GDP Measuring Methods

Methods of Measuring Gross Domestic Product (GDP)

The ABS Opens in new window produces three different methods of calculating GDP, of which economists adhere to.

1. The production method.

The sum of the value of all goods and services produced by industries in the economy in a year minus the cost of goods and services used in the productive process, leaving the value added by the industries.

2. The expenditure method.

The expenditure method is the sum of the total expenditure on final goods and services by households, investors, government and net exports (the expenditure on exports minus the expenditure on imports).

3. The income method.

This is the sum of the income generated from the production of goods and services, which includes profits, wages and other employee payments, income from rent and interest earned.

The following section will demonstrate how these methods all lead to the calculation of the same level of GDP.

Production, Income and the Circular-Flow Diagram

When we measure the value of total production in the economy Opens in new window by calculating GDP we are simultaneously measuring the value of total income and the value of total expenditure on goods and services.

First, to see why the value of total production is equal to the value of total income, consider what happens to the money you spend on a single product.

Suppose you buy a streak meal for $25 at PJ O’Reilly’s pub. All of that $25 must end up as someone’s income.

  • Suppliers of meat, potato chips and salad, plus PJ O’Reilly’s will receive some of the $25 as profits.
  • Workers at the food suppliers will receive some as wages,
  • the waiters who served you the meal will receive some as wages,
  • the farms that sell ingredients will receive some as profits,
  • the workers on these farms will receive some as wages and so on: every cent must end up as someone’s income.

(Note, however, that any sales tax on the meal will be collected by PJ O’Reilly and sent to the government without immediately ending up as anyone’s income.)

Therefore, if we add up the value of every good and service sold in the economy, we must get a total that is exactly equal to the value of all the income in the economy.

The circular-flow diagram (shown below) is used to illustrate the flow of spending and money in the economy Opens in new window.

The circular-flow of income in an economy Figure 1. The circular-flow and measurement of GDP. The complete circular flow has five sectors: a household sector, a firm sector, a government sector, a foreign sector, and a financial sector. Opens in new window

As the circular-flow diagram depicts, firms sell goods and services to three groups:

  1. domestic households,
  2. foreign (overseas) firms and households,
  3. and the government.
We can measure GDP by adding up the total expenditures of these three groups on goods and services.

To produce goods and services firms use factors of production Opens in new window: labor, capital, natural resources and entrepreneurship.

Households supply the factors of production to firms in exchange for income in the form of wages, interest, profit and rent.

Firms make payments of wages and interest to households in exchange for hiring workers and other factors of production.

The sum of wages, interest, rent and profit is total income in the economy.

We can measure GDP as the total income received by households.

The diagram also shows that households use their income to purchase goods and services, pay taxes and save. Firms and the government borrow the funds that flow from households into the financial system.

We can measure GDP Opens in new window either by calculating the total value of expenditure on final goods and services or by calculating the value of total income.