Economy Simplified: Methods for calculating GDP

1. The Product or Value Added Method

In the product method we calculate the aggregate annual value of goods and services produced.
The production approach sums the “value-added” at each stage of production, where value-added is defined as total sales less the value of intermediate inputs into the production process. For example, flour would be an intermediate input and bread the final product; or an architect’s services would be an intermediate input and the building the final product.

In the above picture,  let us suppose that there are only two kinds of producers in the economy. They are the wheat producers (or the farmers) and the bread makers (the bakers).
The farmers had produced Rs 100 worth of wheat for which it did not need assistance of any inputs. Therefore the entire Rs 100 is rightfully the contribution of the farmers. But the same is not true for the bakers. The bakers had to buy Rs 50 worth of wheat to produce their bread. The Rs 200 worth of bread that they have produced is not entirely their own contribution. Therefore the net contribution made by the bakers is, Rs 200 – Rs 50 = Rs 150.
Hence, the aggregate value of goods produced by this simple economy is Rs 100 (net contribution by the farmers) + Rs 150 (net contribution by the bakers) = Rs 250.
Therefore, the term that is used to denote the net contribution made by a firm is called its value added.
The value added of a firm=  value of production of the firm – value of intermediate goods used by the firm.
  • The value added of a firm is distributed among its four factors of production, namely, labour, capital, entrepreneurship and land. 
  • Therefore wages, interest, profits and rents paid out by the firm must add up to the value added of the firm. 
  • Value added is a flow variable.
  • If we include depreciation in value added then the measure of value added that we obtain is called Gross Value Added. 
  • If we deduct the value of depreciation from gross value added we obtain Net Value Added.
Calculating GDP through Value Added approach:
Gross value added of firm, i (GV Ai) ≡ Gross value of the output produced by the firm i (Qi) – Value of intermediate goods used by the firm (Zi).

Net value added of the firm i ≡ GVAi – Depreciation of the firm i (Di).

If there are N firms in the economy, each assigned with a serial number from 1 to N, then GDP ≡ Sum total of the gross value added of all the firms in the economy.

GDP= ≡ GVA1 + GVA2 + ….. + GVAN

2. Expenditure Method

The expenditure approach adds up the value of purchases made by final users—for example, the consumption of food, televisions, and medical services by households; the investments in machinery by companies; and the purchases of goods and services by the government and foreigners.

The sum total of the revenues that the firm i earns is given by: 
RVi ≡ Sum total of final consumption, investment, government and exports expenditures received by the firm i
RVi ≡ Ci + Ii + Gi + Xi
If there are N firms then summing over N firms we get,
Calculating GDP through Expenditure Method:
GDP ≡ Sum total of all the final expenditure received by the firms in the economy.
In other words, 
C= Final Consumption
I= Investment 
G= Government Expenditure 
X= Expenditure by the foreigners on the exports of the economy 
I= Import Expenditure incurred by the economy

3. Income Method

The sum of final expenditures in the economy must be equal to the incomes received by all the factors of production taken together. 
This follows from the simple idea that the revenues earned by all the firms put together must be distributed among the factors of production as salaries, wages, profits, interest earnings and rents.
Calculating GDP through Income Method:

Let Wi be the wages and salaries received by the i-th household in a particular year.
Similarly, Pi, Ini, Ri are the gross profits, interest payments and rents received by the i-th household in a particular year. 

Therefore, GDP is given by
Comparing Value Added, Expenditure method and Income method in GDP calculation
GDPValue Added MethodExpenditure MethodIncome Method

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