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:

$${{\text{GDP}}=(P_{1}\cdot Q_{1})+(P_{2}\cdot Q_{2})+\ldots +(P_{n+1}\cdot Q_{n+1})+(P_{n}\cdot Q_{n})}$$

What is the GDP of the economy in 2015 when $20$ cookies worth $$1.50$ each and $10$ milk cartons worth $$3.00$ each were purchased? 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: $(P_{1}\cdot Q_{1})+(P_{2}\cdot Q_{2})=30+30=60$.

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:

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

In 2019, two goods were sold in Carlandia: one Honda Civic 2019 car for $$19,550$; and two Toyota 2019 Avalon Hybrid cars, each $$36,650$. In 2020, two Honda Civic 2019 cars were produced, each $$21,520$; and three Toyota 2019 Avalon Hybrid cars were produced, each $$35,550$. Let the base year be 2019, where 2020 is the current year. What is the real GDP in the economy of Carlandia? 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. $${{\text{Real GDP}}=(P_{B,1}\cdot Q_{C,1})+(P_{B,2}\cdot Q_{C,2})}$$ $${\implies {\text{Real GDP}}=(19,550\cdot 2)+(36,650\cdot 3)}$$ $${\implies {\text{Real GDP}}=75,750}$$

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 ($M$)

$\mathrm {\ } GDP=C+G+I+(X-M)$

Consumption, $\mathbf {C}$ 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, $\mathbf {G}$ is the sum of all the goods and services purchased by the government.

Investment, $\mathbf {I}$ 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, $\mathbf {X}$ 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, $\mathbf {M}$ 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

Point added for a correct answer:
Points for an incorrect answer:
Ignore the questions' coefficients:

1 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.)

	Yes, since the steel is sold to a car company outside the U.S., the consumption component and the export component increase.
	Yes, since the steel is sold to a car company outside the U.S., the investment component and the export component 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.
	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.
	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.

2 A Japanese company called Lightbulb is making cars worth $$30$ million inside the U.S. economy. Currently, a foreign company, BulbLight, offers a deal that purchases $10\%$ of all the cars made from Lightbulb in the U.S. economy, currently purchasing $$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.)

$ million.

3 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.)

$ thousand.