What Is Gross Domestic Product?

Gross domestic product (GDP) is the total market value of all final goods and services produced in a country in one year. To calculate GDP, complete the following steps:

1. Find the market value for each good produced: Multiply the price of each good by the quantity of the good produced.

2. Sum the market values: Add the dollar amounts found in step 1.

Why Count Only Final Goods?

GDP is the total market value of all final goods and services produced in a country in one year. A final good is a good sold to its final user. For example, when you buy a hamburger at a fast-food restaurant, the hamburger is a final good. You are the final user. No one uses (eats) the hamburger besides you. An intermediate good, in contrast, has not reached its final user.

When computing GDP, economists count only final goods and services. If they counted both final and intermediate goods and services, they would be double counting, or counting a good more than once.

Does GDP Omit Anything?

Some exchanges that take place in an economy are not included in the GDP measurement.

Illegal Goods and Services

For something to be included as part of GDP, we have to be able to count it. We cannot count illegal trades. No record is made of these transactions.

Transactions of Legal Goods and Services with No Record

Suppose a gardener mows someone’s lawn and prunes the shrubbery for $35 a week. The gardener asks to be paid in cash and does not want a sales receipt for the work. No evidence shows that a transaction was ever made.

Some Nonmarket Goods and Services

Some goods and services are traded outside of official markets. Suppose Eileen Montoya cooks, cleans, and takes care of all financial matters in the Montoya household. She is not paid for doing these activities. She does not receive a weekly salary from the family. Because she is not paid, the value of her work is not counted in GDP.

Sales of Used Goods

The sale of a used good is not recorded in this year’s GDP statistics. The value of a used good was counted when the good was originally produced. A used car is an example of such a good.

Stock Transactions and Other Financial Transactions

A stock transaction is not included in GDP because it is not a good or service. GDP counts only goods and services. A person who buys stock is not buying a good or a service. The person is buying a right to own part of the firm that originally issued the stock.

Government Transfer Payments

When the government makes a payment to someone, it often does not get a good or service in exchange. This type of payment is referred to as a government transfer payment. For example, a Social Security check is a government transfer payment.

GDP counts only current goods and services produced. A transfer payment has nothing to do with current goods and services produced. So, transfer payments are omitted from GDP statistics.

The Difference between GDP and GNP

Gross national product (GNP) is the total market value of final goods and services produced by U.S. citizens, no matter where in the world they reside. GDP, in contrast, is the total market value of final goods and services produced within the borders of the United States, no matter who produces them.

How Is GDP Measured?

Economists break the economy into four sectors: household, business, government, and foreign. The people in each of these sectors buy goods and services.

Economists give names to the expenditures made by each of the four sectors. The expenditures made by the household sector (or by consumers) are called consumption. The expenditures made by the business sector are called investment. The expenditures made by the government sector are called government purchases. (Government purchases include purchases made by all three levels of government— local, state, and federal.) The expenditures made by the residents of other countries on goods produced in the United States are called export spending. All goods produced in the United States must be bought by the four sectors. However, people in the four sectors also purchase foreign-produced goods. To compute GDP, economists have to adjust for U.S. purchases of foreign-produced goods.

Spending by Americans for foreign-produced goods is called import spending. To compute U.S. GDP, we add consumption (C), investment (I), government purchases (G), and export spending (X), and then subtract import spending (M). In symbol form, GDP = C + I + G + X - M.

For example, in the second quarter of 2009, consumption in the United States was $9.99 trillion, investment was $1.56 trillion, government purchases were $2.92 trillion, export spending was $1.49 trillion, and import spending was $1.83 trillion. Thus, GDP was $14.13 trillion.

Is Every Good That Is Produced Also Sold?

The definition of GDP refers to goods and services produced. The calculation of GDP refers to expenditures on goods and services. Nevertheless, something that is produced but not purchased is included in GDP.

For example, suppose a car company produces 10,000 new cars this year. The household sector buys only 8,900 of the 10,000 cars. That means that 1,100 cars were produced but not sold. The government statisticians who compute GDP assume that everything that is produced is purchased by someone. They assume the 1,100 cars are “purchased” by the car company that produced them. These cars get counted in GDP.

GDP Versus Quality of Life

Quality of life is determined by a number of factors. A high GDP is only one of them. Look at the issue on an individual basis. One person may have many more expensive goods than another person has. However, the second person may have more time to enjoy life. We cannot say who is better off.

Similarly, country X may have a higher GDP than country Y. We cannot say that people in country X are better off. Being better off involves much more than simply how much output is produced.

When comparing countries, we need to look at more than their GDPs. We need to look at each country’s per capita GDP—that is, its GDP divided by its population. This gives us the average amount of goods and services each person in the country has. Suppose country X has double the GDP of country Y. However, the population of country X is three times the population of country Y. On average, each person in country X has fewer goods and services than does each person in country Y. In short, higher GDP does not necessarily mean higher per capita GDP.

The Two Variables of GDP: P and Q

To compute GDP in a simple, one-good economy, we multiplied price (P) by quantity (Q) to find GDP. If either P or Q rises and the other remains constant, GDP will rise.

To see how this relationship works, look at the following table:

Price / Quantity / GDP
$10 / 2 / $20
$15 / 2 / $30
$10 / 3 / $30

With a price of $10 and a quantity of 2, GDP is $20. When the price rises to $15 and the quantity stays at 2, GDP rises to $30. When the price stays at $10 and the quantity rises to 3, GDP again is $30. GDP can increase because price increases, because quantity of output increases, or because both price and quantity increase.

To find out whether an increase in price, quantity, or both causes a rise in GDP, economists keep price constant. If price stays constant, then any rise in GDP must be due to a rise in quantity. Economists keep price constant by using the price that existed in one particular year in the past. This year is called the base year. GDP that is measured in base-year prices is real GDP. When real GDP is computed, the outputs of different years are priced at base-year levels. Recall that GDP is measured using price in the current year multiplied by quantity in the current year. In contrast, real GDP is measured using price in the base year multiplied by quantity in the current year. Economists prefer working with real GDP to working with GDP. They know that if real GDP in one year is higher than real GDP in another year, output is greater in the year with the higher real GDP.