EXPLAINER: What Does GDP Mean & How Is It Calculated?
(All references are below the article)
Yesterday, a friend tagged me to a post where the poster expressed contempt for Nigeria being considered the country with the biggest GDP in Africa. I have seen a few people say that Nigeria does not merit that position and that countries like Egypt, Morocco, and South Africa deserve that appellation.
I am not sure I agree with them. In fact, as I will explain shortly, my perception is that Nigeria’s GDP is underestimated.
GDP stands for Gross Domestic Product (1) and it is used to measure the overall health of a nation. The PDP made so much noise in 2014 when the economy was rebased (2). Nigeria’s GDP doubled from about USD 270 billion to USD 510 billion in 2013 (3).
Understanding The Terms
GDP is the total value of all final goods and services produced in a single year in all geographic areas of a country.
It’s important to take note of some keywords here:
- Value — whatever goods and services that will be considered would need to have a cost (4). For instance, this writing will be beneficial to some people, but because they would not pay for it, it cannot be included in the GDP calculations. But if I package it as an E-book and sell it for a price, it becomes part of GDP calculations. It becomes valued. Invaluable does not count if it is not valued (good pun).
- Final Goods and Services — What is included has to be the final good or service (5). A final good or consumer good is a final product ready for sale that is used by the consumer to satisfy current wants or needs. If you buy an Innoson car, it gets counted. If you sell that Innoson car to another person, it is not counted. It becomes second-hand. It is no longer a final good.
Still on Final Goods, Intermediate goods are not counted (6). Intermediate goods are goods used to make the finished goods. For instance, if you use cotton to make t-shirts, the cotton is not counted, but the t-shirt is counted when sold. A good can be an intermediate or final good depending on what it is used for. Pepper, for example, can be consumed directly by you at home as a final good and used by Indofood to manufacture Indomie, as an intermediate good. It is counted in your case, but it is not counted for Indofood.
Still on Final Goods, Capital Goods are counted (7). Capital goods are physical assets that a company uses in the production process to manufacture products and services that consumers will later use. Capital goods are not finished goods, instead, they are used to make finished goods. A tractor is a capital good for the production of rice. A warehouse is a capital good for the storage of rice paddy. Do you get the point? Capital goods are counted.
3. Single Year. Whatever is calculated is what is produced for the year under review.
4. Geographic Areas of a Country. Whatever is manufactured outside a country is not counted. This means that even when goods and services are exported, they are counted. Imports are not. iPhones are not counted because they are imported. Anything not manufactured inside the border of a country is not counted.
How is GDP Calculated?
- Output Approach
This is also called the Production Approach or Value-Added Approach. It calculates how much value is contributed at each stage of production.
Let’s use the example of a t-shirt produced in a design house: Say the cotton is sold for N1000 by the farmer to the processor. Then the processor turns it into a useful raw material the tailor can work on for N2000. Then the tailor sells the cloth to an embroider for N3000. Finally, the final cloth is sold to you for N5000.
In this case, N1000 is taken by the farmer, plus N1000 taken by the processor (remember N2000-N1000), plus N1000 taken by the tailor (N3000-N2000), then plus N2000 (N5000-N3000) taken by the embroider.
As you can see, the total is N5000 (N1000 + N1000 + N1000 + N2000).
By calculating this way, you have taken away the value of intermediate consumption. Intermediate consumption, in the example, is the cost of materials, supplies and services used to produce final goods or services. They were taken away as the product exchanged hands from one intermediate to another (processor, tailor, embroider) until it ended up with you.
- Income Approach
This approach equates the total output of a nation to the total factor income received by residents of the nation.
We start by calculating all the income earned by all factors of production.
Factors of production, for those who still remember elementary economics, are inputs used to produce final products. There are 4 factors of production and they have their rewards — labour (wages), land (rent), capital (interest), and management (profits). All of these added together are equal to the National Income and are used to calculate GDP.
To make it Gross GDP, we need to add depreciation of capital and net foreign factor income (NFFI).
Capital Depreciation refers to the decline in the value of a capital asset. For instance, if a machine is bought for N10,000 but only has a useful lifespan of five years, then every year, the value of this machine will decline by N2,000. After four years, the machine is worth N2,000.
Net Foreign Factor Income (NFFI) is the income earned by the rest of the world in this country minus the income earned by the country in the rest of the world. This means that the income of the Chinese in Nigeria is calculated while the income of Nigerians in China is removed.
Once you have all these values, you can calculate the GDP. The formula is:
GDP (Factor Cost) = Net National Income + Depreciation + NFFI
This is basically the sum of the final income of all factors of production contributing to a business in a country before tax.
But GDP Factor Cost is not usually used because you need to make allowance for taxes. To include taxes, the formula becomes:
GDP (Market Cost) = GDP (Factor Cost) + Indirect Taxes — Subsidies
As you can see, the more subsidies are in a country, the less the GDP would be.
The GDP (Market Cost) is also adopted in the Output Approach.
- Expenditure Approach
This approach is an output accounting method (remember the first approach?). It focuses on finding the total output of a nation by finding the total amount of money spent.
The formula is:
GDP = consumption + investment + govt expenditure + (Exports — Imports)
Consumption is paying for goods and services, e.g paying for bread, garri, or haircut.
Investment includes activities such as buying a house, putting money in shares, etc. As you know, these assets are acquired with the anticipation of generating an income or profit or price appreciation. All investments made in the country are accounted for. These include FDI, FPI, FII, etc.
Govt Expenditure includes roads and bridges constructed by the government, salaries paid to civil servants, etc.
Exports are goods or services sent to another country for sale.
Imports are those goods sent to one’s country for sale.
Getting this value and using them in the formula above gives you the GDP calculation under the Expenditure Approach
Rebasing the GDP
I mentioned earlier that PDP was excited that the GDP was rebased in 2014. This was because it bumped up Nigeria’s GDP value from $270 billion to $510 billion. Why was this done? Rebasing was done to update the methods and base data used to calculate GDP. Before 2014, the base year for calculating GDP was 1990. That was too far away.
Calculating GDP is all about using data. Before 2014, only data from 33 industries were used. With the rebasing, it was updated to 46 (8). The share of oil and gas in the GDP before 2014 was 32%. It was updated to 14% during rebasing. Agriculture from 35% to 22%. Telecommunications increased from 2% to 7%, leading to the service’s sector increasing to 51% of the GDP value from 26%. Manufacturing also rose from 0.9% to 9%.
A couple of people from APC said it was a gimmick (9). Lai Mohammed who was the National Publicity Secretary of APC at the time called it “an orchestrated distraction”. However, it was not unique to Nigeria. In 2014 alone, Kenya (10), Tanzania (11), Uganda (12), and Zambia (13) all completed rebasing exercises, which led to significant revaluations of their GDPs. Earlier in 2010, Ghana’s GDP rebasing updated the base year from 1993 to 2006, which led to a 60% jump (14).
Ironically, the APC-led government has decided to rebase the GDP again. In 2021, the National Bureau of Statistics says it has begun the national business sample survey (NBSS) as part of efforts to rebase the country’s gross domestic product (GDP) (15). It will update the base year from 2013 to 2018. Right now, Nigeria’s GDP has shrunk from $568 it was in 2014 to $442 in 2021 (16). The World Bank says that at this rate, Nigeria’s GDP could decline by $139bn by 2030 (17). It is left to be seen how much the GDP would increase after the rebasing.
Drawbacks of GDP Calculations
There have been criticisms of the approaches to calculating GDP. The methodology I just described for calculating GDP used by World Bank, IMF and others is the international standard and is contained in the book System of National Accounts (18). But these are a couple of things it does not capture which is why some have said it is not holistic enough. A few are:
- Underground economy. GDP only calculates value where it has a lot of data. If it has no data, it is unable to calculate it. Activities that take place outside the recorded marketplace are not captured. For instance, revenue for cocaine sales in the U.S. was estimated to be $34 billion in 2013, the equivalent of Nigeria’s annual budget (19). And that’s just one illegal drug. A United Nations publication of 1998 said the US illegal drug market is worth at least $400 billion per annum (20). All these are not captured in GDP calculations. Prostitution activities too. And earnings from corruption which is considered considerable in most places in the world.
In many countries in Africa, there is the shadow economy which is also called the informal economy. An informal economy is the part of any economy that is neither taxed nor monitored by any form of government (21). The size of the informal sector in Nigeria is estimated to be 65% (22). In Egypt, it constitutes up to 50 per cent of the country’s GDP (23). In South Africa, it is 34% (24). India is 15% (25). So, yes, it’s likely Nigeria’s GDP is higher than calculated, but so are those of other countries.
- Non-Market Production. Goods and services produced but not exchanged for money are not measured. They are not measured even when they have value. For instance, if you grow your food, the value of the food will not be recorded in the GDP. But if you decide to watch TV but then buy the food, it will be included in the GDP. That seems like a flaw and the reason is obvious.
- Calculation Complexities. As a concept GDP was introduced when the economy was manufacturing-driven. It was introduced in 1934 (26), just before the second world war in the thick of the industrial revolution. But now, with a lot of economies service-driven, using a manufacturing mechanism becomes tricky. Statisticians take many assumptions to calculate complex outputs such as financial services, housing services, etc. The trickiest part is adjusting for inflation. While I got a tuber of yam for N150 in 2013, the price today is N750. It is the same yam. How do we adjust for variables like this in the GDP calculations? It’s complex and there is no magic wand that can make these assumptions the same across different countries.
- Changes in Product Quality. Changes in the quality of the product may not be attributed to the GDP calculation. The smartphone may cost more than last year but it will also do more. It is difficult for statisticians to attribute the change in price to a change in quality. It is more difficult with services such as the price of a haircut. The price of the barber may go up, but the barber is also much better in his experience. How do you account for these important intangibles in the calculations?
While GDP as a concept is not perfect, statisticians have not come up with a better measurement of the overall health of an economy. GDP is significant because it provides information on the size and performance of an economy. An increase in real GDP is viewed as a sign that the economy is performing well in general.
When real GDP grows rapidly, employers are more willing to hire additional workers for their factories, and people have more money in their purses. When GDP falls, as happened in many nations during the recent COVID-19 pandemic crisis (27), employment typically falls. In some circumstances, GDP may be increasing, but not quickly enough to produce enough jobs for individuals looking for work.
Therefore, until we get a better method, we are stuck with this valuable but flawed metric.