Principles of Economics/GDP

GDP is Gross Domestic Product (distinct from GNP, which is Gross National Product). There are two ways of determining a nation's GDP.

You've probably heard this term on the news or read about it in the paper when the national or global economy is being discussed. GDP is formally defined as the value of all the final goods and services produced in a country during a given time period. Intermediate goods — produced goods that are used up in making other goods and services — aren't counted because they would in effect cause double-counting to occur (as you will later see). Finally, capital goods — long-lived goods where they are used to create goods rather than be used up in producing other goods — are included only if they are produced within a given year.

Reasoning for not including Intermediate Goods.

Let Good A be an intermediate good that makes it possible to produce final Good B. Assume that we are allowed to count Good A and Good B into the GDP. We would have to effectively count Good A once when it was made, and count Good B and Good A; after all, Good B is effectively Good A as well. Ergo, we counted Good A twice. However, if we allowed that counting, we would vastly overestimate the GDP. Therefore, we count only final Good B.

Reasoning for including Capital Goods.

Let Good A be an capital good that creates final Good B. Assume that we are allowed to count Good A and Good B into the GDP. We would have to effectively count Good A once when it was made, and count Good B only; after all, Good B is not Good A, but a byproduct of Good A. Another reason why we count Good A is because if we did not count it, then a country that invested in the future would look worse off than one that did not.

GDP also refers to the income of the country as well. GDP also only refers to goods produced within a certain country. This means that if a firm is located in one country but manufactures goods in another, those goods are counted as part of the foreign country's GDP, not the firm's home country. For example, BMW is a German company but cars manufactured in the United States are counted as part of the United States GDP.

You can think of it another way, GDP is a way for us to measure how productive a country is on the whole. Let's break down the name for concrete understanding. Gross refers to the summation of all the country's resources towards producing output. Domestic just relates the output to the country from which the output was produced. Lastly, product just refers to the goods and services that make up output.

Measuring the Gross Domestic Product

Market Value

The market value of a good or service is the posted price at which the final good is sold at a market. The GDP measures the market values of final goods made within a domestic market during a specified period of time. Any good or service is sold in a market such that the prices at which goods are posted determine the quantity demanded. However, for goods that have a higher price than others, the market value is higher because it costs the most to consumers. The goods with a higher market value $h$ will contribute more to the GDP per marginal purchase of the good or service than lower market value goods because if $P_m<P_h$, then when purchasing $z$ goods, $P_m\cdot z<P_h\cdot z$. Our goal with this is to measure the total market value of goods sold within a domestic economy – i.e., how much total money is made within an economy using purchased final goods and services.

Therefore, to measure the GDP using the market value, we need to add the total revenue made from selling final goods or services within a domestic economy. Let the price of a product $n$ be $P$, and let the quantity of product $n$ purchased be $Q$. The total revenue made from selling product $n$ is $P_n\cdot Q_n$. We can therefore model an equation of the GDP of an economy:

$$\text{GDP}=(P_1\cdot Q_1)+(P_2\cdot Q_2)+\dots +(P_{n+1}\cdot Q_{n+1})+(P_n\cdot Q_n)$$

Since the $20$ cookies are worth $$1.50$ each, and the $10$ milk cartons are worth $$3.00$ each, calculate the total revenue of each purchase of the goods. Let $P_1=1.5$, and let $Q_1=20$: $P_1\cdot Q_1=1.5\cdot 20=30$, Finally, let $P_2=3$, and let $Q_2=10$: $P_2\cdot Q_2=3\cdot 10=30$. Add each revenue made and you get the GDP of the economy: $(P_1\cdot Q_1)+(P_2\cdot Q_2)=30+30=60$.Template:Robox/Close

In using the equation we learned, we assume that we are only looking at the current year production. Such an assumption makes the calculation above a nominal GDP. However, this is limiting for one very large reason: the price of any product can increase in an economy in the future, so the change in GDP cannot always signify a change for the better. To fix this, economists use the real GDP to compare the current year GDP with a "base-line GDP" (i.e. a set "base year" GDP). Let $P_{B,n}$ be the base year price of product $n$, and let $Q_{C,n}$ be the quantity of good $n$ purchased in the current year. The total revenue made from selling product $n$ is $P_{B,n}\cdot Q_{C,n}$. We can therefore model an equation of the real GDP of an economy:

$$\text{Real GDP}=(P_{B,1}\cdot Q_{C,1})+(P_{B,2}\cdot Q_{C,2})+\dots +(P_{B,n+1}\cdot Q_{C,n+1})+(P_{B,n}\cdot Q_{C,n})$$

Template:ExampleRobox Any time there is a quantity for the base year (2019), ignore it and focus only on the price. The price in the base year for the Honda Civic 2019 is $$19,550$ and the Toyota 2019 Avalon Hybrid car is $$36,650$; let the prices be $P_{B,1}$ and $P_{B,2}$, respectively.

Any time there is a price for the current year (2020), ignore it and focus only on the amount of the product purchased in that year. The quantity of Honda Civic 2019 purchased in 2020 is two, and the quantity of the Toyota 2019 Avalon Hybrid purchased is three; let the quantity purchased be $Q_{C,1}$ and $Q_{C,2}$, respectively. Now you may multiply the two "total revenues" together and you get the real GDP of the economy. $$\text{Real GDP}=(P_{B,1}\cdot Q_{C,1})+(P_{B,2}\cdot Q_{C,2})$$ $$⟹\text{Real GDP}=(19,550\cdot 2)+(36,650\cdot 3)$$ $$⟹\text{Real GDP}=75,750$$Template:Robox/Close

National Income Accounting Model

GDP < the sum of all income earned = :

• Employee compensation
• Corporate profits (this is income that accrues to public companies' shareholders)
• Proprietors' income (this is income that accrues to private companies' owners)
• Net interest
• Rental income

This interpretation is missing two additional, non-income components that must also be added to find GDP:

• Depreciation costs
• Indirect (excise and sales) taxes and subsidies

National Expenditure Accounting Model

The gross domestic product or the GDP is a measure of the total productivity of a country. It is a quantifiable figure that tells how much better the country and its people are at that point of time. GDP is defined as the market value of all the total goods and services produced in the country for the given period of time.

GDP = :

• Consumption ($C$)
• Investment ($I$)
• Government spending ($G$)
• Exports ($X$)
• Imports ($M$)

$GDP=C+G+I+(X-M)$

Consumption, $𝐂$ is essentially the aggregate of all the goods and services consumed in the country. Haircuts, hamburgers, gasoline, etc. are all part of the GDP in the country in which they are purchased.

Government Spending, $𝐆$ is the sum of all the goods and services purchased by the government.

Investment, $𝐈$ is a bit trickier because most people confuse this term with financial investment. In economics, we refer to investment as the purchase of new capital by firms or individual consumers. That is, firms can buy non-residential capital (buildings, equipment etc.) and individual consumers can purchase residential capital (i.e. houses). If we ever mean the kind of investment done through the stock market or finances, we will specifically use the term financial investment. So unless otherwise noted, investment will always mean capital investment.

Exports, $𝐗$ are all the goods and services exported to foreign countries. That is, the goods and services produced by the domestic country and consumed by foreign countries.

Imports, $𝐌$ are just the opposite. These are goods and services produced by other countries but consumed by the domestic country.

Together $X-M=\text{net exports}$. This is just a way of getting the net value of the goods traded between the domestic country and the rest of the world. Why do we add exports but subtract imports? Well, exports are added to the GDP because the domestic country receives payment for those goods produced and that is part of the value added to the economy by the domestic country. However we subtract imports, instead of just NOT counting imports, because the payment of these goods is taken away from the domestic country and added to the foreign country from which they came. You can think of subtracting imports as taking out the part of consumption where the good or service came from a foreign country.

Limitations with the GDP Model

Despite the clear usefulness of GDP, there are some problems associated with GDP that all economists must understand before moving to see what the changes in GDP mean:

• Sometimes, it is not easy to know what constitutes final goods or intermediate goods.
• Some goods or services are not recorded in the GDP because they are not seen in market activities.

Top 10 highest countries listed by GDP (US dollars at current nominal exchange rates)

1st Usa 18 trillion,

- EU (European Union) 16 trillion

2nd China 11 trillion

3rd Japan 4.9 trillion

4th Germany 3.4 trillion

5th UK 2.6 trillion

6th France 2.4 trillion

7th India 2.2 trillion

8th Italy 1.8 trillion

9th Brazil 1.8 trillion

10th Canada 1.5 trillion

Check your Understanding

<quiz shuffle=none> {A U.S. steel company makes $$200,000$ worth of steel in the U.S. economy. In an attempt to make zero economic profits, the steel company sells $500$ pounds of steel to a Japanese car company. The Japanese car company uses the $500$ pounds of steel to make cars, in the US, worth $$10$ million. Should the steel be included in the U.S. GDP? (2 marks.) |type="()" coef="2"} - Yes, since the steel is sold to a car company outside the U.S., the consumption component and the export component increase. || Although the car company purchased the steel, the material is used to make a final good, a car. Because the steel is an intermediary good for the car, the purchase is not counted in the GDP. Plus, it should be noted that even if a good is exported, the good must be final first before you count it into the GDP. Finally, it is important to note that consumption, $C$, applies to only purchases made by households, not firms. However, since no domestically located firms have purchased the five-hundred pounds of steel, the investment, $I$, component does not increase either. - Yes, since the steel is sold to a car company outside the U.S., the investment component and the export component increase. || Although the car company purchased the steel, the material is used to make a final good, a car. Because the steel is an intermediary good for the car, the purchase is not counted in the GDP. Plus, it should be noted that even if a good is exported, it still needs to be a final good first before it is counted. Finally, no company domestically purchased the five-hundred pounds of steel, so the investment component does not increase. - No, since the steel is sold to a car company outside the U.S. to make a car, it should not be counted because such purchases would increase the import component. || Goods made inside the domestic economy is by definition counted in the GDP. If it was sold outside the domestic economy, such purchases would count as exports, not imports, which would be added into the U.S. economy. Even if such purchases were imports, it would be subtracted from the GDP. Finally, this distracter does not give the right reason for not including the steel into the U.S. GDP. + No, since the steel is made in the U.S. and then sold to a Japanese company to be made later in the U.S., it should not be counted because it would double-count the GDP. || This is the correct response because double-counting occurs whenever intermediate goods are included in the GDP. If intermediate goods were included in the GDP, the steel purchase would be counted twice. - It is impossible to determine whether or not the steel should be included in the GDP because the steel was purchased by a foreign company; export, $X$, increases to make a good domestically. || If the steel was made in the U.S. economy, and the steel was then sold to a foreign company, located outside the U.S., then it would be an increase in export, $X$. However, after making the car domestically, it would then use the steel from now to make a car in the U.S. during that period. The steel would double-count the GDP because it was used to make a car, the final good. As such, we know that we cannot include the steel into the GDP.

{A Japanese company called Lightbulb is making cars worth $$30$ million inside the U.S. economy. Currently, a foreign company, BulbLight, offers a deal that purchases $10\mathrm{\%}$ of all the cars made from Lightbulb in the U.S. economy, currently purchasing $$3$ million worth of cars. In 2019, $$5$ million worth of Japanese-produced apples were purchased by consumers. Most domestic companies of the U.S. have purchased $$10$ million worth of Lightbulb U.S. produced cars for their employees. Finally, the Texas Government purchased $$5$ million worth of LightBulb U.S. cars for government employees working in the Police Department. What is the GDP of the U.S. economy? (3 marks.) |type="{}" coef="3"} ${ 43 _5 } million. || Although a Japanese company, Lightbulb is making cars inside the U.S. economy worth $$30$ million. As such, those cars are included in the U.S. GDP. BulbLight, a foreign company, is purchasing $$3$ million worth of domestically produced cars from Lightbulb. Because such purchases are considered exports, $X$, you are adding that to the GDP. If $$5$ million worth of foreign apples were purchased by domestic citizens, those purchases are considered imports, $M$, and would be subtracted from the U.S. GDP. If $$10$ million worth of Lightbulb domestically produced cars are purchased from companies, you are adding what is considered to be investments, $I$, to the U.S. GDP. Finally, if $$5$ million worth of Lightbulb domestically produced cars are purchased from a government institution, such purchases are considered Government purchases, $G$, and are added in the U.S. GDP. From the information we have, we substitute the information we have to $GDP=C+I+G+(X-M)$, to get $12=0+10+5+(2-5)$. Finally, because we need to add the $$30$ million worth from the Lightbulb company's final goods of cars, we get the final answer: $$43$ million.

{Sarah is a farmer. Sarah made $500$ apples in the U.S. She sold $200$ apples for $$3$ each at a U.S. farmer's market and used the remaining $$900$-worth of apples to make apple sauces. She sold the $300$ apple sauces at a farmer's market for $$4$ each. What is Sarah's contribution to the U.S. nominal GDP? (2 marks.) |type="{}" coef="2"} ${ 1.8 _5 } thousand. || Since Sarah sold $200$ apples for $$3$, she made $$600$ total revenue. Since the $$900$-worth of apples were used to make apple sauces, those apples are considered intermediate goods, which are not included in the GDP. She sold $300$ apple sauces (final goods) for $$4$ each, meaning she made $$1,200$ in total revenue. Adding the total revenues together, we get a GDP of $$1,800$ or $1.8 thousand. </quiz>