GDP Does not Equal Gross Domestic Income

One of the first things learned in any introductory macroeconomics class is that national income equals national product. This is called the national income identity. The identity works fine in theory given certain assumptions, but it does not hold in the real world, nor does it hold in theory under realistic assumptions.

The national income identity has many problems in the real world and one useful delineation is to draw a distinction between application problems and theoretical problems. Economists are generally aware of and accept the existence of the former, while the interest of this article is in the latter.

GDP and GDI are actually measured and almost always diverge. Consistent with the main view of economists, Investopedia notes that these values diverge due to measurement error. The Bureau of Economic Analysis, responsible in large part for the government’s official measurement of GDP and GDI, elaborates on exactly what sort of measurement errors there are. They say that such errors include, “including sampling errors, coverage differences, and timing differences.” There are also other reasons they don’t mention such as arbitrary definitions of what constitutes income, arbitrary valuing of certain complex goods and services, tax-related behavioral bias which encourages over-reporting expenses and under-reporting income, and much more. One economics blog notes that the Fed cherrypicks whether it uses GDP or GDI as the indicator of choice. This is obviously problematic for policymakers and also the general public as it results in general misconception on the state of the economy which can and does in turn drive misguided policy decisions.

There are also widely known issues with GDP in particular, some of which I mention on the Economics Page. Press control + F to search the page for the term “GDP” and several articles will come up mentioning problems. These measurement issues are generally known to intelligent economists even if they are less known by the policymakers and public. What is not generally known to even well educated economists is that there is a theoretical error in the national income identity.

The theoretical error is in thinking that the primary and secondary markets for goods and services can be well delineated. It is well known that these markets have strong interactions due to such substitution effects and others, but there are larger effects which cannot be delineated.

A great example is a pawn shop. Used goods are sold but they generate new income. An economist could argue that the income for the employee is for the service the pawn shop renders regarding the used goods rather than the goods themselves, but this argument fails for two reasons.

First, there is a de facto demand for pawn shop service but there is no teleological demand. Because there is no teleological demand there is clearly no market from an Austrian perspective. From a neoclassical or non-Austrian perspective the story is a touch more complex because de facto demand may suffice under such paradigms. What these schools cannot deny is that the market would collapse absent the secondary good.

In other words, a non-Austrian may be able to deny that pawn shop good demand is fully a secondary market demand, but they also cannot reasonably treat such demand as purely a demand for new product or service. Therefore the corresponding income related to such demand is in part derived from the secondary market, nevermind the practical difficulty in separating the degree of the income which belongs to each part.

It also seems that the goods sold in a pawn shop would be highly substituted by pure secondary market transactions. Service rendered by a pawn shop is analogous to the service rendered by a private individual in transaction of a used good on the secondary market. It creates a double standard of accounting to consider one sort of service as a contribution to GDP while the other does not.

Such problems also exist in many other markets where the actual good demanded is a used good yet some new service is involved, such as the refurbished goods market, or markets where the good itself is a new good yet there is some used good input into the production process, such as goods made with recycled plastic, metal, glass, or other recycled material.

In conclusion, for the national income identity to be true there must be inclusion of the secondary market. This means that GDP, measured as the final value of all new goods and services, will never be expected to equal GDI, measured as the final value of all new income, in any particular year even as a matter of theory.

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