Empowering Economic Minds
Gross Domestic Product
The Production Output and Payments to Factors of Production
When we say production, this is the process of transforming (factors of production like land, labor, and capital) into outputs (goods and services). For example, when you bake a chocolate cake, you'll need various inputs, which include both ingredients and resources. The ingredients, like cake flour, sugar, cocoa powder, eggs, and butter, represent the raw materials. Additionally, you'll need resources like labor to mix and bake the cake, capital in the form of equipment such as an oven and mixing bowls, and even electricity to power the oven. All these inputs combine through the production process to create the final output, which is the delicious chocolate cake.
Another important concept is the Production Function, which is a mathematical expression that illustrates the relationship between inputs (such as land, labor, and capital) and outputs (goods or services). In the production function, output is typically expressed as a function of these inputs, as shown in the following equation:
Using the chocolate cake example, we can say that the cake is a function of its ingredients, labor, capital (such as equipment), and other necessary inputs, as expressed by the production function:
The function shows that the final output, the chocolate cake, depends on the combination of these inputs.
Moreover, an output is defined in two ways, particularly in terms of the production side and on the demand side. On the production side, output is measured by the payments made to each factor of production. These factor payments include:
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Rent Income: Compensation for the use of land, buildings, equipment, and other properties.
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Salaries/Wages: Payments received by employees or workers as compensation for their labor.
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Interest: Payments made for the use of capital, such as earnings from deposits, bonds, other securities, and credit instruments.
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Proprietor’s Income: Earnings from a business owned by a sole proprietor or entrepreneur.
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Dividends: A portion of corporate income or profit distributed to shareholders as their share in the company’s profit.
Using the chocolate cake as an example, we need to pay for the ingredients we purchase, provide a salary for the labor involved, pay rent for the space where the cake is made or for the equipment used, and allocate profit to the entrepreneur for making and selling the cake.
Meanwhile, on the demand side, output is measured by the purchases made by various sectors of the economy. These include the households, firms, government sector, financial sector, or even foreign trade sector. Demand refers to consumers' willingness and ability to purchase or pay for a product at a given price. For example, if a customer buys a cake for PHP 500.00, that transaction reflects the demand for the cake. The total demand from households, businesses, the foreign trade sector, and government spending all contribute to the overall output of the economy.
Circular Flow Model of Income and Expenditure
The circular flow model of income and expenditure is a key concept that explains the how an economy as a whole works. It shows the movement of money, goods, and services among various sectors within an economic system. The model emphasizes that every peso spent by a buyer turns into income for the seller, establishing an ongoing cycle of economic transactions. For example, imagine a consumer buys a candy for one peso. The one peso the consumer spends goes directly to the shop owner. That one peso becomes the shop owner's income, demonstrating how every peso spent by a buyer turns into income for the seller.
Simple Circular Flow Model of an Economy
Let’s start with a simple circular flow model, where there are only two sectors: the households and the firms. This model also includes two markets: the market for factors of production and the market for goods and services.
Source: Mankiw (2018)
Households own the factors of production—such as labor, land, and capital—and sell or rent these factors to firms in the market for factors of production. In return, households earn income, which they then use to purchase and consume goods and services in the market for goods and services.
On the other hand, firms purchase or hire factors of production from households, making payments such as wages for labor, rent for land, and interest for capital. These factors are then used by firms to produce goods and services, which are sold in the market for goods and services. The money households spend on these goods and services becomes income for the firms. Firms, in turn, use this income to purchase or hire more factors of production to continue producing goods and services, creating a continuous cycle, or circular flow, within the economy.
5-sector Circular Flow Model of an Economy
In the simple circular flow model, we introduced only two sectors: households and firms. However, in a 5-sector circular flow model, we expand this by adding three more sectors: the financial sector, the government sector, and the foreign trade sector. The figure below illustrates the 5-sectors circular flow model, which demonstrates how the economy functions as a whole.
Source: Mankiw (2018)
First, let's add the financial sector, which includes banks, financial markets, and cooperatives. This sector plays a crucial role in helping households and firms manage money, save, invest, and borrow. The financial sector channels funds between savers and borrowers, significantly influencing the flow of money in the economy. In the circular flow model, we assume that households save money in the financial sector, and the financial sector, in turn, lends this money to firms in the form of investments.
Savings (S) represent an outflow of money from households to the financial sector, while investments (I) represent an inflow of money to firms. Firms then use these funds for investments or business activities to produce more goods and services.
Next, let’s add the government sector, which plays a vital role in the economy by collecting taxes and using that revenue to provide public goods and services, such as education, infrastructure and healthcare. The government also redistributes income and implements policies that impact economic activity. In the circular flow model, households and firms both pay taxes to the government sector.
Taxes (T) represent an outflow of money, for example, when households pay taxes to the government. The government then uses these tax revenues to fund its projects and programs, which often involve purchasing goods and services from firms. This government spending (G) creates an inflow of money to firms, as the government buys goods and services from them.
Lastly, let’s incorporate the foreign trade sector, which represents trade with other countries, including exports (goods and services sold abroad) and imports (goods and services purchased from abroad). This sector introduces international transactions into the economy’s flow of money, goods, and services. In the circular flow model, households and firms may purchase goods and services from other countries, which is considered import spending (M). For example, a Filipino household might import clothes from China. This import spending represents an outflow of money, as funds are sent abroad to purchase foreign goods and services. Conversely, foreign nations can purchase goods and services from domestic firms, generating export earnings (X). For instance, a firm in the Philippines may sell electronics to another country. These export earnings are considered an inflow of money into the domestic economy, as the revenue from foreign sales flows back to the domestic firms.
By summing up the transactions across all sectors, we can see how the economy operates, illustrating the movement of money, goods, and services. In this circular flow model, Savings (S), Taxes (T), and Import Spending (M) are considered leakages, as they represent outflows of money from the economy. On the other hand, Investments (I), Government Spending (G), and Export Earnings (E) are considered injections, as they bring money into the economy.
The Gross Domestic Product
The monetary value of transactions, such as the income earned by sellers or the consumption by households in the market for goods and services, as illustrated in the circular flow model of economy, is reflected in the Gross Domestic Product (GDP). Therefore, GDP measures the total income of all participants in the economy and also reflects the total expenditure on the economy's output of goods and services.
According to the book of Mankiw in his Principles of Economics:
GDP Measures the Total Market Value
Activities that do not have a market value, such as housework you do for yourself, are not included in GDP. Since goods are measured in different units, we use their market prices to make them comparable and easier to account for in GDP.
For example, imagine we have one sack of rice and three gallons of water. It’s hard to compare them directly or even add them because they have different units (sacks and gallons). But by using market prices, we can calculate their value in Philippine pesos. Let’s say the sack of rice costs PHP 2,500, and each gallon of water costs PHP 50. The total market value of these goods, which is reflected in GDP, would be:
This example in the table shows how GDP converts different goods into a common value using market prices.
GDP accounts for all Final Goods and Services
When we say final goods, these include only those items intended for the end user or final consumption. In contrast, intermediate goods, which are used as components or ingredients in the production of other goods, are not included. Take note that GDP includes only final goods because they already incorporate the value of the intermediate goods used in their production, which helps prevent double counting.
To accurately measure this, the value-added approach is used, which considers the additional value created at each stage of production. Let’s illustrate this with an example across different economic sectors:
Based on the example shown in the table above, in the agriculture sector, sugar cane is produced and sold for PHP 50, with this entire amount representing the value added by the sector. In the industry sector, the sugar cane is processed into sugar and sold for PHP 120.
The value added here is the difference between the selling price of the processed sugar and the cost of the sugar cane, which amounts to PHP 70. Finally, in the service sector, the processed sugar is sold in a retail store for PHP 145, with the value-added being PHP 25, the difference between the retail price and the cost of the processed sugar. By summing up the value added at each stage—PHP 50 from agriculture, PHP 70 from industry, and PHP 25 from services—we arrive at a total contribution to GDP of PHP 145.
This amount matches the price of the final good, which is also PHP 145. This approach ensures that only the additional value created at each stage is counted, thereby preventing the double counting of intermediate goods.
When we say final goods and services:
This includes tangible goods, such as cell phones, bags, and mountain bikes, as well as intangible services, such as cell phone repairs, massage therapy, and concerts.
GDP considers final goods that are currently produced:
This means that GDP includes only final goods and services that are currently produced, not those produced in the past. For example, the production of a new car this year would be included in GDP this year, but the resale of an old car would not, as it was already counted when it was first produced. Another example, the computer was produced in 2023, it should be accounted to the GDP in year 2023 not in year 2024, even if it is not sold in 2023.
Additionally, when we say within the country:
This means that goods and services that are accounted to GDP should be domestically produced. For instance, a smartphone manufactured within the country is included in GDP, while a smartphone imported from abroad is not. Another example, if a car is produced in Japan, it is included in Japan’s GDP.
Moreover, when we refer to a given a specific period of time:
This means that GDP is measured annually, quarterly (every 3 months), or monthly.
To sum up, GDP is a total market value of final goods and services that are currently produced within the country given a specific period of time.
Components of GDP
As mentioned, GDP accounts for the total expenditure on the economy's output of final goods and services. Using the expenditure approach, which breaks down the economy's total output based on spending, GDP (Y) is composed of four key components: Consumption (C), Investment (I), Government purchases of goods and services (G), and Net Exports (NX) – difference between exports and imports. The fundamental national income identity, incorporating these components, is shown as:
Let's discuss each component of GDP.
Consumption
This represents the total spending by households on goods and services. This includes expenditures on everyday items, such as food, clothing, and entertainment. When it comes to housing costs, for renters, consumption includes their rent payments. For homeowners, it includes the imputed rental value of their home—an estimate of what the house would rent for—rather than the actual purchase price or mortgage payments.
However, it is important to note that the purchase of new housing is not counted under consumption; instead, it is classified as investment (I) in GDP calculations. This is because new housing contributes to the economy's productive capacity over time. When a household buys a new home, it is not just acquiring a good for immediate use, like groceries or clothing; it is making a long-term investment in an asset that will provide value over many years. This asset can also generate income, such as when it is rented out to others.
For example, when a family purchases a newly built home, this transaction is treated as an investment because the house will provide shelter for the family for many years and may increase in value over time. On the other hand, the family’s spending on daily necessities, such as food or entertainment, is counted as consumption because these goods and services are used up immediately or within a short period.
Investment
Investment in economic terms refers to the total spending on goods that will be used in the future to produce more goods or to make business. Another term for this is the Gross Capital Formation. This includes various types of capital:
Business capital – encompasses business structures, equipment, and intellectual property products. For example, when a company builds a new factory or buys new machinery, it is investing in business capital, which will help the company produce more goods in the future.
Residential capital – such as a landlord’s apartment building or a homeowner’s personal residence. For example, when a developer constructs a new apartment building, this is an investment in residential capital that will generate rental income over time.
Inventory accumulations – goods that have been produced but not yet sold. For example, suppose a manufacturer produces PHP 20 million worth of clothes in 2023, but only PHP 15 million worth is sold that year. The remaining PHP 5 million worth of unsold clothes is considered inventory accumulation for that year, as they are ready for sale but have not yet been purchased by consumers. Meanwhile the PHP 15 million worth of clothes that were sold in the year 2023 is counted as consumption. Despite the difference in sales, the total contribution of this production to the GDP in 2023 is still PHP 20 million.
Furthermore, it is important to note that in this context, “investment” does not refer to the purchase of financial assets like stocks and bonds. These are not included in GDP calculations because they do not involve the production of new goods or services; rather, they represent a transfer of ownership of existing assets. Therefore, investment in GDP specifically refers to spending on capital goods that contribute to future economic productivity, rather than to financial investments.
Government purchases on goods and services
These include all spending on goods and services by the government at the national, state, and local levels. This encompasses expenditures on everything from infrastructure projects, such as building roads and schools, to public services, like police and fire departments. However, it is important to note that government purchases do not include transfer payments. For example, when the government builds a new highway, this is considered a government purchase because it involves the procurement of goods and services. However, when the government distributes Social Security checks to retirees, this is considered a transfer payment and is not included in GDP.
Transfer payments are non-labor income that the government transfers to households. Examples of transfer payments are Social Security benefits, unemployment insurance, or welfare payments. These payments are not counted as government purchases because they do not involve the purchase of goods or services; instead, they represent a redistribution of income within the economy.
Net Exports
Net exports (NX) are determined by subtracting imports from exports (NX = exports – imports). Exports reflect the expenditure by foreign countries on goods and services produced domestically. For instance, when a country sells cars or software internationally, this transaction is recorded as an export, which positively impacts the country’s GDP.
Conversely, imports represent the parts of consumption (C), investment (I), and government spending (G) that are allocated to purchasing goods and services from other countries. For example, if a country imports electronics or machinery, the value of these imports is deducted from the GDP because the spending was on foreign-produced goods.
Moreover, net exports can be positive (+NX), indicating a trade surplus, where exports exceed imports (X > M). On the other hand, net exports can be negative (-NX), signifying a trade deficit, which occurs when exports are lower than imports (X < M).
Nominal GDP versus Real GDP
Inflation, which refers to the general increase in the levels of prices of goods and services, can significantly impact economic variables such as the Gross Domestic Product (GDP). This is why it is necessary to differentiate between its two versions: Nominal GDP and Real GDP.
Nominal GDP (NGDP) measures the value of all goods and services produced within an economy using the prices that are current in the year in which the output is produced. Because it uses current prices, it does not account for inflation, meaning that changes in Nominal GDP could reflect changes in both the quantity of output and the price level. In computing the nominal GDP, we have the following formula:
In contrast, Real GDP (RGDP) adjusts for inflation by valuing output using the prices from a specific base year. By holding prices constant, Real GDP provides a more accurate reflection of an economy's true growth by isolating the changes in the quantity of goods and services produced, rather than changes driven by fluctuating prices. In computing the real GDP, we have the following formula:
Thus, while Nominal GDP gives us a snapshot of the economy's size at current market prices, Real GDP gives a clearer picture of economic growth by removing the distortions caused by inflation.
GDP and Economic Well-being
Real GDP per capita is widely regarded as a primary indicator of the standard of living for the average person in an economy. It measures the average economic output or income per individual, providing a sense of how much, on average, each person contributes to or receives from the economy. The Real GDP per capita is expressed on this formula:
This calculation helps in comparing living standards across different countries or over time within the same country. However, it is important to recognize that GDP per capita, while useful, is not a perfect measurement on the individual’s well-being.
Limitations of GDP in Measuring Well-being
GDP per capita provides a snapshot of economic activity but does not capture all aspects of well-being. There are limitations of GDP in measuring well-being. For instance, it does not account for income distribution, the environmental quality, leisure time, non-market activity (e.g., child care), or the overall quality of life. As a result, relying solely on GDP as a measure of well-being can be misleading.
Robert Kennedy famously criticized GDP, pointing out that it measures everything "except that which makes life worthwhile." This critique shows the idea that while GDP is a valuable economic indicator, it falls short in capturing the full spectrum of human welfare and the quality of life in a society.
Why do we still care for GDP given its limitations?
Despite the limitations of GDP, it remains an important macroeconomic variable. This is because a higher GDP allows a country to allocate more resources towards improving infrastructure, such as better schools, a cleaner environment, and more comprehensive healthcare services. Essentially, a large GDP reflects a nation’s economic strength, enabling it to invest in public goods and services that enhance the overall quality of life for its citizens. The GDP is associated on how an economy could afford things to improve the quality of life of its citizens.
Additionally, many indicators of a high quality of life—such as education levels, human development, and employment rates—are positively correlated with GDP. As GDP increases, these indicators often improve as well, thereby contributing to the well-being of the population. Therefore, while GDP is not a perfect measure of well-being, it remains a vital metric that reflects a country’s capacity to meet the needs of its people and improve their living standards.
Further Learning
References
Dornbusch, R., Fischer, S., & Startz, R. (2011). Macroeconomics (11th ed.). McGraw-Hill.
Mankiw, N.G. (2018). Principles of Macroeconomics (Eight Edition). Cengage Learning: Boston, United States of America.
Orejana, A.J., & Teves, M.R.Y. (2014). Introduction to Economics, Land Reform, Taxation and Cooperatives: Text and Workbook. MSU-IIT: Iligan City, Philippines.