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Gross Domestic Product (GDP) and Consumer Price Index (CPI)

Value Added Method for Measuring GDP


Value Added Method for Measuring GDP

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Alright now let's discuss a specific method for calculating GDP. The value added method. Now this isn't so common but it's nice to go over because it's pretty simple and you can see a question about this on your test and it's easy points. Let's go through it. So remember that the G. D. P. It's the value of final goods and services, right? The final goods and services. But as we've discussed, sometimes there's intermediate steps in producing a final good right? If we're producing let's say a T shirt, well we gotta pick the cotton and the cotton needs to be woven into fabric, the fabric made into a T shirt, right? There's all these steps that go into producing the final product. But remember only the final value is what's included in GDP. So the normal approach takes the market value of these goods. When we were talking about the expenditure approach for calculating GDP, we just took the market value of those final goods. The value added approach takes the value that's added at along each step of the way, and we get to the same final answer. So the value added, this is the market value that affirm adds to a product, the value added to a product. So if they purchase, let's say a raw material and turn it let's let's say it's a key candy company that purchases sugar and turns it into candy. Well the value they add is the value of the sugar. Well they let's say they pay a dollar per pound of sugar and they turn it into $5 per pound of candy. Well they added $4 of value there in between. Right? So that is the value added approach. The easiest way to see this is in an example. So let's go ahead and check out this example here. Mining company corporation extracts iron ore from its deposits and is able to sell the ore for a price of 5100 per ton. The refinery company corporation refines iron ore and sells the refined ore for 7800 per ton. Steel. Company corporation purchases refined iron ore and produces steel which it sells for 11,200 per ton. Chevrolet purchases steel to produce a Malibu which it sells to its customers at a price of 16,900. What is the increase in GDP for each Malibu produce? Okay, so if you think about when we talked about what is the increase in GDP? When we don't even think about the value added method, we know that the final good in service is worth 16,900. So that is the increase to G. D. P. But let's see how this works from a value added approach and how we come up with the same answer in that case. So the mining company corporation, they extracted iron ore, what was the sales value of the material? It was $5100 right now I obviously made up these numbers. I have no idea, no experience with mining and the value of these products. But I'm assuming this is way overvalued, there's a lot more that goes into a car anyways, let's just say they all you need for a car is steel and that's all that goes into it. You got a big steel box, you roll around in. So they extract this iron ore and its sales values 5100. So how much value did they add to this economy? Well there was no value before and now they've turned it into 5100 value. So they've added 5100 worth of value by extracting this or next the refinery corporation. Well they're gonna extract, they're gonna take the iron ore and refine it and now it's worth 7800. However they had to purchase it for 5100. So they didn't make value of 7800. Right? They took value of 5100 and turned it into 7800. So actually I'm gonna put this over on the end. So we keep all our numbers over here. So next we the refinery company, They created something worth 70 800 but it cost them 50 100. So their value added was 2700 there. Right, that's the value they added to the the raw iron ore. So next the steel company, they're gonna take that refined or and turned it into steel and that was worth 11,200. However, again they didn't they didn't produce something worth 11 to 200 by itself, they had to purchase something worth 7800. So what was their value added? 11,200 minus the 7800 for what they purchased? Oh man, I can't do it in my head right now. It's been a long day. Where's my phone? Let's go through this 11200 -70 830 400. Alright, 3400 is the value they added to the product. Let me scroll down a little bit here And finally, Chevrolet, they're gonna buy this steel and produce their Malibu that they can sell for a price of 16 900 16 900 here. And what's the value they added? So they produce something worth 16 900. But they needed to spend 11,200 on it. So what do we got here? We're gonna have 16 900 -11 200. They added value of 55,705,700. So that is the value added there at each step of the way. So notice if we were to include these intermediate products, remember we only were only supposed to include in GDP the final value of the goods and services. However, if we were to count each thing along the way, what is the sales value of all of these things together? 5100 plus 7800. Mhm Plus 11,200 plus 16,900. It gives us a value of 41,000 right? 41,000 if we included each intermediate step. However, that's not what got produced. All that got produced was one Malibu worth 16,900. So what is that value? If we add the value added by each step, that's the right way to do it. 5100. Value added in the first step plus 2700 value added in the second step plus 3400 value added in the third step. Finally plus 5700 Gets us to that final value of 16,900. Um by adding all the value added by each step. So notice the final value of the Malibu is equal to the value added by the four steps in the production process. And this is why it's important to exclude those intermediate steps in G. D. P. Or else we're going to over inflate what our production was. If we have a lot of intermediate steps. Okay, so the value added approach, it takes the value added at each step to come up with G. D. P. In the end. Cool. Alright, let's pause here and do a practice problem related to this topic

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?