Chapter 7: GDP: Measuring Total Production and Income

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Chapter 7: GDP: Measuring Total Production and Income

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 CHAPTER
CHAPTER 77

GDP: Measuring
Total Production
and Income
Chapter 7: GDP: Measuring Total Production and Income

In the more than 100

years that Ford
Motor Company has
been in business, its
experiences have
often mirrored those
of the U.S economy. Prepared by:
Fernando Quijano

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 CHAPTER
CHAPTER 77
Chapter Outline and
Learning Objectives

7.1 Gross Domestic Product Measures

GDP: Measuring Total Production

Explain how total production is

Total Production measured.

and Income
7.2 Does GDP Measure What We Want It
to Measure?
Discuss whether GDP is a good
measure of well-being.
Chapter 7: GDP: Measuring Total Production and Income

7.3 Real GDP versus Nominal GDP

Discuss the difference between real
GDP and nominal GDP.

7.4 Other Measures of Total Production

and Total Income
Become familiar with other measures
of total production and total income.

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 GDP: Measuring Total Production and Income

Microeconomics The study of how

households and firms make choices, how
they interact in markets, and how the
government attempts to influence their
choices.

Macroeconomics The study of the

Chapter 7: GDP: Measuring Total Production and Income

economy as a whole, including topics such

as inflation, unemployment, and economic
growth.

Business cycle Alternating periods of

economic expansion and economic
recession.

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 GDP: Measuring Total Production and Income

Expansion The period of a business cycle

during which total production and total
employment are increasing.

Recession The period of a business cycle

during which total production and total
employment are decreasing.
Chapter 7: GDP: Measuring Total Production and Income

Economic growth The ability of an

economy to produce increasing quantities of
goods and services.

Inflation rate The percentage increase in

the price level from one year to the next.

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 7.1 LEARNING OBJECTIVE
Gross Domestic Product Explain how total production is
Measures Total Production measured.

Measuring Total Production: Gross Domestic Product

Gross domestic product (GDP)

The market value of all final goods
and services produced in a country
during a period of time, typically one
year.
Chapter 7: GDP: Measuring Total Production and Income

GDP Is Measured Using Market Values, Not Quantities

The word value is important in the

definition of GDP.

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 7.1 LEARNING OBJECTIVE
Gross Domestic Product Explain how total production is
Measures Total Production measured.

Measuring Total Production: Gross Domestic Product

GDP Includes Only the Market Value of Final Goods

Final good or service A good or

service purchased by a final user.
Chapter 7: GDP: Measuring Total Production and Income

Intermediate good or service A

good or service that is an input into
another good or service, such as a
tire on a truck.

GDP Includes Only Current Production

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

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 7.1 LEARNING OBJECTIVE
Solved Problem 7-1 Explain how total production is
measured.
Calculating GDP

PRODUCTION AND PRICE STATISTICS FOR 2011

(1) (2) (3)
PRODUCT QUANTITY PRICE PER UNIT
Eye examinations 100 $50.00
Pizzas 80 10.00
Textbooks 20 100.00
Paper 2,000 0.10
Chapter 7: GDP: Measuring Total Production and Income

(1) (2) (3)

PRODUCT QUANTITY PRICE PER UNIT VALUE
Eye examinations 100 $50 $5,000
Pizzas 80 10 800
Textbooks 20 100 2,000

YOUR TURN: For more practice, do related problem 1.12 at the end of this
chapter.
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 7.1 LEARNING OBJECTIVE
Gross Domestic Product Explain how total production is
Measures Total Production measured.

Production, Income, and the Circular-Flow Diagram

FIGURE 7-1
The Circular Flow and the
Measurement of GDP
The circular-flow diagram illustrates
the flow of spending and money in
the economy.
Firms sell goods and services to three
groups: domestic households, foreign
firms and households, and the
Chapter 7: GDP: Measuring Total Production and Income

government.
To produce goods and services, firms
use factors of production: labor,
capital, natural resources, and
entrepreneurship. Households supply
the factors of production to firms in
exchange for income in the form of
wages, interest, profit, and rent.
Firms make payments of wages and
interest to households in exchange
for hiring workers and other factors of
production.
The sum of wages, interest, rent, and
profit is total income in the economy.
We can measure GDP as the total
income received by households.

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 7.1 LEARNING OBJECTIVE
Gross Domestic Product Explain how total production is
Measures Total Production measured.

Production, Income, and the Circular-Flow Diagram

FIGURE 7-1 (continued)
The Circular Flow and the
Measurement of GDP
The diagram also shows that
households use their income to
purchase goods and services, pay
taxes, and save. Firms and the
government borrow the funds that
flow from households into the
Chapter 7: GDP: Measuring Total Production and Income

financial system.
We can measure GDP either by
calculating the total value of
expenditures on final goods and
services or by calculating the value
of total income.

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 7.1 LEARNING OBJECTIVE
Gross Domestic Product Explain how total production is
Measures Total Production measured.

Production, Income, and the Circular-Flow Diagram

Transfer payments Payments

by the government to individuals
for which the government does
not receive a new good or
service in return.
Chapter 7: GDP: Measuring Total Production and Income

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 7.1 LEARNING OBJECTIVE
Gross Domestic Product Explain how total production is
Measures Total Production measured.

Components of GDP

Personal Consumption Expenditures, or “Consumption”

Consumption Spending by
households on goods and services,
not including spending on new houses.
Chapter 7: GDP: Measuring Total Production and Income

Gross Private Domestic Investment, or “Investment”

Investment Spending by firms on new
factories, office buildings, machinery, and
additions to inventories, and spending by
households and firms on new houses.

Don’t Let This Happen to YOU!

Remember What Economists Mean by Investment
YOUR TURN: Test your understanding by doing related problem 1.8 at the end of this
chapter.
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 7.1 LEARNING OBJECTIVE
Gross Domestic Product Explain how total production is
Measures Total Production measured.

Components of GDP

Government Consumption and Gross Investment, or

“Government Purchases”

Government purchases
Spending by federal, state,
and local governments on
Chapter 7: GDP: Measuring Total Production and Income

goods and services.

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 7.1 LEARNING OBJECTIVE
Gross Domestic Product Explain how total production is
Measures Total Production measured.

Components of GDP

Net Exports of Goods and Services, or “Net Exports”

Net exports Exports

minus imports.
Chapter 7: GDP: Measuring Total Production and Income

An Equation for GDP and Some Actual Values

Y  C  I  G  NX

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 7.1 LEARNING OBJECTIVE
Gross Domestic Product Explain how total production is
Measures Total Production measured.

An Equation for GDP and Some Actual Values

Chapter 7: GDP: Measuring Total Production and Income

FIGURE 7-2
Components of GDP in 2008
Consumption accounts for 70 percent of GDP, far more than any of the other components. In recent
years, net exports typically have been negative, which reduces GDP.

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 7.1 LEARNING OBJECTIVE
Gross Domestic Product Explain how total production is
Measures Total Production measured.

An Equation for GDP and Some Actual Values

• Consumer spending on services is greater than the sum

of spending on durable and nondurable goods.

• Business fixed investment is the largest component of

investment.

• Purchases made by state and local governments are

Chapter 7: GDP: Measuring Total Production and Income

greater than purchases made by the federal

government.

• Imports are greater than exports, so net exports are

negative.

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 7.1 LEARNING OBJECTIVE
Making
Will U.S. Consumers
the Explain how total production is
measured.
Connection Be Spending Less?
Chapter 7: GDP: Measuring Total Production and Income

YOUR TURN: Test your understanding by doing related problem 1.11 at the end
of this chapter.
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 7.1 LEARNING OBJECTIVE
Gross Domestic Product Explain how total production is
Measures Total Production measured.

Measuring GDP by the Value-Added Method

Value added The market value

a firm adds to a product.
Table 7-1
Calculating Value Added

VALUE OF
FIRM PRODUCT VALUE ADDED
Chapter 7: GDP: Measuring Total Production and Income

Cotton farmer Value of raw cotton = $1 Value added by cotton farmer =1

Textile mill Value of raw cotton
woven into cotton fabric Value added by cotton textile
= $3 mill = ($3 – $1) =2
Shirt company Value of cotton fabric Value added by shirt
made into a shirt = $15 manufacturer = ($15 –$3) = 12
L.L. Bean Value of shirt for sale on
L.L. Bean’s Web site = Value added by L.L. Bean
$35 = ($35 – $15) = 20
Total Value Added = $35

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 7.2 LEARNING OBJECTIVE
Does GDP Measure What Discuss whether GDP is a good
We Want It to Measure? measure of well-being.

Shortcomings in GDP as a Measure of Total

Production
Household Production
Household production refers to goods and
services people produce for themselves.
Chapter 7: GDP: Measuring Total Production and Income

The Underground Economy

Underground economy Buying and

selling of goods and services that is
concealed from the government to avoid
taxes or regulations or because the
goods and services are illegal.

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 7.2 LEARNING OBJECTIVE
Making Why Do Many Developing Countries Discuss whether GDP is a good
measure of well-being.
the Have Such Large Underground
Connection Economies?

A large informal sector can be a

sign of government policies that
are retarding economic growth.
Chapter 7: GDP: Measuring Total Production and Income

In some developing countries, more than half the

workers may be in the underground economy.

YOUR TURN: Test your understanding by doing related problem 2.6 at the end of
this chapter.

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 7.2 LEARNING OBJECTIVE
Does GDP Measure What Discuss whether GDP is a good
We Want It to Measure? measure of well-being.

Shortcomings of GDP as a Measure of Well-Being

The Value of Leisure Is Not Included in GDP

GDP Is Not Adjusted for Pollution or Other

Negative Effects of Production

GDP Is Not Adjusted for Changes in Crime and

Chapter 7: GDP: Measuring Total Production and Income

Other Social Problems

GDP Measures the Size of the Pie but Not

How the Pie Is Divided Up

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 7.2 LEARNING OBJECTIVE
Making Discuss whether GDP is a good
the Did World War II Bring Prosperity? measure of well-being.
Connection
Chapter 7: GDP: Measuring Total Production and Income

World War II was a period of extraordinary sacrifice and achievement by

the “greatest generation.” But statistics on GDP may give a misleading
indication of whether it was also a period of prosperity.

YOUR TURN: Test your understanding by doing related problem 2.8 at the end of
this chapter.
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 7.3 LEARNING OBJECTIVE
Real GDP versus Nominal GDP Discuss the difference between
real GDP and nominal GDP.

Calculating Real GDP

Nominal GDP The value of final

goods and services evaluated
at current-year prices.
Chapter 7: GDP: Measuring Total Production and Income

Real GDP The value of final

goods and services evaluated at
base-year prices.

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 7.3 LEARNING OBJECTIVE
Solved Problem 7-3 Discuss the difference between
Calculating Real GDP real GDP and nominal GDP.

2005 2011
PRODUCT QUANTITY PRICE QUANTITY PRICE
Eye examinations 80 $40 100 $50
Pizzas 90 11 80 10
Textbooks 15 90 20 100
Chapter 7: GDP: Measuring Total Production and Income

2011 2005
PRODUCT QUANTITY PRICE VALUE
Eye examinations 100 $40 $4,000
Pizzas 80 11 880
Textbooks 20 90 1,800

YOUR TURN: For more practice, do related problem 3.3 at the end of this
chapter.
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 7.3 LEARNING OBJECTIVE
Real GDP versus Nominal GDP Discuss the difference between
real GDP and nominal GDP.

Comparing Real GDP and Nominal GDP

FIGURE 7-3
Nominal GDP and
Real GDP, 1990–2008
Currently, the base year for
calculating GDP is 2005. In
the years before 2005,
prices were, on average,
lower than in 2005, so
nominal GDP was lower
Chapter 7: GDP: Measuring Total Production and Income

than real GDP. In 2005,

nominal and real GDP were
equal. After 2005, prices
have been, on average,
higher than in 2005, so
nominal GDP is higher than
real GDP.

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 7.3 LEARNING OBJECTIVE
Real GDP versus Nominal GDP Discuss the difference between
real GDP and nominal GDP.

The GDP Deflator

Price level A measure of the average

prices of goods and services in the
economy.

GDP deflator A measure of the price

Chapter 7: GDP: Measuring Total Production and Income

level, calculated by dividing nominal

GDP by real GDP and multiplying by
100.

Nominal GDP
GDP deflator   100
Real GDP

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 7.3 LEARNING OBJECTIVE
Real GDP versus Nominal GDP Discuss the difference between
real GDP and nominal GDP.

The GDP Deflator

2007 2008
NOMINAL GDP $14,078 billion $14,441 billion

REAL GDP $13,254 billion $13,312 billion

Chapter 7: GDP: Measuring Total Production and Income

FORMULA APPLIED TO 2007 APPLIED TO 2008

GDP 
Nominal GDP
100
 $14,078 billion 
  100  106
 $14,441 billion 
   100  108
Deflator Real GDP  $13,254 billion   $13,312 billion 

From these values for the deflator, we can calculate that the price level
increased by 1.9 percent between 2007 and 2008:

 108  106 
   100  1.9%
 106 

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 7.4 LEARNING OBJECTIVE
Other Measures of Total Become familiar with other
Production and Total Income measures of total production and
total income.

Gross National Product (GNP)

Gross national product (GNP) is the value of final goods and
services produced by residents of the United States, even if the
production takes place outside the United States.

National Income
National income is calculated as GDP minus the consumption of
Chapter 7: GDP: Measuring Total Production and Income

fixed capital, or depreciation.

Personal Income
Personal income is income received by households.

Disposable Personal Income

Disposable personal income is equal to personal income minus
personal tax payments.

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 7.4 LEARNING OBJECTIVE
Other Measures of Total Become familiar with other
Production and Total Income measures of total production and
total income.
Chapter 7: GDP: Measuring Total Production and Income

FIGURE 7-4
Measures of Total Production
and Total Income, 2008
The most important measure of total production and total income is gross domestic product (GDP). As we will see in
later chapters, for some purposes, the other measures of total production and total income shown in the figure turn
out to be more useful than GDP.

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 7.4 LEARNING OBJECTIVE
Other Measures of Total Become familiar with other
Production and Total Income measures of total production and
total income.

The Division of Income

Chapter 7: GDP: Measuring Total Production and Income

FIGURE 7-5
The Division of Income
We can measure GDP in terms of total expenditure or as the total income received by households. The
largest component of income received by households is wages, which are more than three times as large
as the profits received by sole proprietors and the profits received by corporations combined.

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 AN INSIDE LOOK
>> Falling Auto Purchases Lead to
Lower GDP
A Slowing Descent: Auto Sales
Fell 37Percent, but Improved Slightly
Chapter 7: GDP: Measuring Total Production and Income

Real GDP declined for three consecutive quarters beginning in the third quarter of
2008.

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 KEY TERMS

Business cycle Macroeconomics

Consumption Microeconomics
Economic growth Net exports
Expansion Nominal GDP
Final good or service Price level
Chapter 7: GDP: Measuring Total Production and Income

GDP deflator Real GDP

Government purchases Recession
Gross domestic product (GDP) Transfer payments
Inflation rate Underground economy
Intermediate good or service Value added
Investment

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