What this lesson teaches
I can explain why national income, expenditure and output are equal.
Syllabus 9570, 3.1.1(b). Circular Flow of Income: National income equals expenditure equals output
Make a guess
A farmer sells wheat to a baker for $40, and the baker sells bread to shoppers for $100. How much do these sales add to GDP?
- $100, the value of the final bread.
- $140, the total value of both sales.
- $60, the baker's profit on the bread.
Show the answer
$100, the value of the final bread.
GDP counts final goods, or the value added at each stage: $40 by the farmer plus $60 by the baker. Adding $40 and $100 would count the wheat twice.
Output, expenditure and income give the same total, as long as each good is counted once.
National income can be measured in three ways. The output method adds up the value added at each stage of production. The expenditure method adds up spending on final goods and services. The income method adds up wages, rent, interest and profit.
All three give the same total, because every dollar spent on a final good becomes someone's income.
Only count final goods, or value added at each stage. Counting both the flour and the bread made from it would count the flour twice.
This total is gross domestic product (GDP): the value of all final goods and services produced in the country in a year.
- Three methods
- Output, expenditure, income.
- Avoid
- Double counting of intermediate goods.
Worked example: Count the wheat once
A farmer sells wheat for $40 to a baker. The baker sells bread for $100 to households.
- Value added: the farmer adds $40, the baker adds $100 - $40 = $60. Total: $100.
- Final spending: households spend $100 on bread.
- Income: $40 to the farmer's household and $60 to the baker's. Total: $100.
- Adding $40 + $100 = $140 would count the wheat twice.
Watch out for this
GDP adds up the value of every sale in the economy.
Only final goods, or value added, are counted, otherwise inputs would be counted twice.
Check your understanding
A factory buys $300 of steel and sells a machine for $1,000 to a business. How much does this add to GDP?
- $1,000.
- $1,300.
- $700.
Show the answer
$1,000.
Right. The machine is the final good; the steel is part of its value.