The Science of Everything Podcast - Episode 76: GDP and Unemployment

Episode Date: June 2, 2016

An introduction to the economic concepts of GDP (Gross Domestic Product) and unemployment, including a discussion of how these concepts are defined, how they are measured, their relevance to understanding economic activity, and some limitations of these concepts as they are currently employed. Recommended pre-listening is Episode 65: Inflation and Interest Rates.

You're listening to The Science of Everything podcast, episode 76, GDP and unemployment. I'm your host, James Fodor. In this episode, we're going to look at the two economic concepts of gross domestic product, or GDP, and unemployment, both of which are very relevant for understanding the business cycle, which I wanted to a future episode on. So this is sort of preparatory for that, but also important concepts in their own right. So I will discuss how these two concepts are defined, how they are measured in practice, their relevance for understanding economic policy and some of the limitations of these concepts as they're currently defined and used. Recommended pre-listing for this is episode 65 inflation and interest rates, which will contain a bit of background information about inflation, which will be useful to know.

Okay, so let's get started and begin by talking about gross domestic product or GDP. A good way to start understanding what GDP is is to look at what it stands for, gross domestic product. You've probably heard people talk about GDP because it's very commonly discussed in the news, particularly financial news and other things like that. But perhaps you don't know exactly what it actually refers to or how it's calculated. So that's what we're going to talk about in this show. But let's consider the acronym Gross Domestic Product. Let's think about that.

So product comes from the word production, which obviously means, you know, what is produced, the output of an economy. Domestic means that the production occurs in the country. domestically, that is, as opposed to, overseas. And gross means that, essentially, everything is included. There are not subtractions made, and what that means exactly, we'll unpack it a moment. But the basic idea, then, if we put gross domestic product together, is the total value of all production that occurs in a country.

And that's exactly what it is. It's the total value of all the production of goods and services that occurs within a country in a given year. Or more specifically, it's the total, market value of all the final goods and services produced within a country in a given time period. Now, there's a couple of caveats there that are important. One is the market value. So a market value is a value or price that's traded in some sort of market. So the output of all of the different factories and industries and firms in the economy is valued at the market

value. That's important. The second important aspect is that it is, the GDP only includes the value of final goods and services. Now, a final good or a service is one that is sold onto a consumer. So this definition would exclude and does exclude intermediate goods or services, so that is goods that are used in the process of making some other good. So a lot of industrial machinery, for example, would be intermediate goods because they are used to then make further goods, which are then sold onto consumers for ultimate consumption. So GDP excludes all intermediate forms of production and only includes the value of final products. To understand why it's done this way, think about the production of bread, or a simple idealized form of the production of bread, which

is useful for thinking about these things. Just think about bread needs to be baked, and to bake bread, you need flour. To get flour, in turn, you need to grind wheat, which in turn is produced in a field. So wheat is used to make flour, flour is used to make bread. Flower is an intermediate good, which is produced from wheat, but is in turn not generally, or for the most part, sold separately to consumers, but mostly it's used to make bread and other baked goods. So flour would be an intermediate good here. Now, the way GDP works is that instead of adding up, say, the value of the wheat sold by the farmer, plus the value of the flour, sold by the flour mill, plus the value of the bread sold by the baker, that would be double counting, right? You're counting the value of the wheat three times. You're counting it in the original sale of the wheat. In the the sale of the flour and then in the final sale of the bread, obviously because each stage of production has to recoup their costs, the costs of their inputs. So if you just included the total value of all goods produced, you'd be counting intermediate goods or primary materials that are used in the production, you'd be counting them more than once.

This would lead to inaccuracies, because if you just extended the number of stages of production, you'd artificially inflate GDP, which wouldn't really give an indication of how much is actually being produced. The way GDP works is that it doesn't just add on sale value of the wheat plus sale value of the flour plus sale value of the bread. What it does is it looks at the sale value of the wheat and then it takes the sale value of the flour and subtracts the cost of the wheat and only adds on the additional increment. Likewise for the bread, you take the sale value of the bread, subtract the cost of all of the inputs and only add on the value, the additional extra value of the bread. This is called a value-added method where the cost of all of the inputs needed to supply some good or services subtracted from the market value of that good or service.

So what you actually have is a net gain of each stage of production. This is to avoid the double-counting problem. So that's the basic idea of what GDP is, but there's a lot more to unpack about how it's measured and some problems with it, and also there's an issue of adjusting for inflation, which I want to discuss. But first of all, let's talk a bit about how it's actually measured in practice. So far, we've just been talking about it as an abstract idea. There are three independent ways of measuring GDP, the so-called production, income, and expenditure methods.

In principle, all of these three different methods should yield exactly the same result. Of course, in practice, as a result of measurement errors, they're not going to yield exactly the same result, but they should yield basically the same result, because they are three different ways of looking at the same thing. So the production method adds up the value at each stage of production for all of the goods that are produced in the economy. This is sort of like the value-added method that I was talking about before. Implicitly, I was describing the production method to calculating GDP.

So the way you do this is that you estimate the gross value of all of the domestic output of all of the different economic activities. Then you determine the cost of intermediates, cost of materials and supplies and so on, and deduct those from the final value to obtain the gross value, which you then add. into gross domestic product, and you need to add that up over all of your different industries, of course, and weight them appropriately. There are many different complicated measures that are used to do this. But the basic idea is you add up the total cost of production, subtract the cost of intermediates, and then sum that over all your different industries and sectors of the economy. So that's the production method. The income method, instead of adding up

values of production, it adds up pre-tax incomes of all different types in the economy. So this includes salaries, wages, capital income, so interest, profits, and rent. It adds all of that up, so all of the different types of income that people in the economy earn. And then it adds back in taxes, minor subsidies. So that's to include government spending, because if you didn't include government spending, you'd be missing a large proportion of the economy. So private incomes plus government incomes, basically. And then you add on back depreciation as well.

Depreciation is usually deducted from income in doing accounting measures of profit, but for gross domestic product, we don't want to subtract off depreciation because we want gross domestic product. This is really where the gross comes from, is that depreciation is not subtracted off. Because we want to say that while some of GDP is used to offset depreciation, that is machinery getting old and wearing out and so on. The basic point of the income method is you add up all incomes, including government income, and add back on depreciation, and you get the total income of the whole economy, of everyone in the economy. Finally, the third and last method, the expenditure method, calculates the total amount of money that's spent on final domestically

produced goods and services. So this includes consumption, investment, and government spending. It also, you want to add on exports, but subtract off imports, because remember we're interested in gross domestic product, only what's produced in the country. So we want to subtract off everything that's produced overseas, spending on everything that's produced overseas, so imports, but we want to add on the spending sales to people who live in other countries of goods that were produced here. So that is we want to add on exports.

Now, to see why these three methods, income, production, and expenditure should all produce the same result. Just think about, I think the easy way to think about is to start with production and then look at the implications for that on income and expenditure. So if you start with production, production is the total amount of stuff that's produced. Now, if something's produced, be that a good or a service, it needs to go somewhere. Something has to happen to it, right? So that means someone must buy it.

The way that national accounts are constructed, by the way, is that if firms produce too much of a good and just have it sitting in inventory, then it's assumed or sort of pretended that firms purchase their own inventory. The reason to do this is just so that you don't have all the complexity of dealing with inventory changes, and therefore so we can say that all production is purchased, essentially by definition. If it's not sold at the market, it's assumed that the firm who produced it purchased it for themselves, and you impute a market value to that. So all production must be sold to someone, but whenever something is being sold, something is also being purchased.

This tells us that the production method should give us the total value of production should be the same as the total value of expenditure, because if the total value of production or production is purchased by someone, or someone has to spend that money, right? So the total value of production should be the same as the total value of expenditure. Likewise, you can't buy something. They can't be expenditure that doesn't correspond to some production. Because what would it be? What would you buy that wasn't produced?

So therefore, we can see that production and expenditure methods should come to the same result. And as for income, well, think about where people get their income from. They get it from selling something, be that their labour or providing services from their capital. So that's profits or rents or whatever else. The point is income always comes as a result of the expenditure. of someone else. Income for you is an outflow for somebody else. So clearly income and expenditure should be the same thing. Whenever someone spends money, someone else gets that money. So therefore, we can see that production, income and expenditure methods to calculate GDP, or should in principle

with appropriate corrections, yield the same result. There's another point I should make is that when we're looking at GDP, generally it's only the sale of newly produced final goods and services that are included. So not only are intermediate goods subtracted at, which I mean, mentioned before, but resale of second-hand items is also not included. At least, that is my understanding. It may differ somewhat between different countries. If so, it would need to be handled in a consistent way, because obviously you can buy a second-hand item which was not produced in this year. So that would be a way that production and expenditure and income could be decoupled. Usually the way that that's handled as I understand it is that only sales of newly produced goods or services

are included, not used goods. and use goods are generally a relatively small section of the economy, with the exception of housing, therefore it doesn't make a huge difference. And the housing is generally handled in a special category, which I'll mention later. So just bear that in mind. When we talk about GDP, we're just talking about newly produced goods and services, not resale of existing goods and services that were produced in a previous year. Now, you may recall that I mentioned that GDP is the total,

market value of all final goods and services produced in a country. That reference to the market value presupposes that there's some market price, the price at which an exchange is freely made between buyer and seller. Now, that's the case for a lot of things, probably most things, in modern industrialized countries, but there are still many things for which no meaningful market price can be established, or for which no trading exists. So one of the largest categories of these are goods and services that are provided by governments or charities, either free of charge or for very small, highly subsidised prices. So, for example, healthcare and education that are provided by the government or various forms of subsidies for different types of activity, transportation or whatever else for different people or zoo visits if the zoo is free, all of these sorts of things that the government provides. Police, fire, the military.

none of these things are really traded in markets. Now, remember, don't get confused here. Textbooks, for example, are traded in markets, and teachers are paid salaries, which are market-based, and military weaponry is traded in markets. But that's not what I'm talking about. Those things are included in GDP. Sale of those things is included.

What's not included is the production of educational services itself, at least not from public schools, or the production of military defense services, whatever services you think the military provides. Those things are not even. included in GDP. So don't get confused between the objects or goods that are used by these industries and the services provided by these industries or services sectors themselves. These sectors or services of the economy are not traded in markets or for the most part aren't. So how can we value them?

What price do we put on them when there is no price? Well the traditional way of doing this, because we want to include them in GDP, they're a very important part of the economy. The traditional way of doing this is to value them at the cost of production. Now this is problem because it sort of assumes that, well, it's sort of a problem in both directions. It's a problem on the one side because it eliminates any possibility of a consumer surplus. That is, normally we think that a good is worth more than the cost of its production. Otherwise, why would you bother to produce it, right? If its value was exactly the same as the value of its inputs, why bother?

Just keep the inputs and not bother with the production. No, the whole point of producing something for sale is that the product or service is worth more than the inputs and time etc that you used to make it. But that's not possible for government services, or at least it's not possible, essentially by the assumption of the way they're put into GDP, their value is assumed to be their cost of production. You might say, well, the value of having police and fire services

is far greater than the cost needed to pay the salaries and for equipment and so on one of these things. That's the point of having them, right, because they're really valuable. But that's not reflected in GDP. On the other hand, we could say that this value in government services the cost of production is problematic in the other direction? That is, what if the government is providing services that no one wants, or goods that are pretty useless?

This certainly was the case in many communist countries where a lot of production was demonstrably of goods that were such a low quality that they were worth less than the inputs used to make them. We might think that's a rather extreme case, but say something like the military, arguably, we don't think that the services provided by the military are worth the enormous costs that are required to support them. Again, I'm not taking a position on that. I'm just saying, at least plausibly, we might say that that's not the case.

Just because it costs many billions of dollars to support a military. It doesn't necessarily mean we think we get many billions of dollars of value out of that military. So the point is, valuing goods and services produced by governments at the cost of production is problematic either way. You might think it overvalues or undervalues those services. But that's the way it is when you don't have a market price to use. Another category of goods that are included in GDP that are not traded in markets are basically the value of homes or renovations and upkeep of an individual home. Now, I mentioned before that only goods, newly produced goods and services are generally included in GDP. Houses, as I understand, are different because typically houses, when they're sold, are used.

Most people don't buy a new house, or at least very many people don't. but also the value of a house is generally a large proportion of a family or an individual's total assets. And so it's important that those be included in GDP figures. And the way that this is generally done, again, as I understand it, the details of this can be quite complicated, but as I understand it, the way this is done is that it is assumed, remember, just like we, GDP statistics assume, that firms buy up all of their own inventories, it's also assumed that house owners, owners of houses rent the houses to themselves at the prevailing market rate. So this might seem weird.

Why would you assume that someone rents the house to themselves? It's so that we can include that economic activity in GDP. Otherwise, you can imagine a situation where everyone swapped houses with their neighbors, right? Everyone moved into their next-door neighbor's house and rented their house to the other next-door neighbor. And so everyone just swaps houses and starts renting to the other person. So basically everyone, the housing stock hasn't changed. everyone's still living in the same collective set of houses that just swapped around who's living in what.

But now the total rent payments have gone through the roof because everyone is renting now. And therefore GDP would go up dramatically because incomes and production would look much higher. And this is going to be not a small effect, but a very large effect, because housing is such a significant fraction of the economy. It's a very large proportion of many people's incomes.

So we don't want that. We want to include housing in GDP figures. And so in order to do that, it's assumed that everyone rents, their house, sorry, it's assumed that owners of houses who live in their own house rent their house to themselves, and therefore that economic activity is picked up in GDP. A final category of goods that I'll mention that are included in GDP that are not traded in markets are agricultural production for your own consumption. This is especially important when a large proportion of the economy consists of subsistence agriculture, that is, people basically who are traditional farmers, producing food largely to feed themselves and their families. Maybe they'll sell a little bit, but much of it's just consumed by themselves.

That sort of thing is obviously not traded in markets, but because it's very important for a lot of countries, it's generally included in GDP using estimates about the total market value of these agricultural products. Okay, so that's the basic idea of GDP and how it's calculated, as well as some of the nuances of that. GDP statistics are collected by basically all countries these days, and they're widely reported. They're used as a measure of economic progress and the performance of the economy, but I guess partly you might say with this excessive GDP

have come a lot of criticisms of GDP as a concept and criticisms of how it's used. There are a number of those, and I want to discuss some of them here with the view to help my listeners to be, I guess, critical consumers of this sort of information, to understand the strengths and limitations of GDP as a concept. So let's go through some of the problems and some of the issues surrounding it. First of all, one I've already mentioned.

government services and other services that are not sold in markets, like education, health and defense, are added to GDP according to their cost of production, not according to how much value they yield to consumers. I've already discussed some of the limitations of that, which you may think depending on the sector, could lead to over or undervaluing of the values of those goods and services. Another limitation of GDP is that it relates only to a flow, not stock variables. Now, what that means is that GDP records the income of a country every year, or the production in a country every year. It doesn't say anything about the total asset value in that economy. So one problem with this is that if a country is obtaining a large GDP by selling

its natural resources at a very prodigious rate, say oil or diamonds or whatever, its GDP will look high, but what's not reflected in that is the fact that assets are progressively being sold, and therefore wealth is accruing at the expense, well, income is accruing at the expense of a declining stock of wealth. So GDP is only a measure of income, not a measure of assets, and in that sense it's quite limited. Another big limitation of GDP is that it does not factor in what are called externalities. I'm pretty sure I have talked about externalities in a past episode. An externality, just in brief, is a cost or benefit to production that is not factored in to the price at which that good or service is sold because there are no property rights associated with it.

So pollution released as a result of producing coal power, for example, is a classic example of an externality. So there's a negative cost associated with that pollution, but it doesn't have to be paid by anyone when coal is burnt and when the power is produced. Therefore, the cost is not factored in to decisions about production and pricing and so on, and therefore maloptimal decisions are made concerning the relative amount of this production that are concerned. We tend to get too much negative externalities and not enough positive externalities. Now the point about economic growth is that, sorry, the point about GDP is that it does not include externalities, either positive or negative. Obviously because an externality is something that's not going to be reflected in the market cost, and therefore it's not going to be reflected in GDP.

So if a country increases its GDP by producing a lot of pollution, that pollution is a negative effect, but is not reflected in GDP. Another criticism of GDP is that does not include non-market economic activities. Now, this is not exactly a criticism because it's not designed to include non-market activities, but it's more of a limitation because there are important non-market economic activities that we might think are valuable or we might think should be paid more attention to than they are, but it's sort of neglected because they're not included in GDP statistics. So some examples of this are volunteer work, unpaid housekeeping services, barter and other types of trade that don't involve money, and also underground economic activity

that doesn't involve or that is not generally recorded or reported to official channels, like a lot of tradesmen, babysitters and things like that. Also drugs and other illegal activities typically not counted in GDP, so all of these non-market or quasi-market economic activities tend to be excluded, and these can be quite important, especially in a lot of developing countries. GDP is purely a measure of the amount of production or the amount of income. It doesn't say anything about who receives that income or the distribution of income, so it has nothing to say about distribution. You can, of course, look at the amount of income that different sections of the population

occur, but that's a different question to GDP itself. So it says nothing about equality of income. And another criticism of GDP is that it doesn't factor in any consideration for what is being produced. and this is an interesting one, I think. I'm still, to be honest, not quite sure I had to think about this. So maybe I'll give you the idea, and you can mull it over and see what you think. The criticism is this. GDP counts any work that is the value of any good or service that is sold at a market price

or plus government services and other things like that that have imputed values to them. But the point is some types of products that are sold at markets, we want to think of as providing value. and therefore a good thing. And other types of things that are sold at markets, we want to think of, or we would tend to think of, as compensating for some bad thing that happened,

and therefore not value-adding in the same way. So, for example, after a natural disaster or a war, there may be a considerable amount of economic activity, maybe even boosting GDP, as a result of rebuilding housing and factories and other things like that. But we probably wouldn't want to say that that's valuable in the same way as building new factories.

Another example is the value of healthcare, or spending on lawyers and other things like this, or insurance. These are sorts of things that, I mean, they have value in a sense, but in another sense, the only reason they're valuable is because we're trying to protect ourselves from various costs that we would rather not have to bear, other people suing us or being injured or something like that. Or cleaning up pollution is another example. It seems to be odd that the activity of producing pollution is not incorporated into GDP,

but cleaning it up, because that costs money, is included in GDP. That seems odd to a lot of people. So a lot of people think that there should be some distinction made between types of economic activity that we think is conducive to good living in a sense and other types of economic activity which are sort of more defensive or try to offset other bad things that happen. I'm not sure quite what to think about that because, I mean, bad things do happen and it's good to be able to avoid those bad things by having health care or police protection or insurance or whatever else. But on the other hand, it would be better not to have to bother about that in the first place. So it's a bit of a tricky issue about how to think about that, I think. But anyway, it is a criticism that's been made of GDP. A final critique that I wanted to mention here is that there are many intangible aspects of quality of life,

which are not included in GDP. This includes things like traffic congestion, amount of leisure time, public safety, the amount of open space, civic organizations, levels of trust, all of this sort of stuff, not factored into GDP in any direct way. And this is mainly, I guess, a reaction to the tendency to use GDP, or specifically GDP per capita. That means GDP per person. So divide GDP by the number of people in a country and you get the GDP per person. There's been a tendency to use this as a measure of living standards.

And the trouble with that is that GDP was never intended to measure living standards. It was developed during the era of the Great Depression, actually, to provide a measurement for total levels of production and employment. in the economy. It was not intended to be used as a measure of standards of living, but in a sense being adopted for that purpose. It can be useful for that purpose, because if you look at other things that we would care about, like say life expectancy or infant mortality or education levels or access to communication and other technologies, these things all correlate quite strongly with GDP per capita, although not perfectly. There are, of course, exceptions. GDP per capita does not directly measure any of the aspects of a good life. So at best, it's useful as a proxy

that is not as a direct measurement of something, but as an indicator, an indirect indicator for it, because we can use GDP to buy things that are valuable, like health and education and leisure time and other things like that, greater safety, etc. So there are correlations, but GDP per capita itself does not measure the standard of living. And so it's important to remember that because it's often abused and misinterpreted as to what it actually tells us. Now, before moving on to unemployment, there's one final aspect of GDP that I wanted to discuss, and that is the issue of adjustments for inflation. Now, I've spoken about inflation in episode 65, so listen to that if you're not really sure what the idea is,

but the basic idea of inflation is that it refers to rising prices over time, as a result of an increase in the money supply generally. Now, the reason this is relevant to GDP is that raw GDP figures are calculated based on current prices. you're adding up the total cost of production or sales figures or whatever across the economy or incomes. That's done in basically current money value. Now that's fine if we're just looking at how GDP is going this year. But if we want to look at GDP over time, especially over long periods of time, we need to adjust to the fact that price levels are changing.

And so $50 today doesn't buy as much as $50 did 20 years ago or 100 years ago. And so we need to be able to adjust for these changing price levels. doing that is, well, really quite difficult. I think really the big issue is not so much that we don't have data on prices, because we have data on how prices change over time, so you might just think, okay, we can just sort of take an average of that and figure it out. The trouble is that in order to work out how much prices are going up over time, we need to be able to compare the same good.

It's not so helpful if we have a new good that is a different price. I mean, how can you compare the price changes if the good is different? But the trouble is, especially over long periods of time, the goods almost always are different. You can look at a car now and a car 30 years ago and compare their prices, but the thing is cars now are not the same as they were 30 years ago. They're going to have additional features like, say, airbags, and ABS braking, and air conditioning and GPS devices, and all sorts of other things that they didn't have 30 years ago. Likewise, with computers. Even clothing and fruits and vegetables can potentially change in their quality and range and so on over time. and so it's very difficult to adjust or control for the changes in quality of products over time.

And there are various ways of doing this, which I won't get into here, but the difficulties in properly adjusting for inflation is actually one of the biggest challenges with measuring GDP over periods of time. There's one final aspect of comparability, but the difficulty of compatibility of GDP figures, which concerns not comparability over time, but comparability between countries, because that's one of the biggest things we want to do with GDP, right? We want to compare different countries and see how they're going.

But the trouble is many countries use different currencies. So if I want to compare the GDP of Japan to the United States, I have to find some way of comparing a total GDP in yen to a total GDP in US dollars. How do I make that comparison? Well, a simple way to do it would be to use the market exchange rate at which yen are exchanged for US dollars and just convert one to the other. So they convert all foreign currency GDPs to. US dollars and compare them in that. That is done and that's called GDP at nominal exchange rates.

The trouble with that, though, is that the exchange rate that prevails on international currency markets does not reflect the relative value of all goods and services. It only reflects the value of goods and services that are traded between those countries, or at least could be traded. So, for example, the price of commodities like oil and steel and things like that or even industrial machinery and all sorts of other things that are easily chipped between Japan and the United States. The value of those things is likely to have an impact on the yen-US dollar exchange rate. But the price of haircuts or McDonald's happy meals that are sold in Japan and the United States is not likely to have any impact or any significant impact on the exchange rate,

because those things can't be traded between those countries. You can't ship fast food meals or haircuts from one country to the other. So only goods that can be traded internationally have an impact on the nominal exchange rate. But that poses a problem because it can mean that the prices of goods that are not exchangeable between countries can be dramatically different from one country to another. So the famous example of this is the so-called Big Mac Index, where I think it's The Economist magazine made a comparison of the price of McDonald's Big Mac meals in different countries or converted to common US dollars.

And they vary dramatically, like by almost 10 times. times, I think, from the cheapest to the most expensive countries, even though the good itself, the Big Mac as a product, is nearly the same. Now, the importance of this is that this doesn't just apply to random things like Big Mac, so it can apply across the board, so that one US dollar tends to buy a lot more goods and services in a poor country, like Thailand or something, than it would in the US. And anyone who's traveled to developing countries would have experienced this. Your money goes much further in a developing country. for most things than it does in a developed country.

And the reason for this is because of that, those differences in exchange rates. Now, in order to adjust for this, what economists do is construct a new exchange rate, which is called the purchasing power parity exchange rate, or PPP. This is the rate at which one currency is exchanged for another when purchasing a common basket of goods across the different countries. So it doesn't really have anything to do with market exchange rates.

It just asks the question, how many yen would it cost me to buy this particular basket of goods in Japan, and how many US dollars would it cost me to buy that same basket of goods in the US? And whatever the ratio between the number of yen and dollars is to buy that same basket, then that forms the purchasing power parity exchange rate. If all goods could be easily exchanged between countries and services could be easily exchanged between countries, then we would expect nominal exchange rates and purchasing power parity exchange rates to be the same. Because if there were price differences between any goods in different countries, people would just buy them where they were cheap and ship them to where they're expensive and equalize out the prices. But because that's not possible, lots of things can't easily be traded,

like ready-cooked meals or haircuts, two famous examples, many other things as well. Therefore, there's no easy way to equalize out these price differences, and therefore price differences can remain for a long period of time. So therefore, when comparing GDP between countries, it's best to look at purchasing power parity comparisons, which provide a more realistic comparison between the value of the output of one country compared to another. So be aware for that if you're ever looking at GDP figures. Make sure that for most purposes you want to look at purchasing power parity figures.

And of course there are many difficulties with computing the purchasing power parity exchange rates, and sometimes they're changed and that can lead to big changes. One big controversy at the moment is how to value the exchange rate between the Chinese UN and the US dollar, because the official exchange rates generally thought to undervalue the UN, relative to the dollar. But if you think that the official exchange rate is not the best one, then what alternative you're going to use? And it's sort of very difficult to tell. This is relevant because different estimates in terms of the correct exchange rate between a UN and a US dollar can lead to big differences in the reported size of the Chinese economy compared to the US economy.

And you can see why that might have economic and geopolitical relevance. So these things, you know, they actually do matter. Okay, so finishing with GDP and now moving on to discuss unemployment, which is perhaps a more familiar category, but also still an important and complicated one. So the basic idea of unemployment is, well, someone who's not working, right? Well, not really. It's actually a lot more complicated than that. First of all, we need to define a concept called the labour force. The labour force consists of all those people who are currently employed in work, doesn't have to be full-time work, just some job, some paid remuneration, plus all of those people who are not employed but are

actively looking for work. This idea of active, looking is important and it generally means like attending job interviews, looking through want ads and replying to them, sending out resumes, things like this, or collecting unemployment benefits is another one. People who sort of say they would like a job but aren't doing anything to find one are not counted as unemployed under most measures. So the labour force consists of all of those people who are employed plus actively looking for work. Usually there's a further restriction that only people within a certain age range are considered. So maybe between the ages of 15 and 65 or 15 and 70 or something like that. Of course, this can differ between different countries, which causes a problem for comparability. But anyway, now, for a lot of developed countries, the labour force only comprises about two-thirds of the whole population. Maybe for different countries, it's 60 to 70%, something like that. So there's a good chunk of people who are just not in the labor force. And this includes people who are stayed-at-home moms and dads, people who are retired. people who are too young to work, people who are full-time students, also people who are living full-time in, say, hospitals or institutions for the mentally disabled, in prisons in the military are also usually excluded.

So there's a wide variety of people who are just not considered to be part of the labour force. If someone's in the labour force, but they're not actually working currently, that is in whatever period, the survey, the labour force survey, whatever is carried out, these things are conducted by surveys. if the person is in the labour force but not actively working, not currently working, then they are counted as unemployed. So the unemployment rate is the percentage of people in the labour force who do not have a job, that is, who are actively looking for work but not currently working. It is not the percentage of the total population that is unemployed. It's the total number of unemployed people as a percentage of the total labour force. That's very important to remember because the denominator is different in those cases.

The denominator of this fraction is not the whole population. only the labour force. And those differ by considerable amounts. We're talking only about 65% of the total population is in the labour force. Once we've established what we mean by unemployment, we need to understand that there are different types of unemployment. If you ask an individual person who was unemployed, they typically won't be able to tell you what type of unemployed they are. Even an economist likely wouldn't be able to tell, or at best they might be able to make a guess. These are not types that apply to specific individuals. Like you can point to this person and say that they're this type of unemployment and

another person and say they're a different type. At least in many cases, you won't be able to. No, the idea is that we can conceptually think about different reasons why unemployment happens and then class them into these categories. But you can't necessarily point to specific people and identify why they are unemployed. It may be a mixture of different reasons, but conceptually we can think about these different categories. So the three main categories are frictional unemployment, structural unemployment, and cyclical unemployment. So frictional unemployment, the first one, is the least problematic form. In fact, it can even be good, really.

You want a certain amount of frictional unemployment in a healthy labour market. Frictional unemployment is caused by workers moving between jobs, or looking for their first job or trying to find a better job. So someone who's just graduated college, say, and has been looking for an entry-level position, if they haven't been looking for one in fact too long, and we can debate about how long too long is, but if it's not been too long, then you would say they're frictional unemployed.

They're looking for their first job, or someone who has finished at one place but has moved house, are now looking for a new job. Again, if they haven't been at it too long, you'd say they're frictional unemployed. It's called frictional because there's an idea that, you know, you can't just jump from one job to another. It takes time to find work and to find a good match between skills and job needs. And this is not a bad thing to have this frictional employment. You would not want to live in an economy where there's no frictional unemployment because this would mean it would be basically impossible to leave a job and get a new one or impossible

for employers to take the time to find someone who is a good fit for the position. available. They just sort of have to pick the very first person who turned up, which would not be good. So a certain level of frictional unemployment is important for a functioning labour market. And frictional unemployment doesn't last very long and is usually voluntary or substantially voluntary. I mean, people might not like to have to spend as long as they do finding a job, but they're still in some sense choosing to spend the time to find a job that fits them properly or in their new house, in the new area they live or something like that. So frictional unemployment's generally not thought of as a big problem. The next time of unemployment, however, is a much big

problem, and this is called structural unemployment. This is long-term unemployment, which occurs because of a mismatch between the skills required of workers or demanded by companies and the skills possessed by workers or the desires or aspirations of those workers. There may also be aspects of discrimination, language barriers, having high minimum wage laws, other barriers that prevent people from finding and keeping jobs on a longer-term basis. This type of unemployment is much more problematic because it's typically involuntary. It's not because people are just looking for a new job or a better job. It's they just cannot find a job that meets their needs

or that they have their right skills for or not allowed, officially or unofficially for various reasons to accept that job. That would constitute structural unemployment. Tends to last a long time. Tends to be very difficult to get around, unless you acquire new skills or the circumstances change or something like that. The third type of unemployment that I mentioned is called cyclical unemployment. This type of unemployment is the result of

contractions of the business cycle. Now, we'll talk about this in more detail when I do an episode on the business cycle. The basic idea, though, is that cyclical unemployment is caused by an insufficiency in aggregate demand. So there's not enough spending in the total economy, therefore not enough jobs available, and people go out of work because there's not enough jobs being offered as a result of the insufficient spending. It differs from structural unemployment in that there's no particular, there's nothing

particular that the workers lack. They don't lack skills, or they don't lack language skills, or it's not that wages have been set too high by legislation or anything like that. It's just that there's not enough demand in the economy. Structural unemployment's not caused by a lack of aggregate demand. You could have as much demand as you wanted, but still have structural unemployment because of the mismatch and other barriers preventing people from getting jobs. So structural unemployment and cyclical unemployment are distinct.

Cyclicical unemployment can get very high during recessions or depressions, but it tends not to be very high over a long-term period. So you can't really have cyclical unemployment that lasts 10 or 20 years. years because it's not really cyclical at that point. It tends to come in waves and then diminish over the course of the business cycle. However, cyclical unemployment can lead to structural unemployment as a result of if the people who were originally went out of work as a result of recession, then find it very difficult to reenter the labour force as a result of not having relevant skills or deteriorating skills over time or just having been unemployed for a long period of time, etc.

So they can interact with each other. There's a final form of unemployment, which is it's not exactly distinct from the others, and it's sort of similar to structural, but I wanted to mention it, and that is hidden unemployment, or under-employment. And this is people who want work, but are not actually counted as being unemployed, because they're not actively seeking work. This might be because they already have work, but maybe they have a part-time job, but they want a full-time job, or they want more hours than they're able to get. Or it could be because they're just discouraged from actively seeking work because they think that the odds of finding a job are very poor. Or people who are

are involved in various government programs, but would rather be, and it's therefore not counted as being unemployed, but would rather be in a paying job, retraining programs and other things like that. Various people who have been discouraged or not counted among the unemployed, but kind of really should be. And it's important to remember that these people exist and can actually, if you include these people in the unemployment rates, for many, many countries that could double the unemployment rate if you include these sort of hidden, under-employed people. Unemployment is a big point. problem. It's not just a big problem because people don't earn the money, though that is one reason it's a problem. There have been a number of studies done about the cost of unemployment in

terms of psychological and sociological effects on people. It's been found that, particularly long-term unemployment, a little bit of unemployment, it's not so much of a problem, but over a long period of time where people can't find a job, especially because of structural unemployment, that leads to a great deal of loss of self-esteem, loss of feeling of control of one's life. It tends to lead to people to become. depressed and increases levels of stress. People have even found a significant increase in total mortality and various rates of diseases and suicides with people who are unemployed, a long-term unemployed compared to those who are working. There are, even apart from the economic costs of unemployment,

there are a lot of social and psychological costs which need to be more in mind, and that's the reason I think why unemployment is something to be concerned about, and a reason we want to try and promote a dynamic labour market, which allows people to find work without having to wait a ridiculously long amount of time. Now, final little issue that I want to talk about before ending this show is technological unemployment. This is something that's received, I mean, it sort of comes and goes. It's receiving a bit more attention lately as a result of the recent progress in machine learning and artificial intelligence and this sort of stuff, leading people to be more concerned about machinery, automation, and particularly artificial intelligent computer programs,

replacing labor and leading to loss of jobs. So this is the notion of technological. unemployment, people who lose their jobs as a result of technological change and introduction of new inventions, machinery, and computers, etc. The concerns about technological unemployment are not new. There are records of Roman emperors being concerned about this, and kings and other figures in the Middle Ages talking about this and banning various new inventions or taxing them or whatever because of concerns about putting people out of work. There was a big discussion of this in the late 18th, early 19th century, with the Industrial

Revolution and the rise of mechanization. than all these people who were previously working by hand were going to be put out of work and what would they do. Over the course of the 19th century, it was gradually observed that unemployment rates weren't increasing. In fact, new jobs were being created in new industries that people hadn't even imagined before, and economic theory was developed to understand this.

Basically, it was understood that. The amount of work that can be done or that needs to be done is not fixed. It's going to depend upon what tasks are available, to be done and are sort of conceived as tasks that need to be done. And those change over time and they change when new technologies are introduced, when new inventions are available. So nearly all of the jobs that people do today, in industrialized countries at least, would not have existed even 50 years ago, certainly 100 years ago.

Not all of them, but many of them. I mean, you think about anyone who drives any sort of automobile. Well, that didn't exist a bit over 100 years ago. Aircraft pilots, people couldn't have even conceived of that sort of occupation in the mid-19th century. But more of the point, anyone who works with computers, that's something that would have been inconceivable only a few decades ago. Certainly people like internet developers. Many, even, many types of medical specialties didn't exist not that long ago. All sorts of jobs that we could mention exist as a result of various technological and sometimes

there's also social changes that bring about the need and the ability to do that type of work. And what we've observed throughout history is a constant change and flux in the range of jobs that are available and that are completed based on the technological and the social infrastructure that exists. So this is typically what economists have said since that time around the mid-nineteenth century is that technological change can certainly produce short-term unemployment. It can put particular people out of work because their labour is not needed anymore. They can be done by a machine or a computer now. However, economists have generally said there's no reason to think that technological progress is going to lead to an increase.

in long-term unemployment over a long period of time. Certainly, I mean, the big argument for this is if that was the case, there should be about 98% unemployment now, because about 200 years ago in most countries in the world, over 95% of people were involved in agriculture in many places. So since only about 2 or 3% of the most developed countries, only about 2% or 3% of the labour forces working in agriculture, a simple argument would say, well, although the rest of those people should be unemployed, since we've now found a way of producing enough food to feed everyone with only a few percent of the population. Of course, that's not the case, everyone else has found, or most other people have found new things to do that didn't exist two or three hundred

years ago. The question, though, is whether this is going to continue indefinitely into the future. The fact that it's happened in the past doesn't imply that it necessarily will in the future. Maybe new technological developments, particularly with ever smarter computers and artificial intelligence, will eliminate the need for any sort of human input at all into the productive process, and humans will cease to have any value, or for the most part, will cease to have any value. That's the concern anyway. I'm a bit skeptical about this. I think many economists still don't really buy this argument.

The basic idea is that just because we can't see now what a lot of people will be doing in 30 years' time or 40 years' time doesn't mean that they won't be doing something. Past experience indicates that things will be found for them to do. There's also the notion of comparative advantage as long as humans have some comparative advantage relative to machines, that means there'll be some market niche for them. You can look at one of my past episodes where I talked about comparative advantage

for further explanations to what I mean by that. Bottom line is no one can say for sure because the future is uncertain. Generally, economists are not too worried about technological unemployment, at least in the long term, is certainly the case that in the short term there can be significant adjustment costs, and structural unemployment can result from rapid technological change. So I definitely think that there's concerns there and something we need to look into. I don't think it's going to be the case that, you know, in 30 years' time,

computers have going to take over 90% of jobs in the economy, but we can never be completely sure about things, and at the very least it's a good to understand the debate and sort of the arguments pro and con these sorts of concerns, and certainly an understanding of what is meant by unemployment and how it's measured and how the concept is understood in an economic sense is important to understand these concerns. And hopefully you got that out of today's show.

So that brings to a conclusion of what I wanted to talk about today. Hopefully you enjoyed this episode. If so, or if not, or regardless, I'd love to hear your feedback about the show. You can send me an email at FODs12 at gmail.com. That's F-O-D-S-1-2 at gmail.com. I'd also be obliged if you would go to iTunes or the iTunes website and leave a review for The Science of Everything podcast.

That's helpful to attract new listeners to the show. Thanks for listening, and I'll talk to you next time.