Beginning with the third quarter of this year, the BEA plans to report the U.S. GDP and national income accounts on a new basis. One of the purposes of the change is to better reflect the importance of intellectual capital and technological innovation in the modern economy. These changes are expected to cause the reported value of GDP to be about 3% higher than when calculated under the present system. I have been thinking about how I would explain these changes to an undergraduate economics class, and this is what I came up with.
Robinson Crusoe, as you may have heard, lives by himself on an island, meaning his actions alone comprise the entire economy. To entertain himself (and to serve as a didactic device for students), Rob likes to calculate GDP for his little economy.
Hard Workin’ Rob works as an employee of R.C. Farms, which pays H.W. Rob $1 for every potato he grows and harvests. In a typical year, he produces 100 potatoes, and earns $100 in wages. R.C. Farms takes 20 of these potatoes and replants them in strategic locations around the island, a step that will make sure that the economy will have some new potatoes that will be produced next year. R.C. Farms sells the remaining 80 potatoes for $2 each to Crusoe’s Restaurant. Hard Workin’ Rob (the laborer) does not mind the mark-up because he is also the sole owner of R.C. Farms, and any profit the company makes is also part of his income. Crusoe’s restaurant in turn takes the 80 potatoes it buys and turns them into 240 potato pancakes, which it sells to its customers (well, customer actually) for $1 each. The restaurant has no costs other than the potatoes– it’s a prepare-it-yourself concept in restaurants that probably works best in a beautiful island setting where everybody wants to keep the accounts very simple.
So the question is, what is the island’s GDP? Clearly it’s not appropriate to add the $160 in potatoes sold by R.C. Farms to the $240 in cakes sold by Crusoe’s restaurant, because that would be double counting– those potatoes that R.C. Farms sold to the restaurant were used for no purpose other than to produce cakes. The concept behind GDP is that we want to calculate the market value of all final goods and services sold (in this case, $240 in cakes), but not count sales of intermediate goods (in this case, not count the 80 potatoes used up in producing those cakes). But what about the 20 potatoes that R.C. Farms replanted rather than sold to Crusoe’s Restaurant?
Suppose first that we decided to treat those 20 replanted potatoes as just another cost of doing business, thinking of them as something that got used up in the process of creating the 240 cakes. If that’s our approach, then we’re all done– the island’s GDP would just be the $240 in final goods (cakes) that got produced.
Again sticking with that expensing concept for the moment, Rob knows that we’re also supposed to be able to calculate GDP by adding up the income earned by everyone in the economy. So to check his math, he notes that the owner of Crusoe’s Restaurant earned $80 in profit, the owner of R.C. Farms earned $60 in profit, and Hard Workin’ Rob (the laborer) earned $100 in wages, which indeed sums to $240, which we claimed was the economy’s GDP. By the way, it was the income going to the owners of the firms that gave the restaurant’s customers the funds they needed to buy all those expensive cakes.
But it’s really not reasonable to say that the 20 potatoes replanted by R.C. Farms were used up in the process of making the cakes. In fact, those 20 potatoes weren’t used at all in producing the cakes, and they weren’t even used up, but hopefully will turn into 100 or more new potatoes for next year. The owners of R.C. Farms were enriching themselves by choosing to replant those potatoes, laying the “groundwork”, if you will, for future production and profits. So it seems more appropriate to say that R.C. Farms, and not Crusoe’s Restaurant, was the final user of those 20 potatoes, and that the $20 the farm paid Hard Workin’ Rob for those potatoes is not an expense of getting potatoes ready to sell to the restaurant, but instead is part of the income of the owners of the farm that they decided to devote to “growing” future profits.
If we value these investment goods at cost, and regard R.C. Farms as the final user of those investment goods, we would calculate the market value of all final goods and services to be $240 in consumption goods (the cakes) plus $20 in investment goods (the replanted potatoes) for a total GDP of $260. Treating capital goods as an investment rather than a current expense thus makes reported GDP higher. From the income side, since the $20 investment spending is no longer regarded as an expense, we calculate the profits of R.C. Farms as $80 (the $160 revenue from sales to the restaurant minus the $80 cost of those goods). The restaurant still earned $80 and Hard Workin’ Rob still earned $100, so GDP from the income side is 80 + 80 + 100 = 260, equal to what we calculated on the product side. Some of the income is now in the form of an imputed benefit the owner of R.C. Farms associates with the firm’s decision to replant potatoes. Under this accounting scheme, the island’s income now exceeds its total consumption spending, with the excess (saving) going to finance the economy’s investment.
After several years of this, Rob realizes he’s not getting anywhere (literally). So he decides to try to experiment with some new ideas to see if he can come up with a better way to do things. Can you get two viable plants if you take a potato and cut it in two before planting? Can you grow them in vessels, or other exotic locations? So, instead of just replanting all 20 potatoes in the usual way, R.C. Farms decides to just replant 15 potatoes, and use the others for experimentation– its R&D budget. Maybe these experiments will produce more potatoes, maybe they won’t– mostly they’ll just help Rob to learn if there’s a better way to do things. The question now is, how should we treat R.C. Farm’s 5-potato R&D budget?
One idea would be to say that R&D is just another expense. From that perspective, the economy’s final goods are $240 in cakes plus $15 in investment, for a GDP of $255. On the income side, since we’re expensing the R&D, the profits of R.C. Farms are only $75 ($160 revenue from the restaurant minus $85 in costs), which combine with $80 income from the restaurant and $100 income from the worker for $255 GDP on the income side.
But the same arguments against expensing investment could be used to say we shouldn’t be expensing R&D, either. The purpose of the R&D was to produce a final good– namely knowledge– and producing this knowledge should directly benefit the owners of the firm. So if we decide instead to treat the R&D as a similar kind of activity as usual investment, we’re led to a view that GDP consists of $240 worth of cakes, $15 worth of investment, and $5 worth of knowledge creation. That new knowledge in turn is going to now be counted as part of the income of the owners of the firm that conducted the R&D.
In other words, changing from expensing R&D (the current U.S. system) to treating R&D as a form of investment (the system that will be in place starting next quarter) would increase the reported GDP from $255 as calculated under the old system to $260 as calculated under the new. So on July 1, Rob plans to begin calculating GDP on the new basis, and report himself to be earning $5 more each year than he used to.
But the truth is Rob won’t actually be any richer when he wakes up on July 1 than when he goes to bed on June 30.