Why GDP counts only final goods
GDP is "the value of everything a country produces in a year". So a student adds up every sale: the wheat, the flour, the bread. The total comes out far too big, and the mistake has a name, double counting. The fix is one word in the definition, final, and once you see why it is there you will never add the wheat again.
A loaf of bread, three sales
Take the island of Coralia from Macro Lesson 1. A farm sells wheat to the mill for $100. The mill grinds it and sells flour to the bakery for $250. The bakery bakes it and sells bread to islanders for $600. Three sales, $950 of money changing hands. How much did the island produce? Move the slider one sale at a time and compare the two bars.
The top bar is what a careless adviser would report: $950. The bottom bar is what the island really made: $600, the price of the bread. The wheat did not disappear. It is inside the flour, and the flour is inside the bread. When the bakery sold the loaf for $600, that price paid for the flour, and the flour's price had paid for the wheat. Add the three sales and you charge the island for the same wheat three times.
Final and intermediate
This is why the definition says final. A final good is bought by its last user, the family that eats the bread. An intermediate good is bought to be used up in making something else: the wheat, the flour. GDP counts the bread and leaves the wheat and flour out, not because they are worthless but because their value is already in the loaf.
Notice that "final" is about the buyer, not the thing. The same bag of flour is intermediate when the bakery buys it and final when a family buys it to bake at home. And a new oven the bakery buys is a final good too: it is not used up this year, so it counts, as investment, in the year it is built.
Value added: the other road to $600
There is a second way to reach the honest number, and it is the one statistics offices actually use, because they cannot ask every buyer what they plan to do with every bag of flour. Ask each firm: what did you sell, and what did you buy from other firms? The difference is its value added, the new value it created on top of what it bought in.
| Firm | Sells | Inputs bought | Value added |
|---|---|---|---|
| Farm | $100 | $0 | $100 |
| Mill | $250 | $100 | $150 |
| Bakery | $600 | $250 | $350 |
| Total | $950 | $600 |
100 + 150 + 350 = 600, the price of the bread. That is not luck. Every input bought by one firm was sold by another, so when you add the differences everything cancels except the last sale. Try it: change the price the mill charges for flour and watch what happens to the two totals.
Whatever the flour costs, the three firms together add exactly the price of the bread. The sum of every sale, on the other hand, goes up and down with a price that is only passed along the chain. If GDP were that sum, an island could raise its GDP by splitting its mill into two companies that sell to each other. A measure of production should not care how many hands a loaf passes through, and this one does not.
The trap on tests
- "Money changed hands" is not the test. The question is whether something new and final was produced this year. The wheat sale is a real sale, and it is still left out.
- Only the last sale, or all the values added. Never both. If you count the bread at $600 and then add the mill's $150, you have double counted again.
- Final depends on the buyer. Flour to a bakery is intermediate; flour to a family is final. A new oven for the bakery is final (investment), not intermediate.
- Value added = sales − inputs bought from other firms. Wages are not an input bought from another firm: they are part of the value the firm adds, and they come back as income in the income approach.
- Check your answer. The values added must sum to the final price. If they do not, one line is wrong.
Quick check
1. A fishing crew sells fish to a cannery for $120. The cannery sells canned fish to a supermarket for $300. The supermarket sells the cans to islanders for $500. How much does this chain add to GDP?
$500, the price of the final cans. Value added: crew $120, cannery 300 − 120 = $180, supermarket 500 − 300 = $200; 120 + 180 + 200 = 500. Adding the three sales gives $920, which counts the fish three times and the cans twice.
2. The mill sells one bag of flour to the bakery for $5 and an identical bag to a family for $5. Which one is in GDP?
The family's bag, as a final good: the family is its last user. The bakery's bag is intermediate: it will be used up in bread, and the bread's price will count it. Same bag, same price; what matters is who buys it and what for.
3. A cotton farm sells cotton for $40, a spinner sells yarn for $90, a weaver sells cloth for $200, a tailor sells the shirt for $350. What is the value added at each step, and the total?
Farm $40, spinner 90 − 40 = $50, weaver 200 − 90 = $110, tailor 350 − 200 = $150. Total 40 + 50 + 110 + 150 = $350, the price of the shirt. Four steps instead of three changes nothing: the sum of every sale would be $680, but GDP rises by $350.