Output Market: Output and the Price Level "[b]y the curious standard of the GDP, the nation's hero is a terminal cancer patient who is going through a costly divorce." Overview Let’s start with two seemingly simple questions. 1. Who is better off - you, your parents, your grandparents, or great grandparents? 2. In what country would you want to live because of its high standard of living? If you could choose, where and when would you live? It turns out these are not easy questions to answer. What do use as a guide in making the choice? Is it income and earnings, education, political freedom, war and peace, education, or maybe health reflected in average height, weight, or life expectancy? All of these affect what we would call our standard of living, and each of us would value them differently. For example, in revolutionary America it was “give me liberty or give me death,” while in modern China it is, “Give me liberty or give me growth.” The French, meanwhile, have accepted less income as the price of more leisure, and Americans have accepted greater economic anxiety as the price of faster growth. In many respects asking which country is the best is similar to asking what is the best college football team, or the best university, and in each case a "magic" number has been produced to answer the question. In college football we measure teams by their BCS ranking, in college it would be US News’ National University Rankings, and for economies it tends to be Gross Domestic Product (GDP). None of these is perfect because it is extremely difficult to come up with single measures of performance, especially when it is an economy with hundreds of millions of people and millions of firms.i One argument for using GDP is a strong correlation between it and many other performance indicators. For example, below is a scatter diagram with GDP per capita and life expectancy that clearly indicates a positive relationship – as GDP per person rises so does life expectancy, although there does seem to be an upper limit to life expectancy. The impact of AIDS on life expectancies in some sub Saharan countries, such as South Africa, is also evident. These countries have lower life expectancies than expected based on GDP per capita. 1 There are, however, some challenges to the use of GDP and GDP per capita as the macro economy’s primary performance indicators. China, for example, is recognized as an economic “rock star” because of its ability to sustain over decades GDP growth in excess of 10%, but there are growing questions about the value of GDP as an indicator of well-being. There have been numerous articles with headlines like, “GDP per capita record masks economic woes, didn’t transform lives: experts,”ii and “Cost of Environmental Damage in China Growing Rapidly Amid Industrialization.”iii In a 2010 report that cost was estimated at 3.5% of GDP, although there is reason to believe it is a low estimate. A World Bank study a few years earlier pegged the cost of just air and water pollution at nearly 6% of GDP.iv There have also been challenges to GDP’s dominance by those offering alternative measures that get closer to happiness and to well-being, an example of the latter being the Social Progress Index. Production - GDP Definition The National Income and Product Accounts (NIPA) provide the framework for generating estimates of Gross Domestic Product (GDP) that is defined as: the market value of final goods and services produced annually within a country. It turns out each term in this definition is there for a reason and if we look briefly at each of the terms we will have a better sense of what GDP is - and what it is not.v GDP is the market value ... GDP is simply the weighted sum of output from all sectors of the economy, where output is valued at market prices. If market prices reflect what people pay for goods and services, then prices must reflect how people value them. If you pay $16 for a CD and 10 CDs are produced and sold at that price, then $160 worth of value has been created. GDP is the market value of final ... Let's assume you have a summer job in a factory producing CD ROMs to be used to store computer software. The manufacturer sells the CDs to the software company for $10, and the software company adds the software instructions to the CD and sells it for $50. The $10 would be considered an intermediate product and would not be included in GDP. The only final good would be the CD with the software sold to the computer user for $50. [Note: we could also calculate GDP by looking at the value added of each producer. The CD maker adds $10 in value assuming the material to produce the CD and the software maker adds $40 ($50-$10), so the entire operation adds $50 - precisely the value of the final goods produced. GDP is the market value of final goods and services ... Included in GDP are the values of goods, such as the cars you drive, and the value of services, such as the education and medical treatment you receive this semester. There was a time when nearly all people were employed in agriculture - the time of Plimouth Plantations - but the agrarian life gave way to the industrial life reflected in the mills you see in Pawtucket and Fall River - and that is giving way to a post-industrial or information age economy where growth will be in the production of services. GDP is the market value of final goods and services produced ... There are a number of things we buy that are not the product of current production and are thus excluded from GDP. Missing from GDP calculations would be the value of the sales of existing homes, used cars, and antiques, although the sales commissions are included because they represent payment for a currently provided service. Similarly, when you buy stocks, bonds, or mutual funds, only the commissions / fees would be included in GDP because there is no production directly involved. GDP is the market value of final goods and services produced annually ... GDP is defined as the value of goods and services produced during a year, although the data is tabulated and reported four times a year. What would be reported for the first quarter of 2007 would be the value of what would be produced for the year if the rate of production that existed during January, February and March were maintained for the entire year. 2 GDP is the market value of final goods and services produced annually within a country... The work of Juan, a Mexican national who works in the fields of Southern California helping to harvest a crop of avocados would be included in GDP while the value created by Mary, a native of Boston working in Germany for IBM would not be included.vi Regardless of what you look at, you need to recognize the fact they are both measures of value and therefore, as we saw in the Data Analysis unit, we need to be careful to adjust the data for price changes, so now let's look at the adjustment. Real vs. Nominal GDP: Correcting for price changes. Because GDP is the price-weighted sum of all "stuff" produced, GDP can rise if prices rise or if output rises, and there is a substantial difference between the two since in the first you simply have higher prices, while in the second you have more "stuff." To separate the two effects the Bureau of Economic Analysis (BEA) calculates two measures of GDP.vii Current-dollar GDP (Nominal GDP) is calculated using actual prices, while Constant-dollar GDP (Real GDP) is calculated using constant prices. viii The difference between the two GDP measures is evident in the table and graph below that are based on BEA web site data. Based on the nominal GDP data, the 1970s looks like the period of most rapid growth - about 10% a year - but this is wrong because no adjustment has been made for inflation, and as you saw earlier, the US experienced rapid inflation in the 1970s. It turns out that the major share of the increase in GDP came from rising prices rather than actual output. In the graphs below the table you see that the 10.4% per year nominal growth is only a 3.2% per year rise in real GDP. This adjustment reveals that the fastest growth was in the 1960s when the growth rate exceeded 4% per year, while the slowest was the 2000s when growth averaged approximately 2.5% a year.ix Current $ and Constant $ GDP Current GDP Real GDP (Billions of (Billions $s) 2000 $s) 1950 293.8 1,777.30 1960 526.4 2,501.80 1970 1,038.50 3,771.90 1980 2,789.50 5,161.70 1990 5,803.10 7,112.50 2000 9,817.00 9,817.00 2006 13,246.60 11,415.30 It is real GDP that should be used when examining changes in the size of the economy, 3 Decomposition of GDP: If you demand it, they will build it. There are three approaches to measuring GDP: who produces it, who earns the income generated in the production process, and who buys it. Of the three approaches, the last is by far the most popular and the one on which we will focus.