Download Definitions and measurement

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