The definition of Gross Domestic Product

Gross Domestic Product is defined as the value of all final goods and services produced in a country or area during a certain period of time. A final product is one that is sold in its final form. It is not a smaller part of another product. To illustrate how GDP is computed, let’s look at a simple, hypothetical country that produces only two products: yogurt and economics textbooks. Five thousand yogurt cups are produced and sold at $1 per cup in a certain year. And one hundred economics textbooks are produced and sold at $80 per book, that same year.

Problem: What is the country’s GDP in the above example?
Solution: Both products are final products, so both products are included in the calculation of GDP. The value of the yogurt is $5,000 (5,000 times $1) and the value of the textbooks is $8,000 (100 times $80). Adding the two values together gives us a nominal GDP of $13,000.
Problem: Let’s say that the next year, the quantities produced remain constant, but the prices double. Yogurt now sells for $2, and textbooks for $160 (some textbooks are actually this expensive, ah!). How will nominal GDP change?
Solution: The value of the yogurt cups is 5,000 times $2, or $10,000. The value of the textbooks is 100 times $160, or $16,000. Adding the two values together gives us a nominal GDP of $26,000. It might appear that our economy improved one hundred percent; GDP is twice as high! Can we say that the economy is growing? The answer is no. The increase results from an increase in prices, and not from an increase in production. For that reason, we say that nominal GDP (production times prices) has doubled, but real GDP (GDP keeping prices constant) stays the same.

Real GDP is a more meaningful statistic for a country because it measures the actual quantity of final goods and services a country produces. See also section 3 in this unit for more examples of the difference between nominal and real GDP.

What is Included and What is Excluded in the Calculation of GDP?
The following products are included in the calculation of GDP:

All legally produced final goods and services produced for purchase by consumers, businesses, the government, and other countries, as well as changes in business inventories, artistic works, and research and development, are included in the calculation of Gross Domestic Product. Final products are those that are consumed or used in their final stage. For example, a car is a final product. The opposite of a final product is an intermediate product. A tire bought by Chrysler used in the production of its cars and trucks is an intermediate good. The ultimate purchase of the tire is not as a tire, but as part of a final product (the car). On the other hand, if a consumer buys a tire to replace a tire on an existing car, then the tire is considered a final product and it is included in GDP.

The following products are excluded in the calculation of GDP:
1. Intermediate products.

The argument for not including intermediate goods is that if they were included, they would be counted more than one time in the calculation of GDP – once as part of the final good, and once as the intermediate good. If intermediate goods were included, a tire would be counted at the moment it was sold by the tire company to Chrysler, and also when it was sold by Chrysler to the buyer for final consumption.

2. Used products.

Any good produced in another year, even though it is sold in the current one, is not included. For instance, a used car produced and sold in 2009, but resold today, is not included in today’s GDP because the actual production did not take place in this year. The commission of the used car dealer, however, is included, because that is a productive service provided this year. So if a used car sells this year for $5,000 and of that amount $800 is commission (profit), then the $800 is included in this year’s GDP and the remaining $4,200 is not. Another example of a good that can be sold in one year but produced in a previous year is an inventory item. If Ford produces a car this year, but does not sell it until next year, it is included in this year’s GDP, and not in next year’s GDP. However, the Ford car dealer’s commission from the sale of the car is included in next year’s GDP.

3. Financial transactions.

Any transaction not directly representing production is excluded. Examples are financial transactions such as the purchase of stocks, bonds, mortgage securities and credit default swaps. The commission a stockbroker earns on the sale of financial instruments is included in GDP, so if a stock broker sells $10,000 in stocks this year and charges $200 in commissions (fees), then the $200 is included in this year’s GDP, but the $10,000 is not. Government expenditures on welfare and other transfer programs are excluded, as well.

4. Non-reported transactions.

Products, which are difficult to measure, or which are illegal, are excluded. Examples are do-it-yourself household activities, services not reported as income to the government, prostitution, illegal drug trade, and other so-called underground market activities. An interesting discussion is whether marijuana produced and sold in states in which it is legal is included in GDP. At the moment, any marijuana (and more potent drugs) sold in the United States is illegal according to federal (national) law. Therefore, marijuana production is not included in our country’s GDP. However, it is included in the GSP (Gross State Product) of the states in which it is legal.

5. Barter trade.

Barter trade occurs when people exchange products for other products without payment of money. Examples are barbers exchanging haircuts for legal advise with their lawyers or hotel chains exchanging hotel services for airline tickets with airline firms. Some barter trade (especially between large firms) is included, but only if the firms report their economic activities to the government.

Video Explanation
For a video explanation of what is included and not included in Gross Domestic Product, please watch the following:

The Components of GDP

The following spending components are included in GDP:

1. Consumption (C).

Goods and services bought by households are called Consumption (C). Examples of typical consumption goods and services include cars, computers, smart phones, food, haircuts, banking services, and college courses.

2. Gross private domestic investment (I).

Goods and services bought by businesses are called Gross Private Domestic Investment (I). Examples include computers purchased by businesses, forklifts, trucks, business supplies, and buildings. The investment category also includes purchases of new residential homes and changes in business inventories.

3. Government expenditures (G).

Final products purchased by the government are called government expenditures (G). Examples include weapons, airplanes, construction materials for building roads and highways, and government office supplies.

4. Net exports (X).

When other countries purchase our final products, they are called Net Exports (X). The components C, I, and G include the consumption of domestically, as well as foreign-produced products. Because Gross Domestic Product measures only production of domestically produced products, net exports must subtract foreign-produced products. Therefore, net exports equals exports minus imports. 

The table below (http://www.bea.gov) shows the breakdown into the components of United States nominal GDP for selected years since 2008 (annualized and seasonally adjusted in billions of dollars). All components of GDP decreased between 2008 and 2009 (except for government spending), because of the recession that started in the third quarter of 2008. After 2009, the amounts increased in most categories.

GDP Component Total Amount
2008
Percentage of Total GDP*
2008
Total Amount
2009
Total Amount 2010 Total Amount 2012 Total Amount 2016 (est. ) Percentage of Total GDP 2016*
Entire GDP $14,150.8 100 $14,075.5 $14,735.9 $15,539.6 $19,031.58 100
Consumption (C) $10,047.0 71.0 $9,955.7 $10,401.9 $10,584.9  13,081.80 68.7
Gross Private Domestic Investment (I) $2,056.1 14.5 $1,579.8 $1,770.9 $2,441.8  3,070.2 16.1
Federal, State and Local Government Expenditures on Final Goods and Services (G) $2,798.1 19.8 $2,877.7 $3,065.2 $2,935.2  3,347.1 17.6
Net Exports (X) $-705.7 -5.0 $-337.7 $-502.1 $-412.1  -468.2 -2.4

 

 

 

 

Source: http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=3&isuri=1&903=5

*Percentages of the four GDP components may not add to 100% due to rounding.
Is Two-thirds of Our Economy Consumption?

The table above indicates that more than two-thirds of our final production is consumption. This makes many economists conclude that consumption primarily drives the economy, and that if we primarily stimulate consumption in our economy, then production, employment, and earnings will increase, as well. Even though consumption is a very important part of overall spending, this conclusion is deceiving. The definition of GDP  includes mainly final products. But this is merely a definition. In the real world, many other products, in particular intermediate products (auto parts, equipment, machine parts, nuts, bolts, etc.), are produced. These products also contribute to a significant amount of production, employment, and earnings. 

The economist George Reisman agrees. In his book, Capitalism, he argues that all intermediate goods and all capital goods should be included in the calculation of GDP in order to accurately reflect the importance of all production in our economy. Too much emphasis is placed upon consumer products in the calculation of GDP. Because of the over-emphasis on consumption in our economy, our government has adopted spending and taxation policies that favor consumption and discourage savings (for example, the taxing of interest from savings). However, lower savings lead to fewer funds available for investments to purchase and produce capital goods. As the production possibilities model in our Unit 1 shows, the fewer capital goods we have, the less capacity we have to produce products (both capital and consumer) in the future. This will actually lead to a decrease in our long-term economic growth and a relative increase in unemployment and poverty.

Reisman suggests that we adopt a measure called “Gross National Revenue.” This would include the production of all products, including intermediate products, to more accurately reflect economic activities in the actual economy.