Factor Income Approach

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. Still here? Check out Marginal Revolution University's other popular videos.