Shortcomings of GDP

What is Gross domestic product (GDP)?

Gross domestic product (GDP) measures the monetary worth of all final products and services produced in a nation over a certain period. It offers a country's economic landscape at a glance, allowing one to evaluate an economy's size and growth rate.

There are three different methods for calculating GDP: output, expenditures, and income. In addition, it can be adjusted for inflation and population to provide deeper insights. It is currently the most commonly used indicator of a country's economic performance.

GPD can be measured in several different ways. The most common methods include the following:

• Nominal GDP – the entire value of all produced goods and services at the going rate on the market. It comprises all price changes on the market that have occurred this year due to inflation or deflation.
• Real GDP – the total amount of products and services produced at fixed pricing. The prices used to calculate the gross domestic product are predicated on a base year or year prior. 
• Actual GDP – measurement of all outputs in real-time at any particular period or interval. It exemplifies how the economy is currently doing in terms of commerce.
• Potential GDP – a perfect economy with full employment in all sectors, stable currency, and constant product prices.

Economic policymakers can determine if the economy is strengthening or developing, whether it has to be improved upon or restrained, and whether recession or inflation risks are present. 

Governmental organizations can determine from these analyses if expansionary monetary measures are required to address economic problems. GDP growth rates are important to investors because they help them assess the economy's development and alter their asset allocation accordingly. 

However, a downturn in the economy results in poor corporate profitability, reduced stock prices, and a tendency for consumers to reduce their spending. Based on comparisons between nations' growth rates, investors are also looking for possible domestic and international investments.

What are the Gross domestic product (GDP) Limitations?

The uses of Gross Domestic Product (GDP) might be hampered by its inherent limitations because of structural considerations that are frequently disregarded.

GDP limitations include:

• The inability to capture non-market transactions.
• Illegal activity.
• The costs imposed on the environment.
• The costs imposed on human health.
• The failure to account for the degree of income inequality in society.

The exclusion of non-market transactions

GDP is a gauge of market-based production. Therefore, market-unrelated productive activities are not included.

For instance, domestic production, like food preparation and child care services, is excluded from GDP since it does not include market transactions.

Products and services produced for personal use but without a formal production record are referred to as "non-market production.". Think of those who make their food or power, for instance.

The size of this sector is tough to predict, much like the black market economy. The scale of the industry also differs significantly between nations.

For instance, economies with less subsistence farming will more correctly record GDP, whereas economies with more subsistence farming will understate GDP.

Even while domestic and volunteer labor complement the market economy and raise living standards, the GDP does not consider these activities despite their significant beneficial effects on social welfare.

Further, GDP does not measure non-marketed goods, like babysitting, house cleaning, lawn mowing, car washing, etc.

For instance, if a person uses a cab, the cost of the fare will be deducted from GDP.

However, it would not be included in GDP if they hired a friend or family member to drive them. Therefore, it is a non-marketed service even if the same service has already been rendered.

In the second instance, the individuals providing the service weren't attempting to market it. As a result, it wouldn't be included in GDP.

Another illustration is that the cost of hiring a babysitter to look after your child should be accounted for in GDP. However, caring for your child alone will not be included because taking care of your child would be a non-marketed service.

Inability To Capture Illegal Or Under-The-Table Activity GDP

Since the GDP excludes income from unlawful operations, it understates actual economic activity. Despite being immoral, they are not excluded, and the sums are not disclosed. 

Cash payments made "under the table" to dishonest authorities, and businesspeople are also not disclosed.

Black market trade and other unlawful activities negatively influencing societal well-being are not included in GDP.

Activities that are illegal or unreported cannot be tracked. Hence they cannot be stopped.

For example, if someone pays their babysitter and it is not registered in taxes. As a result, it will not be reflected in the GDP figure.

Although it is not unlawful, the activity should have been reported and included in GDP.

GDP does not account for illicit trade or manufacturing, which may account for a sizable portion of the economy in some nations.

Additionally, there is unlawful production, which is the creation of products wholesale, distribution, or possession prohibited by local law.

This kind of output is typically not documented by official sources by nature.

Essential activities in this category include the following:

• The making of pharmaceuticals (for which, in many cases, an authorized legal production exists as well)
• Smuggling (which usually amounts to the production of transportation services concealed for tax evasion),
• Prostitution (for which legal forms may exist as well),
• Unauthorized gambling
• Reproduce protected content (where the same activity would be permitted if properly authorized).

In certain situations, the GDP is not a reliable indicator of several essential factors to a nation's economic health.

In other words, if someone sold anything illegally, they would not disclose it to the authorities. Therefore, the item or service won't be included in GDP.

The Failure To Account For The Costs Imposed On The Environment

Another constraint is pollution. Many emerging nations have little concern for environmental issues and focus on high output to drive economic expansion.

The increased use of non-renewable resources, rising pollution levels, global warming, and the possible loss of natural ecosystems are some of the environmental effects of economic expansion.

Many nations are unaware that if a nation's GDP increases quickly, it also has high pollution levels, and the quality of life in some places may suffer. Increased use of fossil fuels can cause immediate issues like soot and poor air quality (London smogs of the 1950s).
The Clean Air Acts, which restrict the burning of coal in urban areas, have helped to alleviate some of the worst issues related to burning fossil fuels proving that a specific form of pollution reduction can coexist with economic growth.

However, unlike growing CO2 emissions, which are less immediately evident and hence less motivation for politicians to address, smogs were a very plain and obvious risk.

According to scientists, increasing CO2 emissions are to blame for global warming and unpredictable weather. 

This shows that economic expansion raises long-term environmental costs, affecting the present and the coming generations.

The opportunity cost suggests a reduced supply of non-renewable resources as we increase consumption.

In the last century, for instance, the rate of global economic expansion has led to the clearing of forests for agricultural purposes and increased demand for wood, reducing the number of natural resources available.

Pollution of the air, land, and water pollution can harm human health, decrease land and marine production, and ultimately hurt human health.

The Failure To Measure The Costs Imposed On Human Health

There are several ways to calculate and assess GDP. Still, neither one contains any measure of welfare or well-being because GDP merely measures the value of all completed items produced inside an economy over a specific period.

Although using GDP as a "proxy of a proxy" has a substantial impact on its validity, this does not necessarily imply that it cannot be a robust estimate of well-being.

More cash for the populace to spend on fundamental needs like food, clothes, housing, education, and healthcare results from higher GDP per capita.

More money coming in from taxes would also mean more money for the government to spend on social programs.

The global economy has increased living standards. However, modern economies have forgotten that the gross domestic product (GDP), the commonly used indicator of economic development, reflects the size of a country's economy and does not represent that country's well-being.

However, economists and politicians frequently see GDP, or GDP per capita in some situations, as a comprehensive measure of a country's progress that combines its economic success and societal well-being.

Therefore, economic growth-promoting measures are viewed as being advantageous for society as a whole.

Due to ample and varied resources, countries with high GDP per capita typically have adequate health care.

Stress and other mental health problems are top of the most prevalent health disorders in those nations, but GDP does not account for them.

It's time to accept the limitations of GDP and broaden our definition of development to include a society's standard of living.

Many nations are starting to do this. For instance, India is creating an Ease of Living Index that evaluates the economic potential, sustainability, and quality of life.

Conclusion

There is no such thing as a perfect measure of economic activity, but GDP is currently the best measure.

Even though economists like to use GDP as a measure of output or a country's well-being, GDP has some limitations when meeting those needs. 

GDP excludes economic production, such as vegetables are grown in your garden or other non-marketed goods.

Furthermore, GDP is frequently used to capture a society's well-being, which it was never intended to do. As a result, it excludes essential aspects of well-being, such as pollution or even happiness.

Different national and international organizations have developed alternative indicators to provide a more comprehensive measure of a country's quality of life.

The Human Development Index (HDI), the Genuine Progress Indicator (GPI), and the Happy Planet Index (HPI) are a few examples.

Each of these indices is a composite measure that considers income and non-income variables such as life expectancy, literacy rates, environmental indicators, inequality measures, etc. 

By including these variables, they provide a measure of life quality that goes beyond the narrowness of a country's GDP value.

Researched and Authored by Mahdi Naouar | LinkedIn

Reviewed and Edited by Sakshi Uradi | LinkedIn

Free Resources 

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Engel's Law
• Real Economy
• Stagflation
• Trade Wars
• Veblen Goods