Posted: February 19th, 2023

Consider an economy with three firms:

• Firm 1 sells $75 of steel to Firm 3. From its earnings, it pays $25 in wages and keeps $50 in profits.

• Firm 2 sells $30 of rubber to Firm 3. Firm 2 pays $10 in wages and keeps $20 in profits.

• Firm 3 sells $240 of cars to households. It pays for its inputs (from Firm 1 and Firm 2); keeps one third of its remaining earnings as profits,and pays two thirds in wages. Let’s calculate GDP various ways.

(a) What is the final value of goods and services?

SOLUTION

The final value of goods and services is the total value of cars sold to households, which is $240.

(b) What is the value added by each firm?

The value added by each firm is the difference between the value of their output and the cost of their inputs.

For Firm 1: value added = $75 – $25 = $50

For Firm 2: value added = $30 – $10 = $20

For Firm 3: value added = $240 – ($75 + $30) = $135

(c) What is the GDP of the economy?

There are three ways to calculate GDP: using the production approach, the expenditure approach, and the income approach.

Using the production approach, GDP is the sum of the value added by each firm, which is:

GDP = value added by Firm 1 + value added by Firm 2 + value added by Firm 3

= $50 + $20 + $135

= $205

Using the expenditure approach, GDP is the sum of final expenditures on goods and services, which is:

GDP = final expenditure on cars by households

= $240

Using the income approach, GDP is the sum of factor incomes earned in the production of goods and services, which is:

GDP = wages paid by Firm 1 + wages paid by Firm 2 + two thirds of the remaining earnings of Firm 3

= $25 + $10 + (2/3) x ($240 – $75 – $30)

= $25 + $10 + (2/3) x $135

= $25 + $10 + $90

= $125

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