What Is the Factor Income Approach?

What Is the Factor Income Approach?


♪ [music] ♪ – [woman] What is
the “factor income approach”? It describes one approach
to calculating GDP through income. Also known
as the “income approach,” the factor income approach
measures GDP by adding up employee compensation,
rent, interest, and profit. Now this may seem a little bit odd. Didn’t we define GDP as the market value
of final goods and services? How can we measure it
by looking at incomes? The reason is that
when a consumer spends money on final goods and services, that money ultimately
is received by someone — namely by workers, landlords,
lenders, and entrepreneurs. So we can measure GDP
by looking at the spending or the other side of the ledger —
by looking at the receiving. Now, in practice, there are
some tricky accounting issues, such as what to do
about sales tax and depreciation, but we’re going to leave that
to the accountants. The basic idea here
is that we can compute GDP by looking at the spending
or the receiving, and, in fact, we do both. When we calculate GDP
by the factor income approach, by adding up employee compensation,
rent, interest, and profit, we call it “gross domestic income,”
or GDI. Why the different name? Well, in theory, GDP and GDI
are exactly equal. But since they’re calculated
in very different ways, they usually give
slightly different results, hence the different names. Let’s take a look
at the FRED database. Here we graphed GDP and GDI. Hard to see a difference, right? But zoom in a little bit, however. We can now see
that they’re not perfectly identical, and in a recession, economists
often look at both figures since one of them
might sometimes give us an earlier or more accurate picture
of the economic situation. Keep in mind, however,
the key idea. We can split or measure GDP
in many different ways, depending on the questions
we’re asking. Regardless of what
we choose to measure, GDP is always the market value
of all finished goods and services produced within a country in a year. If you want to learn more
about GDP, click here. Or, if you want to test yourself
on the factor income approach, click here. ♪ [music] ♪ Still here? Check out Marginal Revolution
University’s other popular videos. ♪ [music] ♪

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