CHAPTER 17
How do economists measure the economy’s overall health?©i9370/Shutterstock
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
1. LO1Explain how economists define an economy’s output.
2. LO2Apply the production, expenditure, and income methods for measuring GDP to analyze economic activity.
3. LO3Define and compute nominal GDP and real GDP.
4. LO4Discuss the relationship between real GDP and economic well-being.
5. LO5Calculate the unemployment rate and the participation rate and discuss the costs of unemployment.
“Real GDP increased 2.2 percent in the fourth quarter, according to the U.S. Bureau of Economic Analysis . . .”
“Total nonfarm payroll employment increased by 209,000 in July, and the unemployment rate was little changed at 4.3 percent, the U.S. Bureau of Labor Statistics reported today . . .”
“Inflation appears subdued as the consumer price index registered an increase of only 0.1 percent last month . . .”
News reports like these fill the airwaves and the web—some TV and radio stations and some websites and blogs carry nothing else. In fact, all kinds of people are interested in economic data. The average person hopes to learn something that will be useful in a business decision, a financial investment, or a career move. The professional economist depends on economic data in much the same way that a doctor depends on a patient’s vital signs—pulse, blood pressure, and temperature—to make an accurate diagnosis. To understand economic developments and to be able to give useful advice to policymakers, businesspeople, and financial investors, an economist simply must have up-to-date, accurate data. Political leaders and policymakers also need economic data to help them in their decisions and planning.
Interest in measuring the economy, and attempts to do so, date back as far as the mid-seventeenth century, when Sir William Petty (1623–1687) conducted a detailed survey of the land and wealth of Ireland. The British government’s purpose in commissioning the survey was to determine the capacity of the Irish people to pay taxes to the Crown. But Petty used the opportunity to measure a variety of social and economic variables and went on to conduct pioneering studies of wealth, production, and population in several other countries. He was a firm believer in the idea that scientific progress depends first and foremost on accurate measurement, an idea that today’s economists endorse.
Not until the twentieth century, though, did economic measurement come into its own. World War II was an important catalyst for the development of accurate economic statistics because its very outcome was thought to depend on the mobilization of economic resources. Two economists, Simon Kuznets in the United States and Richard Stone in the United Kingdom, developed comprehensive systems for measuring a nation’s output of goods and services, which were of great help to Allied leaders in their wartime planning. Kuznets and Stone each received a Nobel Prize in economics for their work, which became the basis for the economic accounts used today by almost all the world’s countries. The governments of the United States and many other countries now collect and publish a wealth of statistics covering all aspects of their economies.
In this chapter and the next, we will discuss how economists measure three basic macroeconomic variables that arise frequently in analyses of the state of the economy: the gross domestic product (or GDP), the rate of unemployment, and the rate of inflation. The focus of this chapter is on the first two of these statistics, GDP and the unemployment rate, which both measure the overall level of economic activity in a country. The third statistic, the inflation rate covered in the next chapter, measures how fast prices change in a country.
Measuring economic activity might sound like a straightforward and uncontroversial task, but that is not the case. Indeed, the basic measure of a nation’s output of goods and services—the gross domestic product, or GDP—has been criticized on many grounds. Some critics have complained that GDP does not adequately reflect factors such as the effect of economic growth on the environment or the rate of resource depletion. Because of problems like these, they charge, policies based on GDP statistics are likely to be flawed. Unemployment statistics have also been the subject of some controversy. By the end of this chapter, you will understand how official measures of output and unemployment are constructed and used and will have gained some insight into these debates over their accuracy. In particular, you will understand how these statistics are defined and measured, and you will be able to discuss the strengths and limitations of the definitions as well as the measurement difficulties that governments face when turning the definitions into actual, published estimates. You will see, for example, what goes into the calculation of a nation’s GDP and, importantly, what is left out. So next time you hear or read about the most recent economic statistics, you will avoid misinterpreting them.
Understanding the strengths and limitations of economic data is the first critical step toward becoming an intelligent user of economic statistics, as well as a necessary background for careful economic analysis in the chapters to come.
GROSS DOMESTIC PRODUCT: MEASURING THE NATION’S OUTPUT
Chapter 16, Macroeconomics: The Bird’s-Eye View of the Economy emphasized the link between an economy’s output of goods and services and its living standard. We noted that high levels of output per person, and per worker, are typically associated with a high standard of living. But what, exactly, does “output” mean? To study economic growth and productivity scientifically, we need to be more precise about how economists define and measure an economy’s output.
The most frequently used measure of an economy’s output is called the gross domestic product, or GDP. Gross domestic product (GDP) is intended to measure how much an economy produces in a given period, such as a quarter (three months) or a year. More precisely, GDP is the market value of the final goods and services produced in a country during a given period. To understand this definition, let’s take it apart and examine each of its parts separately. The first key phrase in the definition is “market value.”
MARKET VALUE
A modern economy produces many different goods and services, from dental floss (a good) to acupuncture (a service). Macroeconomists are not interested in this kind of detail, however; rather, their goal is to understand the behavior of the economy as a whole. For example, a macroeconomist might ask: Has the overall capacity of the economy to produce goods and services increased over time? If so, by how much?
To be able to talk about concepts like the “total output” or “total production”—as opposed to the production of specific items like dental floss—economists need to aggregate the quantities of the many different goods and services into a single number. They do so by adding up the market values of the different goods and services the economy produces. Market value is the selling prices of goods and services in the open market. We use these prices because they are the prices at which buyers and sellers agree to make their transactions. Examples 17.1 and 17.2 will illustrate the process.
EXAMPLE 17.1Orchardia’s GDP: Part I
What is Orchardia’s GDP?
In the imaginary economy of Orchardia, total production is 4 apples and 6 bananas. To find the total output of Orchardia, we could add the number of apples to the number of bananas and conclude that total output is 10 pieces of fruit. But what if this economy also produced 3 pairs of shoes? There really is no sensible way to add apples and bananas to shoes.
Suppose though that we know that apples sell for $0.25 each, bananas for $0.50 each, and shoes for $20.00 a pair. Then the market value of this economy’s production, or its GDP, is equal to
Notice that when we calculate total output this way, the more expensive items (the shoes) receive a higher weighting than the cheaper items (the apples and bananas). Since, in general, the amount people are willing to pay for an item is an indication of the economic benefit they expect to receive from it, market values provide a convenient way for aggregating output into one number.
EXAMPLE 17.2Orchardia’s GDP: Part II
What is Orchardia’s new GDP?
Now suppose instead that Orchardia were to produce 3 apples, 3 bananas, and 4 pairs of shoes at the same prices as in the preceding example. What is its GDP now?
Now the Orchardian GDP is equal to
Notice that Orchardian GDP is higher in Example 17.2 than in Example 17.1, even though two of the three goods (apples and bananas) are being produced in smaller quantities than before. The reason is that the good whose production has increased (shoes) has a much higher market value than the goods whose production has decreased (apples and bananas).
CONCEPT CHECK 17.1
Suppose Orchardia produces the same quantities of the three goods at the same prices as in Example 17.1. In addition, it produces five oranges at $0.30 each. What is the GDP of Orchardia now?
Market values provide a convenient way to add together, or aggregate, the many different goods and services produced in a modern economy. A drawback of using market values, however, is that not all economically valuable goods and services are bought and sold in markets. For example, the unpaid work of a homemaker, although it is of economic value, is not sold in markets and so isn’t counted in GDP. But paid housekeeping and child care services, which are sold in markets, do count. As a result, new moms or dads who decide to take an extended unpaid leave from work and dedicate all their time and energy to providing for their newborn’s physical, cognitive, and emotional development in the first months of the child’s life may be making a priceless contribution to the health and well-being (including economic) of a society in the present and future; yet their decision is likely to make present GDP smaller because it withdraws activity from markets. Example 17.3 illustrates some of the pitfalls that the distinction between market and nonmarket value creates.
EXAMPLE 17.3Women’s Labor Force Participation and GDP Measurement
How has GDP been affected by women joining the labor force?
The percentage of adult American women working, or seeking work, outside the home increased dramatically in the second half of the twentieth century, from less than 35 percent in 1950 to about 60 percent in 2000 (see Figure 17.1). This trend has led to a substantial increase in the demand for paid day care and housekeeping services as working wives and mothers require more help at home. How have these changes affected measured GDP?
FIGURE 17.1 Percentages of American Men and Women over Age 16 Working or Seeking Work Outside the Home, 1950–2016.The fraction of American women working outside the home rose by about 25 percentage points between 1950 and 2000, while the fraction of men working outside the home declined.Source: Bureau of Labor Statistics, www.bls.gov/cps.
The entry of many women into the labor market has raised measured GDP in two ways. First, the goods and services that women produce in their new jobs have contributed directly to increasing GDP. Second, the fact that paid workers took over previously unpaid housework and child care duties has increased measured GDP by the amount paid to those workers. The first of these two changes represents a genuine increase in economic activity, but the second reflects a transfer of existing economic activities from the unpaid sector to the market sector (moreover, it is possible that this transfer lowered the quality of these activities). Overall, then, the increase in measured GDP associated with increased participation in the labor force by women probably overstates the actual increase in economic activity.
Although homemaking activities are excluded from measured GDP, in a few cases, goods and services that are not sold in markets are included in GDP. By far the most important are the goods and services provided by federal, state, and local governments. The protection provided by the army and navy, the transportation convenience of the interstate highway system, and the education provided by the public school system are examples of publicly provided goods and services that are not sold in markets.
Because market prices for publicly provided goods and services do not exist, economic statisticians add to the GDP the costs of providing those goods and services as rough measures of their economic value. For example, to include public education in the GDP, the statisticians add to GDP the salaries of teachers and administrators, the costs of textbooks and supplies, and the like. Similarly, the economic value of the national defense establishment is approximated, for the purposes of measuring GDP, by the costs of defense: the pay earned by soldiers and sailors, the costs of acquiring and maintaining weapons, and so on.
While approximating value by looking at costs is much better than ignoring nonmarket goods and services altogether, it is far from perfect: A more efficient government could deliver more value at a lower cost. For example, as a report by the Organization for Economic Cooperation and Development (OECD)1 suggests, the children in countries whose governments spend less (per child) than other governments do not always show worse outcomes on indicators such as health and safety, educational well-being, and quality of school life. In fact, using cost as a substitute for market value means that every dollar a government spends adds a dollar to GDP regardless of how efficiently or wastefully it is spent!
With a few exceptions, like publicly provided goods and services, GDP is calculated by adding up market values. However, not all goods and services that have a market value are counted in GDP. As we will see next, GDP includes only those goods and services that are the end products of the production process, called final goods and services. Goods and services that are used up in the production process are not counted in GDP.
Why was the female labor force participation rate in 2000 more than 70 percent greater than in 1950?
FINAL GOODS AND SERVICES
Many goods are used in the production process. For instance, before a baker can produce a loaf of bread, grain must be grown and harvested and then ground into flour. The flour is then used along with other ingredients to make bread. Of the three major goods that are produced during this process—the grain, the flour, and the bread—only the bread is used by consumers. Because producing the bread is the ultimate purpose of the process, the bread is called a final good. In general, a final good or service is the end product of a process, the product or service that consumers actually use. The goods or services produced on the way toward making the final product—here, the grain and the flour—are called intermediate goods or services.
Since we are interested in measuring only those items that are of direct economic value, only final goods and services are included in GDP. Intermediate goods and services are not included. To illustrate, suppose that the grain from the previous example has a market value of $0.50 (the price the milling company paid for the grain). The grain is then ground into flour, which has a market value of $1.20 (the price the baker paid for the flour). Finally, the flour is made into a loaf of fine French bread, worth $2.00 at the local store. In calculating the contribution of these activities to GDP, would we want to add together the values of the grain, the flour, and the bread? No, because the grain and flour are intermediate goods, valuable only because they can be used to make bread. So in this example, the total contribution to GDP is $2.00, the value of the loaf of bread, the final product.
Example 17.4 illustrates the same distinction but this time with a focus on services.
EXAMPLE 17.4GDP for the Barber and His Assistant
How do we count a haircut in GDP?
Your barber charges $10 for a haircut. In turn, the barber pays his assistant $2 per haircut in return for sharpening the scissors, sweeping the floor, and other chores. For each haircut given, what is the total contribution of the barber and his assistant, taken together, to GDP?
The answer to this problem is $10, the price, or market value, of the haircut. The haircut is counted in GDP because it is the final service, the one that actually has value to the final user. The services provided by the assistant have value only because they contribute to the production of the haircut; thus they are not counted in GDP.
Example 17.5 illustrates that the same good can be either intermediate or final, depending on how it is used.
EXAMPLE 17.5A Good That Can Be Either Intermediate or Final
What is an intermediate good?
Farmer Brown produces $100 worth of milk. He sells $40 worth of milk to his neighbors and uses the rest to feed his pigs, which he sells to his neighbors for $120. What is Farmer Brown’s contribution to the GDP?
The final goods in this example are the $40 worth of milk and the $120 worth of pigs sold to the neighbors. Adding $40 and $120, we get $160, which is Farmer Brown’s contribution to the GDP. Note that part of the milk Farmer Brown produced serves as an intermediate good and part as a final good. The $60 worth of milk that is fed to the pigs is an intermediate good, and so it is not counted in GDP. The $40 worth of milk sold to the neighbors is a final good, and so it is counted.
A special type of good that is difficult to classify as intermediate or final is a capital good. A capital good is a long-lived good, which is itself produced and used to produce other goods and services. Factories and machines are examples of capital goods. Houses and apartment buildings, which produce dwelling services, are also a form of capital goods. Capital goods do not fit the definition of final goods since their purpose is to produce other goods. On the other hand, they are not used up during the production process, except over a very long period, so they are not exactly intermediate goods either. For purposes of measuring GDP, economists have agreed to classify newly produced capital goods as final goods. Otherwise, a country that invested in its future by building modern factories and buying new machines would be counted as having a lower GDP than a country that devoted all its resources to producing consumer goods.
We have established the rule that only final goods and services (including newly produced capital goods) are counted in GDP. Intermediate goods and services, which are used up in the production of final goods and services, are not counted. In practice, however, this rule is not easy to apply because the production process often stretches over several periods. To illustrate, recall the earlier example of the grain that was milled into flour, which in turn was baked into a loaf of French bread. The contribution of the whole process to GDP is $2, the value of the bread (the final product). Suppose, though, that the grain and the flour were produced near the end of the year 2017 and the bread was baked early the next year in 2018. In this case, should we attribute the $2 value of the bread to the GDP for the year 2017 or to the GDP for the year 2018?
Neither choice seems quite right because part of the bread’s production process occurred in each year. Part of the value of the bread should probably be counted in the year 2017 GDP and part in the year 2018 GDP. But how should we make the split? To deal with this problem, economists determine the market value of final goods and services indirectly, by adding up the value added by each firm in the production process. The value added by any firm equals the market value of its product or service minus the cost of inputs purchased from other firms. As we’ll see, summing the value added by all firms (including producers of both intermediate and final goods and services) gives the same answer as simply adding together the value of final goods and services. The value-added method thus eliminates the problem of dividing the value of a final good or service between two periods.
To illustrate this method, let’s revisit the example of the French bread, which is the result of multiple stages of production. We have already determined that the total contribution of this production process to GDP is $2, the value of the bread. Let’s show now that we can get the same answer by summing value added. Suppose that the bread is the ultimate product of three corporations: ABC Grain Company Inc. produces grain, General Flour produces flour, and Hot’n’Fresh Baking produces the bread. If we make the same assumptions as before about the market value of the grain, the flour, and the bread, what is the value added by each of these three companies?
ABC Grain Company produces $0.50 worth of grain, with no inputs from other companies, so ABC’s value added is $0.50. General Flour uses $0.50 worth of grain from ABC to produce $1.20 worth of flour. The value added by General Flour is thus the value of its product ($1.20) less the cost of purchased inputs ($0.50), or $0.70. Finally, Hot’n’Fresh Baking buys $1.20 worth of flour from General Flour and uses it to produce $2.00 worth of bread. So the value added by Hot’n’Fresh is $0.80. These calculations are summarized in Table 17.1.
You can see that summing the value added by each company gives the same contribution to GDP, $2.00, as the method based on counting final goods and services only. Basically, the value added by each firm represents the portion of the value of the final good or service that the firm creates in its stage of production. Summing the value added by all firms in the economy yields the total value of final goods and services, or GDP.
This example also illustrates how the value-added method solves the problem of production processes that bridge two or more periods. Suppose that the grain and flour are produced during the year 2017 but the bread is not baked until 2018. Using the value-added method, the contribution of this production process to the year 2017 GDP is the value added by the grain company plus the value added by the flour company, or $1.20. The contribution of the production process to the year 2018 GDP is the value added by the baker, which is $0.80. Thus part of the value of the final product, the bread, is counted in the GDP for each year, reflecting the fact that part of the production of the bread took place in each year.
CONCEPT CHECK 17.2
Amy’s card shop receives a shipment of Valentine’s Day cards in December 2017. Amy pays the wholesale distributor of the cards a total of $500. In February 2018, she sells the cards for a total of $700. What are the contributions of these transactions to GDP in the years 2017 and 2018?
We have now established that GDP is equal to the market value of final goods and services. Let’s look at the last part of the definition, “produced within a country during a given period.”
PRODUCED WITHIN A COUNTRY DURING A GIVEN PERIOD
The word domestic in the term gross domestic product tells us that GDP is a measure of economic activity within a given country. Thus, only production that takes place within the country’s borders is counted. For example, the GDP of the United States includes the market value of all cars produced within U.S. borders, even if they are made in foreign-owned plants. However, cars produced in Mexico by a U.S.-based company like General Motors are not counted.
What about cars that are produced in the United States from parts that are produced in Mexico? The value-added method introduced earlier could again be used to suggest an answer. Recall that we used this method to divide the market value of a product that was produced over two years into its contribution to the GDP of each of the years. Similarly, we can use this method to divide the value of a product that was produced in part in two different countries into its contribution to each country’s GDP. Revisiting our French bread example, suppose now that ABC Grain Company produces the grain in Mexico. General Flour buys $0.50 worth of grain from ABC in Mexico, imports it to the United States, and uses it to produce $1.20 worth of flour (in the U.S.). Finally, Hot’n’Fresh Baking buys $1.20 worth of flour from General Flour and uses it to produce $2.00 worth of bread (in the U.S.). Using the value-added method, Table 17.1 suggests that the total value of the bread, $2.00, is divided across the two countries’ national accounts: $0.50 is included in Mexico’s GDP (the value of the grain produced in Mexico), and $1.50 is included in the United States’ GDP (the value added in the U.S.).
We have seen that GDP is intended to measure the amount of production that occurs during a given period, such as the calendar year. For this reason, only goods and services that are actually produced during a particular year are included in the GDP for that year. Example 17.6 and Concept Check 17.3 demonstrate this point.
EXAMPLE 17.6The Sale of a House and GDP
Does the sale of an existing home count in GDP?
A 20-year-old house is sold to a young family for $200,000. The family pays the real estate agent a 6 percent commission, or $12,000. What is the contribution of this transaction to GDP?
Because the house was not produced during the current year, its value is not counted in this year’s GDP. (The value of the house was included in the GDP 20 years earlier, the year the house was built.) In general, purchases and sales of existing assets, such as old houses or used cars, do not contribute to the current year’s GDP. However, the $12,000 fee paid to the real estate agent represents the market value of the agent’s services in helping the family find the house and make the purchase. Since those services were provided during the current year, the agent’s fee is counted in current-year GDP.
CONCEPT CHECK 17.3
Lotta Doe sells 100 shares of stock in Benson Buggywhip for $50 per share. She pays her broker a 2 percent commission for executing the sale. How does Lotta’s transaction affect the current-year GDP?
RECAP
MEASURING GDP
Gross domestic product (GDP) equals the market value
· GDP is an aggregate of the market values of the many goods and services produced in the economy.
· Goods and services that are not sold in markets, such as unpaid housework, are not counted in GDP. An important exception is goods and services provided by the government, which are included in GDP at the government’s cost of providing them.
of final goods and services
· Final goods and services (which include capital goods, such as factories and machines) are counted in GDP. Intermediate goods and services, which are used up in the production of final goods and services, are not counted.
· In practice, the value of final goods and services is determined by the value-added method. The value added by any firm equals the firm’s revenue from selling its product minus the cost of inputs purchased from other firms. Summing the value added by all firms in the production process yields the value of the final good or service.
produced in a country during a given period.
· Only goods and services produced within a nation’s borders are included in GDP.
· Only goods and services produced during the current year (or the portion of the value produced during the current year) are counted as part of the current-year GDP.
METHODS FOR MEASURING GDP
GDP is a measure of the quantity of goods and services produced by an economy. But any good or service that is produced will also be purchased and used by some economic agent—a consumer buying Christmas gifts or a firm investing in new machinery, for example. For many purposes, knowing not only how much is produced, but who uses it and how, is important. Furthermore, when an economic agent purchases a good or a service, that agent’s spending is some other economic agent’s income. For some purposes, it is also important to track this income from the production of goods and services.
THE EXPENDITURE METHOD FOR MEASURING GDP
Economic statisticians divide the users of the final goods and services that make up the GDP for any given year into four categories: households, firms, governments, and the foreign sector (that is, foreign purchasers of domestic products). They assume that all the final goods and services that are produced in a country in a given year will be purchased and used by members of one or more of these four groups. Furthermore, the amounts that purchasers spend on various goods and services should be equal to the market values of those goods and services. As a result, GDP can be measured with equal accuracy by either of two methods: (1) adding up the market values of all the final goods and services that are produced domestically or (2) adding up the total amount spent by each of the four groups on final goods and services and subtracting spending on imported goods and services. The values obtained by the two methods will be the same.
Corresponding to the four groups of final users are four components of expenditure: consumption, investment, government purchases, and net exports. That is, households consume, firms invest, governments make government purchases, and the foreign sector buys the nation’s exports. Table 17.2 gives the dollar values for each of these components for the U.S. economy in 2016. As the table shows, GDP for the United States in 2016 was about $18.6 trillion, roughly $57,500 per person. Detailed definitions of the components of expenditure, and their principal subcomponents, follow. As you read through them, refer to Table 17.2 to get a sense of the relative importance of each type of spending.
FIGURE 17.2 The Three Faces of GDP.The GDP can be expressed equally well as (1) the market value of production, (2) total expenditure (consumption, investment, government purchases, net exports), or (3) total income (labor income and capital income).
Consumption expenditure, or simply consumption, is spending by households on goods and services such as food, clothing, and entertainment. Consumption expenditure is subdivided into three subcategories:
· Consumer durables are long-lived consumer goods such as cars and furniture. Note that new houses are not treated as consumer durables but as part of investment.
· Consumer nondurables are shorter-lived goods like food and clothing.
· Services, a large component of consumer spending, include everything from haircuts and taxi rides to legal, financial, and educational services.
Investment is spending by firms on final goods and services, primarily capital goods and housing. Investment is divided into three subcategories:
· Business fixed investment is the purchase by firms of new capital goods such as machinery, factories, and office buildings. (Remember that for the purposes of calculating GDP, long-lived capital goods are treated as final goods rather than as intermediate goods.) Firms buy capital goods to increase their capacity to produce.
· Residential investment is construction of new homes and apartment buildings. For GDP accounting purposes, residential investment is treated as an investment by the business sector, which then sells the homes to households.
· Inventory investment is the addition of unsold goods to company inventories. In other words, the goods that a firm produces but doesn’t sell during the current period are treated, for accounting purposes, as if the firm had bought those goods from itself. (This convention guarantees that production equals expenditure.) Inventory investment can be positive or negative, depending on whether the value of inventories on hand rises or falls over the course of the year. In 2009, for example, inventories fell, and the inventory investment component contributed a negative value to GDP.
People often refer to purchases of financial assets, such as stocks or bonds, as “investments.” That use of the term is different from the definition we give here. A person who buys a share of a company’s stock acquires partial ownership of the existing physical and financial assets controlled by the company. A stock purchase does not usually correspond to the creation of new physical capital, however, and so is not investment in the sense we are using the term in this chapter. We will generally refer to purchases of financial assets, such as stocks and bonds, as “financial investments,” to distinguish them from a firm’s investment in new capital goods, such as factories and machines.
Government purchases are purchases by federal, state, and local governments of final goods, such as fighter planes, and services, such as teaching in public schools. Government purchases do not include transfer payments, which are payments made by the government in return for which no current goods or services are received. Examples of transfer payments (which, again, are not included in government purchases) are Social Security benefits, unemployment benefits, pensions paid to government workers, and welfare payments. Interest paid on the government debt is also excluded from government purchases.
Net exports equal exports minus imports.
· Exports are domestically produced final goods and services that are sold abroad.
· Imports are purchases by domestic buyers of goods and services that were produced abroad. Since imports are included in consumption, investment, and government purchases but do not represent spending on domestic production, they must be subtracted. Imports are subtracted from exports to find the net amount of spending on domestically produced goods and services. A shorthand way of adding exports and subtracting imports is to add net exports, which equals exports minus imports.
A country’s net exports reflect the net demand by the rest of the world for its goods and services. Net exports can be negative since imports can exceed exports in any given year. As Table 17.2 shows, the United States had significantly greater imports than exports in 2016.
The relationship between GDP and expenditures on goods and services can be summarized by an equation. Let
Using these symbols, we can write that GDP equals the sum of the four types of expenditure algebraically as
Y = C + I + G + NX.
EXAMPLE 17.7Measuring GDP by Production and by Expenditure
Do we get the same GDP using two different methods?
An economy produces 1,000,000 automobiles valued at $15,000 each. Of these, 700,000 are sold to consumers, 200,000 are sold to businesses, 50,000 are sold to the government, and 25,000 are sold abroad. No automobiles are imported. The automobiles left unsold at the end of the year are held in inventory by the auto producers. Find GDP in terms of (a) the market value of production and (b) the components of expenditure. You should get the same answer both ways.
The market value of the production of final goods and services in this economy is 1,000,000 autos times $15,000 per auto, or $15 billion.
To measure GDP in terms of expenditure, we must add spending on consumption, investment, government purchases, and net exports. Consumption is 700,000 autos times $15,000, or $10.5 billion. Government purchases are 50,000 autos times $15,000, or $0.75 billion. Net exports are equal to exports (25,000 autos at $15,000, or $0.375 billion) minus imports (zero), so net exports are $0.375 billion.
But what about investment? Here we must be careful. The 200,000 autos that are sold to businesses, worth $3 billion, count as investment. But notice too that the auto companies produced 1,000,000 automobiles but sold only 975,000 (700,000 + 200,000 + 50,000 + 25,000). Hence 25,000 autos were unsold at the end of the year and were added to the automobile producers’ inventories. This addition to producer inventories (25,000 autos at $15,000, or $0.375 billion) counts as inventory investment, which is part of total investment. Thus total investment spending equals the $3 billion worth of autos sold to businesses plus the $0.375 billion in inventory investment, or $3.375 billion.
Recapitulating, in this economy consumption is $10.5 billion, investment (including inventory investment) is $3.375 billion, government purchases equal $0.75 billion, and net exports are $0.375 billion. Summing these four components of expenditure yields $15 billion—the same value for GDP that we got by calculating the market value of production.
CONCEPT CHECK 17.4
Extending Example 17.7, suppose that 25,000 of the automobiles purchased by households are imported rather than domestically produced. Domestic production remains at 1,000,000 autos valued at $15,000 each. Once again, find GDP in terms of (a) the market value of production and (b) the components of expenditure.
GDP AND THE INCOMES OF CAPITAL AND LABOR
The GDP can be thought of equally well as a measure of total production or as a measure of total expenditure—either method of calculating the GDP gives the same final answer. There is yet a third way to think of the GDP, which is as the incomes of capital and labor.
Whenever a good or service is produced or sold, the revenue from the sale is distributed to the workers and the owners of the capital involved in the production of the good or service. Thus, except for some technical adjustments that we will ignore, GDP also equals labor income plus capital income.
· Labor income comprises wages, salaries, and the incomes of the self-employed.
· Capital income is made up of payments to owners of physical capital (such as factories, machines, and office buildings) and intangible capital (such as copyrights and patents). The components of capital income include items such as profits earned by business owners, the rents paid to owners of land or buildings, interest received by bondholders, and the royalties received by the holders of copyrights or patents.
How much of GDP is labor income versus capital income? Answering this question is not a simple task. Consider, for example, the income of a self-employed person (who owns his or her work equipment) or the income of a small-business owner: How much of their incomes should we count as labor income, and how much should we count as capital income? Economists do not always agree on the answers, and different estimation methods result in somewhat different numbers. For our purposes, as a rough approximation, we will think of labor income as being equal to about 75 percent of GDP and of capital income as equal to about 25 percent of GDP.
Both labor income and capital income are to be understood as measured prior to payment of taxes; ultimately, of course, a portion of both types of income is captured by the government in the form of tax collections.
Figure 17.2 may help you visualize the three equivalent ways of thinking about GDP: the market value of production, the total value of expenditure, and the sum of labor income and capital income. The figure also roughly captures the relative importance of the expenditure and income components. In 2016, about 69 percent of expenditure was consumption spending, about 18 percent was government purchases, and the rest was investment spending and net exports. (Actually, as Table 17.2 shows, net exports have been negative in recent years, reflecting the U.S. trade deficit.) As we mentioned, we think of labor income as being about 75 percent of total income, with capital income making up the rest.
Figure 17.2 can be also viewed in the context of what is called a circular flow diagram of the economy. Such a diagram is drawn in Figure 17.3. It depicts a simplified economy where consumption, C, is the only component of GDP—not a bad simplified model of the U.S. economy, where C accounts for more than two-thirds of GDP (as discussed, it was roughly 69 percent in 2016). The left panel of Figure 17.3 conveys the economy as a flow of resources from households to firms, accompanied by a flow of final goods and services from firms to households. The production approach to measuring GDP would amount to counting that flow of goods and services (the blue arrow on the left in Figure 17.3) produced in a country in a given time period.
FIGURE 17.3 Two Circular Flow Diagrams.The left panel shows that households supply labor and capital to firms, which use those resources to produce goods and services for households. The right panel shows that households receive income from firms for the resources they supply, which they then spend on goods and services from firms.
The right panel of Figure 17.3 conveys the economy as a flow of spending, paid by households to firms, in return for goods and services, and a flow of income, paid by firms to households, in return for resources such as labor and capital. The expenditure approach to measuring GDP would amount to counting the former (the blue arrow on the right), and the income approach would amount to counting the latter (the red arrow on the right) in a country in a given time period. As the diagram suggests, all three methods should yield the same GDP figures because, in principle, everything that is produced (and is therefore counted with the production method) is bought by some buyer (and is therefore counted with the expenditure method), and that buyer’s spending is, in turn, someone else’s income (counted with the income method).
Figure 17.3 suggests a simple story that captures much—though far from all—of what is going on in the more complex U.S. economy. In this story, there are two main players in the economy—households and firms—and there are two main markets where these players trade: the market for production inputs and the market for goods and services. In the mornings, households meet firms in the market for production inputs (or for resources), sell labor and capital to those firms, and get paid labor and capital income. The red arrows in the figure show these transactions. In the evenings (and weekends), the same households meet the same firms in the goods and services market, and now households buy from firms the goods and services produced in the mornings, and pay for them (through household expenditures) with the same income earned in the mornings. The blue arrows in the figure show these transactions. The total value of these goods and services produced in a given time period—GDP—can thus be measured by counting total production, or total expenditures, or total income. In principle, the three methods would yield the same outcome.
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METHODS FOR MEASURING GDP
Expenditure Components of GDP
· GDP can be expressed as the sum of expenditures on domestically produced final goods and services. The four types of expenditure that are counted in the GDP, and the economic groups that make each type of expenditure, are as follows:
Incomes of Capital and Labor
· GDP also equals labor income plus capital income.
NOMINAL GDP VERSUS REAL GDP
As a measure of the total production of an economy over a given period, such as a particular year, GDP is useful in comparisons of economic activity in different places. For example, GDP data for the year 2016, broken down state by state, could be used to compare aggregate production in New York and California during that year. However, economists are interested in comparing levels of economic activity not only in different locations but over time as well. For example, a president who is running for reelection on the basis of successful economic policies might want to know by how much output in the U.S. economy had increased during their term.
Using GDP to compare economic activity at two different points in time may give misleading answers, however, as the following example shows. Suppose, for the sake of illustration, that the economy produces only pizzas and calzones. The prices and quantities of the two goods in the years 2013 and 2017, the beginning and end of the president’s term, are shown in Table 17.3. If we calculate GDP in each year as the market value of production, we find that the GDP for 2013 is (10 pizzas × $10/pizza) + (15 calzones × $5/calzone) = $175. The GDP for 2017 is (20 pizzas × $12/pizza) + (30 calzones × $6/calzone) = $420. Comparing the GDP for the year 2013 to the GDP for the year 2017, we might conclude that it is 2.4 times greater ($420/$175).
Can you see what is wrong with this conclusion? The quantities of both pizzas and calzones produced in the year 2017 are exactly twice the quantities produced in the year 2013. If economic activity, as measured by actual production of both goods, exactly doubled over the four years, why do the calculated values of GDP show a greater increase?
The answer, as you also can see from the table, is that prices as well as quantities rose between 2013 and 2017. Because of the increase in prices, the market value of production grew more over those four years than the physical volume of production. So in this case, GDP is a misleading gauge of economic growth during the president’s term because the physical quantities of the goods and services produced in any given year, not the dollar values, are what determine people’s economic well-being. Indeed, if the prices of pizzas and calzones had risen 2.4 times between 2013 and 2017 with no changes in the quantities of pizzas and calzones produced, GDP would have risen 2.4 times as well, with no increase in physical production! In that case, the claim that the economy’s (physical) output had more than doubled during the president’s term would obviously be wrong.
As this example shows, if we want to use GDP to compare economic activity at different points in time, we need some method of excluding the effects of price changes. In other words, we need to adjust for inflation. To do so, economists use a common set of prices to value quantities produced in different years. The standard approach is to pick a particular year, called the base year, and use the prices from that year to calculate the market value of output. When GDP is calculated using the prices from a base year, rather than the current year’s prices, it is called real GDP, to indicate that it is a measure of real physical production. Real GDP is GDP adjusted for inflation. To distinguish real GDP, in which quantities produced are valued at base-year prices, from GDP valued at current-year prices, economists refer to the latter measure as nominal GDP.
EXAMPLE 17.8Calculating the Change in Real GDP over a Four-Year Span
How much did real GDP grow over a four-year span?
Using data from Table 17.3 and assuming that 2013 is the base year, find real GDP for the years 2017 and 2013. By how much did real output grow between 2013 and 2017?
To find real GDP for the year 2017, we must value the quantities produced that year using the prices in the base year, 2013. Using the data in Table 17.3,
The real GDP of this economy in the year 2017 is $350.
What is the real GDP for 2013? By definition, the real GDP for 2013 equals 2013 quantities valued at base-year prices. The base year in this example happens to be 2013, so real GDP for 2013 equals 2013 quantities valued at 2013 prices, which is the same as nominal GDP for 2013. In general, in the base year, real GDP and nominal GDP are the same. We already found nominal GDP for 2013, $175, so that is also the real GDP for 2013.
We can now determine how much real production has actually grown over the 4-year period. Since real GDP was $175 in 2013 and $350 in 2017, the physical volume of production doubled between 2013 and 2017. This conclusion makes sense—Table 17.3 shows that the production of both pizzas and calzones exactly doubled over the period. By using real GDP, we have eliminated the effects of price changes and obtained a reasonable measure of the actual change in physical production over the 4-year span.
Of course, the production of all goods will not necessarily grow in equal proportion, as in the previous example. Concept Check 17.5 asks you to find real GDP when pizza and calzone production grow at different rates.
CONCEPT CHECK 17.5
Suppose production and prices of pizzas and calzones in 2013 and 2017 are as follows:
These data are the same as those in Table 17.3, except that pizza production has tripled rather than doubled between 2013 and 2017. Find real GDP in 2017 and 2013, and calculate the growth in real output over the four-year period. (Continue to assume that 2013 is the base year.)
After you complete Concept Check 17.5, you will find that the growth in real GDP between 2013 and 2017 reflects a sort of average of the growth in physical production of pizzas and calzones. Real GDP therefore remains a useful measure of overall physical production, even when the production of different goods and services grows at different rates.
The Economic Naturalist 17.1
Can nominal and real GDP ever move in different directions?
In most countries, both nominal and real GDP increase in almost every year. It is possible, however, for them to move in opposite directions. The last time this happened in the United States was 2007–2008. Using 2009 as a base year, real GDP fell by 0.3 percent, from $14.87 trillion in 2007 to $14.83 trillion in 2008. This reflected an overall reduction in the physical quantities of goods and services produced. Nominal GDP, however, rose by 1.7 percent, from $14.48 trillion to $14.72 trillion, over the same period because prices rose by more than quantities fell.
The preceding example also illustrates the fact that nominal GDP will be less than real GDP if prices during the current year are less than prices during the base year. This will generally be the case when the current year is earlier than the base year.
Could real GDP ever rise during a year in which nominal GDP fell? Once again, the answer is yes. For example, this could happen when a country experiences economic growth and falling prices (deflation) at the same time. This actually happened in Japan during several years in the 1990s.
The method of calculating real GDP just described was followed for many decades by the Bureau of Economic Analysis (BEA), the U.S. government agency responsible for GDP statistics. However, in recent decades, the BEA has adopted a more complicated procedure of determining real GDP, called chain weighting. The new procedure makes the official real GDP data less sensitive to the particular base year chosen. However, the chain-weighting and traditional approaches share the basic idea of valuing output in terms of base-year prices, and the results obtained by the two methods are generally similar.
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NOMINAL GDP VERSUS REAL GDP
Real GDP is calculated using the prices of goods and services that prevailed in a base year rather than in the current year. Nominal GDP is calculated using current-year prices. Real GDP is GDP adjusted for inflation; it may be thought of as measuring the physical volume of production. Comparisons of economic activity at different times should always be done using real GDP, not nominal GDP.
REAL GDP AND ECONOMIC WELL-BEING
Government policymakers pay close attention to real GDP, often behaving as if the greater the real GDP, the better. However, real GDP is not the same as economic well-being. At best, it is an imperfect measure of economic well-being because, for the most part, it captures only those goods and services that are priced and sold in markets. Many factors that contribute to people’s economic well-being are not priced and sold in markets and thus are largely or even entirely omitted from GDP. Maximizing real GDP is not, therefore, the right goal for government policymakers. Whether or not policies that increase GDP will also make people better off has to be determined on a case-by-case basis.
WHY REAL GDP ISN’T THE SAME AS ECONOMIC WELL-BEING
To understand why an increase in real GDP does not always promote economic well-being, let’s look at some factors that are not included in GDP but do affect whether people are better off.
Leisure Time
Most Americans (and most people in other industrialized countries as well) work many fewer hours than their great-grandparents did 100 years ago. Early in the twentieth century, some industrial workers—steelworkers, for example—worked as many as 12 hours a day, 7 days a week. Today, the 40-hour workweek is typical. Also, Americans tend to start working later in life (after college or graduate school), and, in many cases, they are able to retire earlier. The increased leisure time available to workers in the United States and other industrialized countries—which allows them to pursue many worthwhile activities, including being with family and friends, participating in sports and hobbies, and pursuing cultural and educational activities—is a major benefit of living in a wealthy society. These extra hours of leisure are not priced in markets, however, and therefore are not reflected in GDP.
The Economic Naturalist 17.2
Why do people work fewer hours today than their great-grandparents did?
Americans start work later in life; retire earlier; and, in many cases, work fewer hours per week than people of 50 or 100 years ago. The opportunity cost of working less—retiring earlier, for example, or working fewer hours per week—is the earnings you forgo by not working. If you can, say, make $400 per week at a summer job in a department store, then leaving the job two weeks early to take a trip with some friends has an opportunity cost of $800. The fact that people are working fewer hours today suggests that their opportunity cost of forgone earnings is lower than their grandparents’ and great-grandparents’ opportunity cost. Why this difference?
Cost-Benefit
We can use the Cost-Benefit Principle to help us understand this phenomenon. Over the past century, rapid economic growth in the United States and other industrialized countries has greatly increased the purchasing power of the average worker’s wages. In other words, the typical worker today can buy more goods and services with his or her hourly earnings than ever before. This fact would seem to suggest that the opportunity cost of forgone earnings (measured in terms of what those earnings can buy) is greater, not smaller, today than in earlier times. But because the buying power of wages is so much higher today than in the past, Americans can achieve a reasonable standard of living by working fewer hours than they did in the past. Thus, while your grandparents may have had to work long hours to pay the rent or put food on the table, today the extra income from working long hours is more likely to buy relative luxuries, like nicer clothes or a fancier car. Because such discretionary purchases are easier to give up than basic food and shelter, the true opportunity cost of forgone earnings is lower today than it was 50 years ago. As the opportunity cost of leisure has fallen, Americans have chosen to enjoy more of it.
Nonmarket Economic Activities
Not all economically important activities are bought and sold in markets; with a few exceptions, such as government services, nonmarket economic activities are omitted from GDP. We mentioned earlier the examples of parenting and child care services and unpaid housekeeping services. Another example is volunteer services, such as the volunteer fire and rescue squads that serve many small towns. The fact that these unpaid services are left out of GDP does not mean that they are unimportant. The problem is that because there are no market prices and quantities for unpaid services, estimating their market values is very difficult.
How far do economists go wrong by leaving nonmarket economic activities out of GDP? The answer depends on the type of economy being studied. Although nonmarket economic activities exist in all economies, they are particularly important in poor economies. For example, in rural villages of developing countries, people commonly trade services with each other or cooperate on various tasks without exchanging any money. Families in these communities also tend to be relatively self-sufficient, growing their own food and providing many of their own basic services. Because such nonmarket economic activities are not counted in official statistics, GDP data may substantially understate the true amount of economic activity in the poorest countries.
Closely related to nonmarket activities is the underground economy, which includes transactions that are never reported to government officials and data collectors. The underground economy encompasses both legal and illegal activities, from informal babysitting jobs to organized crime. For instance, some people pay temporary or part-time workers like housecleaners and painters in cash, which allows these workers to avoid paying taxes on their income. Economists who have tried to estimate the value of such services by studying how much cash the public holds have concluded that these sorts of transactions make up an important share of overall economic activity, even in advanced industrial economies.
Environmental Quality and Resource Depletion
China has experienced tremendous growth in real GDP. But in expanding its manufacturing base, it also has suffered a severe decline in air and water quality. Increased pollution certainly detracts from the quality of life, but because air and water quality are not bought and sold in markets, the Chinese GDP does not reflect this downside of its economic growth.
The exploitation of finite natural resources also tends to be overlooked in GDP. When an oil company pumps and sells a barrel of oil, GDP increases by the value of the oil. But the fact that there is one less barrel of oil in the ground, waiting to be pumped sometime in the future, is not reflected in GDP.
A number of efforts have been made to incorporate factors like air quality and resource depletion into a comprehensive measure of GDP. Doing so is difficult since it often involves placing a dollar value on intangibles, like having a clean river to swim in instead of a dirty one. But the fact that the benefits of environmental quality and resource conservation are hard to measure in dollars and cents does not mean that they are unimportant.
Quality of Life
What makes a particular town or city an attractive place to live? Some desirable features you might think of are reflected in GDP: spacious, well-constructed homes, good restaurants and stores; a variety of entertainment; and high-quality medical services. However, other indicators of the good life are not sold in markets and so may be omitted from GDP. Examples include a low crime rate, minimal traffic congestion, active civic organizations, and open space. Thus, citizens of a rural community may oppose the construction of a new shopping center because they believe it may have a negative effect on the quality of life—even though the new shopping center may increase local GDP.
Poverty and Economic Inequality
GDP measures the total quantity of goods and services produced and sold in an economy, but it conveys no information about who gets to enjoy those goods and services. Two countries may have identical GDPs but differ radically in the distribution of economic welfare across the population. Suppose, for example, that in one country—call it Equalia—most people have a comfortable middle-class existence; both extreme poverty and extreme wealth are rare. But in another country, Inequalia—which has the same real GDP as Equalia—a few wealthy families control the economy, and the majority of the population lives in poverty. While most people would say that Equalia has a better economic situation overall, that judgment would not be reflected in the GDPs of the two countries, which are the same.
In the United States, absolute poverty has been declining. Today, many families whose income is below today’s official “poverty line” (in 2016, $24,560 for a family of four) own a television, a car, and in some cases their own home. Some economists have argued that people who are considered poor today live as well as many middle-class people did in the 1950s.
But, though absolute poverty seems to be decreasing in the United States, inequality of income has generally been rising. The chief executive officer of a large U.S. corporation may earn hundreds of times what the typical worker in the same firm receives. Psychologists tell us that people’s economic satisfaction depends not only on their absolute economic position—the quantity and quality of food, clothing, and shelter they have—but also on what they have compared to what others have. If you own an old, beat-up car but are the only person in your neighborhood to have a car, you may feel privileged. But if everyone else in the neighborhood owns a luxury car, you are likely to be less satisfied. To the extent that such comparisons affect people’s well-being, inequality matters as well as absolute poverty. Again, because GDP focuses on total production rather than on the distribution of output, it does not capture the effects of inequality.
BUT GDP IS RELATED TO ECONOMIC WELL-BEING
You might conclude from the list of important factors omitted from the official figures that GDP is useless as a measure of economic welfare. Indeed, numerous critics have made that claim. Clearly, in evaluating the effects of a proposed economic policy, considering only the likely effects on GDP is not sufficient. Planners must also ask whether the policy will affect aspects of economic well-being that are not captured in GDP. Environmental regulations may reduce production of steel, for example, which reduces the GDP. But that fact is not a sufficient basis on which to decide whether such regulations are good or bad. The right way to decide such questions is to apply the Cost-Benefit Principle: Are the benefits of cleaner air worth more to people than the costs the regulations impose in terms of lost output and lost jobs? If so, then the regulations should be adopted; otherwise, they should not.
Cost-Benefit
Although looking at the effects of a proposed policy on real GDP is not the only basis on which to evaluate a policy, real GDP per person does tend to be positively associated with many things people value, including a high material standard of living, better health and life expectancies, and better education. We discuss next some of the ways in which a higher real GDP is associated with greater economic well-being.
Availability of Goods and Services
Obviously, citizens of a country with a high GDP are likely to possess more and better goods and services (after all, that is what GDP measures). On average, people in high-GDP countries enjoy larger, better-constructed, and more comfortable homes; higher-quality food and clothing; a greater variety of entertainment and cultural opportunities; better access to transportation and travel; better communications and sanitation; and other advantages. While social commentators may question the value of material consumption—and we agree that riches do not necessarily bring happiness or peace of mind—the majority of people in the world place great importance on achieving material prosperity. Throughout history people have made tremendous sacrifices and taken great risks to secure a higher standard of living for themselves and their families. In fact, to a great extent the United States was built by people who were willing to leave their native lands, often at great personal hardship, in hopes of bettering their economic condition.
Health and Education
While some people question the value of an abundance of consumer goods and services, few question the value of literacy and education, and no one questions the value of having longer and healthier lives. Table 17.4 shows the differences between rich and poor countries with regard to some important indicators of well-being. The data are drawn from the United Nations Human Development Report, which measures economic development using a variety of education and health indicators in addition to GDP. The first row of Table 17.4 shows four groups of countries with radically different levels of GDP per person. Most noticeably, GDP per person in the countries with very high human development is more than 14 times that of the countries with low human development.2
A child born in one of the low human development countries has more than an 8 percent chance of dying before her or his fifth birthday.©Bettmann/Getty Images
How do these large differences in GDP relate to other measures of well-being? Table 17.4 shows that on some of the most basic measures of human welfare, the low human development countries fare much worse than the high human development countries. A child born in one of the countries with low human development has more than an 8 percent chance of dying before his or her fifth birthday. Compare this with a 0.6 percent chance of dying before the fifth birthday in the countries with very high human development. A child born in a country with very high human development has a life expectancy of about 79 years, compared to about 59 years in the low human development countries.
Table 17.4 shows that citizens of very high human development countries attend school for almost twice as many years as those in the low human development countries. Furthermore, data on years of schooling do not capture important differences in the quality of education available in rich and poor countries, as measured by indicators such as the educational backgrounds of teachers and student–teacher ratios.
The Economic Naturalist 17.3
Why do far fewer children complete high school in poor countries than in rich countries?
One possible explanation is that people in poor countries place a lower priority on getting an education than people in rich countries. This seems unlikely since immigrants from poor countries often put a heavy emphasis on education—though it may be that people who emigrate from poor countries are unrepresentative of the population as a whole.
An economic naturalist’s explanation for the lower schooling rates in poor countries would rely not on cultural differences, but on differences in opportunity costs. In poor societies, most of which are heavily agricultural, children are an important source of labor. Sending children to school beyond a certain age imposes a high opportunity cost on the family. Children who are in school are not available to help with planting, harvesting, and other tasks that must be done if the family is to survive. In addition, the cost of books and school supplies imposes a major hardship on poor families. The Cost-Benefit Principle thus implies that children will stay at home rather than go to school. In rich, nonagricultural countries, school-age children have few work opportunities, and their potential earnings are small relative to other sources of family income. The low opportunity cost of sending children to school in rich countries is an important reason for the higher enrollment rates in those countries. It is probably also true that the benefits or returns from receiving an education are higher in rich countries, as there are more employment opportunities for people with education than in poor countries.
Cost-Benefit
In Chapter 19, Economic Growth, Productivity, and Living Standards, we will discuss the costs and benefits of economic growth—which in practice means growth in real GDP per person—in greater depth. In that context we will return to the question of whether a growing real GDP is necessarily equated with greater economic well-being.
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REAL GDP AND ECONOMIC WELL-BEING
· Real GDP is an imperfect measure of economic well-being. Among the factors affecting well-being omitted from real GDP are the availability of leisure time, nonmarket services such as unpaid homemaking and volunteer services, environmental quality and resource conservation, and quality-of-life indicators such as a low crime rate. The GDP also does not reflect the degree of economic inequality in a country. Because real GDP is not the same as economic well-being, proposed policies should not be evaluated strictly in terms of whether or not they increase the GDP.
· Although GDP is not the same as economic well-being, it is positively associated with many things that people value, including a higher material standard of living, better health, longer life expectancies, and higher rates of literacy and educational attainment. This relationship between real GDP and economic well-being has led many people to emigrate from poor nations in search of a better life and has motivated policymakers to try to increase their nations’ rates of economic growth.
UNEMPLOYMENT AND THE UNEMPLOYMENT RATE
In assessing the level of economic activity in a country, economists look at a variety of statistics. Besides real GDP, one statistic that receives a great deal of attention, both from economists and from the general public, is the rate of unemployment. The unemployment rate is a sensitive indicator of conditions in the labor market. When the unemployment rate is low, jobs are secure and relatively easier to find. Low unemployment is often associated with improving wages and working conditions as well, as employers compete to attract and retain workers.
We will discuss labor markets and unemployment in detail in Chapter 20, Workers, Wages, and Unemployment. This section will explain how the unemployment rate and some related statistics are defined and measured. It will close with a discussion of the costs of unemployment, both to the unemployed and to the economy as a whole.
MEASURING UNEMPLOYMENT
In the United States, defining and measuring unemployment is the responsibility of the Bureau of Labor Statistics, or BLS. Each month the BLS surveys about 60,000 randomly selected households. Each person in those households who is 16 years or older is placed in one of three categories:
1. Employed. A person is employed if he or she worked full-time or part-time (even for a few hours) during the past week or is on vacation or sick leave from a regular job.
2. Unemployed. A person is unemployed if he or she did not work during the preceding week but made some effort to find work (for example, by going to a job interview) in the past four weeks.
3. Out of the labor force. A person is considered to be out of the labor force if he or she did not work in the past week and did not look for work in the past four weeks. In other words, people who are neither employed nor unemployed (in the sense of looking for work but not being able to find it) are “out of the labor force.” Full-time students, unpaid homemakers, retirees, and people unable to work because of disabilities are examples of people who are out of the labor force.
Based on the results of the survey, the BLS estimates how many people in the whole country fit into each of the three categories. The working age population is the sum of these three categories, and consists of the population age 16 and over.3
To find the unemployment rate, the BLS must first calculate the size of the labor force. The labor force is defined as the total number of employed and unemployed people in the economy (the first two categories of respondents to the BLS survey). The unemployment rate is then defined as the number of unemployed people divided by the labor force. Notice that people who are out of the labor force (because they are in school, have retired, or are disabled, for example) are not counted as unemployed and thus do not affect the unemployment rate. In general, a high rate of unemployment indicates that the economy is performing poorly.
Another useful statistic is the participation rate, or the percentage of the working-age population in the labor force (that is, the percentage that is either employed or looking for work). Figure 17.1 showed participation rates for American women and men since 1950. The participation rate is calculated by dividing the labor force by the working-age (16 years and older) population.4
Table 17.5 illustrates the calculation of key labor market statistics, using data based on the BLS survey for July 2017. In that month unemployment was 4.3 percent of the labor force. The participation rate was 62.9 percent; that is, almost two out of every three adults had a job or were looking for work. Figure 17.4 shows the U.S. unemployment rate since 1965. Unemployment rates were exceptionally low—just below and just above 4 percent—in the late 1960s and the late 1990s. By this measure, the latter part of the 1990s was an exceptionally good time for American workers. However, unemployment rose in 2001–2002 as the nation fell into recession, then declined to a low of 4.6 percent, and then more than doubled during the 2007–2009 recession. Since 2010, unemployment has been declining, reflecting the economic recovery. We will discuss these economic upswings (or expansions) and downswings (recessions) and their relationship with unemployment in greater detail in Chapter 24, Short-Term Economic Fluctuations: An Introduction.
FIGURE 17.4 The U.S. Unemployment Rate since 1965.The unemployment rate—the fraction of the U.S. labor force that is unemployed—was just above 4 percent in the late 1990s, the lowest recorded rate since the latter part of the 1960s. Unemployment rose to 6 percent in 2003 due to a recession and then decreased to just above 4.5 percent in 2007. During the 2007–2009 recession unemployment increased dramatically. It has been declining in recent years from its 2010 peak of 9.6 percent.Source: Bureau of Labor Statistics, www.bls.gov.
CONCEPT CHECK 17.6
Following are July 2017 BLS U.S. employment data for African Americans.
Find the labor force, the working-age population, the unemployment rate, and the participation rate for African Americans and compare your results to those in Table 17.5.
THE COSTS OF UNEMPLOYMENT
Unemployment imposes economic, psychological, and social costs on a nation. From an economic perspective, the main cost of unemployment is the output that is lost because the workforce is not fully utilized. Much of the burden of the reduced output is borne by the unemployed themselves, whose incomes fall when they are not working and whose skills may deteriorate from lack of use. However, society at large also bears part of the economic cost of unemployment. For example, workers who become unemployed are liable to stop paying taxes and start receiving government support payments, such as unemployment benefits. This net drain on the government’s budget is a cost to all taxpayers.
The psychological costs of unemployment are felt primarily by unemployed workers and their families. Studies show that lengthy periods of unemployment can lead to a loss of self-esteem, feelings of loss of control over one’s life, depression, and even suicidal behavior.5 The unemployed worker’s family is likely to feel increased psychological stress, compounded by the economic difficulties created by the loss of income.
The social costs of unemployment are a result of the economic and psychological effects. People who have been unemployed for a while tend not only to face severe financial difficulties, but also to feel anger, frustration, and despair. Not surprisingly, increases in unemployment tend to be associated with increases in crime, domestic violence, alcoholism, drug abuse, and other social problems. The costs created by these problems are borne not only by the unemployed but by society in general, as more public resources must be spent to counteract these problems—for example, by hiring more police to control crime or increasing spending on social services.
THE DURATION OF UNEMPLOYMENT
In assessing the impact of unemployment on jobless people, economists must know how long individual workers have been without work. Generally, the longer a person has been out of work, the more severe are the economic and psychological costs that person will face. People who are unemployed for only a few weeks, for example, are not likely to suffer a serious reduction in their standard of living, experience psychological problems such as depression or loss of self-esteem, and have their skills deteriorate (in turn reducing future earnings)—at least not to the same extent as someone who has been out of work for months or years.
In its surveys, therefore, the BLS asks respondents how long they have been unemployed. A period during which an individual is continuously unemployed is called an unemployment spell; it begins when the worker becomes unemployed and ends when the worker either finds a job or leaves the labor force. (Remember, people outside the labor force are not counted as unemployed.) The length of an unemployment spell is called its duration. The duration of unemployment rises during recessions, reflecting the greater difficulty of finding work during those periods.
At any given time, a substantial fraction of unemployed workers have been unemployed for six months or more; we will refer to this group as the long-term unemployed. Long-term unemployment creates the highest economic, psychological, and social costs, both for the unemployed themselves and for society as a whole.
When the economy is not in a recession, most unemployment spells are relatively short. For example, in July 2017, 31 percent of the unemployed had been out of work for just 5 weeks or less, another 29 percent had been unemployed for 5 to 14 weeks, and about 40 percent of the unemployed had been without a job for more than 14 weeks (about three months). However, during the latest recession, unemployment spells grew longer, and stayed longer for a few years. For example, in April 2011, 20 percent of the unemployed had been out of work for 5 weeks or less, 22 percent had been unemployed for 5 to 14 weeks, and 58 percent of the unemployed had been searching for work without any success for more than 14 weeks.
Even these statistics are a bit deceptive, however, because short unemployment spells can arise from two very different patterns of labor market experience. Some people have short unemployment spells that end in their finding a stable long-term job. For the most part, these workers, whom we will refer to as the short-term unemployed, do not typically bear a high cost of unemployment. But other workers have short unemployment spells that typically end either in their withdrawal from the labor force or in a short-term or temporary job that soon leaves the worker unemployed again. Workers whose unemployment spells are broken up by brief periods of employment or withdrawals from the labor force are referred to as the chronically unemployed. In terms of the costs of unemployment, the experience of these workers is similar to that of the long-term unemployed.
THE UNEMPLOYMENT RATE VERSUS “TRUE” UNEMPLOYMENT
Like GDP measurement, unemployment measurement has its critics. Most of them argue that the official unemployment rate understates the true extent of unemployment. They point in particular to two groups of people who are not counted among the unemployed: so-called discouraged workers and involuntary part-time workers.
Discouraged workers are people who say they would like to have a job but have not made an effort to find one in the past four weeks. Often, discouraged workers tell the survey takers that they have not searched for work because they have tried without success in the past or because they are convinced that labor market conditions are such that they will not be able to find a job. Because they have not sought work in the past four weeks, discouraged workers are counted as being out of the labor force rather than unemployed. Some observers have suggested that treating discouraged workers as unemployed would provide a more accurate picture of the labor market.
Involuntary part-time workers are people who say they would like to work full-time but are able to find only part-time work. Because they do have jobs, involuntary part-time workers are counted as employed rather than unemployed. These workers are sometimes referred to as underemployed or part-time workers for economic reasons. Some economists have suggested that these workers should be counted as partially unemployed.
In response to these criticisms, since the 1990s, the BLS has been releasing special unemployment rates that include estimates of the number of discouraged workers and involuntary part-time workers. In July 2017, when the official unemployment rate was 4.3 percent (see Table 17.5), the BLS calculated that if both discouraged workers and involuntary part-time workers were counted as unemployed, the unemployment rate would have been 8.6 percent. So the problem of discouraged and underemployed workers appears to be fairly significant.
Whether in an official or adjusted version, the unemployment rate is a good overall indicator of labor market conditions. A high unemployment rate tends to be bad news even for those people who are employed, since raises and promotions are hard to come by in a “slack” labor market. We will discuss the causes and cures of unemployment at some length in Chapter 20, Workers, Wages, and Unemployment and subsequent chapters.
SUMMARY
· The basic measure of an economy’s output is gross domestic product (GDP), the market value of the final goods and services produced in a country during a given period. Expressing output in terms of market values allows economists to aggregate the millions of goods and services produced in a modern economy. (LO1)
· Only final goods and services (which include capital goods) are counted in GDP since they are the only goods and services that directly benefit final users. Intermediate goods and services, which are used up in the production of final goods and services, are not counted in GDP, nor are sales of existing assets, such as a 20-year-old house. Summing the value added by each firm in the production process is a useful method of determining the value of final goods and services. (LO1)
· GDP can also be expressed as the sum of four types of expenditure: consumption, investment, government purchases, and net exports. These four types of expenditure correspond to the spending of households, firms, the government, and the foreign sector, respectively. (LO2)
· To compare levels of GDP over time, economists must eliminate the effects of inflation. They do so by measuring the market value of goods and services in terms of the prices in a base year. GDP measured in this way is called real GDP, while GDP measured in terms of current-year prices is called nominal GDP. Real GDP should always be used in making comparisons of economic activity over time. (LO3)
· Real GDP per person is an imperfect measure of economic well-being. With a few exceptions, notably government purchases of goods and services (which are included in GDP at their cost of production), GDP includes only those goods and services sold in markets. It excludes important factors that affect people’s well-being, such as the amount of leisure time available to them, the value of unpaid or volunteer services, the quality of the environment, quality of life indicators such as the crime rate, and the degree of economic inequality. (LO4)
· Real GDP is still a useful indicator of economic well-being, however. Countries with a high real GDP per person not only enjoy high average standards of living; they also tend to have higher life expectancies, low rates of infant and child mortality, and high rates of school enrollment and literacy. (LO4)
· The unemployment rate, perhaps the best-known indicator of the state of the labor market, is based on surveys conducted by the Bureau of Labor Statistics. The surveys classify all respondents over age 16 as employed, unemployed, or not in the labor force. The labor force is the sum of employed and unemployed workers—that is, people who have a job or are looking for one. The unemployment rate is calculated as the number of unemployed workers divided by the labor force. The participation rate is the percentage of the working-age population that is in the labor force. (LO5)
· The costs of unemployment include the economic cost of lost output, the psychological costs borne by unemployed workers and their families, and the social costs associated with problems like increased crime and violence. The greatest costs are imposed by long unemployment spells (periods of unemployment). Critics of the official unemployment rate argue that it understates “true” unemployment by excluding discouraged workers and involuntary part-time workers. (LO5)
KEY TERMS
capital good
consumption
consumption expenditure
discouraged workers
duration (of an unemployment spell)
final goods or services
government purchases
gross domestic product (GDP)
intermediate goods or services
investment
involuntary part-time workers
labor force
market value
net exports
nominal GDP
participation rate
real GDP
unemployment rate
unemployment spell
value added
REVIEW QUESTIONS
1. Why do economists use market values when calculating GDP? What is the economic rationale for giving high-value items more weight in GDP than low-value items? (LO1)
2. A large part of the agricultural sector in developing countries is subsistence farming, in which much of the food that is produced is consumed by the farmer and the farmer’s family. Discuss the implications of this fact for the measurement of GDP in poor countries. (LO1)
3. Give examples of each of the four types of aggregate expenditure. Which of the four represents the largest share of GDP in the United States? Can an expenditure component be negative? Explain. (LO2)
4. Al’s Shoeshine Stand shined 1,000 pairs of shoes last year and 1,200 pairs this year. He charged $4 for a shine last year and $5 this year. If last year is taken as the base year, find Al’s contribution to both nominal GDP and real GDP in both years. Which measure would be better to use if you were trying to measure the change in Al’s productivity over the past year? Why? (LO3)
5. Would you say that real GDP per person is a useful measure of economic well-being? Defend your answer. (LO4)
6. True or false: A high participation rate in an economy implies a low unemployment rate. (LO5)
7. What are the costs of a high unemployment rate? Do you think providing more generous government benefits to the unemployed would increase these costs, reduce these costs, or leave them unchanged? Discuss. (LO5)
PROBLEMS
1. George and John, stranded on an island, use clamshells for money. Last year George caught 300 fish and 5 wild boars. John grew 200 bunches of bananas. In the two-person economy that George and John set up, fish sell for 1 clamshell each, boars sell for 10 clamshells each, and bananas go for 5 clamshells a bunch. George paid John a total of 30 clamshells for helping him to dig bait for fishing, and he also purchased five of John’s mature banana trees for 30 clamshells each. What is the GDP of George’s and John’s island in terms of clamshells? (LO1)
2. How would each of the following transactions affect the GDP of the United States? (LO1)
a. The U.S. government pays $1 billion in salaries for government workers.
b. The U.S. government pays $1 billion to Social Security recipients.
c. The U.S. government pays a U.S. firm $1 billion for newly produced airplane parts.
d. The U.S. government pays $1 billion in interest to holders of U.S. government bonds.
e. The U.S. government pays $1 billion to Saudi Arabia for crude oil to add to U.S. official oil reserves.
3. Intelligence Incorporated produces 100 computer chips and sells them for $200 each to Bell Computers. Using the chips and other labor and materials, Bell produces 100 personal computers. Bell sells the computers, bundled with software that Bell licenses from Macrosoft at $50 per computer, to PC Charlie’s for $800 each. PC Charlie’s sells the computers to the public for $1,000 each. Calculate the total contribution to GDP using the value-added method. Do you get the same answer by summing up the market values of the final goods and services? (LO1)
4. MNLogs harvested logs (with no inputs from other companies) from its property in northern Minnesota. It sold these logs to MNLumber for $1,500, and MNLumber cut and planed the logs into lumber. MNLumber then sold the lumber for $4,000 to MNFurniture. MNFurniture used the lumber to produce 100 tables that it sold to customers for $70 each. (LO1)
a. Complete the following table to calculate the value added by each firm.
b. Suppose that all of these transactions took place in 2016. By how much did GDP increase because of these transactions?
c. Suppose that MNLogs harvested the logs in October 2016 and sold them to MNLumber in December 2016. MNLumber then sold the finished lumber to MNFurniture in April 2017 and MNFurniture sold all 100 tables during the rest of 2017. By how much did GDP increase in 2016 and 2017 because of these transactions?
5. For each of the following transactions, state the effect both on U.S. GDP and on the four components of aggregate expenditure. (LO2)
a. Your mother-in-law buys a new car from a U.S. producer.
b. Your mother-in-law buys a new car imported from Sweden.
c. Your mother-in-law’s car rental business buys a new car from a U.S. producer.
d. Your mother-in-law’s car rental business buys a new car imported from Sweden.
e. The U.S. government buys a new, domestically produced car for the use of your mother-in-law, who has been appointed the ambassador to Sweden.
6. Calculate the four components of expenditure and GDP for the following economy using data from the following table. (LO2)
7. The nation of Potchatoonie produces hockey pucks, cases of root beer, and sandals. The following table lists prices and quantities of the three goods in the years 2014 and 2017. (LO3)
Assume that 2014 is the base year. Find nominal GDP and real GDP for both years.
8. The government is considering a policy to reduce air pollution by restricting the use of “dirty” fuels by factories. In deciding whether to implement the policy, how, if at all, should the likely effects of the policy on real GDP be taken into account? (LO4)
9. We discussed how the opportunity cost of sending children to school affects the level of school enrollment across countries. The United Nations Human Development Report 2016 reports the following data for per capita income in 2015 (in the equivalent of 2011 U.S. dollars): (LO4)
a. Which country would you expect to have the highest school enrollment rate? The lowest rate?
b. Discuss what other factors besides GDP per capita a family might consider when applying the cost-benefit principle to the decision of whether or not to send a child to school.
10. The following is a report from a BLS survey taker: “There were 65 people in the houses I visited, 10 of them children under 16; 25 people had full-time jobs, and 5 had part-time jobs. There were 10 retirees, 5 full-time homemakers, 5 full-time students over age 16, and 2 people who were disabled and cannot work. The remaining people did not have jobs but all said they would like one. One of these people had not looked actively for work for 3 months, however.” Find the labor force, the unemployment rate, and the participation rate implied by the survey taker’s report. (LO5)
11. Ellen is downloading labor market data for the most recent month, but her connection is slow and so far this is all she has been able to get:
Find the labor force, the working-age population, the number of employed workers, and the number of unemployed workers. (LO5)
12. The towns of Sawyer and Thatcher each have a labor force of 1,200 people. In Sawyer, 100 people were unemployed for the entire year, while the rest of the labor force worked continuously. In Thatcher, every member of the labor force was unemployed for 1 month and employed for 11 months. (LO5)
a. What is the average unemployment rate over the year in each of the towns?
b. What is the average duration of unemployment spells in each of the towns?
c. In which town do you think the costs of unemployment are higher?
ANSWERS TO CONCEPT CHECKS
17.1In the text, GDP was calculated to be $64.00. If in addition Orchardia produces 5 oranges at $0.30 each, GDP is increased by $1.50 to $65.50. (LO1)
17.2The value added of the wholesale distributor together with the ultimate producers of the cards is $500. Amy’s value added—her revenue less her payments to other firms—is $200. Since the cards were produced and purchased by Amy during the year 2017 (we assume), the $500 counts toward year 2017 GDP. The $200 in value added originating in Amy’s card shop counts in year 2018 GDP since Amy actually sold the cards in that year. (LO1)
17.3The sale of stock represents a transfer of ownership of part of the assets of Benson Buggywhip, not the production of new goods or services. Hence, the stock sale itself does not contribute to GDP. However, the broker’s commission of $100 (2 percent of the stock sale proceeds) represents payment for a current service and is counted in GDP. (LO1)
17.4As in Example 17.7, the market value of domestic production is 1,000,000 autos times $15,000 per auto, or $15 billion.
Also as in Example 17.7, consumption is $10.5 billion and government purchases are $0.75 billion. However, because 25,000 of the autos that are purchased are imported rather than domestic, the domestic producers have unsold inventories at the end of the year of 50,000 (rather than 25,000 as in Example 17.7). Thus inventory investment is 50,000 autos times $15,000, or $0.75 billion, and total investment (autos purchased by businesses plus inventory investment) is $3.75 billion. Because exports and imports are equal (both are 25,000 autos), net exports (equal to exports minus imports) are zero. Notice that because we subtract imports to get net exports, it is unnecessary also to subtract imports from consumption. Consumption is defined as total purchases by households, not just purchases of domestically produced goods.
Total expenditure is C + I + G + NX = $10.5 billion + $3.75 billion + $0.75 billion + 0 = $15 billion, the same as the market value of production. (LO2)
17.5Real GDP in the year 2017 equals the quantities of pizzas and calzones produced in the year 2017, valued at the market prices that prevailed in the base year 2013. So real GDP in 2017 = (30 pizzas × $10/pizza) + (30 calzones × $5/calzone) = $450.
Real GDP in 2013 equals the quantities of pizzas and calzones produced in 2013, valued at 2013 prices, which is $175. Notice that because 2013 is the base year, real GDP and nominal GDP are the same for that year.
The real GDP in the year 2017 is $450/$175, or about 2.6 times what it was in 2013. Hence the expansion of real GDP lies between the threefold increase in pizza production and the doubling in calzone production that occurred between 2013 and 2017. (LO3)
17.6Labor force = Employed + Unemployed = 18.617 million + 1.479 million = 20.096 million.
Working-age population = Labor force + Not in labor force = 20.096 million + 12.163 million = 32.259 million.
Unemployment rate = Unemployed/Labor force = 1.479 million/20.096 million = 7.4%.
Participation rate = Labor force/Working-age population = 20.096 million/32.259 million = 62.3%.
In July 2017, African Americans represented approximately 13 percent of the U.S. labor force and the working-age population. Note that while the participation rate for African Americans is similar to that of the overall population, the unemployment rate for African Americans is substantially higher. (LO5)
1OECD, Doing Better for Children, 2009. See also coverage in The Economist, “The Nanny State,” September 3, 2009.
2The GDP data in Table 17.4 use U.S. prices to value goods and services in low human development nations. Because basic goods and services tend to be cheaper in poor countries, this adjustment significantly increases measured GDP in those countries.
3See www.bls.gov/cps/cps_htgm.htm for complete details on how the government collects and categorizes these data.
4We note that different governmental agencies use slightly different definitions of the participation rate. In particular, the numbers underlying the figures, tables, and discussion in this chapter (including Figure 17.1, Figure 17.4, Table 17.5, etc.) are published by the U.S. Bureau of Labor Statistics (BLS), which defines participation rate as “the labor force as a percent of the civilian noninstitutional population.” The civilian noninstitutional population includes only those working-age (16+) people “who are not inmates of institutions (for example, penal and mental facilities, homes for the aged), and who are not on active duty in the Armed Forces.”
5For a survey of the literature on the psychological effects of unemployment, see William Darity Jr. and Arthur H. Goldsmith, “Social Psychology, Unemployment and Macroeconomics,” Journal of Economic Perspectives 10 (Winter 1996), pp. 121–140.