How big is the Economy?

It is said that the United States is the biggest economy in the world. Some estimates indicate that India may rank as the 12th largest economy. How does one measure the size of an economy? We measure the level of economic activity and hence the size of an economy by the volume of goods and services produced during a specified period of time. But since we cannot add tons of steel to liters of milk, we must convert everything to a common denominator. The most acceptable such common denominator is money. We can add monetary values of the millions of different goods and services produced. Gross Domestic Product (GDP) and Gross National Product (GNP) are two types such rupee denominated measures of the level of economic activity. To avoid double counting only final goods and services are included. In one of its versions, GDP is the market value of all final goods and services produced in an economy during a specified interval of time, usually a year, irrespectively of who owns the productive assets or provides productive services such as labor – domestic residents or foreigners.

What are final goods and services? They are those that do not enter as inputs in the production of something else. Thus raw materials, intermediate goods, and other inputs in production like fuels, electric power are left out. Bread sold to households is included but the wheat flour that goes into it is not; value of a car is included but not things like steel, plastics and aluminum that go into its manufacture.

Why are intermediate inputs excluded? The answer is that the market value of the final product includes the value of all the inputs that have gone into it a loaf of bread priced at say Rs 10 includes the value of the flour it contains and the market price say Rs 5 lakhs of a car includes the value of all the inputs that go into it. Including them again would be double counting.

What about machinery equipment and other capital items? Aren’t they used as inputs in production processes? Should they therefore be left out? The answer is while they are indeed used to produce something else, this happens over time and unlike raw materials their entire value does not get incorporated in the value of the product being produced in a single period. In the year in which they are produced they are counted as part of final outputs as investments in fixed capital.

What about steel or cement or any other intermediate that is produced in a year but is not used up? It gets added to the year end inventory investments in working capital and would have to be included in GDP calculations. Does the sale of an existing house add to GDP? Only to the extent that a real estate agent’s services might have been used in the transaction. What about transactions in financial assets such as Mr X selling Infosys shares to Ms Y? Once again, the only item to enter GDP will be brokers’ commission. What about services provided by the government such as police force, justice system etc? These are not bought and sold in the market and hence have no market valuation; but they are produced like any other services provided by the private sector and certainly contribute to a people’s well being and hence must be included in GDP. The convention is to value them simply at their cost of production i.e. we include in GDP all the expenditure of the government on current goods and services. To para-phrase, included are all the goods and services which have not been used up as inputs into the production of something else during the period under consideration.

There is an alternative approach to measuring GDP which focuses on income generation. The most obvious valuation of final product, e.g. a loaf of bread is its market price. It consists of cost of all intermediate inputs (wheat flour, butter, electricity, fuels etc) used in its manufacture plus value added which consists of wages and salaries, interest, rents and profits. In economies these items of value added are known as factor payments. Labor capital and land are called factors of production and value added consists of payments for these services of these factors. Now take a step back. We can break up the cost of intermediates like wheat flour into:

1. The cost of raw materials that are used in their manufacture (e.g. wheat in wheat flour).
2. Value added in their production.