Measuring Productivity – GDP

I’ve had to take a few weeks off to sketch out the the next series of post, to make sure that I can follow a logical sequence of ideas that will take us neatly to a concept that will be the cornerstone of the entire blog.

In the opening posts of the blog I pointed out that if we want an economy that meets everyone’s basic needs then we’re interested in how much the economy can produce – its productive capacity or productivity – both now and in the future.  So we’re going to spend a little bit of time thinking about how we understand the productive capacity of an economy – how do we describe how productive an economy is?  And we’re going to do that by looking at completely conventional economics (a first for this blog!).  In fact, today’s topic would be the opening chapter of most conventional macroeconomics textbooks.

The economics profession has put a lot of effort into the question of measuring productivity.  The standard measure is Gross Domestic Product (GDP) – other measures include Net Domestic Product and Net National Income, and we’ll look at the differences between these and the precise meanings of the different terms along the way.

The obvious way to measure the productive capacity of a national economy is to measure the value of all the goods and services that it produces, taking the price of a good as its value.  In doing this, we are accepting money and price as the measure for the value of what we produce – this might seem obvious but there are subtle complications with this.  If prices are rising the nominal figure of GDP will rise without any increase in productivity.  Economists therefore make adjustments to GDP figures to allow for inflation.  When we find ways to compensate for inflation, we are looking at ‘real GDP’ rather than ‘nominal GDP’, and this is almost always what we want to do.

However, prices do not move uniformly – the prices of goods are always moving around in relation to each other.  This creates its own complications (that we won’t go into now) and also means that adjustments to GDP to allow for inflation are always estimates.  So we’re starting off by putting a mild health warning on the figures that are collected, and this lack of precision in the data applies pretty much every step of the way.

But anyway, let’s come back to the basic idea that we can measure the productivity of an economy by adding together the prices of all the goods and services that it produces.  This doesn’t actually work where goods and services are sold between businesses.

When a company sets a price for its products, it needs to cover all the costs in producing that product as well as a profit margin.  Therefore, the value of all business-to-business transactions are included in the costs of goods sold to consumers.  This is easiest to show with an example.  If Company A sells screws to Company B, and Company B uses those screws in making widgets to sell to consumers, it needs to cover the cost of those screws in the price of its widgets.  If, when calculating GDP, we include both the price of the screws and the price of the widgets, we end up counting the value of the screws twice, because the cost of the screws is already included in the price of the widgets.

Therefore, when calculating GDP we only want to include the cost of final goods and services.  This means goods and services sold to households, to the public sector, or to overseas (exports).  Most business-to-business transactions are not included because the value of these transactions will be reflected in the price of final goods and services.

There are two exceptions to this.  If a business has increased its inventory of unfinished or finished goods (e.g. its stock of parts or its stocks of goods waiting to be sold), the value of this production won’t be reflected in final sales because these goods have not yet been sold.  Secondly, there are goods that are used repeatedly in the production process of many other goods over several years, for example factories or machines.  These are known as fixed capital – they are used in manufacturing goods, but not used up in the production of a particular good, and the cost of these goods will be spread over many years.

If you’ve followed the blog from the start (and have a good memory) you’ll know that these two types of expenditure are called investment (a more complete explanation and definition is given in this post).  Any increase in inventory or fixed capital has to be added into GDP calculations, as it is not reflected in the prices of final goods.

So what we can see so far is that we can calculate GDP by adding together household consumption (C), public sector consumption (G for Government), investment expenditure (I), and exports (X).  However, any of those first 3 categories could include purchase of imports, which are goods produced in other countries.  We therefore want to subtract these from our calculation so that we only measure what was produced in our country.

And hence we get to the classic definition of Gross Domestic Product:

GDP = C + I + G + (X-M)

Understanding all the detail above is not vital, as long as you understand this basic equation.

Of course, finding the data for each of these variables is a whole other matter – it is a highly complicated process and this is where the lack of precision mentioned earlier comes in.  It’s worth noting that there is a lot of room for inaccuracy in calculating GDP.

I also want to point out a subtle nuance in the way that I have described the public sector in this model.  In saying that G is expenditure on goods and services sold by the public sector, it implies that everything of value in society is produced by private businesses and the public sector simply passively consumes that (out of our taxes).  In fact, the largest component of public sector expenditure is the salaries of public sector staff.  The model presented above is effectively treating all those staff as sole traders in the private sector, selling their services to public sector bodies.  This, of course, is not how things work in practice.  It makes no difference to the mathematical model of GDP, and indeed, it is actually simpler to explain that model as I have done here (which is how it is presented in any standard textbook).  But this simplification subtlly reinforces the idea that only the private sector produces goods and services, and this is far from the case.  The public sector, through the agency of its employed staff, produces a vast amount of goods and services of critical value to the functioning of society.  The value of this production is reflected in GDP figures in public sector expenditure (G).

Right, that’s some boring, basic macro out of the way.  This is just a building block to reach the most important point in this blog so far in 2 weeks time.

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