Chapter 12
Production, Income,
and Employment
INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL
CHAPTER 12 / PRODUCTION, INCOME, AND EMPLOYMENT
©2005, South-Western/Thomson Learning
Slides by John F. Hall
Animations by Anthony Zambelli
Production and Gross Domestic
Product, GDP: A Definition
U.S. government has been measuring
nation’s total production since 1930s
 Many conceptual traps and pitfalls
 This is why economists have come up with a

very precise definition of GDP
 The nation’s gross domestic product (GDP)
• Total value of all final goods and services produced for
the marketplace during a given period within the
nation’s borders
Lieberman & Hall; Introduction to Economics, 2005
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Production and Gross Domestic
Product, GDP: A Definition

The total value
 Approach of GDP is to add up dollar value of every good or
service—the number of dollars each product is sold for
• However, using the dollar prices at which goods and services actually
sell also creates a problem



If prices rise, then GDP will rise, even if we are not actually producing more
GDP must be adjusted to take away the effects of inflation
…of all final…
 When measuring production, we do not count every good or service
produced in the economy
• Only those that are sold to their final users
• Avoids over-counting intermediate products when measuring GDP

Value of all intermediate products is automatically included in value of final
products they are used to create
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Production and Gross Domestic
Product, GDP: A Definition

…goods and services…
 We all know a good when we see one
 Final services count in GDP in the same way as
final goods

…produced…
 In order to contribute to GDP, something must be
produced
• During the period being considered
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Figure 1: Stages of Production
$1.00
(Wood Chips)
Lumber
Mill
$1.50
(Raw Paper)
Paper
Mill
Lieberman & Hall; Introduction to Economics, 2005
$2.25
(Notebook
Paper)
Office Supplies
Manufacturer
$3.50
(Notebook
Paper)
Wholesaler
$5.00
(Notebook
Paper)
Retailer
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Production and Gross Domestic
Product, GDP: A Definition

…for the marketplace…
 GDP does not include all final goods and services
produced in the economy
• Includes only the ones produced for the marketplace—that is,
with the intention of being sold

…during a given period…
 GDP measures production during some specific period of
time
• Only goods produced during that period are counted
• GDP is actually measured for each quarter, and then reported as
an annual rate for the quarter
• Once fourth quarter figures are in, government also reports
official GDP figure for entire year
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Production and Gross Domestic
Product, GDP: A Definition
 …within
the nation’s borders
 GDP measures output produced within
U.S. borders
• Regardless of whether it was produced by
Americans
 Americans
abroad are not counted
 However, foreigners producing goods or services
within the country are
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The Expenditure Approach to GDP

The Commerce Department’s Bureau of Economic Analysis
(BEA)
 Agency responsible for gathering, reporting, and analyzing
movements in the nation’s output
 Calculates GDP in several different ways

Expenditure approach divides output into four categories
according to which group in the economy purchases it as
final users
 Consumption goods and services (C)—purchased by households
 Private investment goods and services (I)—purchased by
businesses
 Government goods and services (G)—purchased by government
agencies
 Net exports (NX)—purchased by foreigners
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The Expenditure Approach to GDP

Everyone who purchases a good or service
included in U.S. GDP must be either a
 U.S. household
 U.S. business or
 U.S. government agency (including state and
local government)
 Or else is part of the foreign sector

When we add up the purchases of all four
groups we get GDP
• GDP = C + I + G + NX
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Consumption Spending

Consumption is the part of GDP purchased by
households as final users
 Almost everything households buy during the year is


included as part of consumption spending when we
calculate GDP
One exception is construction of new homes
• Counted as private investment
Some quirky exceptions to the definition of consumption
• Total value of all food products that farm families produce and
consume themselves
• Total value of the housing services provided by owner-occupied
homes
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Private Investment

Private investment has three components
 Business Purchases of Plant, Equipment, and Software
• A firm’s plant, equipment, and software are intended to last for many years—only
•
a small part of them is used up to make the current year’s output
Are regarded and software as final goods, and firms that buy them as final users
of those goods
 New Home Construction
• Residential housing is an important part of nation’s capital stock
• House will continue to provide services into the future
 Changes in Inventories
• We count the charge in firms’ inventories as part of investment in measuring GDP
• Why?



When goods are produced but not sold during the year, they end up in some firm’s
inventory stocks
Part of the nation’s capital stock
Will provide services in the future, when they are finally sold and used
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Private Investment and the Capital
Stock: Some Provisos


Changes in the nation’s capital stock are somewhat more complicated
than we are able to capture with private investment alone
Specifically, private investment does not include
 Government Investment
• An important part of the nation’s capital stock is owned and operated not by
business, but by government—federal, state, and local
 Consumer durables
• Goods such as furniture, automobiles, washing machines, and personal
computers for home use can be considered capital goods

Will continue to provide services for many years
 Human capital
• To measure the increase in capital stock most broadly we include the additional
skills and training acquired by workforce during the year

In addition to excluding some types of capital formation, private
investment also errs in the other direction
 Ignores depreciation—the capital that is used up during the year
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Government Purchases


Purchases by state, local governments and federal
government are included
Government purchases include
 Goods

• Fighter jets, police cars, school buildings, spy satellites, etc.
Services
• Such as those performed by police, legislators, and military
personnel

Government is considered to be a purchaser even
if it actually produces the goods or services itself
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Government Purchases

Important to distinguish between
 Government purchases
• Which are counted in GDP
 Government outlays
• As measured by local, state, and federal budgets and reported in the
media

Transfer payments represent money redistributed from one
group of citizens (taxpayers) to another (poor, unemployed,
elderly)
 While transfers are included in government budgets as outlays they
are not purchases of currently produced goods and services
• Not included in government purchases or in GDP
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Net Exports

Once we recognize dealings with the rest of
the world, we must correct an inaccuracy in
our measure of GDP
 Deduct all U.S. imports during the year, leaving
us with just output produced in United States

To properly account for output sold to, and
bought from, foreigners
 Must include net exports—difference between
exports and imports—as part of expenditure in
GDP
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Other Approaches to GDP: The ValueAdded Approach
 Value
added
 Firm’s contribution to a product or
 Revenue it receives for its output
• Minus cost of all the intermediate goods that it
buys
 GDP
is sum of values added by all firms
in economy
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Other Approaches to GDP: The Factor
Payments Approach


In any year, value added by a firm is equal to total factor
payments made by that firm
GDP equals sum of all firms’ value added
 Each firm’s value added is equal to its factor payments
• Thus, GDP must equal total factor payments made by all firms in the
•
economy
All of these factor payments are received by households in the form of
wages and salaries, rent, interest or profit


GDP is measured by adding up all of the income—wages and salaries, rent,
interest, and profit—earned by all households in the economy
Gives us an important insight into the macroeconomy
 Total output of economy (GDP) is equal to total income earned in the
economy
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Measuring GDP: A Summary

Different ways to calculate GDP
 Expenditure Approach
• GDP = C + I + G + NX
 Value-Added Approach
• GDP = Sum of value added by all firms
 Factor Payments Approach
• GDP = Sum of factor payments made by all firms
• GDP = Wages and Salaries + interest + rent + profit
• GDP = Total household income
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Real Versus Nominal GDP


Since GDP is measured in dollars, a serious
problem exists when tracking change in output over
time
 Value of the dollar—its purchasing power—is changing
Usually need to adjust our measurements to reflect
changes in the value of the dollar
 Nominal—when a variable is measured over time with no


adjustment for the dollar’s changing value
Real—when a variable is adjusted for the dollar’s
changing value
Most government statistics are reported in both
nominal and real terms
 Economists focus almost exclusively on real variables
Lieberman & Hall; Introduction to Economics, 2005
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The Importance of Real Values: A Basic
Principle
The distinction between nominal and real
values is crucial in macroeconomics
 The public, the media, and sometimes even
government officials have been confused by
a failure to make this distinction
 Since our economic well-being depends, in part,

on the goods and services we can buy
• It is important to translate nominal values—which are
measured in current dollars—to real values—which
are measured in purchasing power
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How GDP Is Used

Government’s reports on GDP are used to steer the
economy over both short-run and long-run
 In short-run, to alert us to recessions and give us a


chance to stabilize the economy
In long-run, to tell us whether our economy is growing
fast enough to raise output per capita and our standard
of living, and fast enough to generate sufficient jobs for a
growing population
Many (but not all) economists believe that, if alerted
in time
 Government can design policies to help keep the
economy on a more balanced course
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Figure 2: Real GDP Growth Rate,
1960–2003
Real GDP
Growth
Rate
(Percent
Change
from
Previous
Period)
8
7
6
5
4
3
2
1
0
-1
-2
-3
Actual GDP growth rate
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GDP growth
needed for constant
unemployment
rate
GDP growth
needed for constant
output per capita
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Problems With GDP

Quality changes
 While BEA includes impact of quality changes for
many goods and services (such as automobiles
and computers)
• Does not have the resources to estimate quality
changes for millions of different goods and services

By ignoring these quality improvements,
GDP probably understates true growth from
year to year
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The Underground Economy

Some production is hidden from government
authorities
 Either because it is illegal or
• Drugs, prostitution, most gambling
 Because those engaged in it are avoiding taxes
• Production in these hidden markets cannot be
measured accurately

BEA must estimate it
 Many economists believe that BEA’s estimates are too
low
 As a result, GDP may understate total output
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Non-Market Production

GDP does not include non-market production
 Goods and services that are produced, but not sold in the marketplace

Whenever a non-market transaction becomes a market transaction GDP will rise
 Even though total production has remained the same
• Can exaggerate the growth in GDP over long periods of time

What do these problems tell us about value of GDP?
 For certain purposes—especially interpreting long-run changes in GDP—we must
exercise caution

GDP works much better as a guide to short-run performance of economy
 Short-term changes in real GDP are fairly accurate reflections of the state of the


economy
A significant quarter-to-quarter change in real GDP virtually always indicates a change
in actual production; rather than a measurement problem
This is why policy makers, business people, and the media pay such close
attention to GDP as a guide to the economy from quarter to quarter
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Types of Unemployment

In United States, people are considered
unemployed if they are not working and actively
seeking a job
 Unemployment can arise for a variety of reasons, each

with its own policy implications
This is why economists have found it useful to classify
unemployment into four different categories




Frictional unemployment
Seasonal unemployment
Structural unemployment
Cyclical unemployment
 Each arises from a different cause and has different
consequences
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Frictional Unemployment



Short-term joblessness experienced by people who
are between jobs or who are entering the labor
market for first time or after an absence
Because frictional unemployment is, by definition,
short-term, it causes little hardship to those affected
by it
By spending time searching rather than jumping at
the first opening that comes their way
 People find jobs for which they are better suited and in
which they will ultimately be more productive
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Seasonal Unemployment


Joblessness related to changes in weather, tourist
patterns, or other seasonal factors
Is rather benign
 Short-term
 Workers are often compensated in advance for
unemployment they experience in off-season

To prevent any misunderstandings, government
usually reports the seasonally-adjusted rate of
unemployment
 Rate that reflects only those changes beyond normal for
the month
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Structural Unemployment

Joblessness arising from mismatches
between workers’ skills and employers’
requirements
 Or between workers’ locations and employers’
locations

Generally a stubborn, long-term problem
 Often lasting several years or more
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Cyclical Unemployment



When the economy goes into a recession and total output falls, the
unemployment rate rises
Since it arises from conditions in the overall economy, cyclical
unemployment is a problem for macroeconomic policy
Macroeconomists say we have reached full employment when cyclical
unemployment is reduced to zero
 But the overall unemployment rate at full employment is greater than zero
• Because there are still positive levels of frictional, seasonal, and structural
unemployment

How do we tell how much of our unemployment is cyclical?
 Many economists believe that today, normal amounts of frictional, seasonal,
and structural unemployment account for an unemployment rate of between
4 and 4.5% in United States
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Unemployment Rate (Percent)
Figure 3: U.S. Quarterly
Unemployment Rate, 1960–2003
11
10
9
8
7
6
5
4
3
2
1
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The Costs of Unemployment: Economic
Costs


Chief economic cost of unemployment is the opportunity
cost of lost output
 Goods and services the jobless would produce if they were working
 But do not produce because they cannot find work
The unemployed are often given government assistance
 Costs are spread among citizens in general
 However, when there is cyclical unemployment, nation produces less
output
• Some groups within society must consume less output

Potential output
 Level of output economy could produce if operating at full
employment
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Actual and Potential Real GDP
(Billions of 1996 Dollars)
Figure 4: Actual And Potential Real
GDP, 1960–2003
10,000
Potential output
9,000
8,000
7,000
6,000
5,000
Actual output
4,000
3,000
2,000
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Broader Costs


Unemployment—especially when it lasts for many
months or years
 Can have serious psychological and physical effects
 Also causes setbacks in achieving important social goals
Burden of unemployment is not shared equally
among different groups in the population
 Tends to fall most heavily on minorities, especially
minority youth
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How Unemployment is Measured


The unemployed are those willing and able to work,
but who do not have jobs
Others were able to work, but preferred not to
 Including millions of college students, homemakers, and


retired people
Still others were in the military and are counted in the
population
• But not counted when calculating civilian employment statistics
To be counted as unemployed, you must have
recently searched for work
 But how can we tell who has, and who has not, recently
searched for work?
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The Census Bureau’s Household
Survey

Every month, thousands of interviewers from United States
Census Bureau—acting on behalf of the U.S. Bureau of
Labor Statistics (BLS)—conduct a survey of 60,000
households across America
 Household members who are under 16, in the military, or currently
residing in an institution like a prison or hospital are excluded from
survey

Official unemployment rate
 Percentage of the labor force that is unemployed
Unemployme nt rate 
Lieberman & Hall; Introduction to Economics, 2005
Unemployed
Unemployed

Labor Force (Unemploye d  Employed)
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Figure 5: How BLS Measures
Employment Status
Worked one or
more hours
for pay?
Yes
Employed
No
Yes
Temporary
layoff?
Unemployed
No
Searched for
work?
Yes
Unemployed
No
Not in Labor Force
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Problems In Measuring Unemployment

Many economists believe that our official measure seriously
underestimates extent of unemployment in our society due
to
 Treatment of involuntary part-time workers
• Some economists have suggested that involuntary part-time workers
should be regarded as partially employed and partially unemployed
 Treatment of discouraged workers
• Individuals who would like to work but, because they feel little hope of
finding a job, have given up searching


How many discouraged workers are there?
 No one knows for sure
Still, the unemployment rate—as currently measured—tells
us something important
 Number of people who are searching for jobs, but have not yet found
them
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Figure 6: Employment Status of the
U.S. Population—June 2003
U.S. Population June 2003
Civilian
Noninstitutional
Population
Labor
Force
Lieberman & Hall; Introduction to Economics, 2005
Under 16 Military or
Institutionalized
70 Million
Not in Labor Force
73.9 Million
Unemployed
9.4 Million
Employed
137.7 Million
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GDP After September 11


On September 11, 2001, United States suffered an
unprecedented terrorist attack
What would happen after September 11?
 Would the recession deepen?
• How badly?
 Could the economy actually tilt into a depression?
 What was the appropriate economic policy, and how should it be
orchestrated?

Helpful to distinguish between
 Direct impact of GDP
• Direct result of destruction itself
 Indirect impact
• Resulting from choices of economic-decision makers in the weeks,
months, and even years following the attack
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The Direct Impact On GDP
At first, it seems that the direct impact of the
attacks on GDP should be huge
 GDP is not designed to measure the
resources at our disposal, but rather the
production we get from those resource
 The destruction caused by the terrorist attacks of

September 11 had almost no direct impact on the
U.S. economy or U.S. GDP
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Indirect Impacts on GDP: The Short
Run


Indirect losses to GDP were significant
Useful to distinguish between
 Short-run impact


• Weeks and months following the attacks
long-run impact
• We’ll be experiencing for several years
Did not take long for aftermath of attacks to affect
economic decision making
 Federal government immediately shut down airports
nationwide for more than 48 hours
• With fewer people flying, hotel occupancy rates also decreased—
by about 20%
• Problem spread to manufacturing and raw materials sectors of
the economy
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Indirect Impacts on GDP: The Short
Run

Consumers made other decisions that affected
production
 Instances of increased production
 But these increases in production were swamped by
production cuts already rippling through the economy

GDP did a good job of capturing all of these
changes in spending and production
 Bureau of Economic Analysis reported that production
turned southward in the third quarter of 2001
• With much of the decline occurring during the three weeks of the
quarter that remained after September 11
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The Long-Run

In the weeks following the attack, it became clear that U.S.
was about to start on a course it would follow for many
years
 Huge reallocation of national resources toward fighting terrorism
abroad and achieving greater security at home


Some of these resources are being purchased by the
government
Over the next two years, U.S. spent billions of additional
dollars pursuing a more aggressive foreign policy including
 Invasion to overthrow regime of Saddam Hussein in Iraq
 Increased aid to allies—and potential allies—in war against terrorism
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The Long-Run


But private businesses have been spending more
for security each year than they did before
All these security expenses are slowing growth of
our potential output
 Therefore slowing growth of real GDP over long-run
 In long-run, as the nation shifts production away from

other goods and services and toward security in the
wake of September 11, impact on real GDP will be
negative
Potential output—and over the long-run, actual output—
will grow more slowly than it otherwise would have
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