Compare Methods of Calculating GDP

There are two approaches that are used in the calculation of the Gross Domestic Product (GDP). The first one is the income approach. This method measures GDP as a summation of all income generated in the economy in a given year. The income includes all that is earned by all households, firms, companies, and institutions in the economy.

The other approach used in the calculation of GDP is the expenditure approach. Also known as the output approach, this method uses the value of all the goods and services produced in the economy as the base for calculating GDP. The expenditure approach includes all goods and services produced by domestically-owned firms. However, this approach has two methods for finding GDP, the value-of-final-output method and the sum-of-value-added method.

Value-of-Final-Output Method

As the name suggests, this method takes the final value of goods and services. In this case, the final value of output is simply the market price at which a final consumer purchases a product.

Example of Value-of-Final-Output Method

If a customer buys a loaf of bread at $1.40, this is the product’s final price. There is no need to explain how this bread was baked, how much the wheat cost, or how much the miller charged for milling the wheat into flour. All these costs are assumed to be part of the price. Therefore, the final market price of bread forms part of the GDP.

Sum-of-Value-Added Method

In this method, we calculate GDP as the sum of all costs incurred in making a product ready for consumption. The value added is summed up for every stage that a good goes through.

Example of Sum-of-Value-Added Method

Using the wheat-bread example, the sum-of-value added is calculated as follows:

First, we take the amount at which the farmer sold wheat to the miller. If the farmer sold the wheat to the miller at $0.40, we assume that the value added by the farmer is $0.40. Also, by milling the wheat into flour, the miller adds value to the wheat.

If the miller sells the flour to a baker for $0.90, then the miller will add a value worth $0.50 (0.90-0.40) to the wheat. The baker then uses the flour to bake bread. Consequently, if the baker sells the bread to a retailer at $1.10, the baker has added $0.20 (1.10-0.90) to the flour. Finally, if the retailer sells the bread to a customer at $1.40, the retailer will have added a value worth $0.30 (1.40-1.10) to the bread.

The following table clearly summarizes the above methods using the stated examples.

$$
\begin{array}{l|c}
\textbf{Value Captured} & \text{Sum-of-Value-Added} & \text{Value-of-Final Output} \\
\hline
\begin{array}{l} \text{The farmer sells wheat to the} \\ \text{miller for \$0.40} \end{array} & \$0.40 & \\
\hline
\begin{array}{l} \text{The miller sells flour to} \\ \text{the baker for \$0.90} \end{array} & \$0.90 – \$0.40 = \$0.50 & \\
\hline
\begin{array}{l} \text{The baker sells bread to} \\ \text{the store for \$1.10} \end{array} & \$1.10 – \$0.90 = \$0.20 & \\
\hline
\begin{array}{l} \text{The store sells bread to} \\ \text{the customer for \$1.40} \end{array} & \$1.40 – \$1.10 = \$0.30 & \$1.40 \\
\hline
\text{Total Value} & \$1.40 & \$1.40 \\
\end{array}
$$

Note that both methods arrive at the same values only that the sum-of-value-added method has more granular details.

Question

Which of the following is least likely to be included in the calculation of GDP using the sum-of-value-added method?

A. The money spent by a farmer in transporting the wheat to the miller

B. Rental costs incurred by a retailer in storing goods for sale

C. The cash paid by a customer to purchase bread from the retailer

Solution

The correct answer is C.

Option A, the money spent by a farmer to transport wheat to the miller is taken as a value added to the farm produce.

Option B, rental costs incurred by a retailer, is also taken as value added to the products in the shop.

However, the amount spent by customers to purchase bread should be calculated as the cost of the final product, because the bread has become a complete product and is ready for use.