OAUCDL LECTURE NOTES 3 ECN 002

BASIC PRICES AND MARKET PRICES

Basic prices: these are prices as received by producers

Market prices: these are prices as paid by consumers

We add taxes less subsidies to convert basic prices into market prices

Basic prices + taxes – subsidies = market prices OR

Basic prices + net taxes = market prices

We subtract subsidies add taxes to convert market prices into basic prices

Market prices – taxes + subsidies = basic prices OR

Market prices – net taxes = basic prices

GDP measured at basic prices is that from output or income approach. It is also
called GDP at factor cost. GDP measured at market prices is that from expenditure
approach

Example
Given the data, what is the expenditure-based GDP?
GDP by value-added method $300bn
Subsidies 50bn
Taxes 20bn

Solution
Expenditure-based GDP = Value-added GDP + Taxes – Subsidies
= 300bn + 20bn – 50bn
= $270bn

CURRENT PRICES AND CONSTANT PRICES

Current prices: prices in the current period; they change as time changes

Constant prices: prices in the base period; they do not change as time changes

GDP measured at current prices is called nominal GDP. The nominal GDP is
inflation-unadjusted

GDP measured at constant prices is called real GDP. The real GDP is inflation-
adjusted

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OAUCDL LECTURE NOTES 3 ECN 002

Example
An economy groups all its output into three commodities (X, Y and Z). Compute the
nominal and real GDP for each year (2008 is the base year)
Year Commodities (units) Prices (N)
X Y Z X Y Z
2007 20 45 100 5 10 6
2008 20 44 150 6 15 7
2009 25 48 250 5 20 10

Solution
Nominal GDP in 2007: (20  5)  (45 10)  (100  6)  1150
Nominal GDP in 2008: (20  6)  (44 15)  (150  7)  1830
Nominal GDP in 2009: (25  5)  (48  20)  (250 10)  3585
Real GDP in 2007: (20  6)  (45 15)  (100  7)  1495
Real GDP in 2008: (20  6)  (44 15)  (150  7)  1830
Real GDP in 2009: (25  6)  (48 15)  (250  7)  2620

Important notes: nominal GDP is more driven by prices than by output. Real GDP is
more driven by output than by prices

GDP DEFLATOR
The GDP deflator (or implicit price deflator) is determined by multiplying the ratio of
nominal GDP to real GDP by 100. That is, GDP deflator = Nominal GDP
Real GDP
× 100. The GDP
deflator is a measure of price index of overall goods and services produced in the
economy. In addition, to convert the GDP from nominal status to real status and vice
versa, we employ the use of GDP deflator, bearing in mind that the deflator is always
100 in the base period/year.

Example
Suppose the GDP of a country is given as $200b while the GDP deflator is 110.
Compute the value of the real GDP.

Solution
Nominal GDP
GDP deflator = Real GDP
× 100
200𝑏
110 = 𝑋 × 100
200𝑏
1.1 = 𝑋
200𝑏
𝑋 = 1.1
𝑋 = 181.8𝑏

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OAUCDL LECTURE NOTES 3 ECN 002

USES OF GDP

You will probably have been noticing that our lessons have been centred on GDP.
Why is our attention mostly on GDP? GDP is famous for five major purposes:

1. GDP is used to measure size of economic activity: how much is produced in

an economy is measured by no other means than GDP. At current, there is no
alternative. Anyone interested in knowing how the country has performed
turns to GDP figure.

2. GDP is used to classify countries as small, emerging or large: The size of the
economy, as estimated by GDP, shows the largeness or smallness of the
economy. In-between the large and small countries is the emerging countries.
GDP also shows if the economy is expanding or contracting.

3. GDP is used to design economic policy and national planning: Policymakers

(government, finance ministry, central bank, etc) within an economy uses
GDP figure to shape their policy direction. For example, government can
decide to spend more or cut taxes if the GDP is falling; central bank can
increase interest rates if GDP is rising, and so on.

4. GDP is used to compare living standards: Standards of living are measured

by GDP per capita. They are used to separate the rich from poor countries.
The size of GDP is used to compare living stands between generations in a
country and across countries.

5. GDP is used by international organizations: Multinational organizations such

as the World Bank, IMF, OECD, OPEC, ECOWAS, AfDB, EU, etc use the
size of GDP to classify members, admit new members, shape their aid and
borrowing policy, and so on.

CRITICISMS OR PROBLEMS OF GDP

We discuss above that GDP is the only known indicator of economic activity the
world ever invented. It serves many important functions in knowing how the economy
is performing (expanding, contracting or stagnating) and is famously used to
compare living standards over time and across countries. But GDP is not without
flaws. Critics of GDP have gone to establish five major pitfalls of relying on GDP as a
yardstick to measure economic activity:

1. GDP does not measure happiness: having high GDP does not imply a
significant portion of people are happy. Countries with very high GDP (the US,
China, India) do not score highest on happiness index. This means GDP fails
to include some parameters that are important to people’s state of joy such as
how wealth is distributed, pollution and environmental hazards, excessive
working hours, etc.

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2. GDP is not accurate measure of economic activity: Output produced in

informal economy is largely ignored by GDP. Such unreported activities by
non-incorporated businesses and non-profit organizations are not included in
the GDP figure. Some unmarketed activities such as output of housewives
and self-services are not accounted for in GDP computation.

3. GDP does not exclude economic bads: In the process of production, there
could be emission of gases into atmosphere, exhaust of harmful chemical
substances and other pollution activities. GDP overestimates how much is
actually produced by failing to exclude these bads that are dangerous to the
survival of man.

4. Increase in GDP may not trickle down on the economy: In principle, having a
high GDP means having a lot of wealth. This implies that when the GDP
increases, poverty should decrease because a lot of people should be
wealthier. But this may not be so in real life. There is abundance of cases of
when economic growth does not significantly reduce poverty in the country.
Nigeria is a typical example.

5. It may be difficult to avoid the problem of double counting in real life: the
computation of the GDP requires that items of output, income or expenditure
are not counted more than once. However, the problem of double counting
the items is sometimes unavoidable in real life. This is another reason why the
GDP is often criticized as inaccurate measure of economic activity.

Tutorial Question Set 4

The following information applies to an economy

Consumption expenditure……$150b
Investment expenditure……80b
Government expenditure……92b
Export expenditure……24b
Import expenditure……20b
Capital consumption……12b
Net income from abroad……18b
Indirect business taxes……35b
Indirect business subsidies……27b

You are required to determine the size of:

a) GDP at market prices
b) GDP at basic prices
c) GNP at market prices
d) NNP at basic prices

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