Narrator: In the last video we took a look at what is probably the simplest possible economy and it's not even clear that this economy is even possible; this one person economy. To make it more analogous to the real world where we have household and we have firms. In this one island this guy set up a firm and he essentially leashed out all of the factors of production to that firm, including his own labor. He leased it out, the rent on his labor is essentially his wages and then he bought all of the goods and services he needed from that same firm. So, his expenditures would be the revenue of that firm and then the revenue of that firm would be turned into the expenses and the profit of the firm, so whatever the revenue wasn't used in expenses ended up being profit. Then all of that went back to that one household as income. When we talked about how we would measure the economic activity in this island right over here, how would we measure its gross domestic product, we said, well look we could measure it in multiple different ways. As it's leaving his hands, the dollars that is going to the firm, you could view it as the total expenditures, or as it's approaching the firm that's the same thing as the total revenue for this firm, total revenue for this simplified, one firm economy. That total revenue is the same thing as the total expenses plus the profit for that firm. That's the same thing as this one households income. So, let me write this down. The way we looked at it in the last video, in the very simple example, GDP was equal to household, household expenditures which was equal to firm, firm revenues which was equal to firm expenses, expenses plus profit, which is equal to household income. (writing) household income, household .. I'll just write inc for income, household income. and of course household income is then, at least in this case right over here, it ended up being equal to household expenses. What I want to do in this video now is think about it in more general terms. Let's extend it to a more complex economy, to the world we live in and with that I want to look at the more formal definition for GDP. This is the more formal definition of GDP, or I guess you could say the definition of GDP and it's the market value of all final goods and services, and we're going to talk about what each of these things mean ... of all, of all final goods and services. I'll underline all separately, all final goods and services. Let me do that in a different color. ... all final goods and services produced within a country, produced within a country in a given period. You can have a GDP for a month, you could have a GDP for a quarter of a year which would be three months or you could have the GDP in a given year. I guess you could even have GDP over a 10 year period, but it tends to be we always think of GDP in terms of annual GDP or quarterly GDP or sometimes even ... so there are some estimates of even monthly GDP but it tends to be annually or quarterly. Let's parse a little bit more because these little terms can be interesting. The first one I'd like to parse is the idea of market value. (writing) Market value. What this is saying is we need someway to measure what we've produced and the best way we can do it is say, how much benefit are people getting and what they're willing to pay for it in the market is the best way that we can measure how much benefit they're actually getting out of it. For example, if someone in the year, I don't know, if an avocado was produced, if an avocado is produced in some farm and also an orange is produced, and an orange is produced, we won't say that for each of these, we won't say, oh GDP is increased to buy one fruit we'd look at the market value for it. If the market value of this avocado is $1 and the market value of this orange is 0.50 cents then by producing this fruit the GDP has increased by 0.50 cents by producing this avocado its GDP has increased by a dollar. In the next year, maybe there's whatever, demand for avocado's goes down or whatever and people pay less for it and the market value of an incremental avocado is 0.50 cents, then in the next year even though the actual number of fruit that was produced is the same as the previous year, now all of a sudden the contribution from avocado's might be the same as a contribution from oranges. It really depends on the market value. Then we can focus on this all, the market value of all goods and services, all goods and services. We would do all the different avocado's and oranges, but we would do computers, we would do cars, we would do tires, and we're doing services, so if you have help at home, if you go to the doctor; the market value of all of those things are going to be put in to GDP. This won't include some things. This does not include, this does not include illegal things. If someone sells someone else drugs we're not keeping track of it. Some would argue that maybe it should be kept track of in some way, that you have this kind of black market in things, but you're not keeping track of illegal, (writing) illegal activity. And you're also not keeping track of goods and services that are produced within the household and consumed within the household. For example, if you hire an outside person to babysit your child that would be considered part of GDP, that is a service that you are paying for, but if you, yourself, are babysitting your children that is not going to be considered in GDP. If I start a lawn-mowing business and I go mow other people's lawns, or maybe before my wife and I were dating, she used to pay me to mow my lawns then it would be included in GDP, but maybe once we get married I just mow her lawn because we're in the same family now then it will not be included in GDP. All does include pretty much everything that can be tracked, anything where there is an exchange of money, there's some payment between two parties for that good or service. Now a really interesting thing and this is something I used to find confusing when I first got exposed to GDP, is the whole notion of final goods and services. To understand this, let's think about, let's think about how jeans might be produced. You have a cotton farmer, a cotton farmer and there's some service that needs to be performed so whatever some farming, some labor that needs to be performed. Let's say that that is$5 of labor and let's say that some land has to be rented. Let's say that that is $5 of ... I'll just make it a different number,$4 of land. (writing) $4 of land. There are other inputs, but we don't have to go into all the details. With that, there's going to be some electricity and things like that, but we won't count all of it. You can produce some cotton, just the plant cotton. (writing) you can produce, you can produce some cotton, some raw cotton. That raw cotton is worth, the market value of that raw cotton is worth, let's say it's worth$10. So, it's $10 worth of raw cotton. Then you can take that raw cotton and you could combine it with some more labor (writing) with some more labor so let's say you combine that with another, I don't know,$6 of labor. (writing) $6 of labor and it would also probably require some machinery and electricity and things like that, but I won't factor all of those things in just now. We don't need them to get the point across. If I do that, if I combine the$10, this intermediate good with the $6 of labor then all of a sudden I can produce cotton thread. (writing) I can produce, I can produce cotton thread. That cotton, the worth of the market value of that cotton thread let's say is now$20. (writing) is now $20 And maybe there is another intermediate good there, maybe it's some dye. We'll put the dye in later, let's do the dye in later. I have a$20 thread, and let's say I can take that $20 thread. (writing) I can take that$20 thread, stay with white just because I started there. I can take that $20 thread and I can put in some more labor, maybe I can take$10 of labor (writing) $10 of labor and then I can essentially create, it will essentially create$30 worth of, $30 of cotton fabric. (writing)$30 worth of cotton fabric. Then I can take that $30 worth of cotton fabric (writing)$30 worth of cotton fabric plus some more labor, let's say another $5 of labor. (writing)$5 of labor and let's say we're also going to put in $1 of dye. (writing)$1 of dye right over here. In the process I can create, I can create the market value, let's say this is $50 worth of blue jeans. (writing)$50 worth, worth of, blue jeans, blue jeans. I do this all over the course of the year, so the period in question. So the period for this one I'll assume the period is a year, so it's all happening over the course of the period in question. We're talking about the GDP in 2012, this is all happening in 2012. What would be the contribution to GDP. If we didn't have the word final here, we just had the market value of all goods and services then we would add this $5 to this$4 to this $10 to this$6 and because of the production of this jeans we would get a very, very large number, a very, very large contribution to GDP. But that would be, not even double counting that would be triple, or quadrupling, or quintuple counting the value that's actually being created because all of this value is essentially being created for in this end $50. The actual contribution to GDP you would only put the final good, so you wouldn't include all of these other intermediary goods and services, you would just say this whole chain of event results in a$50 increase in GDP. In another video we'll talk about what happens if they don't get to this point during the course of the year, if we just stop at one of the intermediary goods. Assuming you get to this point, you just include the final good in GDP. This last part of it is, produced within a country. (writing) produced within a country. This is, you might have heard GNP, gross national product and that's the main difference. GDP says, let's say we're talking about the United States, that's my best attempt at drawing the United States. GDP says look, if it was produced inside the country, if it was produced inside the country, we don't care who it was produced by. It could have been produced by someone from Mexico, or it could have been produced by someone from Canada, it could have been a factory that's owned by the Chinese, but if it was produced within the borders of the United States it gets counted as GDP. (writing) It gets counted as GDP. If an American, if an American who's an American national goes overseas and produces something, that is not counted as GDP. If an American owns a firm in another country and that firm in the other country produces something, that is not the GDP. When you focus on peoples' nationality that is GNP. Not to confuse things, but if you wanted to focus on GNP then you do care about the earnings of American nationals and so you wouldn't count the Canadian, but you would include the American who's making money overseas. GDP fairly simple idea, you say what's being produced within these boundaries, we don't care who's doing the producing and what their actual nationality is, and we're going to ignore production by that nationality outside of these borders.