<p>No it doesn't. If the government can build the bridge more efficiently, because it does not require profit, then the 10 million in your example is the correct added value.</p>
<p>The GDP is build on the idea that value of something is how much money others are willing to give up for it, there is good explanation about it in Mankiw Macroeconomics, in chapter 1. The idea is that consumers already shop around for the best offer, and the offer they accept is for sure at least the minimum value of the good and this is what GDP records. If the same apple in Aldi is cheaper than in TESCO, we do not say that Aldi undervalues the apple. If consumer buys the cheaper apple at Aldi for 1 euro, then that is the Aldi's apple addition to GDP, if they buy it in TESCO for 2 euro, then that is TESCO's addition to the GDP. We do not second guess where the people find value (maybe TESCO is closer).</p>
<p>Things get more complicated when we talk about government, because government spends other's people money so they do not necessary always show around for the best deal.</p>
<p>So here we have two possibilities:</p>
<ol>
<li>Assume there is no corruption and government wants to get the best deal.</li>
</ol>
<ul>
<li>Then if the best deal is to buy it privately for 12 million, then that is the value of that bridge for GDP.</li>
<li>If the best option is to build it directly by hiring workers for 10 million, then that is the value of GDP.</li>
</ul>
<ol start="2">
<li>If the government does not go for the best deal but purchases the 12 million bridge even when it could build it for 10 million, then we are not dealing with undervaluing, but exactly the opposite. The extra 2 million is a waste, and it would just artificially inflate GDP.</li>
</ol>

CC BY-SA 4.0
2024-08-14T17:33:06.380Z
2024-08-14T17:33:06.380Z
Lorenzo Pozzi
<p>Your arguments are not correct if we talk about 'correctly' valuing goods or services.  For a second forget about government provided goods and lets apply the same argument just to private consumption expenditure, I will return to your example after this short excursion.</p>
<p>Suppose the following;</p>
<p>We have two firms:</p>
<ul>
<li>firm A that can produce and sell car for 100 dollars</li>
<li>firm B that can produce and sell car for 50 dollars</li>
</ul>
<p>Now if consumer chooses car A we record consumption and thus also GDP increases by 100 dollars, if consumer chooses car B we record GDP increase of 50 dollars.</p>
<p>Does this mean that GDP somehow 'undervalues' car B? No! The car B simply costs less money than car A. GDP <em>by design</em> is a measure of finished goods sold at market prices, which is the way how we measure production (see discussion in Blanchard et al Macroeconomics Ch 2). In the above example, GDP is not undervaluing the car B the value of car B is recorded correctly at 50 dollars. That is the correct measurement of the value added by firm B.</p>
<p>Similarly, in your example of bridge construction, if government can produce the bridge more efficiently than private firm (which is what you assume implicitly since you assume government only needs to spend 10 million whereas private firm because of profit requires 12 million), and government decides to build it inhouse, then the correct measurement of value of that bridge is 10 million not 12 million. This 10 million is the correct value added, hence there is no measurement problem here.</p>
<p>What happens here is that if you just single out one good, no matter whether produced by government or private firm (as the example above shows), then the cheaper the single good can be produced the smaller the addition of that single good to GDP will be. This might make it look like GDP punishes efficiency, but this is not actually true.</p>
<p>GDP is <strong>macroeconomic</strong> measure. It tries to capture the production at macro level, not a production of a single good. If the consumer can get car B cheaper they will have 50 more dollars to spend on other goods or services or 50 more dollars to save. Similarly, if government gets the bridge 2 million dollars cheaper, they will have 2 million dollars more to spend or invest which will be reflected on GDP.</p>
<p>Consider the following numerical example for closed economy;</p>
<p><span class="math-container">$$Y = C+ I +G \tag{*}$$</span></p>
<p>Where <span class="math-container">$Y$</span> is the national income/GDP, <span class="math-container">$C$</span> consumption, <span class="math-container">$G$</span> government spending. Moreover, <span class="math-container">$I$</span> is by definition also given by <span class="math-container">$I =S+T-G \tag{**}$</span> since saving is given as <span class="math-container">$S=Y-C-T$</span>, where <span class="math-container">$S$</span> is private saving, <span class="math-container">$T$</span> taxes and <span class="math-container">$G$</span> government spending (hence T-G is public saving), and if you plug this to * you will get **.</p>
<p>Suppose for the sake of simplicity we only look at the example of bridge so consumer spending or saving is 0. Suppose national income is <span class="math-container">$Y=12$</span>. Next the government takes all that income from private hands through lump-sum taxes <span class="math-container">$T$</span> so <span class="math-container">$T=12$</span> (hence no saving or consumer spending, here government just takes in all resources). Then;</p>
<p>Scenario A) government purchases the bridge for 12 from private company GDP is 12, because <span class="math-container">$G=12$</span>, we have <span class="math-container">$Y=0+0+12=12$</span>.</p>
<p>Scenario B) government builds the bridge itself for 10, then we have <span class="math-container">$G=10$</span>, but that also implies that <span class="math-container">$I=0+12-10=2$</span>. Hence, again <span class="math-container">$GDP =12$</span> because we have <span class="math-container">$Y=C+I+G=0+2+10=12$</span>.</p>
<p>As you can see GDP is exactly the same from more bird's eye macro perspective. The unspent money that government saved simply became part of public saving and entered GDP that way. Alternatively, government could spend that 2 million on something else and again <span class="math-container">$G=12$</span>.</p>
<p>Consequently, even though GDP seemingly punishes efficiency, this is just a fallacy of composition. Something that is true for one part is not true for whole e.g. if you stand up in stadium you see better, if everyone does, nobody sees better. In this example, if you just look at it from micro perspective it seems that GDP punishes efficiency (although again this holds both for private and publicly produced goods and services) but that is not true macroeconomically, you are just making mistake of assuming that something that is true for one good is true for whole economy.</p>
<p>This doesn't mean that GDP is a perfect measure, it ignores non-market activity etc. However, market activity privately produced or publicly produced is measured as intended. If anything, if you want to use GDP as measure of welfare, not just production it could be argued it actually allows governments to 'cheat', like China producing ghost cities that artificially inflate GDP. However, here again the problem is not with measurement of GDP which still correctly measures production that took place but rather in using GDP as welfare measurement.</p>

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2024-08-14T17:04:40.977Z
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1muflon1
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@R.Walker you said you want to continue in chat
1muflon1
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2024-08-13T22:17:24.603Z
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1muflon1
<p>I have thought of this problem and after searching it appears a similar question is asked <a href="https://economics.stackexchange.com/questions/50891/is-gdp-biased-against-public-goods">here</a> (apparently spawned by a debate on twitter), but I'm afraid the top reply doesn't fully resolve the issue.</p>
<p>First off, I know that government expenditures on final goods and services are included in the GDP. However, it appears to me that the &quot;value added&quot; by government production is not.</p>
<p>As an example, suppose the government wants to build a bridge. The cost of materials is 8 million and the cost of labor is 2 million. In total, the cost of constructing the bridge is 10 million (I don't know if these numbers are realistic). In Scenario A, the government hires a private contractor. Since the firm profits, the government pays more for the bridge than the cost of construction. The government pays 12 million for the bridge, with the firm profiting 2 million. In Scenario B, the government purchases the materials and labor at 10 million and organizes production of the bridge.</p>
<p>It appears that in Scenario A government expenditure is 12 million on the bridge. In Scenario B, government expenditure is 10 million on materials and labor necessary to build the bridge. Hence, in Scenario B, the &quot;value added&quot; in the process of constructing the bridge is not included in the GDP, even though it is arguably part of the final goods and services which are produced in the economy.</p>
<p>I want to clear up any possible confusion. It is possible that the private firm is capable of constructing the bridge more efficiently than the government. In this case, the amount the government pays the private firm might be less than the amount it costs the government to construct the bridge. We are assuming that it costs the same amount for the government to construct the bridge as it costs the private firm. We are also assuming that the time it takes to produce the bridge, quality of the final product, and all other aspects of the production process are identical. In calculating the cost of labor, we did not ignore the costs any architects, engineers, managers or other any other workers. We are also not concerned with which scenario the government would in fact choose, since this is ultimately a policy decision and I can imagine reasons the government would choose either. The point is that there is difference in GDP although output is the same.</p>
<p>The only difference between Scenario A and Scenario B is that in A the profits of the firm are included in the GDP while in B they are not, since the bridge is never exchanged on the market. We can even imagine a &quot;privatization&quot; scenario where after constructing the bridge the government sells it to a private firm for 12 million. Let's call this Scenario C. This case confuses me the most, because it appears that the 10 million necessary to construct the bridge is a government expenditure. However, when the bridge is sold to the firm these are now intermediary goods and should not be included in the GDP. Rather, investment has increased by 12 million. The government now has 12 million in revenue, which will become government expenditure, so GDP has increased by 24 million in Scenario C?</p>
<p>In many ways this is similar to how non-market production is not included in the GDP. For instance if I grow tomatoes in my backyard and eat them this is not included in the GDP. However, introductory textbooks always mention this, but I have not been able to find any source which mentions that the value added by government production is not included in GDP.</p>
<p>Returning to the post which I linked above, the top reply states</p>
<blockquote>
<p>If NHS would be converted into private company but they would spend the same amount of money for doctors, medical equipment, medical procedures and medicine GDP would stay same.</p>
</blockquote>
<p>However, if you consider my example above this is just not true. The reply misunderstands the definition of GDP, which includes only the cost of <em>final</em> goods and services. In the medicine example, the cost of the doctors, equipment, etc. are costs to the hospital (a private firm) and would be considered intermediary goods. The final service would be the medical procedures offered to the consumer. Since the hospital will receive a profit, the cost of the final service is greater than the cost to produce it. However, if the government is capable of producing the same service for the same cost as the hospital, the value that was added by the private firm is not included in the GDP since the government will not sell the medical service for profit. In both cases economic output is the same, although the GDP is calculated differently.</p>

<macroeconomics><gdp><government-spending>
Macroeconomics - Does GDP undervalue government produced goods and services?
R. Walker
# Macroeconomics - Does GDP undervalue government produced goods and services?

(Asked by: username_0 on 2024-08-13)

I have thought of this problem and after searching it appears a similar question is asked [here](https://economics.stackexchange.com/questions/50891/is-gdp-biased-against-public-goods) (apparently spawned by a debate on twitter), but I'm afraid the top reply doesn't fully resolve the issue.

First off, I know that government expenditures on final goods and services are included in the GDP. However, it appears to me that the "value added" by government production is not.

As an example, suppose the government wants to build a bridge. The cost of materials is 8 million and the cost of labor is 2 million. In total, the cost of constructing the bridge is 10 million (I don't know if these numbers are realistic). In Scenario A, the government hires a private contractor. Since the firm profits, the government pays more for the bridge than the cost of construction. The government pays 12 million for the bridge, with the firm profiting 2 million. In Scenario B, the government purchases the materials and labor at 10 million and organizes production of the bridge.

It appears that in Scenario A government expenditure is 12 million on the bridge. In Scenario B, government expenditure is 10 million on materials and labor necessary to build the bridge. Hence, in Scenario B, the "value added" in the process of constructing the bridge is not included in the GDP, even though it is arguably part of the final goods and services which are produced in the economy.

I want to clear up any possible confusion. It is possible that the private firm is capable of constructing the bridge more efficiently than the government. In this case, the amount the government pays the private firm might be less than the amount it costs the government to construct the bridge. We are assuming that it costs the same amount for the government to construct the bridge as it costs the private firm. We are also assuming that the time it takes to produce the bridge, quality of the final product, and all other aspects of the production process are identical. In calculating the cost of labor, we did not ignore the costs any architects, engineers, managers or other any other workers. We are also not concerned with which scenario the government would in fact choose, since this is ultimately a policy decision and I can imagine reasons the government would choose either. The point is that there is difference in GDP although output is the same.

The only difference between Scenario A and Scenario B is that in A the profits of the firm are included in the GDP while in B they are not, since the bridge is never exchanged on the market. We can even imagine a "privatization" scenario where after constructing the bridge the government sells it to a private firm for 12 million. Let's call this Scenario C. This case confuses me the most, because it appears that the 10 million necessary to construct the bridge is a government expenditure. However, when the bridge is sold to the firm these are now intermediary goods and should not be included in the GDP. Rather, investment has increased by 12 million. The government now has 12 million in revenue, which will become government expenditure, so GDP has increased by 24 million in Scenario C?

In many ways this is similar to how non-market production is not included in the GDP. For instance if I grow tomatoes in my backyard and eat them this is not included in the GDP. However, introductory textbooks always mention this, but I have not been able to find any source which mentions that the value added by government production is not included in GDP.

Returning to the post which I linked above, the top reply states

> If NHS would be converted into private company but they would spend the same amount of money for doctors, medical equipment, medical procedures and medicine GDP would stay same.

However, if you consider my example above this is just not true. The reply misunderstands the definition of GDP, which includes only the cost of *final* goods and services. In the medicine example, the cost of the doctors, equipment, etc. are costs to the hospital (a private firm) and would be considered intermediary goods. The final service would be the medical procedures offered to the consumer. Since the hospital will receive a profit, the cost of the final service is greater than the cost to produce it. However, if the government is capable of producing the same service for the same cost as the hospital, the value that was added by the private firm is not included in the GDP since the government will not sell the medical service for profit. In both cases economic output is the same, although the GDP is calculated differently.

**Tags:** macroeconomics, gdp, government-spending

---

## 2 answers

### Answer by username_1 on 2024-08-14. Score: 2

No it doesn't. If the government can build the bridge more efficiently, because it does not require profit, then the 10 million in your example is the correct added value.

The GDP is build on the idea that value of something is how much money others are willing to give up for it, there is good explanation about it in Mankiw Macroeconomics, in chapter 1. The idea is that consumers already shop around for the best offer, and the offer they accept is for sure at least the minimum value of the good and this is what GDP records. If the same apple in Aldi is cheaper than in TESCO, we do not say that Aldi undervalues the apple. If consumer buys the cheaper apple at Aldi for 1 euro, then that is the Aldi's apple addition to GDP, if they buy it in TESCO for 2 euro, then that is TESCO's addition to the GDP. We do not second guess where the people find value (maybe TESCO is closer).

Things get more complicated when we talk about government, because government spends other's people money so they do not necessary always show around for the best deal.

So here we have two possibilities:

1. Assume there is no corruption and government wants to get the best deal.

* Then if the best deal is to buy it privately for 12 million, then that is the value of that bridge for GDP.
* If the best option is to build it directly by hiring workers for 10 million, then that is the value of GDP.

2. If the government does not go for the best deal but purchases the 12 million bridge even when it could build it for 10 million, then we are not dealing with undervaluing, but exactly the opposite. The extra 2 million is a waste, and it would just artificially inflate GDP.


---

### Answer by username_2 on 2024-08-13. Score: 1

Your arguments are not correct if we talk about 'correctly' valuing goods or services. For a second forget about government provided goods and lets apply the same argument just to private consumption expenditure, I will return to your example after this short excursion.

Suppose the following;

We have two firms:

* firm A that can produce and sell car for 100 dollars
* firm B that can produce and sell car for 50 dollars

Now if consumer chooses car A we record consumption and thus also GDP increases by 100 dollars, if consumer chooses car B we record GDP increase of 50 dollars.

Does this mean that GDP somehow 'undervalues' car B? No! The car B simply costs less money than car A. GDP *by design* is a measure of finished goods sold at market prices, which is the way how we measure production (see discussion in Blanchard et al Macroeconomics Ch 2). In the above example, GDP is not undervaluing the car B the value of car B is recorded correctly at 50 dollars. That is the correct measurement of the value added by firm B.

Similarly, in your example of bridge construction, if government can produce the bridge more efficiently than private firm (which is what you assume implicitly since you assume government only needs to spend 10 million whereas private firm because of profit requires 12 million), and government decides to build it inhouse, then the correct measurement of value of that bridge is 10 million not 12 million. This 10 million is the correct value added, hence there is no measurement problem here.

What happens here is that if you just single out one good, no matter whether produced by government or private firm (as the example above shows), then the cheaper the single good can be produced the smaller the addition of that single good to GDP will be. This might make it look like GDP punishes efficiency, but this is not actually true.

GDP is **macroeconomic** measure. It tries to capture the production at macro level, not a production of a single good. If the consumer can get car B cheaper they will have 50 more dollars to spend on other goods or services or 50 more dollars to save. Similarly, if government gets the bridge 2 million dollars cheaper, they will have 2 million dollars more to spend or invest which will be reflected on GDP.

Consider the following numerical example for closed economy;

$$Y = C+ I +G \tag{\*}$$

Where $Y$ is the national income/GDP, $C$ consumption, $G$ government spending. Moreover, $I$ is by definition also given by $I =S+T-G \tag{\*\*}$ since saving is given as $S=Y-C-T$, where $S$ is private saving, $T$ taxes and $G$ government spending (hence T-G is public saving), and if you plug this to \* you will get \*\*.

Suppose for the sake of simplicity we only look at the example of bridge so consumer spending or saving is 0. Suppose national income is $Y=12$. Next the government takes all that income from private hands through lump-sum taxes $T$ so $T=12$ (hence no saving or consumer spending, here government just takes in all resources). Then;

Scenario A) government purchases the bridge for 12 from private company GDP is 12, because $G=12$, we have $Y=0+0+12=12$.

Scenario B) government builds the bridge itself for 10, then we have $G=10$, but that also implies that $I=0+12-10=2$. Hence, again $GDP =12$ because we have $Y=C+I+G=0+2+10=12$.

As you can see GDP is exactly the same from more bird's eye macro perspective. The unspent money that government saved simply became part of public saving and entered GDP that way. Alternatively, government could spend that 2 million on something else and again $G=12$.

Consequently, even though GDP seemingly punishes efficiency, this is just a fallacy of composition. Something that is true for one part is not true for whole e.g. if you stand up in stadium you see better, if everyone does, nobody sees better. In this example, if you just look at it from micro perspective it seems that GDP punishes efficiency (although again this holds both for private and publicly produced goods and services) but that is not true macroeconomically, you are just making mistake of assuming that something that is true for one good is true for whole economy.

This doesn't mean that GDP is a perfect measure, it ignores non-market activity etc. However, market activity privately produced or publicly produced is measured as intended. If anything, if you want to use GDP as measure of welfare, not just production it could be argued it actually allows governments to 'cheat', like China producing ghost cities that artificially inflate GDP. However, here again the problem is not with measurement of GDP which still correctly measures production that took place but rather in using GDP as welfare measurement.

> **Comments:**
> **username_2**: **Comments have been [moved to chat](https://chat.stackexchange.com/rooms/154649/discussion-on-answer-by-1muflon1-macroeconomics-does-gdp-undervalue-government); please do not continue the discussion here.** Before posting a comment below this one, please review the [purposes of comments](/help/privileges/comment). Comments that do not request clarification or suggest improvements usually belong as an [answer](/help/how-to-answer), on [meta], or in [chat]. Comments continuing discussion may be removed.  
> **username_2**: @R.Walker you said you want to continue in chat  

---

