One of the most common ways to measure the size of an economy, in other words the aggregate output of a country, is by compiling the gross domestic product (GDP). As defined by the World Bank, GDP represents the market value of all final goods and services produced within a country’s borders, during the course of one year. However, this definition which is often referred to as the production approach (or the output approach) is not the only way to compile GDP.
OECD proposes a different approach to GDP, since it shows that GDP can also be calculated as the sum of the gross value added of all resident institutional units engaged in production to which we need to add taxes and subtract any subsidies on products not included in the value of their outputs. This is called the income approach in the specialized literature. Yet another method of calculating GDP is the expenditure approach, defined as the sum of the final uses of goods and services (all uses except intermediate consumption) measured in purchasers’ prices, less the value of imports of goods and services, or the sum of primary incomes distributed by resident producer units.
Before understanding all the three approaches, read the following terms to understand the basic concepts.
- Final Goods and Services: Goods and services produced for final usage (by the consumer)
- Intermediate Goods: Goods that are used for processing of other goods. Or you can say goods that are produced by firms for further use of other firms.
- Value Added: It is the difference between Value of Good as they leave a stage of production to another and the cost of that good as they entered that stage.Read the complete details of the concept below.
3 methods of calculating GDP
1. The Production (output) approach
This method of compiling GDP leads to counting the production by sector of activity. Most countries using this approach extrapolate value added with tools such as the Index of Industrial Production (IIP), physical quantity indicators or sales type statistics for estimates of value added in manufacturing.
While most countries still use the production approach since 1979, one major drawback of this method is the difficulty to differentiate between intermediate and final goods. This is why some countries such as the United States and Japan prefer other methods, like the income or the expenditure approach.
2. The Income approach
This method of calculating GDP refers to compiling data from employment and earnings surveys to estimate salaries and wages by industrial activity. However, there are sectors of activity for which it is not easy to measure compensation. Therefore, many countries such as Canada, the United States, Japan or Australia use the income approach through trend extrapolation to estimate GDP.
By definition, incomes approach is the total income earned by the factors of production that is owned by a country’s citizen
This includes the following:
- Compensation of Employees (wages, salaries etc)
- Proprietor’s Income (Unincorporated business income)
- Rental Income (Property owner income)
- Personal Income
- Disposable Income (After Tax income)
- Corporate Profits (From corporate business)
- Net Interest (paid interest by business)
- Indirect taxes – subsidies (Sales tax, custom duty and other fees – subsidies that the government pays)
- Net business transfer payments (Transfer payments from one business to another)
- Surplus of Government enterprises (Govt entities income) etc
3. The Expenditure approach
Although the two approaches presented above are still popular, the most widely used approach to measure GDP is the expenditure approach. This method suggests simply looking at how much do households, government, non-profit institutions and financial institutions consume within a country to which one must add the net exports of that country.
There are 4 categories of Expenditure
- Personal Consumption made by households
- Gross private domestic investment that is the spending by firms and households on new capital. for example : Inventory, residential infratstructure, plant etc.
- Gross Investment and consumption by the Government
- Net Export that equals Exports minus Imports
The formula of calculating GDP, using the expenditure approach is the following:
GDP = C + I + G + (X- M)
C = Private consumption expenditure
I = Investment Expenditure
G= Government Consumption Expenditure
X = Value of Exports
M = Value of Imports
The expenditure approach not only facilitates the compilation of GDP, but it can also offer insights on the economic policies of a country, like in the graph below (source: OECD)
NOTE: GDP is only concerned with NEW and FINAL Production. It excludes:
- Used Goods and Paper transactions
- Output produced in another country that is owned by domestic factors of production (thats GNP)