This was written as Appendix 1.1 for an early draft of In Stormy Seas. In the process of reducing the text for publication it was dropped, but it turns up ghost like on page 11). This version is from the September 1994 version.
Economists typically measure the output of an economy by Gross Domestic Product (at market prices), or GDP, that is the market production for some period usually over a year, or sometimes three months (a quarter). The basic notion is that the production of each commodity – good or service – is valued at market prices and totalled up, after deducting inputs. It is a measure fraught with subtle assumptions.
Some are indicated by the phrase. Gross means the measure includes the depreciation of capital as a part of output. If during the period the ability of the capital buildings and equipment to provide productive services was reduced, an amount should be subtracted from output to give a measure of Net Domestic Product. However such depreciation is difficult to measure.
Domestic refers to the production in a country (or region), not the production of a country (or region) or nation. Thus the income of a visiting popstar or overseas economic consultant is a part of the GDP of the country, even though it is not a part of the nation’s income. By far the largest difference between domestic output and National Income arise from the foreign investment. Some of the domestic output belongs to foreigners by virtue of their profits from their investments (and other returns such as royalties and interest payments). Similarly some local nationals receive income from their foreign investments. There is greater foreign investment in New Zealand than New Zealanders invest abroad, so New Zealand’s GDP is greater than its Gross National Product (GNP). The difference between the two is Net Factor Payments, the largest item of which is interest and profits to foreigners.
However the issues of `gross’ and `domestic’ are minor in contrast to the issue of what constitutes product. The convention has been that, with a few exceptions, if a market transaction occurs then it is a candidate for being a part of the production of the economy. The measured contribution is the added value in the transaction, that is the value of the sales less the purchased inputs. This value added is typically divided between compensation to employees (i.e. payments to employed labour), consumption of capital i.e. depreciation of capital), and operating surplus, which is a residual of labour payments to the self employed, royalties, profits, interest, and so on. In addition any indirect taxes have to be added and subsidies deducted to convert the transaction into market prices.
Obviously it is by no means an easy task to calculate the added value of each transaction. Official statisticians acknowledge that their estimates are subject to error, which they hope average to zero. In addition there are some market transactions that the statisticians cannot measure, either because they are legal but miss the estimating procedure, or illegal. There is a considerable literature on the size of this `hidden’ economy, much of it of little value being dependent upon tenuous assumptions.
But there are many economic transactions which are deliberately omitted from official estimates because they are not market transactions. The most noteworthy omissions are those which occur within a household and those which involve the environment. Detailing these omissions is a book unto itself (Waring 1988). It suffices here to observe that GDP, or any related measure, cannot claim to encompass all economic activity, or be a measure of total human welfare. It merely focuses upon the market aspect of the human condition.
Moreover the boundary between what is measured and what is not measured changes over time. Once virtually all childcare occurred within the household, and hence did not appear in the GDP. However commercial or publicly provided childcare involves a market transaction, and is included in the GDP aggregate. Thus a (small) increment in the growth of GDP arises from the switch from household to market childcare, rather than any fundamental change to total activity. Similarly, depleting a resource – as when a hydrocarbon is converted from a reservoir under the ground into a tank above it – involves a market transaction and hence an increment to GDP, even though the net wealth of the nation may be the same or even reduced.
Economists have worried about these issues even to the extent of proposing augmented measures such as Net Economic Welfare, which attempt to incorporate non market transactions. While such measures maybe useful for some purposes the effort is misconceived if it is based upon the view that there is some single index which measures output, income, expenditure, or welfare in some unique, indisputable, objective, and broad-sweeping way.
For instance, how is the distribution of income to be assessed? Two economies may have the same GDP, but have vast differences in the way the output is distributed between its members. How then are the indices to be compared, except in a very limited way? So while GDP is some indicator of overall economic welfare, it is a partial one, by no means definitive, and not to be used uncritically.
The final part of the full name for GDP is at market prices. The prices are used to aggregate all the various products into a single index of production. The use of market prices arises because economists take market prices to reflect the relative values consumers place upon the transactions.
But even if this is true, measures such as GDP are usually used for comparisons, either through time or between countries. Since relative prices will vary, it is not obvious how to make such comparisons. In practice, and as we shall see, the aggregates are measured using the same set of prices. Thus the data might be calculated on the basis of 1977/8 prices, so that in principle product in every year is valued at what its price would have been in the 1977/8 year. The constant price series of GDP are sometimes called Real GDP or Volume GDP series.
There are theoretical justifications for sophisticated versions of the constant price approach, but practical experience has shown that the exact choice of prices rarely affects the overall comparison providing the underlying concepts are correct.
The measure GDP is a good example of an economic statistic which is used extensively, but often without a great understanding of the intricacies or subtleties involved.
1. e.g. The output of motor assemblers would be the value of the cars with a deduction for the value of its tyres (etc.), since they would be included as the output of the tyre manufacturer.
2. Notably the imputed rent on owner occupied homes – that is the return if each owner occupiers were to lease the house to themselves.
3. In 1981 the Government Statistician (1981) estimated the hidden economy in New Zealand to amount to just over 2 percent of GDP.