GDP Defined

GDP is defined as the total market value of all final goods and services produced within a region in a given period of time (usually a quarter or year). GDP is the sum of value added at every stage of production (the intermediate stages) of all final goods and services produced within a country in a given period of time. In other words, GDP is the wealth created by industry activity. In a social accounting matrix (SAM) model such as IMPLAN, this is the sum of value added. Furthermore, in a balanced SAM model, total value-added = total final demand.

Note that GDP is only concerned with new and domestic production; therefore, it excludes the value of used goods and output produced in another country that is owned by domestic factors of production (including the latter yields Gross National Product). Note also that not all productive activity is included in GDP. For example, unpaid work (such as that performed in the home or by volunteers) and black-market activities are not included because they are difficult to measure and value accurately. That means, for example, that a baker who produces a loaf of bread for a customer would contribute to GDP, but would not contribute to GDP if he baked the same loaf for his family (although the ingredients he purchased would be counted).¹ GDP takes no account of the wear and tear on the machinery, buildings, etc. (i.e., capital stock) that are used in producing the output. If this depletion of the capital stock, called depreciation, is subtracted from GDP we get net domestic product.¹

Furthermore, GDP is not a measure of the overall standard of living or well-being of a country. Although changes in the output of goods and services per person (GDP per capita) are often used as a measure of whether the average citizen in a country is better or worse off, it does not capture things that may be deemed important to general well-being. So, for example, increased output may come at the cost of environmental damage or other external costs such as noise. Or it might involve the reduction of leisure time or the depletion of nonrenewable natural resources. The quality of life may also depend on the distribution of GDP among the residents of a country, not just the overall level.¹

Measuring GDP

Theoretically, GDP can be measured in three different ways: the production method, the income method, and expenditure method. Conceptually, all of these measurements are tracking the exact same thing. Some differences can arise based on data sources, timing and mathematical techniques used.

Production Method

The production approach sums the “value-added” at each stage of production, where value-added is defined as total output (also known as value of production)² less the value of intermediate inputs into the production process. This can be calculated either by subtracting input costs from the final output of each industry or by summing each industry’s payments made to the factors of production.³

National Income Method

The income approach sums the incomes generated by production, which includes the following:

1. Compensation of employees (wages, salaries, benefits, etc)
2. Proprietor income (sole proprietorship and unicorporated business income
3. Rental income (property-owner income)
4. Corporate profits
5. Net interest (paid by business)
6. Taxes on production and imports (sales tax, property tax, custom duties, and other taxes and fees) less government subsidies
7. Net business transfer payments (net payments by businesses to persons, government, and the rest of the world for which no current services are performed
8. Surplus of government enterprises

National Expenditure Method

The expenditure approach is the most widely-used approach to measure GDP. This approach adds up the value of purchases made by final users. Final demand expenditures consist of:

1. Personal consumption expenditures: spending by households on non-fixed-capital items.
2. General government final consumption: spending by governments on non-fixed-capital items, excluding transfer payments.⁴
3. Gross domestic fixed capital formation: the value of houses and other durables formed during the year plus increases in stocks and works in progress (i.e., net additions to inventory).
4. Net Exports: exports represent items that are produced in the country and sold to purchasers outside the country. In the same way, imports are subtracted from the calculation.
5. From this sum, institutional sales must be subtracted since they are accounted for elsewhere in GDP. For example, a government institution⁵ might provide hospital services to a household. Government then has extra income and extra spending (e.g., buying more stethoscopes). The sale/purchase of hospital services cannot increase both personal consumption expenditures and government final consumption.

Relationship between GDP and Final Demand

In general macroeconomic terms, both GDP and Final Demand (FD) share the same equation: GDP or FD = total consumption spending (C) + gross private investments (I)⁶ + total government expenditures (G) + net exports (X-M). In compact form:

[1]   FD = C + I + G + (X-M)

Note that total output by industry (O) is the sum of output going to final demand (e.g., production of vegetables that households consume), plus output that serves other industries, also known as intermediate expenditures (IE) (e.g., vegetables that food manufacturing sectors buy as one of their inputs into the production of other food products). So, we now have another equation in compact form:

[2]   O = FD + IE

As mentioned above, output can be measured as the sum of value added and intermediate expenditures. One could ask each business how much raw materials and services they purchased, how much did they pay employees, how much did they pay in taxes, and how much was left over as profit. This gives a third equation:

[3]   O = IE + VA

Note that VA consists of labor income (LI), other property income (OPI), and taxes on production and imports net of subsidies (TOPI):

[4]   VA = LI + OPI + TOPI

If we substitute the right-hand side of equation [3] into the left-hand side of equation [2], we get the following:

IE + VA = FD + IE.

In this case, IE cancels on both sides, and we are left with VA = FD, which demonstrates the equality of Value Added and Final Demand. Thus, it is true that final demand equals value added. This equality can be envisioned graphically in a SAM as well. The row sum for an industry equals the column sum for that same industry. Each transaction where industries intersect is a component of IE. Other than IE, each industry’s row has only FD leftover. Similarly, other than IE, each industry’s column has only VA left over. Since output measured by rows equaled output measured by column to begin with, it is necessarily the case that FD = VA.

One can also use equations [1] and [4] to relate the components of FD and VA as follows:

C + G + I + X – M = LI + OPI + TOPI.

 

---

¹http://www.imf.org/external/pubs/ft/fandd/basics/gdp.htm

²Value of production = sales + net inventory change + on-site use (e.g., on-farm consumption)

³In IMPLAN, the factors of production are Employee Compensation, Proprietor Income, Other Property Income (largely corporate profits), Taxes on Production and Imports less Subsidies.

⁴Transfer payments include Social Security, Medicare, unemployment insurance, welfare programs, and subsidies.

⁵Government institutions represent administrative government and are distinct from government enterprises in that the latter cover a significant portion of their operating expenses through sales (for example, public transportation services cover a large portion of their operating costs through ticket sales).

⁶Savings and investment are the same thing in accounting. Savings are defined as the money left in the business after all costs and profits have been paid/distributed. If these savings are not invested in something concrete, it can still be considered an investment in cash.