Calculating Gross Domestic Product Using Value Added

01
of 05

Calculating Gross Domestic Product

Value-Added-GDP formula

Gross domestic product (GDP) measures an economy's production over a specified period of time. More specifically, gross domestic product is the "market value of all final goods and services produced within a country in a given period of time." There are a few common ways to calculate the gross domestic product for an economy, including the following:

  • The Output (or Production) Approach: Add up the quantities of all final goods and services produced in an economy within a given time period and weight them by the market prices of each of the goods or services.
  • The Expenditure Approach: Add up the money spent on consumption, investment, government spending, and net exports in an economy within a given time period.

The equations for each of these methods are shown above.

02
of 05

The Importance of Only Counting Final Goods

Value-Added-GDP example inputs and outputs

The importance of counting only final goods and services in gross domestic product is illustrated by the value chain for orange juice shown above. When a producer is not fully vertically integrated, the output of multiple producers will come together to create the final product that goes to the end consumer. By the end of this production process, a carton of orange juice that has a market value of $3.50 is created. Therefore, that carton of orange juice should contribute $3.50 to gross domestic product. If the value of intermediate goods were counted in gross domestic product, however, the $3.50 carton of orange juice would contribute $8.25 to gross domestic product. (It would even be the case that, if intermediate goods were counted, gross domestic product could be increased by inserting more companies into the supply chain, even if no additional output was created!)

Notice, on the other hand, that the correct amount of $3.50 would be added to gross domestic product if the value of both intermediate and final goods was counted ($8.25) but the cost of the inputs to production ($4.75) was subtracted out ($8.25-$4.75=$3.50).

03
of 05

The Value-Added Approach to Calculating Gross Domestic Product

Value-Added-GDP activity, cost of inputs, out puts and value added

A more intuitive way to avoid double counting the value of intermediate goods in gross domestic product is to, rather than try to isolate only final goods and services, look at the value added for each good and service (intermediate or not) produced in an economy. Value added is simply the difference between the cost of inputs to production and the price of output at any particular stage in the overall production process.

In the simple orange juice production process, described again above, final orange juice is delivered to the consumer via four different producers: the farmer who grows the oranges, the manufacturer who takes the oranges and makes orange juice, the distributor who takes the orange juice and puts it on store shelves, and the grocery store that gets the juice into the hands (or mouth) of the consumer. At each stage, there is a positive value added, since each producer in the supply chain is able to create output that has a higher market value than its inputs to production.

04
of 05

The Value-Added Approach to Calculating Gross Domestic Product

Value-Added-GDP-4 activity, cost of inputs, output and value added

The total value added at all stages of production is what is then counted in gross domestic product, assuming of course that all stages occurred within the economy's borders rather than in other economies. Note that the total value added is, in fact, equal to the market value of the final good produced, namely the $3.50 carton of orange juice.

Mathematically, this total is equal to the value of the final output as long as the value chain goes all the way back to the first stage of production, where the value of the inputs to production is equal to zero. (This is because, as you can see above, the value of the output at a given stage of production is, by definition, equal to the value of the input at the next stage of production.)

05
of 05

The Value Added Approach Can Account for Imports and Production Timing

Value-Added-GDP activity, cost of inputs, outputs and value added

The value-added approach is helpful when considering how to count goods with imported inputs (i.e. imported intermediate goods) in gross domestic product. Since gross domestic product only counts production within an economy's borders, it follows that only value that is added within an economy's borders is counted in gross domestic product. For example, if the orange juice above were made using imported oranges, only $2.50 of the value added would have taken place within in the economy's borders and thus $2.50 rather than $3.50 would be counted in gross domestic product.

The value-added approach is also helpful when dealing with goods where some inputs to production are not produced in the same time period as the final output. Since gross domestic product only counts production within the specified time period, it follows that only value that is added during the specified time period is counted in gross domestic product for that period. For example, if the oranges were grown in 2012 but the juice wasn't made and distributed until 2013, only $2.50 of the value added would have taken place in 2013 and therefore $2.50 rather than $3.50 would count in gross domestic product for 2013. (Note, however, that the other $1 would count in gross domestic product for 2012.)

Format
mla apa chicago
Your Citation
Beggs, Jodi. "Calculating Gross Domestic Product Using Value Added." ThoughtCo, Jan. 8, 2018, thoughtco.com/calculate-gross-domestic-product-using-value-added-1147520. Beggs, Jodi. (2018, January 8). Calculating Gross Domestic Product Using Value Added. Retrieved from https://www.thoughtco.com/calculate-gross-domestic-product-using-value-added-1147520 Beggs, Jodi. "Calculating Gross Domestic Product Using Value Added." ThoughtCo. https://www.thoughtco.com/calculate-gross-domestic-product-using-value-added-1147520 (accessed January 20, 2018).