Problem Set 1:
Value added by each person is the value of the good produced minus the amount the
person paid for the materials needed to make the good.
Therefore, the value added by the
farmer is $2.00 ($2.00 – 0 = $2.00).
The value added by the miller is $1:
the miller sells
the flour to the baker for $3 but paid $2 for the flour.
The value added by the baker is $4:
she sells the bread to the engineer for $7 but paid the miller $3 for the flour.
GDP is the
total value added, or $2 +$1 +$4 = $7.
Note that GDP equals the value of the final good
When a woman marries her gardener, GDP falls by the amount of the gardener’s
This happens because measured total income, and therefore measured GDP, falls
by the amount of the gardener’s loss in salary.
If GDP truly measured the value of all
goods and services, then the marriage would not affect GDP since the total amount of
economic activity is unchanged.
Actual GDP, however, is an imperfect measure of
economic activity because the value of some goods and services is left out.
gardener’s work becomes part of his household chores, his services are no longer counted
As this example illustrates, GDP does not include the value of any output
produced in the home.
Similarly, GDP does not include other goods and services, such as
the imputed rent on durable goods (e.g., cars and refrigerators) and any illegal trade.
The advantage Real GDP is the ease and speed with which it can be calculated.
value of real GDP is related to the level of employment which does concern many
However, strictly speaking real GDP is not a welfare measure.
First, it only
measures market transactions and second bigger is only better if it improves welfare.
When increases in output cause pollution, increases in crime, or increases in sickness,
etc., welfare is not improved.
In addition, GDP ignores the imputed rent on durable
goods such as cars, refrigerators, and lawnmowers.
Also, welfare would be better
measured by a per capita statistic than an aggregate measure.
Moreover if the per capita
measure increases over time but the imperfections in the measure stay approximately
constant as time progresses then the increase in the measure would represent an increase
For the entirety of the problem define r = R/P (the real rental rate of capital) and w
= W/P (the real wage rate).