Gross Domestic Product 11.1

OBJECTIVES Describe what the gross domestic product measures. Learn two ways to calculate the gross domestic product, and explain why they are equivalent.

The Great Depression of the 1930s convinced economists to get a better handle on what was happening with the economy. P. 321: In the News – Tracking a $12 Trillion Economy

Why is it important for the U. S Why is it important for the U.S. government to keep track of the economy & why should people care about production? The U.S. gov. keeps track of the economy in order to ensure the welfare of citizens & businesses. People should care about production because it will give them an insight into the health of the economy & help them make better personal decisions.

Macroeconomics overall performance of the national economy Economy – describes structure of economic activity in a geographic area. What is produced, how Measured: Value of production Number employed Total income

GDP Gross domestic product Measures all final goods and services during a given period (year) Goods: bikes, toothbrush,contact lenses Services: pedicures, bus rides Includes production in the U.S. by foreign firms Excludes foreign production by the U.S. firms.

Final goods and services Only goods sold to final end users are counted. No Double Counting Intermediate goods and services are not counted. Purchased for additional processing and resale Secondhand & used goods are also ignored Increased value is included

2 Why wouldn’t you add $100 to GDP if you produced a table that you sold for $100? You had to pay for wood, screws, and varnish to construct the table. Therefore, including the entire price of the table in GDP would have resulted in double counting.

√1 What does the Gross Domestic Product Measure? The GDP measures the market value of all final goods and services produced in the U.S. during a given period.

Calculating GDP Calculating the value of production is complicated. Marvin bakes a cake that sells for $10.00. Did Marvin produce $10.00 worth of value? What resource costs had to be paid beyond his labor? Why is the task of measuring the value of production much easier when only the value of final goods and services measured.

Calculating GDP Cake sold for $10.00 Measure the price of Marvin’s contribution Cake mix $1.89 Other ingredients $0.83 Electricity $0.21 Share of rent $0.33 Share of marketing $0.25 Share of management $0.20 Other costs $0.48 Total $5.19 How much of the of the $10.00 price should be allocated to profit for the owner’s entrepreneurship?

Calculating GDP Cake sold for $10.00 Assume that Marvin earns $7.00 per hours and used 30 minutes to bake the cake. What’s Marvin’s labor worth? ($7.00 / 2 = $3.50) How much profit did the owner receive? ($10.00 – 3.50 – 5.19 = $1.31)

Calculating GDP The national accounts are based on the idea that one person’s spending is another person’s income. Double entry bookkeeping: GDP can be measured by either total spending or by total income.

3 Money spent by one person is income received by someone else. Further, this is the only way to receive income. (Wages are a form of spending because employers are buying labor. Interest is a form of spending because borrowers are buying the use of someone else’s money, etc.) Therefore, the value of spending must equal the value of income.

Expenditure Approach Adds up the spending on all final goods and services produced in the economy. Components: Consumption: purchases by households (2/3 of all spending) Nondurable goods: soap Durable goods: expected to last at least 3 years Investment: spending on current production that is not used for current consumption. (15% of US GDP) New Physical capital (existing physical capital is not counted) inventories

Expenditure Approach Components: (cont.) Government purchases (20% of GDP) Spending by all levels of government for goods and services. Net exports Spending on imports does not count of GDP The value of imports must be subtracted from value of exports. (X-M)

4 When a business builds a new factory and the government builds a new road, they are both using current production in ways that do not addd to current consumption.

Aggregate (total) expenditure Consumption + Investment + government purchases + net exports (X-M) C + I + G + (X-M) = GDP If the value of imports exceeds the value of exports, that means net exports are negative. Negative exports means that the sum of consumption, investment and government purchases exceeds GDP.

5 “Aggregate” means “total”. So, this statement means that the total income received by all students in the class was $52,315.28 last year.

Income approach to GDP Adds up the total income earned by production. Double entry bookkeeping ensures : Total expenditure = GDP = Total income You avoid double counting either by focusing on the market value of the product when it is sold or by calculating the value added at each stage of production

√2 The two ways to calculate GDP are the expenditure approach and the income approach. According to the expenditure approach, C+I+G+(X-M) = GDP, where C is the sum of consumption, I is investment, G is government purchases, X is exports, M is imports, and (X-M) is net exports. According to the income approach, GDP equals aggregate income. They are equivalent because they both measure the market value of the final goods and services produced.

6 Government spending and investment spending were larger parts of GDP in 1970. This corresponded to a relatively smaller share of share of GDP being allocated to personal consumption. A large part of 2000 spending was used to buy imported goods that caused a negative net trade.

7 The price of a gallon of gasoline would be $1.00 $20/40= $.50 $.50+$.18 = $.68 $.68 x 1.25 = $.85 $.85 + $.07 = $.92 $.92 = $.08 = $1.00 If the value of the gasoline at each step in its production process were added, the total value would far exceed the price charged to consumers. This is why only the final price is included when calculating GDP

8 French fries were produced using more resources, particularly labor. This justifies their greater value and contribution.