The very small country of Absurdia is famous for two things: beer steins and flugelhorns. As a matter of fact, they produce nothing else. The following is the total of how much of each they made in the years 2020 and 2019.
Quantity 2020 | Quantity 2019 | |
Steins | 100,000 | 200,000 |
Flugelhorns | 50,000 | 25,000 |
Total | 150,000 | 225,000 |
Apparently Absurdia produced 33% fewer items in 2020 than they did in 2019. But does that mean they were worse off? While they did produce twice as many steins in 2019, they also produced only half as many flugelhorns. Which matters more? To determine whether Absurdia is doing better or 55worse than in 2019, we have to “weight” these two items according to how important they are. Common practice is to use market price as a measure of customer value. We’ll do that here. A stein sells for 20 Absurd Dollars ($10) while a flugelhorn sells for $200.
Quantity 2019 | Price | Value 2019 | |
Steins | 200,000 | $20 | $4,000,000 |
Flugelhorns | 25,000 | $200 | $5,000,000 |
Total | 225,000 | $9,000,000 |
Quantity 2020 | Price | Value 2020 | |
Steins | 100,000 | $20 | $2,000,000 |
Flugelhorns | 50,000 | $200 | $10,000,000 |
Total | 150,000 | $12,000,000 |
And so, while it’s true that Absurdia produced many fewer items in 2020, the bundle of items it did produce was much more valuable. To see this, imagine if Absurdia sold all these additional flugelhorns to other countries. They’d generate an additional $5 million. How many more steins could they buy from these other countries with that $5 million? 250,000! That’s way more than the 100,000 fewer they produced.
Consider South Korea and Guatemala. In 2019 Guatemala produced literally billions of bananas. South Korea produced only 4 million automobiles. But automobiles are very valuable, while bananas are not. And so, median household income in Guatemala was only around $4,500 while it was roughly 10 times that in South Korea. It’s not how many things you produce that matters. It’s the value of what you produce that matters.
Gross Domestic Product
To measure the relative economic well-being of a nation, economists rely heavily on this value-weighted approach. Gross Domestic Product (GDP) is such a value-weighted measure of economic activity. While it has its limitations, and even a few drawbacks, GDP does seem to correlate fairly well with material standard of living. So, let’s give it a look.
Gross Domestic Product (GDP) is the market value of all final goods and services produced domestically during some specified period of time (typically one year).
Market Value – As described above, countries produce a wide variety of items. And some of these items are much more valuable than others (e.g. microwave ovens versus microwave dinners). And so, to determine the value of a given country’s economic activity these items must be somehow weighted. We use market value (or price) because it’s the best approximation we have to genuine consumer value. But do be aware. Markets are imperfect and so market prices are as well. A professional athlete may earn as much as all the teachers in a public elementary combined. But does that really make her or him more valuable than these teachers?
Final Goods and Services – We limit the items we include in our measure. For example, the production of a flugelhorn in turn requires the production of brass. But the value of this brass is imbedded in the price of the flugelhorn. To count both the brass and the flugelhorn in our GDP would be to count it twice. So, only goods and services that won’t be used to produce another good or service count.
Produced Domestically – This is somewhat arbitrary. We used to do it the other way. Do we care how much is produced by the brave citizens of Absurdia, wherever in the world they may be? Or do we care about how much is produced within the country of Absurdia, regardless of by whom? GDP assumes the latter. And perhaps with good reason. If my primary concern is with finding a job, I don’t much care if my employer is Ford Motor or Nissan. Similarly, if a Japanese citizen is working in the US, renting an apartment in the US, buying food and other goods in the US, it’s the US economy that benefits, not the Japanese economy. There are reasons why sometimes we do it the other way (referred to as Gross National Product), but they mostly relate to Finance and don’t have any bearing here.
Specified Period of Time – This is also arbitrary. If someone tells you they make $10,000, that could be great, or troublesome. If they make $10,000 per year and can’t rely on anyone else, they’re going to have a hard time. But if they make $10,000 a month, they’re doing okay. Comfortably middle-class. And if they’re making $10,000 a week, they’re killing it. Generally, GDP is reported as annual figure. But this is just by convention, so we don’t confuse one another.