Chapter 17
Measuring
Economic Activity:
Gross Domestic
Product
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• How do economists measure the state of the economy?
– Economists aggregate the quantities of many different goods and services into a single number.
– They do so by adding up the market
values of the different goods and services that the economy produces.
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• So, GDP =
– The market value of final goods and services produced in a country during a given period
But keep in mind…..
– Measuring GDP has been criticized on many grounds:
• As we will see from the calculation,
GDP does not accurately reflect factors like income distribution and the effect of economic growth on the environment.
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• Example
– The economy’s total production is 4 apples,
6 bananas and 3 pairs of shoes.
– Suppose apples sell for €0.25 each, bananas sell for €0.50 each, and shoes sell for €20.00 a pair.
– This economy is equal to:
( 4 apples
 € 0 .
25 / apple )

( 6 bananas
 € 0 .
50 / banana )

( 3 shoes
 €
20 .
00 / pair )
 €
64 .
00
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• When we calculate GDP this way, the more expensive items receive a higher weighting than the cheaper items.
• The amount people are willing to pay for an item is an indication of the economic benefit they expect to receive from it (more on this in your micro course).
• Higher priced items should count for more in a measure of aggregate output.
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• Example
– Suppose an economy now produced 3 apples, 3 bananas and 4 pairs of shoes with the same prices as before.
– What is the GDP now?
( 3 apples
 €
0 .
25 / apple )

( 3 bananas
 €
0 .
50 / banana )

( 4 shoes
 €
20 .
00 / pair )
 €
82 .
25
– GDP is higher than before.
– This because the good whose production has increased is much more valuable than the goods whose production has decreased.
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• Market values provide a convenient way to aggregate the many different good and services produced in a modern economy.
• Problem: not all economically valuable goods and services are bought and sold in markets = another flaw in GDP measure
(informal economy)
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• Example
– Mary is a single mother who does not work. Mary spends a lot of time looking after her children, but this is unpaid work and is not counted as part of GDP.
– Suppose Mary finds a job that pays
€500 a week. Mary then pays a childminder €200 a week to look after the children. This adds €700 to
GDP.
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
– The childminder has taken over
Mary’s previously unpaid work, which was not counted as part of
GDP.
– While Mary’s job represents a genuine increase in GDP, paying the childminder does not. It just transfers activity from the unpaid to the paid sector. Hence the increase in GDP may be overstated.
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• Final goods or services
– Goods or services consumed by the ultimate user
– As they are the end products of the production process, they are counted as part of GDP.
– For example: bread
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• Intermediate goods or services
– Goods or services used up in the production of final goods and services, and therefore not counted as part of GDP
– Example: Grain and flour, both used to produce the final good, bread.
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• Example: A farmer produces €100 worth of milk.
€40 worth of milk is sold to his neighbours, with the rest used to feed his pigs, which he sells at the local market for €120.
What is the farmer’s contribution to GDP?
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• The final goods in this example are €40 worth of milk and €120 of pigs,
• which makes a €160 contribution to GDP.
• The farmer used milk both as an intermediate good and as a final good.
• Some goods can be either intermediate or final. This is known as a capital good:
– A long lived good, which is itself produced and used to produce other goods and services.
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• So far we have said that only final goods and services (including newly produced capital goods) are counted in GDP.
• In practice this rule is not easy to apply because the production process often stretches over several periods.
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• Example: Suppose grain is milled into flour, which in turn is baked into a loaf of bread.
– Bread is valued at €2.
– The grain and the flour are produced near the end of the year 2002, and the bread is baked early in 2009.
– Should we attribute the €2 value of the bread to GDP for 2002 or to GDP for 2009?
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• To deal with this problem, economists determine the market value of final goods and services indirectly by adding up the value added by each firm in the production process.
• Value added
– For any firm, the market value of its product or service, minus the cost of inputs purchased from other firms
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
Value added in bread production
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Gross Domestic Product (GDP):
Measuring the Economy’s Output
• Example:
– A 20 year-old house is sold to a family for €200,000. The family pay the estate agent €10,000 and pay the solicitor €6,000.
– The contribution of this transaction to GDP is €16,000.
• As the house was not built this year, it is not counted in this year’s GDP. Only the value of the services that the family purchased are included.
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The Expenditure Method for
Measuring GDP
• Economic statisticians divide the users of the final goods and services that make up the
GDP for any given year into four categories:
– Households (= “Consumption”)
– Firms (= “Investment”)
– Government (= “Government Purchases”)
– Foreign sector (= “Net Exports”)
• Economists assume that all final goods and services that are produced in a country in a given year will be purchased and used by members of one or more of the four groups.
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The Expenditure Method for
Measuring GDP
• GDP can be measured with equal accuracy by either of two methods:
– Adding up the market value of all the final goods and services that are produced domestically
– Adding up the total amount spent by each of the four groups on final goods and services and subtracting spending on imported goods and services
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The Expenditure Method for
Measuring GDP
• Consumption expenditure
– Spending by households on goods and services such as food, clothing and entertainment
• Investment
– Spending by firms on final goods and services, primarily capital goods and housing
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The Expenditure Method for
Measuring GDP
• Government purchases
– Purchases by central and local governments of final goods and services
– Government purchases do not include transfer payments, which are payments made by the government in return for which no current good or service is required.
Nor do they include interest paid on government debt.
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The Expenditure Method for
Measuring GDP
• Net Exports
– Exports minus imports
• Exports
– Domestically produced final goods and services that are sold abroad
• Imports
– Purchases by domestic buyers of goods and services that were produced abroad
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The Expenditure Method for
Measuring GDP
Expenditure Components of UK GDP, 2009 (£ million)
Source: Monthly Digest of Statistics, September 2010 (UK Office for National Statistics).
1 Includes expenditures by non-profit institutions.
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GDP and the Incomes of
Capital and Labour
• Whenever a good or service is produced or sold, the revenue from the sale is distributed to the workers and owners of the capital involved in the production of the good or service.
• Thus, except for some technical adjustments, GDP also equals labour income plus capital income.
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GDP and the Incomes of
Capital and Labour
• Labour income comprises wages, salaries and the incomes of the self-employed.
• Capital income is made up of payments to owners of physical capital and intangible capital.
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Nominal GDP versus Real GDP
• Real GDP
– A measure of GDP in which the quantities produced are valued at the prices in a base year, rather than at current prices
– Real GDP measures the actual physical volume of production.
• Nominal GDP
– A measure of GDP in which the quantities produced are valued at current-year prices
– Nominal GDP measures the current money value of production.
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Nominal GDP versus Real GDP
• Calculating real GDP
• Assume 2004 is the base year.
• Real GDP for the year 2008 is:
(20*1,000)+(30*100)=€23,000
• Real GDP for the year 2004 is:
(10*€1000)+(15*€100)=€11,500
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Nominal GDP Versus Real GDP
• Does the choice of the base year matter?
Prices and Quantities, 2006 and 2010
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Nominal GDP Versus Real GDP
• Using 2006 as a base year:
– 2006 Real GDP:
(10*€1,000)+(15*€100)=€11,500
– 2010 Real GDP:
(20*€1000)+(30*€100)=€23,000.
• GDP is 2 times what it was in 2006.
• Using 2010 as a base year:
– 2006 real GDP:
(10*€1200)+(15*€110)=€13,650
– 2010 Real GDP:
(20*€1200)+(30*€110)=€27,300
• GDP is 2 times what it was in 2006.
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GDP and Economic Well-Being
• There a number of things that
GDP cannot necessarily measure:
– Environmental quality and resource depletion
– Quality of life
– Poverty and economic inequality
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GDP and Economic Well-Being
• GDP captures only those goods and services that are priced and sold in markets.
• People with higher incomes may want to take more leisure time.
• Leisure is not priced and sold in markets and, therefore, is not counted in real GDP.
• GDP may understate economic wellbeing.
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GDP and Economic Well-Being
• GDP is related to economic wellbeing:
– Availability of goods and services
– Health and education
– Countries with high real GDP per head of population tend to have higher life expectancy, lower infant mortality, better nutrition and healthcare, etc.
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GDP and Economic Well-Being
GDP and Basic Indicators of Well-being
Source: United Nations, Human Development Report (2007–2008), http://hdr.undp.org/.
All data are for 2005, except incidence of HIV (2003) and undernourished people
(1999–2001). GDP data are adjusted to account for local differences in prices of basic commodities and services (adjusted for purchasing power parity).
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