No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Eighteen: The “macro” view of the economy 451 production is consumption. However, final consumption is an unrepresentative measure of economic activity. Much of our economic activity is to produce intermediate goods (which will subsequently be used in the production of final goods), so GDP only includes final goods to avoid double counting. To see why this matters, let’s imagine a simple pencil. Say that total annual pencil production valued at $20M is sold to consumers, but there is $10M of wood that was used in the pencils, as well as $5M of graphite, $1M in erasers and brass, with $500K in yellow paint. If we include all of these venders that supply the raw materials to pencil manufacturers in our GDP calculation, at the end of the year, all the firms together would have $36.5M in sales. But we only count the $20M in final sales as part of GDP. Why? Because the $20M in sales prices of the final product includes the $16.5M in costs of materials the pencil manufacturers had to pay. To count all of the economic activity would be to count the value of the intermediate activities twice . Yet to think of the final producer of the pencils as responsible for all $20M is equally misleading—pencil manufacturers effectively consumed $16.5M. This shows that the dominant focus on consumption as the most important part of the economy is misleading— if you are concerned about understanding the locus of economic activity. The next category in GDP is investment, which includes all business spending on goods and services that will increase the productive capacity of the firm in the future. It could include hardware and software—anything that increases future productive capacity. The category of investment also includes one major consumer item: new housing. When a new house is constructed—even when sold to an individual—it is assumed the house will provide a flow of housing services over many years; therefore it is counted as investment. Sales of existing houses, however, are not included in GDP (except the portion of the price of the sale that would go to real estate agents or banker’s fees), because the purchase of an existing home is merely a transfer. You might ask why only houses are treated this way. Why not other durable consumer goods such as washing machines or furnaces? There is no particularly good reason; ultimately it is a judgment call of the Bureau of Economic Analysis (the government agency that creates the GDP statistic). They chose to include housing in investment rather than consumption—but their choice makes no difference to the total value of GDP. For further information, the interested reader can find a nice primer on GDP calculation here. Finally we consider Net Exports, which is simply the amount of exports minus the amount of imports. The U.S. has large and growing imports and exports; globalization is transforming the U.S. economy as it is the rest of the world. Exports are goods and services that we produce to sell to citizens of foreign nations, while imports are foreign goods and services that we consume. We add exports to GDP since exports are domestic production , but we have to subtract that value of spending on imports, since that represents foreign production . The GDP total from each category, with relative importance, is shown in Figure 18.4 , from BEA data. We can formally define GDP as the market value of all final goods and services produced in a country during a given time period. Let’s briefly review the definition, paying close