I know enough economics to get into things, but generally am far from complete understanding. So I’m writing this about something I’ve been thinking about and hope for comments from people more knowledgeable. In my Googling around I can’t find this brought up anywhere, so I’m assuming I’m wrong. That or it’s really interesting.

Say you and 999 of your friends live in a nice little country called Libertania. Everyone is gainfully employed and the 1000 people earn $5/hour, $10k per year producing a GDP of $10 million.

People in Libertania are naturally quite self-sufficient. I spend 40 hours a year fixing my own car, and 35 hours mowing my lawn – 75 hours total. You are more efficient at both, requiring only 30 hours to fix a car, and 32 hours for lawn mowing – 62 hours total.

One day we each read a book on the theory of comparative advantage. Following the recommendation, we decide to specialize. You fix both our cars. This takes you a total of 60 hours, saving you 2 hours or $10. I mow both our lawns, taking a total of 70 hours, saving me five hours or $25. Granted, it would probably get more equitable in time but it doesn’t really matter.

Win-win! Together we saved seven hours in time, worth $35! Even though you are better at both things, we can both benefit by specializing in what we do best.

With our savings, we could now either relax and enjoy more leisure time, or use that time to work more and earn an additional $35. But for now lets ignore that.

Other citizens of Libertania notice us relaxing with our extra time and want in on this deal. Bartering services becomes rather tedious to keep track of so we all switch to just paying each other. Keeping it simple, fixing a car for a year costs $200, and a year of lawn mowing costs $200. The system works so well that all citizens now specialize in one or the other.

The government of Libertania (a small one…) is a modern economy and interested in knowing GDP – roughly, the total goods and services produced by the economy. Before this specialization trend the GDP was $10 million. Now, each citizen pays another $200 a year for one of the two tasks, a total of $200,000 changing hands. The GDP increases to $10,200,000, and the government marvels at it’s success in raising GDP 2% over the prior year.

But remember, what we actually saved was 7 hours in time between us, for a national savings of 3500 hours annually. At our average wage of $5/hour, that’s worth $17,500. Still good, but it’s hardly the $200,000 increase that the GDP showed. $182,500 of that increase is due simply to a transaction taking place. It didn’t add any actual value to anything – nothing was produced. It appears to be 91% overstated.

The more we specialize and exchange services the more we grow GDP. That’s good. But the actual value to the citizens is overstated in the GDP growth. They didn’t get 2% better off. They got 0.175% better.

I don’t know what the actual gap between true comparative-advantage savings, and the transaction amount is. But I’m confident that it’s significant. To be the same would require the savings for each of us to equal the price of the service, which is absurd. We would have had to have saved 40 hours each in the deal to justify the full $200 in GDP. You can play with the numbers but I can’t see any way to make it close to accurate.

But you say, remember the 7 hours in savings. We’re hard-working Libertanians and would spend that time working and making more money to make our lives better. So in addition to the transaction, we work an additional 7 hours, or a total of 3500 hours for the entire country, for a total of $17,500 in true, new, value and income (depending on how you’re measuring GDP)

But, the true value did not go up. I traded my newly-freed-up leisure time for money, which is a net zero.

So now, that income is added to reported GDP growth to make it $217,500, with a true increase remaining $17,500. That actually makes the overstatement worse at 92%.

That seems like a big deal. Services are roughly 68% of the US GDP

Almost any conceivable number would indicate that GDP growth has been significantly overstated.

Thoughts?

Next up, tax implications…

The tax rate at which the original transaction becomes a net loss for us is equal to 1 minus the overstatement – or 9%.