Adding Apples and Oranges: Keeping Score with Gross Domestic Product At this very moment at our house, we have three apples, two oranges, four bananas and an overripe pear in the fruit basket on top of the refrigerator. You might have something similar. Go look in your fruit basket. What s in it? Like we do, you have so many of this, so many of that, and you could surely provide a list of contents like I did for our fruit basket. But what if I say to you that I don t want a list of what s in your fruit basket, I want to know the total amount in the basket. Now you might have a problem, because we all know that you cannot add apples and oranges, let alone apples, oranges, bananas and pears. One possible way to address the problem would be to establish a more general category to which all contents of the basket belong, say fruit. In our basket we have ten pieces of fruit. You also have some number of pieces of fruit. Alternatively, you could weigh the contents of the basket, and tell me how many pounds of fruit you have. This would be a very useful bit of information if you were carrying the fruit somewhere, say in a backpack. Now, as a busybody social scientist, suppose I ask you what you have in your fruit basket, your refrigerator, and your closet. After sufficient time to check your household inventory, you could again produce a list. Suppose I again say I don t want a list. Could you summarize it for me? Can you see that the total number of items is not a very satisfactory answer, because now, instead of a reasonably tight and meaningful category like fruit, we have fruit, meat, cheese, vegetables, beer, butter, margarine, jam,
and tonic water. O.K, because beer is food, we could summarize that we have some number, some weight, or some amount of calories of food in the fridge. Not totally satisfactory, but it might do. But now we go to the closet. How do we combine food, with shirts, shoes, pants, skirts, shorts, and blouses? Aggregation is not easy. The list of things produced annually in the U.S. economy would be quite a bit longer than our household inventory. Yet it is not unreasonable that someone might want to know how much we produced in the U.S. economy last year, how much we re producing this year, and perhaps what we expect to produce in the future. Many people are employed producing this stuff, and most people get their income from employment. The higher the production, the higher the employment in an economy. But the real reason the amount of production is important is that most economists are guys, and guys like to keep score. We like to know is we are producing more from year to year, and how our economy compares to others. Fortunately, in a market economy like ours, we have prices for goods and services that make the process of adding apples and oranges easier. We simply add the value of the goods and services together. The most added-together economic magnitude in any economy is something called gross domestic product (GDP), the market value of all final goods and services produced in an economy in a given time period, usually a year. GDP and its simple definition contain many tricky parts that highlight the perils of measurement of national output, which we will address step by step. Let s start first with the first word in GDP, gross. It doesn t mean that it s big (which it is), or in the common vernacular, boorish or crude. The term gross means that some of the stuff we produce in a year is to replace worn out machines, assembly lines,
buildings and trucks. When we keep score, it might not always be appropriate to give credit for keeping up with the onslaught of mold, rust and decay. If we subtracted off the value of this maintenance production, we d have something called net domestic product. I d suggest you forget about this distinction and leave it to professional economists to worry about. The next word, domestic, is a recent substitution in the U.S. Perhaps you ve heard of Gross National Product, a concept we measured for years, until we finally came around to what the rest of the world does. Domestic product, in contrast with national product, is the value of goods and services produced within the borders of a country, regardless of the nationality of who produces them. The goods and services don t have to be produced by a country s citizens, or resources owned by those citizens. The output of a Japanese company producing in the U.S., using Japanese workers who send their paychecks home to Tokyo, is counted as U.S. GDP. On the other hand, if I take a leave from my university and go teach in Canada for a year, the value of my teaching output would be part of Canadian GDP. GNP counts things differently, the value of production from a country s resources wherever the production takes place. The Japanese production mentioned above would be part of Japan s GNP and our GDP, and my teaching in Canada would be part of U.S. GNP and Canadian GDP. Again, if you are confused, don t worry about it, unless you are lacking cocktail party material to make you look smart. The third word in GDP is the important one, production. GDP is a measure of new stuff produced. This is important because it doesn t count the value we get from using what has been produced in the past. This means that GDP cannot be a measure of
national well-being. Go to your closet. Even if you are not an economist, you probably have an old raincoat or parka hanging there. Go to your garage. Was you car produced this year? If not it s not part of GDP. This is not a problem unless we make GDP a measure of national well-being (which we do). In the definition of GDP we see the word final. This means that we add up the value of goods and services at their final point of sale. We do this to avoid counting the production of something more than once. A loaf of bread is a common example. The value of the loaf of bread sold in the supermarket is in GDP. We don t count the value of the wheat, the value of the flour (which contains the value of the wheat), and the value of the bread (which contains the value of the wheat and the value of the flour) separately. All these values are counted in the value of the final good. Because we measure the economy s production over a particular time period, GDP is a flow measure. It has a time dimension, like cubic feet per second and miles per hour. GDP is not a national inventory of goods we have around, only the new ones we produce in the current year. Finally, while measuring the market value of production allows us to use a monetary value such as the dollar as a common denominator in the process of adding apples and oranges, using monetary magnitudes introduces it s own set of problems. A simple example illustrates the point. Suppose from one year to the next we produce exactly the same amount of stuff in the economy, but the price of everything rises ten percent. GDP rises by ten percent. Is this a good way of keeping score? Obviously not. We have not produced any more stuff, but our measure of production, GDP, has risen. The problem here is that we have not allowed for the shrinking of our common
denominator, the dollar. We have not accounted for the fall in the purchasing power of the dollar, something we call inflation. But this is another topic.