W8- GROSS DOMESTIC PRODUCT MEASURES TOTAL PRODUCTION BSB113

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1 W8- GROSS DOMESTIC PRODUCT MEASURES TOTAL PRODUCTION BSB113 Gross Domestic Product (GDP): the market value of all final goods and services produced in a country during a period. In measuring GDP, we include only the market value of final goods and services. A new good or service which is the product of the production process that is purchased by the final user. A final good or service is one that is purchased by its final user and is not included in the production of any other good or service. e.g. Burgers or computers purchased by consumers are final goods. Market Value of all final goods and services Production and Price Statistics for Economy X Product Quantity Price Per Unit ($) Value ($) Sunglasses Suntan Lotion Swimmers TOTAL (or GDP): $ GDP = Sum of value of final goods and services = $ $ $8 000 = $ Some goods and services, though, are used in the production of other goods and services and are termed intermediate goods and services (Intermediate good or service is an input into another good or service). For example, Baker s Delight does not produce the flour used in its bread making; it buys the flour from a flour mill. The flour purchased by Bakers Delight stores is an intermediate good, whereas a loaf of bread purchased by a person for their consumption is a final good. In calculating GDP, we include the value of the bread but not the value of the flour. If we included the value of the flour we would be double counting. The value of the flour would be counted once when sold to Bakers Delight stores and a second time when the bread was sold to a customer. Market Value firms add to a product Firm Output Value Cost of Intermediate Goods Value Added Farmer Wheat $ Flour Mill Flour $ Bakery Bread $ GDP = Sum of value added by each firm = $100 + $60 + $140 = $300

2 MEASURING GDP USING THE VALUE-ADDED METHOD GDP can be calculated by adding together all expenditures on final goods and services. An alternative way of calculating GDP is the value-added method. Value added refers to the additional market value a firm adds to a product and is equal to the difference between the price the firm sells a good for and the price it paid other firms for intermediate goods. FIRM VALUE OF PRODUCT VALUE ADDED Sheep Farmer Value of raw wool = $1.00 Value added by sheep farmer = $1.00 Woollen Mill Value of raw wool woven into woollen thread = Value added by woollen mill = ($ $1.00) = $2.00 $3.00 Clothing Manufacturer Value of woollen thread made into a jumper = Value added by clothing manufacturer = ($15.00 = $12.00 $ $3.00) Big W Value of jumper for sale by Big W = $35.00 Value added by Big W = ($ $15.00) = $20.00 Total Value Added = $35.00 OTHER MEASURES OF TOTAL PRODUCTION AND TOTAL INCOME Net Domestic Product (NDP): NDP is calculated by measuring GDP and subtracting the value of depreciation on capital equipment. Depreciation is the reduction in the value of capital equipment that results from use or obsolescence. Gross National Income (GNI): GDP is the market value of final goods and services produced within Australia. Gross National Income, or GNI, is Australia s GDP, plus income generated overseas by Australian residents and firms, minus the income generated in Australia by non-residents and foreign firms. BHP Billiton, for example, has mines overseas and Campbell s Soup (an American company) has production plants in Australia. GNI included foreign production by Australian firms but excludes Australian production by foreign firms. METHODS OF MEASURING GROSS DOMESTIC PRODUCT The ABS produce three different methods of calculating GDP: 1. The production method: The sum of the value of all goods and services produced by industries in the economy in a year minus the cost of goods and services used in the productive process, leaving the value added by the industries. 2. The expenditure method: The sum of the total expenditure on final goods and services by households, investors, government and net exports (net exports is the expenditure on exports minus the expenditure on imports). 3. The income method: The sum of the income generated from the production of goods and services, which includes profits, wages, and other employee payments, income from rem and interest earned. COMPONENTS OF GDP The ABS divide its statistics on GDP into four major categories of expenditures. These are consumption, investment, government and net exports expenditures. Economists use these categories to understand why GDP fluctuates and to forecast future GDP: - Consumption: Spending by households on goods and services, not including spending on new houses - Investment: Spending by firms on new factories, office buildings, machinery and inventories, plus spending by households on new houses. Consumption expenditures are made by households and are divided into expenditures on services, such as medical care, education and haircuts; expenditures on non-durable goods, such as food and clothing; and expenditures on durable goods, such as cars and furniture. Spending on gross private domestic investment, or simply investment, is divided into three categories: business fixed investment is spending by firms on new factories, office buildings and machinery used to produce other goods; residential investment is spending by households on new housing; changes in business inventories are also included in investment.

3 THE BASIC CIRCULAR FLOW MODEL Output = Expenditure = Income CIRCULAR FLOW MODEL

4 GOVERNMENT CONSUMPTION AND GROSS INVESTMENT, OR GOVERNMENT PURCHASES Government purchases are spending by federal, state and local governments on goods and services, such as education, roads, and aircraft. Again, government spending on transfer payments is not included in government purchases because it does not result in the production of new goods and services. NET EXPORTS OF GOODS AND SERVICES, OR NET EXPORTS Net exports is equal to the expenditure on exports minus the expenditure on imports. Exports are goods and services produced in Australia, but purchased by foreign firms, households and governments. We add exports to our other categories of expenditures because otherwise we would not be including all spending on new goods and services produced in Australia. For example, if Australian universities receive $10 billion in fees from overseas students, those exports are included in GDP because they represent production in Australia. Imports are goods and services produced in foreign countries, and purchased by Australian firms, households and governments. We subtract imports from total expenditure, because otherwise we would be including spending that does not result in production of new goods and services as Australia. For example, if Australian consumers buy $1 billion worth of furniture manufactured in Indonesia, that spending is included in consumption expenditure. But the value of those imports is subtracted from GDP because the imports do not represent production in Australia. EQUATION FOR GDP A simple equation sums up the components of GDP: Y = C + I + G + NX C = Consumption = Spending by households on goods and services, not including spending on new houses I = Investment = Spending by firms on capital goods and inventories, and spending by households on new houses G = Government purchases = Spending by federal governments on goods and services NX = Net Exports = Net purchases of Australian output by overseas countries (NX = Exports Imports) ($ millions) Consumption Investment Dwellings Buildings and Structures Machinery and Equipment Other Change in inventories (3512) Total Government Net Exports Exports Imports Total (5621) Total GDP

5 DOES GDP MEASURE WHAT WE WENT IT TO MEASURE? Economists use GDP to measure total production in the economy. For that purpose, we would like GDP to be as comprehensive as possible, not overlooking any significant production that takes place in the economy. Most economies believe that GDP does a good but not flawless job of measuring production. GDP is also sometimes used as a measure of wellbeing. Although it is generally true that the more goods and services people have the better off they are, we will see that GDP is not a comprehensive measure of wellbeing, and nor is it intended to be. Shortcomings of GDP as a measure of wellbeing: - Distribution of GDP is not captured in GDP measured - Value of leisure is not included in GDP - Level, quality of, and access to health care and education is not measured 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 What is the underground economy? Buying and selling of goods and services that is concealed from the government to avoid taxes of regulations or because the goods and services are illegal. LIMITATIONS OF GOODS - GDP does a good job at measuring production, and provides an indication of wellbeing, but it is not flawless. - GDP does not include: o Household production Goods and services people produce for themselves Home cooking, cleaning, child care, gardening, maintenance Black/ cash economy Trading concealed from the government to avoid taxes or regulations or because the goods and services are illegal. THE NON-OBSERVED ECONOMY The shadow economy includes all market based legal production of goods and services that are deliberately concealed from public authorities, excluding economic crime activities. World Bank estimate the size of Australia s shadow economy to be 14% of total GDP (129,478 US$ millions in value). ALTERNATIVE METRICS: HAPPINESS? You can measure happiness. Subjective well- being. Several national and local governments use happiness data and research in their search for policies that could enable people to live better lives. - Bhutanese o National objective of Gross National Happiness

6 IS GDP RISING? Australia s GDP comparison: 2012/ / 14 Nominal GDP $ million $ million What s wrong with this data everything looks fine? - Nominal Values o The market value of final goods and services evaluated at current year prices o Increase in GDP may be due to price changes rather than increases in real quantity changes NOMINAL TO REAL DATA 2012/ /14 Nominal GDP $ million $ million Real GDP $ million $ million REAL GDP: - Measures volume of final goods and services, holding prices constant - Real GDP shows changes in output only - ABS use chain volume measures to estimate real GDP - Prices in each year are chained to prices from the previous year to minimise the distortion from changes in relative prices. Step 1: Identifying the base year Production and Price Statistics for Economy X 2015 (base year) 2016 Product Quantity Price Per Unit Quantity Price per Unit Sunglasses 1000 $ $22 Pizzas 400 $ $12 Hair cuts 125 $8 150 $10 Nominal GDP

7 Step 2: Calculating real GDP using the base year prices Production and Price Statistics for Economy X 2015 (base year) 2016 nominal 2016 real Product Quantity Unit Price Quantity Unit Price Quantity Unit Price Sunglasses 1000 $ $ $20 Pizzas 400 $ $ $10 Hair cuts 125 $8 150 $ $8 GDP $ Nominal GDP in 2016 = (1050 x $22) + (450 x $1) + (150 x $10) = $ Real GDP in 2016 = (1050 X $20) + (450 x $10) + (150 X $8) = $ THE GDP DEFLATOR Economist and policy makers are interested not just in the level of total production, as measured by real GDP, but also in the price level. The price level measures the average prices of goods and services in the economy. GDP deflator measures the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100. Stable prices are a key economic goal Nominal GDP GDP Deflator = 100 Real GDP GDP Deflator = = 12.35%