Calculating GDP using Expenditure and Income Approaches

The aggregate output of an economy is the value of all the goods and services produced within a predetermined period of time. On the other hand, aggregate income refers to the economic value of all payments received by the suppliers of the factors of production of goods and services.

Approaches for Calculating GDP

Gross Domestic Product (GDP) has two different approaches: the income approach and the expenditure (or output) approach. In the case of the income approach, GDP refers to the aggregate income earned by all households and companies that operate within an economy over a given period of time.

In the expenditure (or output) approach, GDP refers to the market value of all final goods and services produced in an economy over a given period of time. Intuitively, GDP calculates how income and output flow in an economy.

Naturally, the results obtained by the income approach must be equal to those obtained by the expenditure (output) approach.

Income Approach

Here, GDP can be calculated by taking the total amount earned by every household, company, and all firms in the economy. It’s possible to express the income approach formula to GDP as follows:

GDP = Total national income + Sales taxes + Depreciation + Net foreign factor income

Where:

Total national income is equal to the sum of all wages plus rents plus interest and profits; and

Net foreign factor income is the difference between foreign payments to domestic citizens and domestic income payments to foreign citizens.

Expenditure Approach

In this approach, GDP must be calculated by taking the total amount spent on goods and services that have been produced in the economy within a given period of time.

In the expenditure approach, there are two measurement methods used to calculate GDP. The first uses the value of final outputs, and the other method uses the sum of value-added.

Usually, the formula used is:

GDP = Gross private consumption expenditures (C) + Gross private investment (I) + Government purchases (G) + Exports (X) – Imports (M)

Criteria for Measuring Gross Domestic Product

The first criterion states that all goods and services included in the calculation must have been produced in the economy and during the period of measurement. Therefore, goods produced in the previous periods should not be included in the calculation. Moreover, transfer payments made by the government should also be excluded from the calculation. Usually, this could be in the form of compensations or welfare benefits.

Secondly, goods and services included in the calculation should only be those whose values can be determined by selling them in the market. As a result, this makes it possible for the price of supplied goods and services to be well determined.

Lastly, the calculation of GDP only includes the market value of final goods and services. Final goods are those that are not resold, as opposed to intermediate goods. An alternative approach to calculating GDP is by summing all the value-added during the production and distribution process.

Example of GDP Using the Expenditure Approach

The best example is that of a wheat farmer. This farmer sells one kilogram of his wheat to a miller at $0.21. The miller sells it to the baker at $0.49. The baker bakes bread and sells it to a retailer at $0.92. Consequently, the retailer then sells the bread to the final customer at $1.00. Finally, by using the final goods method, we come up with the following table:

$$
\begin{array}{l|c}
\textbf{} & \textbf{Receipts at each stage (in \$)} \\
\hline
\text{Receipt of the farmer from the miller} & 0.21 \\
\hline
\text{Receipt of a miller from the baker} & 0.49 \\
\hline
\text{Receipts of the baker from the retailer} & 0.92 \\
\hline
\text{Receipts of the retailer from a final customer} & 1.00 \\
\hline
\text{Value of final output} & 1.00 \\
\end{array}
$$

By summing the total value added to the wheat, we get the following table:

$$
\begin{array}{l|c}
\textbf{} & \begin{array}{c} \textbf{Value added = Income created} \\ \textbf{at each stage (in \$)} \end{array} \\
\hline
\text{Value added by the farmer} & 0.21 \\
\hline
\text{Value added by the miller} & 0.28 \\
\hline
\text{Value added by the baker} & 0.43 \\
\hline
\text{Value added by the retailer} & 0.08 \\
\hline
\text{Total value added / total income earned} & 1.00 \\
\end{array}
$$

Question 1

Which of the following should least likely be included in measuring the Gross Domestic Product?

A. Rent paid by a retailer.

B. The salary of a cleaning lady.

C. Welfare programs paid by the government.

Solution

The correct answer is C.

Welfare programs paid by the government should not be included. Transfer payments include Social Security, Medicare, unemployment insurance, welfare programs, and subsidies. These are not included in GDP because they are not payments for goods or services but rather means of allocating money to achieve social ends.

A is incorrect.  The rent paid by retailers, must be included as value added to the goods sold by the retailer.

B is incorrect: The salary of the cleaning lady, must be included in finding the total income.

 

Question 2

Suppose an artist draws a painting, for which he spends $200 on painting materials. The artist then exposes the painting on his website and it gets sold at $500. Using the sum-of-value-added method of calculating GDP, which of the following is most likely the value added by the artist?

A. $200

B. $300

C. $500

Solution

The correct answer is B.

To get the value added by the artist, one should subtract the cost of painting materials from the selling price.

$500 – $200 = $300