Tuesday, November 3, 2015

The Economics of Squirrels! or What is GDP and how does it grow?

The economic world of squirrels
After reading my last post on minimum wage policy, a friend of mine asked: “does increasing the minimum wage actually increase the overall supply of goods, or does it simply redistribute that existing fixed quantity?” This is a very cool question, and to answer it, we first have to understand what makes up gross domestic product (GDP).
           
What is GDP?
GDP is the total amount of value produced by a country in a calendar year. It is the sum of what everyone spends, what everyone invests, what the government spends and what the country sends to and receives from other countries. The equation looks like this:

GDP =


So, let’s say that six squirrels live in the same tree and each squirrel can gather 100 nuts in a year. The government then taxes each squirrel 10 nuts, and spends those 60 nuts fixing up the tree. A squirrel-preneur, whom we will call Richard spends 50 of his nuts building a store to sell peanut butter, and Jim (the really excited guy on the right) exports 10 nuts to a neighboring tree and all other nuts are consumed. The GDP here is:

Consumer: Production: (100 x 6) – Taxes: (10 x 6) – Savings: (50 + 10) = 480
Government: 60
Investment: 50
Exports: 10
Imports: 0
GDP = 600.

What makes GDP grow?
Because GDP is the main measure of prosperity in our world, we are often obsessed with making it grow. So how could we increase the GDP of this tree?

The first way of increasing the output of the tree would be to add more squirrels. As population grows, so does GDP, because each additional squirrel can harvest 100 more nuts per year.
Squirrel Babies!
The second major influence on GDP is technology. If the squirrels are given reacher-grabbers, they can gather more nuts, increasing their production and the tree’s GDP.
The internet does not yet have a picture of squirrels using reacher-grabbers, 
it’s never let me down like this before. 
The last major influence is capital. This is the investment in factories, machines, buildings, etc. that can be used to produce additional goods. In this example, the peanut butter store built by Peter is an investment in capital. Technology and capital both add to GDP because they increase the productivity of workers, or replace workers and allow them to labour elsewhere without decreasing the tree’s productivity.


These three things: population growth, technology and capital are the only methods of increasing total economic output in the long run. If the population doesn’t grow, and investment and technology remains the same, GDP does not grow.

But GDP changes all the time!
Yes, GDP changes all the time for a variety of reasons: first, the human population continues to grow.


Second, technology is making us more productive:
This is okay, but my dream is to be an automatic teller.
Third, since 2006, Canada has invested an average of 23.5% of its GDP into fixed capital (stores, factories, oil rigs, etc.). This money continues to improve the efficiency of works and develop new products like the iPhone 6S.

Last, there are many methods of adjusting when certain transactions are realized. For example, if you raise interest rates, people are more likely to save their money, deferring the production and purchase of things like cars and houses. This means GDP this year will decrease, but the total economic output of the system is not necessarily impacted, as that money might be spent next year instead. This gets at the concept of long-run equilibrium, which you can read about here.

So back to the original question: would increasing minimum wage raise total economic output?
The answer is: not necessarily. This is because when you raise minimum wage, you are mostly diverting money that would have otherwise been saved or spent elsewhere into increased labour costs.  Thus, you are not changing the total economic value of the system, but just adjusting when that value is realized. 

For example, McDonald’s will be required to pay its employees more money, meaning they will charge more for cheeseburgers, so families dining there will have less disposable income to save or spend elsewhere. Therefore, money that would have been spent later (perhaps after retirement?) is being spent now on a more expensive Big Mac.

However, the additional money that is being earned by minimum wage employees is then spent, and spent again, and again (according to the multiplier effect – see my last blog post), which could produce more economic value this year than would have been created if that money had been saved or spent elsewhere. This additional economic value might then be invested (in technology or factories), or used to afford more children, increasing long-run economic output.

Thanks for reading
Let me know if you have any questions about minimum wage policy, or if you would like me to cover a particular economic topic in the future. For my next post, I am going to look at murder rates and gun policy.