Topic 4: Different approaches to GDP

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1 Topic 4: Different approaches to GDP PRINCIPLES OF MACROECONOMICS Dr. Fidel Gonzalez Department of Economics and Intl. Business Sam Houston State University

2 Three different approaches to measure the GDP The production of an economy is measured by the GDP. There are three ways to calculate it: 1) Spending approach. 2) Value added approach. 3) Income approach.

3 1) Spending approach: we look at the spending patterns of households, firm and the government (we covered this before). Y = C + I + G + NX If a household buys a good or services to consume it, it is considered part of C. If a firm or the government or a firm buys machinery, equipments, software, etc, (including changes in inventories) it is considered investment, I. The payments of the local, state and federal government to professors, national guard, etc. is considered government expenditures, G The goods and services sold and bought abroad are considered NX. In this approach we care who buys the good or service and for what purpose.

4 2) Value added: we measured how much value was added in the different stages of production. The sum of the value added in each stage of production for all goods is equal to the GDP. For instance in the production of a can of coke, we measure how much value was added by the aluminum, how much by the bottling company, how much by the delivery company, and how much by the final seller. In this approach we do not care who buys the good and the purpose of the purchase.

5 3) Income approach. We add the income of workers, business owners and government. Because each sale represents a source of income for the seller the market value of production is equal to the income of the people that produced the good plus the taxes paid to the government. Also, in this approach we do not care who buys the good and the purpose of the purchase.

6 Example: Consider an economy composed of two sectors: farm and bakery. The farm sector produces corn. One part of the corn is sold directly to household and the other part is sold to the bakery. The bakery produces bread using the corn. The bakery sells the bread to households. Farm Sector Wages: $20 Taxes: $10 Corn sold to households: $90 Total revenue from corn selling:$200 Bakery Sector Wages: $50 Taxes: $25 Corn bought to the farm: $110 Total revenue from corn selling:$300

7 Lets obtain the GDP using the three different approaches. Spending approach: The value of households consumption is: $90 from buying corn and $300 from buying bread. In this simple example there is no investment, government spending or foreign sector. GDP = C = = ) Value added approach: The farm sector sold $200 worth of corn. They used rain and seeds and turn them into corn. Because in this easy example rain and seeds are free, the farm added $200 dollars to the production of corn. Farm s value added: $200 The bakery sector sold $300 worth of bread. In order to do this, they used corn worth $110 from the farm sector. Hence from the total $300 worth of bread $110 is due to the corn, the bakery only added $190 to the final value of the bread. Bakery s value added: $190 GDP= value added farm + value added bakery = = 390

8 3) Income approach. Wages paid by the farm: $20 Profit for the farmer after taxes: ( )=$170 Wages paid by the bakery: $50 Profit for the baker after taxes: ( ) =$115 Government revenue from taxes : = $35 GDP = = 390 All three approaches give you the same number

9 Real Life Numbers: In the US for 2010 the breakdown for each approach is the following: 1) Spending Approach: GDP = C + I + G + NX GDP = 71% + 12% + 21% - 4% (we talked about this in detailed in the previous topic) 2) Value Added: GPD = Agriculture and others (1.1%) + Mining (1.9%) + Utilities (1.9%) + Construction (3.4%) + Manufacturing (11.7%)+ Trade (11.4%) + Transportation (2.8%) + Information (4.6%) + Finance (21.1%) + Business (12.1%) + Education (8.7%) + Recreation (3.6%) + Others (2.3%) + Government (13.4%) 3) Income Approach: GDP = Wages + Taxes + Profits GDP = 54.9% + 6.9% % In the national accounts GDP from the income approach is referred as Gross Domestic Income (GDI) but it is the same number as GDP. Currently, there is a controversy about how wages and profits are divided in the US. Many economists have pointed out that profits as a percentage of GDP have increased over the last 30 years. While this seems to be true, it is hard to know why this is happening and whether this is a problem or not.

10 Wages and Profits as a % of GDP in the USA Wages as a % of GDP Profits as a % of GDP Wages (left y-axis) Profits (right y-axis)

11 Market for goods and services (firms sell, households buy) Firms taxes Government taxes Households Labor, capital, natural resources money Market for factor of production (firms and government buy labor, capital and natural resources, households sell)

12 Looking at previous graph you can see that: 1) The spending approach is based on what happens in the top part of the diagram. This approach looks only at the transactions that take place in the market for goods and services. 2) The value added approach takes place inside the box that says firms. That is, it takes place during the production of goods and services. 3) The income approach takes place in the bottom part of the diagram. In the market for factor of production. As you can see all the approaches give you the same answer, it is just a different way to look at the economy.

13 One final conclusion is important. When the final sale of a good or services takes place that represents a revenue from the seller. After the sale the seller distributes that money into payment to its suppliers, wages to his workers, taxes to the government and his own profit. The money from the sale does not disappear. Hence, a purchase is also a source of income. The value of the sale is measure in the spending approach of the GDP, the income from the sale is measure in the income approach of the GDP. Because those two are exactly the same, we arrive to a very important conclusion: Production = Income GDP = Production = Income The GDP is the income and production of a region during a period of time.

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