I have the following question to answer in my macroeconomics textbook. Steel producer makes steel worth 4000 out of which 0.25 is sold to machines producer and 0.75 of steel is being sold to the car producer. Machines are being sold to car producer for 2000. Car producer also buys tires from tires producer for 500. In effect he produces cars worth 5000 out of which 1/5 is being exported. Calculate GDP by three different methods. And below in my textbook there is a table to calculate transaction value, value added, final goods expenditures etc. But how out of those data calculate GDP by three different methods? I know the equation GDP=C+I+G+NX, but how does it help?
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2 Answers
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There are three ways to define GDP:
Expenditure approach: The sum of all expenditures on final products. The only final products in this economy are cars; steel, machines, and tires are intermediate products. By this definition, GDP is 5000. Of this amount, 1000 is exported (NX), so 4000 must be consumed domestically (C). There is no information about I and G, so we must assume they're zero.
Production approach (value added approach). The output of the steel, machine tool, and tire sectors is worth 6500 combined (4000 for steel, 2000 for machines, 500 for tires). All output of these three sectors is "consumed" by the auto sector, whose output is worth 5000. Total sales of all four sectors: 11,500. GDP is obtained by subtracting sales of intermediate products from total sales: 11500 - 6500 = 5000. The car sector appears to be making a net loss of 1500.
Income approach (GDI: gross domestic income, i.e., sum of wages and net profits). By definition, one entity's expenditures is another entity's income. We have no information about income shares (wages, profits, losses) of the various sectors, but in the aggregate GDI = GDP. Therefore, total GDI is also 5000. Total domestic consumption C on final products is 4000. Thus, aggregate saving S must be 1000 (since GDP = C+S). Of this aggregate, 2500 is net saving of the household, steel, machines, and tire sectors, and -1500 is the dissaving of the car sector. For the non-car sectors, the only additional piece of information we have is that whereas the machine sector "consumes" 1000 in steel, its output is 2000. Thus, the entire net saving in this economy is due to the machine sector.
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Machines are capital goods and are thus an investment by the firm.
There are three ways to define GDP:
Expenditure approach: The final products in this economy are cars and machines (which are capital goods); steel, and tires are intermediate products. So Consumption (of cars) is 5000. Of this amount, 1000 is exported (NX), so 4000 must be consumed domestically (C). Machines are capital goods and are thus an investment by the car firm. Hence I is 2000. There is no information about G, so we must assume it is zero. so GDP is 5000 + 2000= 7000
Production approach (value added approach). The value added by a firm is obtained by subtracting the value of intermediate products from the transaction value (i.e. sales value of its product). The steel and tire producer are assumed to have no intermediates and so their value added is 4000 and 500. the machine producer sells the machine at 2000 but uses 1000 worth of steel in production. Therefore, its value added is 2000 - 1000 = 1000. The car producer sells its output at 5000 but its intermediates are steel worth 3000 and tires worth 500. Thus its value added is 1500. Aggregating the value added by each firm gives, 4000 + 500 +1000 + 1500 = 7000.
Income approach. Firms ultimately distribute their revenue back to households through factor payments (e.g. wages, profits etc). Thus the money left after firms pay for their intermediate goods is ALL paid to households as wages, profits and so on. Thus value of the income paid by a firm equals the value added. So aggregating the factor payments by each firm (i.e. household incomes) will still equal 7000.
Note that the above explanation gives you all the information you need to complete the table you mentioned.