The Idea of Gross Domestic Product - dummies

# The Idea of Gross Domestic Product

As of late 2015, the U.S. GDP is more than \$18 trillion, and projections are that it will grow by 2.7 percent to over \$18.5 trillion before 2016 is over.

In other words, if you add the value of all final sales recorded in the U.S. in one year it comes to more than \$18 trillion. But note the qualifier final: To avoid double counting, economists count only the value of final goods produced, not intermediate goods. So, if a car manufacturer produces a car worth \$20,000 but buys component parts worth \$8,000 to physically make the car, the total addition to GDP is just the final \$20,000.

Sometimes you hear people calling GDP the total value added. They do so because you can think of the contribution of a good or service to GDP as the value that is added to it at each stage of production.

For example, the car manufacturer we mentioned has added value worth \$12,000 (by buying the parts for \$8,000 and then selling the car for \$12,000 more). The same applies to the parts for which component manufacturers may have had to buy raw materials for \$2,000 in order to produce the \$8,000 worth of parts. They have then added value worth \$6,000.

As the table shows, the value of the car (the final good being produced) is \$20,000. This is exactly equal to the total value added by the raw materials, the component manufacturer, and the car manufacturer. If a dealer now sells the car for \$23,000, it implies further added value of \$3,000 in advertising and sales services.

 Cost of Inputs (\$) Value of Output (\$) Value Added (\$) Raw materials — 2,000 2,000 Component manufacturers 2,000 8,000 6,000 Car manufacturer 8,000 20,000 12,000 Total value added — — 20,000

## Determining national income — and not consuming it all at once

Someone pays for the value of whatever is produced. So, someone gets paid for the production, too. Those payments are income for whoever receives them. Thus, GDP tells you not just the aggregate production but also everyone’s individual income summed in total. And that should be equal to GDP, the aggregate amount of income of the economy. In other words, the total of everyone’s income should equal the total of all expenditures made to buy domestic goods, and both should equal GDP.

To continue the example from the preceding section, the car manufacturer has managed to turn \$8,000 worth of parts into a \$20,000 car, leaving it with a surplus of \$12,000. Some of this surplus goes to pay the workers in the factory (say \$8,000), leaving a profit of \$4,000. Ultimately, people own firms, so this profit also provides an income to somebody. Thus, the manufacturer’s value added is entirely distributed as income either to its workers or its shareholders.

The same is true for the component manufacturer and the owners of the raw materials: The value added must have been paid to someone as income. Because the total value added equals GDP, so too must total income equal GDP.

Of course, when you have your part of national income or GDP, you have to decide what to do with it. Here you have a number of options:

• You can consume it all: Which would mean spending all your income on consumer goods, such as food, entertainment, and similar goods and services. Another way of thinking about this option is that your income gives you a claim to a certain share of national output. By spending it all now, you’re choosing to use your entire claim on consumption today.
• You can consume some of it and save the rest: This would mean you spend only part of your income on consumer goods. By saving some of it, you give up some of your claim to consumption today and trade it for a claim to consumption in the future. The interest rate tells you the terms of this trade. If you save some of your income by putting it in a savings account or perhaps a bond fund that pays 5 percent, it means that by giving up \$100 worth of consumer goods today, you will establish a claim to \$105 worth of consumer goods one year from now. Thus, economists think of saving as a way of converting consumption today into consumption in the future.
• You can consume more than your share: How? By borrowing from someone who wants to save part of his share. The catch is that you’ll have to pay that person back at some point by giving up some of your own future consumption. This is the same trade as before but in reverse. In this trade, every extra \$100 worth of consumer goods you buy today requires a sacrifice of \$105 worth of consumer goods in a year. Thus, economists think of borrowing as a way of converting income in the future into consumption today.

## Watching a nation’s GDP flow

GDP is the same thing as aggregate annual income and so therefore it must be a flow variable, one that’s measured per unit of time — yearly, in this case.

It’s important to remember then that as a flow variable, GDP “restarts” each year. Roughly \$18 trillion worth of goods and service were produced in 2015. On January 1, 2016, the nation started producing all over again and will probably produce \$18.6 trillion by the end of 2016. The point is that because GDP is a flow variable, it has a rate of time or per year dimension. Over 2015 and 2016, the U.S. has been producing at an average rate of \$18.3 trillion worth of goods and services per year, with some acceleration in this pace over time.

Because GDP is a flow, all the component variables such as household consumer spending, private investment spending, and so on, are also flow variables. A new, hopefully bigger pie or flow will be produced next year because we’ll have more workers, more capital, and better technology.