Double counting can cause miscalculations in the gross domestic product (GDP). This error will overstate the GDP number because it counts the same item more than once. To avoid these mistakes, we can use a value-added approach.
How can double counting occur?
By definition, GDP is the market value of all final goods and services produced within a country during a given year. Here, our keyword is “final goods and services.”
Double counting occurs when we count the same item more than once. That is possible because production involves various inputs of goods and services, not only raw products but also semi-finished goods.
For example, in making cars, manufacturers need some inputs such as aluminum and tires. Each sourced from an external supplier. If we calculate the market value of vehicles, tires, aluminum as economic output, it will produce double counting. Why?
That’s because the price of the car has included the prices of tires and aluminum metal. Remember, to determine the selling price of a car, the automaker takes into account the cost of production (ie, the price of tires and aluminum) in its calculations plus profit markup.
Therefore, when measuring GDP, calculating the market value of all three outputs is wrong. This error can cause you to overstate GDP because it counts the same item more than once.
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Use value-added numbers to avoid double counting
Calculating GDP using the output approach is very complicated. An economy’s output involves a variety of goods and services.
You might calculate GDP from the value of all goods and services produced in an economy. However, this is not entirely true, because you might compute the same output multiple times, at various stages of production. Some goods are inputs (such as raw materials and semi-finished products) for the production of other goods, so they are not final goods.
Let’s use a simple illustration of this problem. Imagine, bread production involves three different stages: wheat, wheat flour, and bread.
Company A, an agricultural company, grows wheat seeds and sells wheat to Company B in the amount of Rp100. Company B, a flour company, processes wheat seeds into wheat flour. The company then sells it to the bread producer, Company C, for Rp250.
Company C finally sells bread to consumers for Rp300. If you calculate GDP by adding the sales price at each stage (Rp100 + Rp250 + Rp300), the result will be Rp650. That number will overstate the amount of output because you calculated the value of wheat three times and the value of wheat flour twice.
A way to avoid overcounting is to focus on adding value. We calculate it by reducing the output value to the input value. More precisely, value-added is equal to the selling price of goods or services minus the cost of all non-work inputs used to produce it.
In the above case, we need to calculate the added value of the three stages of production. Because Company A sells wheat for Rp100 and is assumed not to buy material inputs, it generates Rp100 added value to the economy. Company B adds another Rp150 because it paid Rp100 for input from Company A and sold flour to Company C in the amount of Rp250. Finally, Company C added another Rp50 in value, after buying Rp250 flour and selling Rp300 bread to consumers. If we add up the added value at each stage (Rp100 + Rp150 + Rp50), we will find that the value is equal to Rp300 of the price of bread (the final product).