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About this Lesson
 Type: Video Tutorial
 Length: 8:16
 Media: Video/mp4
 Use: Watch Online & Download
 Access Period: Unrestricted
 Download: MP4 (iPod compatible)
 Size: 89 MB
 Posted: 03/29/2010
This lesson is part of the following series:
Economics: Full Course (269 lessons, $198.00)
Economics: Macroeconomic Measurements (16 lessons, $25.74)
Economics: Aggregate Output and Income (8 lessons, $13.86)
In this video lesson, we'll cover the new BEA procedure for calculating Real GDP. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.
Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.
About this Author
 Thinkwell
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11/13/2008
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A country's gross domestic product is defined as the market value of all final goods and services produced in that country in a given period of time. And the real gross domestic product seeks to hold constant the effect of changing prices, as we look at how a country's output changes from one year to another. That is, when gross domestic products changes, part of the change is due to a change in market values  that's prices  and part of the change is due to a change in the physical output of goods and services in that economy. So we invent the concept of real gross domestic product, which tries to isolate the effect of increasing output, and hold constant the effect of prices. Let's look at an example to remind ourselves of how real gross domestic product works. And as we work through this example, we'll see a problem that arises in the course of calculating the change in real gross domestic product from one year to another.
Let's start with year one. In year one, let's suppose that we have two goods produced in our economy  apples and oranges  and the price of apples is $1.00 apiece, and ten apples are produced, for a total market value of $10.00 from apples. Let's suppose that the price of oranges is $2.00 apiece, and the quantity produced is ten oranges, for a total market value of $20.00 from oranges. Ten dollars in apples plus $20.00 in oranges gives us a gross domestic product for this economy of $30.00 in year one.
Now consider year two. In year two, let's suppose that there is a big increase in orange production, perhaps due to some new technological advance that allows oranges to be produced at lower cost. What happens in this case is that the quantity of oranges produced increases to 20 oranges, and the price falls through the interaction of supply and demand; that is, the surplus of oranges pushes down the price so that oranges now sell for $1.00 apiece. Twenty oranges at $1.00 apiece gives us a market value of $20.00 from oranges. Over here in apples, let's suppose we still have $1.00 per apple and 10 apples produced, for a total market value of $1.00 from apples. Ten dollars plus $20.00 means that our gross domestic product for year two is $30.00.
Now, we know that our economy became more productive because there are more oranges being produced because of this technological advance that I described. But what is the actual increase in real gross domestic product? By what percentage did the physical output of our economy expand? How much better off are we in terms of the quantity of goods and services available to meet our wants and needs?
Well, the percentage number that we wind up with depends on the base year that we select for our price weights. Let me see if I can give you the intuition of this problem. Suppose you work for a company that moves furniture, and your boss pays you $50.00 a day. The next day, you come to work and the boss says, "Good news, I'm giving you a raise to $100.00." The percentage increase in your wage is 100, the new wage, minus 50, the old wage, divided by 50, the old wage, for a percentage increase of 100%. Now, suppose the next day you come back to work and the boss says, "Sorry, I've got bad news; that is, your wage is going to be cut to $40.00." You do a quick calculation  $40.00, if this is your new wage, minus $100.00, your wage from the previous day, divided by that $100.00 base rate, gives you a percentage decrease of 60%. You complain to your boss, "I was making 50, then you gave me 100, now I'm cut back to 40; I'm worse off than I was before. And the boss counters, "No, I gave you a 100% increase, and only a 60% decrease; you shouldn't complain." Well, this is ridiculous, isn't it? And it points out a problem with the calculation of percentage changes. Percentage changes depend entirely on where you start; that is, the base with which you calculate that percentage determines the amount of the percentage change. We're going to see this problem now as we look at a change in real gross domestic product. The percentage change that we wind up calculating depends on where we start  that is, which year we choose for our base.
Suppose we want to calculate the percentage change using the year one prices as our weights. Well, look at this. In this case, we keep the year one prices of $1.00 for an apple, and $2.00 for an orange, and we use the year two quantities of 10 apples and 20 oranges. If we do this, multiplying $1.00 times 10 and $2.00 times 20, we get a real gross domestic product using year one prices as our base rates of $50.00. Compare $50.00 with the original gross domestic product of 30, and that's going to be a percentage increase of 66.7%  50 minus 30, divided by 30 is a percentage increase of , or 66%.
However, if we do the same calculation from year one to year two, and we use the year two prices as our base rates, we wind up with a different percentage altogether. Let's go back and look at the year one quantities of 10 apples and 10 oranges, and now let's use the year two prices as our base rates  $1.00 per apple, and $1.00 per orange. That is, if we go back and look at the original year's output of apples and oranges and weight those outputs by the year two prices, we wind up with a real GDP of $20.00. That is, in terms of year two prices, the gross domestic product  the output of this country  was worth $20.00 in year one, measured in year two prices.
So the change in real gross domestic product is from $20.00  the year one output  to $30.00  the year two output. Notice you're comparing two years for which you're using the same prices  $1.00 per apple, $1.00 per orange. And using those weights, the real GDP increased from $20.00 to $30.00; that's a 50% increase. See you got a bigger percentage when you used the price of $2.00 per orange, because the higher price put a heavier weight on the change in output of oranges.
Well, there's something kind of messy about this. We don't like the idea that you get a different answer, depending on whether you start in year one or year two. This is confusing, and it makes the concept of real gross domestic product less useful. So what the Bureau of Economic Analysis has done since 1995 is to try to correct for the percentage oddity problem. By using neither $2.00  the year one price  or $1.00  the year two price, but using some number in between  that is, a weighted average of the twoyear prices  that makes the percentage change more consistent. That is, it gives you the same percentage change whether you use the year one prices or the year two prices. You don't use either price; you use something in between. So whether you're moving forward or backwards, you get the same percentage change, and that's definitely an improvement, and it avoids the problem with percentages that we described earlier.
This problem comes up frequently in economics. Percentages are sometimes a messy thing to deal with, especially whenever you're looking at different base years as possible candidates for calculating the percentage. But here's a simple explanation of how you wind up with a problem with percentage changes, depending on which year you select as your base.
Macroeconomic Measurements
Aggregate Output and Income
The New BEA Procedure for Calculating Real GDP Page [2 of 2]
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