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On the right-hand side, we have the sum of all fac-
Notice that national income is a measure of the fac-
tor incomes: payments to labor, land, and capital. On
tor incomes of all Americans, regardless of whether
the left-hand side, we have total sales minus sales of
they work in this country or somewhere else. Like-
intermediate goods. This means that we have sales of
wise, incomes earned by foreigners in the United
final goods, which is precisely our definition of GDP.
States are excluded from (our) national income. We
Thus, the accounting identity for the entire economy
will return to this distinction shortly.
can be rewritten as follows:
But, reading down Table 4, we next encounter a
GDP 5 Wages 1 Interest 1 Rents 1 Profits
new concept: net national product (NNP), a meas-
This definition gives national income accountants an- ure of production. For reasons explained in the chap-
other way to measure the GDP. ter, NNP is conceptually identical to national
Table 4 shows how to obtain GDP from the sum of income. However, in practice, national income ac-
all incomes. Once again, we have omitted a few details countants estimate income and production independ-
in our discussion. By adding up wages, interest, rents, ently; and so the two measures are never precisely
and profits, we obtain only $11,180 billion, whereas equal. The difference in 2007 was $29 billion, or
GDP in 2007 was $13,841 billion. When sales taxes, ex- just 0.2 percent of NNP; it is called the statistical
cise taxes, and the like are added to the sum of wages, discrepancy.



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Chapter 8 171
Aggregate Demand and the Powerful Consumer



Moving further down the table, the only difference upsetting the economy™s performance, the average
between NNP and gross national product (GNP) is worker would get a raise of about 20 percent!
depreciation of the nation™s capital stock. Thus the
adjective “net” means excluding depreciation, and GDP AS THE SUM OF VALUES ADDED
“gross” means including it. GNP is thus a measure of
all final production, making no adjustment for the fact It may strike you as strange that national income ac-
that some capital is used up each year and thus needs countants include only final goods and services in
to be replaced. NNP deducts the required replace- GDP. Aren™t intermediate goods part of the nation™s
ments to arrive at a net production figure. product? Of course they are. The problem is that, if all
intermediate goods were included in GDP, we would
Depreciation is the value of the portion of the nation™s
wind up double- and triple-counting certain goods
capital equipment that is used up within the year. It tells
and services and therefore get an exaggerated impres-
us how much output is needed just to maintain the
sion of the actual level of economic activity.
economy™s capital stock.
To explain why, and to show how national income
From a conceptual point of view, most economists
accountants cope with this difficulty, we must intro-
feel that NNP is a more meaningful indicator of the
duce a new concept, called value added.
economy™s output than is GNP. After all, the deprecia-
The value added by a firm is its revenue from selling a
tion component of GNP represents the output that is
product minus the amount paid for goods and services
needed just to repair and replace worn-out factories
purchased from other firms.
and machines; it is not available for anybody to con-
sume.10 Therefore, NNP seems to be a better measure The intuitive sense of this concept is clear: If a firm
of production than GNP. buys some inputs from other firms, does something to
Alas, GNP is much easier to measure because depre- them, and sells the resulting product for a price higher
ciation is a particularly tricky item. What fraction of his than it paid for the inputs, we say that the firm has
tractor did Farmer Jones “use up” last year? How much “added value” to the product. If we sum up the values
did the Empire State Building depreciate during 2007? added by all firms in the economy, we must get the
If you ask yourself difficult questions like these, you total value of all final products. Thus:
will understand why most economists believe that we
GDP can be measured as the sum of the values added by
can measure GNP more accurately than NNP. For this
all firms.
reason, most economic models are based on GNP.
The final two adjustments that bring us to GDP To verify this fact, look back at the accounting identity
return to a fact mentioned earlier. Some American citi- in the left column bottom of page 170. The left-hand side
zens earn their incomes abroad, and some of the pay- of this equation, sales revenue minus purchases from
ments made by American companies are paid to other firms, is precisely the firm™s value added. Thus:
foreign citizens. Thus, to obtain a measure of total pro-
Value added 5 Wages 1 Interest 1 Rents 1 Profits
duction in the U.S. domestic economy (which is GDP)
rather than a measure of the total production by U.S. Because the second method we gave for measuring
nationals (which is GNP), we must subtract the income GDP is to add up wages, interest, rents, and profits,
that Americans receive for factors supplied abroad we see that the value-added approach must yield the
and add the income that foreigners receive for factors same answer.
supplied here. The net of these two adjustments is a The value-added concept is useful in avoiding
very small number, as Table 4 shows. Thus, GDP and double-counting. Often, however, intermediate goods
GNP are almost equal. are difficult to distinguish from final goods. Paint
In Table 4, you can hardly help noticing the prepon- bought by a painter, for example, is an intermediate
derant share of employee compensation in total factor good. But paint bought by a do-it-yourselfer is a final
payments”about 70 percent. Labor is by far the most good. What happens, then, if the professional painter
important factor of production. The return on land is buys some paint to refurbish his own garage? The in-
well under 1 percent of factor payments, and interest termediate good becomes a final good. You can see
accounts for about 5 percent. Profits account for the re- that the line between intermediate goods and final
maining 24 percent, although the size of corporate goods is a fuzzy one in practice.
profits (just 12 percent of GDP in 2007) is much less If we measure GDP by the sum of values added,
than the public thinks. If, by some magic stroke, we however, we need not make such subtle distinc-
could convert all corporate profits into wages without tions. In this method, every purchase of a new good
or service counts, but we do not count the entire
selling price, only the portion that represents value
If the capital stock is used for consumption, it will decline, and the
10


added.
nation will wind up poorer than it was before.




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Part 2
172 The Macroeconomy: Aggregate Supply and Demand



To illustrate this idea, consider the data in Table 5 calculations enable us to come up with the right an-
swer ($10) by counting only part of each transaction.
and how they would affect GDP as the sum of final
products. Our example begins when a farmer who The basic idea is to count at each step only the contri-
grows soybeans sells them to a mill for $3 per bushel. bution to the value of the ultimate final product that is
This transaction does not count in the GDP because the made at that step, excluding the values of items pro-
miller does not purchase the soybeans for her own duced at other steps.
use. The miller then grinds up the soybeans and sells Ignoring the minor items (such as fertilizer) that the
the resulting bag of soy meal to a factory that pro- farmer purchases from others, the entire $3 selling
duces soy sauce. The miller receives $4, but GDP still price of the bushel of soybeans is new output pro-
has not increased because the ground beans are also duced by the farmer; that is, the whole $3 is value
an intermediate product. Next, the factory turns the added. The miller then grinds the beans and sells
beans into soy sauce, which it sells to your favorite them for $4. She has added $4 minus $3, or $1 to the
Chinese restaurant for $8. Still no effect on GDP. value of the beans. When the factory turns this soy
meal into soy sauce and sells it for $8, it has added $8
TA BL E 5 minus $4, or $4 more in value. Finally, when the
An Illustration of Final and Intermediate Goods restaurant sells it to hungry customers for $10, a fur-
Item Seller Buyer Price ther $2 of value is added.
The last column of Table 6 shows this chain of cre-
Bushel of soybeans Farmer Miller $3
ation of value added. We see that the total value added
Bag of soy meal Miller Factory 4
Gallon of soy sauce Factory Restaurant 8 by all four firms is $10, exactly the same as the restau-
Gallon of soy sauce rant™s selling price. This is as it must be, for only the
used as seasoning Restaurant Consumers 10
restaurant sells the soybeans as a final product.
Total: $25
Addendum: Contribution to GDP $10
TA BL E 6
An Illustration of Value Added
But then the big moment arrives: The restaurant
sells the sauce to you and other customers as a part of Value
Item Seller Buyer Price Added
your meals, and you eat it. At this point, the $10 worth
of soy sauce becomes part of a final product and does Bushel of
count in the GDP. Notice that if we had also counted soybeans Farmer Miller $3 $3
Bag of soy
the three intermediate transactions (farmer to miller,
meal Miller Factory 4 1
miller to factory, factory to restaurant), we would have
Gallon of
come up with $25”21„2 times too much.
soy sauce Factory Restaurant 8 4
Why is it too much? The reason is straightforward. Gallon of soy
Neither the miller, the factory owner, nor the restaura- sauce used
as seasoning Restaurant Consumers 10 2
teur values the product we have been considering for
Total: $25 $10
its own sake. Only the customers who eat the final
Addendum: Contribution to GDP
product (the soy sauce) have increased their material
Final Products $10
well-being, so only this last transaction counts in the Sum of values added $10
GDP. However, as we shall now see, value-added




| SUMMARY |
1. Gross domestic product (GDP) is the sum of the money constitute the national income and then add indirect
values of all final goods and services produced during a business taxes and depreciation.
year and sold on organized markets. There are, however, 4. A third way to measure the GDP is to sum up the values
certain exceptions to this definition. added by every firm in the economy (and then once
2. One way to measure the GDP is to add up the final de- again add indirect business taxes and depreciation).
mands of consumers, investors, government, and for- 5. Except for possible bookkeeping and statistical errors,
eigners: GDP 5 C 1 I 1 G 1 (X 2 IM). all three methods must give the same answer.
3. A second way to measure the GDP is to start with all fac-
tor payments”wages, interest, rents, and profits”that




Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Chapter 8 173
Aggregate Demand and the Powerful Consumer



| KEY TERMS |
National income accounting 168 National income 170 Depreciation 171
Gross domestic product Net national product Value added 171
(GDP) 168 (NNP) 170
Gross private domestic Gross national product
investment (I) 169 (GNP) 171


| TEST YOURSELF |
1. Which of the following transactions are included in the iii. Sales at Super Duper markets amounted to $14 million,
gross domestic product, and by how much does each all of it sold to consumers.
raise GDP? iv. All farmers in Trivialand are self-employed and sell
a. You buy a new Toyota, made in the United States, all of their wares to Super Duper.
paying $25,000. v. The costs incurred by all of Trivialand™s businesses
b. You buy a new Toyota, imported from Japan, paying were as follows:
$25,000.
Specific Motors Super Duper Farmers
c. You buy a used Cadillac, paying $12,000.
d. Google spends $500 million to increase its Internet Wages $3,800,000 $4,500,000 $ 0
capacity. Interest 100,000 200,000 700,000
Rent 200,000 1,000,000 2,000,000
e. Your grandmother receives a Social Security check
Purchases 0 7,000,000 0
for $1,500.
of food
f. Chrysler manufactures 1,000 automobiles at a cost of
$15,000 each. Unable to sell them, the company holds
3. (More difficult) Now complicate Trivialand in the fol-
the cars as inventories.
lowing ways and answer the same questions. In addi-
g. Mr. Black and Mr. Blue, each out for a Sunday drive,
tion, calculate national income and disposable income.12
have a collision in which their cars are destroyed.
a. The government bought 50 cars, leaving only 150 cars
Black and Blue each hire a lawyer to sue the other,
for export. In addition, the government spent
paying the lawyers $5,000 each for services rendered.
$800,000 on wages and made $1,200,000 in transfer
The judge throws the case out of court.
payments.
h. You sell a used computer to your friend for $100.
b. Depreciation for the year amounted to $600,000 for
2. The following outline provides a complete description
Specific Motors and $200,000 for Super Duper. (The
of all economic activity in Trivialand for 2007. Draw up
farmers had no depreciation.)
versions of Tables 3 and 4 for Trivialand showing GDP
c. The government levied sales taxes amounting to
computed in two different ways.11
$500,000 on Specific Motors and $200,000 on Super
i. There are thousands of farmers but only two big
Duper (but none on farmers). In addition, the govern-
business firms in Trivialand: Specific Motors (an auto
ment levied a 10 percent income tax on all wages, in-
company) and Super Duper (a chain of food mar-
terest, and rental income.
kets). There is no government and no depreciation.
d. In addition to the food and cars mentioned in Test
ii. Specific Motors produced 1,000 small cars, which it
Yourself Question 2, consumers in Trivialand im-
sold at $6,000 each, and 100 trucks, which it sold at
ported 500 computers from the United States at
$8,000 each. Consumers bought 800 of the cars, and
$2,000 each.
the remaining 200 cars were exported to the United
States. Super Duper bought all the trucks.




In Trivialand, net national product and net domestic product are
11

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