Output and GDP

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This is an article from Macroeconomics. To get back to the list of all topics click here.

In order to evaluate macroeconomic performance against the first two criteria (rising living standards and avoiding extremes of macroeconomic performance), a measure of the economy's output is used. This measure is formally known as Gross Domestic Product or GDP.

Contents

Textbook Readings

Bernanke, Olekalns and Frank, Principles of Macroeconomics, (3rd ed, Sydney, McGraw Hill, 2011), pp. 6-22 (Chapter 1).

Definition and Explanation

Formally, GDP is defined as the market value of the final goods and services produced in a country during a given time period[1]. A breakdown of the definition follows.

Market Value

In order to measure the value of goods and services produced, the value in currency (i.e AUD$ in Australia) is used as a common ground for valuation. The rationale for this is that:

a. It would be inconvenient to list GDP in terms the number of all the different goods and services produced
b. In general, the amount people are willing to pay for an item is a measure of the benefit they expect to receive from it

An exception to this rule is publicly provided goods and services (such as roads, defence, education etc) which are added to the calculation of GDP based on the cost of providing them rather than their market value since this value does not actually exist.

Final Goods and Services

It is important to note that only final goods are added to the calculation of GDP, that is, goods that are complete in their production and are available for the end user with no plans to be used as inputs for further production[2]. Other goods that are used as inputs for further production are called intermediate goods and these are excluded from the calculation of GDP. This is because if they were included in calculating GDP then their value would be over stated.

To illustrate the distinction, imagine the production of books. The process involves (amongst many other things):

  1. Cutting trees
  2. Processing trees into paper
  3. Printing

While goods are produced along the way (paper and ink), their value is not added to GDP because they are not available to the end user- only the final goods, the books, are.

Since this distinction complicates the calculation of GDP (as production often spans many time periods), this method is not practical and is not used. See calculation methods for more practical GDP calculations.

Produced Within a Country

GDP is only concerned with goods and services produced within a country's borders. This means that even if a foreign entity owns a production company within australia, its goods and services produced are still counted in Australia's GDP. Imports however are not.

Over a Time Period

GDP is a flow variable, that is, it is calculated over time. Typically these time periods are yearly quarters and there are two main methods of dividing the year into quarters:

  1. By calendar year:
  1. January - March
  2. April - June
  3. July - September
  4. October - December.
  1. By financial year:
  1. July - September
  2. October - December.
  3. January - March
  4. April - June

In order to calculate GDP for a whole year we just add up all four quarterly GDP values for that year.

Exclusions

In reality GDP calculation excludes many items. Such exclusions are:

  1. Goods and services not bought or sold on the market (such as home made food)
  2. Intermediate goods and services
  3. Second hand goods and services
  4. Imports

Calculation Methods

As mentioned above ( Final Goods and Services), calculating GDP becomes very complicated since only final goods are included but not all goods are finalised before GDP is calculated. Therefore, three alternate methods are used to calculate GDP. They are:

  1. Production or Value Added Method
  2. Expenditure Method
  3. Income Method

Production or Value Added Method

Value added is defined as:

Value Added = Product Market Value - Cost of Inputs

Continuing from the books production example illustrated above, the idea is that at each stage of the production of books, value is added to the materials, or inputs. So by cutting trees, value is added to them since now they can be transported and processed. Once they are turned into paper, value is again added as now that paper is usable as a product and so on. By adding up the value added at each stage until the final good is produced, we arrive at the value to be used in calculating GDP.

To illustrate this better, the following table outlines costs and value added at each stage of the process.

Process Revenues - Cost of Purchased Inputs = Value Added
Tree Cutting $10 $0 $10
Tree Processing $15 $10 $5
Printing $25 $15 $10
Total $25

What is important to notice here is that by the end of all the processing, the company makes a revenue of $25 from selling the book which is that same as adding up the value added at each stage of the production. This value is then added to GDP.

In addition to providing a secondary method to calculate GDP, this method also avoids the problem that arises from production spanning multiple time periods as GDP can be calculated at any stage.

Expenditure Method

The expenditure method relies on the assumption that anything produced is also used by some entity. It therefore states that by adding up the amount of spending made by all individuals and firms (as well as the government and exports) will equal GDP.

Products that have been produced but not sold are counted in this method as inventories and are seen as expenditure by the producing firms.

To calculate GDP by this method, analysts divide the economy into four categories of users (or spenders):

  1. Households
  2. Firms
  3. Governments
  4. Foreign Sector (i.e. exports)

And related to these four end user categories are the four components of expenditure:

  1. Consumption (C)
  2. Investment (I)
  3. Government Purchases (G)
  4. Net Exports (NX) = Exports (X) - Imports (M)

By adding up all these expenditure categories we get a value for GDP (Y). That is,

Y = C + I + G + NX or
Y = C + I + G + X - M

This equation is known as the national income accounting identity. This identity is often written as

Y + M = C + I + G + X

Where the left hand side is the supply of goods and services and the right hand side of the equation is the demand for those goods and services.

Income Method

A third way of calculating GDP is by adding up the income and capital of all individuals and firms (and the government). The rationale here is that any revenue made by firms by selling products is distributed to the workers and the owners. Then GDP is the addition of all:

  1. Income (~75% of GDP)- includes salaries, wages and incomes of the self employed
  2. Capital (~25% of GDP)- includes payments to owners through physical objects such as machines, buildings and factories and non physical payments such as copy right and patents

It is important to note that these values are counted before tax.

Nominal GDP VS. Real GDP

Considering that GDP is a flow variable, it is useful to compare GDP for different time periods. The problem is that GDP relies on the market value of goods produced, which changes every year due to inflation. The result is that even if the production does not change (between two time periods), but the market value does, then the value of GDP will change as well. In other words GDP is not comparable for two time periods as price changes are not taken into account. This unadjusted value is known as nominal GDP.

In order to allow comparability, the calculated GDP is adjusted to inflation giving the real GDP. To calculate real GDP, a base year is chosen and any GDP calculated for other years uses the base years' market values. In this way price variation is eliminated from GDP making it comparable. It is important to note that choice of the base year does not really matter, however as one moves further away from the base year, the less relevant are the base year prices.

Another way of comparing GDP values is known as the chain volume measurement, or chain weighted measurement. It is generally used to compare two consecutive years. It is calculated by:

  1. Finding GDP values based on first years' prices
  2. Finding GDP values based on second years' prices
  3. Taking the average of these two values for each of the years

Discussion Points

[3]GDP is a measure of output but it is not a measure of economic wellbeing. It ignores such (economically valuable) factores as:

  • How much leisure time workers have
  • Economic activities not bought/sold on the market- these include services such as volunteering as well as the underground (or black) market
  • The quality of the environment and surroundings of workers
  • How much of the country's resources have been used up
  • Quality of life - that is things like low crime rates or lower mortality rates
  • Poverty

Having said this, GDP is still related to wellbeing in that it is still a measure of how many goods or services the country possesses. On an individual level, GDP per capita gives a measure of how many goods and services individuals can possess in a time period, giving some indication of wellbeing. GDP per capita is calculated by:

GDP Per Capita = GDP/Populaion

References

  1. Textbook, p.6
  2. Definition of final goods and services, definition at Economic Glossary. 2012. Definition of final goods and services, definition at Economic Glossary. [ONLINE] Available at: http://glossary.econguru.com/economic-term/final+goods+and+services. [Accessed 19 July 2012].
  3. Textbook, pp.19-22
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