Module 6. National income

Lesson 27

27.1 Introduction

We defined GDP as the total production of final goods and services. A final product is one that is produced and sold for consumption or investment. GDP excludes intermediate goods-goods that are used up to produce other goods. GDP therefore includes cheese but not milk and home computers but not computer chips.

For the flow-of –product calculation of GDP, excluding intermediate products poses no major complications. We simply include the bread and computers in GDP but avoid including the wheat and computer that went into the bread or the chips and plastic that went into the computers. If you look again at the upper loop in Figure 6-1, you will see that Cheese appear in the flow of products, but you will not find any milk on it.

What has happened to products like curd and whey? They are intermediate products and are simply cycling around inside the block. If they are not bought by consumers, they never show up as final products in GDP.

Table 27.1 Income statement of typical farm and national product accounts

Upper-loop product approach to GDP will avoid including intermediate products. But when we use the lower-loop cost or earning approach? After all, when we gather income statements from the accounts of firms, won’t we pick up what grain merchants pay to wheat farmers, what bakers pay to grain merchants, and what grocers pay to bakers? Won’t this result in double counting or even triple counting of items going through several productive stages?

These are good questions, but there is an ingenious answer that resolves the problem. In making lower-loop earnings measurements, which include in GDP only a firm’s value added. Value added is the difference between a firm’s sales and its purchases of materials and services from other firms.

Table 27.2 GDP sums value added at each production stage


To avoid double counting of intermediate products, we calculate value added at each stage of production. This involves subtracting all the costs of materials and intermediate products bought from other businesses from total sales. Note that every black intermediate-product item both appears in column (1) and is subtracted in the next stage of production in column (2). How much would we overestimate GDP if we counted all receipts, not just value added? The overestimate would be 186 ` per loaf.

In other words, in calculating the GDP earnings or value added by a firm, we include all costs except for payments made to other business. Hence business costs in the form of wages, salaries, interest payment and dividends are included in value added, but purchases of wheat or steel or electricity are excluded from value added. Why are all the purchases from other firms excluded from value added to obtain GDP? Because those purchases will get properly counted in GDP in the values added by other firms.

Table 6-1 uses the stages of bread production to illustrate how careful adherence to the value-added approach enables us to subtract purchases of intermediate goods that show up in the income statements of farmers, millers, bakers, and grocers. The final calculation shows the desired quality between (1) final sales of bread and (2) total earnings, calculated as the sum of all values in all the different stages of bread production.

Value-added approach

To avoid double counting, we take care to include only final goods in GDP and to exclude the intermediate goods that are used up in making the final goods. By measuring the value added at each stage, taking care to subtract expenditures on the intermediate goods bought from other firms, the lower loop earnings approach properly avoids all double counting and records wages, interest, rent and profit exactly one time.

Last modified: Thursday, 8 November 2012, 6:16 AM