EDIT 12ce Ch20

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Chapter 20
The Measurement of
National Income
Copyright © 2008 Pearson Education Canada

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In this chapter you will learn
1. how the concept of value added solves the problem of

“double counting” when measuring national income.
2. the income approach and the expenditure approach to

measuring national income.
3. the difference between real and nominal GDP and the

meaning of the GDP deflator.

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In this chapter you will learn
4. about the many important omissions from official measures

of GDP.
5. why real per capita GDP is a good measure of average

“material” living standards but an incomplete measure of
overall “well-being.”

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20.1 NATIONAL OUTPUT

AND VALUE ADDED
Production occurs in stages — most firms produce outputs

that are other firms’ inputs
- intermediate products
- final products
Each firm’s contribution to total output is its value added

= revenues - non-labour costs

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Summing value added avoids the problem of double counting

when measuring total output.
Total value added in the economy is called Gross Domestic

Product (GDP).
APPLYING ECONOMIC CONCEPTS

20-1
Value Added Through Stages of
Production
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20.2 NATIONAL INCOME ACCOUNTING:

THE BASICS
Three methods for measuring national income (output):
• total value added from domestic production

• total expenditures on domestic output
• total income generated by domestic production
Because of the circular flow of income, these three measures

yield the same total — GDP.

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Start with a very simple economy
Domestic Households
Factor income: Revenue from

wages, rents, profits Domestic Firms sales of final G & S

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How does household income actually get used up?
Domestic Households Imports
Savings Consumption
Taxes


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Do any other agents buy final G & S from Cdn firms?
Domestic Households
Investment
Consumption
Governments
Foreigners
(Exports)


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GDP from the Expenditure Side

Consider adding up the expenditures needed to purchase the
final output produced in any given year.
There are four broad expenditure categories:

- consumption
- investment
- government purchases
- net exports
Actual consumption expenditure (Ca) includes expenditure

on all final goods during the year.
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Actual investment expenditure (Ia) is expenditure on the

production of goods not for present consumption, including:
• inventories
• plant and equipment
• residential housing
Actual government purchases (Ga) are the purchases of

currently produced goods and services by the government
- excluding transfer payments.

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Actual net exports (NXa) is the difference between exports and

imports: NXa = (Xa - IMa)
Exports are purchases of Canadian-produced goods and

services by foreigners. We subtract imports because they are
not produced in Canada.
Since total domestic output must equal total expenditure on

domestic output, we have:
GDP = Ca + Ia + Ga + NXa

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Ca + Ia + Ga + (Xa - IMa)
= GDP
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Does the accounting identity
GDP = Ca + Ia + Ga + (Xa - IMa)
imply that everything that firms produce each

year is automatically sold to customers?
NO! INVENTORIES!
INVENTORIES!
INVENTORIES!

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GDP from the Expenditure Side: 2005
Category $billion % of GDP

Consumption $761.9 55.7
Government purchases 254.4 18.6
Investment 297.6 21.7
Net exports 54.3 4.0
Statistical discrepancy 0.7 0.0
$1368.9 100.0
Total
Source: Statistics Canada website: www.statcan.ca. Go to “Canadian Statistics” and click on “Economic
Conditions” and then “National accounts.”

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GDP from the Income Side

GDP is also the sum of factor incomes and other claims on
the value of output.
Factor incomes include:

- wages net domestic
income
- rent, interest, and profits
Non-factor payments include:

- indirect taxes (net of subsidies)
- depreciation of existing physical capital

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GDP from the income side is therefore equal to:
GDP = Net domestic income +

Indirect taxes (less subsidies) +
Depreciation
EXTENSIONS IN THEORY 20-1

Arbitrary Decisions in National
Income Accounting

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GDP from the Income Side: 2005 Billions of $ % of GDP
Factor Incomes
Wages, salaries and supplementary income 678.9 49.6%
Interest and miscellaneous investment income 61.2 4.5%

Business profits (including net income of 293.1 21.4%
farmers and unincorporated businesses)
1033.2 75.5%
Net Domestic Income at factor cost
Non Factor Payments

Depreciation 181.4 13.3%
Indirect taxes less subsidies 154.7 11.3%
Statistical discrepancy -0.4 -0.0%
1368.9 100.0 %
Total
Source: Statistics Canada website: www.statcan.ca. Go to “Canadian Statistics” and click on “Economic
Conditions” and then “National accounts.”
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Wages + Rent + Interest + Profits Ca + Ia + Ga + (Xa - IMa)

+ Indirect taxes + Depreciation
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What goes into the firm’s revenue must come out as wages,
rent, interest, profits, indirect taxes or depreciation.
The total revenue of all Canadian firms (the total expenditure

on Canadian final goods and services) must equal the total
value of factor payments plus indirect taxes and depreciation.
Therefore as accounting identities it must be true that:

Ca + Ia + Ga + (Xa - IMa) = Wages + Rent + Interest
+ Profits + Indirect taxes
+ Depreciation
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20.3 NATIONAL INCOME ACCOUNTING:

SOME EXTRA ISSUES
GDP and GNP

A measure of national output closely related to GDP is Gross
National Product (GNP).
The difference between GDP and GNP is the difference

between income produced and income received.
Income produced in Canada

versus income received by Canadians

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GDP is superior as a measure of domestic economic activity.
GNP is superior as a measure of living standards of residents.
A more “refined” measure is disposable personal income:
It equals GNP minus:

- any part not actually paid to households
- personal income taxes
- plus transfer payments received by households

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Real and Nominal GDP
GDP that is valued at constant base-period prices is real

national income.
Nominal GDP
GDP Deflator = x 100
Real GDP
The GDP deflator is a very comprehensive index of prices

because it includes the prices of all goods and services
produced in the country.

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Do the CPI and the GDP

Deflator Move Together?
Broadly, the two price indexes move together,

due to underlying inflationary forces. But
because one tracks consumer prices and the
other tracks the prices of goods produced in
Canada, there will be some differences.
APPLYING ECONOMIC CONCEPTS

20-2
Calculating Nominal and Real
GDP
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Output and Well Being

The rise in real GDP over the past century has had two main
causes:
1. The increase in the amount of land, labour, and capital

used in production, and
2. An increase in the amount of output produced per unit of
input.
Per capita output is the amount of output per person — it is
computed by dividing GDP by total population. It measures
the average output (and income) per person (but tells us
nothing about how that income is distributed across people).
GDP per capita in 2005 was $42,548
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A better way of assessing average living standards is to consider

measures of productivity. For example, GDP divided by the number
of employed persons tells us the average output per employed
person. This is one measure of labour productivity.
GDP divided by the total number of hours worked measures output
per hour of labour input, and provides a second measure of labour
productivity.
GDP per worker in 2005 was $79,868
GDP per hour worked in 2005 was $45.99

Changes in overall living standards are better reflected by changes
in productivity than by changes in GDP per capita.
GDP and related measures of national income must be interpreted

with their limitations in mind. What are these limitations?

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Omissions from GDP
National income accountants cannot measure economic

activity that takes place outside of regular, legal markets:
• illegal activities
• Leisure (consumption of non-work time)
• the underground economy (tax & regulation avoidance)
• home production (non-market activity)
• economic “bads” (pollution)

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Unless the unmeasured economic activity changes rapidly,

changes in GDP will do a reasonable job of measuring
changes in material living standards.
GDP and Living Standards

“Well-being” is a broader concept than material living
standards:
- GDP is not a complete measure of economic well-

being
- but income is a very important part of well-being

and GDP is a good measure of income.

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How useful are the various measures of

GDP?
They are very useful for tracking the year-to-year changes in
the level of economic activity (market activity).
They are useful in tracking changes in economic activity,

productivity, etc. over the longer term in a given country.
But remember, GDP measures only what goes through

markets – what is bought and sold.

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How useful are the various measures of

GDP?
Are they good measures of the level of human wellbeing
(happiness) in a society? Only in a limited sense – material,
market activity, with no consideration of things like pollution.
Are they good measures of the change in the level of
material wellbeing over time? Maybe, but care must be taken
in making such an interpretation. (war, more labour force
participation, degree of marketization, etc.)
Do they provide the basis for comparing the level of material

wellbeing across different countries? Only if the counties are
of very similar in a deeper structural sense (Canada and the
US or France maybe ok but Canada and Nigeria or Bolivia
probably not.
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EDIT 12ce Ch20

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1 of 34

Copyright © 2008 Pearson Education Canada

In this chapter you will learn

1. how the concept of value added solves the problem of

2. the income approach and the expenditure approach to

3. the difference between real and nominal GDP and the

Copyright © 2008 Pearson Education Canada

In this chapter you will learn

4. about the many important omissions from official measures

5. why real per capita GDP is a good measure of average

Copyright © 2008 Pearson Education Canada

20.1 NATIONAL OUTPUT

Production occurs in stages — most firms produce outputs

Each firm’s contribution to total output is its value added

Copyright © 2008 Pearson Education Canada

Summing value added avoids the problem of double counting

Total value added in the economy is called Gross Domestic

APPLYING ECONOMIC CONCEPTS

20.2 NATIONAL INCOME ACCOUNTING:

Three methods for measuring national income (output):

• total value added from domestic production

Because of the circular flow of income, these three measures

Copyright © 2008 Pearson Education Canada

Start with a very simple economy

Factor income: Revenue from

Copyright © 2008 Pearson Education Canada

How does household income actually get used up?

Domestic Households Imports

Factor income: Revenue from

Copyright © 2008 Pearson Education Canada

Do any other agents buy final G & S from Cdn firms?

Factor income: Revenue from

Copyright © 2008 Pearson Education Canada

Copyright © 2008 Pearson Education Canada

GDP from the Expenditure Side

There are four broad expenditure categories:

Actual consumption expenditure (Ca) includes expenditure

Actual investment expenditure (Ia) is expenditure on the

Actual government purchases (Ga) are the purchases of

- excluding transfer payments.

Copyright © 2008 Pearson Education Canada

Actual net exports (NXa) is the difference between exports and

Exports are purchases of Canadian-produced goods and

Since total domestic output must equal total expenditure on

Copyright © 2008 Pearson Education Canada

Does the accounting identity

GDP = Ca + Ia + Ga + (Xa - IMa)

imply that everything that firms produce each

Copyright © 2008 Pearson Education Canada

GDP from the Expenditure Side: 2005

Category $billion % of GDP

Copyright © 2008 Pearson Education Canada

Copyright © 2008 Pearson Education Canada

GDP from the Income Side

Factor incomes include:

Non-factor payments include:

Copyright © 2008 Pearson Education Canada

GDP from the income side is therefore equal to:

GDP = Net domestic income +

EXTENSIONS IN THEORY 20-1

Copyright © 2008 Pearson Education Canada

GDP from the Income Side: 2005 Billions of $ % of GDP

Interest and miscellaneous investment income 61.2 4.5%