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I'm trying to understand GDP and what it means.

Say that there are two US software companies, Foo Inc and Bar Inc. Foo Inc produces software and charges Bar \$1 million for its usage, while Bar Inc produces its own software product and charges Foo Inc the same amount of \$1 million.

While money did change hands, the profits of both companies remained the same, as they both incurred the same amount in revenue and expenses.

Would the national GDP increase by \$2 million because of these transactions?

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    $\begingroup$ It's not a circular invoice. They are merely two transactions connecting two companies and which is part of a whole network of transactions. $\endgroup$ – Mozibur Ullah Jul 7 at 20:29
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    $\begingroup$ the profits of both companies remained the same this is not necessarily true in this example. Say for example it cost Foo 500k to produce the software (programmer wages) and it cost Bar 3 million to produce its software. For that particular transaction Foo made 500k profit while Bar lost 2 million $\endgroup$ – slebetman Jul 8 at 6:39
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A firm's contribution to GDP isn't revenues. A firm's contribution to GDP is roughly the sum of the wage bill and the money earned by capital (debt (interest) and equity (economic and not accounting profits)). That is, profits + interest payments + wages (look elsewhere for a more precise definition). Your example doesn't really have enough to go on to estimate the GDP impact.

The contribution could be zero. This can and did happen in the dot com bubble when companies would agree to buy advertisements on each other's sites of equal amounts to boost sales figures. This increases revenues and expenses by the same amount with no changes in wages, profits, or interest expense (maybe minimal changes in practice).

The contribution could also be arbitrarily large. Imagine a firm that makes a buys a piece of software for \$2 million that allows them to make \$10 billion in sales (no other expenses and sales and no profit without this expense). That would make a GDP contribution $9.998 billion. Now imagine splitting that company in half so that two different firms each make \$5 billion in additional sales after buying \$1m in software.

In summary, the impact on GDP depends and there isn't enough detail here to be more specific.

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    $\begingroup$ That'd be \$9.998 billion if they paid \$2mil for the software. $\endgroup$ – Sebastian Lenartowicz Jul 8 at 13:53
  • $\begingroup$ @SebastianLenartowicz, great catch! Now fixed. $\endgroup$ – BKay Jul 8 at 14:05
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GDP is about final production

GDP is about production of final goods or services for consumers, but both these transactions are examples of non-final production - one company provides a good or service to another which might use it to produce something that's actually useful to fulfil a consumer's need or want.

If we suppose that these two transactions represent all that the companies did (which is unrealistic, for example they probably have some salary or other expenses so their profit is not zero but negative) - if there were no other sales or production, then the GDP contribution from these companies is zero because these two transactions don't "count" for GDP.

And that matches common sense - making that software was useful and productive if and only if (and to the extent that) the software facilitated producing something of value that people actually want or need for their lives and wellbeing.

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  • $\begingroup$ GDP stands for Gross Domestic Product. It's ongoing. So it's not final per se, but generally calculated on a year by year basis. After all, every calculation is final, for the time period in question. $\endgroup$ – Mozibur Ullah Jul 8 at 12:45
  • $\begingroup$ @MoziburUllah there seems to be some fundamental misunderstanding - it's not about the time periods or the finality of some calculation, it's about the nature of the good or service (whether it will be consumed or used for producing something else), see the definition at en.wikipedia.org/wiki/Final_good . A transaction on a "non-final good" will never get included in GDP directly, it may facilitate future production and transactions on some final goods or services which would get included in GDP, but those are separate transactions. $\endgroup$ – Peteris Jul 8 at 12:58
  • $\begingroup$ @MoziburUllah for a simple example. Let's say company A makes lumber, company B makes wooden widgets out of lumber. If company A sells \$1m of lumber to company B and company B sells \$2m of widgets to consumers, then the total contribution to GDP is \$2m. But if company A sells \$1m of lumber to company B but company B has 0 revenue (nobody wants their widgets, or their warehouse burns down, or whatever), then the total contribution to GDP is 0. The \$1m of lumber production of company A is excluded from GDP, because it's a non-final good and (in this case) no final goods were produced. $\endgroup$ – Peteris Jul 8 at 13:09
  • $\begingroup$ There is no 'fundamental misunderstanding'. GDP generally abstracts from the nature of the goods under question. This, however happens to be a key criticism of GDP as a quantifier of the economic health of a country, or even of an organisation. For example, this has been pointing out by Amartya Sen in his critique of GDP. $\endgroup$ – Mozibur Ullah Jul 8 at 14:13
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GDP is value added. The cost of the software would be broken out between the final and intermediate.

In reality this is rarely done and lots of errors occur. In principle gdp should only reflect final value added goods.

Circular invoices could easily cause confusion and there is little chance the national statistics would parse this out.

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