National output concepts

Macroeconomics has as its central goal the explanation of the determinants of national income and output. In the next chapter we discuss the forces that determine how national income and output change over long periods of time. Starting in Chapter 23, we then build an analytical framework that helps us to understand the forces that influence these variables over shorter time periods. First, however, we have to understand what it is we are talking about. What exactly do we mean by national income and the national product? What do people mean when they refer to GDP, and how does it differ from GNI (or GNP)?

We start by discussing the measurement of national output, and find that by summing the value added for each industry or sector we arrive at a standard measure of national product. We then discuss how it is that we can arrive at the same measure of national product both from the spending side of the economy and from adding up factor (inputs) incomes. An explicit result of this discussion is a demonstration of the equivalence of the concepts of national income and national product.

The national output, or national product, is related to the sum of all the outputs produced in the economy by Individuals, firms, and governmental organizations. To obtain it, however, we cannot just add up all of the outputs of individual production units.

Value added as output

The reason why getting a total for the nation's output is not quite so straightforward as it may seem at first sight is that one firm's output may be another firm's input. A maker of clothing buys cloth from a textile manufacturer and buttons, zips, thread, pins, hangers, etc., from a range of other producers. Most modem manufactured products have many ready-made inputs. A car or aircraft manufac­turer, for example, has hundreds of component suppliers.

Production occurs in stages: some firms produce outputs that are used as inputs by other firms, and these other firms in turn produce outputs that are used as inputs by yet other firms.

If we merely added up the market values of all outputs of all firms, we would obtain a total that was greatly in excess of the value of the economy's actual output The error that would arise in estimating the nation's output by adding all sales of all firms is called double counting. 'Multiple counting' would be a better term, since, if we added up the values of all sales, the same output would be counted every time it was sold from one firm to another.

The problem of double counting is solved by distinguish­ing between two types of output. Intermediate goods and services are the outputs of some firms that are in turn inputs for other firms. Final goods and services are goods that are not used as inputs by other firms in the period of time under consideration. The term final demand refers to the purchase of final goods and services for consumption, for investment (including inventory accumulation), for use by governments, and for export. It does not include goods and services that are purchased by firms and used as inputs for producing other goods and services.

If the sales of firms could be readily separated into sales for final use and sales for further processing by other firms, measuring total output would still be straightforward. Total output would equal the value of all final goods and ser­vices produced by firms, excluding all intermediate goods and services. However, when a steel maker sells steel to Ford UK it does not care, and usually does not know, whether the steel is for final use (say, construction of a new warehouse) or for use as an intermediate good in the pro­duction of can. The problem of double counting must therefore be resolved in some other manner. To avoid double counting, statisticians use the important concept of value added. Each firm's value added is the value of its output minus the value of the inputs that it purchases from other firms (which were in turn the outputs of those other firms). -Thus, a steel mill's value added is the value of its output minus the value of the ore that it buys from the mining company, the value of the electricity and fuel oil that it uses, and the values of all other inputs that it buys from other firms. A bakery’s value added is the value of the bread and cakes it produces minus the value of the flour and other inputs that it buys from other firms.

The total value of a firm's output is the gross value of its output. The firm's value added is the net value of its output. It is this latter figure that is the firm's contribution to the nation's total output. It is what its own efforts add to the value of what it takes in as inputs.

Value added measures each firm's own contribution to total output the amount of market value that is produced by that firm. Its use avoids the statistical problem of double counting.

The concept of value added is further illustrated in Box 21.1. In this simple example, as in all more complex cases, the value of total output of final goods is obtained by summing all the individual values added.

The sum of all values added in an economy is a measure of the economy's total output. This measure of total output is called gross value added. It is a measure of all final output that is produced by all productive activity in the economy.

Table 21.1 gives the gross value added by major indus­trial sectors for the UK economy in 2001. You will see from this table that gross value added becomes GDP by the addi­tion of a further term (taxes on products minus subsidies). We will explain this step in moving from value added to GDP below.

Notice that we have used 'gross' in two different senses above—first in comparing the gross and net values of a firm's output, and then in the term 'gross value added'. The first usage relies on the common meanings of 'gross' and 'net’. The gross value of the firm's output is the total output before making any deductions, while the net value deducts inputs made by other firms. In 'gross value added' the usage is different. Value added is already defined as firms' net output; the word 'gross' is added because of its specific meaning in national accounts statistics. This distinction is important to understand, as we will be using the word from here on in terms such as gross domestic product and gross national income.

'Gross' in national accounts aggregates refers to the fact that we are measuring currently produced outputs or incomes without taking into account the wearing out or depreciation, of capital goods during their production. Thus, gross value added is the value added of the economy as a whole before any allowance for depreciation.