What is Gross Domestic Product (GDP)?

One of the primary economic indicators is gross domestic product, or GDP for short. GDP is typically defined as the market value of all final goods and services produced within a country in a year.

To understand exactly what GDP measures, let’s examine this definition piece by piece. First, GDP is calculated using final prices, which is the price a consumer paid for the item.

Second, GDP counts only final goods and services. These are goods sold to a final consumer, to avoid double counting. Intermediate goods, those that are used as inputs in other goods, don’t count towards GDP, since their value is included in the price of the final good. For example, tires that Goodyear manufactures in the US and sells to Ford to put on their new cars do not count towards GDP. When Ford sells the car to the customer, the entire car value counts towards GDP, including the value of the wheels. If the tire sales from Goodyear to Ford were also included, the value of the tires would be counted twice in GDP. However, if you live in the United States and buy tires made in the US from a dealer to use on your car, that purchase does count towards GDP because you are the final consumer.

Third, GDP measures what is produced in that country’s geographic borders. If you buy ramen made at a restaurant in New York City by a Japanese chef, that purchase counts towards GDP. On the other hand, if you go to the store and buy a nice French brie, that won’t count toward US GDP. It counts towards France’s GDP since it was made in France.

Fourth, GDP only measures goods and services created this year. It does not count goods that were created previously and sold this year, like a used house, a used car, or sales of older inventory.

In the US, GDP is typically calculated using the expenditure approach, which sums up spending on different categories of goods and services. The first category is consumption spending, or C, such as purchasing food, clothing, or entertainment. The second category is business investment, I, such as purchases of manufacturing equipment or inventory created this year to sell next year. Third is government spending, G, such as infrastructure spending. Note that this category does not count income transfers such as social security payments and unemployment benefits. These get counted when the money is spent on other goods and services. The last category is exports, or X, meaning purchases of US goods by people outside the US. Finally, GDP corrects for the erroneous inclusion of any foreign goods in US GDP by subtracting imports, or M. This is an accounting correction performed by the Bureau of Economic Analysis to account for reports that include imports in C, I, and G. The net effect of imports on GDP is zero. The basic equation, using abbreviations, is commonly written as \(C+I+G+X-M=Y\), with Y representing GDP.

A few modifications are regularly made to GDP to allow better comparisons over time and across countries. Firstly, GDP is commonly adjusted to account for inflation, that is, changes in the overall price levels for goods and services, using a price index such as the Consumer Price Index, or CPI, or GDP deflator. When GDP is adjusted for inflation, it’s called real GDP. Secondly, GDP is commonly divided by the population size to approximate the output per person in an economy and referred to as GDP per capita. When GDP is modified for inflation and population, it is called real GDP per capita.

Although economists in the 1800s started to develop national accounting measures, modernized, detailed national income accounting took shape primarily in the 1930s, amidst the Great Depression and back-to-back world wars. In the US, economist Simon Kuznets worked to develop accurate estimates of national income. He found that America’s national income had halved between 1929 and 1932! Kuznets in particular desired a national accounting that measured welfare as opposed to output, and recommended subtracting measures that “represent dis-service,” including government spending on armaments and infrastructure. Kuznets lost this argument to bureaucrats who wanted government spending and production included in national account figures as the US ramped up arms production for WWII.

Over in England, economist John Maynard Keynes wrestled with how to measure economic activity to understand how much the UK economy could produce for the war effort and how much would be left for consumers. Persuaded by Keynes’ arguments, the Treasury department hired Richard Stone and James Meade, who developed a modernized system of national accounts, with Stone later winning a Nobel prize for his work in developing modern GDP accounting.

Understanding the history of GDP helps to explain some of the shortcomings of using GDP as an economic indicator. Let’s look at some of those shortcomings:

1. GDP does not include free digital services, such as Google search, email, to-do apps, Instagram, etc. Currently, only the ads sold measure the value of these services, but a study from MIT suggests that the true value of these services provided to millions daily are not accurately accounted for in GDP.
2. GDP does not account for household or informal work or black market work. Parents who stay at home to care for their children do not have their work accounted for in GDP, but the same work is calculated in GDP when parents pay for a daycare or a nanny “on the books.” Informal work that escapes GDP calculations could also include the $30 in cash you paid your 15-year-old neighbor to mow your lawn, or the endless hours you spent each weekend repairing your “fixer upper” home. Since these activities aren’t reported and tabulated, they aren’t included in the final GDP numbers, even though these are valuable services rendered this year. This can make it difficult to compare GDP over large time frames when cultures have shifted, say in the US between 1957 and 2017, or between countries with different work cultures.
3. GDP does not account for externalities. Externalities can either be positive or negative, but in criticisms of GDP, most focus on the problems for not including the negative externalities. For example, GDP counts the value of cars manufactured and oil refined, but not the estimated cost of pollution created by the manufacture or use of these items.
4. GDP does not account for depreciation (the wear and tear on buildings, machinery, and other capital goods).
5. GDP does not account for destruction. If a hurricane hits the coast of Florida and destroys millions of dollars of property, no adjustment is made to GDP, but the millions of dollars spent to repair those properties to their original condition does count towards GDP. This can make it look like an economy is better off, when in reality, they may have the exact same amount of goods as before and less savings.
6. GDP does not account for leisure time. This means GDP will go up when everyone works unsustainable overtime hours, but will decrease when workers return to working normal work weeks.
7. GDP does not account for income distribution, which can give a misleading picture of wellbeing for individuals in lower income groups.
8. GDP is an important tool for gauging overall economic activity, but it’s not a perfect tool for measuring economic activity, nor should it be considered an accurate measurement of a country’s wellbeing or happiness level. Additionally, as illustrated by the 2008 Financial Crisis, it’s important to look not just at the aggregate picture given by the GDP, but also at activity in individual industries.

Now for a few review questions.

1. Which of the following transactions is included in US GDP for this year?

1. Joe purchases a Toyota Tacoma built in Kentucky last December for his wife, Tonya.
2. Kira orders windshield wipers for installation in new postal trucks that will be sold to UPS.
3. James, a Frenchman, orders three dozen Maine lobsters to be served at his wedding in Prince Edward Island.
4. Jessica orders five million new SIM cards from a factory in Taiwan run by American businessmen.

 
2. Which of the following statements best illustrates the value of measuring GDP?

1. GDP per capita always increases as the population increases.
2. Real GDP decreases when there is destruction.
3. GDP per capita follows the business cycle and will always increase with a rise in unemployment.
4. Real GDP increases show that overall output in the economy is increasing.

 
3. Which of the following is a shortcoming of GDP?

1. GDP only measures final goods.
2. GDP does not account for wartime destruction.
3. GDP overestimates the contribution of informal household labor.
4. GDP cannot be adjusted for inflation.

All right; that’s the end of the video, but feel free to hit replay as many times as you need, and I’ll be here. Thanks for watching, and happy studying!