GDP counts only final goods. But most products pass through several firms on the way to you. Value added gives a second way to measure GDP that never double-counts, and it shows why the income approach gives the same total.
Key idea
A firm's value added is the value of what it sells minus what it paid other firms for inputs. Adding the value added at every stage of production gives the price of the final good, so the sum of value added across the economy equals GDP.
Why it works
Follow a loaf of bread. A farmer grows wheat and sells it to a miller for \$0.30. The miller grinds it and sells flour to a baker for \$0.50, adding \$0.20. The baker sells the bread to a grocer for \$0.80, adding \$0.30, and the grocer sells it to you for \$1.00, adding \$0.20. The value added sums to $0.30 + 0.20 + 0.30 + 0.20 = 1.00$, the final price. Adding all four sales instead gives \$2.60, which counts the wheat four times. And each stage's value added is paid out as wages, rent, interest and profit, so it is also the income earned at that stage. That is why measuring GDP by spending, by value added, or by income gives the same total.
Worked examples
Worked example: Value added at one stage
A logger sells logs to a sawmill for \$40. The sawmill sells lumber to a furniture maker for \$70. The furniture maker sells a table for \$150. What is the furniture maker's value added?
- It sold the table for \$150 and paid \$70 for lumber.
- Value added $= 150 - 70 = 80$ dollars.
Answer: \$80
Worked example: The income approach
A workshop sells \$300,000 of tables. It buys \$100,000 of materials from other firms and pays \$120,000 in wages, \$20,000 in rent and \$10,000 in interest. Find its value added and its profit.
- Value added $= 300{,}000 - 100{,}000 = 200{,}000$ dollars.
- Profit $$= 200{,}000 - 120{,}000 - 20{,}000 - 10{,}000 = 50{,}000$$ dollars.
- Check: wages + rent + interest + profit $$= 120{,}000 + 20{,}000 + 10{,}000 + 50{,}000 = 200{,}000$$ the value added.
Answer: Value added \$200,000; profit \$50,000
Common mistake
Adding up the sales at every stage of production. That counts the wheat again inside the flour, and again inside the bread. Only purchases from other firms are subtracted to find value added; wages, rent and interest are not subtracted, because they are the value the firm adds. Check: the value added along a chain must add up to the final price.