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CHAPTER CHAPTER 8 Measuring the value of domestic production and income Chapter outline and learning objectives Gross domestic production to represent the value of production Measures of income and expenditure Price-adjusted (real) GDP and nominal GDP Production, income and the quality of life 1 Income, Expenditure and Production • Economists try to measure the income of everyone in the economy to determine a nation’s economic welfare. • The generation of income is ultimately determined by the ability to produce goods and services. 2 Income, Expenditure and Production • Income earned from producing goods and services generates income from expenditure on the goods and services because producers (firms) sell the goods and services that buyers buy. producers (firms) earn income from the expenditure of buyers in market transactions: every $ earned is a $ spent. 3 Income, Expenditure and Production income (or revenue) earned (by sellers) expenditure on goods and services (by buyers) production of goods and services (by producers) 4 Income, Expenditure and Production • Income and expenditure are therefore directly related to the value of goods and services produced, sold and bought in a market economy. We represent this idea with different kinds of transactions in the following diagram: 5 Expenditure, Income, Revenue, et cetera from the Production, Sale and Purchase of Goods and Services Revenue Markets for final goods and services •Firms sell •Households buy final goods and services sold Expenditure final goods and services bought Firms Households • Buy and consume final goods and services • Own, provide and sell factors of production • Produce and sell final goods and services • Buy, pay for and use factors of production factors of production bought Markets for factors of production (labor services, capital, ideas, natural resources) Wages, bonuses and benefits for workers; principal, interest and dividend payments for those who provide funds to pay for/invest in capital, natural resources and ideas •Households provide •Firms pay for factors of production sold Income = Flow of real resources = Flow of money 6 Income, Expenditure and Production • Thus to measure economic activity of individuals and institutions in the domestic economy, we can measure the value of (final) goods and services that they produce and sell. the value of expenditure on those goods and services. the value of income and revenue earned in production and sales. 7 Gross Domestic Production • Gross domestic production (GDP) is the government’s measure of the total, or gross, market value of all final goods and services produced in the domestic economy in the current period (quarter or year). Because it measures the value of production, it also measures the value of income earned from production and expenditure on goods and services produced, sold and bought. 8 Gross Domestic Production • GDP mostly measures the value of marketable production, through a monetary transaction in which a buyer and a seller exchange a product, but also a few non-marketable products whose values are estimated or imputed even though no explicit monetary transaction occurs. The values of these non-marketable products are imputed by using prices of similar market transactions, values of employee compensation, or costs of materials and supplies. 9 Gross Domestic Production • In particular, the following values are imputed: defense services of the national, state and local governments, education services provided by local governments, housing and health care services provided by non-profit institutions (such as the Red Cross), housing services enjoyed by homeowners, compensation in kind, such as employer provided meals and housing, financial and insurance services for which there is no explicit charge to the user, including medical services paid for by government or private insurance. 10 Gross Domestic Production 1. In the cases of defense, education, financial and insurance services; the values are imputed by the salaries of those providing the services. 2. In the case of housing services and health care services, the values are estimated by comparable market transactions. For example, the value of housing enjoyed by homeowners is imputed by using the value of comparable housing of renters, who do make a market transaction with landlords. 3. In the case of compensation in kind, values are imputed by the cost of materials and supplies. 11 Gross Domestic Production • But most products that do not involve a market transaction are excluded from the calculations. The value of work done at home for oneself (ex., cooking, cleaning, home repair,…) is excluded. Natural resources (ex., trees, open land, clean air, clean river water, underground resources) that are not bought and sold are also excluded. This can be a larger issue for some countries. Countries with abundant natural resources that are not sold and bought and poorly developed markets have lower GDP than otherwise. 12 Gross Domestic Production • GDP measures the value of marketable production, through a monetary transaction in which a buyer and a seller exchange a product (product = good or service), but not the value of financial assets like stocks, bonds and loans, although the value of financial services in the transaction are included. and not the value transfer payments—transfers of money—although the value of financial services in the transaction are included. 13 Gross Domestic Production • GDP measures the value of current or new production, not past production, so used goods are not included. The value of new production is measured in the current year or quarter. New goods produced and put into inventory are included as inventory investment, because they are treated as a kind of investment in future sales. 14 Gross Domestic Production • GDP measures the value of final production, not the value of intermediate products. Final products are those that are consumed and not used in a later stage of production, sold, given away, or otherwise transferred to foreign residents, used to produce other goods and that last more than a year, inventoried for future sale. 15 Gross Domestic Production In contrast, intermediate products are those that are used as inputs or integral parts of the final product and do not contribute to future production. Intermediate products are not counted as final production, but as a cost of production. o Examples: tires and engine parts used to make new cars; flour and eggs used to make bread at a bakery. o But tires, engine parts, flour and eggs bought by consumers are recorded in GDP because they are not used to produce other goods and services for a sale in the market. 16 Gross Domestic Production But the purchases of equipment for manufacturing cars or baking bread are classified as a final good (fixed or physical capital) that allows the firm to contribute to or to invest in future production. They are used to produce other goods and last more than a year. 17 Gross Domestic Production Intermediate goods and services are bought and sold in the wholesale market, by firms who use them to produce and sell other goods and services. Final goods and services are bought and sold in the retail market, by individuals and institutions that use the product itself and not for a later stage of production. 18 Gross Domestic Production • GDP represents the value of production in the domestic economy, even if foreign firms and workers are involved. It does not represent the value of production outside of the US, even if it is done by US affiliated or registered companies and US citizens. 19 Gross Domestic Production • GDP represents the value of formal, legal or official production, even though many informal, untaxed, unreported or illegal transactions occur outside the purview of government accountants and tax authorities. Unofficial/illegal transactions include unreported sales and purchases of legal products (for tax evasion) as well as sales and purchases of illegal goods like prostitution. This can be a larger issue for some countries. Some countries like Colombia and Russia have significant criminal and illegal activities. 20 Gross Domestic Production • The first official measure of GDP for the US economy was created by Simon Kuznets and his colleagues in the 1930s. The US and other nations were suffering from the Great Depression, but policy makers had no comprehensive picture of what was happening to the economy. This measure of gross or total production was created to address this shortcoming and has been used in the US and other countries since then to better understand the current state of the economy. 21 Calculating Gross Domestic Production • Since the 1930s, economists have developed different methods to measure GDP. The circular flow diagram shows a link among expenditure, income and marketable production, which are the bases of the different ways to measure GDP. 22 Calculating Gross Domestic Production • GDP can be measured through the value of 1. production (value of gross sales of final products minus the cost of intermediate products plus the value of intermediate products), 2. income earned from production and sales, 3. value added during the production process, 4. expenditure on final products. These values are recorded by the Bureau of Economic Analysis (BEA) in the National Income and Product(ion) Accounts (NIPA). 23 Calculating Gross Domestic Production 1. The value of production is measured by calculating the gross value from sales of firms plus their inventories, and then subtracting the value of intermediate goods and services (expenses) that firms purchase from other firms. 24 Calculating Gross Domestic Production 2. The value of (net) income of individuals and institutions that produce by adding the values of compensation, including the benefits from private and government insurance and employer and employee contributions to private and government retirement plans. net operating surplus or profit of proprietors for private firms. net income of government institutions from tax revenues and expenditures. depreciation or “consumption of fixed capital”. workers’ 25 Calculating Gross Domestic Production • Depreciation or “consumption of fixed capital” refers to the amount that buildings, equipment and other physical items used in the production process deteriorate, become damaged, get dirty or become obsolete in a normal fashion. Investment in depreciated physical capital will simply restore the value of existing capital to its original state. However, theft is usually not measured as depreciation unless it is an ongoing problem with inventories. The costs of catastrophic events are also not recorded as depreciation. Subtracting the value of depreciation from gross domestic production yields net domestic production or national income. the value of goods and services available for consumption or new physical capital. 26 Calculating Gross Domestic Production • Personal income is the income earned by individuals when they produce or finance production. It is calculated by adding workers’ compensation, including the benefits from private and government insurance and employer and employee contributions to private and government retirement plans, proprietors’ income (profit) for sole proprietors (individuals), rental income for owners of property, interest and dividend income for investors in firms, the institutions that produce, the net value of taxes on domestic products and imports minus the value of subsidies from the domestic government. 27 Calculating Gross Domestic Production However, personal income does not include gains or losses from changes in the prices of assets (called capital gains or capital losses) because such price changes do not directly affect production and are not income generated from production. In addition, one person’s capital gains is another person’s capital loss, so that capital gains and losses offer no additional net income for the domestic economy. 28 Measures of production and income • Gross national production (GNP) is the value of production by nationally registered institutions and US citizens. • Net domestic production or national income is gross domestic production minus depreciation. • Disposable personal income is personal income minus taxes. The value of US domestic production and income, 2012 © 2015 Pearson Education, Inc. 29 Calculating Gross Domestic Production 3. The value added approach represents the net value at each stage of the production process. The value added approach and the income approach can be represented in a simple example using the production process for bread: Producer Product Farmer Wheat $0 $1 $1 $1 Miller Flour $1 $3 $2 $2 Baker Bread $3 $7 $4 $4 $4 $11 $7 $7 Total Cost of intermediate products Gross sales Net income Value added Value of final production $7 Value of expenditure on final production $7 30 Calculating Gross Domestic Production This simple example shows that GDP can be calculated as the sum of net incomes (gross sales minus the cost of intermediate inputs) earned by producers or proprietors, $1 + $2 + $4. Because net income for each producer equals the value added (net value) at each stage of the production process, GDP can also be calculated as the sum of value added from each stage in the production process, $1 + $2 + $4. Finally, the total value of net income and value added equals the value of expenditure on final products, $7. 31 Calculating Gross Domestic Production 4. The expenditure approach classifies expenditure by the type of institution that spends money on final products: a. Households engage in consumption expenditure (C), at least when they do not increase productivity or investment in the economy. o Households may be also labeled consumers in this sense. o Consumption expenditure is further separated into expenditure on durable goods (lasting more than 1 year), non-durable goods (lasting 1 year or less) and services (ex., medical services, legal services, transportation services, lawn mowing, haircuts,…). 32 Calculating Gross Domestic Production b. (Gross private domestic) investment expenditure (I) refers to purchases by firms and individuals on new, final goods and services to increase productivity or future sales, which includes o expenditure by firms on new buildings or structures, equipment, infrastructure and intellectual property, all with a useful life of more than 1 year. o expenditure by individuals on new or improved houses, because houses are structures and viewed as an investment. o the value of inventories, which each firm is said to buy from itself, because inventories are an investment in future sales. Intermediate goods, which become an integral part of final products and do not contribute to future production, are not included in investment expenditure. 33 Calculating Gross Domestic Production c. Government expenditure (G) can be a kind of consumption expenditure or a kind of investment expenditure, depending on whether the expenditure is deemed to increase the productivity of the economy. o Government consumption expenditure usually includes expenditure on defense and education, although education is often considered to be an investment in the workforce and some defense spending can increase productivity in the civilian economy. o Government investment expenditure consists of government expenditure on structures, infrastructure, equipment and intellectual property. o Either kind of expenditure does not include transfers for social insurance programs like Medicare, Medicaid, subsidies and interest payments on debt. 34 Calculating Gross Domestic Production d. Foreigners buy exports (X) and domestic citizens buy imports (non-domestic production, M), and the net value contributes to the value of domestic production. o Because imports are produced in a foreign economy, their value is subtracted from the value of domestic production: 35 Calculating Gross Domestic Production GDP = Y = C + I + G + X – M value of domestic value of value of expenditure on domestically (national) produced final goods and services production income The BEA considers the expenditure approach to be the most accurate, given its comprehensive surveys and censuses for consumers and firms. Differences between the results of the expenditure approach and of other approaches are reported as a statistical discrepancy to show the magnitude of the inaccuracies and errors. 36 Expenditure on domestic products in the US, 2012 Components of GDP in 2012 • Consumption is the largest component of GDP; within that, services are the largest component—almost half of GDP. • Net exports are negative: the US imports more than it exports. © 2015 Pearson Education, Inc. 37 Gross Domestic Production • We could revise the circular flow diagram to represent governments and foreigners, but let’s draw a different circular diagram to represent total (gross) production, sales and expenditure in the economy. • We can also represent the role of money in a different way. 38 Who produces and sells? firms, workers governments security/safety regulations/laws judicial/fairness sanitation water electricity foreigners tangible goods, intangible services tangible goods: refrigerators, food, clothing intangible services: insurance, banking, transportation, health care 39 central bank Money is used to finance production and sales buys bonds (indirectly) to finance government expenditure governments security/safety regulations/laws judicial/fairness sanitation water electricity firms, workers payments for factors of production taxes paid, subsidies/transfers received provides money to finance expenditure tariffs paid, credit received domestic money/foreign money influences exchange rates tangible goods: domestic refrigerators, money, credit food, clothing foreigners tangible goods, intangible services foreign money, credit intangible services: insurance, banking, transportation, health care 40 Who buys? investment (housing expenditure) expenditure: housing individuals consumers (who earn income as workers and investors) consumption expenditure the distinction between investment expenditure and consumption expenditure is sometimes arbitrary firms (which earn revenue from profits) investment expenditure: (fixed) capital, inventories governments government expenditure (which earn revenue from taxes) foreigners exports – imports could be + or – 41 ACTIVE LEARNING GDP and its components In each of the following cases, determine how much GDP and each of its components is affected (if at all). A. Debbie spends $200 to buy her husband dinner. B. Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in China. C. Jane spends $1200 on a computer to use in her editing business. She got last year’s model on sale for a great price from a local manufacturer. D. General Motors builds $500 million worth of cars, but consumers only buy $470 million worth of them. 42 ACTIVE LEARNING Answers A. Debbie spends $200 to buy her husband dinner. Consumption expenditure and GDP rise by $200. B. Sarah spends $1800 on a new laptop to use in her publishing business. The laptop was built in China. Investment expenditure rises by $1800, net exports fall by $1800, GDP is unchanged. 43 ACTIVE LEARNING Answers C. Jane spends $1200 on a computer to use in her editing business. She got last year’s model on sale for a great price from a local manufacturer. Current GDP does not change because the computer was built last year. The value of inventories (investment expenditure) falls by $1800, investment expenditure by Jane rises by $1800. D. General Motors builds $500 million worth of cars, but consumers only buy $470 million of them. Consumption expenditure rises by $470 million, inventory investment expenditure rises by $30 million, and GDP rises by $500 million. 44 Real and Nominal Values of Production • Market value is measured by market prices, which can change each year without any change in production. The market value of producing using current prices is called the nominal value of production or nominal GDP. 45 Real and Nominal Values of Production • Economists want to focus on the value or quantity of real goods and services that are produced in the economy. How many houses, how much food, how many computers were produced in the domestic economy? Adjusting the nominal value of production results in real or price-adjusted GDP. 46 Real and Nominal Values of Production • Real GDP values the production of goods and services at constant prices. The calculation of real GDP tries to focus only on the quantity of real goods and services produced, and tries to ignore the effect of changing prices. Constant prices means that economists use average prices over time, but for following simple example we just use “average” prices from one year: 47 Real and Nominal Values of Products 48 Nominal Value of Products 49 Real (Price-Adjusted) Value of Products 50 Real and Nominal Values of Production The value of domestic production in the US, 1947.1-2015.1 real (price-adjusted) value 19000 18000 17000 16000 15000 14000 13000 12000 11000 10000 9000 8000 7000 6000 5000 4000 3000 2000 1000 0 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 billions of dollars nominal value Source: Bureau of Economic Analysis, http://www.bea.gov/ Note: real values use chained prices and 2009 as the index year 51 The GDP Deflator (Implicit Price Deflator) • The GDP deflator (or implicit price deflator) is the ratio of nominal GDP to real GDP. Nominal GDP GDP Deflator Real GDP It represents the rise in nominal GDP attributable to a rise in prices rather than a rise in production. It represents an average measure of prices for goods and services produced in the domestic economy. If prices are rising, nominal GDP will be larger than real GDP. 52 GDP (Implicit Price) Deflator 53 The GDP Deflator (Implicit Price Deflator) • Real GDP and the resulting implicit price deflator can be calculated using average prices from the current period and a past period, and these average prices can value both current production and past production in real terms. As prices change over time, these average prices can also be used to deflate the value of current expenditure (current nominal GDP), as well as inflate the value of past expenditure (past nominal GDP). 54 The GDP Deflator (Implicit Price Deflator) 16% 15% 14% 13% 12% 11% 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% -6% 1948 1949 1950 1951 1953 1954 1955 1956 1958 1959 1960 1961 1963 1964 1965 1966 1968 1969 1970 1971 1973 1974 1975 1976 1978 1979 1980 1981 1983 1984 1985 1986 1988 1989 1990 1991 1993 1994 1995 1996 1998 1999 2000 2001 2003 2004 2005 2006 2008 2009 2010 2011 2013 2014 Domestic expenditure price index inflation rates, 1948.1-2014.4 Gross domestic production price index Personal consumption expenditure price index Personal consumption expenditure price index, goods Personal consumption expenditure price index, services Fixed investment expenditure price index 55 The GDP Deflator (Implicit Price Deflator) • The average of current and past prices is continually updated (or chained) through time, so that “constant” prices are only constant for about 2 years. The average of this year’s prices and last year’s prices is used to determine how much the value of this year’s real production changed. In the next year, the average of next year’s prices and this year’s prices will be used to determine how much the value of next year’s real production will change. 56 The GDP Deflator (Implicit Price Deflator) This updating of average pricing, or chaining, allows prices/values of goods and services to be updated as the types and quality of goods and services change over time. 57 Production and Income per Person • We can also calculate the value of production and income per person. Recall that there is a close relationship between (personal) income and the value of production. The value of production per person represents what an average person produces, sells and earns (per year). In the US, production and income per person was about $46,405 in 2014. 58 GDP and the Quality of Life • GDP is an indicator of economic production, sales and purchases; but it is not a complete measure of social well being that could include measures of poverty, crime, status, equity, health, pollution and literacy. • Yet GDP per person is associated with some non-economic measures of the quality of life. Rich countries in terms of marketable production and income from production often have a better quality of life: 59 Value of Marketable Production and the Quality of Life Country/ Year Year: Real GDP per person (2005 $) Population with electricity (%) Life expectancy (years) Child mortality (per 1000 live births) Adult literacy (%) N2O pollution (CO2 kg equivalent per person) Intentional homicides (per 100,000 people) 2014 2012 2013 2013 2012 2010 2012 US 46405 100 78.8 6.9 99 304082 4.7 Germany 39718 100 81.0 3.9 99 42432 0.8° Japan 37595 100 83.3 2.9 99 25740 0.3° Korea 24566 100 81.5 3.7 99 14686 0.9° Russia 6844 100 71.1 10.1 99.7* 63728 9.2 Mexico 8626 99.1 77.4 14.5 94.2 43134 21.5 Brazil 5970 99.5 73.9 13.7 91.3 207576 25.2 China 3866 100 75.4 12.7 95.1* 550297 1.0* Indonesia 1866 96.0 70.8 29.3 92.8° 91313 0.6 India 1263 78.7 66.5 52.7 62.8♪ 234136 3.5 Pakistan 819 93.6 66.6 85.5 54.7° 30050 7.7 Nigeria 1092 55.6 52.5 117.4 51.1† 35475 20.0 750 59.6 70.7 41.1 58.8 26160 2.7 Bangladesh Source: The World Bank, http://data.worldbank.org/ ♪2006 data, † 2008 data, *2010 data, °2011 data 60 Summary • Because every transaction has a buyer and a seller, total expenditure on goods and services equals total income on goods and services, both of which equal the total value of goods and services produced, sold and bought in market transactions. • Gross domestic production (GDP) measures the gross (total) value of final goods and services produced in the domestic economy, and therefore the total expenditure on these goods and services, and the total income earned from producing these goods and services. 61 Summary • By definition, GDP is the market value of all final goods and services produced within a country in a given period of time. • GDP can be measured by calculating four broad types of expenditure: consumption expenditure, investment expenditure, government purchases, and net exports. 62 Summary • Nominal GDP uses current prices to measure the value of goods and services. • Real GDP uses constant prices from a particular period to measure value. • The GDP deflator—the ratio of nominal GDP to real GDP—measures the level of prices for goods and services. 63 Summary • GDP per person measures of the value of production and income from market transactions for the average person in society. • GDP per person is associated with other measures of welfare, such as life expectancy, although it is not a measure of happiness. 64