Gross Domestic Product (GDP) measures the total market value of all final goods and services produced within a country in one year.
1. Intermediate goods (goods that are input in the production of other goods) are not included in GDP to avoid double counting. In another words, only the value added is counted.
We use seed to produce wheat, wheat to produce flour, and flour to produce bread. In order to produce $5000 worth of bread, we need $3500 worth of flour, which require $2500 worth of wheat, which require $1000 worth of seed.
The value added in each process is illustrated below:
Seed ----------------------- $1000 ----------- Value added = 1000 – 0 = 1000
Wheat --------------------- $ 2500 ------------Value added = 2500 – 1000 = 1500
Flour ----------------------- $ 3500 ------------Value added = 3500 – 2500 = 1000
Bread ---------------------- $ 5000 ------------Value added = 5000 – 3500 = 1500
The sum of Value added = 1000 + 1500 + 1000 + 1500 = 5000.
The sum of value added is the value of the final product, bread in the above example. Therefore, value added approach is the same as counting only the value of the final products.
2. GDP only counts the value of final products produced within a geographical boundary of a country. If U.S. citizens are working in Canada, they do not contribute to the U.S. GDP, but Canada’s GDP and U.S. GNP. Gross National Product (GNP) is the total market value of all final goods and services produced annually by the citizens of a country.
3. GDP sums the dollar value of what has been produced in the economy over the year, not what was actually sold. For example, used car sales are not included.
4. GDP was not designed to be a measure of well being of the society. GDP omits the following:
a. Non-marketable goods and services: tasks that do not involve market transactions, such as baby sitting, house cleaning, lawn mowing etc. Some very useful output is excluded because it is unpaid employment.
b. Underground activities: illegal or cash transactions have no record. Government’s estimates on these transactions are not accurate.
c. Sales of used items: GDP measures only current output. Used car and thrift stores’ transactions are not counted.
d. Financial transactions: trading existing assets, such as stock or bond purchases.
e. Transfer payments: either government or private transfer payments are not included because goods and services are not produced in this process. Examples are social security benefits or kid’s allowances.
f. Leisure: individuals consume leisure, just as they consume all the other tangible goods, which generate satisfactions. But leisure has no price tag, so it is not included in GDP.
g. Social costs: production processes may cause pollution. Polluted air and water may have social costs like bad air quality, and cancer patients. These social costs reduce our economic well being. If money is not spent to clean up the oil spill or to cure the cancer patients, those expenses are not added to the GDP.
h. GDP does not measure quality or nature of the product, which contributes to the satisfaction level of the consumers. Nominal GDP simply adds the dollar value of the product; it makes no differences if the product is a weapon, or a book.
Per capita real GDP (= real GDP / population) gives more information on the standard of living.