GROSS DOMESTIC PRODUCT (GDP)

Led by the auto industry, the United States economy grew rapidly in the 1920s, generating more jobs, more income, and more free time that the American consumer had in order to spend. As long as people were employed, paying for goods and services, there was really no need to measure how the economy was doing. However, in the 1930s, the American economy went bust and a frustrated Congress asked if there was any way to measure the depth of the Great Depression.

On January 4, 1934, economist Simon Kuznets (1901–1985), professor at the University of Pennsylvania, sent to the Senate a report entitled "National Income: 1929–1932," the first accounting of U.S. productivity, essentially the gross national product (GNP). More than 4,500 copies of this report were sold in just eight months. The basic concept that Kuznet had was to limit this accounting measurement to the marketplace, and thus to the amount that consumers paid for goods and services. Until 1992, the term GNP was used to refer to the total dollar value of all finished goods and services produced for consumption in society during a particular period of time (usually one year). In 1992 the Commerce Department began to compute gross domestic product (GDP) instead of GNP. The differences between the two are slight and involve how to count earning of assets owned by foreigners. GNP counts the earnings in the homeland of the owner of the asset, while GDP counts the earnings of a manufacturer in the country in which the assets exists. For the United States, there is virtually no difference between the two measures.

There are three basic components that determine the U.S. GDP:

Consumption, the amount that consumers pay for goods (durable and nondurable).
Investment, the amount of money spent on new production facilities, that is, plants and facilities.
Services, the amount that consumers pay for the services they use.

Several things that were not included in GNP but were subsequently included in the GDP are:

Work that is provided in an economy by nonmarket transactions such as homemakers and military personnel. These factors were too difficult for Kuznets and his team to measure.
Illegal activities such as gambling and drug trafficing. These factors are also difficult to estimate but Kuznets excluded them from GNP because he deemed them a "disservice" to the economy.
Goods and services that are bartered. These were excluded because they cannot be measured.
Sale of intermediate goods (raw materials).
Sale of used goods (used cars, furniture, etc.).
Purely financial transactions such as sale of stocks and bonds.
Imports (goods made outside the United States).

The GDP is the ultimate benchmark that measures the expansion and contraction of the U.S. multitrillion dollar national economy. It covers everything that is produced and sold in the marketplace. Bankers, investment brokers, and government officials use the GDP to determine such things as interest rates, investment opportunities, and tax rates. The GDP is not the only measure of output, however, as economists use the GDP because it is the most comprehensive of output measures. This measure is important because it helps societies understand both inflation and employment.

In the flow of payments in the economy, where does one measure? Consider, for example, an automobile. The mining operator receives income from the sale of iron ore, the mill owner receives income from the sale of finished steel, and the automobile manufacturer receives income from the sale of the finished car. In order to avoid the inaccuracy of counting the same money three times, Kuznets decided to use only final sales. Thus the amount paid to the dealer for the car is the only amount used in calculating GDP. The labor cost of the workers at all three locations is added to GDP. In essence, the price of the automobile includes the cost of the materials purchased from suppliers. The value added to manufacture the automobile can be found by deducting the cost of one product from the total cost of the automobile.

The more goods and services a country produces, the healthier that country's economy becomes. There is a major flaw in measuring economic success, however, in that when GDP (production) increases, negative externalities

Product and prices
	Year 1		Year 2
Goods	Output	Prices	Output	Prices
Balls	10 balls	$50 per ball	10 balls	$55 per ball
Bats	10 bats	$25 per bat	12 bats	$25 per bat
Gloves	10 gloves	$25 per glove	9 gloves	$30 per glove

(air and water pollution) also increase. The environment becomes degraded and negatively affects the quality of life. The GDP measures goods and services traded, but the negative externalities are not included in this counting. However, these negative externalities increase the GDP. For example, when the automobile industry wants to produce more cars, the smoke that is emitted from the smokestacks includes carcinogens that may make people in the area sick. A person who gets sick from the emitted smoke may go to the doctor. The doctor may prescribe medication. The cost of the visit to the doctor and the cost of the medication are added to the total value of the GDP.

Table 1 contains output and price statistics for a simple economy that produces only three goods. In the first year, the value of output, or GDP, is __BODY__,000; in the second year, the GDP is __BODY__,120. These numbers are obtained by multiplying quantities by prices and then summing the resulting values. They give us current dollar or nominal GDP, that is, the value of output measured in prices that existed when the output was produced.

The GDP has risen 12 percent from the first year to the second, but this increase is only partially due to additional output (__BODY__,120 − __BODY__,000 = $120). Part of the increase is due to changes in prices. To get a measure that contains only the increase in output, we can multiply the outputs of the second year by the prices of the first year. When we add up these values, they total __BODY__,025. This number implies that if only the quantities of output had changed and not the prices, GDP would have increased only from __BODY__,000 to __BODY__,025, a rise of only 2.5 percent. This __BODY__,025 is real GDP.

GROSS DOMESTIC PRODUCT (GDP)

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