2.1 Production and aggregate economic activity

Production, output and product

Basic concepts

2.1 Gross domestic product (GDP) is the key measure in the Canadian System of National Accounts. GDP lies at the centre of the two architectures of the Canadian System of National Accounts (CSNA) — the industry-based Input-Output Tables that provide a value added measure, and the sector-based Income and Expenditure Accounts that provide both income-based and expenditure-based measures. GDP reflects the aggregate production of an economy. Production is an activity which uses inputs (labour, capital, goods and services) to produce outputs (goods and services). It excludes purely natural processes without any human involvement or direction, such as the unmanaged growth of fish stocks (whereas fish farming is production).

2.2 Output consists of those goods or services that are produced within an establishment¹ that become available for use outside that establishment.² The output includes work in progress whenever a process of production extends over two or more accounting periods as well as any goods or services produced for its own final use. The gross value added is defined as the value of total output less the value of all goods and services used in the production process (intermediate consumption). GDP (at basic prices) for the economy is equivalent to the sum of the value added by all resident producers. GDP at market prices is the aggregate GDP plus taxes, less subsidies, on products.

2.3 The relationship between output and value added gives an idea of the extent of transformations taking place in the economy. Product or GDP, regardless of how it is measured in the Canadian System of National Accounts, is the end result of productive activities.

Classification of productive activities

2.4 Understanding the production boundary is central to measuring gross domestic product as the level of GDP is affected where the boundary is drawn. Table 2.1 presents a diagram demarcating production.

2.5 The output resulting from production is classified as either market or non-market. Market output is output that is sold, or intended for sale, at economically significant prices. Non-market output consists of other output whose characteristic is that it is not exchanged, disposed of or sold at an economically significant price.

2.6 Market output is generally sold at an economically significant price, that is, a price that has a significant influence on the amounts that producers are willing to supply and the amounts that purchasers wish to buy. Transactions are settled in cash or cash substitutes (that is trade payables or receivables) by barter or in kind. Market output includes:

• the total value of goods and services sold or marketed (at an economically significant price);
• the total value of goods and services bartered;
• the total value of goods and services used for payments in kind, including remuneration in kind;
• the total value of goods and services provided to another establishment within the same enterprise; and,
• the value of changes in inventories of finished goods and work in progress intended for one or another of the above uses.

2.7 The productive activity that results in market output is sometimes unreported or concealed.³ Economic activity where the scale is small enough that traditional sources of information may not pick it up is referred to as the informal economy. Informal activity is relatively insignificant in Canada. Concealed production includes productive activities that are authorized by law but are not reported, for various reasons, such as to avoid paying income taxes or other taxes, or to avoid particular legal obligations, etc. Lastly, illegal production is also concealed activity. It consists of the production of goods and services whose sale, distribution or possession is forbidden by law but is carried out, by mutual agreement between the parties. Examples of such activities include the manufacture and distribution of narcotics, smuggling of goods and prostitution. The different aspects of market production are shown in the upper part of Table 2.1. It should be noted that eventhough no explicit adjustment is made to include illegal activity some illegal activity may enter the market economy through money laundering.

2.8 Non-market output consists of other types of output whose common characteristic is that they are not marketed, exchanged, disposed of or sold at an economically significant price. There are two types of non-market output: own account output and other non-market output.

2.9 The own-account output consists of goods retained by institutional units for their own final consumption or their own capital formation. For business and governments, own-account production takes the form of gross fixed capital formation. For example, the manufacture of specialized tools by an engineering firm when the tools will subsequently be used in the production process.

2.10 The other non-market output includes individual or collective goods and services to which the price mechanism cannot apply. It also includes goods and services that a producing institutional unit has decided to supply to other institutional units either for free or for prices that are not economically significant. General government administration and national defence are examples of output for which the price mechanism does not function freely. The different aspects of non-market production are shown in the lower part of Table 2.1.

2.11 In the case of households, own-account production corresponds to final consumption. For example, some crops produced by farmers may be used for final consumption by the farmer's household. Clothing or pottery may be produced by households for own-consumption.

2.12 Unpaid personal and domestic services are excluded from the production boundary, but occasional estimates are available.⁴ Examples of these are:

• Cleaning, decorating and maintenance of the dwelling occupied by the household, including minor repairs usually done by renters or owners;
• Cleaning, maintenance and repair of durable consumer goods or other goods, including vehicles used for the needs of the household;
• Meal preparation and table service;
• The care, education and training of children;
• The care of ill, disabled or elderly persons;
• Transportation of household members or their goods.

Canadian System of National Accounts production boundary

2.13 As can be seen from Table 2.1 the production boundary in the Canadian System of National Accounts is very close to the System of National Accounts 1993 (SNA 1993). In the domain of market output, the Canadian System of National Accounts currently excludes illegal production except smuggling activity, where significant. Smuggling of cigarettes is an example of where the Canadian System of National Accounts includes an estimate.

2.14 Among the own-account production, the excluded items are: the production and processing of agricultural and related products; other kinds of processing, such as production and alteration of clothes, semi-durable or durable goods such as furniture. The production of these goods can easily be sold on the market. The rationale for exclusion of household and personal services produced by households for their own consumption follows that provided in paragraphs 6.19 to 6.21 of the System of National Accounts 1993:

2.15 However, it is worth noting that paid household and personal services (performed by domestic staff) are included in production, since this is a form of market output.

2.16 The own-account housing services produced and consumed by owner-occupants is included. The housing services of owner-occupants are similar to rental housing services, which are included in market output. For the housing services produced and consumed by owner-occupants, the System of National Accounts 1993 provides this explanation to justify inclusion:

Analytical definitions applied to GDP

Net or gross GDP

2.17 Economic production involves the using up of productive capital assets–the "consumption" of capital. Because capital assets are highly durable, this using up is a gradual process, typically occurring over many years. Fixed capital consumption, often called depreciation, represents the reduction in the value of fixed assets used in production during the accounting period, resulting from physical deterioration or normal obsolescence. This convention parallels financial accounting, as businesses customarily allocate to each period's operating expenses a depreciation charge designed to cover the wearing out of capital assets during the period in question. Depreciation is therefore both an economic and a business cost, which is included in the market price of goods and services sold to final users.

2.18 GDP therefore includes capital consumption allowances. The term gross is used to indicate that the consumption of fixed capital,⁶ is part of the measure. The term net signifies that the consumption of fixed capital is excluded from the definition of production, yielding net domestic product (NDP). Some analysts contend that the gross measure is more useful for some analyses, because in the short term the replacement of capital can be postponed. Consequently, it is gross product that is used for final consumption. However, the continuous consumption of gross product, without replacement of the assets used, would gradually reduce the country's wealth. Other analysts are focused on net national product (NNP), arguing that it provides a better picture of the nation's economic progress since it measures the amount of output that is left after providing for maintenance of the stock of productive capital.

National or domestic product

2.19 In national accounting, an economy is defined by the entire set of resident institutional units. An institutional unit is resident in a country when it has a centre of economic interest in that country's economic territory. A centre of economic interest is a location—a dwelling, place of production or office—from which it engages, and intends to continue to engage, in economic activities and transactions on a significant scale either indefinitely or over a finite but long period of time.⁷ It includes production within diplomatic enclaves.

2.20 Gross domestic product (GDP) is the sum of gross value added across all resident units— industries or institutions regardless of the ownership (Canadian or foreign) of the factors of production. The GDP measure, as the key macroeconomic aggregate, allows for better correspondence to domestic employment and domestic prices.

2.21 Gross national product (GNP) or gross national income (GNI) is a measure of the total unduplicated value of production of goods and services of Canadian residents at market prices (it excludes the activity related to non-resident factors of production). The concept of national refers to the economic activities of the resident economic units, in their capacity as owners of the factors of production within a country or region. Otherwise stated, GNP (GNI) represents the income received by resident economic units due to their ownership of the factors of production, regardless of where the production takes place. GNP (GNI) is more closely associated with the IEA sector-based accounts of the Canadian System of National Accounts. It is equivalent to GDP plus compensation of employees and investment income received from non-residents minus compensation of employees and investment income paid to non-residents.

2.22 Until 1986, the central concept of the Canadian System of National Accounts was gross national product. Since then, gross domestic product has supplanted it. This change was introduced in order to facilitate analysis of the economic situation and statistical integration of the components of the national accounts. The advantages of the domestic measure over the national measure are as follows: GDP is more closely related to employment and domestic prices than is GNI; it is easier to reconcile the components of the Canadian System of National Accounts; regional and national measures are better integrated; and, most countries emphasize GDP as the primary measure of product. That being said, GNI is making a comeback as a main indicator in recent times, where globalization and other current events are causing analysts to look more closely at the ownership of factors of production.

GDP at market price or at basic price

2.23 GDP is valued at both basic price⁸ and at market price. Aggregates expressed at market prices are valued at the prices actually paid by purchasers, meaning that they include all taxes less subsidies on products, such as:

• the Goods and Services Tax (GST) and the Harmonized Sales Tax (HST);
• sales taxes;
• fuel taxes;
• import duties and taxes;
• excise taxes on tobacco and alcoholic beverages;
• subsidies paid on agricultural products;
• subsidies paid on transportation services and energy.

2.24 They also include taxes less subsidies on factors of production, such as:

• property taxes;
• capital taxes;
• payroll taxes;
• subsidies for job creation and training.

2.25 Estimates at basic prices are obtained by leaving out taxes less subsidies on products.

2.26 The two concepts meet different analytical needs. Valuation at market prices is better suited to analysing final demand, where the focus is more on the price that purchasers actually pay. Valuation at basic prices is better suited to analysing the content of the resources incorporated into different goods or services or resource allocation. It represents the sum of the incomes from the factors of production as measured by the cost of the labour and capital factors, including net taxes on the factors of production, used in the production process. In economic terms, the concept of basic prices is considered the most useful concept for analysing the production and relative distribution of primary resources between industries.

Alternative approaches to calculating aggregate GDP

2.27 Gross domestic product can be measured in three ways. The first and most intuitive method is called the production or value added approach. It consists of summing the gross value added of all industries (resident sectors).⁹ For each industry, this involves subtracting intermediate consumption from the industry output. The GDP at market price is obtained by adding taxes less subsidies¹⁰ on products to the sum total of value added. In our simplified hypothetical example that follows, we assume that there is no government and therefore taxes do not exist.

2.28 The second method, the income approach, consists in summing all the factor incomes generated in the production process plus net taxes on products and on production. In our simplified example that follows, workers are compensated by wages and the owners of capital are compensated by profits.

2.29 The third approach, the final expenditure approach, consists of summing the expenditures of those purchasing final goods and services. In the example, this includes final consumption expenditures, and exports minus imports, assuming no capital formation. Table 2.3 shows that the three approaches yield the same value for final output in the economy.

A hypothetical economy with no government and no capital

2.30 Imagine an economy with just three businesses, one producing wheat, another flour and the last one bread. The wheat-producing company (Firm 1) operates farms that grow wheat. It imports seed and fertilizer and pays wages and salaries to its workers. Some of its wheat output is sold to a milling company (Firm 2) and the rest is exported. The wheat company realizes a profit after deducting expenses from its sales revenue.

2.31 The milling firm, in turn, uses the wheat that it purchases from Firm 1 to produce flour. It sells some of the flour to a bakery (Firm 3) and the rest directly to final consumers. Like Firm 1, it pays wages and salaries to its employees and realizes a profit after deducting expenses from revenues.

2.32 Finally, the bakery purchases flour from the second firm and uses it to make bread for sale to final consumers. Table 2.2 depicts this hypothetical economy.

2.33 Data on the hypothetical economy can be used to calculate output. It consists of the sales of each of the firms. In the example, the output of the economy is $515 ($150 + $165 + $200; see Table 2.2).

2.34 However, in this way of measuring value added, there is duplication. The seed and fertilizer used by Firm 1 to grow the wheat are counted in the output of Firm 1, the wheat used by Firm 2 to make flour is counted in the output of Firm 1.The same goes for flour used by Firm 3, which is included in the output of Firm 2. The seed, fertilizer, wheat and flour in the example all have a common characteristic: they are intermediate inputs,¹¹ that is, they are goods and services that were consumed as inputs in the production of other goods and services. When the output of the different industries is added up to obtain the output of the economy as a whole, intermediate inputs are counted both in their industry of origin and in each of the industries that use them, and this is what is known as duplication.

2.35 Another feature of output is that it includes not only domestic output (that which is produced in Canada) but also a portion of foreign output. In the example, seed and fertilizer are imported, and hence are produced abroad, but they are included as output and must be deducted to obtain domestic GDP.

2.36 Using the data on the hypothetical economy, we can calculate the value added of each firm. They are:

• Firm 1: $150 - $15 = $135
• Firm 2: $165 - $100 = $65
• Firm 3: $200 - $130 = $70

2.37 Table 2.3 illustrates the three approaches to calculating GDP.

2.38 This simple example illustrates how Canada's GDP is calculated. The sum of incomes (135+65+70=270) and sum of final expenditure (50+35+200-15=270) methods are both used in the IEA and they yield two essentially independent estimates of GDP. The sum of value added (135+65+70=270) used in the Input-Output Tables provides a third estimate of GDP.

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• 2.2 Institutional sectors dimension of the Canadian System of National Accounts – The Income and Expenditure Accounts

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• 2 Concepts and definitions

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Notes

1. An establishment is an enterprise or part of an enterprise, that is situated in a single location and in which only a single (non-ancillary) productive activity is carried out or in which the principal productive activity accounts for most of the value added, according to paragraphs 5.21 and 6.80 of System of National Accounts 1993. Establishments are grouped into industries.

2. See paragraph 6.38 of System of National Accounts 1993.

3. This is often referred to as the underground economy, but the more recent and broader term is the unmeasured economy. Two separate studies have been published on the underground economy: "Assesssing the Size of the Underground Economy: The Statistics Canada Perspective", Income and Expenditire Accounts Technical Series no 28, May 1994; and, "The Size of the Underground Economy in Canada", Studies in National Accounting, June 1994, catalogue no. 13-603, no 2.

4. "The Value of Household Work in Canada, 1992", Income and Expenditire Accounts Technical Series no 27, March 1994.

5. System of National Accounts 1993, paragraph 6.29.

6. Fixed capital consumption represents the reduction in the value of the fixed assets used in production during the accounting period, resulting from physical deterioration, normal obsolescence or normal accidental damage. See paragraph 10.27 of System of National Accounts 1993. Fixed capital consumption is the term recognized in international accounting. In Canada, the term capital consumption allowance or depreciation is also used.

7. The concept of residence in national accounting is identical to the concept described in the Balance of Payments Manual of the International Monetary Fund (IMF). It is explained in that manual and also in paragraphs 4.15 and 4.16 and Chapter XIV of System of National Accounts 1993.

8. Canadian basic prices in the Input-Output Tables do not correspond exactly to international basic prices. In the Canadian System of National Accounts, the concept of modified basic prices is used. It refers to the price at the factory gate of the producing establishment, excluding sales and excise taxes collected after the final processing stage. The modified basic price of a product is equal to the price receivable from the purchaser minus any transport margins and trade margins at the time of delivery of the product to the purchaser and any taxes on products. In Canada, the modified basic price is the subsidized price on products, while in the System of National Accounts 1993, it is the real price plus subsidies.

9. Resident units are grouped in homogenous sectors.

10. The net taxes are added because they are not included in the values of the outputs and value added of resident producers.

11. The term intermediate inputs is used here to mean intermediate consumption, which System of National Accounts 1993 defines as follows: "Intermediate consumption consists of the value of goods and services consumed as inputs by a process of production, excluding fixed assets whose consumption is recorded as consumption of fixed capital. The goods or services may be either transformed or used up by the production process."