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PERFECT COMPETITION, SHUTDOWN: A perfectly competitive firm is presumed to shutdown production and produce no output in the short run, if price is less than average variable cost. This is one of three short-run production alternatives facing a firm. The other two are profit maximization (if price exceeds average total cost) and loss minimization (if price is greater than average variable cost but less than average total cost).

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GROSS DOMESTIC PRODUCT, INCOME:

A method of estimating gross domestic product (GDP) based on identifying the income (wages, rent, interest, and profit) received by the owners of the four factors of production (labor, capital, land, and entrepreneurship). This is one of two methods used by the Bureau of Economic Analysis in the National Income and Product Accounts to estimate gross domestic product. The other identifies total production from the expenditures by the four macroeconomic sectors.
Gross domestic product is measured by summing the four macroeconomic expenditures--consumption expenditures, investment expenditures, government purchases, and net exports. However, it is also measured by identifying, and summing, the assorted uses of the revenue received by the producers. The primary uses are factor payments (and national) income going to the owners of labor, capital, land, and entrepreneurship. However, other adjusts are also included.

Two Sides of the Market

The reasoning behind this income method of measuring GDP is as fundamental as the market itself. Every market exchange is a two-way process. The buyer trades money for a good. The seller trades a good for money. The market exchange, and the value of the good traded, can be identified from either side of the market--from the expenditure made by the buyer or from the income received by the seller.

The overall value of production, which is what GDP seeks to measure, is determined mutually by buyers and sellers through such market exchanges. On one side of market exchanges is the suppliers, producing and selling goods. On the other side is demanders, purchasing and using goods. For each good sold, someone buys. For each good bought, someone sells. The number crunchers at the Bureau of Economic Analysis use this two-sided notion to derive a relatively accurate estimate of total production (that is, gross domestic product) using total income.

To illustrate, consider the purchase of a Hot Momma Fudge Bananarama Ice Cream Sundae by Duncan Thurly for $2. His demand-side of the transaction involves giving up $2 and getting (and presumably enjoying) a Hot Momma Fudge Bananarama Ice Cream Sundae. However, from the supply-side of this transaction, the Hot Momma Fudge Bananarama Ice Cream Shoppe receives the $2 in payment for producing the Hot Momma Fudge Bananarama Ice Cream Sundae. If the store does not produce, then Duncan does not buy. And if Duncan does not buy, the store does not produce.

As such, a reasonable estimate of Hot Momma Fudge Bananarama Ice Cream Sundae production can be derived by adding up the revenue received by the Hot Momma Fudge Bananarama Ice Cream Shoppe and how the revenue becomes income of the productive resources. Of course, a reasonable estimate of Hot Momma Fudge Bananarama Ice Cream Sundae production can also be derived by aggregating Hot Momma Fudge Bananarama Ice Cream Sundaes expenditures made by all buyers (which is the expenditure approach to measuring GDP). Best of all, both methods result in essentially the same estimate of production.

Paying the Factors

The key to this approach is identifying what happens to the revenue received from production by the business sector. For example, what happens to the $2 received by the Hot Momma Fudge Bananarama Ice Cream Shoppe?

Hot Momma Fudge uses this revenue, first and foremost, to purchase the intermediate goods used to produce the Hot Momma Fudge Bananarama Ice Cream Sundae (ice cream, hot fudge, almond sprinkles, etc.). More on these expenses later.

A portion of this revenue is then used as wages to workers who prepare the sundae. But other resource owners also receive a share. The owners of the land upon which the ice cream shop resides receive a share as rent. The capital owners, the folks who own the building and equipment used in production, receive a share either as rent, interest on a loan, or perhaps even profit. And the entrepreneurs receive the remainder as profit.

Wages, rent, interest, and profit are income received by owners of the four factors of production. If not for the pesky intermediate goods used in production, it would be possible to stop here and simply say that value of the Hot Momma Fudge Bananarama Ice Cream Sundae is CLEARLY equal to the income received by the factors of production.

What about the expense of buying the intermediate goods? Revenue received by firms supplying inputs to the Hot Momma Fudge Bananarama Ice Cream Shoppe are distributed in a manner similar to that of the hot fudge sundae revenue. The owners of labor, capital, land, and entrepreneurship all get a share, with a portion also going for the acquisition of other intermediate good inputs.

For example, ice cream producers buy milk and sugar as inputs. Hot fudge producers buy chocolate as an input. The revenue received by each of these suppliers (milk, sugar, chocolate) is further divided among their resources and any intermediate good inputs they use. Eventually, however, a point is reached in which the only inputs are raw materials, which are part of the land factor of production. Any payment for these raw materials is then a factor payment, and thus income.

The bottom line is that a reasonable estimate of production can be derived by aggregating the income received by ALL factors of production.

Four Factors of Production

The essence of the income approach to measuring GDP is to identify total income earned by the four factors of production (labor, capital, land, and entrepreneurship). The official entries in the National Income and Product Accounts for these factor payments (and their common terms) are: compensation of employees (wages), net interest (interest), rental income of persons (rent), and corporate profits (profit). However, in addition to these four relatively straightforward factor payments, a fifth payment officially designated as proprietors' income is also included.
  • Compensation of Employees: The official measure of wages earned by the household sector for supplying labor services. Compensation of employees is far and away the largest of the five factor payments, typically running about 55 percent of gross domestic product. It includes standard wages and salaries paid directly to employees, as well as fringe benefits paid on behalf of employees to third parties.

  • Net Interest: The official measure of interest earned by the household sector for supplying capital services. Net interest is usually less than 8 percent of gross domestic product, typically in the 5 to 7 percent range. It is revenue generated from borrowed funds but is considered payment for the productive services of capital.

  • Rental Income of Persons: The official measure of rent earned by the household sector for supplying land and related services. Rental income of persons is typically the smallest of the five factor payment categories, usually less than 4 percent of gross domestic product. It includes payments for the use of land, natural resources, and capital goods attached to the land.

  • Corporate Profits: The total accounting profits received by corporations, which is the official measure of profit earned by the household sector for supplying entrepreneurship services through corporations. Corporate profits are the second largest factor payment category, usually coming in around 15 to 20 percent of gross domestic product.

  • Proprietors' Income: The excess of revenue over explicit production cost of owner-operated businesses and includes payments to all factors of production--labor, capital, land, and entrepreneurship. Proprietors' income is usually less than 8 percent of gross domestic product, typically falling in the 6 to 9 percent range.

Other Adjustments

In a simple world, these five items would provide a complete understanding of the income approach to measuring gross domestic product. But, alas, this is not a simple world. The income approach to measuring gross domestic product includes more than just these five factor payment categories. In the real world, revenue received by the business sector is NOT used ONLY for factor payments. Other adjustments are needed.

These "Other Adjustments" include net foreign factor income, capital consumption adjustment, indirect business taxes, business transfer payments, government subsidies less current surplus of government enterprises, and statistical discrepancy.

  • Indirect Business Taxes: The official term for sales taxes. They are termed INDIRECT business taxes because the business sector is only acting as the "collection agency" for the government, collecting the taxes from the household sector.

  • Net Foreign Factor Income: The difference between factor payments received from the foreign sector by domestic citizens and factor payments made to foreign citizens for domestic production. This is also the key difference between gross DOMESTIC product and gross NATIONAL product.

  • Business Transfer Payments: Subsidies, or gifts, made from the business sector to the household sector. It includes outright gifts (such as student scholarships), and more importantly, accounting adjustments for unpaid debts of the household sector.

  • Government Subsidies Less Surplus of Government Enterprises: Government subsidies are transfer payments from the government sector to the business sector which are NOT payments for current production. These subsidies are adjusted by the current surplus of government enterprises, which is the "profit" of government run business activities.

  • Statistical Discrepancy: The official "fudge factor" that ensures gross domestic product measured from the expenditure side is equal to gross domestic product measured from the income side.

A Summary Equation

The following equation is commonly used to summarize the income approach to measuring GDP:

GDP=Wages + Interest + Rent + Profit + Proprietors' Income + Other Adjustments

The first five items on the right-hand side of this equation are officially designated as national income. The "Other Adjustments" include net foreign factor income, capital consumption adjustment, indirect business taxes, business transfer payments, government subsidies less current surplus of government enterprises, and statistical discrepancy. Each compensates for real world differences between income earned by the factors of production and the value of gross domestic product.

<= GROSS DOMESTIC PRODUCT, EXPENDITURESGROSS DOMESTIC PRODUCT, INS AND OUTS =>


Recommended Citation:

GROSS DOMESTIC PRODUCT, INCOME, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2017. [Accessed: December 13, 2017].


Check Out These Related Terms...

     | national income | factor payments | gross domestic product, expenditures | compensation of employees | net interest | rental income of persons | corporate profits | proprietors' income | indirect business taxes | net foreign factor income | business transfer payments | statistical discrepancy | government subsidies less current surplus of government enterprises | gross domestic income |


Or For A Little Background...

     | production | product markets | gross domestic product | National Income and Product Accounts | Bureau of Economic Analysis | National Bureau of Economic Research |


And For Further Study...

     | macroeconomic sectors | circular flow | business cycles | gross domestic product, ins and outs | gross domestic product, welfare | net domestic product | personal income | disposable income | gross national product | real gross domestic product | national income and gross domestic product | national income and net domestic product | government functions | unemployment | inflation |


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