Gross domestic product, often denoted as GDP, refers to the total value of goods produced within a country during a particular time, usually one year. It is widely accepted as a means of measuring the economic progress of a country by economists all over the world. When GDP is calculated within a country any goods used and those produced in other nations are excluded. Inclusion of goods produced by country’s citizens in foreign markets results in Gross National Product (GNP).
History of GDP
Measurement of statistics to describe national economies in the Western world dates back to the 17th century. However, GDP and GNP, which were products of the System of National Accounts (SNA), started to be used only in 20th century. SNA came into being in 1930 in the United States. It was formed to help make the best of production during war-time besides driving the economy out of great depression. It is during this time that the measure of GDP appeared to guide the Keynesian economic policy. To date, GDP have proved to be vital in the measurement of economic and social well-being of people in the United States and in other parts of the world (Henderson 2007).
Computation of the GDP
There are three methods used to compute GDP. First is the Spending Method that takes into consideration all expenditures by the households, firms, governments, and foreigners on the products produced within the borders of the country. Secondly, there is the Income Method that considers all incomes earned by all above mentioned sectors of the economy. Lastly, there is the Production Method that focuses on the value of production within the country’s borders. Calculation of the value of goods and services is done with the help of market price at the time of valuation. This evaluation results in the Nominal GDP (Census and Statistics Dept 2006).
The Spending Method. This method works by first breaking down the expenditures of a country into four categories: Consumption (C), Investment (I), government spending (G), and difference between exports and imports (NX). The Gross Domestic Products is then obtained by summing these components.
GDP= C + I+ G+ NX
To safeguard form double counting, only spending on final goods and services is used in the computation. Final goods refer to those goods that have undergone complete processing.
The Income Method. Sectors of the economy include households, firms, foreigners, and the government. Since one’s spending constitutes another person’s income, summing earnings of these sectors gives the same value as the one obtained by the use of spending method. Again, incomes are grouped into five categories:
1). Labor incomes - include salaries and any accruing benefits for accomplished work.
2). Capital incomes - these include investment returns.
3). Government income - taxes obtained from the sales by the proprietors.
4). Foreign income - this includes income received by citizens in other accounts that were not accounted for in the labor income.
5). Depreciation - since company’s factor in depreciation when evaluating their profits, the value is added in order to compute GDP including the value of new machines. Depreciation refers to the decrease of the value of a machine due to its consistent usage over the years.
Production Method. This entails calculating the sum of all values of goods and services produced by firms and industries in a country. To avoid any instances of double counting only the value added by each manufacturer is computed. Value added is obtained from the difference between the cost of the intermediate good and the worth of the firm’s production. However, the expenditure on labor and capital are never subtracted to obtain the value added since they are a part of it.
Variants of GDP
GDP value obtained can be manipulated in different ways to give different but related values. These are referred to as the variants of GDP. Their types are discussed further.
Gross National Product (GNP). While a majority of countries use GDP to measure their output, there are some that prefer to use Gross National Product measurement. In the US this value is obtained by adding up values of all production by US firms in foreign countries and then subtracting the total value of production by foreign firms in the US. Currently the value of GNP is greater that of GDP since there are fewer foreign firms in the US than there are US firms in foreign countries.
Real Gross Domestic Product. This is the measure of the total value of goods produced within the borders of a country taking into consideration the effect of inflation. Instead of current market prices of goods and services, the base year prices are utilized in the computation of GDP. This measure is considered the most accurate measure of a country’s output over a particular period e.g. one year.
Gross Domestic Product per capita. As the production of a country changes, the size of a population in a country also changes. Therefore, to reflect this change the value of GDP per person in the country is obtained by dividing the computed value of GDP by the total population. Mathematically it can be represented as:
Gross Domestic Product = GDP/ Total population
To evaluate well-being of citizens of a given country, Real GDP can be computed instead of computation of nominal GDP.
Potential Gross Domestic Product. This refers to the tendency of country’s economy to grow in the long-run. Its calculation cannot be done explicitly since it is a measure of a trend. Usually, graphical representation of Real GDP is sufficient to illustrate potential GDP.
Strengths of Gross Domestic Product
Useful in depicting economic activity. GDP can be perceived as single value that can be used to measure the size of economy. Changes in this value over the years can be used to determine the direction in which the economy moves. For instance, a declining GDP implies a recession. Variation of the component can lead to the use of different components to evaluate performance of different sectors of economy. Since the value is reliable, it is often used during the formulation of different economic policies within a country.
A measure of people’s well-being. Changes in GDP values reflect economic growth in a country. Since the value is obtained by measuring total incomes or expenditures of the different sectors of the economy, it can be used to reflect changes in the livelihood of citizens. For instance, increased GDP could be due to increased incomes while increased income implies better standards of living. However, certain critical economists such as William Nordhaus argue that using GDP as a measure of welfare leads to inaccurate depiction of total utility since it is a measure of the output.
Weaknesses of GDP
Though GDP is used as a measure of social welfare of country’s citizens, conclusions about it can be misleading since it does not factor in the effect of environmental costs. These costs are discussed further.
Non-inclusion of the non-market activities. GDP only accounts for those products whose market value can be computed. For instance, it ignores market activities such as sale of illegal drugs or volunteer work. However, non-inclusion of these commodities leads to alteration in productive activities. Therefore, it can be assumed that GDP gives only a bleak picture of reality or rather an approximation.
Accounted expenditures that do not boost the economic welfare. Welfare relates to all daily occurrences that affect the life of country’s citizen. GDP ignores the changes in welfare that result from occurrences such as natural calamities. However, such events often result in expenditures which will not be reflected in GDP. Therefore, use of GDP in the measurement of alteration in social welfare may portray conflicting results. Moreover, using GDP to evaluate people’s progress would imply, for example, that the most admirable occurrence is a tornado since it results in huge expenses (Wikipedia and LLC Books 2010).
Stocks relative to flows. Utilization of non-renewable natural resources is a constituent of the GDP. However, the remnants of natural resources are not revalued as stock. Valuing them as stock would be economically efficient when they are discovered in the future since they add to the wealth of the nation.
Does not account for the allocation of income and the consumption. GDP per capita indicates that citizens of a country contribute to GDP in equal proportion. However, it is more realistic that some people produce more than others. Therefore, the poverty levels of a country may not be reflected by GDP.
GDP has been used as a measure of economic property of different countries in the world today. Though comparisons between different countries have often been marred by complications, GDP has served as a good estimate. Its simplicity of calculation and numerous conclusions it allows to make about a country’s economy are some of its strengths. However, it also has certain weaknesses as indicated above. Measures are being put in place to revise GDP as a measure of economic growth. No significant strides have been made yet.