Accounting for Output and Income Review for AP Economics
Review questions for this study guide can be found at:
Main Topics: Valuing Production, Gross Domestic Product (GDP), National Income Concepts, Real and Nominal GDP, The GDP Deflator, Business Cycles
The key here is to measure the value of the goods that are produced, not just the amount of goods that are produced. Remember the circular flow? If we need to follow the dollars to measure economic activity, we need to know prices of these goods.
Value of Production, Not Just Production
When you track the monthly production of a small coffee shop, you could sum up all of the cappuccinos, café lattes, and scones that were purchased. Table 12.1 represents the output in two recent months. At first glance, the two months produced the same amount (100) of goods, but clearly the mix of goods at the coffee shop is different.
To paint a more accurate picture of production, we need to incorporate the value of these items as shown in Table 12.2.
While the total production at the coffee shop remained the same from month to month, the value of that production has increased in February. There are now more dollars circulating.
- Don't just add up the quantities; multiply by prices and add up the values.
Gross Domestic Product (GDP)
Aggregation, not Aggravation
To move from valuing production of one firm to the entire town, to the state, or to the U.S. economy, we need to aggregate. Simply stated, we need to value all production of all firms and then add them up to get the value of production for the entire domestic economy. It is this aggregated measure of the total value of domestic production that allows us to calculate our first important macroeconomic statistic, GDP. GDP is the market value of the final goods and services produced within a nation in a year. If the good or service is produced within the borders of the United States, it counts toward U.S. GDP. It does not matter if the firm is headquartered in Indonesia; so long as it is producing in Indiana, it appears in the U.S. GDP.
What's In, What's Out
Final goods are those that are ready for consumption. A bottle of ketchup at the Piggly Wiggly is counted. Intermediate goods are those that require further processing before they are counted as a final good. When the tomatoes used to make ketchup are purchased from a grower, they are not counted toward the GDP. At least not until those tomatoes, and their value, find themselves in a bottle of ketchup and sold at the supermarket. A raw material like a tomato might be bought and sold several times before it appears as a final product. If we were to count the dollars at every stage of this process, we would be double counting, and this is to be avoided. Suppose the tomatoes go through three stages: harvest, processing, and retail sale as a bottle of ketchup. Along the way a pound of tomatoes is sold, bought, and altered. The pound of tomatoes was sold from the grower to the processor for 50 cents.
The bottle of ketchup was sold to a grocery store for $1.50 and eventually the ketchup was sold to a consumer for $3. If we added all of these transactions, we come up with $5, which overstates the value of the good in its final use. GDP only adds the final transaction as the value of the final good produced and consumed.
Second-hand sales are not counted. This falls under the "do not double count" rule. If you buy a new Xbox in 2002 at Circuit City, it would count in the GDP for 2002. If you resell it on eBay in 2004, it is not counted again. Final goods and services are only counted once, in the year in which they were produced.
Nonmarket transactions are not counted toward GDP. For example, if I have a clogged drain in my kitchen I have two choices: fix it myself, or call the plumber and pay to have it fixed. Doing it myself does not contribute to GDP, but paying a plumber to do it does. The same job is done, but only the latter ends up in the books. In a similar way, regular housework done at home by an unpaid member of the household is not counted, though it is very much a productive effort. This reality is sometimes cited as a criticism of GDP accounting: some valuable services are counted and others are not.
Underground economy transactions are not counted. For obvious reasons, the illegal sale of goods or services or paying someone cash "under the table" for work are not counted. Informal bartering between individuals is also not counted. You might help a friend study for economics while they help you study for biology, but this kind of bartering would not appear on any official ledger of production, even though it might be quite productive.
As a practical matter, official tabulation of GDP is never 100 percent accurate because the value of final goods and services is based upon a survey of representative firms, not a complete census of all firms throughout the nation. Despite this methodology, economists work very hard to get a fairly accurate picture of the value of a nation's production.
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