Monday, April 12, 2004

GDP for Econophobes: Fun and Sexy!

I swear. Once you've read this post you can go out and radiate the dangerously sexy aura of someone who knows about economic acronyms. It's a real guy or gal magnet, at least in my experience.

GDP is short for Gross Domestic Product. "Gross" doesn't refer to the ugliness of the term, but to the opposite of "Net", meaning that we don't subtract certain things when arriving at this measure. What these things are will become clear later. "Domestic" means that we will ignore stuff that's produced abroad. Sort of. And Product is a term meaning all the stuff we produce within a year: cars and haircuts, psychiatric visits and cups of coffee. Sort of. For the United States, say, GDP then tries to measure the total amount of goods (physical things) and services that are produced within the United States (whether by foreigners or natives) within one year.

The larger the GDP number, the more is being produced. This has made GDP into one measure of economic well-being, with the idea that a larger GDP means we are better off. But there are also problems with this interpretation: First, the GDP doesn't tell us how many people were involved in producing it. If two countries had the same GDP figures, but one had to support twice as many people than the other, the larger country would clearly be worse off. This problem can be solved by dividing the GDP with the population size of a country to arrive at an average or per capita GDP.

This doesn't solve all the problems yet. Another sticky one has to do with the way we add up the amounts of goods and services produced. How do you add up, say, 20,000 Fords and 1,000,000 bagels? The GDP does this using money: the value of the 20,000 Fords is their price multiplied by 20,000, and the value of the million bagels is the price of one bagel multiplied by a million. Ok. But prices change over time. If bagels or Fords double in price, but we still make the same amounts of them as in the past, the GDP figures would tell us that we now produce more even though that's not true. To solve this problem, GDP is often given in real rather than in nominal terms. This means that the prices used in multiplying the quantity items are standardized to some specific year in the past. For example, we could use 1994 prices of bagels and Fords to multiply the quantities produced both in 1994 and in 2004. Then any difference between the two total GDPs would show if we are indeed producing more today. This works some of the time, but we get into some iffy areas when the products produced today didn't even exist in 1994, so they couldn't have any prices then. There are ways around this problem, too, such as using chain-linked indexes for the prices, but the point is to remember that we value the stuff we produce with its prices, and prices may not always reflect what we want them to. Another example of this is when the prices of some product are severely distorted by a monopoly which charges much more than a competitive industry would. The GDP would record these 'too high' prices as an increase in the GDP.

A third problem with the GDP as a measure of economic well-being is in its gross nature. We produce a lot of stuff just to replace the bits that are worn out. I just made a shower curtain to replace a really old moldy one. How much did my personal economic well-being increase? Well, some, as the new curtain is nicer, but on the whole the change wasn't very large. If we really wanted to use the GDP to measure changes in economic well-being we should adjust it by subtracting all the production that goes to replacing worn-out items. But then we'd have Net Domestic Product, and as economists can't agree on the way to measure wear-out, we don't want to have one of those. Still, keep in mind the gross nature of the figure.

And now we come to the really serious problems with the GDP as a measure of economic well-being.* The first of these is that the GDP ignores the negative effects of economic activity on the environment. If I first produce coal and a lot of pollution, the value of the coal increases the GDP, but the negative value of the pollution is not included. If I then start a company to reduce the pollution I caused, the value of this activity increases the GDP! Say the value of my coal in the market is 1,000,000 dollars, and the extent of my pro-environment activity earns me 500,000 dollars, but the environmental degradation I caused would have a value of minus 3,000,000. The GDP gives my contribution as 1,500,000 dollars whereas it really should be -1,500,000. Of course it's really hard to put a dollar value on the environmental effects, and that's one of the reasons why they are ignored.

This omission of environmental consequences is a serious problem with the GDP. Another equally serious one has to do with the omission of nonmarket output in the GDP calculations. By 'nonmarket output' we mean goods and services which are produced but which are not sold and bought in the markets so that they have no easy prices to use in the calculations. Almost all production at home falls into this category: the production of home-cooked meals, childcare of one's own children, cleaning, laundry and yard-work. If I and my neighbor both do this work for ourselves, none of its value will be entered in the GDP figures. If, on the other hand, I hire my neighbor to do my chores, and he hires me, suddenly both of our outputs are entered in the GDP, which now shows an increase in production, even though no increase actually happened.

Our omission of nonmarket outputs in the GDP figures means that it's very hard to compare two countries by using their GDPs if they have very different patterns of market and nonmarket work. Also, the GDP underestimates women's production drastically, as the majority of household work is done by women. Estimates of the omitted value of nonmarket production vary, but most of them suggest that as much as one half of the total GDP may be omitted in omitting this part of the production.

Ok. Given all these omissions and problems, what is included in the GDP? How do we get the actual figures? To understand the procedure, note that we don't have any readily available measures of production, so we need to sort of deduce the production values from other stuff. Something that is produced today in the United States must go to one of the following uses:
-It's consumed by someone in the U.S. ( either because the person consumes it in a private act of consumption or because the person consumes it as part of government-provided consumption (use of roads, say)).

-It's not consumed right away, but it will provide goods or services that can be consumed in the future (this category includes durable consumer goods such as washing machines and also all investment). Some of this investment goes to replacing worn out equipment.

-It's consumed by someone abroad. This is counted as U.S. exports. But note that U.S. citizens can also consume things made abroad, and we don't want to include this in Domestic Product. What we need to do, then, is to add the value of exports to the GDP, and then subtract the value of imports from it.

So if we can add up the values of current and future consumption and correct this for the foreign influences, we should get a measure of GDP (though with all the problems I talked about earlier). By now you are up to reading the following summary of the included items, I hope:

It is common to see the following equation in economics textbooks:
GDP = C + I + G + NX

Consumption spending (C) consists of consumer spending on goods and services. It is often divided into spending on durable goods, non-durable goods and services. These purchases accounted for 68 percent of GDP in the first quarter.
Durable goods are items such as cars, furniture, and appliances, which are used for several years. (10%)
Non-durable goods are items such as food, clothing, and disposable products, which are used for only a short time period. (20%)
Services include rent paid on apartments (or estimated values for owner occupied housing), airplane tickets, legal and medical advice or treatment, electricity and other utilities. (38%) Services are the fastest growing part or consumption spending.
Investment spending (I) consists of nonresidential fixed investment, residential investment, and inventory changes. Investment spending accounts for 19 percent of GDP, but varies significantly from year to year.
Nonresidential fixed investment is the creation of tools and equipment to use in the production of other goods and services. Examples are the building of factories, the production of new machines, and the manufacturing of computers for business use (15%).
Residential investment is the building of a new homes or apartments. (4%)
Inventory changes consist of changes in the level of stocks of goods necessary for production and finished goods ready to be sold. (Less than 1%)
Government spending (G) consists of federal, state, and local government spending on goods and services such as research, roads, defense, schools, and police and fire departments. This spending does not include transfer payments such as Social Security, unemployment compensation, and welfare payments, which do not represent production of goods and services. (17%)
Net Exports (NX) is equal to exports minus imports. Exports are items produced in the US and purchased by foreigners (12%). Imports are items produced by foreigners and purchased by US consumers. (16%). Currently, the US imports more than it exports so that net exports are negative, about -4% of the GDP.

Got it? The total value of what is produced domestically goes either into what people consume (the first item), or into future consumption (investment, the second item) or into what the government consumes (the third item). In addition to that, we consume some things which are produced abroad (imports) and we produce some things which are consumed abroad (exports). The difference: exports-imports adjusts the other three groups for this, so that we are not omitting production that was consumed elsewhere or including consumption that was produced elsewhere.

Pretty simple, isn't it? Well, I hope so anyway.
*I'm not covering all the serious problems with the use of GDP as a welfare indicator. See this link for more information.