Four Factors of ProductionLaborLand

Capital

Payments to Factors of Production

Payments to Factors of ProductionInterestW

age

Rent

Profit

Entrepreneurship

Produce

Goods and Services

Sold

Total Income

Rent

Wage

Profit

Interest

Should be determined by the “free market” Capitalism

Should be determined by the government Communism

Should be determined by free market and the government Socialism

Factors of Production

How should be

distributed?

Capitalism

Economic system in which the means of production are privately owned and operated for private profit

Decisions are made by private actors in a free market

Not owned by Government

Laissez-faire: free market

A market in which there is no economic intervention and regulation by the government,

Except to enforce private contracts and the ownership of property.

Households

Goods and Services

InterestRent

WagesProfits

Firms

Circular Flow Diagram

Buys goods and

services

Foreig

n Goods

$ $$

$

$

$

Measuring Production

Gross Domestic Product

6

Goods and

Services 17T

Why is this number important?

The more goods and services we produce, the more Income is generated and the better our ability to satisfy needs.

7

Goods and

Services 17T

InterestRent

WagesProfits

GDPSum of expenditures on new, final goods and services produced in the U.S during the year.

GDP includes ONLY NEW production

GDP includes ONLY NEW production

GDP is NOT the sum of total sales!

GDP is NOT the sum of total sales!

Excludes used goods

GDP = Total sales of new goods…

Car Manufacturer purchase new tires from tire manufacturer at

$200 each

Car Manufacturer purchase new windows from window manufacturer at $300 each

Consumer buys new car for

$16,000.

GDP = Total sales of new goods…

4 Windows : $1200

4 tires : $800

1 car: $16,000

$18,000Total Sales of New Goods

Include twice the value of the tires and the windows

+

+

=

Intermediate GoodsIntermediate Goods

GDP = Total sales of new goods…

GDP excludes sales of intermediate goods to avoid double counting.

Final GoodFinal Good

Intermediate Good

A good (or service) that is used as an input or component in the production of another good.

A good that will be further processed before sold as final good.

Goods and services purchased by firms…

11

ExcludedExcluded

Final Good

A good (or service) purchased by the final user

With no further transformation, use or as an input in the production of other goods.

12

Included

Included

GDP

Sum of expenditures on new, final goods and services produced in the

U.S during the year.

13

GDP includes ONLY Final goods

GDP includes ONLY Final goods

Excludes goods purchased by firms to produce final goods…

Firms purchase Capital Goods

Capital good: A manufactured factor of production used to produce other goods…

Examples: factories, buildings, trucks, tools, machinery, and equipment.

14

GDP excludes goods purchased by firms to produce final goods…

Intermediate vs. Capital Goods

15

Flour

IncludedIncluded

Excluded

Excluded

DepreciationDepreciation

Investment

The purchase of capital goods

16

Included

Included

GDP

Sum of expenditures on new, final goods and services produced in the

U.S during the year.

17

GDP includes goods purchased by consumsers

and capital gods purchased by firms

GDP includes goods purchased by consumsers

and capital gods purchased by firms

Excludes Intermediate goods purchased by

firms

Households Firms

Unsol

d

goods

are

Inve

stm

ent

Unsol

d

goods

are

Inve

stm

ent

Goods and Services

Goods and Services

UnsoldInventory+

Inve

stm

ent

Purchase of Capital

Goods

Government

Purchases

Investment = Purchase of

• Equipment, tools, software.

• Non-residential construction: shopping malls, factories, airports.

• Inventories and

• New homes and Condominiums purchased by consumers

19

Households

Goods and Services

Saving = purchase of paper goods

Saving = purchase of paper goods

Stocks, FundsBonds, CD’s,Life Insurance

Stocks, FundsBonds, CD’s,Life Insurance

GDP Excludes Paper GoodsGDP excludes purchases of Bonds,

stocks, Certificates of Deposit..

21

22

Included

Included

ExcludedExcluded

Goods Produced by the Government are NOT sold

• All goods and services purchased by the government are FINAL goods.

• Government production is included when the government purchase the inputs necessary to produce: services of government employees, raw materials, tools, equipment.

• Government production is calculated at the value of the inputs used.

24

Government is

the final user

Government is

the final user

Households

U.S. Goods and

Services

Firms

U.Sgoods

U.Sgoods

Imports

Impo

rts Im

portsExp

orts

Purchase of Foreign Goods (IMPORTS)

should not be added as U.S. production

GDP does not include Non-Market Production

Goods or services produced but not paid for.

Cleaning, cooking, home improvement projects, child care, volunteering

27

Non M

arke

t

GDP does not include unreported production

Goods or services produced and paid for but not reported

Illegal goods and services

Legal unreported goods and services

28

Underground

Total Production is larger than GDP

29

Underground

Non M

arke

t

U.S. Goods and Services

GDP is NOT equal to total sales GDP excludes:• Sales of intermediate goods• Sales of paper goods• Sales of used goods• Sales of illegal goods• Non- market goods and services.

30

Limitations of GDP

• Excludes non-market production of goods or services– Child care, elderly care, cooking, cleaning,

gardening, home projects, farming.

• Excludes underground production of goods or services– Illegal and legal goods and services not

reported to tax authority.

31

Limitations of GDP continued…GDP does not ”subtract”.

Deforestation.Contamination.Destruction of animal and plant life.Destruction of assets.

32

China 9T

Germany

3TChina

9T

China 9T

China 9T

Limitations of GDP continued…

Leisure is not accounted for.

USA17T

EU17T

Worked 12 monthsWorked 11 months

34

U.S #1

Does this mean that the U.S. grows faster than any other

country?

36

2012

U.S not in

the top 10!

2014

Does this mean Americans are the richest in terms of income

per person?

2013

U.S Drops

from #1 to #13

Does it mean all Americans earn $53,000/year?

40

0: Perfect Equality

100: Perfect Inequality

GDP alone is not a good measure of wellbeing

We need to know how this income is distributed.

42

Can not be used for cross country comparisons unless we add both: income distribution and population size.

Ger

man

y

Spain

Fran

ce

England

Italy

Japa

n

GDP excludes goods and services produced by Americans outside the U.S

GDP includes goods and services produced by other countries inside the U.S.

U.S. P

rodu

ction

Includes goods and services produced by U.S. companies anywhere in the world

Includes goods and services produced by U.S. companies anywhere in the world

Excludes goods and services produced by other countries inside the U.S.

Excludes goods and services produced by other countries inside the U.S.

Foreign Production in the US

Ger

man

y

Spain

Fran

ce

England

Italy

Japa

n

Add Income earned abroad

Add Income earned abroad

Subtract Income earned by foreign companies in the

U.S.

Subtract Income earned by foreign companies in the

U.S.From Domestic to National

Investment

Purchase of new capital goods.

Net I = Gross I – Depreciation

Purchase of new capital goods

minus Depreciation.

Gross Investment

NetInvestment

Gross Domestic Product

47

GDP = C + I + G + NXGDP = C + I + G + NX

Includes all purchases

of new capital goods

GG II

NET DOMESTIC PRODUCT

48

Purchases of capital

goods minus Depreciation

NDPNDP

From Gross to Net

49

Gross Domestic Product

Net Domestic Product

Subtract DepreciationSubtract Depreciation

Gross Domestic Product

Net Domestic Product

Add DepreciationAdd Depreciation

GDPWe want to know quantity produced We can not add quantities produced because We can not add apples and computers and web pages…One pear is not the same as one computer: there is more value embodied in the computer…

50

Prices provide the best “weight” to approximate value.

Prices allow us to add apples and computers.

Calculating GDPNominal GDPNominal GDP

Multiply quantities purchased by the price at which they sold on that year.

Example: For 2009 GDP, we use prices paid in 2009.Because we use prices of 2009 to compute GDP for 2009 ,

we say that we used “current” prices.

53

GDP at current prices

REAL VERSUS NOMINAL GDP

54

The Sum of expenditures on all goods produced over the year

Year GDPPrice Quantity Price Quantity

PriceXQuantity

$1 100 $3 50 (1X100)+(3X50) = 250

Good X Good Y

2009

If prices rise…

Year GDPPrice Quantity Price Quantity PriceXQuantity

$1 100 $3 50 (1X100)+(3X50) = 250Price Quantity Price Quantity PriceXQuantity

$2 100 $6 50 (2X100)+(6X50) = 500

Good X Good Y

2009

2010

Quantities produced are

the sameBut GDP Increased!

Prices distort our view of true

quantity produced

• We have to use prices

• We must eliminate the effect of changing prices.

57

Nominal GDP: use current prices

58

1 22 33 4

The Short vs. The Long Run

Time

Total Production

Every

year w

e produce m

ore than th

e previous y

ear

Full Employment: z

ero

unemployment, no excess

capacity

Above Full employment

Below Full employment

At Full employment

Potential GDPGDP at Full

Employment

Three Ways of Calculating GDP

The Expenditures Approach

61

C + I + G + X - M

Interest +Rent +

Wages +Profits

The Incomes Approach

Value Added ApproachProduced Sold it for:

Value Added:

Indian community owns forest

tree $2 2-0=$2

Logging Company buys tree transforms into log

log $10 10-2=$8

Wood Company buys logs transforms into plywood

plywood $15 15-10=$5

Furniture Manufacturer buys plywood makes table

table $30 30-15=$15

Macy's buys table places on showroom for display

table in showroom $35 35-30=$5

Sum of Value Added $35

Sum of Value Added = Price paid by final user = $35

Growth

Increases in GDP come from:

Increases in the number of workers and/or

Increases in the number of factories and/or

Improvements in technology

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Growth in GDP come from:

Growth in the labor force and/or

Growth in the country’s stock of capital and/or

Improvements in technology

Growth in GDP come from:

Growth in the labor force and/or

Growth in the country’s stock of capital and/or

Improvements in technology

6464

Real GDP = Hours of work X Output per hour Real GDP = Hours of work x Labor productivity

Growth rate of potential GDP = Growth rate of labor force x Growth rate of labor productivity

Real GDP ~$ 14THours of work per year ~250 BLabor productivity ~$14T/250 B = $ 56 per hour.

Personal Consumption Expenditures 9,734 CDepreciation 1,687

Wages 7,874 Domestic and foreign wages

Indirect Business Taxes 1,041

Rental Income 65 Domestic and foreign Rent

Gross Private Domestic Investment 2,125 I

Profits 2,638 Domestic and foreign Profits

Exports 1,643 XGovernment Purchases 2,690 G

Interest 603 Domestic and foreign Interest

Imports 2,351 MIncome received from other countries 818 Income paid to other countries 722 GDP = C + I + G + X -M 13,841 National Income = Wages + Interest+Rents+Profits+Indirect Business Taxes 12,221 Domestic and

foreign IncomeGNP = GDP - income paid to other countries + income received from other countries 13,937 Income received

by U.S. NationalsNNP = GNP - Depreciation 12,250

Should be equal

Statistical Discrepancy = NNP – NI =29

66

Personal Consumption Expenditures 9,734Depreciation 1,687Wages 8,031Indirect Business Taxes 1,062Rental Income 66.3Gross Private Domestic Investment 2,168Profits 2,691Exports 1,676Government Purchases 2,744Interest 615.06Imports 2,398Income received from other countries 834.36Income paid to other countries 736.44

GDP = C + I + G + X -MNational Income = Wages + Interest+Rents+Profits+Indirect Business TaxesGNP = GDP - income paid to other countries + income received from other countries

67

Personal Consumption Expenditures 9,734Depreciation 1,687Wages 8,031Indirect Business Taxes 1,062Rental Income 66.3Gross Private Domestic Investment 2,168Profits 2,691Exports 1,676Government Purchases 2,744Interest 615.06Imports 2,398Income received from other countries 834.36Income paid to other countries 736.44

GDP = C + I + G + X -M 14,118

National Income = Wages + Interest+Rents+Profits+Indirect Business Taxes

12,465

GNP = GDP - income paid to other countries + income received from other countries

14,216

A bakery’s purchases

68

 Did you use it entirely into the pie?

No: Capital Good Include this purchase in GDP

Yes: Intermediate Good. Do not include this purchase in GDP

Sugar      Flour      Apples      Coffee      Water      Scotch tape      Pens      Notepads      Scissors      Shredder      Phone      Computer      Oven      

1. Bullet proof vests purchased by military.

2. Bullet proof vest purchased by Security Company.

3. Leather4. Bicycle purchased by

Gym.5. Computer6. Newly produced goods

no one purchased7. House8. Tools9. Cash for clunkers

10.Computer purchased by the City of Santa Monica.

11.Coffee and pastries purchased LAPD.

12.Coffee and pastries purchased by Ford for their offices.

13.Goods manufactured in other countries.

14.The State of Florida purchase oil from Venezuela

15.Venezuela purchase corn from Iowa farmers.

69

new

5. Determine if the following items are included in GDP and under what component C, I, G, X or M?

a. Jane buys newly issued shares of stock in Macro.com. Inc.b. Ross buys a new pair of jeans at a local department store.c. Joey has his mustache trimmed at his hair salon.d. Rachel buys an antique chest at a resale shop.e. Phoebe grows her own herbs on her apartment balcony.f. Michael travels to France and buys French wine.g. John, a stay-at-home dad, takes care of his 4 year old twins.h. Mary sends her 3 year old to pre-school.i. Rose volunteers at a homeless shelter.j. Government pays farmers a 10 cent/pound subsidy.k. Amazon. COM buys books from a publisher.l. Mark buys a book from a publisher. m. Mitsubishi Co. builds a car in Illinois and ships it to Japan for sale.n. Mike bets $500 on a basketball game.o. You buy land to build a home.

  Good A Good B

Year Quantity Price per unit Quantity Price per unit

1 2,000 0.1 75 1

2 2,400 0.15 60 1.1

3 2,600 0.25 75 1.2

6. Calculate: Nominal GDP for year 2, Real GDP for year 2 (use year 1 as base), GDP growth rate in

Real GDP for year 2.

Item Billions $Personal Consumption Expenditures 9,734Depreciation 1,687Wages 7,874Indirect Business Taxes 1,041Rental Income 65Gross Private Domestic Investment 2,125Profits 2,638Exports 1,643Government Purchases 2,690Interest 603Imports 2,351Income received from other countries 818Income paid to other countries 722

GNP = National Income (NNP) = GDP =

Label A-M

G A

B

E

CD

H

I

JKL

M F

Practice

74

1. What is GDP? What is included? What is excluded? What are its limitations?2. Explain the difference between GDP & GNP, NDP & GDP, between real GDP and nominal GDP. Provide an example to illustrate your answer.3. Explain how a loaf of bread can be considered both a final good and an intermediate good. Provide an example to illustrate your answer.4. Is the purchase of a home included in the calculation of GDP? If yes how and why? If not, why not?

5. What would happen in a country in which the value of depreciation is larger than the value of gross investment?

6. Why do we calculate GDP in dollars instead of computing GDP in pounds or units produced?

7. When would NX be a negative number and what implication does this have for the computation of GDP?

8. Why do we have to subtract imports in the calculation of GDP? Hint: We could simply not add M into GDP = C+I +G +X. But why do we have to subtract them from the above calculation

GDP = C + I + G + X – M?

9. What would be the effect on GDP with legalization of marijuana, cocaine, prostitution and gambling?

76

10.Are there key differences between an increase in the capital stock and an improvement in the level of technology?

11.Describe how the labor force, the nation's capital stock, and the rate of technical progress contribute to potential GDP growth and labor productivity.

12.During the course of the twentieth century, the average workweek in the United States has gotten shorter and Americans have enjoyed greater amounts of leisure time. How has this development affected potential GDP and labor productivity?

Why NNP and income are not the same?

• They are constructed using different sources of information which produce different results due to:– Sampling errors– Coverage differences– Timing differences when expenditures and incomes

are recorded.

• The overall difference between GDP and GDI is known as the statistical discrepancy

77

78

1. Net Investment includes all business’ purchases of new equipment, buildings, software. ______

2. Gross Investment includes only business’ purchases of new equipment which add to the stock of capital. ______

3. Gross Domestic product includes all business’ purchases of new equipment, buildings and software as part of the Investment component______

4. Net Domestic Product includes only production inside U.S. borders regardless of national ownership. ______

5. Gross National Product includes production of goods and services by U.S. nationals regardless of where in the world production takes place. ______

6. If the value of depreciation is greater than the value of gross investment, then the stock of capital will decrease. ______

7. If the value of depreciation is greater than the value of gross investment, then Net Investment is negative. ______