Gross domestic product (GDP) is the market value of all final goods and services produced
within an economy in a given period of time. It is the National Total Income and the total expenditure of a particular nation.
Imagine a nation A economy that produces many different goods and services—hamburgers, haircuts, cars, computers, teaching, chiropractor, yoga, gym, and so on. GDP combines the value of these goods and services into a single measure. The diversity of products in the economy complicates the calculation of GDP because different products have different values.
Suppose, for example, that the economy produces four electric bikes and three road bikes. How do we compute GDP? We could simply add electric bikes and road bikes and conclude that GDP equals seven bicycles. But this makes sense only if we thought electric bikes and road bikes had equal value, which is generally not true. (This would be even clearer if the economy had produced four regular bicycles and three moutain bikes.)
To compute the total value of different goods and services, the national income accounts use market prices because these prices reflect how much people are willing to pay for a good or service. Thus, if electric bikes cost $5,000 each and road bikes cost $2,000 each, GDP would be:
GDP = (Price of electric bikes × Quantity of electric bikes) + (Price of road bikes × Quantity of road bikes)
= ($5,000× 4) + ($2,000 × 3)
*the sale of used goods is not included as part of GDP.
So, if a used bike is to be sold, that money involved is not added to GDP.
*sale out of inventory does not affect GDP either.
*GDP includes only the value of final goods.
So, when a bike shop purchase tires and breaks to assemble a bike, that price is not included in GDP. The reason is that the value of intermediate goods is already included as part of the market price of the final goods in which they are used. To add the intermediate goods to the final goods would be double counting.
*the rent is part of GDP, both as expenditure by the renter and as income for the landlord.
*Finally, no imputation is made for the value of goods and services sold in the underground economy. The underground economy is the part of the economy that people hide from the government either because they wish to evade taxation or because the activity is illegal. Examples include domestic workers paid “off the books” and the illegal drug trade.
Real GDP Versus Nominal GDP
Economists call the value of goods and services measured at current prices as nominal GDP.
Real GDP is the value of goods and services measured using a constant set of prices. That is, real GDP shows what would have happened to expenditure on output if quantities had changed but prices had not.
To see how real GDP is computed, imagine we wanted to compare output in 2009 with output in subsequent years for our electric bike-and-road bike economy. We could begin by choosing a set of prices, called base-year prices, such as the prices that prevailed in 2009. Goods and services are then added up using these base-year prices to value the different goods in each year. Real GDP for 2009
Real GDP = (2009 Price of electric bikes × 2009 Quantity of electric bikes) + (2009 Price of road bikes × 2009 Quantity of road bikes).
Similarly, real GDP in 2010 would be:
Real GDP = (2009 Price of electric bikes × 2010 Quantity of electric bikes) + (2009 Price of road bikes × 2010 Quantity of road bikes).
And real GDP in 2011 would be:
Real GDP = (2009 Price of electric bikes × 2011 Quantity of electric bikes) + (2009 Price of road bikes × 2011 Quantity of road bikes).
Notice that 2009 prices are used to compute real GDP for all three years. Because the prices are held constant, real GDP varies from year to year only if the quantities produced vary. Because a society’s ability to provide economic satisfaction for its members ultimately depends on the quantities of goods and services produced, real GDP provides a better measure of economic well-being than
The GDP Deflator
The Components of Expenditure:
Economists and policymakers care not only about the economy’s total output of goods and services but also about the allocation of this output among alternative uses. The national income accounts divide GDP into four broad categories of spending:
■ Consumption (C)
■ Investment (I )
■ Government purchases (G)
■ Net exports (NX).
Thus, letting Y stand for GDP: Y = C + I + G + NX.
Other Measures of Income
GNP – Gross National Product
GNP = GDP + Factor Payments from Abroad − Factor Payments to Abroad
NNP – Net National Product
NNP = GNP − Depreciation
The six categories, and the percentage of national income paid in each category, are
■ Compensation of employees (63.7%). The wages and fringe benefits earned by workers.
■ Proprietors’ income (8.6%). The income of noncorporate businesses, such as small farms, mom-and-pop stores, and law partnerships.
■ Rental income (0.3%). The income that landlords receive, including the imputed rent that homeowners “pay” to themselves, less expenses, such as depreciation.
■ Corporate profits (13.4%). The income of corporations after payments to their workers and creditors.
■ Net interest (5.4%). The interest domestic businesses pay minus the interest they receive, plus interest earned from foreigners.
■ Indirect business taxes (8.6%). Certain taxes on businesses, such as sales taxes, less offsetting business subsidies. These taxes place a wedge between the price that consumers pay for a good and the price that firms receive.
You can learn more about the GDP quantity of inputs, called the factors of production, and its ability to turn inputs into output here.
Reference: Chapter 2