Macroeconomics

Lecture 3:GDP, variants of GDP and it

limitations to assessing welfare.
 Learning Objectives

1) To explain the concept of value added and how it can used to calculate GDP
2) The explain GDP and the limitations of GDP is assessing the welfare of the
population
 GDP and the output approach
Recall the economy can be measured using the output
approach, it involves:
1) The Final output approach
2) The Value added approach.
The final output approach involves adding the values of final
goods produced by all industries, however this is not as easy
as it first appears. This is because the output of some goods
may be used as inputs by other firms e.g. milk from the dairy
industry is used to produce milk by ice-cream manufacturers.
Therefore to solve the problem of double counting the value
added approach is used. Keep in mind that both approached
would give you the same answer.
A pencil manufacturer would buy inputs from other producers for
instance wood, paint and rubber would be purchased from other
suppliers.
A car manufacturer would purchase inputs from other producers
such as steel, tyres and engines.
Sometimes a firm may buy hundreds of inputs from other suppliers.
These inputs are called intermediate goods.
If we add the final output of all firms we would end up with an
overstated size of the actual economy.
This is known as the ‘double counting’ problem. Sometimes its
referred to as multiple counting.
If adjustments are not to prevent double counting calculations
would overstate the size of GDP.
 The Value added approach
A firm’s value added is the value of output minus the value of inputs used
that were purchased from other firms.
For example, a bakery’s value added is the value of bread minus the value of
inputs it bought from other firms.
A clothing manufacturer’s value added is the value of clothes it produces
minus the value of cloth, buttons, zips and threads that it buys from other
firms.
A soft drink manufacturer’s value added is the difference between the value
of the soft drink and the ingredients that were purchased from other
suppliers.
Value added measures each firm’s own contribution to total output, the
amount of market value produced by that firm.
The sum of the values added in an economy is a measure of the economy’s
total output.
 Illustration
A wheat farmer sells wheat to a flour manufacturer for $50. The flour manufacturer
then converts the wheat into flour and sells it to a bread maker for $125. The bread
maker then uses the flour and then sells bread to a restaurant for $225. The consumer
then buys a sandwich for $350. If we were to add the values of all the output produced
by each firm we would get a GDP of $750. However this would overstate the true size
of GDP because some output was double counted e.g. wheat, flour and bread.

Intermediate goods are not included in the calculation of GDP because it will lead to double
counting and an overstated GDP.

The avoid double counting we use the value added approach.

The value of final output and the sum of the values added are equal.
 Value added approach to calculating GDP
Producer Value-Added ($)
Wheat farmer $50
Flour manufacturer $75 ($125-$50)
Bread maker $100 ($225-125)
Restaurant $125 ($350-225)
Consumer 0

The Value of GDP = 50 + 75 + 100 + 125 = $350

Value added measures each firm’s own contribution to total
output, the amount of market value that is produced by that
firm. It used avoids the statistical problem of double
counting.

The sum of all values added in an economy is a measure of

the economy’s total output.
Hence in the previous example the sum of the value added
components is equal to the value of the final good sold to the
consumer.
 Measuring National Income
National Income accounts can be measure from two sides: The
production side and the income side.
The production side measures production and sales.
The income side measures the distribution of proceeds from
sales.

On the product side the two most widely used ways to measure
the economy are:
1. Gross Domestic Product (GDP)
2. Gross National Product (GNP)
 Gross Domestic Product
The is the value of good and services produced within a country’s borders over a given
period of time, usually a year.
It includes the value of goods and services produced by residents and non-residents with
one year.
Gross = Total
Domestic = within the borders
Product = Production

GDP is the sum total of all final goods and services produced within the economy in a
given year.

GDP measures the output, hence the income that is produced in a country.

GDP reflects the value of goods and services produced by local and foreign entities
operating within the economy
 List of countries by GDP
Country GDP in 2019 millions in $US
United States 21,247,700
China 14,342,903
South Korea 1,642,383
Singapore 376,976
Iceland 24,188
Bahamas 24,928
Trinidad and Tobago 24,100
Saudi Arabia 792,967
Ethiopia 96,108
Haiti 8499
Limitations of GDP
Limitations of using GDP to assess the welfare
of a country
1. Environmental degradation – Economic growth and
industrialization may be associated with the destruction of
quality of the environment despite the fact that real incomes
are rising. Heightened economic activity may mean more air
pollution, water pollution and noise pollution. Deteriorating air
quality may lead to respiratory problems in the future. Improper
disposal of industrial waste can pollute water courses and
contaminate the water supply. Air pollution is a major problem
in China, the second largest economy in the world. GDP does not
subtract the costs or losses of pollution. In fact if the
government pays for the cost of a clean this would add to GDP
despite the negative impact on welfare.
2) The underground economy – Formal GDP statistics report the
formal economy. However the underground economy accounts for a
sizeable share of the production of goods and services in an economy,
particularly in developing economies. The economic activity that takes
place within the underground economy is not reflected in formal GDP
figure. There is economic activity that takes place however it goes
unreported in order to avoid paying taxes. For instance you may
babysit or barber or provide lessons however these activities are not
reported to the government in order to pay taxes. Illegal activities
such as human trafficking, narcotics and prostitution take place in the
black economy. In developing economies the underground economy
accounts can account for up to 50 percent of all economic activity in a
country. The presence of an underground economy means that formal
GDP numbers are understating the true size of the economy. One
study in 2014 estimated the size of the T&T informal economy to be 28
percent. The is smaller compared to other Caribbean nations but this
still amounts to a whopping $40 billion.
3) Income inequality – This is a major economic issue in the world today.
Despite the growth, income in equality is rising tremendously. The economy
may grow but the most of the real income growth may be enjoyed by a
small percentage of the population. For example, the economy may grow by
five percentage points, however the incomes of the richest 1 percent may
grow by 20 percent while the poorest 40 percent may see their incomes rise
by 1 percent. Recall there are different types of income –wage income,
corporate profits and the income of the self-employed. If most people in the
labour force are wage earners, their income may remain unchanged even
though aggregate incomes may increase. The United States has the most
severe degree of income inequality for any developed nation. Since 1980 as
much as 80 percent of all real income increases went to the richest 1
percent and 35 percent went to the richest 1 percent of 1 percent (16,000
households). The real wages of the average American has remained stagnant
since the early 1980s despite productivity gains. The chart below illustrates
the widening gap between productivity gains and real wages in United
States.
The chart revels that despite improvements in productivity (output per worker) the impact on real
wages have been minimal. Productivity has improved 72.2 percent from 1973 – 2014, this mean that
workers have produced 72.2 percent more goods and services compared to a worker in 1973.
However wages have rise slightly above 9.2 percent over the same period. In other words, despite
the economy improving it is not being reflected in the real incomes of many workers. As a result
many Americans are in debt and are working longer hours to compensate for stagnant real wages.

4. Social ills – The size or the growth of GDP does not reflect many negative social issues that
citizens may face for example crime. In Trinidad and Tobago the economy tripled in size during the
2000s however during the same time period the murder rate quadrupled. Kidnappings became
rampant over the same period. Crime makes the quality of life unpleasant. Another social ill is
discrimination, people may face discrimination due to the gender, race, religion and sexual
orientation. What about those that are differently abled, do they obtain fair treatment? United
States is the world’s richest nation but look at how women and people of colour were treated. South
Africa was a wealthy nation under the Apartheid system but were women, blacks, Indians and
coloureds treated with dignity? The size of the economy pie does not erase prejudice views about
religion or race automatically. So while a country may have a growing economy it does not tell the
entire story about the quality of life people may enjoy there, particularly minorities.
5. Leisure time and working condition – An economy may be large and growing but does not reveal
the working hours or working conditions that people face. In some countries citizens have
mandatory unpaid overtime, have few public holidays, relatively little vacation time and limited
paid maternity leave. In countries such as Japan, China and South Korea, suicide in relatively high
due to the enormous pressure workers face. Leisure does provide utility and in some countries
workers get little leisure time despite a large and robust economy and growing real incomes.

6. Composition of GDP – The economy deals with production of goods and service. However
different goods provide different levels of benefits to the population. For instance if resources are
used to build houses, hospital and roads this would improve welfare. On the other hand if
resources are used mostly to build military goods, stadiums and useless administrative building the
population would notice very little improvement in their welfare. However, whether expenditure
are on military goods or hospitals GDP would change by the same amount. It only reflects the
value of what is produced or total expenditures not what the good or service is. Therefore a rising
GDP may give a misleading indicator of living standard since it does not reflect on the composition
of what is produced.
In conclusion GDP reflects economic activity not welfare!