The goal of GDP is to measure the total production of goods and services produced in the economy each year. This number is important because it gives an indication of how successfully society is addressing the scarcity problem. Generally speaking, with a larger gross domestic product, there are more goods and services that can be used to satisfy unlimited wants and needs.

Why Study?

• First, is scarcity. Gross domestic product, especially real GDP, is the first shot at measuring how well the economy is addressing the economic problem of scarcity. When real GDP is greater, then there are more goods and services--production--that can be used to satisfy wants and needs.


• Second, is instability. Gross domestic product, especially real GDP, is the first measure of record when seeking to identify instability and business cycles. If the economy is expanding, then real GDP is increasing. If the economy is contracting, then real GDP is decreasing.

Like most economic notions, there is more that can be extracted from this concept of GDP.

Total Market Value

The "total" aspect of this phrase is relatively simple. GDP seeks to measure ALL production, the production of ALL goods and services in the economy. Note the word ALL is capitalized for emphasis. GDP does not measure just the production of cars or houses or hot fudge sundaes. It aggregates ALL production.

Okay, what about the "market value" part? With a market-based economy, like in the United States, a great deal, not all, but a great deal, of production is exchanged through markets. Buyers give sellers money in exchange for a good.

Tabulating GDP in terms of market value has three important benefits.

• First, it provides an indication of satisfaction. The price that buyers pay for the good, the amount of money buyers give up, indicates the value of the good (at least to them). The fact that Duncan Thurly is willing to give up $2 for a hot fudge sundae, indicates that the hot fudge sundae provides $2 worth satisfaction of his unlimited wants and needs.

  Suppose that Duncan buys 10 hot fudge sundaes, paying $2 each. This indicates that he gets $20 worth of hot-fudge-sundae, wants-and-needs-satisfying value. The value of other production can be measured in the same way, that is, to multiply the quantity produced by price. By doing this, then adding ALL resulting values, the total market value of production is identified, which is GDP.



• Second, information is readily available. The preponderance of business records that track market exchanges provides a solid source of information that makes estimates of market value relatively easy to obtain. Having a solid source of information when calculating something like GDP, especially for an economy as large and complex as the United States, is almost always good.


• Third, it establishes a common denominator. Market value generates a common denominator--dollars--that can be used to aggregate different goods. While production could be measured in physical units, this means very little when aggregated. If, for example, GDP is measured as 10,001 units of "stuff", an interpretation proves difficult. What does this mean? Such a number has a different wants-and-needs-satisfaction meaning if it contains 10,000 hot fudge sundaes and 1 car compared to 10,000 cars and 1 hot fudge sundae. Market value denominated in dollars helps to avoid this ambiguity.

Final Goods and Services

• Intermediate Goods: The alternative to final production is intermediate production. Almost any production involves a multitude of steps. In some cases, all steps are performed by the same business. A truckload of raw materials enters the front door and finished products exit the back. However, these steps, these intermediate production steps, are often performed by separate businesses. One business makes part A, another makes part B, then a third assembles both into a finished product.

  For example, a standard, run-of-the-mill, car contains a number of intermediate goods--steel from one firm, tires from another, lug nuts from a third--which are combined to make the finished car. As a profit-seeking business, the car company includes the cost of these intermediate goods in the price of the final product. This observation is important to GDP.



• Final Goods: The calculation of GDP is based only on the market value of, the price buyers are willing to pay for, the final product. Because the market value of the final product already includes the value of ALL intermediate goods, there is no reason to separately include the market value of intermediate goods in GDP. Doing so is double counting, that is, counting the value of intermediate goods twice, or even more--once as the intermediate transaction then once as the sale of the final good. For example, with thousands of parts exchanged among hundreds of different firms, a $20,000 car requires hundreds of thousands of dollars worth of intermediate transactions.

  Conceptually, a final good can be thought of as one that has reached its final user. If Jonathan McJohnson, a normal household consumer, buys a new car to satisfy his personal wants and needs, then this car is a final good. It is produced for Jonathan, for his satisfaction.

  Business investment in capital goods also falls into the final goods category. A capital good purchased by the business sector has also reached its final user. For example, a wrench used to attach lug nuts to a car is intended to be used for just such a purpose. When a car company buys a newly produced wrench, then this production is part of GDP. Like Jonathan's car, this wrench is a final good.

  Government and foreign sectors also purchase final goods. A car, for example, purchased by the Shady Valley local police department is a final good. A wrench exported to a foreign car company in a far-away land is a final good. Final goods are purchased by the household, business, government, and foreign sectors.

Given Year

The "time period" notion is important because production, and by inference GDP, is a flow. Production is a process that takes place over time. To stress this point, the phrase "current production" is often used, with "current" meaning the specific year or quarter of interest.

The direct contrast with a flow measure such as GDP is another type of measure--a stock. While flows are measures that take place over a period of time, stocks are measures that exist at a point in time. The quantity of money in the economy is a stock measure. While a flow like GDP is measured from January 1st to December 31st, a stock like money is measured at an instant in time, like July 26th at 8:15 am.

The best analogy for stocks and flows is that of a bathroom sink (although a bathtub works just as well). Flow is analogous to the water coming through the faucet during a period. Stock is the amount of water in the sink at any instant.

In addition to GDP, other production and income measures, especially national income, personal income, and consumption expenditures, fall into the flow category. In addition to money, other useful stock measures include employment, business inventories, and the labor force.

Four Expenditures

• Personal Consumption Expenditures: The official measure of consumption expenditures on gross domestic product by the household sector. Personal consumption expenditures average about 65 to 70 percent of gross domestic product. These expenditures come in one of three varieties: (1) durable goods, (2) nondurable goods, and (3) services.


• Gross Private Domestic Investment: The official measure of investment expenditures on gross domestic product by the business sector. Gross private domestic investment averages about 15 percent of gross domestic product. These expenditures come in two broad categories: (1) fixed investment and (2) changes in private inventories.


• Government Consumption Expenditures and Gross Investment: The official measure of government purchases for gross domestic product by the government sector. Government consumption expenditures and gross investment also average about 15 percent of gross domestic product. These purchases are divided into two groups: (1) federal and (2) state and local.


• Net Exports of Goods and Services: The official measure of net exports of gross domestic product by the foreign sector, the difference between exports and imports. Net exports of goods and services also average about 2 percent of gross domestic product, with exports and imports individually in the range of about 10 percent.

In and Out

• Market Transactions of Economic Production: The most important activity included in GDP is the vast array of market transactions that involve the exchange of economic production. This is the normal, day-to-day, buying and selling of final goods and services that make up the economy.


• Past and Future: However, a number of market transactions, those for past and future production, are excluded from GDP. Future production includes intermediate goods that WILL become part of GDP in the future, when the finished product is finished. Past production includes used cars, used houses, rummage sale items, and any good produced before the start of our current time period.


• Estimated Value: Some economic production does NOT involve market transactions, but is included in GDP. Two examples are in-kind payments and services of owner-occupied housing. In-kind payments are production of a business given to owners or employees in lieu of a monetary payment. The services of owner-occupied housing is the estimated rental value of a house owned by the occupant.


• Home Production: Other economic production also does NOT involve market transactions, and is excluded from GDP due to measurement problems. This includes productive activities performed around the house, such as cooking, cleaning, home repairs, and even entertainment.


• Illegal Goods: Lastly, a whole range of illegal activities, much of which involves market transactions should be included in GDP, but is not. This includes illegal activities such as gambling, drugs, prostitution, and more. These are also excluded due to measurement problems.

Welfare Considerations

• Excluded Production: First, not all current economic production is actually included in gross domestic product. To the extent that some production is missed, especially household production and illegal activity, then GDP falls short of indicating the well-being of society.


• Included Negative Production: Second, GDP includes "production" whether or not the production contributes to welfare or satisfaction. In fact, some of the "production" included actually reduces welfare.


• Environmental Quality: Environmental quality is often (not always, but often) diminished with increased economic production. This reduction in environmental quality, which can reduce welfare, is seldom included in measured production.


• Income Distribution: Lastly, GDP is an aggregate measure for the economy, but it does not indicate who receives the production and income generated by the production.

The Other Four

• Net Domestic Product: The total market value of all final goods and services produced within the political boundaries of an economy during a given period of time, usually a year, after adjusting for the depreciation of capital.


• National Income: The total income earned by the citizens of the national economy as a result of their ownership of the resources used in the production of final goods and services during a given period of time, usually one year. This is the official measure of the total income generated by the economy.


• Personal Income: The total income received by the members of the domestic household sector, which may or may not be earned from productive activities during a given period of time, usually one year.


• Disposable Income: The total income that can be used by the household sector for either consumption or saving during a given period of time, usually one year.