Survey of ECON
© ARCHIVE PICS/ALAMY
Robert L. Sexton
Chapter 12
Economic
Growth
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Chapter 12 Sections
– Economic Growth
– Determinants of Long-Run Economic
Growth
– Public Policy and Economic Growth
– Measuring Economic Growth and Its
Components
– Measuring Total Production
– Problems in Calculating an Accurate GDP
– Problems with GDP as a Measure of
Economic Welfare
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Economic Growth
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Section 1
SECTION 1 QUESTIONS
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Economic Growth
• Economic growth is usually measured
by the annual percent change in real
output of goods and services per capita
(real GDP per capita), reflecting the
expansion of the economy over time.
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Economic Growth
• An increase in population, ceteris paribus,
will lower the standard of living because
more people will be sharing a fixed real
GDP.
• The economic growth rate is not indicative
of the distribution of output and income.
• A country could have extraordinary growth
in per capita output and yet the poor might
make little or no improvement in their
standard of living.
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Economic Growth
• Along the production possibilities curve,
the economy is producing at its potential
output.
• How much the economy will produce at its
potential output, sometimes called its
natural rate of output, depends on the
quantity and quality of an economy’s
resources, including labor, capital, and
natural resources.
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Economic Growth
• Technology can increase the economy’s
production capabilities.
• Improvements in and greater stocks of land,
labor, and capital can shift out the production
possibilities curve.
• Another way of saying that economic growth has
shifted the production possibilities curve out is to
say that growth has increased potential output.
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Exhibit 12.1: Economic Growth and the
Shifting Production Possibilities Curve
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The Rule of 70
• A nation with greater economic growth
will end up with a much higher standard
of living, ceteris paribus.
• The Rule of 70 can tell how long it will
take a nation to double its output.
– Dividing a nation’s growth rate into 70, one
gets the approximate time it will take to
double the income level. If a nation grows
at 3.5% per year, then the economy will
double every 20 years (70/3.5).
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The Rule of 70
• The “richest” or “most-developed”
countries today have many times the
per capita output of the “poorest” or
“least-developed” countries.
• The international differences in income,
output, and wealth are striking and
have caused a great deal of friction
between developed and less-developed
countries.
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SOURCE: Bureau of Economic Analysis, National Economic Accounts, Current-dollar and “real” GDP. Washington,
D.C., February 26, 2010. Available at http://bea.gov/national/index.htm#gdp (accessed March 25, 2010).
Exhibit 12.2: U.S. Real GDP per Capita
(year 2005 dollars)
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SOURCE: Bureau of Labor Statistics, International Comparisons of GDP per Capita and per Employed Person, Table
2. Washington, D.C. July 28, 2009. pg13. Available at http://www.bls.gov/fl/flgdp.pdf (accessed March 25, 2010).
Exhibit 12.3: Growth in Real GDP per
Capita in Selected Industrial Countries
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China and India
• Both China and India have per capita real
GDP levels that are far less than those of
the United States.
• The power of compound interest could
well change this ranking in the future.
• India has experienced an average annual
growth rate of 6 percent since 1961.
– India has a highly educated English-speaking
population and is a major exporter of software
services and software workers.
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China and India
• China is growing at about 10 percent
per year. Foreign investment in China
has helped spur output of both
domestic and export goods.
• China’s investment and export-led
economy has grown 70 times bigger
and is the fastest-growing major
economy in the world.
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Productivity: The Key to a
Higher Standard of Living
PRODUCTIVITY
the amount of goods and services a
worker can produce per hour
• Productivity is especially important
because it determines a country’s
standard of living.
• Sustained economic growth occurs when
workers’ productivity rises.
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Productivity: The Key to a
Higher Standard of Living
• On the other hand, increases in productivity
and higher wages can occur as a result of
carefully crafted economic policies, such as
tax policies that stimulate investment or
programs that encourage research and
development.
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Productivity: The Key to a
Higher Standard of Living
• The link between productivity and the
standard of living may be understood most
easily by recalling the circular flow model
where we show that aggregate expenditures
are equal to aggregate income.
• Thus, the only way an economy can increase
its rate of consumption in the long run is by
increasing the amount it produces.
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Section 1
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Determinants of LongRun Economic Growth
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Section 2
SECTION 2 QUESTIONS
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Determinants of
Economic Growth
• Real GDP per capita depends on
increases in labor productivity.
LABOR PRODUCTIVITY
output per unit of worker
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Determinants of
Economic Growth
• Other things being equal, an increase in
the quantity of labor inputs does not
necessarily increase output per capita.
• It is also true that the rate of employment
growth and the rate of population growth
are similar.
• So, while real GDP could rise as a result
of population growth, it is not likely to lead
to large increases in real GDP output per
worker.
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Factors That Contribute
to Economic Growth
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Physical Capital
• Recall that physical capital includes
goods such as tools, machinery, and
factories that have already been
produced and are now producing other
goods and services.
• Combining workers with more capital
makes workers more productive. Thus,
capital investment can lead to
increases in labor productivity.
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Physical Capital
• Most economists agree that capital
formation has played a significant role
in the economic development of
nations.
• Physical capital, such as human
capital, increases labor productivity.
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Per-Worker Production
Function
• Because resources are scarce, in order to
invest in new capital, society must sacrifice
some current consumption. To save more
now, we need to consume less now.
Ultimately, this will allow society to consume
more in the future.
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Exhibit 12.4: Per-Worker Production
Function
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Per-Worker Production
Function
• In Exhibit 12.4, we see how the amount of capital
per worker influences the amount of output per
worker. This positively sloped curve is called the
per-worker production function.
• The curve eventually becomes flatter as more
capital per worker is added. That is, capital is
subject to diminishing marginal returns.
• Thus, in the long run, other things equal, the
benefits of a higher saving rate and additional
capital stock become smaller and the rate of
growth slows.
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Per-Worker Production
Function
• Even in primitive economies, workers
usually have some rudimentary tools to
further their productive activity.
• Most economists agree that capital
formation has played a significant role
in the economic development of
nations.
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Per-Worker Production
Function
• Some economists believe diminishing
marginal returns to capital can help
explain the variation in growth rates
between rich and poor countries.
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Human Capital
• When workers acquire qualitative
improvements (learning new skills, for
example), output increases.
• Like physical capital, human capital must
be produced, usually by means of
teachers, schoolrooms, libraries,
computer labs, and time devoted to
studying.
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Human Capital
• Human capital may be more important than
physical capital as a determinant of labor
productivity.
• Human capital also includes improvements
in health.
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Natural Resources
• An abundance of natural resources,
such as fertile soil, and other raw
materials, such as timber and oil, can
enhance output.
• Many scholars cite the abundance of
natural resources in the United States
as one reason for its historical success.
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Natural Resources
• Resources are, however, not the whole
story. Japan and Hong Kong have had
economic success despite relatively few
natural resources.
• It appears that a natural resource base can
affect the initial development process, but
sustained growth is influenced by other
factors.
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Technology
• Most economists believe that it is the
progress in technology that drives
productivity.
• Technological advances stem from
human ingenuity and creativity in
developing new ways of combining the
factors of production to enhance the
amount of output from a given quantity
of resources.
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Technology
• The process of technological advance
involves invention and innovation.
INNOVATION
applications of new knowledge that create
new products or improve existing products
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Technology:
Examples
• In the United States, the invention
and innovation of the cotton gin, the
Bessemer steel-making process, and
the railroad were important stimuli to
economic growth.
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Technology
• Technological advances permit us to economize
on one or more inputs used in the production
process.
• In short, better methods of organization and
production can lead to increases in labor
productivity.
• Exhibit 12.5 shows that technological change can
shift the per-worker production curve upward,
producing more output per worker with the same
amount of capital per worker.
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Exhibit 12.5: Technological Change and the
Per-Worker Production Function
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New Growth Theory
• The greater the reward for new
technology, the more research and
technology will occur.
• Some say that economic growth can
continue unimpeded, as long as we keep
coming up with new ideas.
• And there is a role for government, too—
encouraging the creation of new ideas.
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New Growth Theory
• While the market is a great engine for
economic growth, it can be “turbocharged”
with strong institutional support for
education and science.
• Economic growth comes from increases in
value—rearranging fixed amounts of
matter and making new combinations that
are more valuable.
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Section 2
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Public Policy and
Economic Growth
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Section 3
SECTION 3 QUESTIONS
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Public Policy and
Economic Growth
• Economic growth means more than an
increase in the real income (output) of the
population.
• Changes in output are accompanied by a
number of other important changes.
• There are a number of policies that a
nation can pursue to increase economic
growth.
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Saving Rates, Investment, Capital
Stock, And Economic Growth
• One of the most important determinants
of economic growth is the saving rate.
– In order to consume more in the future, we
must save more now.
– Generally speaking, higher levels of
saving will lead to higher levels of
investment and capital formation and,
therefore, to greater economic growth.
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Saving Rates, Investment, Capital
Stock, And Economic Growth
• If individuals choose to consume all their
income, with little investment in capital
stock, there will be little economic growth.
• Capital can also increase as a result of
injections of capital from abroad (foreign
direct investments), but the role of national
saving rates in economic growth is of
particular importance.
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Saving Rates, Investment, Capital
Stock, And Economic Growth
• Sustained rapid economic growth is
associated with high rates of saving and
investment around the world.
• Investment alone does not guarantee
economic growth, which hinges importantly
on the quality and the type of investment
as well as on investment in human capital
and improvements in technology.
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NOTE: Data are annual averages for the periods indicated.
SOURCE: World Bank, World Development Report, 1996, Oxford University Press, 1996. Republished with permission of the
World Bank, from World Development Report 1996; permission conveyed through Copyright Clearance Center, Inc.
Exhibit 12.6: Saving Rates and GDP Growth during
High-Growth Periods in Selected Economies
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Infrastructure
• Infrastructure is critical to economic
coordination and activity.
• It includes private and public
infrastructure.
• In the past several decades, the amount
of government investment in U.S.
infrastructure has fallen.
• Some economists argue that
improvements in infrastructure could lead
to higher productivity.
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Infrastructure
• Others argue the causality runs in the
other direction; that higher productivity
leads to greater infrastructure.
• In addition, a special interest problem
concerns favored districts with political
clout that end up as the recipients of
improved infrastructure—which may not
be an efficient solution.
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Research And
Development
• Some scholars believe that the
importance of research and
development (R&D) is understated.
• It can include
– New products
– Management improvements
– Production innovations
– Simply learning by doing
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Research And
Development
• It is clear that investments in R&D and
rewarding innovators with patents has paid
big dividends in the past 50 to 60 years.
• Some would argue that even larger
rewards for research and development
would spur even more rapid economic
growth.
• There is an important link between
research and development and capital
investment.
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Research And
Development
• When capital depreciates over time, it is
replaced with new equipment that embodies
the latest technology.
• Consequently, R&D may work hand-in-hand
with investment to improve growth and
productivity.
• Lastly, R&D may benefit foreigners as they
import goods from technologically advanced
countries to make their firms more efficient.
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The Protection of Property Rights
Impacts Economic Growth
• Economic growth rates tend to be higher
in countries where the government
enforces property rights.
• In most developed countries, property
rights are effectively protected by the
government, but in developing countries,
this is not normally the case.
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The Protection of Property Rights
Impacts Economic Growth
• And if the government is not enforcing
property rights, the private sector must
respond in costly ways that stifle economic
growth.
• If government is not adequately protecting
property rights, the incentive to invest will
be hindered, and political instability,
corruption, and lower rates of economic
growth will be likely.
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Free Trade and
Economic Growth
• Free trade can lead to greater output
because of the principle of comparative
advantage.
• If two nations or individuals with different
resource endowments and production
capabilities specialize in producing a
smaller number of goods and services,
then they are relatively better at and
engage in trade that both parties will
benefit from as total output rises.
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Education
• Education, investment in human capital, is
just as important as improvements in
physical capital.
• Accepting a reduction in current income to
acquire education and training can
increase future earning ability, which can
raise the standard of living.
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Education
• One argument for government subsidizing
education is that the investment can
increase the skill level of the population
and raise the standard of living.
• However, even if the individual does not
benefit financially from increased
education, society may benefit culturally
and in other respects from having its
members highly educated.
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Education
• With economic growth, illiteracy rates fall
and formal education grows.
• The correlation between per capita output
and the proportion of the population that is
unable to read or write is striking.
• Improvements in literacy stimulate
economic growth by reducing barriers to
the flow of information and raise labor
productivity.
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Education
• Because children in developing countries
are an important part of the labor force at a
young age, there is a higher opportunity
cost of education in terms of forgone
contribution to family income.
• Education is a consequence of economic
growth, becoming a consumption good, as
well as a means of investing in human
capital.
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Section 3
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Measuring Economic Growth
and Its Components
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Section 4
SECTION 4 QUESTIONS
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National Income Accounting: A Standardized
Way to Measure Economic Performance
• The measure of aggregate economic
performance that gets the most
attention in the popular media is gross
domestic product (GDP), which is
defined as the value of all final goods
and services produced within a country
during a given period.
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National Income Accounting: A Standardized Way
to Measure Economic Performance
• By convention, that period is almost
always one year.
• What is meant by “final good or service”
and “value”?
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Measuring the Value of
Goods and Services
• Value is determined by the market
prices at which goods and services sell.
• Underlying the calculations, then, are
the various equilibrium prices and
quantities for the multitude of goods
and services produced.
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What Is a Final Good or Service?
• The word final means that the good is
ready for its designated ultimate use.
• Many goods and services are
intermediate goods or services—that is,
used in the production of other goods.
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What Is a Final Good or Service?
• For example, if we counted the value of
steel used in making the car as well as the
full value of the finished auto in the GDP,
we would be engaging in double
counting—adding in the value of the steel
twice, first in its raw form and second in its
final form, the automobile.
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Production, Income, and the
Circular Flow Model
• When we calculate GDP in the
economy, we are measuring the value of
total production—our total expenditures
on the economy’s output of goods and
services. However, we are also
measuring the value of total income.
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Production, Income, and the
Circular Flow Model
• In short, expenditures (spending) must
equal income.
– This is true whether it is a household, firm,
or the government that buys the good or
service.
• The main point is that when we spend
(the value of total expenditure), it ends
up as someone’s income (the value of
total income). Buyers have sellers.
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Production, Income, and the
Circular Flow Model
• The circular flow model shows the flow
of money in the economy.
• When income flows into the financial
system as saving, it makes it possible
for consumers, firms, and government
to borrow.
• This market for saving and borrowing is
vital to a well-functioning economy.
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Production, Income, and the
Circular Flow Model
• Wages, rent, interest, and profit comprise
aggregate income in the economy.
• The government provides transfer
payments such as Social Security and
unemployment insurance payments.
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Production, Income, and the
Circular Flow Model
• Whether we add up the aggregate
expenditure on final goods and services or
the value of aggregate income, we get the
same GDP.
• For an economy as a whole, expenditures
and income are the same.
• While the two should be exactly the same,
slight variations can occur due to data
issues.
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Exhibit 12.7: The Expanded Circular
Flow Model
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Section 4
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Measuring Total
Production
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Section 5
SECTION 5 QUESTIONS
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The Expenditure Approach
to Measuring GDP
• With the expenditure approach, GDP is
calculated by adding how much market
participants spend on final goods and
services over a specific period of time.
• For convenience and for analytical
purposes, economists usually group
spending into four categories.
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The Expenditure Approach To
Measuring GDP
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SOURCE: Bureau of Economic Analysis, National Economic Accounts, Gross Domestic Product News Release, Table 3. Washington, D.C.,
February 26, 2010. Available at http://bea.gov/national/index.htm#gdp (accessed March 25, 2010).
Exhibit 12.8: GDP: The Expenditure
Approach
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Consumption (C )
• Consumption refers to the purchase of
consumer goods and services by
households.
• For most of us, a large percentage of our
income in a given year goes to consumer
goods and services.
• The consumption category does not
include purchases by business or
government.
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Investment (I )
INVESTMENT
the creation of capital goods to augment
future production
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How Stable Are
Investment Expenditures?
• In recent years, investment expenditures
generally hovered around 15 percent of
gross domestic product.
• Investment spending is the most volatile
category of GDP, however, and tends to
fluctuate considerably with changing
business conditions.
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How Stable Are
Investment Expenditures?
• When the economy is booming, investment
purchases tend to increase dramatically.
• The reverse is true of downturns.
• In recent years, expenditures on capital
goods have been a smaller proportion of
GDP in the United States than in many
other developed nations.
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How Stable Are
Investment Expenditures?
• This fact worries some people who are
concerned about GDP growth in the United
States compared to that in other countries,
because investment in capital goods is
directly tied to a nation’s future production
capabilities.
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Government Purchases in
GDP (G )
• The portion of government purchases
included in GDP is expenditures on goods
and services.
– A government must pay the salaries of its
employees, and it must also make payments to
the private firms with which it contracts to
provide various goods and services, such as
highway construction companies and weapons
manufacturers.
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Government Purchases in
GDP (G )
• All these payments would be included in
GDP.
– However, transfer payments (such as Social
Security, farm subsidies, and welfare) are not
included in government purchases, because
this spending does not go to purchase newly
produced goods or services.
– It is merely a transfer of income among the
country’s citizens (which is why such
expenditures are called transfer payments).
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Exports (X – M )
• Goods and services produced and
exported from the United States means that
they should be included in a measure of
U.S. production.
• Thus, we include the value of exports when
calculating GDP.
– Simultaneously, some of our expenditures in
other categories (consumption and investment
in particular) were for foreign-produced goods
and services.
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Exports (X – M )
• These imports must be excluded from
GDP to obtain an accurate measure of
U.S. production.
• Thus, GDP calculations measure net
exports, which equals total exports (X)
minus total imports (M).
• Net exports are a small proportion of GDP
and are often negative for the United
States.
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Other Measures of Total
Production and Total Income
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Other Measures of Total
Production and Total Income
• Incomes received by people providing
goods and services are actually payments
to the owners of productive resources.
• These payments are sometimes called
factor payments.
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Other Measures of Total
Production and Total Income
• Factor payments include wages for the use
of labor services, rent for land, payments
for the use of capital goods in the form of
interest, and profits for entrepreneurs who
put labor, land, and capital together.
• Before we can measure national income,
we must make three adjustments to GDP.
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Other Measures of Total
Production and Total Income
• We must look at the net income of
foreigners—the income earned abroad by
U.S. firms or citizens minus the income
earned by foreign firms or citizens in the
United States.
• This difference between net income of
foreigners and GDP is called gross
national product (GNP).
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Other Measures of Total
Production and Total Income
• In the United States, the difference
between GDP and GNP is small because
net income of foreigners is a small
percentage of GDP.
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Other Measures of Total
Production and Total Income
• The second adjustment we make to find
national income is to deduct depreciation
from GNP.
DEPRECIATION
annual allowance set aside to replace
worn-out capital
NET NATIONAL PRODUCT (NNP)
GNP minus depreciation
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Other Measures of Total
Production and Total Income
• The final adjustment is to subtract indirect
business taxes.
• The best example of an indirect business
tax is a sales tax.
• Besides sales taxes, other important
indirect business taxes include excise
taxes (e.g., taxes on cigarettes,
automobiles, and liquor) and gasoline
taxes.
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Other Measures of Total
Production and Total Income
• Now we can measure national income (NI),
which is a measure of the income earned by
owners of resources—factor payments.
• Accordingly, national income includes
payments for labor services (wages,
salaries, and fringe benefits), payments for
use of land and buildings (rent), money lent
to finance economic activity (interest), and
payments for use of capital resources
(profits).
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Other Measures of Total
Production and Total Income
• To obtain the GDP, we add indirect
business taxes, depreciation, and net
income of foreigners.
PERSONAL INCOME (PI)
the amount of income received by
households before personal taxes
DISPOSABLE PERSONAL INCOME
the personal income available after
personal taxes
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Section 5
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Problems in Calculating
an Accurate GDP
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Section 6
SECTION 6 QUESTIONS
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Problems in Calculating
an Accurate GDP
• The primary problem in calculating
accurate GDP statistics becomes evident
when attempts are made to compare the
GDP over time.
• Between 1970 and 1978, a period of
relatively high inflation, GDP in the
United States rose more than 100
percent.
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Problems in Calculating
an Accurate GDP
• Unfortunately, however, the “yardstick”
used in adding the values of different
products, the U.S. dollar, also changed in
value over this period.
• A dollar in 1979, for example, would
certainly not buy as much as a dollar in
1970, because the overall price level for
goods and services increased.
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How Do We Solve This
Problem?
• One solution to this problem would be to
use physical units of output—which,
unlike the dollar, do not change in value
from year to year—as the measure of
total economic activity.
• The major problem with this approach is
that different products have different units
of measurement.
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How Do We Solve This
Problem?
• To compare GDP values over time, the
calculations must use a common, or
standardized, unit of measure, which
only money can provide.
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A Price-Level Index
• The dollar is the yardstick of value we
can use to correct the inflation-induced
distortion of the GDP.
• We must adjust for the changing
purchasing power of the dollar by
constructing a price index.
• Essentially, a price index attempts to
provide a measure of the prices paid for
a certain bundle of goods and services
over time.
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A Price-Level Index
• The price index can be used to deflate
the nominal or current dollar GDP
values to a real GDP expressed in
dollars of constant purchasing power.
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Real GDP
• Once the price index has been calculated,
the actual procedure for adjusting nominal,
or current dollar, GDP to get real GDP is
not complicated.
• For convenience, an index number of 100
is assigned to some base year.
• The base year is arbitrarily chosen—it can
be any year.
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Real GDP
• The formula for converting any year’s
nominal GDP into real GDP (in base year
dollars) is as follows:
• Suppose the GDP deflator (price-level index)
was expressed in terms of 2005 prices
(2005 = 100), and the index figure for 2010
was 110.
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Real GDP
• The increase in the figure means that
prices were 10 percent higher in 2010
than they were in 2005.
• To correct the 2010 nominal GDP, we
take the nominal GDP figure for 2010
and divide it by the price-level index.
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Real GDP
• Multiplying this number by 100, we get
what would be the 2010 GDP in 2005
dollars (that is, 2010 real GDP, in terms
of a 2005 base year).
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Real GDP
• As a caveat, note that in recent years, the
Bureau of Economic Analysis (BEA) has
calculated real GDP using a new
procedure called chain weighting.
• The purpose of the change is to make the
real GDP figure more accurate by
updating the base year more frequently.
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Real GDP
• Exhibit 12.9 shows nominal and real GDP
rates from 1960–2009, with 2005 as the
base year.
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SOURCE: Louis D. Johnston and Samuel H. Williamson, “What Was the U.S. GDP Then?” MeasuringWorth, 2008.
Available at http://www.measuringworth.org/usgdp/ (accessed March 17, 2010).
Exhibit 12.9: Nominal and Real GDP
1950–2009 (2005 base year)
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Is Real GDP Always Less
Than Nominal GDP?
• In modern times, inflation has been
prevalent.
• Adjustment of nominal (money) GDP to
real GDP will tend to reduce the growth in
GDP suggested by nominal GDP figures.
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Real GDP Per Capita
• The measure of economic well-being, or
standard of living, most often used is
real gross domestic product per
capita.
• To calculate real GDP per capita, we
divide the real GDP by the total
population to get the value of real output
of final goods and services per person.
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Real GDP Per Capita
• Ceteris paribus, people prefer more goods
to fewer, so a higher GDP per capita would
seemingly make people better off,
improving their standard of living.
• Economic growth, then, is usually
considered to have occurred any time the
real GDP per capita has risen.
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Real GDP Per Capita
• Falling real GDP per capita can bring
on many human hardships, such as
rising unemployment, lower profits,
stock market losses, and bankruptcies.
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NOTE: Shaded areas represent recessions.
SOURCE: Bureau of Economic Analysis, Survey of Current Business, Selected NIPA Tables. 90(3) Washington, D.C., March 2010.
D-53. Available at http://www.bea.gov/scb/ (accessed March 25, 2010).
Exhibit 12.10: Real GDP per Capita
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Why Is the Measure of Per
Capita GDP so Important?
• One purpose of using GDP as a crude
welfare measure is to relate output to
human desires, so we need to adjust for
population change.
• If population growth is not accounted for,
we can be misled by real GDP values.
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Why Is the Measure of Per
Capita GDP so Important?
• For example, in some less-developed
countries in some periods, real GDP has
risen perhaps 2 percent a year, but the
population has grown just as fast.
• In these cases, the real output of goods
and services per person has remained
virtually unchanged, but this would not be
apparent in an examination of real GDP
trends alone.
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Section 6
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Problems with GDP as a
Measure of Economic Welfare
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Section 7
SECTION 7 QUESTIONS
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Problems with GDP as a
Measure of Economic Welfare
• The accuracy of using GDP as a
measure of economic welfare is
questionable, because several important
factors are excluded from its calculation.
• These factors include non-market
transactions, the underground economy,
leisure, externalities, and the quality of
the goods purchased.
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Nonmarket Transactions
• Nonmarket transactions include the
provision of goods and services outside
traditional markets for which no money
is exchanged.
• We simply do not have reliable enough
information on this output to include it in
the GDP.
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Nonmarket Transactions
• The most important single nonmarket
transaction omitted from the GDP is the
services of housewives (or
househusbands).
• These services are not sold in any
market, so they are not entered into the
GDP; but they are nonetheless
performed.
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Nonmarket Transactions
• For example, if a single woman hires a tax
accountant, those payments enter into the
calculation of GDP.
– Suppose, though, that the woman marries
her tax accountant.
– Now the woman no longer pays her husband
for his accounting services. Reported GDP
falls after the marriage, although output does
not change.
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Nonmarket Transactions
• In less-developed countries, where a
significant amount of food and clothing
output is produced in the home, the failure
to include nonmarket economic activity in
GDP is a serious deficiency.
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Nonmarket Transactions
• Even in the United States, homemade
meals, housework, and the vegetables and
flowers produced in home gardens are
excluded, even though they clearly
represent an output of goods and services.
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The Underground
Economy
• It is impossible to know for sure the
magnitude of the underground economy,
which includes unreported income from
both legal and illegal sources.
– For example, illegal gambling and
prostitution are not included in the GDP,
leading to underreporting of an unknown
magnitude.
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The Underground
Economy
• The reason these activities are
excluded, however, has nothing to do
with the morality of the services
performed; rather, the cause of the
exclusion is that most payments made
for these services are neither reported
to government authorities nor go
through normal credit channels.
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The Underground
Economy
• Likewise, cash payments made to
employees “under the table” slip through
the GDP net.
• Estimates of the size of the underground
economy vary from less than 4 percent to
more than 20 percent of GDP.
– It also appears that a significant portion of this
unreported income comes from legal sources,
such as self-employment.
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Measuring the Value
of Leisure
• The value that individuals place on
leisure is omitted in calculating GDP.
• The opportunity cost of working in the
evenings, or over the weekends, is too
high—we would have to forgo some
leisure.
• The opportunity cost of leisure is the
income forgone by not working.
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Measuring the Value
of Leisure
• Leisure, then, has a positive value that
does not show up in the GDP accounts.
• The problem that this omission in GDP
poses can be fairly significant in
international comparisons or
observations of one nation over time.
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GDP and Externalities
• As a result of positive and negative
externalities occurring from the
production of some goods and services,
the equilibrium prices of these goods and
services—the figures used in GDP
calculations—do not reflect their true
values to society (unless, of course, the
externalities have been internalized).
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GDP and Externalities:
Examples
• For example, if a steel mill produces 100,000
more tons of steel, GDP increases; GDP does
not, however, decrease to reflect damages from
the air pollution that results from the production of
that additional steel.
• Likewise, additional production of a vaccine
would be reflected in the GDP, but the positive
benefit to members of society—other than the
purchaser—would not be included in the
calculation.
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GDP and Externalities
• In other words, while GDP measures the
goods and services produced, it does not
adequately measure the “goods” and
“bads” that result from the production
processes.
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Quality Of Goods
• GDP can also miss important changes
in the improvements in the quality of
goods and services.
– For example, the quality of a computer
bought today differs significantly from one
that was bought 10 years ago, but it will
not lead to an increase in measured GDP.
• The same is true of many other goods,
from cellular phones to automobiles to
medical care.
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Other Measures of
Economic Well-Being
• Even if we included some of these
statistics that are difficult to measure,
such as nonmarket transactions, the
underground economy, leisure,
externalities, and the quality of
products, GDP would still not be a
precise measure of economic wellbeing.
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Other Measures of
Economic Well-Being
• Many other indices of well-being should be
considered, such as life expectancies,
infant mortality rates, education and
environmental quality, levels of
discrimination and fairness, health care,
low crime rates, and minimum traffic
congestion, just to name a few.
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Other Measures of
Economic Well-Being
• GDP is a measure of economic production,
not a measure of economic well-being.
• However, greater levels of GDP can lead to
improvements in economic well-being,
because society will now be able to afford
better education and health care and a
cleaner, safer environment.
144
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Section 7
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