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IB Diploma Economics:
Learning outcomes for the Measures of Economic Activity
- Distinguish between GDP and GNP/GNI as measures of economic activity.
- Distinguish between the nominal value of GDP and GNP/GNI and the real value of GDP and GNP/GNI.
- Distinguish between total GDP and GNP/GNI and per capita GDP and GNP/GNI.
- Examine the output approach, the income approach and the expenditure approach when measuring national income.
- Evaluate the use of national income statistics, including their use for making comparisons over time, their
use for making comparisons between countries and their use for making conclusions about standards of living.
- Explain the meaning and significance of “green GDP”, a measure of GDP that accounts for environmental destruction.
Gross Domestic Product
Gross National Income
Measures of GDP
Gross Domestic Product (GDP) is the total value of final goods and services produced in an economy in a year. GDP is a measure of a nation’s real income. Real income refers to actual economic output; i.e., the total number of goods and services produced by an economy. Using the two sector circular flow model it is easy to see that the total value of output of an economy can be obtained by measuring the incomes earned in production or the pending on this same production. This measure equates to GDP. If there is an increase in a country’s real GDP this indicates that there is an increase in the number of goods and services made in the country which are available for individuals to enjoy.
There are three ways to measure GDP:
For all firms in the economy in a year, the value added to the inputs of production are summed. Thus, the sales revenue (price x quantity of goods and services sold) for each firm operating in the economy are summed, and then the costs of the inputs the firms use in the production process are subtracted. In this way, inputs into the production process will not be double counted.
The income method
This method of determining GDP is to add up all the income earned by households and firms in the year. This is all income associated with the four factors of production: wages for labour, rent for land, interest for capital, and profit for enterprise. The total expenditures on all of the final goods and services are also income received as wages, profits, rents, and interest income. By adding together all of the wages, profits, rents, and interest income, GDP is determined.
The expenditure method
This method of determining GDP adds up the market value of all domestic expenditures made on final goods and services in a single year, including consumption expenditures, investment expenditures, government expenditures, and net exports. Add all of the expenditures together and you determine GDP.
The three approaches to measuring GDP are numerically equivalent
Essential statement: Income for the factors of production equals goods and services expenditure equals the total value of all goods and services produced.
The three methods of measuring GDP should result in the same number, with some possible difference caused by statistical and rounding differences. The credibility of data is always a significant concern in any form of research. An advantage of using the Expenditure Method is data integrity. Most countries consider the source data for expenditure components to be more reliable than for either income or output components.
As such IB Economics concentrates on the Expenditure Approach which is the most commonly discussed method of representing GDP particularly in non-academic examinations of economic activity.
The expenditure Method
The expenditure approach to calculating GDP: GDP = C + I + G + (X - M)
Essential statement: To determine GDP, total expenditure sums the following forms of economic expenditure:
GDP, GNP and GNI
nominal and real GDP
Distinguishing between GDP, GNP and GNI
GDP is the total value of goods and service produced in an economy in a given year. In this measure of national income, the ownership of the factors of production is not considered. For example, an American may own a New Zealand dairy farm, and a New Zealander may own a factory in America. Sometimes foreigners will own significant factors of production, and some (or much) of this income will be returned overseas. Likewise, domestic residents may own factors of production in other countries and some of this income will be returned to the domestic economy. However, GDP doesn’t consider where the income is earned, even though profits and other income earned overseas makes a country wealthier, and profits and other income earned on domestic assets which are then transferred to their overseas owners, makes a country poorer.
Gross National Product (GNP) and Gross National Income (GNI) accounts for income received from a country’s factors of production, regardless of where in the world these factors are located. So profit earned by a New Zealand-owned factory in the US is included in NZ’s GNP/GNI.
GNP/GNI accounts for income earned based on national ownership of factors of production. To calculate GNP, the income earned by foreign-owned firms is subtracted from GDP. Similarly, income earned in foreign countries by domestically owned factor of production is added to GDP. Net property income from abroad is the difference between the two: net property income = income earned from abroad – income earned by foreign factor ownership.
Thus, GNP/GNI = GDP + net property income from abroad.
Foreign investment into a country is generally encouraged by governments. Foreign direct investment will increase GDP. Where large numbers of a country’s assets are foreign-owned, the country’s GDP is going to be higher than its GNP. Income that is earned on these overseas-owned assets is included in the GDP figure, but this income doesn’t necessarily remain in the country and much of it will be transferred offshore to its overseas owners. Profits from Starbucks in the UK will flow to its US shareholders. A Mexican service worker in the US, will transfer part of his earnings to his or her family in Mexico. Income transferred out of the economy in this way is considered a loss, as if it is not spent within the domestic economy, it has no contribution to make to economic growth in that country.
Net national product
Capital goods depreciate in value as they suffer from wear and tear and are made obsolete by better technology. Capital goods, and thus, the value of a country’s capital stock is termed depreciation, and business spending to replace this capital stock is termed capital consumption. The replacement of capital is investment that does not necessarily add to the productive capacity of an economy (e.g., a new delivery van doesn’t make more deliveries than the old one). However, this particular form of investment is included in GNP, and this means that at least some of the growth in GNP from year to year is due to this capital replacement. Thus GNP cannot be an accurate measure of an increases in productive capacity.
To more accurately determine a country’s actual current performance, as well as its potential performance, firms’ spending on capital replacement (i.e., capital consumption) is subtracted when calculating net national product. NNP = GNP – depreciation, or NNP = GNP – capital consumption.
The value of national output (GDP) and the total incomes in producing that output can be shown in nominal terms or in real terms. Nominal GDP refers to the value of output at current market prices, whereas real GDP refers to nominal GDP adjusted for price changes (inflation) relative to some base year. It is the changes in real GDP that allow for measuring economic growth in real terms and determining increases in the standard of living.
If prices in an economy rise on average, say 5 per cent, the GDP will also increase by 5 per cent. There is no real change in economic output and no change in the standard of living. Whereas, if average actual output increased by 5 per cent, then GDP increases by 5 per cent and standards of living rise. To account for the effect of inflation, we adjust nominal GDP. Now we can measure GDP at constant prices and measure the real value of national output.
Nominal GDP: The value of output at current market prices.
Real GDP: Refers to nominal GDP adjusted for prices changes relative to some base year. It is changes in real GDP that allows us to measure economic growth in real terms or increases in the standard of living.
Real GDP = nominal GDP – inflation
What is inflation?
Nominal Vs Real GDP
Essential statement: When economists use the term ‘real’ in front of a variable such as GDP, it means that they are looking at the true value of the variable by taking into account the effect of inflation. This way, we can make a valid comparison of the variable across different time periods.
GDP per capita
GDP per capita (per head of population)
GDP per capita is a measure of average income per person in a country. This measure National income/National Output and National expenditure. GDP per capita divides the GDP by the population.
GDP per capita = GDP ÷ population
For example, the 2015 GDP figure for India was US$ 2066.90 billion, and for New Zealand, it was just US$192 billion. Thus, the Indian economy dwarfs the New Zealand economy. Is the standard of living greater in India than it is in New Zealand? After all, India has an economy 10 times the size of New Zealand, produces 10 times more goods and services, and has a national income 10 times that of New Zealand. However, as we all know, India is the second most populous nation on earth and has a population of over 1.25 billion people (1 252 000 000). New Zealand has a population of just 4 million people (4 000 000). If we distribute national income (GDP) between each country’s citizens, we see on a per head basis, New Zealand has a much higher average income per person, and would be considered to be richer and have a higher standard of living. GDP per capita in India is US$1 262, and in New Zealand, it is much larger at $36 152. Qatar has the highest average national income, having a GDP per capita of US$145 000, and Somalia the lowest at just US$600.
The world's wealthiest
What is GDP Per Capita?
Usefulness of National income statistics
National income estimates provide not only a single figure showing the national income, but they also supply detailed figures regarding the various components of national income. It is both the national income figure and the details regarding its various constituents that throw light on the functioning and performance of the economy.
The following are some of the important uses of national income estimates:
Production creates negative externalities. The green gross domestic product (green GDP) is an index of economic growth with the environmental consequences of that growth factored into a country's conventional GDP. Green GDP monetizes the loss of biodiversity, and accounts for costs caused by climate change.
Green GDP is actual GDP less the external costs of production.
It is very difficult to accurately evaluate and cost negative externalities. It is hard to put a dollar figure on environmental damage. Take for example the true external costs placed on households (e.g., less ski days) and businesses (e.g., lower ski revenues, the increased cost of more snow-making equipment) from climate change are controversial, subjective, debatable and very difficult to accurately quantify.
Limitations of National Income statistics
However, there are important considerations that need to be taken into account when making comparisons and drawing conclusions from GDP statistics. The limitations of GDP statistics include:
Here is a real-life illustration of the above shortcoming. While the Soviet Union saw massive increases in GDP between 1970 and 1980 (from $430 billion to over $900 billion), the average life expectancy of a Russian male over the same period actually decreased. Alcohol abuse was rampant, infant mortality began to climb, and the crude death rate reversed its previously downward trend. Perhaps the Soviet Union was producing more, but quality of life and overall social welfare definitely took a hit in 1970s Russia.
New Zealand has seen GDP growth driven by a large increase in the dairy industry. Lots of land has been converted into dairy farms, and the pollution associated with agricultural runoff into rivers and waterways have made many of this country’s lakes unfit for swimming and for many other recreational activities.
Social welfare may have increased in line with increased GDP, but there is an argument that can be made that because of such increases in pollution and congestion, that increase in social welfare should be adjusted downwards to reflect the negative externalities of such economic activity.
PROGRESS CHECK - TEST YOUR UNDERSTANDING BY COMPLETING THE ACTIVITIES BELOW
You have below, a range of practice activities, flash cards, exam practice questions and an online interactive self test to ensure you have complete mastery of the IB Economics requirements for the Macroeconomics – The Level of Overall Economic Activity: 2.2 Measures of Economic Activity topic.
IB Economics interactive QUIZZES AND TWO CLASSROOM GAMES
Test how well you know the IB Economics Macroeconomics – The Level of Overall Economic Activity: 2.2 Measures of Economic Activity topic with the interactive self-assessment quizzes below. Aim for a score of at least 80 per cent.