Question

Which of the following transactions are included in gross domestic product, and by how much does each raise GDP? a. Smith pays a carpenter \(\$ 50,000\) to build a garage. b. Smith purchases \(\$ 10,000\) worth of materials and builds himself a garage, which is worth \(\$ 50,000\). c. Smith goes to the woods, cuts down a tree, and uses the wood to build himself a garage that is worth \(\$ 50,000\) d. The Jones family sells its old house to the Reynolds family for \(\$ 400,000\). The Joneses then buy a newly constructed house from a builder for \(\$ 500,000\). e. You purchase a used computer from a friend for \(\$ 200\). f. Your university purchases a new mainframe computer from IBM, paying \(\$ 25,000\). g. You win \(\$ 100\) in an Atlantic City casino. h. You make \(\$ 100\) in the stock market. i. You sell a used economics textbook to your college bookstore for \(\$ 60\). j. You buy a new economics textbook from your college bookstore for \(\$ 100\).

Short answer

Answer: The transactions that raise GDP and their respective amounts are as follows: a. Smith pays a carpenter to build a garage: raises GDP by $50,000. b. Smith purchases materials and builds himself a garage: raises GDP by $50,000. c. Smith uses a tree to build himself a garage: raises GDP by $50,000. d. Jones family buys a newly constructed house: raises GDP by $500,000. f. University purchases a new computer: raises GDP by $25,000. j. Buying a new textbook: raises GDP by $100.

Step-by-step solution

a. Smith pays a carpenter to build a garage.

Since the carpenter provides a service of building the garage and the garage is a newly constructed good, this transaction raises the GDP by $50,000.

b. Smith purchases materials and builds himself a garage.

In this case, Smith undertakes a do-it-yourself project. Even though Smith built the garage himself, it should still be a part of the GDP. The addition to GDP is the value of the final good, which is $50,000.

c. Smith uses a tree to build himself a garage.

In this scenario, Smith creates a good (garage) and the value-added method should be used. This method would include the value of what Smith has produced minus the value of the intermediate goods used (the tree). As no cost is given for the tree, the increase in GDP would be the value of the garage, which is $50,000.

d. Jones family sells and buys homes.

The sale of the old house does not raise GDP because it involves the resale of goods already produced. However, the purchase of the newly constructed house contributes to GDP. This increases GDP by $500,000.

e. You purchase a used computer.

The transaction from purchasing a used computer does not raise GDP because it is not the production of a new good or service.

f. Your university purchases a computer.

The purchase of a new mainframe computer by the university is considered a new investment, thus contributing to GDP. This raises GDP by $25,000.

g. You win \(100 in a casino.

The \)100 winnings from the casino are considered a transfer of money and do not involve the production of any new goods or services. Thus, it does not affect GDP.

h. Making $100 in the stock market.

Similar to the casino winnings, the earnings from the stock market are considered a transfer of money instead of the production of new goods or services. This does not raise GDP.

i. Selling a used textbook.

The sale of a used textbook does not raise GDP because it is a transaction involving resale of already produced goods.

j. Buying a new textbook.

The purchase of a new textbook is considered a new consumption, and therefore, contributes to GDP. This raises GDP by $100.

Key concepts

GDP Components

Gross Domestic Product (GDP) is a comprehensive measure of a country's economic activity. It is the total market value of all final goods and services produced within a country in a specific time period. To understand GDP more fully, it is essential to know its components, often abbreviated as C+I+G+(X-M).

• Consumption (C): This represents the total value of all goods and services consumed by households. This includes spending on merchandise, services, dwellings, and utilities, among others.
• Investment (I): This includes business expenditures on equipment and structures, residential construction, and change in inventories. It also includes the purchase of new computers and software by firms or universities, such as in step 6 of our exercise.
• Government purchases (G): These are goods and services consumed by the government, such as military equipment and public salaries.
• Net exports (X-M): This is the total value of a country's exports minus its imports. Exporting goods and services can increase GDP, while importing subtracts from it.

While calculating GDP, it's important to exclude financial transactions like stock market gains (step 8), and resales of goods (steps e and i). The inclusion of the newly constructed items like the garage (step 1) and new textbook (step 10) exemplify how GDP accounts for new production in the economy.

Economic Transactions

Economic transactions included in the calculation of GDP are those that involve the production of new goods and services within a country during a given period. Transactions that do not correspond to a new production, like used goods sales or purely financial transactions, do not contribute to the GDP.

As seen in the exercise, the construction of a new garage (step 1) or a new house (step 4) adds value to GDP because they are new productions. Similarly, a new computer (step 6) or textbook (step 10) contribute to the Investment and Consumption components, respectively. Meanwhile, selling a used computer (step 5), gambling winnings (step 7), making money in the stock market (step 8), or selling a used textbook (step 9) do not affect GDP because these activities do not represent the production of new goods and services.

Value-Added Method

Another way to look at GDP is through the 'value-added' method. This approach totals the value added at each stage of production for all goods and services. 'Value added' refers to the additional value created at each stage of production, which is the sale price less the cost of intermediate goods. The total of value added across all producers is the GDP.

The concept is exemplified in part c of the exercise, where Smith cuts down a tree and builds a garage. The value-added is the market value of the garage minus the cost of the tree (which is not specified). Since we're considering the implementation of GDP, the market value of the final good, the garage, is added to GDP even though no explicit intermediate cost is given (step 3). It is also important to note that to avoid double counting, only final goods and services' values are considered, not those of intermediate goods.

Final Goods and Services

Final goods and services are those which have been purchased for final use and not for resale or further processing. They are what consumers ultimately buy, use, and include in GDP calculation. These contrast with intermediate goods, which are used to produce other goods and are not counted separately in GDP.

When looking at steps a, b, and c of the exercise, we focus on the value of the final good – in this case, the built garage – which is considered in the GDP calculation. In step j, the purchase of a new textbook represents consumption of a final good. On the other hand, the transaction involving the old house in step d only includes the newly constructed house in GDP because the old house is not a new production. Understanding the distinction between final goods and the non-inclusion of intermediate goods or resale items helps to avoid overestimation of GDP.