Gross Domestic Product (GDP)

Gross domestic product is the market value of all final goods and services produced within a country in a given period of time.

This definition might seem simple enough. But in fact, many subtle issues arise when computing an economy’s GDP. Let’s therefore consider each phrase in this definition with some care.

GDP is the market value ….

You have probably heard the proverb, ‘You can’t compare apples and oranges’. Yet GDP does exactly that. GDP adds together many different kinds of products into a single measure of the value of economic activity.  To do this, it uses market prices. Because market prices measure the amount people are willing to pay for different goods, they reflect the value of those goods. If the price of an apple is twice the price of an orange, then an apple contributes twice as much to GDP as does an orange.

GDP tries to be comprehensive. It includes all items produced in the economy and sold legally in markets. GDP measures the market value of not just apples and oranges but also pears and grapefruit, books and movies, haircuts and healthcare and on and on.

GDP also includes the market value of the housing services provided by the economy’s stock of housing. For rental housing, this value is easy to calculate – the rent equals both the tenant’s expenditure and the landlord’s income. Yet many people own the place where they live and, therefore do not pay rent. The government includes this owner occupied housing in GDP by estimating its rental value. In effect, GDP is based on the assumption that the owner is renting the house to himself. The notional rent is included both in the homeowner’s expenditure and in his income so it adds to the GDP.

There are some products, however, that GDP excludes because measuring them is so difficult. GDP excludes most items produced and sold illicitly such as illegal drugs. It also excludes most items that are produced and consumed at home and therefore never the marketplace. Vegetables you buy at the grocery store are part of GDP; vegetables you grow in your garden are not.

These exclusions from GDP can at times lead to paradoxical results.

When international paper makes paper, which Hallmark then uses to make a greeting card, the paper is called an immediate good, and the card is called the final good. GDP includes only the value of final goods. The reason is that the value of intermediate goods is already included in the prices of the final goods. Adding the market value of the paper to the market value of the card would be double counting. That is, would (incorrectly) count the paper twice.

An important exception to this principle arises when an intermediate good is produced and rather than being used, is added to a firm’s inventory of goods for use or sale  at a later date. In this case, the intermediate good is taken to be “final” for the moment, and its value as inventory investment is added to GDP.  When the inventory of the intermediate good is later used or sold, the firm’s inventory investment is a negative and GDP for the later period is reduced accordingly.

Goods and services

GDP includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits). When you buy a CD by your favourite band, you are buying a good, and the purchase price is part of GDP. When you pay to hear a concert by the same band, you are buying a service, and the ticket price is also part of the GDP.

GDP includes goods and services currently produced. It does not include transactions involving items produced in the past. When an Automobile manufacturer produces and sells a new car, the value of the car is included in GDP. When one person sells a used car to another person, the value of the used car is not included in GDP.

Within a country :

GDP measures the value of production within the geographic confines of a country. When a Canadian citizen works temporarily in the United States his production is part of US GDP. When an American citizen owns a factory in Haiti, the production at his factory is not part of US GDP (It is part of Haiti’s GDP). Thus, items are included in a nation’s GDP if they are produced domestically regardless of the nationality of the producer.

GDP measures the value of production that takes place within a specific interval of time. Usually that interval is a year or a quarter (three months) GDP measures the economy’s flow of income and expenditure during that interval.

When the government reports the GDP for a quarter it usually presents GDP at an annual rate. This means that the figure reported for quarterly GDP is the amount of income and expenditure during the quarter multiplied by 4. The government uses this convention so that quarterly and annual figures on GDP can be compared more easily.

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