Value added approach to calculating GDP | AP Macroeconomics | Khan Academy

In previous videos, we talked about GDP as the market value of final goods and services produced in a country in a given time period, let's say in a given year. We gave the example of producing jeans, where maybe the farmer helps produce the cotton, and then the thread maker takes that cotton and makes thread. Then the fabric maker takes the thread and makes fabric, and then the jean maker takes the fabric and produces jeans and so on. The market value of those jeans was 50, and so assuming all of this happened in one year, in the time period that we're measuring GDP for, then we would just count the fifty dollars.

If we're looking at the final market value, or the market value of final goods and services, you would say the GDP for at least for this component of the GDP from these jeans is 50. But I do want to clarify that there are multiple ways that you can measure GDP, and you could even think about it from a value-added approach. But the key idea is, no matter how you measure it, you should get to the same value.

So let's think about the various actors here and what their value add was. First, let's think about the farmer. Right over here, this is the farmer, my not so elegantly drawn rectangle around what he's doing. So the farmer's value add is what? Well, before, you just had some dirt and things, and so maybe you could say that the market value was zero. Then he's able to produce something, or she's able to produce something that now has a market value of ten dollars. So their value add is ten dollars.

Now, from there, the cotton goes to the thread maker. The thread maker, they take that ten dollar cotton. So this is thread. The thread maker takes the ten dollar cotton and are able to produce twenty dollars' worth of thread. What is their value add? Value add here, well, they took something worth ten dollars and they were able to do something to it to make it worth twenty dollars. So their value add is now another ten dollars.

Then this is the thread maker, and then from there it goes to the fabric maker. The fabric maker—and I think you see where this is going. The fabric maker is this part of our process. Fabric maker, and their value add is what? Pause this video and think about it. Well, they take something worth 20 and they're able to create it. They're able to turn it into something that has a market value of 30. So their value add is also 10.

And then last but not least, you have the gene company, so the gene manufacturer. I’ll call them the gene producer. The gene producer, they take something that has a market value of 30 and they're able to sell it for 50. So their value add, value add here, if you take something from 30 and you make it worth 50, then you've added 20 dollars of value.

The value-added approach to GDP will just sum up these value adds. This is going to be this 10 from the farmer, plus the value add of the thread maker, plus ten dollars from the thread maker, plus ten dollars from the fabric maker, plus twenty dollars from the gene maker. What will that all add up to? Well, that's all going to add up to ten plus ten is twenty, plus ten is thirty, plus twenty is fifty dollars.

Lucky for us, that has added up to the same amount as we had before, where we just looked at the market value of the final goods and services. Now, one benefit of the value-added approach is that real supply chains are quite complex. Things might be going from one country to another. They might, as we've talked about in another video, the year might end right over here. When something is made in China and there's value add in China, but then it's shipped to the U.S. and some value add is placed on it and then shipped back to China or Mexico, you have to be careful to only count the value add in the country for which you are measuring the GDP.

So that's one useful way of—or one useful reason or one way in which the value-added approach might be useful. The key idea, though, is that you're getting to the same value. You should get to the same value as the market value of the final goods and services produced in a given time period.