid.
(vii) Problem of valuing output in the subsistence sector as goods/services are
never priced/sold/marketed.
(viii) Inflation/price fluctuation which may cause output appreciate/deprecate in
value
(ix) Inaccurate /incomplete data leading to wrong valuation and overstatement
of national output
(x) Problem of valuing unrecorded and illegal economic activities e.g. drug
trafficking and smuggling
(xi) Difficulty to value closing stock/unsold stock as they differ with their value
at production.
National Income Statistics
It refers to data collected/computed from various places giving information about
national income.
The uses of national income statistics

KCSE2018P1Q17: Highlight four benefits of the national income statistics to the

government. (4 marks)
KCSE2015PPP2Q1a: Explain five uses of national income statistics to a country
(10 marks)

(i) Used to indicate standards of living of people in a country in terms of per

capital income
(ii) Used to compare standards of living of people in different countries as a
country with high national income is assumed to be have high standards of
living
(iii) Provide information on income contribution and distribution thus enable
the government to address disparity in income.
(iv) Help government to assess the performance of the economy such that if
the GDP goes up, then the economy is growing.
(v) Assist the government to plan the economy-for better and efficient
allocation of resources.
(vi) Help investors to make appropriate investment decisions as growth in
national income attract investors.
(vii) Used to determine/calculate per capita income by dividing national
income with total population.
(viii) Used to attract foreign donor funding when a country shows strong
economic growth.
(ix) Provide information about factor income in the economy e.g. rent from
land and salaries and wages from labour.
Drawbacks/disadvantages/demerits of using national income statistics to compare
the standards of licking in different countries

(i) Counties have different currencies and their conversion is tedious

(ii) Different countries consume different goods and services
(iii) Disparity in income distribution due to a wide gap between the rich and
the poor
(iv) Differences in needs, tastes, fashion and preference for people living in
different countries

Factors that influence the level of national income

KCSE 2006PP2Q5B: Explain five factors that may influence the level of national
income of a country. (10 marks)
KCSE2010PP1Q12: State four factors that may influence the level of national
income. (4 marks)
Influence means you discuss both positive and negative factors
(i) Political stability and good governance
This attract investor’s thus high production of goods and services and high income
while political instability scares away investors leading to low production and
income.
(ii) Level of technology
A county using high/appropriate/modern technology will produce better quality
goods and services thus high national income while a county with
poor/outdated/inappropriate technology will produce low quality goods and
services thus low income
(iii) Attitude of citizens towards work
A county with hardworking citizens with appositive attitude to work will record high
national income than a county whose citizens have negative attitude to work and are
lazy
(iv) Size of the subsistence sector
A country with large subsistence sector register low national income whole a country
with small subsistence but a large manufacturing sectors records high national
income.
(v) Foreign investments
Increased foreign investments increases the level of national income due to increased
production of goods and services while decreased foreign investments lowers the
production of goods and services thus low income.
 (vi) Labour supply
A country with skilled labour force produces high quality goods and services thus
high income while a country with unskilled labour force produces low quality goods
and services thus low income
(vii) Land/natural resources
A country with rich fertile land and more natural resource like mineral will produce
more goods and services hence high income while a country with scarce natural
resource and infertile land will produce low quality goods and services thus low
income
(viii) Capital
Availability of sufficient capital like more tools and equipment will lead to high
quality goods and services thus high income while a county with inadequate capital
will produce low quality of goods and services thus low income.

(ix) Entrepreneurship
A county with good positive entrepreneurial culture will produce high quality goods
and services thus high national income while a country with negative entrepreneurial
culture will produce low quality goods and services thus low income

Factors that may led to an increase in the national income

KCSE 2019PP1Q17: Highlight four factors that may lead to an increase in
national income. (4 marks)
KCSE 2022PP2Q2A: Explain five factors that may lead to an increase in the
level of national income of a country. (10 marks)
(i) Political stability/accountability/transparency and good governance
which leading to better use of resources
(ii) Improved infrastructure leading to efficient production and fast flow
of goods and services
(iii) Use of high/appropriate/modern technology will produce better
quality goods and services and output thus high national income
(iv) Hardworking citizens with appositive attitude to work will record high
national income
(v) A country with small/reduced subsistence sector but a large
manufacturing sectors records high national income as most of what is
produced is sold to generate income.
(vi) Increased foreign investments which increases injections to the
economy and increased production of goods and services leading to
more income
(vii) Favourable term of trade leading to increased export earnings
 (viii) A country with skilled/trained labour force produces high quality goods
and services thus high income
(ix) A country with rich fertile land and more natural resource to be
exploited for production like mineral will produce more goods and
services hence high income
(x) Availability of sufficient/adequate capital like more tools and
equipment will lead to high quality goods and services thus high income
(xi) Enhanced security that encourages foreign and local investments
(xii) Established/good/positive entrepreneurial culture which promote
effective exploitation of resources and enhanced productivity.

Factors that may led to a decrease in the national income

(i) Political instability scares away investors leading to low production and
income
(ii) A county with poor/outdated/inappropriate technology will produce
low quality goods and services thus low income
(iii) County whose citizens have negative attitude to work and are lazy
(iv) A country with large subsistence sector register low national income
(v) Decreased foreign investments lowers the production of goods and
services thus low income.
(vi) Unskilled labour force produces low quality goods and services thus
low income
(vii) Scarce natural resource and infertile land will produce low quality
goods and services thus low income
(viii) Inadequate capital will produce low quality of goods and services thus
low income
(ix) Negative entrepreneurial culture will produce low quality goods and
services thus low income
(x) Unfavourable terms of trade leading to reduced export earnings
(xi) Poor infrastructure leading to inefficient production and slow flow of
goods and services
(xii) Insecurity which reduces local and foreign investment

KCSE 2008PP1Q16: The economy of county x has grown at the rate of 10% p.a for
the last two years. However, the standards of living among citizens has not changes.
Outline four reasons that may have contributed to this trend.
(i) Economic growth could have been at the expense of peoples leisure
(ii) Use of incorrect statistics- wrong/exaggerated data
 (iii) Uneven/unequal distribution of income to only few people in the
economy
(iv) Lack of political goodwill which encourages corruption.
(v) High inflation rate which retards/lowers peoples purchasing power
(vi) Long term projects undertaken by government taking much income
(vii) High cost of living which erodes additional income earned.
(viii) Expenditure pattern by government leading to unequal economic
development
(ix) Income growth could have been obtained through strain on people’s
health due to overworking labour force
(x) Increased income could be due to detrimental economic activities like
logging
(xi) Income may have been earned through illegal business like
poaching/corruption/commercial sex work
(xii) Income earned could be used in ways that don’t benefit people directly
(xiii) High population growth may have eroded the value of income.

Reasons why an increase in per capita income may not necessary mean an
increase in the standards of living
KCSE 2009PP1Q15: Outline four reasons why an increase in per capita income
may not necessary lead to a rise in the standards of living of citizens.(4 marks)
(i) Increased income may be use to serves peoples debts
(ii) Increased income could be earned through straining/overworking
which compromises leisure time
(iii) High taxes which erodes people’s purchasing power and real value of
income.
(iv) Rise in inflation which affect people’s purchasing power.
(v) Inclusion of people who do not generate income in the calculation e.g.
the output of housewives.
(vi) Uneven distribution of income leading to high per capita figures
(vii) The per capita income is an average income arrived through mere
statistics.

WILLIAM ONYANGO ONONO

0722711428
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