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In order to analyze the health of an economy or examine economic growth, it's necessary to have a way to measure the size of an economy. Economists usually measure the size of an economy by the amount of stuff it produces. This makes sense in a lot of ways, mainly because an economy's output in a given period of time is equal to the economy's income, and the economy's level of income is one of the main determinants of its standard of living and societal welfare.
It may seem strange that output, income, and expenditure (on domestic goods) in an economy are all the same quantity, but this observation is simply the result of the fact that there is both a buying and a selling side to every economic transaction. For example, if an individual bakes a loaf of bread and sells it for $3, he has created $3 of output and made $3 in income. Similarly, the buyer of the loaf of bread spent $3, which counts in the expenditure column. The equivalence between overall output, income and expenditure is simply a result of this principle aggregated over all of the goods and services in an economy.
Economists measure these quantities using the concept of Gross Domestic Product. Gross domestic product, commonly referred to as GDP, is the "market value of all final goods and services produced within a country in a given period of time." It's important to understand precisely what this means, so it's worth giving some thought to each of the definition's components:
GDP Uses Market Value
It's pretty easy to see that it doesn't make sense to count an orange the same in GDP as a television, nor does it make sense to count the television the same as a car. The GDP calculation accounts for this by adding up the market value of each good or service rather than adding up the quantities of the goods and services directly.
Although adding up market values solves an important problem, it can also create other calculation problems. One problem arises when prices change over time since the basic GDP measure doesn't make it clear whether changes are due to actual changes in output or just changes in prices. (The concept of real GDP is an attempt to account for this, however.) Other problems can arise when new goods enter the market or when technology developments make goods both higher quality and less expensive.
GDP Counts Market Transactions Only
In order to have a market value for a good or service, that good or service has to be bought and sold in a legitimate market. Therefore, only goods and services that are bought and sold in markets count in GDP, even though there may be a lot of other work being done and output being created. For example, goods and services produced and consumed within a household don't count in GDP, even though they would count if the goods and services were brought to the marketplace. In addition, goods and services transacted in illegal or otherwise illegitimate markets don't count in GDP.
GDP Only Counts Final Goods
There are many steps that go into the production of virtually any good or service. Even with an item as simple as a $3 loaf of bread, for example, the price of the wheat used for the bread is perhaps 10 cents, the wholesale price of the bread is maybe $1.50, and so on. Since all of these steps were used to create something that was sold to the consumer for $3, there would be a lot of double counting if the prices of all of the "intermediate goods" were added into GDP. Therefore, goods and services are only added into GDP when they have reached their final point of sale, whether that point is a business or a consumer.
An alternate method of calculating GDP is to add up the "value added" at each stage in the production process. In the simplified bread example above, the wheat grower would add 10 cents to GDP, the baker would add the difference between the 10 cents of the value of his input and the $1.50 value of his output, and the retailer would add the difference between the $1.50 wholesale price and the $3 price to the end consumer. It's probably not surprising that the sum of these amounts equals the $3 price of the final bread.
GDP Counts Goods at the Time They Are Produced
GDP counts the value of goods and services at the time they are produced, not necessarily when they are officially sold or resold. This has two implications. First, the value of used goods that are resold doesn't count in GDP, though a value-added service associated with reselling the good would be counted in GDP. Second, goods that are produced but not sold are viewed as being purchased by the producer as inventory and thus counted in GDP when they are produced.
GDP Counts Production Within an Economy's Borders
The most notable recent change in measuring an economy's income is the switch from using gross national product to using Gross Domestic Product. In contrast to gross national product, which counts the output of all of an economy's citizens, Gross Domestic Product counts all output that is created within the borders of the economy regardless of who produced it.
GDP Is Measured Over a Specific Period of Time
Gross Domestic Product is defined over a specific period of time, whether it be a month, a quarter, or a year.
It's important to keep in mind that, while the level of income is certainly important to the health of an economy, it's not the only thing that matters. Wealth and assets, for example, also have a significant effect on the standard of living, since people not only buy new goods and services but also get enjoyment from using the goods that they already own.