Value Added Method for Measuring GDP: Videos & Practice Problems
A cotton farmer produces raw cotton, which it can sell to a processor at a price of \$2. The processor weaves the cotton into fabric and sells it for \$3. A clothing company purchases the fabric and creates a crappy t-shirt, which it can sell for \$7. Urban Outfitters buys crappy t-shirts and resells them for \$45. What is the value added by the clothing company?
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The value added method for measuring GDP calculates the total value added by firms producing final goods and services. It sums the value added at each stage of production, where value added is defined as the sale price of a good minus the cost of intermediate goods used to produce it. For example, if a farm sells wheat for \$2 with no intermediate goods, its value added is \$2. A flour mill buying that wheat for \$2 and selling flour for \$5 adds \$3 in value (\$5 - \$2). A bakery buying flour for \$5 and selling bread for \$7.50 adds \$2.50 in value (\$7.50 - \$5). Adding these values (\$2 + \$3 + \$2.50) gives the total GDP contribution of \$7.50. This method aligns with the expenditure and income approaches, all yielding the same GDP figure.
Value added is calculated by subtracting the cost of intermediate goods from the sale price of the final good at each production stage. Mathematically, it is expressed as: . For example, if a bakery sells bread for \$7.50 and the cost of flour (an intermediate good) is \$5, the value added by the bakery is \$7.50 ā \$5 = \$2.50. This calculation is repeated for each firm in the production chain, and the sum of all value added equals the GDP. This method ensures that only the new value created at each stage is counted, avoiding double counting of intermediate goods.
The value added approach avoids double counting by only including the additional value created at each stage of production, rather than the total sales value of goods at every stage. It subtracts the cost of intermediate goods from the sale price, so only the net contribution of each firm is counted. For example, if a flour mill buys wheat for \$2 and sells flour for \$5, only the \$3 difference is counted as value added. This prevents counting the \$2 wheat value multiple times. By summing value added across all firms, the method accurately reflects the total economic output without inflating GDP figures.
The value added approach, expenditure approach, and income approach all calculate GDP but from different perspectives. The value added approach sums the net value created at each production stage. The expenditure approach totals spending on final goods and services. The income approach sums incomes earned by factors of production, like wages and profits. Despite these differences, all three methods yield the same GDP figure because they measure the same economic activity from different angles. Understanding the value added approach highlights the role of intermediate goods and the production process in national income accounting.
Consider a simple production chain: a farm sells wheat for \$2, a flour mill buys the wheat and sells flour for \$5, and a bakery buys the flour and sells bread for \$7.50. The farm's value added is \$2 (sale price \$2 minus zero intermediate goods). The flour mill's value added is \$3 (\$5 sale price minus \$2 cost of wheat). The bakery's value added is \$2.50 (\$7.50 sale price minus \$5 cost of flour). Adding these values (\$2 + \$3 + \$2.50) gives a total value added of \$7.50, which equals the final sale price of the bread and the GDP contribution of this production chain. This example shows how value added at each stage sums to total GDP.
