CHAPTER 6
PRODUCTION, INCOME, AND EMPLOYMENT
MASTERY GOALS
The objectives of this chapter are to:
1. State the definition of Gross Domestic Product (GDP) and describe the problems with
GDP.
8. Explain the differences among the expenditure, value-added, and factor payments
THE CHAPTER IN A NUTSHELL
Gross Domestic Product (GDP) and the unemployment rate are important because they describe
aspects of the economy that dramatically affect each of us individually and our society as a
GDP is the total value of all final goods and services produced for the marketplace during a
given period, within a nation’s borders. Three ways to measure GDP are the expenditure
Tracking and reporting GDP can be difficult because GDP changes are reported quarterly but on
In the expenditure approach to measuring GDP, we add up the value of the goods and services
purchased by each type of final user: households, businesses, government, and foreigners. When
measuring private investment spending, it is important to include changes in business
Total investment spending has two components: private investment spending and government
investment spending. Net investment spending is equal to total investment minus depreciation.
Since our economic well-being depends, in large part, on the goods and services we can buy, it is
important to translate nominal GDP, which is measured in current dollars, to real GDP, which is
GDP provices two types of important information regarding economic performance. In the short
run, changes in real GDP alert us to recessions, and give us a chance to stabilize the economy. In
the long run, changes in real GDP tell us whether our economy is growing fast enough to raise
output per capita and our standard of living, and fast enough to generate sufficient jobs for a
There are four types of unemployment: frictional, seasonal, structural, and cyclical. Our
economy is at full employment when there is no cyclical unemployment. Unemployment is
costly for individuals and for our society. The purely economic cost of unemployment can be
The unemployment rate is defined as the percentage of the labor force that is unemployed, and is
calculated each month based on a survey conducted by the U.S. Census Bureau. This measure
understates unemployment because it fails to account for involuntary part-time employment and
This chapter ends with a Using the Theory section on the economic effects of sudden disasters.
The destruction caused by the terrorist attacks of September 11, 2001 and Hurricanes Katrina and
In order presented in chapter.
Gross domestic product (GDP): The total value of all final goods and services produced
Intermediate goods: Goods used up in producing final goods.
Nominal variable: A variable measured without adjustment for the dollar’s changing vaue.
Consumption (C): The part of GDP purchased by households as final users.
Government purchases (G): Spending by federal, state, and local governments on goods
and services.
resources.
Net exports (NX): Total exports minus total imports.
Value-added approach: Measuring GDP by summing the values added by all firms in the
economy.
Factor payments approach: Measuring GDP by summing the factor payments earned by
all households in the economy.
Frictional unemployment: Joblessness experiences by people who are between jobs or
Structural unemployment: Joblessness arising from mismatches between workers’ skills
cycle.
Full employment: A situation in which there is no cyclical unemployment.
employment.
Labor force: Those people who have a job or who are looking for one.
Involuntary part-time workers: Individuals who would like a full-time job, but who are
1 See Greg Ip, “How to Allocate for Accuracy,” The Wall Street Journal, 8/1/2002, for a
discussion of the advantages of increasing the Census Bureau’s budget and the Bureau of
2 Explain to students that inventory changes must be included in private investment
spending in order to get an accurate measure of GDP. This is because inventory changes
3 Relate inventory decreases (which measure expenditures on past production) to
4 Comparing GDP among countries can sometimes be misleading. Even after making the
necessary exchange rate adjustments, the size of the underground economy differs
5 Explain to students that GDP is not an accurate measure of our economic well-being.
GDP ignores things like the amount of leisure we have, the cleanliness of our
6 See “How the Government Measures Unemployment”, available at
7 See Lincoln Anderson, “Labor Statistics Are Lying,” The Wall Street Journal,
DISCUSSION STARTERS
1 Give students the figures for “inventory on January 1,” “total production for the year,”
“total sales for the year,” and have them calculate “inventory on December 31” and
Case 1: When inventories are unchanged over the course of a year
Since current expenditures accurately measure current production, the inventory
component of GDP is $0.
Case 2: When inventories increase over the course of a year
Since current expenditures understate current production, we add $200 to our measure of
Case 3: When inventories fall over the course of a year
Since current expenditures overstate current production, we subtract $450 from our
measure of GDP (by subtracting $450 from private investment spending). If we fail to
15. Economists Lawrence Katz and Alan Krueger have found that the proportion of the
U.S. population in prison has doubled since 1985 (Katz and Krueger, “The
a. Have students use their knowledge of how the Census Bureau measures
b. Discuss why black unemployment rates, in particular, are significantly lower than
16. Net investment spending, net consumer durable goods purchases, and human capital
17. Students have a hard time understanding the importance of and the difference between
Consider an economy where the only product is bread. If a worker is paid $5 per hour to
produce bread, and if bread sells for $1 per loaf, then the worker’s hourly real wage is 5
loaves of bread. If the worker gets a 10% raise, the nominal wage becomes $5.50 per
Have students extend this example, as follows:
a. If the worker gets a 10% raise, what would have to happen to bread prices to make
b. If the worker gets a 10% raise, what would have to happen to bread prices to keep his