Topic 2: Output, Income and Depreciation


We have seen how the level of output can be viewed as the flow of returns off the economy's stock of human and physical capital. Physical capital, it will be recalled, consists of machinery, buildings, land, inventories, clothing, and so forth. Human capital consists of the whole range of human skills and human knowledge possessed by the population as well as such things as work habits, attitude, etc. It is important to note here that the total output flow is the output of final goods---intermediate goods are simply inputs into the process of producing the goods that are ultimately consumed or added to the capital stock.

Embedded in this human capital is what might be called the stock of knowledge and technology---an understanding of how the world works and of how to produce goods and services using the mix of human and physical capital available to the community. This knowledge must be possessed by, or accessible to, somebody in the economy to be treated as part of the communities' capital stock.

Most components of the capital stock have a tendency to wear out with the passage of time. This is obvious with respect to your clothes or your car---clothes wear thin and tear, and cars rust from the road salt and develop wear on the tires, breakshoes, engine and transmission. The amount of car services you get from your car will thus tend to decline through time as the car gets older. This means essentially that unless expenditures are made to maintain the car in mint condition your stock of "automobile capital" will get smaller as time passes. And, as noted, that smaller stock of capital will yield a smaller flow of services.

Human capital may or may not deteriorate with time. Your knowledge of algebra will fade if you do not use it, but skills you use every day will not deteriorate---in fact, they will improve. Even if nobody ever forgets anything, societies' stock of human capital will be reduced when people die. To keep the economy's stock of human capital from deteriorating through time, the young must be educated to replace the skills lost when the old die.

Some types of physical capital---natural resources, for example---do not deteriorate with time but become depleted as they are used up. Once burned, coal and oil are gone forever. The world stocks of coal and oil reserves will therefore necessarily fall through time.

If society is to keep its aggregate stock of capital (the aggregate is the sum of the stocks of capital of all types) from declining through time, it must build new capital stock to replace that which wears out, dies, or is depleted. The amount of goods which must be diverted to maintain the capital stock is called the allowance for depreciation or, simply, depreciation. Depreciation is the flow of additions to the capital stock necessary to keep it constant in the face of wear and tear and depletion.

After allowance has been made for depreciation, only a portion of the current final output from the economy's capital stock is available for use. The amount of output available after provision for maintaining the capital stock intact is called income. Income is thus equal to output minus depreciation, or the amount that society could consume in any given period and still maintain constant its stock of capital and its ability to produce output and income for consumption in the future.

The relationship between output, depreciation and income can be presented in the form of a simple equation as follows:

Y = X - D

where X refers to the level of output, Y to the level of income and D to the amount of depreciation.

In the national accounting statistics collected and published by the government, the aggregate (i.e. total) final output flow from domestically employed capital is referred to as Gross Domestic Product (GDP) and the flow of final output from domestically owned capital is referred to as Gross National Product (GNP). And the level of aggregate income produced by domestically employed capital is referred to as Net Domestic Product and Net National Product is level of aggregate income produced by domestically owned capital. If residents of the country own no capital in other countries and none of the domestically employed capital is owned by foreigners, Domestic Product and National Product will be the same thing. The difference between the Gross and the Net values is the allowance for depreciation.

You should now be ready to take a test on your understanding of what is meant by output, income, depreciation, Gross National Product, Gross Domestic Product, Net National Product, and Net Domestic Product. While detailed answers are available on-screen for all questions, you should think about the question and construct your own answer before going to the one here provided.

Question 1
Question 2
Question 3
Question 4

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