GDP: Measuring Total Production and Income. Prepared by: CHAPTER19 CHAPTER. Fernando Quijano. 1 of of 33

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1 1 of 33 2 of 33 CHAPTER19 CHAPTER 19 GDP: Measuring Total Production and Income In the more than 100 years that Ford Motor Company has been in business, its experiences have often mirrored those of the U.S economy. Prepared by: Fernando Quijano 3 of 33

2 CHAPTER19 CHAPTER 19 Chapter Outline and Learning Objectives GDP: Measuring Total Production and Income 19.1 Measures Total Production 19.2 Does GDP Measure What We Want It to Measure? Discuss whether GDP is a good measure of well-being Real GDP versus Nominal GDP 19.4 Other Measures of Total Production and Total Income Become familiar with other measures of total production and total income. 4 of 33 GDP: Measuring Total Production and Income Microeconomics The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices. Macroeconomics The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. Business cycle Alternating periods of economic expansion and economic recession. 5 of 33 GDP: Measuring Total Production and Income Expansion The period of a business cycle during which total production and total employment are increasing. Recession The period of a business cycle during which total production and total employment are decreasing. Economic growth The ability of an economy to produce increasing quantities of goods and services. Inflation rate The percentage increase in the price level from one year to the next. 6 of 33

3 Measuring Total Production: Gross domestic product (GDP) The market value of all final goods and services produced in a country during a period of time, typically one year. GDP Is Measured Using Market Values, Not Quantities The word value is important in the definition of GDP. 7 of 33 Measuring Total Production: GDP Includes Only the Market Value of Final Goods Final good or service A good or service purchased by a final user. Intermediate good or service A good or service that is an input into another good or service, such as a tire on a truck. GDP Includes Only Current Production GDP includes only production that takes place during the indicated time period. 8 of 33 Solved Problem 19-1 Calculating GDP PRODUCTION AND PRICE STATISTICS FOR 2011 (1) PRODUCT (2) QUANTITY (3) PRICE PER UNIT Eye examinations 100 $50.00 Pizzas Textbooks Paper 2, PRODUCT (1) QUANTITY (2) PRICE PER UNIT (3) VALUE Eye examinations 100 $50 $5,000 Pizzas Textbooks ,000 YOUR TURN: For more practice, do related problem 1.12 at the end of this chapter. 9 of 33

4 Production, Income, and the Circular-Flow Diagram FIGURE 19-1 The Circular Flow and the Measurement of GDP The circular-flow diagram illustrates the flow of spending and money in the economy. Firms sell goods and services to three groups: domestic households, foreign firms and households, and the government. To produce goods and services, firms use factors of production: labor, capital, natural resources, and entrepreneurship. Households supply the factors of production to firms in exchange for income in the form of wages, interest, profit, and rent. Firms make payments of wages and interest to households in exchange for hiring workers and other factors of production. The sum of wages, interest, rent, and profit is total income in the economy. We can measure GDP as the total income received by households. 10 of 33 Production, Income, and the Circular-Flow Diagram FIGURE 19-1 (continued) The Circular Flow and the Measurement of GDP The diagram also shows that households use their income to purchase goods and services, pay taxes, and save. Firms and the government borrow the funds that flow from households into the financial system. We can measure GDP either by calculating the total value of expenditures on final goods and services or by calculating the value of total income. 11 of 33 Production, Income, and the Circular-Flow Diagram Transfer payments Payments by the government to individuals for which the government does not receive a new good or service in return. 12 of 33

5 Components of GDP Personal Consumption Expenditures, or Consumption Consumption Spending by households on goods and services, not including spending on new houses. Gross Private Domestic Investment, or Investment Investment Spending by firms on new factories, office buildings, machinery, and additions to inventories, and spending by households and firms on new houses. Don t Let This Happen to YOU! Remember What Economists Mean by Investment YOUR TURN: Test your understanding by doing related problem 1.8 at the end of this chapter. 13 of 33 Components of GDP Government Consumption and Gross Investment, or Government Purchases Government purchases Spending by federal, state, and local governments on goods and services. 14 of 33 Components of GDP Net Exports of Goods and Services, or Net Exports Net exports Exports minus imports. An Equation for GDP and Some Actual Values Y = C + I + G + NX 15 of 33

6 An Equation for GDP and Some Actual Values FIGURE 19-2 Components of GDP in 2008 Consumption accounts for 70 percent of GDP, far more than any of the other components. In recent years, net exports typically have been negative, which reduces GDP. 16 of 33 An Equation for GDP and Some Actual Values Consumer spending on services is greater than the sum of spending on durable and nondurable goods. Business fixed investment is the largest component of investment. Purchases made by state and local governments are greater than purchases made by the federal government. Imports are greater than exports, so net exports are negative. 17 of 33 Making Will U.S. Consumers the Connection Be Spending Less? YOUR TURN: Test your understanding by doing related problem 1.11 at the end of this chapter. 18 of 33

7 Measuring GDP by the Value-Added Method Value added The market value a firm adds to a product. Table 19-1 Calculating Value Added VALUE OF FIRM PRODUCT VALUE ADDED Cotton farmer Value of raw cotton = $1 Value added by cotton farmer = 1 Textile mill Value of raw cotton woven into cotton fabric = $3 Value added by cotton textile mill = ($3 $1) = 2 Shirt company L.L. Bean Value of cotton fabric made into a shirt = $15 Value of shirt for sale on L.L. Bean s Web site = $35 Value added by shirt manufacturer = ($15 $3) = 12 Value added by L.L. Bean = ($35 $15) = 20 Total Value Added = $35 19 of 33 Does GDP Measure What We Want It to Measure? 19.2 LEARNING OBJECTIVE Discuss whether GDP is a good measure of well-being. Shortcomings in GDP as a Measure of Total Production Household Production Household production refers to goods and services people produce for themselves. The Underground Economy Underground economy Buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are illegal. 20 of 33 Making the Connection Why Do Many Developing Countries Have Such Large Underground Economies? 19.2 LEARNING OBJECTIVE Discuss whether GDP is a good measure of well-being. In some developing countries, more than half the workers may be in the underground economy. A large informal sector can be a sign of government policies that are retarding economic growth. YOUR TURN: Test your understanding by doing related problem 2.6 at the end of this chapter. 21 of 33

8 Does GDP Measure What We Want It to Measure? 19.2 LEARNING OBJECTIVE Discuss whether GDP is a good measure of well-being. Shortcomings of GDP as a Measure of Well-Being The Value of Leisure Is Not Included in GDP GDP Is Not Adjusted for Pollution or Other Negative Effects of Production GDP Is Not Adjusted for Changes in Crime and Other Social Problems GDP Measures the Size of the Pie but Not How the Pie Is Divided Up 22 of 33 Making the Connection Did World War II Bring Prosperity? 19.2 LEARNING OBJECTIVE Discuss whether GDP is a good measure of well-being. World War II was a period of extraordinary sacrifice and achievement by the greatest generation. But statistics on GDP may give a misleading indication of whether it was also a period of prosperity. YOUR TURN: Test your understanding by doing related problem 2.8 at the end of this chapter. 23 of 33 Real GDP versus Nominal GDP 19.3 LEARNING OBJECTIVE Calculating Real GDP Nominal GDP The value of final goods and services evaluated at current-year prices. Real GDP The value of final goods and services evaluated at base-year prices. 24 of 33

9 Solved Problem 19-3 Calculating Real GDP 19.3 LEARNING OBJECTIVE PRODUCT QUANTITY PRICE QUANTITY PRICE Eye examinations 80 $ $50 Pizzas Textbooks PRODUCT 2011 QUANTITY 2005 PRICE VALUE Eye examinations 100 $40 $4,000 Pizzas Textbooks ,800 YOUR TURN: For more practice, do related problem 3.3 at the end of this chapter. 25 of 33 Real GDP versus Nominal GDP 19.3 LEARNING OBJECTIVE Comparing Real GDP and Nominal GDP FIGURE 19-3 Nominal GDP and Real GDP, Currently, the base year for calculating GDP is In the years before 2005, prices were, on average, lower than in 2005, so nominal GDP was lower than real GDP. In 2005, nominal and real GDP were equal. After 2005, prices have been, on average, higher than in 2005, so nominal GDP is higher than real GDP. 26 of 33 Real GDP versus Nominal GDP 19.3 LEARNING OBJECTIVE The GDP Deflator Price level A measure of the average prices of goods and services in the economy. GDP deflator A measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100. Nominal GDP GDP deflator = 100 Real GDP 27 of 33

10 Real GDP versus Nominal GDP 19.3 LEARNING OBJECTIVE The GDP Deflator NOMINAL GDP $14,078 billion $14,441 billion REAL GDP $13,254 billion $13,312 billion FORMULA APPLIED TO 2007 APPLIED TO 2008 GDP Deflator Nominal GDP $14,078 billion = = 106 Real GDP $13,254 billion = 1.9% 106 $14,441 billion 100 = 108 $13,312 billion From these values for the deflator, we can calculate that the price level increased by 1.9 percent between 2007 and 2008: 28 of 33 Other Measures of Total Production and Total Income 19.4 LEARNING OBJECTIVE Become familiar with other measures of total production and total income. Gross National Product (GNP) Gross national product (GNP) is the value of final goods and services produced by residents of the United States, even if the production takes place outside the United States. National Income National income is calculated as GDP minus the consumption of fixed capital, or depreciation. Personal Income Personal income is income received by households. Disposable Personal Income Disposable personal income is equal to personal income minus personal tax payments. 29 of 33 Other Measures of Total Production and Total Income 19.4 LEARNING OBJECTIVE Become familiar with other measures of total production and total income. FIGURE 19-4 Measures of Total Production and Total Income, 2008 The most important measure of total production and total income is gross domestic product (GDP). As we will see in later chapters, for some purposes, the other measures of total production and total income shown in the figure turn out to be more useful than GDP. 30 of 33

11 Other Measures of Total Production and Total Income 19.4 LEARNING OBJECTIVE Become familiar with other measures of total production and total income. The Division of Income FIGURE 19-5 The Division of Income We can measure GDP in terms of total expenditure or as the total income received by households. The largest component of income received by households is wages, which are more than three times as large as the profits received by sole proprietors and the profits received by corporations combined. 31 of 33 AN INSIDE LOOK >> Falling Auto Purchases Lead to Lower GDP A Slowing Descent: Auto Sales Fell 37Percent, but Improved Slightly Real GDP declined for three consecutive quarters beginning in the third quarter of of 33 KEY TERMS Business cycle Consumption Economic growth Expansion Final good or service GDP deflator Government purchases Gross domestic product (GDP) Inflation rate Intermediate good or service Investment Macroeconomics Microeconomics Net exports Nominal GDP Price level Real GDP Recession Transfer payments Underground economy Value added 33 of 33