A number of methods are used to estimate the total economic activity in a country or a region. Some of the commonly used measures of regional income and output are:
- Gross Domestic Product (GDP)
- Gross National Product (GNP)
- Net National Income (NNI)
These measures are for the most part limited to counting goods and services that are exchanged for money: production not for sale but for barter, for one's own personal use, or for one's family, is largely left out of these measures, although some attempts are made to include some of those kinds of production by imputing monetary values to them.
In order to count a good or service it is necessary to assign some value to it. The value that all of the measures discussed here assign to a good or service is its market value – the price it fetches when bought or sold. No attempt is made to estimate the actual usefulness of a product.
Some useful terms
Gross: Total product, regardless of the use to which it is subsequently put.
Net: Gross minus the amount that must be used to offset depreciation – ie., wear-and-tear of the nation's fixed capital assets. "Net" gives an indication of how much product is actually available for consumption or new investment.
Domestic: The term domestic implies that the boundary is geographical: we are counting all goods and services produced within the country's borders, regardless of by whom it is produced.
National: The term national implies that the boundary is defined by citizenship (nationality). We count all goods and services produced by the nationals of the country (or businesses owned by them) regardless of where that production physically takes place.The output of a America-owned cotton factory in India counts as part of the Domestic figures for India, but the National figures of America.
From the above it is clear that while GDP is product produced withing the nation's borders, GNP would be the product produced by the citizens of the country or region. Similarly "Net" products for both national and domestic boundaries can be defined. The income of a particular state may be referred to as the State Domestic Product which is similar to the Gross Domestic Product.
There are three main methods of calculating GDP, they are as follows:
1) Expenditure Method
In contemporary economies, most things produced are produced for sale. Therefore, measuring the total expenditure of money used to buy things is a way of measuring production. This is known as the expenditure method of calculating GDP. Note that if you knit yourself a sweater, it is production but does not get counted as GDP because it is never sold. Sweater-knitting is a small part of the economy, but if one counts some major activities such as child-rearing (generally unpaid) as production, GDP ceases to be an accurate indicator of production.
GDP (Y) is a sum of Consumption (C), Investment (I), Government Spending (G) and Net Exports (X - M).
Y = C + I + G + (X − M)
Explanation:
C (consumption): It is normally the largest GDP component in the economy, consisting of private (household final consumption expenditure) in the economy. These personal expenditures fall under one of the following categories: durable goods, non-durable goods, and services. Examples include food, rent, jewelry, gasoline, and medical expenses but does not include the purchase of new housing.
I (investment): It includes business investment in equipments and does not include exchanges of existing assets. Examples include construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. Spending by households (not government) on new houses is also included in Investment. In contrast to its colloquial meaning, 'Investment' in GDP does not mean purchases of financial products. Buying financial products is classed as 'saving', as opposed to investment. This avoids double-counting: if one buys shares in a company, and the company uses the money received to buy plant, equipment, etc., the amount will be counted toward GDP when the company spends the money on those things; to also count it when one gives it to the company would be to count two times an amount that only corresponds to one group of products. Buying bonds or stocks is a swapping of deeds, a transfer of claims on future production, not directly an expenditure on products.
G (government spending): It is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments, such associal security or unemployment benefits.
X (exports) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations' consumption, therefore exports are added.
M (imports): represents gross imports. Imports are subtracted since imported goods will be included in the terms G, I, or C, and must be deducted to avoid counting foreign supply as domestic.
Note that C, G, and I are expenditures on final goods and services; expenditures on intermediate goods and services do not count. (Intermediate goods and services are those used by businesses to produce other goods and services within the accounting year.)
2) Income Method
Another way of measuring GDP is to measure total income. If GDP is calculated this way it is sometimes called Gross Domestic Income (GDI), or GDP(I). GDI should provide the same amount as the expenditure method described above. (By definition, GDI = GDP. In practice, however, measurement errors will make the two figures slightly off when reported by national statistical agencies.)
Total income can be subdivided according to various schemes, leading to various formulae for GDP measured by the income approach. A common one is:
GDP = compensation of employees + gross operating surplus + gross mixed income + taxes less subsidies on production and imports
GDP = COE + GOS + GMI + T - S
Compensation of employees (COE): It measures the total remuneration to employees for work done. It includes wages and salaries, as well as employer contributions to social security and other such programs.
Gross operating surplus (GOS): It is the surplus due to owners of incorporated businesses. Often called profits, although only a subset of total costs are subtracted from gross output to calculate GOS.
Gross mixed income (GMI): It is the same measure as GOS, but for unincorporated businesses. This often includes most small businesses.
The sum of COE, GOS and GMI is called total factor income; it is the income of all of the factors of production in society. It measures the value of GDP at factor (basic) prices. The difference between basic prices and final prices (those used in the expenditure calculation) is the total taxes and subsidies that the government has levied or paid on that production. So adding taxes less subsidies on production and imports converts GDP at factor cost to GDP(I).
Market output is defined as that which is sold for "economically significant" prices; economically significant prices are "prices which have a significant influence on the amounts producers are willing to supply and purchasers wish to buy." An exception is that illegal goods and services are often excluded even if they are sold at economically significant prices (Australia and the United States exclude them).
This leaves non-market output. It is partly excluded and partly included. First, "natural processes without human involvment or direction" are excluded. Also, there must be a person or institution that owns or is entitled to compensation for the product. An example of what is included and excluded by these criteria is given by the United States' national accounts agency: "the growth of trees in an uncultivated forest is not included in production, but the harvesting of the trees from that forest is included."
Within the limits so far described, the boundary is further constricted by "functional considerations." The Australian Bureau for Statistics explains this: "The national accounts are primarily constructed to assist governments and others to make market-based macroeconomic policy decisions, including analysis of markets and factors affecting market performance, such as inflation and unemployment." Consequently, production that is, according to them, "relatively independent and isolated from markets," or "difficult to value in an economically meaningful way" [ie., difficult to put a price on] is excluded. Thus excluded are services provided by people to members of their own families free of charge, such as child rearing, meal preparation, cleaning, transportation, entertainment of family members, emotional support, care of the elderly.
Services which are generally included:
- Goods and services provided by governments and non-profit organisations free of charge or for economically insignficant prices are included. The value of these goods and services is estimated as equal to their cost of production.
- Goods and services produced for own-use by businesses are attempted to be included. An example of this kind of production would be a machine constructed by an engineering firm for use in its own plant.
- Renovations and upkeep by an individual to a home that she owns and occupies are included. The value of the upkeep is estimated as the rent that she could charge for the home if she did not occupy it herself. This is the largest item of production for own use by an individual (as opposed to a business) that the compilers include in GDP.
- Agricultural production for consumption by oneself or one's household is included.
- Services (such as chequeing-account maintenance and services to borrowers) provided by banks and other financial institutions without charge or for a fee that does not reflect their full value have a value imputed to them by the compilers and are included. The financial institutions provide these services by giving the customer a less advantageous interest rate than they would if the services were absent; the value imputed to these services by the compilers is the difference between the interest rate of the account with the services and the interest rate of a similar account that does not have the services.
Usually in this approach the producer units of an economy are classified into classes of industries: agriculture, construction, manufacturing, etc. Their outputs are estimated largely on the basis of surveys which businesses fill out, but also the services from dwellings owned by households are counted towards production. To avoid "double-counting" in cases where the output of a producer unit is not a final good or service, but serves as intermediate input into another producer unit, either only final goods and services outputs must be counted, or a "value added" approach must be taken, where what is counted is not the total value output of a producer unit, but its value added: the difference between the value of its gross output and the value of its intermediate consumption.
Gross Value Added (GVA) = Sum of gross value added by all producer units = Gross output - intermediate consumption of goods and services to produce the output.
Depending on how gross value added has been calculated, it may be necessary to make an adjustment to it before it can be considered equal to GDP. This is because GDP is the market value of goods and services – the price paid by the customer – but the price received by the producer may be different than this if the government taxes or subsidises the product. For example, if there is a sales tax:
Depending on how gross value added has been calculated, it may be necessary to make an adjustment to it before it can be considered equal to GDP. This is because GDP is the market value of goods and services – the price paid by the customer – but the price received by the producer may be different than this if the government taxes or subsidises the product. For example, if there is a sales tax:
Producer's price + sales tax = market price
If taxes and subsidies have not already been computed as part of GVA, we must compute GDP as:
If taxes and subsidies have not already been computed as part of GVA, we must compute GDP as:
GDP = GVA + Taxes on products - Subsidies on products
The notes provided here are far from perfect. Please feel free to use the comments section to inform me about any additions or omissions that you may deem necessary.
A big thank you to wikipedia.
