GDP Examined

So what is so important about GDP, and why do we economists fret about it so much?

For pretty much the same reason that parents agonize over the grades that their children get in school. Grades may not be the perfect indicator of how well a child is doing, but they do happen to be universally accepted, and remain a useful method of comparing how well your child has done compared to your neighbour's.

In much the same fashion, GDP is not a perfect, all-encompassing measure for getting an idea about how well a nation did in the year past, but it is one that every country uses, and it serves as a useful guide when you run comparisons with other nations.

So how does one go about calculating GDP? One simply sums up, as I said in the previous post, all of the economic activity that went on in the economy in one accounting period. As you can imagine, however, things can get pretty complicated.

For example, economic activity by definition is a transaction. So first of all, care should be taken to ensure that you are counting all sales, or all purchases, and not some mixture of the two. In fact, when researchers step out to 'measure' GDP, they use both methods.

GDP is measured using both the expenditure and the income method. Either sum up all of the expenditures in an economy - whether done by firms, households, governments, or sum up incomes of firms, households and governments. We will, for the moment, ignore the international economy, although that is a complication we'll come back to in great detail shortly.

A third measure that is usually preferred when dealing with industrialized economies (pretty much every country in the world today, really) is known as the value-added approach. The idea in this case - and you want to follow this notion through very carefully indeed - is that GDP is nothing but the value added at each stage, taking care to not count value added in earlier stages.

For example, if you were to eat, say, a sandwich purchased from a deli, you would be eating a final product (the sandwich) which was made by purchasing a lot of other products. The meat in the sandwich, for example, has already been accounted for as income for the butcher or expenditure by the shop that purchased the meat. What should really be counted is the value added by the restaurant in cooking the meat and packaging it nicely enough within two slices of bread for you to want to eat it.

Avoiding, or not counting value produced in earlier stages of production circumvents the problem of double counting, which would inflate the total production in an economy far beyond it's actual quantity.

So there you have the three measures of GDP. In the next post, we'll think through some additional nuances that arise in the calculation of this (increasingly complicated) metric.

The Model: Part II

Economics is essentially a study of trade.

You are, for example, trading time that you could have spent playing Angry Birds in exchange for time spent spent reading this blog. When you go to work for a firm, you are trading your free time in exchange for getting paid for work done. The firm is trading the money that it pays you in exchange for whatever role you fulfill in the production of whichever goods your firm makes. And so on and so forth.

Trade takes place only when both parties sense they will benefit from the transaction. The more trade there is in an economy, the more benefits there are to the economy - this is what we mean when we say economies grow.

Identifying the trading parties as households, firms, governments, the international economy and the financial system, and thereby distinguishing one from the others enables us to understand which part of the economy is responsible for growth in the economy.

Before we go deeper into our model though, let's tackle a fairly important concept early on - what do we mean when we say growth in the economy? How can one measure how much an economy has grown?

Economists usually account for growth in an economy by measuring something called GDP - a concept you'll hear bandied about in newspapers often enough. GDP, or Gross Domestic Product is a concept often used, and oftener misunderstood.

In terms of our model, it simply is the adding together all the economic activity that households, firms, governments and financial systems do, and netting out the influence of the international economy. That's GDP.

Yes, but over what duration of time? Are we taking about the economic activity done in a day? A month? A year?

The numbers that you hear about in newspapers, news channels and the like usually refer to either annual GDP, or quarterly GDP - that is, all of the economic activity that goes on in our little world, as measured over a year.

This might seem like a fairly easy concept to understand at first blush, and it actually isn't all that difficult to grasp. The difficulties begin when one starts thinking about the nuances, which is what we shall do the next time around.

One Model To Explain It All. Well, Almost All.

We're going to learn about the circular flow of income model today. Or at least, that's what we economists call it.

In more simple, less convoluted English, we're going to learn about a model that is seemingly simple, yet retains the power to shed light on the most complicated concepts in economics. Get a grasp of what's going on here, and you are halfway through to Mount Economics Nirvana.

Promise.

Here goes: economists tend to view the world through a special lens. Through this lens, the world appears grouped into certain categories. These are, in no particular order: households, firms, the government, the international economy and the financial system.

Any economic interaction in the real world is necessarily going to involve two or more of the entities above. If you step out of your house (households) to buy groceries (firms), you have done a transaction that is of interest to a member of my tribe. If the grocer (firms) was present at the local wholesale market (firms) to stock up his vegetables, the grocer was party to a transaction that is of interest to a member of my tribe.

If both you (households) and the grocer (firms) paid taxes (government) - and so on.

Economists like to focus on any one of these entities in isolation and study their particular (and often peculiar) characteristics. Focusing on households alone, for example, might lead economists to ask questions along the lines of "Will the demand for coffee go down if the price of sugar rises? If yes, to what extent?". We would be talking about microeconomics in this case, and particularly the case of consumer equilibrium.

Focusing on firms, on the other hand, would lead to questions along the lines of "Given that workers expect me to pay 100 rupees every hour, and the cost of renting a bulldozer is 1000 rupees for the day, what combination of workers and bulldozers should I be hiring in order to get my work done?". That would be microeconomics again, and particularly the case of producer equilibrium.

A laser like focus on governments would land you in the realm of public economics, while the study of those features that arise out of international trade falls under the domain of international economics. Behavioral economics, a field of study that is proving to be extremely exciting (and counter-intuitive), would focus on consumers and their inherent irrationality.

The point is this: any subject within economics can be quite neatly, and satisfactorily slotted into any of the entities we just spoke about.

Here's where economics gets really interesting though - the study of each of these in isolation is one thing. Studying the big picture - the whole thing - at one go can be unbelievably messy, unpredictable and (surprise, surprise) controversial. That would be the field of macroeconomics, and one which is going through a bit of an existentialist crisis at the moment.

But we're getting ahead of ourselves.

In the next post, we'll examine our model a little more thoroughly. And cross those other bridges when we come to them.

Economics Explained

I used to teach economics for a living, not such a long time ago.

It was mostly introductory economics, although I taught some specialized courses as well. And teaching those courses, particularly the former, led me to realize that there is no freely available, easily accessible online resource that serves as a good introduction to various aspects of economics.

Sure, there are textbooks aplenty (some funnier than most), and sure there are books that do a very good job indeed of introducing the subject in plain simple English, but they are not as broad, all-encompassing and topical as a blog can (in theory!) be.

The purpose of this blog, then, is to fill that lacunae. It is to explain economics.The idea is to explain different concepts in economics by writing about them, and by applying these concepts to current events in the world around us.

Not that there aren't blogs that fulfill such ambitions already, of course. In fact, one might quite successfully argue that there is a surfeit of them.

How then, is this blog any different? Well, for the first part, maybe it isn't. It is my take on economic theory and its application, and where there a million blogs on the subject, what's one more?

For the second part, I'd like to think it is different (wouldn't we all?). It is different in the sense that my primary endeavor will be to explain economic theory , and that in as simplistic a manner as possible. Anybody who has had no formal training in economics whatsoever should be able to understand any post on this blog without using anything more than her grey cells. Or at most, by clicking through to other posts on this blog.

Too ambitious an aim, perhaps?

Well, we shall see.