Introduction to economics II
CHAPTER 1
Measuring the Economy: Production
Aims of the lecture
What is Macroeconomics about? We will define a key measure of the economy:
◦ Gross Domestic Product (GDP)
See how it is calculated: differences between nominal and real measures.
See the three methods to calculate GDP: Production approach, Expenditure approach and Income
approach. What are the drawbacks of GDP as a measure of wellbeing?
How GDP correlates with other indicators?
Macroeconomics vs. Microeconomics
Microeconomics focuses on how decisions are made by individuals and firms and the consequences
of those decisions. One product. One price. A single market.
Olie market
Macroeconomics examines the aggregate behaviour of the economy ─ how the actions of all the
individuals and firms in the economy interact to produce a particular level of economic performance
as a whole. Aggregate production. Price index. Economy as a whole.
Small country
Macroeconomics answers questions such as the following:
◦ Why is average income high in some countries and low in others?
◦ Why do prices rise rapidly in some time periods while they are more stable in others?
◦ Why do aggregate production and employment expand in some years and contract in others?
Need for Measurements:
To understand the state of the world, and give advise to policymakers, and individuals, economists
rely on various sets of data.
Gross Domestic Product (GDP)
It is the most frequent measure of an economy’s production.
Intended to measure how much is produced in a country in a given period. Aggregates the quantities
of all the goods produced into a single number.
1
,More precisely, it is the market value of the final goods and services produced domestically (within a
country) during a given time period (usually one year).
This is a flow variable (as opposed to stock variable). You have to measure GDP over a time period.
GDP
- Market value
- Final goofs and s
- Domestillally
- Time period
Stock vs Flow Variables
Flow variables à income
Stock variables à wealth
Market Value (prices)
The problem is how to aggregate apple and oranges. A common metric exists money Rather than
trying to determine a value for each good, we use its market value (price). Markets are providers of
information.
Domestic production
All goods and services produced within the border counts, whatever the nationality of the producer.
Goods produced abroad by local firms are not included.
Goods and Services
GDP includes both tangible goods (food, clothing, cars) and intangible services (haircuts, house
cleaning, doctor visits).
2
,Produced in the current year
It includes goods and services currently produced, not transactions involving goods produced in the
past (e.g. a second hand car).
Final Goods and Services
Final goods are used by customers. Goods used to produce other goods are called intermediate
goods and are not included in the GDP measure in order to avoid multiple accounting of the values.
For example: What is GDP of an economy producing wheat, flour and bread?
The farmer sells the wheat for €25 to the mill, that grind the grains into flour that, in turn, is sold to
the bakery for €50. The bakery sells the bread to consumers for €100
The GDP is: €175 or €100?
Solution
The customers did not buy the wheat, nor the flour used to bake the bread, but only the final
product. So grains and flour are intermediate goods.
If they were included in the GDP calculations they would actually be counted several times, once as
grain, once as flour and once as bread.
GDP will be the value of the final good (bread): €100
Difficulties in Measuring GDP
• However, deciding whether goods are intermediate or final is not always easy.
• For example, are tyres final or intermediate goods? It depends on whom are they sold to.
• A tyre maker produces 100 tyres. It sells 80 to a carmaker and 20 directly to consumers.
• Then, 20 tyres are final goods and 80 tyres are intermediate goods needed to produce cars.
• In order to overcome this difficulty we will use the value added method (ze voegen elke
keer waarde toe aan het product).
• VA = value product – value item
Value added method
GDP = sum of value added
o In practice, the valuation of GDP relies on the value added by each firm
o Value added= Value of production – value of intermediate goods
o Former example of wheat, flour and bread:
o Value added of the farm = €25 (wheat) – €0 = €25
o Value added of the mill = €50 (flour) – €25 (wheat) = €25
o Value added of the bakery = €100 (bread) – €50 (flour) = €50
o GDP = Sum of every value added in the Country
o GDP = €25 (farm) + € 25 (mill) + € 50 (bakery) = €100
o Firms create value added by transforming raw materials into products. A final purchase
includes the value added at each stage of the production
3
, More difficulties in Measuring GDP
o Capital goods (building, machines) are used in the production of final goods but are not
destroyed in the process. How should they be classified?
o By convention, new capital goods are classified as final goods (Investments)
o Unsold goods (to be sold in the future) are also classified as investment (inventories).
o What about the value of non-traded goods?
o Goods (services) produced and consumed at home are not counted
o Goods provided by Government free of charge (education, road, safety...) are given a value
equal to the costs of their provisions.
o GDP used to exclude items produced and sold illicitly, such as illegal drugs. (Not any more.
Nowadays they are estimated and included)
Nominal GDP versus real GDP
GDP is the monetary value of goods and services produced domestically measured at current prices:
Nominal GDP
If we want to compare GDP overtime, we need to eliminate the effect of price change (inflation) on
the nominal GDP (GDP measured at the current year prices).
To do so, we fix the prices at a given base year, and calculate the GDP using those prices so that any
variation in GDP is only due to a change in the quantities produced. This is the Real GDP (GDP
measured at base year prices).
Nominal value = Value (t) = P (t) Q (t)
Nominal value = Value (t+1) = P (t+1) Q (t+1)
Real value (t) = P (t) x Q (t)
Real value (t+1) = P (t) Q (t+1)
Nominal GDP versus real GDP
t
q − quantity of good "i" in year t i
t
p − price of good "i" in year t i
0
p − price of good "i" in the base year i
4
CHAPTER 1
Measuring the Economy: Production
Aims of the lecture
What is Macroeconomics about? We will define a key measure of the economy:
◦ Gross Domestic Product (GDP)
See how it is calculated: differences between nominal and real measures.
See the three methods to calculate GDP: Production approach, Expenditure approach and Income
approach. What are the drawbacks of GDP as a measure of wellbeing?
How GDP correlates with other indicators?
Macroeconomics vs. Microeconomics
Microeconomics focuses on how decisions are made by individuals and firms and the consequences
of those decisions. One product. One price. A single market.
Olie market
Macroeconomics examines the aggregate behaviour of the economy ─ how the actions of all the
individuals and firms in the economy interact to produce a particular level of economic performance
as a whole. Aggregate production. Price index. Economy as a whole.
Small country
Macroeconomics answers questions such as the following:
◦ Why is average income high in some countries and low in others?
◦ Why do prices rise rapidly in some time periods while they are more stable in others?
◦ Why do aggregate production and employment expand in some years and contract in others?
Need for Measurements:
To understand the state of the world, and give advise to policymakers, and individuals, economists
rely on various sets of data.
Gross Domestic Product (GDP)
It is the most frequent measure of an economy’s production.
Intended to measure how much is produced in a country in a given period. Aggregates the quantities
of all the goods produced into a single number.
1
,More precisely, it is the market value of the final goods and services produced domestically (within a
country) during a given time period (usually one year).
This is a flow variable (as opposed to stock variable). You have to measure GDP over a time period.
GDP
- Market value
- Final goofs and s
- Domestillally
- Time period
Stock vs Flow Variables
Flow variables à income
Stock variables à wealth
Market Value (prices)
The problem is how to aggregate apple and oranges. A common metric exists money Rather than
trying to determine a value for each good, we use its market value (price). Markets are providers of
information.
Domestic production
All goods and services produced within the border counts, whatever the nationality of the producer.
Goods produced abroad by local firms are not included.
Goods and Services
GDP includes both tangible goods (food, clothing, cars) and intangible services (haircuts, house
cleaning, doctor visits).
2
,Produced in the current year
It includes goods and services currently produced, not transactions involving goods produced in the
past (e.g. a second hand car).
Final Goods and Services
Final goods are used by customers. Goods used to produce other goods are called intermediate
goods and are not included in the GDP measure in order to avoid multiple accounting of the values.
For example: What is GDP of an economy producing wheat, flour and bread?
The farmer sells the wheat for €25 to the mill, that grind the grains into flour that, in turn, is sold to
the bakery for €50. The bakery sells the bread to consumers for €100
The GDP is: €175 or €100?
Solution
The customers did not buy the wheat, nor the flour used to bake the bread, but only the final
product. So grains and flour are intermediate goods.
If they were included in the GDP calculations they would actually be counted several times, once as
grain, once as flour and once as bread.
GDP will be the value of the final good (bread): €100
Difficulties in Measuring GDP
• However, deciding whether goods are intermediate or final is not always easy.
• For example, are tyres final or intermediate goods? It depends on whom are they sold to.
• A tyre maker produces 100 tyres. It sells 80 to a carmaker and 20 directly to consumers.
• Then, 20 tyres are final goods and 80 tyres are intermediate goods needed to produce cars.
• In order to overcome this difficulty we will use the value added method (ze voegen elke
keer waarde toe aan het product).
• VA = value product – value item
Value added method
GDP = sum of value added
o In practice, the valuation of GDP relies on the value added by each firm
o Value added= Value of production – value of intermediate goods
o Former example of wheat, flour and bread:
o Value added of the farm = €25 (wheat) – €0 = €25
o Value added of the mill = €50 (flour) – €25 (wheat) = €25
o Value added of the bakery = €100 (bread) – €50 (flour) = €50
o GDP = Sum of every value added in the Country
o GDP = €25 (farm) + € 25 (mill) + € 50 (bakery) = €100
o Firms create value added by transforming raw materials into products. A final purchase
includes the value added at each stage of the production
3
, More difficulties in Measuring GDP
o Capital goods (building, machines) are used in the production of final goods but are not
destroyed in the process. How should they be classified?
o By convention, new capital goods are classified as final goods (Investments)
o Unsold goods (to be sold in the future) are also classified as investment (inventories).
o What about the value of non-traded goods?
o Goods (services) produced and consumed at home are not counted
o Goods provided by Government free of charge (education, road, safety...) are given a value
equal to the costs of their provisions.
o GDP used to exclude items produced and sold illicitly, such as illegal drugs. (Not any more.
Nowadays they are estimated and included)
Nominal GDP versus real GDP
GDP is the monetary value of goods and services produced domestically measured at current prices:
Nominal GDP
If we want to compare GDP overtime, we need to eliminate the effect of price change (inflation) on
the nominal GDP (GDP measured at the current year prices).
To do so, we fix the prices at a given base year, and calculate the GDP using those prices so that any
variation in GDP is only due to a change in the quantities produced. This is the Real GDP (GDP
measured at base year prices).
Nominal value = Value (t) = P (t) Q (t)
Nominal value = Value (t+1) = P (t+1) Q (t+1)
Real value (t) = P (t) x Q (t)
Real value (t+1) = P (t) Q (t+1)
Nominal GDP versus real GDP
t
q − quantity of good "i" in year t i
t
p − price of good "i" in year t i
0
p − price of good "i" in the base year i
4
