There are several different methods of calculating an economy’s GDP. Theoretically, all the different techniques should give you the same number, but that’s rarely the case due to the massive amount of data that needs to be dealt with in addition to all the points in the process where errors can creep in. That being the case, the real world results still tend to be pretty similar to each other.

One method of calculating GDP that isn’t efficient or even feasible in the real world is the value added approach. (The reason why I’m still writing about it is because I know some textbooks mention it and some professors teach it.) As its name implies, GDP is calculated by summing up all of the value that is added to a product during the production process. To calculate the value added to a good between firms, we take the price that it was sold for and subtract it from the price that it was bought at. When we sum up all of the value added over the entire production process, we have the dollar amount that the good contributed to GDP. I briefly went over this when introducing GDP in my last post. Let’s go over it again.

Value Added Example

Suppose that creating a bicycle from scratch requires five different steps from five different firms. Firm A mines the raw metal from the earth and sells it to the metal refinery for $90, so Firm A has added $90 to the value of the metal (we’ll ignore the inherent value of metal to simplify things). Firm B, the metal refinery, processes the metal it receives, purifying it and turning it into a metal that can be used for manufacturing purposes. Firm B sells the now processed metal to Firm C for $150. Because Firm B sold the metal for $150, but bought it for $90, Firm B only added $60 worth of value to the product, not the full $150. Firm C turns the metal into a functioning bike, adding $250 worth of value to the good, before selling it to Firm D for $400. Firm D distributes the bicycles to retailers at $500 a piece, adding $100 worth of value based on the service Firm D provides. Firm E, the bike shop, then retails the bicycle to a consumer for $700, which means Firm E added $200 worth of value to the bike when it provided its bike shop services (having a centralized place to peruse through many bikes, being able to talk to an expert, being able to test drive bikes before purchasing, etc.). If we sum up all the values added to this product throughout all its intermediate stages, we would come up with $700, which is the exact same price that the final form of the good sold for.

As you can see, this is a lot of work to do just to cover one product. When we introduce more goods into the economy, especially ones that have a much more complicated production process, you can easily see why the value added method isn’t used to compute an economy’s GDP. That being said, it still serves as good material to place on an exam so it doesn’t hurt to know it.
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Reference
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
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Next economics post: Calculating GDP: Income Approach
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