Definition of Gross Domestic Product (GDP)
Gross Domestic Product (GDP) is the market value of the products made in an economy over a particular time period. It is usually published quarterly or yearly. GDP comprises the output made by both indigenous and foreign-owned producers operating within the country’s geographical boundary. The Gross Domestic Product (GDP) is the value of all the goods and services produced within a country’s geographical boundary. It can be measured in three ways: product (output), income and expenditure methods. The methods should produce the same figure.
Content
Definition of Gross Domestic Product (GDP)
Measurement of GDP
Nominal GDP and Real GDP
Calculating real GDP using prices in the base year
Calculating real GDP using GDP deflator
GDP at current prices and GDP at constant prices
GDP at factor cost and GDP at market price
Other national income statistics
The usefulness of the GDP
Limitations of the GDP
Measurement of GDP
The product or output method
This method involves the addition of the value of the output of all the firms operating in different industries in a particular country over a given period. The problem with this method of calculating the GDP is that there could be overstatement due to double counting. There is, usually, more than one stage involved before a product is completely made. It starts from the extraction of raw materials (primary stage) to the conversion to a finished product (secondary state) and product distribution (tertiary stage). And the output of a firm in one stage of production is the input of a firm in another stage. Adding up the values of the output in all the stages without making any adjustment will overstate the GDP. For example, the output of the primary sector is sold to the secondary sector. The output of the secondary sector, therefore, will include the cost of purchases from the primary sector. Likewise, the output in the tertiary sector will include the cost of purchases from the secondary sector. The cost of purchasing raw materials or components has to be deducted from the sales revenue to ascertain the true value created in each stage of production. This is known as value added.
Value added is the difference between the sales revenue and the cost of materials and components. The values added in all the industries in the economy are added together in order to arrive at the Gross Value Added (GVA). The GVA is equivalent to GDP at basic prices. The GDP at basic prices does not account for taxes and subsidies. And because GDP is normally measured at market prices, an adjustment has to be made to GVA or GDP at basic prices. GDP at market prices is obtained by adding taxes and subtracting subsidies from GDP at basic prices.
In Table 1 below, the value added in each stage of production is obtained by deducting the cost of materials and components from the sales value of output. The total value added to the GDP is $80 billion, i.e. the addition of value added in the three stages of production. The same result can be obtained by using the final sales value of the finished product which is $80 billion value by the chocolate retailer.
Table 1: Numerical example of value-added method
| Sector | Cost of materials & components | Value of output | Value added | |
| Cocoa farmer | Primary | $0 | $40b | $40b (40-0) |
| Chocolate maker | Secondary | $40b | $60b | $20b (60b-40b) |
| Chocolate retailer | Tertiary | $60b | $80b | $20b (80b-60b) |
| Total | $100b | $180b | $80b |
The income method
Another method is summing up all the incomes paid to the factors engaged in the production of goods and services in the economy. These incomes are rents, wages, salaries, interests and profits. The sum of all the values added should be equal to the sum of incomes paid to productive resources of land, labour, capital and enterprise. This is because the output of a firm is valued by considering all payments incurred in the production which are payments made to the factors of production.
Transfer payments are excluded when calculating GDP by the income method. These payments are not made for productive purposes, e.g. welfare benefits or pensions. Besides, the incomes added are incomes before income taxes and subsidies that are adjusted for. Taxes are added and subsidies are subtracted in order to get the GDP at market prices.
The expenditure method
This method involves totalling the spending on domestic goods and services. These are already at market prices. The GDP is given as:
C + I + G + (X-M)
C stands for consumption, i.e. spending by households on goods and services.
I stands for investment, i.e. purchase of capital goods by businesses or firms.
G stands for government spending.
X-M is net exports, i.e. exports minus imports.
X stands for export of goods and services.
M stands for import of goods and services.
Nominal GDP and real GDP
Nominal GDP is GDP in money terms, i.e. goods and services are valued at the prevailing prices in the relevant year. Real GDP, on the other hand, is nominal GDP that has been adjusted for inflation.
The GDP can increase if only prices rise, only quantities rise or both prices and quantities rise. Real GDP measures the change in the output produced in a country more accurately than nominal GDP since it removes the effect of rising prices on the value of a country’s output. An adjustment has to be made because the GDP can increase due to rising prices of goods and services in a country even though the output has not increased. The goods and services in a particular year are priced at the base-year prices to eliminate the effect of inflation.
Nominal GDP is also known as money GDP or GDP at current prices. Real GDP is also called GDP at constant prices.
Calculating real GDP using prices in the base year
In Table 1 below, nominal GDP increased from $620,000 in year 1 (base year) to $774,000 in year 2. Nominal GDP for year 1 is obtained by using year 1 prices and nominal GDP for year 2 is obtained by using year 2 prices (see calculations below the table). If rising prices were ignored in year 2, GDP actually decreased from $620,000 to $465,000 since the base period, year 1. The goods in year 2 are valued at the base year (year 1) prices to obtain the real GDP of $465,000.
Table 1: Goods produced in Year 1 and Year 2
| Year 1 (base year) | Year 2 (current year) | |||
| Quantity | Price | Quantity | Price | |
| Petroleum | 4,000 | $5 | 3000 | $8 |
| Cars | 2,000 | $300 | 1500 | $500 |
Nominal GDP in year 1 (using year 1 prices) = (4,000 x $5) + (2,000 x $300) = $620,000
Nominal GDP in year 2 (using year 2 prices) = (3,000 x $8) + (1,500 x $500) = $774,000
Real GDP in year 2 (using year 1 prices) = (3,000 x $5) + (1,500 x $300) = $465,000
Calculating real GDP using GDP deflator
Alternatively, real GDP can be computed from the division of the nominal GDP by the GDP deflator. The GDP deflator removes the effect of inflation and shows how prices have increased compared to a base or reference period.
Real GDP = Nominal GDP
———————-
GDP deflator
where
GDP deflator = Price index in the current year
————————————————–
Price index in the base year
Therefore,
Real GDP = Nominal GDP X Price index in the base year
—————————————————————————
Price index in the current year
Example
The nominal GDP of country X is £5,000,000. Calculate the real GDP if prices of goods and services have risen by 5% from the base year.
GDP deflator = 105 → (current year index is 100 + 5)
——–
100 → (base year index is 100)
= 1.05
Real GDP = £5,000,000
——————
1.05
= £4,761,905
GDP at current prices and GDP at constant prices
GDP at current prices is the economy’s output valued at the prices obtainable in the year under consideration. For instance, GDP at current prices for year 1 is the output obtained when the goods and services are measured at year 1 prices.
GDP at constant prices is the GDP that has been adjusted for inflation. For example, GDP at constant prices for year 1 is obtained when the goods and services of year 1 are valued at the ruling prices in a base year.
GDP at factor cost and GDP at market price
GDP at market price is measured using prices at retail outlets. The market price includes indirect tax but excludes subsidies.
GDP at market prices = GDP at factor cost + indirect taxes – subsidies
GDP at factor cost is GDP valued using incomes paid to factors of production. It adjusts for indirect taxes and subsidies. GDP at factor cost is also known as GDP at basic prices.
GDP at factor cost = GDP at market prices – indirect taxes + subsidies
Other national income statistics
GDP is the most common national income statistic. Other measures of economic performance derived from the GDP include Gross National Product (GNP), Net National Product (NNP) and Net Domestic Product (NDP).
Gross National Product/Income (GNP/GNI)
GNP, also known as Gross National Income (GNI), is the total output produced by the country’s citizens and businesses irrespective of where they are located. It is derived from the addition of net property (factor) income from abroad (NPIFA) and the GDP.
GNP = GDP + NPIFA
Net property income from abroad is the difference between incomes earned by a country’s residents on their assets abroad and incomes on assets held in the country by foreigners.
Net National Product (NNP)
NNP is GNP minus capital consumption allowance or depreciation (D). NNP considers the output of the indigenous entities after adjusting for a fall in the value of the economy’s capital. Capital consumption allowance is a provision made for the replacement of an economy’s capital that has fallen in value from wear and tear. Capital consumption allowance is subtracted from gross investment (IT) to give net investment (IN). Gross investment is the total amount spent on capital; net investment represents the addition to the economy’s capital or productive capacity having adjusted for capital consumption. NNP is the most realistic figure for national income.
NNP = GDP + NPIFA -D
NDP is GDP minus capital consumption. It considers the total output of the economy after adjusting for a fall in the value of capital from wear and tear.
National Income (NI)
National Income (NI) can be defined as the total value of the goods and services produced by an economy or the total sum of incomes paid for the use of an economy’s productive resources in a given period. It can be determined by subtracting indirect business taxes from the NNP. Alternatively, it is obtained by adding rents, wages, interests and profits.
Personal Income (PI)
Personal Income (PI) is the sum of the incomes individuals receive in a country before the deduction of direct taxes. It includes employees’ compensation (wages, salaries and income from self-employment), rent, interest and profit, transfer payments, and dividends received by individuals. The items deducted include undistributed or retained corporate profit and employees’ contributions to social security. PI minus income tax produces Personal Disposable Income (PDI).
The usefulness of the GDP
To ascertain the direction of the economy
The output or GDP of an economy is useful in determining the direction the economy is headed. Increasing output is an indication that the economy is growing while a fall in output for two consecutive quarters shows that the economy is in a recession. The government would need to know the state of the economy in order to formulate policies that can address any problem discovered.
To determine the performance of specific sectors of the economy
Apart from the general state of the economy, GDP can reveal the state of different sectors of the economy. This will determine the policies or actions that the government would take in repositioning a troubled sector. For example, if the output in the agricultural sector is declining, the government can decide to grant subsidies to farmers or deal with specific problems faced by farmers such as lack of access to finance, fertilisers or high-yield seeds.
To determine the average income
Average income is obtained by dividing the GDP of a country by its population. This can then be compared with the previous year to show how the living standard has changed over time or compared with another country’s figure. In comparing countries, the GDP has to be converted to a common currency such as the dollar.
To attract foreign aids
Aids from richer countries or multilateral institutions can be based on a country’s need as obtained from the GDP figures. This will help to direct aid to an ailing sector in the economy as revealed by the official statistics.
Attraction of investment
The GDP is a common way of estimating the expected level of demand for products in an economy. If the GDP is rising, it means more people are employed to produce these goods. These people earn incomes and demand for goods is expected to rise. A decrease in GDP will make investors cut their investments in the country as demand would be expected to fall.
Limitations of the GDP
The GDP is a quantitative measure of how much has been produced in an economy, it does not measure many things that affect living standards or quality of life. Some problems associated with the use of GDP are explained below.
Distribution of income
The GDP shows the size of the economy; it does not reveal how GDP or the national income is distributed among the citizens of a country. The bulk of the income may be concentrated in the hands of a few individuals, thereby causing income inequality in the economy.
Environmental damage
The GDP does not record the value of the damage caused to the environment in an attempt to produce the country’s output. Air pollution and the destruction of wildlife habitats are examples of damage from production. These costs have a negative effect on the quality of life of the people.
Leisure time is ignored
Leisure time improves the quality of life of the workers. It can improve the mental health and physical health of the workers. GDP does not account for this as increasing output might come at the expense of leisure as workers have to spend long hours at work.
Underground economic activities are omitted
Some activities are not covered by the official statistics. This leads to an understatement of the GDP of a country. Those activities may not be declared due to their illegality, e.g., smuggling, dealing in hard drugs and prostitution. People may also understate their incomes in order to avoid paying taxes. The size of the underground economy is larger in developing countries than in developed countries. This could be due to the existence of many informal activities that are not registered with the government. The underground economy is also known as the hidden or shadow economy.
Non-marketed activities
These are activities that are not included in the measurement of the GDP because they are provided either free of charge or at prices below clearing or market prices, e.g., volunteer work, services rendered by charities, public education, government services, etc.
Data accuracy
Data availability and accuracy pose a challenge to accurately determining the GDP of a country. This is more pronounced in developing countries because of weak data-capturing systems.
GDP fails to measure happiness
It excludes many factors that promote the happiness and well-being of the people, such as health, education, safety, political participation and fundamental rights. These factors are captured in the Gross National Happiness Index.