In any given year, people in the United States produce goods and services. They produce television sets, books, pencil sharpeners, DVD players, attorney services, haircuts, and much more. Have you ever wondered what the total dollar value of all those goods and services is? In 2007, it was $13.84 trillion. In other words, in 2007, people living and working in the United States produced $13.84 trillion worth of goods and services. That dollar amount—$13.84 trillion—is what economists call the gross domestic product. Simply put, gross domestic product (GDP) is the total market value of all final goods and services produced annually within a country’s borders.
Three Ways to Compute GDP Consider a simple economy in which one good is produced and sold.1. Bob finds a seed and plants it. Sometime later, an orange tree appears. 2. Bob pays Harry $5 in wages to pick and box the oranges. 3. Next, Bob sells the oranges to Jim for $8. 4. Jim turns the oranges into orange juice and sells the orange juice to Caroline for $10. Caroline drinks the juice.
What is the GDP in this simple economy? Is it $5, $13, $10, $18, or some other dollar amount? Economists use three approaches to compute GDP: the expenditure approach, the income approach, and the value-added approach. The following paragraphs describe each approach in terms of our simple economy.
EXPENDITURE APPROACH To compute GDP using the expenditure approach, addthe amount of money spent by buyers on final goods and services. The words “final goods and services” are important in computing GDP because not all goods are final goods.
Some goods are intermediate goods.
A final good (or service) is a good in the hands of the final user, or ultimate consumer. Think of buyers standing in line one after another. The first buyer in our simple economy was Jim. He bought oranges from Bob. The second buyer was Caroline, who bought orange juice from Jim.
Caroline is the final buyer in this economy; she is the final user, the ultimate consumer. No buyer comes after her. The good that she buys is the final good. In other words, the orange juice is the final good. So, then, what are the oranges? Aren’t they a final good too? No. The oranges are an intermediate good. An intermediate good is an input in the production of a final good. In other words, the oranges were used to produce orange juice (the final good). So what does GDP equal if we use the expenditure approach to compute it? Again, it is the dollar amount spent by buyers for final goods and services. In our simple economy, there is only one buyer (Caroline), who spends $10 on one final good (orange juice).
Thus, GDP in our tiny economy is $10. You may be wondering why expenditures on only final goods are counted when computing GDP. The reason is because we would be double counting if we counted expenditures on both final goods and intermediate goods. Double counting refers to counting a good more than once when computing GDP. To illustrate, if we count both Caroline’s purchase of the orange juice ($10) and Jim’s purchase of the oranges ($8), we count the purchase of the oranges twice—once when the oranges are purchased by Jim and once when the oranges are in the orange juice.
INCOME APPROACH In our simple economy, income consists of wages and profits.1 To compute GDP using the income approach, simply find the sum of all the wages and profits. First, Harry earns $5 in wages. Second, Bob’s profit is $3: (1) Bob pays $5 to Harry, so the $5 is a cost to Bob; (2) Bob receives $8 for the oranges he sells to Jim; (3) $8 in revenue minus $5 in costs leaves Bob with $3 profit.
Third, Jim’s profit is $2: (1) Jim pays $8 to Bob for the oranges, so the $8 is a cost to Jim; (2) Jim receives $10 for the orange juice he sells to Caroline; (3) $10 in revenue minus $8 in costs leaves Jim with $2 profit. In our simple economy, the sum of Harry’s wages, Bob’s profit, and Jim’s profit is $10. So GDP is equal to $10.
VALUE-ADDED APPROACH In our tiny economy, orange juice is sold for, or has a market value of, $10. How much of the $10 market value is attributable to Jim? Stated differently, how much of the $10 market value is value added by Jim? If your intuition tells you $2, then your intuition is correct. Value added is the dollar value contributed to a final good at each stage of production. That is, it is the difference between the dollar value of the output the producer sells and the dollar value of the intermediate goods the producer buys.