Gross Domestic Product (GDP)
When an entrepreneur organizes a business, she does so in the hope of making money, by buying the inputs to produce a product or service that can be sold for a higher price than the cost of the inputs. However, businesses take time to organize and to become profitable. In the meantime, a business has to know how it is doing. Accounting is a means of assessing that performance. Similarly, it would be advantageous to be able to assess the state of the economy and its rate of growth.
National income accounting is accounting for the nation as a whole. The Bureau of Economic Analysis (BEA), an agency of the Commerce Department, assesses the health of the economy by collecting statistics about the economy periodically and comparing levels of production with recent and historical measurements. The most important national account is the gross domestic product.
Gross domestic product (GDP) is the total market value of all final goods and services produced in a given year within the United States, whether produced by citizens, companies, or by foreigners in the United States. Hence, cars manufactured by GM, Ford, Toyota, and Honda in the United States are considered part of the gross domestic product. However, cars produced by GM and Ford in China are not included nor are Toyotas and Hondas that are manufactured in Japan.
GDP is a monetary measure — output is measured by summing the prices of all final products and services produced within the United States. Only final goods and services are counted, to avoid multiple counting, since their prices covers the cost of all intermediate products and services that were used to produce the final output. Another way to calculate GDP is to measure the value added to each product or service at each stage of its production.
GDP excludes nonproduction transactions: public transfer payments, such as Social Security, private transfer payments, such as gifts, and financial market transactions, since securities represent either ownership, such as with stocks, or they represent loans, such as bonds. Financial securities do not represent real production, but simply represent the means to finance production. Likewise, secondhand sales are excluded because no production is involved except for the sales service. For instance, goods sold in a consignment shop would not be part of the GDP, but the services provided by the consignment shop would be included.
Because GDP measures output in terms of prices, the buyer pays the price and the seller receives it. Therefore, GDP can be measured by using either the expenditures approach, which sums the amount paid for final goods and services, or the income approach, which measures the income received for producing products and services.
Determining GDP Using the Expenditures Approach
Since everything that is produced by the economy is purchased, one method of measuring GDP is by measuring total expenditures. Expenditures can be divided into 4 major categories: personal consumption expenditures, gross private domestic investment, government purchases, and net exports. Personal consumption expenditures includes purchases for durable consumer goods, which are goods that have an expected lifetime of greater than one year, such as automobiles, household appliances, and electronic equipment; nondurable consumer goods, which are goods with an expected lifetime of less than 1 year, such as food and toiletries, and consumer expenditures for services, such as for doctors, dentists, and lawyers.
Gross private domestic investment includes all final purchases of machinery, equipment, and tools by businesses; all construction; plus changes in inventories. Private domestic investment means that the goods were not purchased by a government or one of its agencies. Domestic means that it was purchased within the country. Investment includes residential construction, since residential buildings can be rented out, even if they are occupied by owners. Owner occupied residences have an imputed rent, which is added to GDP, even though the homes are not actually rented out.
Inventory is included because businesses invest in producing inventory; however, not all of it is sold. If inventories declined during the year, then the difference between the prior year's and the current year's inventory is subtracted from investments; otherwise, it would be counted twice, since some inventory was sold that was produced in a previous year. For instance, suppose there was an inventory of 10 million cars at the beginning of the year and 5 million cars at the end of the year. That means that 5 million cars were sold but not produced in the current year, so they would be counted as consumer expenditures since they are durable consumer goods, but since they were not produced in the current year, their value would have to be subtracted.
Business investment does not include the transfer of securities or tangible assets, such as real estate, furniture, or motor vehicles. Securities simply represent ownership or some other financial relationship but are not actual goods or services. Tangible assets that are resold are also not included in GDP, since this simply transfers ownership — it does not represent production. Investment in the economic sense means the production of real goods and services, not the transfer of ownership.
Another important measure of the economy is the net addition of capital stock. Since some of the capital goods that were produced are used to replace worn-out machinery and equipment, this investment does not increase the stock of real capital in the economy. Gross investment includes all investment, including capital for replacing worn-out machinery and equipment. Net investment equals the gross investment minus depreciation, which is a measure of the capital stock that must be replaced. An increase in the stock of capital expands the production possibility frontier – the economy can produce a greater output.
Net Investment = Gross Investment – Depreciation
Remember: Financial Investments Are Not Capital Investments
Economists use the word investment differently from most people. People tend to think of investments as financial investments, such as the purchasing of stocks or bonds. However, in economics, investment refers to the purchase of capital stock, which is used to produce other goods or services. When you buy stock on a stock exchange, you are simply buying your shares from another investor. However, even if you bought shares in an IPO, only the amount of that money that is invested in capital stock would be considered an investment in the economic sense. Much of the IPO money is used to pay founders and early investors, or to pay debt or operating expenses rather than to the purchase of capital stock.
Most goods that consumers buy is considered a consumption good, but not always. Sometimes the distinction between consumption goods and investment goods is arbitrary, but there must be an official distinction between the 2 so that they are not double counted. For instance, economists classify buying a new car as the purchase of a consumption good, even though it leads to a demand for auto services in the future. On the other hand, paying to have a new house built is considered a capital investment, because a new house will lead to more demand for housing services, such as additions or repairs, cleaning, landscaping, and other services for houses. Buying an existing house, however, does not add to the residential capital stock, so it is not considered to be a capital investment, even if it turns out to be a wise financial investment.
Government purchases include goods and services that the government uses to provide public services and expenditures for social capital, such as for schools and highways. Government purchases include purchases made by all government entities, including federal, state, and local governments. However, it does not include transfer payments, such as the payment of Social Security or welfare benefits.
When computing total expenditures, imported goods must be subtracted from purchases, since imported goods and services were not produced within the country. Exports, however, are included since they are produced within the country. However, they must be added as a separate item because they are purchased by foreigners and so would not be included in the other categories. Rather than subtracting imports and adding exports, government economists use net exports, which is simply equal to exports minus imports, which is often represented by the symbol X. Note that when the value of imports is greater than the value of exports, then net exports is negative, and is subtracted from the GDP.
Net Exports (X) = Exports – Imports
To summarize, GDP can be calculated thus:
GDP = Personal Consumption Expenditures + Gross Private Domestic Investment + Government Purchases + Net Exports
Usually, this equation is written in the following abbreviated form:
GDP = C + I + G + X
Determining GDP Using the Income Approach
Since goods and services are sold, someone receives that income. Hence, another way of calculating GDP is by calculating the national income, which is equal to the compensation of all employees, rents, interest, proprietors' income, and corporate profits. The largest part of national income is, by far, employee compensation. Compensation includes payments by the employer into social security and private pension funds, and payments for health and disability insurance for employees. Rents include the money received for renting out real estate by owners of the property, whether they are households or businesses. However, only net rents are included, which is the total rent minus depreciation of rental property.
Interest includes the total sums paid by private businesses for loans, including the interest paid on savings, certificates of deposits, and corporate bonds.
Proprietors' income includes not only income earned by proprietorships, but also partnerships and other unincorporated businesses, such as limited partnerships. Corporate profits are generally divided into 3 categories:
- corporate income taxes;
- retained earnings, which is used for future expansion and to maintain liquidity;
- dividends, which is that portion of after-tax earnings paid to stockholders of the company.
The first 5 terms of the equation yield national income, which is the total income of Americans, whether earned domestically or abroad.
The national income approach yields a figure which is less than the expenditures approach, because indirect business taxes are added to the expenditures approach. These taxes include general sales taxes, excise taxes, property taxes, license fees, and custom duties. For example, if a consumer purchases something for one dollar and there is a 6% sales tax, then the consumer will have to pay $1.06 total. This $1.06 is added as a whole to the expenditure approach, but the $.06 sales tax was not used to produce the good or service, so it is not included in national income — indirect business taxes are simply a form a transfer payment from the taxpayer to the government. Hence, indirect business taxes must be added to national income to more accurately compare it to the expenditures approach.
Another adjustment that must be made is the consumption of fixed capital, which is the depreciation of durable goods. Any good that has a lifetime greater than one year will wear out over time, which is calculated as depreciation. If capital goods were expensed in the year that they were produced, it would understate profits for the first year, but overstate profits in succeeding years, resulting in a distortion of actual profits. To account for the extended lifetime of durable goods, various methods of depreciation are used, that expense capital goods over their expected lifetime, thus giving a better measure of profitability. For instance, suppose you purchased a delivery truck for $50,000. If this was all expensed in the first year, then your profit would be less by $50,000. In the 2nd year, profits would increase by $50,000 for the same revenue and expenses except for the truck, since you do not have to purchase a new truck. However, at some point the truck will have to be replaced. Hence, some money must be set aside to make this purchase, and this is usually done by apportioning part of the cost of the capital good over its expected lifetime.
Because national income includes income earned by Americans abroad, which is not counted in the expenditures approach, this income must be subtracted in the income approach, while the income earned by foreigners from domestic production must be added since such income is not included in national income but is counted as part of the expenditure approach. These adjustments are summarized as the net foreign factor income:
Net Foreign Factor Income = Income Earned by Foreigners from Domestic Production – Income Earned by Americans Abroad
Hence, the net foreign factor income is added in the income approach to equalize it to the figure derived from the expenditures approach. To summarize:
Consumption Expenditures by Households + Investment Expenditures by Businesses + Government Purchases of Goods and Services + Domestic Expenditures by Foreigners
= Wages + Rents + Interest + Profits + Indirect Business Taxes + Net Foreign Factor Income = GDP
GDP Does Not Measure What Is Not Reported
GDP does not measure total output or total utility. Because GDP measures only the value of all final goods and services, which is measured by the prices of those goods and services, any output that is not sold or not reported will not be included in the GDP. For instance, if someone sells his services as a housecleaner, and he cleans someone's house for payment, that is included as GDP. (Assuming that he claims the income!) However, if he cleans his own residence, then that is not included as part of the GDP, even though it is economic output. (After all, the house gets cleaned whether he does it himself or pays someone else to do it.)
Another source of economic output that is not measured in the GDP is the underground economy, whose output is unreported because people wish to avoid taxes or because the output is illegal, such as selling heroin or other illicit drugs. Many immigrants, for instance, work under the table, as they say, to avoid detection by immigration authorities and to avoid the payment of taxes. Other activities of the underground economy include the manufacture and transport of drugs, money laundering services, and prostitution.
Not all illegal activities would be included in the GDP anyway, even if they were reported. Burglary and robbery, for instance, would not be included since these activities simply transfer the ownership of the stolen items.
Activities that are free are not included in the GDP, while those that cost money are included. For instance, playing basketball at an outdoor court would not be included in GDP, but paying to see a movie would be included.
GDP also does not account for the quality of the goods and services, since there is no simple relationship between the price of the output and the quality of the output. GDP also does not include the cost of negative externalities, such as littering and pollution, unless the government forces companies to pay for them, such as by the assessment of a carbon tax.
Leisure has value, evidenced by the fact that as compensation increases, most people choose to consume more leisure and work less. However, because leisure does not have a price tag, there is no measure of it in the GDP.
GDP also does not measure whether the distribution of output is fair. More of the GDP is distributed to those with more money. However, more money does not necessarily go to those who work the hardest. Indeed, it often goes to those who work the least, since inheritance is generally taxed much less than working income. Tax laws are skewed to favor the wealthy, since they can influence legislators with their money. In most countries, working income is taxed the most, while investment income and inheritance is taxed considerably less — both forms of income accrue mostly to the wealthy, and with lower taxation, the wealthy increase their wealth even more.
Even though GDP does not measure all output, it still allows economists to assess the state of the economy, providing a solid foundation to predict its future course and to measure the results of public policies.