Gdp a concept,principles and application

by Dr.Rajesh Patel, Director , NRV MBA
4/6/2012 8:18:53 PM 1
,email:1966patel@gmail.com

Gross domestic product (GDP) refers to the
market value of all final goods and services produced in
a country in a given period. GDP per capita is often
considered an indicator of a country's standard of living.
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GDP can be determined in three ways, all
of which should, in principle, give the same
result. They are the product (or output)
approach, the income approach, and the
expenditure approach.
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The most direct of the three is the product approach , which
sums the outputs of every class of enterprise to arrive at the total. The
expenditure approach works on the principle that all of the product must be
bought by somebody, therefore the value of the total product must be equal to
people's total expenditures in buying things. The income approach works on the
principle that the incomes of the productive factors ("producers," colloquially)
must be equal to the value of their product, and determines GDP by finding the
sum of all producers' incomes.

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Example: the expenditure method:
GDP = private consumption + gross investment + government spending +
(exports − imports), or

GDP = C + I + G + (X - I)
Note: "Gross" means that GDP measures production regardless of the various uses to
which that production can be put. Production can be used for immediate consumption,
for investment in new fixed assets or inventories, or for replacing depreciated fixed
assets. "Domestic" means that GDP measures production that takes place within the
country's borders. In the expenditure-method equation given above, the exports-minus-
imports term is necessary in order to null out expenditures on things not produced in the
country (imports) and add in things produced but not sold in the country (exports).

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Economists (since Keynes) have preferred to split the general
consumption term into two parts; private consumption, and public
sector (or government) spending.Two advantages of dividing total
consumption this way in theoretical macroeconomics are:

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•Private consumption is a central concern of welfare economics. The private
investment and trade portions of the economy are ultimately directed (in
mainstream economic models) to increases in long-term private consumption.
•If separated from endogenous private consumption, government
consumption can be treated as exogenous, so that different government
spending levels can be considered within a meaningful macroeconomic
framework.

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Production approach
The production approach is also called as net Product or Value added method.
This method consists of three stages:
1.Estimating the Gross Value of domestic Output in various economic activities
2.Determining the intermediate consumption i.e., the cost of material,supplies
and services used to produce final goods or services; and finally
3.Deducting intermediate consumption form Gross Value to obtain the Net
value of Domestic Output.

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Symbolically,
Gross Value Added = Value of output- Value of Intermediate Consumption.
Value of Output= Value of the total sales of goods and services + Value of changes in
the inventories.
The sum of gross value added in various economic activities is known as GDP at factor
cost.
GDP at factor cost plus indirect taxes less subsidies on products is GDP at Producer
Price.
For measuring gross output of domestic product, economic activities (i.e. industries) are
classified into various sectors. After classifying economic activities, the gross output of
each sector is calculated by any of the following two methods:
1.By multiplying the output of each sector by their respective market price and adding
them together and
2.By collecting data on gross sales and inventories from the records of companies and
adding them together.
Subtracting each sector's intermediate consumption from gross output, we get sectoral
gross value added (GVA)at factor cost. We, then add gross value of all sectors to get
GDP at factor cost. Adding indirect tax less subsidies in GDP at factor cost, we get
GDP at Producer prices.

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Income approach
Another way of measuring GDP is to measure total income. If GDP is
calculated this way it is sometimes called Gross Domestic Income (GDI), or
GDP(I). GDI should provide the same amount as the expenditure method
described above. (By definition, GDI = GDP. In practice, however,
measurement errors will make the two figures slightly off when reported by
national statistical agencies.)
This method measures GDP by adding incomes that firms pay households for
the factors of production they hire- wages for labour, interest for capital, rent
for land and profits for entrepreneurship.

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The US "National Income and Expenditure Accounts" divide incomes into five
categories:
1.Wages, salaries, and supplementary labour income
2.Corporate profits
3.Interest and miscellaneous investment income
4.Farmers’ income
5.Income from non-farm unincorporated businesses
These five income components sum to net domestic income at factor cost.
Two adjustments must be made to get GDP:
1.Indirect taxes minus subsidies are added to get from factor cost to market prices.
2.Depreciation (or capital consumption) is added to get from net domestic product to
gross domestic product.
Total income can be subdivided according to various schemes, leading to various
formulae for GDP measured by the income approach. A common one is:

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GDP = compensation of employees + gross operating surplus + gross mixed income +
taxes less subsidies on production and imports
GDP = COE + GOS + GMI + TP & M – SP & M
•Compensation of employees (COE) measures the total remuneration to employees
for work done. It includes wages and salaries, as well as employer contributions to social
security and other such programs.
•Gross operating surplus (GOS) is the surplus due to owners of incorporated
businesses. Often called profits, although only a subset of total costs are subtracted
from gross output to calculate GOS.
•Gross mixed income (GMI) is the same measure as GOS, but for unincorporated
businesses. This often includes most small businesses.

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The sum of COE, GOS and GMI is called total factor income; it is the income of all of the
factors of production in society. It measures the value of GDP at factor (basic) prices.
The difference between basic prices and final prices (those used in the expenditure
calculation) is the total taxes and subsidies that the government has levied or paid on
that production. So adding taxes less subsidies on production and imports converts GDP
at factor cost to GDP(I).
Total factor income is also sometimes expressed as:
Total factor income = Employee compensation + Corporate profits + Proprieter's income
+ Rental income + Net interest[5]
Yet another formula for GDP by the income method is
GDP = R + I + P + SA + W
where R : rents
I : interests
P : profits
SA : statistical adjustments (corporate income taxes, dividends, undistributed corporate
profits)
W : wages

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Expenditure approach
In economics, most things produced are produced for sale, and sold. Therefore,
measuring the total expenditure of money used to buy things is a way of measuring
production. This is known as the expenditure method of calculating GDP. Note that if you
knit yourself a sweater, it is production but does not get counted as GDP because it is
never sold. Sweater-knitting is a small part of the economy, but if one counts some
major activities such as child-rearing (generally unpaid) as production, GDP ceases to
be an accurate indicator of production. Similarly, if there is a long term shift from non-
market provision of services (for example cooking, cleaning, child rearing, do-it yourself
repairs) to market provision of services, then this trend toward increased market
provision of services may mask a dramatic decrease in actual domestic production,
resulting in overly optimistic and inflated reported GDP. This is particularly a problem for
economies which have shifted from production economies to service economies.

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GDP (Y) is a sum of Consumption (C),
Investment (I), Government Spending (G) and
Net Exports (X – M).
Y = C + I + G + (X − M)
Here is a description of each GDP component:

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•C (consumption) is normally the largest GDP component
in the economy, consisting of private (household final
consumption expenditure) in the economy. These personal
expenditures fall under one of the following categories: durable
goods, non-durable goods, and services. Examples include food,
rent, jewelry, gasoline, and medical expenses but does not include
the purchase of new housing.

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•I (investment) includes business investment in equipments for example and does not
include exchanges of existing assets. Examples include construction of a new mine, purchase of
software, or purchase of machinery and equipment for a factory. Spending by households (not
government) on new houses is also included in Investment. In contrast to its colloquial meaning,
'Investment' in GDP does not mean purchases of financial products. Buying financial products is
classed as 'saving', as opposed to investment. This avoids double-counting: if one buys shares in
a company, and the company uses the money received to buy plant, equipment, etc., the amount
will be counted toward GDP when the company spends the money on those things; to also count it
when one gives it to the company would be to count two times an amount that only corresponds to
one group of products. Buying bonds or stocks is a swapping of deeds, a transfer of claims on
future production, not directly an expenditure on products.

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•G (government spending) is the sum of government
expenditures on final goods and services. It includes salaries of public servants,
purchase of weapons for the military, and any investment expenditure by a
government. It does not include any transfer payments, such as social security
or unemployment benefits.

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•X (exports) represents gross exports. GDP captures the amount a
country produces, including goods and services produced for other nations'
consumption, therefore exports are added.
•M (imports) represents gross imports. Imports are subtracted since imported
goods will be included in the terms G, I, or C, and must be deducted to avoid
counting foreign supply as domestic.

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A fully equivalent definition is that GDP (Y) is the
sum of final consumption expenditure (FCE),
gross capital formation (GCF), and net
exports (X – M).
Y = FCE + GCF+ (X − M)
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FCE can then be further broken down by three sectors (households,
governments and non-profit institutions serving households) and GCF by five
sectors (non-financial corporations, financial corporations, households,
governments and non-profit institutions serving households). The advantage of
this second definition is that expenditure is systematically broken down, firstly,
by type of final use (final consumption or capital formation) and, secondly, by
sectors making the expenditure, whereas the first definition partly follows a
mixed delimitation concept by type of final use and sector.

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Note that C, G, and I are expenditures on final goods and services;
expenditures on intermediate goods and services do not count. (Intermediate
goods and services are those used by businesses to produce other goods and
services within the accounting year.[6] )
According to the U.S. Bureau of Economic Analysis, which is responsible for
calculating the national accounts in the United States, "In general, the source
data for the expenditures components are considered more reliable than those
for the income components [see income method, below]."[7]

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GDP vs GNP
GDP can be contrasted with gross national product (GNP) or
gross national income (GNI). The difference is that GDP defines
its scope according to location, while GNP defines its scope
according to ownership. In a global context, world GDP and world
GNP are therefore equivalent terms.
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GDP is product produced within a country's borders; GNP is product produced by
enterprises owned by a country's citizens. The two would be the same if all of the
productive enterprises in a country were owned by its own citizens, and those citizens
did not own productive enterprises in any other countries. In practice, however, foreign
ownership makes GDP and GNP non-identical. Production within a country's borders,
but by an enterprise owned by somebody outside the country, counts as part of its GDP
but not its GNP; on the other hand, production by an enterprise located outside the
country, but owned by one of its citizens, counts as part of its GNP but not its GDP.

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To take the United States as an example, the U.S.'s GNP is the value of output produced
by American-owned firms, regardless of where the firms are located. Similarly, if a
country becomes increasingly in debt, and spends large amounts of income servicing
this debt this will be reflected in a decreased GNI but not a decreased GDP. Similarly, if
a country sells off its resources to entities outside their country this will also be reflected
over time in decreased GNI, but not decreased GDP. This would make the use of GDP
more attractive for politicians in countries with increasing national debt and decreasing
assets.
Gross national income (GNI) equals GDP plus income receipts from the rest of the world
minus income payments to the rest of the world.

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International standards
The international standard for measuring GDP is contained in the book System of
National Accounts (1993), which was prepared by representatives of the International
Monetary Fund, European Union, Organization for Economic Co-operation and
Development, United Nations and World Bank. The publication is normally referred to as
SNA93 to distinguish it from the previous edition published in 1968 (called SNA68)
SNA93 provides a set of rules and procedures for the measurement of national
accounts. The standards are designed to be flexible, to allow for differences in local
statistical needs and conditions.

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National measurement
Within each country GDP is normally measured by a national
government statistical agency, as private sector organizations
normally do not have access to the information required
(especially information on expenditure and production by
governments).

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Interest rates
Net interest expense is a transfer payment
in all sectors except the financial sector. Net
interest expenses in the financial sector are
seen as production and value added and
are added to GDP.
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Adjustments to GDP
When comparing GDP figures from one year to another, it is desirable to compensate for
changes in the value of money – i.e., for the effects of inflation or deflation. The raw GDP
figure as given by the equations above is called the nominal, or historical, or current,
GDP. To make it more meaningful for year-to-year comparisons, it may be multiplied by
the ratio between the value of money in the year the GDP was measured and the value
of money in some base year. For example, suppose a country's GDP in 1990 was $100
million and its GDP in 2000 was $300 million; but suppose that inflation had halved the
value of its currency over that period. To meaningfully compare its 2000 GDP to its 1990
GDP we could multiply the 2000 GDP by one-half, to make it relative to 1990 as a base
year. The result would be that the 2000 GDP equals $300 million × one-half = $150
million, in 1990 monetary terms. We would see that the country's GDP had, realistically,
increased 50 percent over that period, not 200 percent, as it might appear from the raw
GDP data. The GDP adjusted for changes in money-value in this way is called the real,
or constant, GDP.

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Cross-border comparison

GDP (PPP) share of world / per capita per nation 1980–2015, Source:
International Monetary Fund (WEO April 2011)
The level of GDP in different countries may be compared by converting their
value in national currency according to either the current currency exchange
rate, or the purchase power parity exchange rate.

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•Current currency exchange rate is the exchange rate in the
international currency market.
•Purchasing power parity exchange rate is the exchange rate based on the purchasing power
parity (PPP) of a currency relative to a selected standard (usually the United States dollar). This is a
comparative (and theoretical) exchange rate, the only way to directly realize this rate is to sell an
entire CPI basket in one country, convert the cash at the currency market rate & then rebuy that
same basket of goods in the other country (with the converted cash). Going from country to country,
the distribution of prices within the basket will vary; typically, non-tradable purchases will consume a
greater proportion of the basket's total cost in the higher GDP country, per the Balassa-Samuelson
effect.

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The ranking of countries may differ significantly based on which method is used.
•The current exchange rate method converts the value of goods and services using global currency
exchange rates. The method can offer better indications of a country's international purchasing
power and relative economic strength. For instance, if 10% of GDP is being spent on buying hi-tech
foreign arms, the number of weapons purchased is entirely governed by current exchange rates,
since arms are a traded product bought on the international market. There is no meaningful 'local'
price distinct from the international price for high technology goods.
•The purchasing power parity method accounts for the relative effective domestic purchasing power
of the average producer or consumer within an economy. The method can provide a better indicator
of the living standards of less developed countries, because it compensates for the weakness of
local currencies in the international markets. For example, India ranks 11th by nominal GDP, but
fourth by PPP. The PPP method of GDP conversion is more relevant to non-traded goods and
services.

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Per unit GDP
GDP is an aggregate figure which does not account for differing sizes of nations.
Therefore, GDP can be stated as GDP per capita (per person) in which total GDP is
divided by the resident population on a given date, GDP per citizen where total GDP is
divided by the numbers of citizens residing in the country on a given date, and less
commonly GDP per unit of a resource input, such as GDP per GJ of energy or Gross
domestic product per barrel. GDP per citizen in the above case is pretty similar to GDP
per capita in most nations, however, in nations with very high proportions of temporary
foreign workers like in Persian Gulf nations, the two figures can be vastly different.

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Standard of living and GDP
GDP per capita is not a measurement of the standard of living in an economy. However, it is often used as such
an indicator, on the rationale that all citizens would benefit from their country's increased economic production.
Similarly, GDP per capita is not a measure of personal income. GDP may increase while real incomes for the
majority decline. The major advantage of GDP per capita as an indicator of standard of living is that it is measured
frequently, widely, and consistently. It is measured frequently in that most countries provide information on GDP on
a quarterly basis, allowing trends to be seen quickly. It is measured widely in that some measure of GDP is
.
available for almost every country in the world, allowing inter-country comparisons. It is measured consistently in
that the technical definition of GDP is relatively consistent among countries.
The major disadvantage is that it is not a measure of standard of living. GDP is intended to be a measure of total
national economic activity— a separate concept.
The argument for using GDP as a standard-of-living proxy is not that it is a good indicator of the absolute level of
standard of living, but that living standards tend to move with per-capita GDP, so that changes in living standards
are readily detected through changes in GDP.
Proponents of GDP as a metric of social well being argue that it is a value neutral measure and expresses what
we can do, not what we should do. This is compatible with the fact that different people have different preferences
and different opinions on what well-being is. Competing measures like GPI define well-being to mean things that
the definers ideologically support. Therefore, they cannot function as the goals of a plural society. Moreover, they
are more vulnerable to political manipulation.[22]

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Externalities
GDP is widely used by economists to gauge economic recession and recovery and an
economies general monetary ability address externalites. Its not meant to measure
externalities. Its serves as a general metric for a nominal monetary standard of living
and is not adjusted for costs of living within a region. GDP is a neutral measure which
merely shows an economy's general ability to pay for externalities such as social and
environmental concerns.[23] Examples of externalities include:

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•Wealth distribution – GDP does not account for
variances in incomes of various demographic groups. See income
inequality metrics for discussion of a variety of inequality-based
economic measures.

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•Non-market transactions–GDP excludes activities that are not provided through
the market, such as household production and volunteer or unpaid services. As a result, GDP is
understated. Unpaid work conducted on Free and Open Source Software (such as Linux) contribute
nothing to GDP, but it was estimated that it would have cost more than a billion US dollars for a
commercial company to develop. Also, if Free and Open Source Software became identical to its
proprietary software counterparts, and the nation producing the propriety software stops buying
proprietary software and switches to Free and Open Source Software, then the GDP of this nation
would reduce, however there would be no reduction in economic production or standard of living.
The work of New Zealand economist Marilyn Waring has highlighted that if a concerted attempt to
factor in unpaid work were made, then it would in part undo the injustices of unpaid (and in some
cases, slave) labour, and also provide the political transparency and accountability necessary for
democracy. Shedding some doubt on this claim, however, is the theory that won economist
Douglass North the Nobel Memorial Prize in Economic Sciences in 1993.[citation needed] North argued
that the encouragement of private invention and enterprise due to the creation and strengthening of
the patent system became the fundamental catalyst behind the Industrial Revolution in England.

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•Underground economy–Official GDP estimates may
not take into account the underground economy, in which
transactions contributing to production, such as illegal trade and
tax-avoiding activities, are unreported, causing GDP to be
underestimated.

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•Asset Value–GDP does not take into
account the value of all assets in an economy.
This is akin to ignoring a company's balance
sheet, and judging it solely on the basis of its
income statement.

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•Non-monetary economy–GDP omits economies where no money comes into
play at all, resulting in inaccurate or abnormally low GDP figures. For example,
in countries with major business transactions occurring informally, portions of
local economy are not easily registered. Bartering may be more prominent than
the use of money, even extending to services (I helped you build your house
ten years ago, so now you help me).

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•Quality improvements and inclusion of new products–By not adjusting for quality
improvements and new products, GDP understates true economic growth. For instance,
although computers today are less expensive and more powerful than computers from
the past, GDP treats them as the same products by only accounting for the monetary
value. The introduction of new products is also difficult to measure accurately and is not
reflected in GDP despite the fact that it may increase the standard of living. For
example, even the richest person from 1900 could not purchase standard products, such
as antibiotics and cell phones, that an average consumer can buy today, since such
modern conveniences did not exist back then.

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•What is being produced–GDP counts work that produces no net change or
that results from repairing harm. For example, rebuilding after a natural disaster
or war may produce a considerable amount of economic activity and thus boost
GDP. The economic value of health care is another classic example—it may
raise GDP if many people are sick and they are receiving expensive treatment,
but it is not a desirable situation. Alternative economic estimates, such as the
standard of living or discretionary income per capita try to measure the human
utility of economic activity. See uneconomic growth.

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•Sustainability of growth– GDP is a measurement of economic historic
activity and is not a necessarily a projection. A country may achieve a temporarily high
GDP from use of natural resources or by misallocating investment.
•Nominal GDP doesn't measure variations in purchasing power or costs of living by area,
so when the GDP figure is deflated over time, GDP growth can vary greatly depending
on the basket of goods used and the relative proportions used to deflate the GDP figure.
•Cross-border comparisons of GDP can be inaccurate as they do not take into account
local differences in the quality of goods, even when adjusted for purchasing power parity.
This type of adjustment to an exchange rate is controversial because of the difficulties of
finding comparable baskets of goods to compare purchasing power across countries.
For instance, people in country A may consume the same number of locally produced
apples as in country B, but apples in country A are of a more tasty variety. This
difference in material well being will not show up in GDP statistics. This is especially true
for goods that are not traded globally, such as housing.
•As a measure of actual sale prices, GDP does not capture the economic surplus
between the price paid and subjective value received, and can therefore underestimate
aggregate utility.

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Gdp a concept,principles and application

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