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5.3.2IMPLICATIONS FOR BUSINESS AND GOVERNMENT

The fact that business cycles appear as regular short/medium-run features of economies means that business and government are regularly faced with them. Businesses must take account of them in their planning cycles and in the development and execution of their business strategies. Declines or increases in sales should not be interpreted as major strategic problems if they are just part of a business cycle, but a business must somehow be able to analyse whether such a feature is simply a reflection of a business cycle or a symptom of a more serious problem that must be identified for their firm to retain and improve its competitive position.

Firms need to manage their production and inventories in the knowledge that there will be cycles in demand, sales and profits, over which they have little if any control. In managing their factors of production, management of labour is vitally important. Firms may need to reduce output, which will sometimes require making people redundant. In doing so they must try to ensure minimal adverse impact to their reputation as they may well require additional staff once the economy experiences its next boom period. Given that many countries’ labour laws are quite strict regarding redundancies and labour regulations generally, letting workers go is not easy in many situations, which sets constraints on firms’ flexibility in dealing with the business cycle.

As well as the argument that governments may play a role in causing business cycles, governments are also faced with the challenge of dealing with them. Governments attempt to manage expenditures and tax revenues in their economies, where the business cycle creates some problems. For example, in recessions, when unemployment rises, governments will pay out substantial amounts in benefits and at the same time receive fewer tax receipts as economic activity slows down, and may find that it must borrow to meet its requirements. The hope would be that, when the recession ends and economic growth recommences, enough resources are raised through taxes and reduced benefits to cover the costs of any borrowing. How governments try to deal with business cycles is discussed further below and again later in Chapter 8.

5 . 4 R E A L O U T P U T A N D I T S C O M P O N E N T S

Any estimate of economic activity, whether over the short or long run, involves measuring the total value of the flow of income/output generated by an economy over a specific period. The definition of economic activity presented in Chapter 3

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corresponds to real output if all components are in real terms, i.e. real output (Yr ) consists of real consumption (Cr ) plus real investment (Ir ) plus real government expenditure (Gr ) plus real net exports (Xr − Mr ) as follows;

Real economic activity: Yr = Cr + Ir + Gr + (Xr − Mr )

This approach to measuring economic activity is called the expenditure approach as it consists of summing up the various parts of economic expenditures by consumers, firms and government. This measure of economic activity is called gross domestic product (GDP).

Gross domestic product (GDP) is a location-based measure of economic activity. It measures the value of real output produced in an economy

Not all real output remains in the economy where it is produced creating a wedge between the values of real output produced and earned by the citizens of a country. Profit repatriation may occur where foreign companies send some of their profits back to their headquarters in their home country. Property income from abroad may be earned by citizens earning returns on assets they own in other countries. When real output takes all the flows of real output to and from an economy into account, gross national product (GNP) is measured.

Gross national product (GNP) is the value of real output that is retained by the citizens in a country after all inflows and outflows are allowed for.

The difference between GDP and GNP is called net property income from abroad.

If a country’s net income flows from abroad are positive, then inflows exceed outflows and GNP is greater than GDP. If net income flows are negative, GDP is greater than GNP. For most countries the difference between GDP and GNP is minor, although countries that have many multinational companies that repatriate substantial profits usually experience a large wedge between GDP and GNP (GDP is larger than GNP). Since both GDP and GNP are used to measure economic activity nationally and internationally it is worth remembering the distinction between them.

GNP is also called gross national income (GNI), since national economic activity is the same whether measured in terms of output (the product in GNP) or income that is generated by citizens providing their factor resources to markets for payment.

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5.4.1OTHER MEASURES OF ECONOMIC ACTIVITY

The income method and the value-added method are alternative approaches to measuring economic activity. The income method involves summing up all income received by an economy’s citizens in payment for supplying resources to the economy. Payments of wages or salaries are received by owners of labour, interest by owners of capital, rent by owners of land, and profit by those who apply their entrepreneurial ability successfully. In each country’s national accounts (published annually or in many cases also quarterly) the corresponding income categories are called employee compensation, interest, corporate profit, rental income and proprietors’ income. Summing up these payments gives us an estimate of national income.

The value-added method involves summing up the value added by different economic units (usually firms) as products or services are provided for the market. In the example in Table 5.1 four firms are involved in the transactions that produce wooden tables. Initially the tree grower sells trees to a sawmill for processing. The tree grower receives £125 from the mill for each tree it produces. Once the mill transforms the tree into planks of wood, the value of the wooden planks bought by a carpenter is £200. The value added by the sawmill is £75 (£200 − £125). Once the carpenter transforms the planks to tables, their value has risen to £550. The carpenter has added value of £350 to the planks he bought (£550 − £200). The carpenter supplies the tables to a furniture shop which sells the tables for £1000 adding value of another £450.

If the market values of each transaction are added up the total is £1875 while totting up value added gives rise to £1000. In assessing the value of economic activity, value added is the relevant amount to be considered because summing up the value of each transaction gives rise to double counting. For example, payment

T A B L E 5 . 1 V A L U E A D D E D

Firm	Product	Market value	Value added by firm
Tree grower	Trees	£125	£125
Sawmill	Wood planks	£200	£75
Carpentry firm	Tables	£550	£350
Furniture shop	Tables	£1000	£450

Total

£1875

£1000

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for the planks sold by the sawmill for £200 includes the payment to the tree grower of £125. To avoid double counting, the value of intermediate goods is ignored in computing the value of economic activity.

Intermediate goods are sold by firms to other firms and are used in making final goods (goods that are not resold to other firms).

Final goods are not purchased for further processing or resale but for final use.

In measuring national economic activity it is the total value of all final goods and services produced in an economy over a specified period that is of interest. In theory, whether economic activity is measured using the expenditure, income or value-added method, the same amount of activity is measured. In practice, some statistical discrepancies are common due to how data are collected.

5.4.2ECONOMIC ACTIVITY: GNP, GDP AND INCOME

The relationship between measures of economic activity is illustrated in Figure 5.3 where it is possible to see at a glance the components of the different measures and their relationship to each other.

Beginning on the left of Figure 5.3 in column 1, GNP and GNI are presented. The relationship between GNP (GNI) and GDP is clear from the first two columns,

1

2

3

GNP/GNI:

GDP + GDP

Expenditure

NPIFA

estimate

	4	5	6
	Income:		GNP/GNI:
		NNP at mkt	NI(bp) +
	factor
		prices	indirect taxes +
	earnings
			depreciation

Net property						Depreciation
income from
abroad
					Indirect
		G			Taxes
				Rent
						NI/NNP
				Profit	NI/NNP
						at
GDP	GDP	I		Income from	at basic
				self-	prices	market
				employment		prices
		X − M
				Wages and
		C
				salaries

F I G U R E 5 . 3 C O M P A R A T I V E M E A S U R E S O F E C O N O M I C A C T I V I T Y

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which show that GNP is made up of GDP plus net property income from abroad (assuming NPIFA is a net inflow into the economy). If NPIFA is a net outflow then GDP would be greater than GNP. Figure 5.3 column 3 shows the expenditure components of GDP. Next we see that the sum of income (factor earnings) plus indirect taxes add up to national income at market prices, which include indirect taxes. Basic prices exclude indirect taxes.

Indirect taxes are paid on expenditure whereas direct taxes are paid on income.

Adding on the value of depreciation to NI (national income) at market prices provides a measure of GNP or GNI. Depreciation is included because it is the rate at which the capital stock is reduced each year (for annual accounts) due to wear and tear.

If economic activity of £100bn is generated in a year, the economy ‘loses’ some of its capital stock since it deteriorates over the year and net measures of economic activity subtract the value of depreciation from measured economic activity.

To summarize, there are several measures of economic activity and sometimes it is necessary to decide which is most suited to a particular purpose. GDP is generally accepted as a sound measure but for countries where a significant amount of net property income flows to or from abroad, GNP might be a more appropriate measure. There are several ways to compute GNP (adding indirect taxes and depreciation to national income at basic prices or adding net factor inflows from abroad to the components of GDP) but irrespective of which method is used the same measure is being estimated.

W H A T G N P O R G D P D O N O T M E A S U R E

Not all economic activity is measured and reported in national statistics. A black economy is said to exist where people do not declare income for tax purposes and hence the activity is not accounted for in national statistics. The extent of hidden economic activity varies across countries and some countries are culturally more comfortable with not reporting income than others.

Some economic activity goes unmeasured if not unnoticed because it is unpaid. Stay-at-home women/men who take over childcare or household duties for no pay do not have their contribution to economic activity measured although the value of their activity could be measured by using estimates of market costs for childcare and housekeeping.

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Arguably the production of pollution, noise, and congestion should be deducted from measured economic activity since they are also part of economic activity but represent negative outcomes. However, this would be difficult to put into practice since there is wide debate about how to decide on the value of their output or to place a cost on it. Hence, measures of economic activity are not perfect but do provide us with some information about economic activity and allow us to make comparisons across countries and for countries and regions over time.

5 . 5 E Q U I L I B R I U M E C O N O M I C A C T I V I T Y

Different methods can be used to estimate the value of economic activity. An interesting question arises as to what determines whether a country’s economic activity is relatively high or low. Many economists enter the discipline with a desire to understand better how to encourage higher rather than lower economic activity. Another way of thinking about the same question is to try to imagine what factors generate high expenditure on each of the components of economic activity, i.e. C,

I , G, X − M .

Having considered short-term business cycle fluctuations in economic activity it is also possible to think about modelling equilibrium economic activity, the longrun trend. This involves assessing those factors we think are the most important determinants of economic activity. A number of different approaches have been used to examine the determinants of economic activity. It is necessary to identify whether the issue of interest is:

•the determination of the level of economic activity; or

•the determination of growth in economic activity;

as the determinants are related but not exactly the same in both cases. In this chapter we focus on the first issue and return in Chapter 9 to the second.

At the level of an economy, analysis of both the demand and supply is required to consider equilibrium economic activity. However, different concepts are used to examine demand and supply in relation to national economic activity compared to those we have met so far.

National economic activity is the sum of activity by all of the economic decisionmakers including households, producers and government. For this reason it is also called aggregate economic activity.