GDP Measures Total Production

Treated by economists as an important framework by which the total production in an economy Opens in new window can be measured, GDP is often the focus of news stories in our society.

What Then Is Gross Domestic Product (GDP)?

In this post we explore what GDP is and how it is measured. We also explore why knowledge of GDP is important to consumers, firms and government policy-makers.

Economists measure total production by gross domestic product, or GDP.

Gross domestic product or GDP is the market value Opens in new window of all final goods and services produced in a country during a period of time.

In Australia, for example, the Australian Bureau of Statistics (ABS) Opens in new window compiles the data needed to calculate GDP. The ABS Opens in new window issues reports on GDP every three months (quarterly).

GDP is a central concept in macroeconomics so we need to consider its definition carefully.

GDP Is Measured Using Market Values, Not Quantities

The word value is an important concept in the definition of GDP. In microeconomics, we measure production in terms of quantity (using Australia as a case study):

When we measure total production in the economy, we can’t just add together the quantities of every good and service because the result would be a meaningless jumble.

Tones of wheat would be added to packets of cereal and numbers of restaurant meals and so on.

Instead, we measure production by taking the value in dollar terms of all the goods and services produced.

GDP Includes Only the Market Value of Goods and Services

In measuring GDP economists include only the market value of final goods and services.

A final good or service is one that is purchased by its final user and is not included in the production of any other good or service. Burgers or computers purchased by consumers are final goods.

Some goods and services, though, are used in the production of other goods and services and are termed intermediate goods and services. For example, Bakers Delight does not produce the flour used in its bread making; it buys the flour from a bread mill.

The flour purchased by Bakers Delight stores is an intermediate good, whereas a loaf of bread purchased by a person for their consumption is a final good.

In calculating GDP, we include the value of the bread but not the value of the flour.

If we included the value of the flour we would be double counting.

The value of the flour would be counted once when sold to Bakers Delight stores and a second time when the bread was sold to a customer.

GDP Includes Only Current Production

GDP includes only production that takes place during the indicated time period.

For example, GDP in 2015 includes only the goods and services produced during that year.

In particular, GDP does not include the value of used goods.

If you buy a new DVD of Star Trek from Kmart, the purchase is included in GDP. If, six months later, you resell that DVD on eBay, that transaction is not included in GDP since nothing new has actually been produced.

Measuring GDP Using the Value-Added Method

We have seen that GDP can be calculated by adding together all expenditures on final goods and services.

An alternative way of calculating GDP is the value-added method.

Value added refers to the additional market value a firm adds to a product and is equal to the difference between the price the firm sells a good for and the price it paid other firms for intermediate goods.

The Table below gives a hypothetical example of the value added by each firm involved in the production of a woollen jumper offered for sale by Big W.

FirmValue of ProductValue Added
Sheep farmerValue of raw wool = $1.00Value added by sheep farmer= $1.00
Woollen millValue of raw wool woven into woollen thread = $3.00Value added by woollen mill = ($3.00 – $1.00)= 2.00
Clothing manufacturerValue of woollen thread made into a jumper = $15.00Value added by clothing manufacturer = ($15.00 – $3.00)= 12.00
Big WValue of jumper for sale by Big W = $35.00Value added by Big W = ($35.00 – $15.00)=20.00
Total value added=$35.00

Suppose a sheep farmer sells $1.00 of raw wool to a woollen mill. If, for simplicity, we ignore any inputs the farmer may have purchased from other firms—such as sheep feed and shearers’ wages—then the farmer’s value added is $1.00.

The woollen mill then weaves the raw wool into woollen thread, which it sells to a clothing manufacturer for $3.00. The woollen mill’s value added ($2.00) is the difference between the price it paid for the raw wool ($1.00) and the price for which it can sell the woollen thread ($3.00).

Similarly, the clothing manufacturer’s value added is the difference between the price it paid for the woollen thread ($3.00) and the price it receives for the woollen jumper from Big W ($15.00).

Big W’s value added is the difference between the price it pays for the jumper ($15.00) and the price it can sell the jumper for in its stores ($35.00).

Notice that the price of the jumper in Big W stores is exactly equal to the sum of the value added by each firm involved in the production of the jumper.

Therefore, we can calculate GDP:

Other Measures of Total Production and Total Income

We have already discussed the most important measure of total production and total income: GDP. In addition to calculating GDP economists calculates the following measures of production and income.

Net Domestic Product (NDP)

Net domestic product (NDP) Opens in new window is calculated by measuring GDP and subtracting the value of depreciation on capital equipment.

Depreciation is the reduction in the value of capital equipment that results from use or obsolescence.

Gross National Income (GNI)

GDP is the market value of final goods and services produced within a country.

Gross national income, or GNI Opens in new window, is the country’s GDP, plus income generated overseas by the country’s residents and firms, minus the income generated in the country by non-residents and foreign firms.

Again using Australia as a case study, Australian firms have facilities in foreign countries and foreign firms have facilities in Australia. BHP Billiton (an Australian company), for example, has mines overseas and Campbell’s Soup (a US company) has production plants in Australia.

GNI Opens in new window includes foreign production by Australian firms but excludes Australian production by foreign firms. In the next post, we explore the methods of measuring gross domestic product or GDP Opens in new window.