Imagine that a bakery hires workers to produce more bread, pays their wages, and then fails to sell the additional bread. How does this transaction affect GDP?
The answer depends on what happens to the unsold bread. Let’s first suppose that the bread spoils. In this case, the firm has paid more in wages but has not received any additional revenue, so the firm’s profit is reduced by the amount that wages are increased.Total expenditure in the economy hasn’t changed because no one buys the bread.Total income hasn’t changed either—although more is distributed as wages and less as profit. Because the transaction affects neither expenditure nor income, it does not alter GDP. Now suppose, instead, that the bread is put into inventory to be sold later. In this case, the transaction is treated differently. The owners of the firm are assumed to have “purchased’’ the bread for the firm’s inventory, and the firm’s profit is not reduced by the additional wages it has paid. Because the higher wages raise total income, and greater spending on inventory raises total expenditure, the economy’s GDP rises.
What happens later when the firm sells the bread out of inventory? This case is much like the sale of a used good.There is spending by bread consumers, but there is inventory disinvestment by the firm.This negative spending by the firm offsets the positive spending by consumers, so the sale out of inventory does not affect GDP. The general rule is that when a firm increases its inventory of goods, this investment in inventory is counted as expenditure by the firm owners.Thus, production for inventory increases GDP just as much as production for final sale.A sale out of inventory, however, is a combination of positive spending (the purchase) and negative spending (inventory disinvestment), so it does not influence GDP. This treatment of inventories ensures that GDP reflects the economy’s current production of goods and services.
Imagine that a bakery hires workers to produce more bread, pays their wages, and then fails to sell the additional bread. How does this transaction affect GDP?
The answer depends on what happens to the unsold bread. Let’s first suppose that the bread spoils. In this case, the firm has paid more in wages but has not received any additional revenue, so the firm’s profit is reduced by the amount that wages are increased.Total expenditure in the economy hasn’t changed because no one buys the bread.Total income hasn’t changed either—although more is distributed as wages and less as profit. Because the transaction affects neither expenditure nor income, it does not alter GDP.
Now suppose, instead, that the bread is put into inventory to be sold later. In this case, the transaction is treated differently. The owners of the firm are assumed to have “purchased’’ the bread for the firm’s inventory, and the firm’s profit is not reduced by the additional wages it has paid. Because the higher wages raise total income, and greater spending on inventory raises total expenditure, the economy’s GDP rises.
What happens later when the firm sells the bread out of inventory? This case is much like the sale of a used good.There is spending by bread consumers, but there is inventory disinvestment by the firm.This negative spending by the firm offsets the positive spending by consumers, so the sale out of inventory does not affect GDP. The general rule is that when a firm increases its inventory of goods, this investment in inventory is counted as expenditure by the firm owners.Thus, production for inventory increases GDP just as much as production for final sale.A
sale out of inventory, however, is a combination of positive spending (the purchase) and negative spending (inventory disinvestment), so it does not influence GDP. This treatment of inventories ensures that GDP reflects the economy’s current production of goods and services.
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