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Gross Domestic Product: Using the Income and Expenditure Approaches

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  • 0:07 Measuring Total Amount…
  • 3:23 GDP (Gross Domestic Product)
  • 5:03 The Income Approach
  • 6:02 The Expenditure Approach
  • 7:18 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

In this lesson, you will learn how economists measure gross domestic product using two different methods - the income approach and the expenditure approach.

Measuring Total Amount of Production

On a warm sunny day a young man, Felix, is sitting on a beach overlooking the beach and the ocean. There's a slight wind blowing towards him that breaks up the heat from the sun, making this a perfect day to not be working at his job. As he sits on the bench, he takes out his wallet and looks inside, finding $300, which is the cash that he received when he took his most recent paycheck to the bank to cash it.

For the sake of a great economic illustration, let's say that Felix really loves ice cream. He loves ice cream so much that he buys a triple banana split in the morning then an hour later, he buys a milkshake as well as gelato. Every time he buys ice cream, he receives a receipt, which he adds to a pile that is beginning now to grow very tall next to the bench that he's sitting on. By the end of the day, he's spent all of the cash that he had in his wallet. It's all gone. That's right; he spent all $300 on ice cream, and he even has a gigantic pile of receipts to show for it.

Now it's 7:00 at night, and the sun's going down. All of a sudden, a young woman, Kelly, who's an economist by the way, sits down next to him. As they begin to talk with each other, Felix tells her the incredible story of how he spent everything in his wallet on ice cream, which represents his entire paycheck. Kelly, who's, by this time, quite astounded at his willingness to risk everything in an attempt to satisfy his unlimited want for ice cream, begins to think about this economically.

Kelly wants to know how much production took place in Felix's one-person economy. So, that's the question. As she thinks about it, she realizes that there are two ways she could find the answer. The first way would be to gather up all the receipts from every purchase that Felix made throughout the day - makes sense. If she adds up all the receipts of what he purchased, she will discover that he spent $300 total. Another way to say this is Felix had expenditures of $300. In addition to counting up all the receipts, Kelly realizes that she could ask Felix how much his paycheck was. So, Felix tells Kelly that he received a $300 paycheck, which he then promptly cashed and placed the money in his wallet.

As you can see from this example, you can measure the total amount of production that takes place using two different approaches. 1) By looking at how much money was spent (which we call expenditures) as well as 2) how much money was earned (which is income), and they both should be exactly the same, assuming that all the income was spent.

The economic activity of households, firms, and the government have a circular flow
Circular Flow Model Diagram

Economists do the same thing that Kelly did when they examine the economy each year and estimate our total production by calculating GDP. GDP stands for gross domestic product, and it measures the total production in an economy. GDP is the total market value of all final goods and services produced during a given time period within a nation's domestic borders. It is equal to the total income of the nation's households and also the total expenditures within the nation. Therefore, we can measure, or estimate, the total value of production from either the income side or the spending side.

So, we have two widely accepted ways to measure the total production in our economy. One is called the income approach, and the other is called the expenditure approach. The income approach measures the total income that is earned by all the households in a nation, while the expenditure approach measures the total amount of spending on goods and services that are produced within the domestic borders of the nation by households, firms, government, and even foreigners.

Both of these methods of measuring GDP are directly tied to the circular flow model for our economy in which households exchange their factors of production (such as labor) for income, and then they spend their income on the products and services that firms produce. At the same time, government receives taxes and makes purchases also within the circular flow of our economy.

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