No Such Thing as a Free Lunch: Principles of Economics (Part 98)

The human world lives in a framework called global economics. We live in a system based on GDP, which drives consumption. it causes people to compete with each other through trade in a way that they all grow.

John Sulston

Measuring National Output and National Income (Part B)

by

Charles Lamson

Calculating GDP

GDP can be counted in two ways, one is to add up the total amount spent on all final goods during a given period. This is the expenditure approach to calculating GDP. The other is to add up the income---wages, rents, interest, and profits---received by all factors of production introducing final goods. This is the income approach to calculating GDP. These two methods lead to the same value for GDP for this reason: Every payment (expenditure) by a buyer is at the same time a receipt (income) for the seller. We can measure either income received or expenditures made, and we will end up with the same total output.

Suppose the economy is made up of just one firm and the firm's total output this year sells for $1 million. Because the total amount spent on output this year is $1 million, this year's GDP is $1 million. (Remember: the expenditure approach calculates GDP on the basis of the total amount spent on final goods and services in the economy.) However, every one of the million dollars of GDP is either paid to someone or remains with the owners of the firm as profit. Using the income approach, we add up the wages paid to employees of the firm, the interest paid to those who lent money to the firm, and the rents paid to those who lease land, buildings, or equipment to the firm. What is left over is profit, which is, of course, income to the owners of the firm. If we add up the incomes of all the factors of production, including profits to the owners, we get a GDP of $1 million.

The Expenditure Approach

Recall from part 95 of this analysis the four main groups in the economy: households, firms, the government, and the rest of the world. There are also four main categories of expenditure:

The expenditure approach calculates GDP by adding together these four components of spending. In equation form:

GDP = C + I + G + (EX - IM)

U.S. GDP was $19.07 trillion in 2019.

Personal Consumption Expenditures (C) The largest part of GDP consists of personal consumption expenditures (C). In 2019 the amount of personal consumption expenditures accounted for 70 percent of GDP (thebalance.com. "Components of GDP Explained"). These are expenditures by consumers on goods and services.

There are three main categories of consumer expenditures: durable goods, nondurable goods, and services. Durable goods, such as automobiles, furniture, and household appliances, last a relatively long time. Nondurable goods, such as food, clothing, gasoline, and cigarettes, are used up fairly quickly. Payments for services---those things that we buy that do not involve the production of physical items include expenditures for doctors, lawyers, and educational institutions. In 2019 durable goods expenditures accounted for 9 percent of GDP, nondurables for 16 percent, and services for 45 percent ("Components of GDP Explained").

Gross private domestic investment (I) Investment, as we use the term in economics, refers to the purchase of new capital---housing, plants, equipment, and inventory. The economic use of the term is in contrast to its everyday use, where investment often refers to purchases of stocks, bonds, or mutual funds.

Total investment in capital by the private sector is called gross private domestic investment (I). Expenditures by firms for machines, tools, plants, and so forth make up nonresidential investment. Because these are goods that firms buy for their own final use, they are part of "final sales" and counted in GDP. Expenditures for new houses and apartment buildings constitute residential investment. The third component of gross private investment, the change in business inventories, is the amount by which firms' inventories change during a period. Business inventories can be looked at as the goods that firms produce now but intend to sell later. In 2019, gross private investment accounted for 18 percent of GDP. Of this, 14 percent was nonresidential investment and 3 percent was residential investment (https://www.thebalance.com/components-of-gdp-explanation-formula-and-chart-3306015).

Change in Business Inventories It is sometimes confusing that inventories are counted as capital and that changes in inventory are counted as part of gross private domestic investment, but conceptually it makes sense. The inventory a firm owns has a value, and it serves a purpose, or provides a service, to the firm. That it has value is obvious. Think of the inventory of a new car dealer or of a clothing store, or stocks of newly produced but unsold computers awaiting shipment. All these have value.

However, what service does inventory provide? Firms keep stocks of inventory for a number of reasons. One is to meet unforeseen demand. Firms are never sure how much they will sell from period to period. Sales go up and down. To maintain the goodwill of their customers, firms need to be able to respond to unforeseen increases in sales. The only way to do that is with inventory.

Some firms use inventory to provide direct services to customers---the main function of a retail store. A grocery store provides a service---convenience. The store itself does not produce any food at all. It simply assembles a wide variety of items and puts them on display so consumers with varying tastes can come and shop in one place for what they want. The same is true for a clothing or hardware store. To provide their services, such stores need light fixtures, counters, cash registers, buildings, and lots of inventory.

Capital stocks are made up of plant, equipment, and inventory; inventory accumulations are part of the change in capital stocks, or investment.

Remember that GDP is not the market value of total final sales during a period---it is the market value of total production. The relationship between total production and total sales is:

GDP = final sales + change in business inventories

Total production (GDP) equals final sales of domestic goods plus the change in business inventories.

Gross Investment versus Net Investment During the process of production, capital (especially machinery and equipment) produced in previous periods gradually wears out. GDP does not give us a true picture of the real production of an economy. GDP includes newly produced capital goods but does not take account of capital goods "consumed" in the production process.

Capital assets decline in value over time. The amount by which an asset's value falls each period is called its depreciation. A personal computer purchased by a business today may be expected to have a useful life of 4 years before becoming worn out or obsolete. Over that period, the computer steadily depreciates.

What is the relationship between gross investment (I) and depreciation? Gross investment is the total value of all newly produced capital goods (plant, equipment, housing, and inventory) produced in a given period. It takes no account of the fact that some capital wears out and must be replaced. Net investment is equal to gross investment minus depreciation. Net investment is a measure of how much the stock of capital changes during a period. Positive net investment means that the amount of new capital changes during a period. Positive net investment means that the amount of new capital produced exceeds the amount that wears out, and negative net investment means that the amount of new capital produced is less than the amount that wears out. Therefore, if the net investment is positive, the capital stock has increased, and if net investment is negative, the capital stock has decreased. Put it another way, the capital stock at the end of a period is equal to the capital stock that existed at the beginning of the period plus net investment:

Government Consumption and Gross Investment (G) Government consumption and gross investment (G) include expenditures by federal, state, and local governments for final goods (bombs, pencils, school buildings) and services (military salaries, congressional salaries, school teachers' salaries). Some of these expenditures are counted as government consumption and some are counted as government gross investment. Government transfer payments (Social Security benefits, veterans disability stipends, etc.) are not included in G because these transfers are not purchases of anything currently produced. The payments are not made in exchange for any goods or services. Because interest payments on the government debt are also counted as transfers, they are also excluded from GDP on the grounds that they are not payments for current goods or services.

Government consumption and gross investment counted for $3.30 trillion or 17 percent of U.S. GDP, in 2019. Federal government consumption and gross investment in 2019 accounted for 7 percent of GDP, and state and local government consumption and gross investment accounted for 10 percent (https://www.thebalance.com/components-of-gdp-explanation-formula-and-chart-3306015).

Net Exports (EX - IM) The value of net exports (EX - IM) is the difference between exports (sales to foreigners of U.S.-produced goods and services) and imports (U.S. purchases of goods and services from abroad). This figure can be positive or negative. In 2019, the United States exported less than it imported, so the level of net exports was negative [-0.95 trillion dollars (thebalance.com)]. Before 1976, the United States was generally a net exporter---exports exceeded imports, so the net export figure was positive (Case & Fair, 2004).

The reason for including net exports in the definition of GDP is simple. Consumption, investment, and government spending (C, I, and G) include expenditures on goods produced both domestically and by foreigners. Therefore, C + I + G overstates domestic production because it contains expenditures on foreign produced goods---that is, imports (IM), which have to be subtracted out of GDP to obtain the correct figure. At the same time, C + I + G understates domestic production because some of what a nation produces is sold abroad and therefore not included in C, I or G---exports (EX) have to be added in. If a U.S. firm produces computers and sells them in Germany, the computers are part of U.S. production and should be counted as part of U.S. GDP. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 393-398*

end