9/18/11

What is GDP? How to measure GDP? Definitions and examples, part 1



Gross domestic product- the market value of all final goods and services produced in a country during a specific period of time which is usually one year.

GDP is measured using market values, and not quantities.  Production is measured in quantities, but then those quantities have to be changed to account for their value.  In economics we use prices to place values on the final goods, so total production times price will give us the total value.

Final goods and services vs intermediate goods or services.  A product is a final good or service when it is purchased by the final user.  Intermediate products are used as an input to produce another good or service such as sugar being purchased to make soda.  Sugar is an intermediate good, while soda is a final good.

GDP only includes the value of final goods, intermediate goods are not included.  GDP only includes
current production, and ignores the sale of used goods.  If you purchase a bike in 2011, then that purchase is included in 2011 GDP measure, not 2010 or 2012.  Also, if you sell that bike at any time in the future, the sale of that bike is not included in GDP.

Calculating GDP:
Production and Price Statistics for 2001
Product
Quantity
Price per unit
Value
Haircuts
200
$25.00
$5,000
Hot Dogs
160
$5
$800
Bikes
40
$50
$2,000
Bike Tires
80
$3
$240

To figure out what GDP will be for this economy follow these steps:
1) Determine which goods should be considered for GDP, meaning identify final and intermediate goods (because intermediate goods won’t be included).
2) Calculate the value of the final goods and services that you have information for.
3) Add up the value of each of these final goods and services.

So first we identify the final products which are haircuts, hot dogs, and bikes.  Bike tires are an intermediate good, because they are used in the production of bikes.  So now we have to figure out the value of each of these goods which is equal to quantity times price.  Then we add up the value for each of the goods and we end up with $7,800.  So the GDP of this mini economy would be $7,800.

Components of GDP- Consumption, Investment, Government purchases, and net exports.
Consumption is spending by households on goods or services.  Investment is spending by firms on capital, such as new buildings, machinery, factories, production of unsold inventory, and spending by consumers on new houses.  

Production of unsold inventory can be confusing.  Imagine a car produced in December, but not sold until January.  Even though the car was sold in January, it would not be counted as consumer spending January, but instead as an investment by a firm in December.

Government purchases includes both government consumption and gross investment.  All levels of government have budgets where they spend money on goods and services.  These include teacher salaries, military, road construction and maintenance, and everyday products purchased by the government.  However, transfer payments are not included in government purchases because those on welfare, unemployment, or social security do not exchange products (or make anything) in return for this money.

Finally we have net exports.  Net exports is equal to exports minus imports.  Remember it is the value of these two components, so even if we export 1,000 units of choose and import 1 TV, if the TV costs $2,000 and cheese $1, our net exports value is -$1,000.

An equation for GDP and some actual values:

Y = C + I + G + NX

The GDP equation shows us that GDP (Y) is equal to consumption (C) plus investment (I) plus government purchases (G) plus net exports (NX). 
 
Components of GDP (in billions)
Consumption


Durable Goods
$1,345

Nondurable Goods
$2,587

Services
$7,894


Total
$11,826
Investment


Business fixed investment
$3,021

Residential construction
$322

Change in business inventories
$-70


Total
$3,273
Government Purchase


Federal
$1,754

State and local
$1,544


Total
$3,298
Net Exports


Exports
$1,371

Imports
$2,083


Total
$-712




Total GDP
$17,685

Consumer spending in our example is by far the largest component of GDP.  This is true for the United States of America, and for most other developed countries.  

Also note that the amount spent on services is higher than spending on durable and non-durable goods combined.  This shows a trend that is currently happening in most developed countries where populations are older and wealthier, and spend more money on services such as health care and financial services.

An alternative way to measure GDP is through the value added method.  This approach means that we look at the difference in market price at each step of the way in the production train.  We can use coffee as an example, if a pound of coffee beans is sold for $2 by the farmer than the value added at this step is $2.  If the beans are processed by a company, and sold for $5, then the value added here is $3 ($5-$2).  Finally, you the consumer go to purchase coffee at a trendy coffee shop for $35.  The value added is $30 ($35-$5).  Note that the final price $35, is the same as the sum of each of the value added measures ($2+$3+$30).

Shortcomings of GDP as a measure of an economy’s production.

GDP doesn’t include measures for household production.  So if you clean your own house, or cook for yourself and your family, this is not included in GDP.  However, if you pay someone to clean your house or cook food for you, this will be included in the GDP measure.  Even though the value of these services is the same (you have a clean house and food on the table), if you do not pay someone to perform these services, they will not be included.

Do a google search for "GDP data" and the first result will give you an opportunity to graph world bank data for almost every country in the world over the past 50 years.  It is very interesting, and can help you understand trends and differences across countries and regions.
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