The value added method calculates economic output by determining the increase in the value of goods and services at each stage of production. In essence, you use it by subtracting the cost of intermediate inputs from the value of the final output.
Here's a breakdown of how to use the value added method:
1. Understand the Basic Principle
The fundamental concept is that the value added is the contribution each producer makes to the overall economy. This prevents double-counting, which would occur if the total value of all sales was simply added up. By focusing on the increase in value at each stage, you accurately measure the economic contribution.
2. Identify the Stages of Production
Determine all the stages involved in producing a final good or service. For example, if you're considering the production of bread:
- Stage 1: Wheat Farming
- Stage 2: Milling the Wheat into Flour
- Stage 3: Baking the Bread
- Stage 4: Retail Sale of the Bread
3. Calculate the Output Value at Each Stage
For each stage, determine the total value of the output produced. This is usually the revenue generated from sales at that stage.
- Wheat Farmer: Sells wheat for $100. Output Value = $100
- Miller: Sells flour for $150. Output Value = $150
- Baker: Sells bread for $250. Output Value = $250
- Retailer: Sells bread for $300. Output Value = $300
4. Calculate the Intermediate Consumption at Each Stage
Intermediate consumption refers to the goods and services used up in the production process. These are the inputs purchased from other producers.
- Wheat Farmer: Intermediate Consumption = $0 (Assuming no significant inputs from other businesses for this simplified example)
- Miller: Intermediate Consumption = $100 (Cost of wheat purchased from the farmer)
- Baker: Intermediate Consumption = $150 (Cost of flour purchased from the miller)
- Retailer: Intermediate Consumption = $250 (Cost of bread purchased from the baker)
5. Calculate Value Added at Each Stage
Subtract the intermediate consumption from the output value at each stage.
- Wheat Farmer: Value Added = $100 - $0 = $100
- Miller: Value Added = $150 - $100 = $50
- Baker: Value Added = $250 - $150 = $100
- Retailer: Value Added = $300 - $250 = $50
6. Sum the Value Added
Add up the value added from all stages to arrive at the total value added for the product or industry.
Total Value Added = $100 + $50 + $100 + $50 = $300
This total value added represents the final market value of the bread, and avoids double-counting the value of the wheat and flour as they move through the production process.
7. Application and Use
The value added method is crucial for:
- Calculating Gross Domestic Product (GDP): It's one of the three primary methods used to calculate GDP (the others being the expenditure and income approaches).
- Industry Analysis: Understanding the value chain and contribution of different industries.
- Economic Policy: Informing decisions related to taxation, subsidies, and trade.
By meticulously calculating the value added at each stage of production, you can accurately measure the economic contribution of various industries and sectors, ultimately contributing to a more precise understanding of the overall economy.
