limitations of gdp essay

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GDP Is Not a Measure of Human Well-Being

• Amit Kapoor
• Bibek Debroy

We need better measures of development.

GDP was not designed to assess welfare or the well being of citizens. It was designed to measure production capacity and economic growth. Yet policymakers and economists often treat GDP as an all-encompassing unit to signify a nation’s development, combining its economic prosperity and societal well-being. It’s time to acknowledge the limitations of GDP and expand our view of development to include welfare. A number of countries, including India, are paving the way.

Economic growth has raised living standards around the world. However, modern economies have lost sight of the fact that the standard metric of economic growth, gross domestic product (GDP), merely measures the size of a nation’s economy and doesn’t reflect a nation’s welfare. Yet policymakers and economists often treat GDP, or GDP per capita in some cases, as an all-encompassing unit to signify a nation’s development, combining its economic prosperity and societal well-being. As a result, policies that result in economic growth are seen to be beneficial for society.

• AK Amit Kapoor  is chair, Institute for Competitiveness, India. He is an affiliate faculty for the Microeconomics of Competitiveness course of Institute for Strategy and Competitiveness at Harvard Business School. He is author of two bestsellers i.e., Riding The Tiger and The Age of Awakening and has worked on the Ease of Living Index 2019 for Ministry of Housing and Urban Affairs, Government of India. His body of work is available at  www.amitkapoor.com and tweets @kautiliya.
• BD Bibek Debroy  is chairman, Economic Advisory Council to the Prime Minister (of India). He was as well a member of NITI Aayog until recently. He is author of over 100 books in the field of Economics, Polity and Sanskrit. He tweets at @bibekdebroy.

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What is Gross Domestic Product (GDP)?

What are the limitations of using gdp, alternatives to gross domestic product, more resources, shortcomings of gdp.

Understanding the shortfalls of GDP and exploring alternative metrics

Gross Domestic Product (GDP) refers to the total economic output achieved by a country over a period of time. While GDP is generally a good indicator of a country’s economic productivity, financial well-being, and standard of living, it does come with shortcomings.

Some of GDP’s limitations as an economic indicator are below:

Underground Economy

The underground economy (or black market) refers to cash and barter transactions that are not formally recorded in GDP and are often used to support the trade of illegal goods and services (i.e., drugs, weapons, prostitution, etc.). The scale of underground economies varies greatly between nations, and, in some cases, they make up a substantial percentage of a country’s economic output.

The underground market is almost impossible to estimate or value, and due to its illegal nature, it is rarely incorporated into a nation’s published GDP figure. Thus, some nations’ economic output may be understated by GDP.

Environmental Abuses

Often, producers can increase their output by polluting or damaging the environment. In developed countries, production is better regulated, and companies that violate environmental laws can face severe fines and penalties.

However, many developing economies rely on high output to support the growth of their own economies and are less concerned with environmental issues. Nonetheless, there is a consensus that such environmental damage should be counted against a country’s GDP since it is not sustainable production and may impact future growth.

Increases in Product Quality

As technology advances, producers are able to offer increasingly better products for reduced production costs. For example, smartphone manufacturers may be producing phones with better cameras, more advanced processors, and higher-quality displays.

Thus, consumers experience higher utility than before without being faced with proportionately inflated prices. Such advancements are not counted in GDP since relative utility gains are difficult to quantify.

Non-Market Production

Non-market production refers to goods and services that are produced for private consumption and for which exists no official record of production. For example, consider people who grow their own food or manufacture their own electricity.

Similar to the black market economy, it is almost impossible to estimate the amount of this sector. The sector’s size also varies greatly between countries. For example, the GDP of countries with many subsistence farmers will be understated, whereas in economies with less subsistence farming will more accurately record GDP.

Gross National Income (GNI)

GNI is a similar measure to GDP, except that it includes net national income. Net national income is the total net income that a country earned over a specific time period from other countries. The figure is referred to as the Net Factor Income from Abroad (NFIA).

For instance, if Country A is home to a major multinational’s headquarters (i.e., reports earnings in this country), and that company oversees operations that generate profits of $100 million in Country B, then Country A’s NFIA would be $100 million. It would, in turn, cause GNI to rise by $100 million. The equation to calculate GNI is:

GDP  – Gross Domestic Product

FIAin  – Factor Income from Abroad “In” (i.e., receivables from abroad business)

FIAout – Factor Income from Abroad “Out” (i.e., payables to abroad business)

(FIAin – FIA out)  – Net Factor Income from Abroad (NFIA)

Green Gross Domestic Product (GGDP)

GGDP essentially penalizes a country for employing manufacturing practices that harm the environment. Such practices are seen as unsustainable, and, thus, many believe that they should be counted against a country’s GDP.

GDP  – Gross Domestic Product

g – Negative environmental impact ($)

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GDP as a measure of economic well-being

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Karen dynan and karen dynan professor of the practice of economics - harvard university, nonresident senior fellow - peterson institute for international economics louise sheiner louise sheiner the robert s. kerr senior fellow - economic studies , policy director - the hutchins center on fiscal and monetary policy @lsheiner.

August 24, 2018

This paper is published as part of the Hutchins Center on Fiscal and Monetary Policy’s  Productivity Measurement Initiative .

Measured growth in productivity and output has been disappointingly slow, even while technological advances appear to be yielding considerable benefits for everyday life. This dissonance has spurred complaints that government economic statistics aren’t capturing reality.

While this new attention is welcome, economists and others who engage in this conversation do not always start on the same page. Conversations are impeded by a lack of understanding of how the statistics are defined and how they are limited, both in terms of the underlying concept and in terms of how they are calculated given the concept.

In a new working paper , Karen Dynan of Harvard University and the Peterson Institute for International Economics and the Hutchins Center’s Louise Sheiner conclude that changes in real Gross Domestic Product (GDP) do a reasonable job in capturing changes in a nation’s economic well-being with one important exception. They argue that the exclusion of non-market activities that increase economic well-being merits more attention, particularly given the growing importance of such activities.

They cite several areas where measurement falls short of the conceptual ideal. First, the national accounts may mismeasure nominal GDP arising from the digital economy and the operation of multinational corporations. Second, deflators used to separate GDP into nominal GDP and real GDP may produce a biased measure of inflation. For goods and services that do not change in quality over time, current deflator methods work reasonably well. For new goods and services, or goods and services that are changing in quality, current methods may not capture consumer surplus well.

Dynan and Sheiner draw several broad conclusions.

GDP, as currently defined, should retain its stature as a major economic statistic. While it is not a comprehensive measure of welfare or even economic well-being, the GDP concept—along with the pieces of GDP available through the national accounts—is useful and provides a great deal of information about economic welfare.

There is scope for materially improving parts of the GDP calculation to be more closely aligned with the conceptual ideal. Doing so should be a goal for the statistical community and the broader community of economists. Such efforts may require the use of alternative data sources and methodologies, particularly in areas such as health care, new technologies, and new methods of payment.

Given the limitations of GDP as a measure of welfare, statistical agencies and other economies should continue to develop complementary measures that more completely capture well-being.

Read the full paper here .

The authors did not receive financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. Neither is currently an officer, director, or board member of any organization with an interest in this article.

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Limitations of GDP as a Measure of Economic Welfare Essay

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Gross Domestic Product (GDP) is an economic parameter that measures economic activity of a nation. Conventionally, GDP measures the market value of goods and services that a nation produces in a given time in terms of per capita. Per capita indicates economic welfare of people.

According to the World Bank, GDP is parameter that compares economic capacities of nations and economic welfare of their respective citizens (Para. 1). GDP is applicable as an indicator of economic welfare because it correlates with amounts of goods and services that people consume. However, GDP is not a sufficient parameter to indicate economic welfare of a nation because it measures activities that have monetary values only.

Wenzel (2009) posits that, the use of GDP as a normative indicator of economic capacity of a nation does not give quality measure of economic growth because it gives a distorted view economic welfare (p. 7). Fundamentally, GDP has several limitations because it does not consider intricate factors that determine economic status of a nation and economic welfare of populations.

The first limitation of GDP as an economic welfare indicator is that it measures overall economic activity of a nation, which indirectly indicate welfare of the population. Although a nation may have so many economic activities, it may also have low welfare status of its citizens.

Rationale of using GDP as a welfare indicator has it basis on the assumption that economic activities directly indicate economic welfare of citizens. Kahneman and Krueger (2006) argue that, economic activities of a nation and economic welfare of individuals are technically different entities that coincidentally correlate (p.6). Thus, it is assumptive to believe that GDP correlates with economic welfare of populations.

The second limitation of DGP is that it does not consider the distribution of wealth in a nation because it gives average production of goods and services in markets. Rogers, Jalal, and Boyd (2008) assert that, GDP does not take into consideration leisure facilities, depletion of natural resources, volunteer labour, household production and other underground economic activities that do not feature in markets (p. 302).

Since many goods and services are not present in markets, use of GDP as an indicator of economic welfare of the population gives an underestimated value of welfare status.

The fact that GDP indicates net production rather than gross production is a third limitation of GDP as an indicator of economic welfare. Riesman (2006) argues that, GDP examines the value of final products and thus exclude value of intermediate products or raw materials that are economically significant (p. 611).

Production of raw materials and intermediate products involve a substantial deal of economic activities that reflect economic welfare of the population, but does not appear in GPD. Therefore, GDP overlooks significant factors of production that deals with raw materials and intermediate products, hence does not reflect economic welfare of a nation or its population.

Fourthly, GDP limitation is that it does not differentiate beneficial production from detrimental production for it just measures overall economic activities.

Smith (2011) contends that, the value of GDP increases even in detrimental activities such as oil spill, pollution, road accidents, outbreak of diseases, and increase in crimes yet welfare status drops (Para. 3). GDP increases in the presence of detrimental activities because government spend a lot of resources in mitigating detrimental effects of varied activities but welfare of the population remains the same or degenerate. Thus, GDP does not sufficiently indicate welfare status of nations and their population.

Kahneman, D., & Krueger, A., 2006. Developments in the Measurement of Subjective Wellbeing. Journal of Economic Perspectives, 20 (1), pp.1-24.

Riesman, G., 2006. The Value of ‘Final Products” Counts Only Itself: Today’s Gross Product Is Net Product. The American Journal of Economics and Sociology , 63 (3), pp. 609-625.

Rogers, P., Jalal, K., & Boyd, J., 2008. An Introduction to Sustainable Development . London: Earthscan.

Smith, H., 2011. Limitations of GDP as a Measure of Economic Welfare. Finland Statistics. Web.

The World Bank. 2011. GDP and Actual Individual Consumption. International Comparison Program. Web.

Wenzel, T., 2009. Beyond GDP: Measuring the Wealth of Nations . Germany: GRIN Verlag.

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1. IvyPanda . "Limitations of GDP as a Measure of Economic Welfare." March 23, 2019. https://ivypanda.com/essays/limitations-of-gdp-as-a-measure-of-economic-welfare/.

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2.2 Limitations of GDP

4 min read • june 18, 2024

Jeanne Stansak

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Uses of GDP in Economics

We've covered what GDP is, but how do economists actually  use GDP? 

Economists use gross domestic product (GDP) in a variety of ways as an economic indicator and comparative tool. One use of GDP is to measure the overall economic performance of a country. GDP reflects the amount of goods and services produced in the economy, and is often used as a broad measure of a country's economic growth . 

Economists use GDP to track changes in the economy over time, and to compare the economic performance of different countries. For example, if a country's GDP is growing, it is generally considered to be a sign of a healthy and expanding economy.

GDP is also used to make international comparisons of economic performance. By comparing GDP data for different countries, economists can get a sense of how different economies are performing relative to one another. This can be useful for policymakers and businesses looking to invest in different countries.

Finally, GDP is used to help inform fiscal and monetary policy decisions. For example, if a country's GDP is declining, policymakers may implement expansionary fiscal or monetary policies to try to stimulate economic growth .

Overall, GDP is a widely used and important economic indicator that helps economists and policymakers understand and compare the economic performance of different countries.

However, GDP isn't perfect. We'll be discussing a few ways GDP falls short of a perfect economic indicator.

Limitations of GDP

There are 4 main areas of the limitations of GDP (Gross Domestic Product). In order to remember these we use the acronym P-I-E-S.

1. Population

When populations are different from country to country and the countries are producing a similar amount of a product than it gives us an inaccurate picture of the standard of living because one country is taking the same amount of production and distributing it amongst a larger population. For example, if one country is producing 15 million computers but has a population of 15 million than each person only has access to 1 computer but if another country produces the same amount of computers but has a population of 3 million than each person in that country has access to potentially 5 computers. This is why economists use  GDP per capita as a better measure of standard of living. GDP per capita is the GDP of a country divided by its population. This helps economists understand if a country is truly rich, or is just very large.

Even GDP per capita , however, is not perfect. A country with high GDP per capita may be very rich on average, but may be corrupt or have harsh social conditions. Many organizations use the  Human Development Index to show overall standard of living. Here's a graph of the two measures. You may notice that some of the highest GDP per capita countries actually have a  lower HDI. This is because many of these countries are rich with oil, but are high in corruption.

2. Inequality

Inequality is also a limit to the use of GDP to measure the standard of living. Two countries can have the same GDP per capita but if income is not evenly distributed to all families then it is not an accurate measure of production and economic stability. In the unequal society, the market will be less resilient and the governing bodies will be less sustainable due to famine, conflict, and unemployment. 

3. Environment

Another limitation regarding using GDP as a measure of the health of our economy is with regard to the various environmental situations. For example, if a factory is polluting during production they are still adding to GDP but GDP does not separate out the costs of this pollution from the actual production, even if the pollution is negatively impacting human life and ecology. These external costs of production are called  externalities , and if you take AP Micro you'll learn about them in depth.

4. Shadow Economy

The final limitation has to do with the  shadow economy . The shadow economy involves the production of items that are not reported so they are not counted in GDP. This shows us that GDP is not always accurate because there are some things not counted. An obvious example of the shadow economy is the  black market which are aspects of the economy deemed illegal and therefore excluded from formal reporting, but there are many other aspects of the shadow economy that are perfectly legal. 

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• The trouble with GDP

Gross domestic product (GDP) is increasingly a poor measure of prosperity. It is not even a reliable gauge of production

ONE of Albert Einstein’s greatest insights was that no matter how, where, when or by whom it is measured, the speed of light in a vacuum is constant. Measurements of light’s price, though, are a different matter: they can tell completely different stories depending on when and how they are made.

In the mid 1990s William Nordhaus, an economist at Yale University, looked at two ways of measuring the price of light over the past two centuries. You could do it the way someone calculating GDP would do: by adding up the change over time in the prices of the things people bought to make light. On this basis, he reckoned, the price of light rose by a factor of between three and five between 1800 and 1992. But each innovation in lighting, from candles to tungsten light bulbs, was far more efficient than the last. If you measured the price of light in the way a cost-conscious physicist might, in cents per lumen-hour, it plummeted more than a hundredfold.

Mr Nordhaus intended this example to illuminate a general point about how flawed economists’ attempts to measure changes in living standards are. Any true reckoning of real incomes must somehow account for the vast changes in the quality of things we consume, he wrote. In the case of light, a measurement of inflation based on the cost of things that generated light and one based on a quality-adjusted measure of light itself would have differed by 3.6% a year.

When a first-year undergraduate first encounters the idea of GDP as the value added in an economy, adjusted for inflation, it sounds pretty straightforward, says Sir Charles Bean, the author of a recent review of economic statistics for the British government. Get into the details, though, and it is a highly complex construct—and, as Mr Nordhaus’s fable shows, a snare for the unwary.

The production boundary

Measuring GDP requires adding up the value of what is produced, net of inputs, across a wide variety of business lines, weighting each according to its importance in the economy. Both the output and the materials (if any) used up in making it have to be adjusted for inflation to arrive at a figure that allows for comparison with what has gone before.

This is tricky enough to do for an economy of farms, production lines and mass markets—the setting in which GDP was first introduced. For today’s rich economies, dominated by made-to-order services and increasingly geared to the quality of experience rather than the production of ever more stuff, the trickiness is raised to a higher level. No wonder GDP statistics are still so prone to constant and substantial revision (see article ).

The problem is not just that it is hard to make these calculations. It is that what the calculations produce is a measure put to too many purposes, and, though useful, not truly fit for any of them. And there are worries that things may be getting worse. As the price of light illustrates, standard measures miss some of the improvements delivered by innovation. But at least new lighting products show up in the figures once people start buying the things in sufficient volume. These days it seems that a growing fraction of innovation is not measured at all. In a world where houses are Airbnb hotels and private cars are Uber taxis, where a free software upgrade renews old computers, and Facebook and YouTube bring hours of daily entertainment to hundreds of millions at no price at all, many suspect GDP is becoming an ever more misleading measure.

The modern conception of GDP was a creature of the interwar slump and the second world war. In 1932 America’s Congress asked Simon Kuznets, a Russian-born economist, to estimate national income over the preceding four years. Until he produced his figures just over a year later, no one knew the full extent of the Depression. In Britain Colin Clark, an enterprising civil servant, had been collecting statistics on national income since the 1920s, and in 1940 John Maynard Keynes made a plea for more detailed figures on Britain’s capacity to make guns, tanks and aeroplanes. He went on to establish the modern definition of GDP as the sum of private consumption and investment and government spending (with account taken for foreign trade). Kuznets had treated government spending as a cost to the private sector, but Keynes saw that if wartime procurement by the state was not treated as demand, GDP would fall even as the economy grew.

Keynes’s idea of GDP won out on both sides of the Atlantic and soon spread further. Countries that wanted to receive post-war aid under America’s Marshall plan had to produce an estimate of GDP. In the 1950s Richard Stone, a protégé of Keynes, was asked by the United Nations to prepare a template for GDP accounting that could be used by all member states. To be a nation was, in part, to know your GDP.

In wartime, GDP was concerned with managing supply. With peace, the influence of Keynes’s ideas on fighting slumps flipped it into a way to manage demand, as Diane Coyle notes in her book, “GDP: A Brief but Affectionate History”. Either way it was (and is) a measure of production, not of welfare—which, as GDP growth became a goal for politicians, also became an occasion for criticism.

A measure created when survival was at stake took little notice of things such as depreciation of assets, or pollution of the environment, let alone finer human accomplishments. In a famous speech in March 1968, Robert Kennedy took aim at what he saw as idolatrous respect for GDP, which measures advertising and jails but does not capture “the beauty of our poetry or the strength of our marriages”.

It’s a manufacturer’s world

From time to time, such dissatisfactions have brought forth alternatives. In 1972 Mr Nordhaus and James Tobin, a colleague at Yale, came up with a “measure of economic welfare” which counted some bits of state spending, such as defence and education, not as output but as a cost to GDP. It also adjusted for wear-and-tear to capital and the “disamenities” of urban life, such as congestion. The paper was in part a response to environmentalist concerns that GDP treats the plunder of the planet as something that adds to income, rather than as a cost. It was much talked about; it was not much acted on. In 2009 a report commissioned by the French president, Nicolas Sarkozy, and chaired by Joseph Stiglitz, a prominent economist, called for an end to “GDP fetishism” in favour of a “dashboard” of measures to capture human welfare.

Kennedy was right. Much that is valuable is neither tangible nor tradable. But much that is tradable is also not tangible. A problem with GDP even when it is being asked to do nothing more than measure production is that it is a relic of a period dominated by manufacturing. In the 1950s, manufacturing made up more than a third of British GDP. Today it makes up a tenth. But the output of factories is still measured much more closely than that of services. Manufacturing output is broken down into 24 separate industries in the national accounts; services, which now make up 80% of the economy, are subdivided into only just over twice that number of categories.

A bias toward manufacturing is not the only distortion. By convention GDP measures only output that is bought and sold. There are reasons for this, only some of them sound. First, market transactions are taxable and therefore of interest to the exchequer, an important consumer of GDP statistics. Second, they can be influenced by policies to manage aggregate demand. Third, where there are market prices, it is fairly straightforward to put a value on output. This convention means that so-called “home production”, such as housework or caring for an elderly relative, is excluded from GDP, even though such unpaid services have considerable value. In early editions of his bestselling economics textbook Paul Samuelson joked that GDP falls when a man marries his maid.

Despite convention, a lot of what is included in GDP lies outside the market economy. Many government services are provided free, and for decades the value given to such output was simply the cost of provision. It is only fairly recently that statisticians have started to measure some bits of public-sector output directly by, for instance, counting the number of operations performed by health services or the number of students taught in schools.

Some private-sector services are also measured indirectly. Housing services is one. This is straightforward wherever householders rent the property they live in. Rental payments capture both the value of housing services to tenants as well as the income of landlords from providing them. But in places where most people own the home they live in, a large part of the total value of housing services has to be imputed.

Finance is another activity that is mostly measured obliquely (and badly). Typically financial services are not paid for directly in fees: banks make a large part of their income from charging more interest on loans than they pay on deposits. To capture the value being added, statisticians use an imputed figure, the “spread” between a risk-free interest rate and a lending rate, and multiply this by the stock of loans. The problem with this method is that the lending spread is a measure of the risk banks take. For this reason its use in GDP figures can have perverse results. For example, at the turn of 2009 Britain’s financial sector was close to collapse. But because fear of bank defaults was driving spreads up, GDP figures recorded a spike in the sector’s value added, and thus its contribution to GDP (see chart 1).

As statisticians try to capture ever more of the economy’s output in their figures, new activities are added to GDP. In 2013 an EU agreement on GDP standards, for example, included income from selling recreational drugs and paid sex work. In Britain, the changes added 0.7% to GDP. How much credence should be given to that figure, though, is open to doubt. The statisticians have to fall back on crude proxies to estimate what is going on: thus the paid-sex market is assumed to expand in line with the male population, and the charges at lap-dancing clubs are taken as a measure of the price of sex. Leaving aside the appropriateness of these approximations, Paul Samuelson might have been spurred to muse on the GDP implications of a woman marrying her gigolo. Robert Kennedy might have asked if a nation is really doing better when its sex- and drug-trades are growing more quickly.

The price is wrong

A further complication is that, for all the caution that statisticians offer against seeing GDP as a measure of welfare, the two are intertwined in perhaps the trickiest part of their calculations: adjusting for inflation. Inflation is a measure of how much more you have to pay this year than you did last year to achieve the same level of well-being. It is at least as challenging to measure as output.

For a start, a change in the price of a product will influence how much of it people buy. If red apples rise in price, people buy more green apples; if the price of beef shoots up, they buy more pork. There are tricks that capture this sort of substitution when compiling price measures. One is the “geometric-mean aggregation” of price quotes. Multiplying together the prices of n goods and then taking the n th root of the product allows price aggregations to take into account a degree of switching proportionate to the change in relative prices. This sounds abstruse: but getting it right has an effect of lowering inflation by half a percentage point or so. Broader shifts in consumer preferences are picked up by updating the weights attached to each category of goods in the overall price index.

Then come adjustments for changes in quality. This year’s smartphone might cost more than last year’s, but if so it will also do more. If statisticians focus only on changes in price, they will overstate the true inflation rate by missing improvements in performance. An advisory committee of leading economists set up by America’s Senate in the mid-1990s and headed by Michael Boskin, of Stanford University, reckoned that failure to adjust for quality and new products meant true inflation was overstated by at least 0.6% a year. It called for greater use of “hedonic” estimation, a technique that captures the implicit value of each particular attribute of a product by measuring how variation in those traits affects the product’s price: for example, how much more do people pay for a brighter light bulb? Once an implicit price for each attribute is established—processor speed, or memory, say, for a phone—prices are tweaked accordingly.

Hedonic estimation helps. But it is a labour-intensive business, because the implicit prices have to be updated frequently to ensure accuracy; in practice only a small fraction of prices are adjusted in this manner. It also runs into problems when quantitative changes get so large as to become qualitative. A modern flat-screen television is simply a different beast from the squat little cathode-ray tube numbers of the 1980s.

Such adjustments are even harder to do for services, which tend to be bespoke, than for goods, which are still for the most part standardised. The value of a meal, for instance, depends on the cooking and ingredients but also on the speed of service, the background noise, how close together the tables are, and so on. Each of these factors can change from one period to the next. The true value of public-sector services is even harder to measure comparably over time. The number of operations can be counted quarter by quarter. Their effects on health and longevity may not be seen for years or decades.

As the Boskin commission pointed out, new products are a particular headache. In theory their value to consumers is the gap between the reservation price (what consumers are willing to pay) and the actual price, known as “consumer surplus”. In practice, new products enter the consumer-price index without any such adjustment. Then there is the sort of novelty that broadens choice. The number of TV channels or over-the-counter painkillers available in America, for instance, is overwhelming. Yet in 1970 there were just five of each. Though people may complain about too much choice, this greater variety is to a great extent a boon. But it is invisible to GDP measures. For GDP, the output of a million of shoes in one size and colour is the same as a million shoes in every size and colour.

The benefits of many new products are simply not picked up at all. The upfront costs of providing services on a digital platform, such as Facebook or Twitter, are hefty. But the marginal cost is close to zero, and the explicit price to users is normally nothing. By global convention, zero-priced goods are excluded from GDP. So are all voluntary forms of digital production, such as Wikipedia and open-source computer programs. Some of this unpaid-for activity can be picked up in the accounting; although there is no charge for a Google search, consumers pay a shadow price by supplying information and attention, for which advertisers pay. But the advertising revenue is likely to be well below the benefits that consumers get.

The review chaired by Sir Charles Bean outlined two other possible approaches to valuing free digital services. One is to estimate the value of the time spent on the internet. The Bureau of Economic Analysis, America’s main statistical body, has used market wage rates to estimate the value of home-production activities, such as cooking, cleaning and ironing. Following a similar approach, Erik Brynjolfsson and Joo Hee Oh of MIT estimated that the welfare gain of free internet products added 0.74% a year to America’s GDP between 2007 and 2011 (other studies reach somewhat lower estimates). The other approach uses rising internet traffic as a proxy (see chart 2). The review cites research which found consumer internet traffic in western Europe growing at 35% a year from 2006 to 2014. If the output of IT services had grown at a similar clip, official GDP growth rates in Britain would have been 0.7 percentage points higher each year.

It is not just that many new services are now given away free; so are some that used to be paid for, such as long-distance phone calls. Some physical products have become digital services, the value of which is harder to track. It seems likely, for instance, that more recorded music is being listened to than ever before, but music-industry revenue has shrunk by a third from its peak. Consumers once bought newspapers and maps. They paid middlemen to book them holidays. Now they do much more themselves, an effort which doesn’t show up in GDP. As commerce goes online, less is spent on bricks-and-mortar shops, which again means less GDP. Just as rebuilding after an earthquake (which boosts GDP) does not make people wealthier than they were before, building fewer shops does not make them poorer.

These problems do not invalidate the use of GDP. But given the direction of technological change in an ever-more digital world they seem likely to grow more serious, and solutions to them are both hard and imperfect. Measuring the consumer surplus from new or free products relies on brave assumptions; estimates vary widely depending on which ones are used. To be consistent over time would require measuring the consumer surplus of goods and services that are well established in the consumer basket.

A sense of the scale of the task can be gained from looking at estimates of how fast the economy grew during a previous time of headlong technological change—the Industrial Revolution. Around the time that GDP was first being used to measure contemporary economies, some economic historians ventured to apply it to the past, too. They concluded that there had been a sudden take-off in economic growth after 1750; a landmark post-war study reckoned that GDP per worker rose by 1.4% a year, an unprecedented rate, in the first half of the 19th century.

You say you measured a revolution

In the 1980s, research by Nicholas Crafts of Warwick University found that the 18th century’s glut of industrially transformative inventions had been applied rather narrowly, with madcap growth seen only in a few sectors of the economy. He put productivity growth at a less revolutionary 0.5% a year. A generation further on colleagues of Mr Crafts, led by Steve Broadberry, published research which nudged the figures back up a bit. Even centuries on, it is hard to settle on GDP estimates in times of upheaval. And they still miss many of the changes wrought—the consumer surplus due to railways, say.

“It is a big mistake to think that one number serves for all purposes,” says Sir Charles. The problem is that, as things stand, GDP risks serving all its purposes ever-less well. The Bank of England has become so chary of GDP figures that it publishes a range of numbers both for its forecasts of growth and for its history. Its latest projections put recent GDP growth in Britain somewhere between zero and 4%. Such hyper-scepticism might seem a bit silly. But is it really no more absurd than proclaiming, with great certainty, that GDP growth in China fell from 6.8% to 6.7% in the year to the first quarter, when it almost certainly didn’t?

If comparisons of GDP from one quarter to the next are dodgy, those from decade to decade are perilous. America’s Census Bureau calculates that median household income, adjusted for inflation, was barely higher in 2014 than it was 25 years earlier. Measured living standards for a typical American have stagnated for a quarter-century, in other words. This finding undoubtedly reflects something real. But would a typical American really be indifferent between 1989 medical care at 1989 prices and today’s medical services at current prices, asks Ken Rogoff of Harvard University? If GDP figures really measured what they try to measure, that would be the rational stance.

The challenge, said Mr Nordhaus in his paper on light, is to construct measures that “account for the vast changes in the quality and range of goods and services that we consume.” But that means finding ways to more readily compare hand-held e-mail with fax machine, self-driving car with jalopy, vinyl records with music-streaming services and custom-made prosthesis with health-service crutches. Perhaps an Einstein could do it. Odds are, though, that he’d take one look and stick with the simplicities of physics instead.

This article appeared in the Briefing section of the print edition under the headline “The trouble with GDP”

Briefing April 30th 2016

• Rewriting history

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Limitations of the GDP as a measure of progress and well-being

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Limitations of GDP as a Measure of Economic Welfare Essay

1. introduction.

Gross Domestic Product (GDP) is defined as "the value of market production of final goods and services taking place within the domestic institutional unit of a country, during a specific time period." GDP is essentially a measure of the economic health of a country and is used to compare the economic performance of one country with another or between different time periods. The virtue of a GDP measure is that it is relatively easy to ascertain. GDP is measured simply by the sum of the total output of goods and services, using the income or output approach. It is a comprehensive measure and is available every quarter, so trends are relatively easy to track. It is widely used and accepted as a good measure of a country's economic welfare and can provide a useful index to compare living standards in different countries and measure their changes over time. With the advent of globalization, it is even more important to have some sort of measure of economic performance of different countries. With its simplicity and international comparability, GDP seems like the perfect tool to gauge and compare the economic welfare of different countries. However, when we look more closely at GDP, it is clear that it is not a comprehensive measure and has several major limitations. This essay aims to identify the limitations of GDP as a measure of economic welfare and determine the validity of GDP as a measure of comparing living standards between various countries and the changes in living standards over time in a single nation.

1.1. Definition of GDP

The GDP can be defined in two ways that are markedly different in terms of focus and measurement. Firstly, it is defined as the market value of all officially recognized final goods and services produced within a country in a given period of time. This definition is constructed in a tautological manner – i.e. the value of production is measured by the value of the expenditure on that production. The problem of tautology does not arise by using the expenditure method, since calculating GDP by this method does not necessarily involve knowing the value of production. A second definition of GDP is the total income of everyone in the economy. Total income and total expenditure are necessarily the same because every transaction has a buyer and a seller. For example, if Vicky sells her car for £5000, the expenditure of the buyer is £5000 and this is also Vicky's income. These two definitions of GDP are essentially the same and are compatible with the definition mentioned in the introduction. Although this can be seen as a simplification, it is nonetheless a fruitful exercise to view all economic activity as an exchange of services. By using these two definitions of GDP, an understanding can be derived of how the GDP is used as a measure of economic welfare and how accurate a measure it is.

1.2. Importance of GDP as a measure

While GDP has many limitations, it is still a very useful tool to measure economic welfare. This is due to the fact that GDP measures the total production of an economy, which gives an indication of the average standard of living in a country, as the more produced, the more there is to consume. It is also widely recognized and used as an indication of welfare and the standard of living in comparing the economic success of different countries. This is often done with the use of GDP per capita, which can be obtained simply by dividing the GDP by the population of the country. This measure is a strong indication of standard of living as it shows the average income of a citizen in that country. This is useful in today's world with global comparisons between the economic successes of countries being made often. For example, if we are to say that the GDP per capita of country A is $30,000 and that of country B is $15,000, it can be said that country A has a higher average standard of living as its citizens are earning more.

1.3. Purpose of the essay

The purpose of the essay is to give an outline of the limitations of GDP as a measure of economic welfare using data from both underdeveloped and developed countries. Firstly, it aims to define what GDP is and any other essential language that is required. It then goes on to explain the two approaches that can be used when using GDP as a measure of economic welfare. Following this, it outlines the conventional view of GDP and the situations under which this holds true. This forms the basis of the first group of limitations, and these are described with evidence of when they have occurred. This first section then goes on to contrast the view of people's living standards and the income they earn, and when a change in these occurs. This provides a good background to the second order of limitations, and these again are backed up with evidence. The essay then looks at the countries that GDP excludes and the illegal or black market activities within an economy, then going on to conclude with an overall evaluation of GDP as a measure of economic welfare. The essay maintains a good focus throughout on the definitions and introduces questions on the validity of GDP as a measure of economic welfare. The two sets of limitations are clearly outlined and are well structured throughout, first by assessing the situations when GDP does reflect living standards and incomes and when changes in these occur, then going on to talk about the countries and activities that GDP does not cover. The conclusion is succinct and readdresses the essay question.

2. Limitations of GDP

The GDP falls short of the welfare target by considering only market activities. Given that the output of households is not bought and sold in the market place, it is not counted. Yet a large and significant proportion of this activity (cooking, child rearing, knitting, etc.) does in fact contribute to the nation's economic well-being. If expenditure on these non-market activities were to increase, people would have less need to buy goods and services in the market place. This means that GDP overestimates the increase in economic welfare because it does not distinguish between market and non-market activities and counts all expenditure as if it were on the former. This problem has become more serious with the increase in outsourcing of business and government services. When a state government pays a private firm to take over a school's meal service from public employees, GDP counts this as an increase in welfare because it does not distinguish between market and non-market activities and counts all expenditure as if it were on the former. This problem has become more serious with the increase in outsourcing of business and government services. When a state government pays a private firm to take over a school's meal service from public employees, GDP counts this as an increase in economic welfare, even though there has been no change in the meals provided. This is because GDP only measures the value of the meal as the cost of hiring the firm and does not ask whether the output is actually an improvement on the previous meal service.

2.1. Exclusion of non-market activities

When measuring the total production in a country, it is assumed that the market is the only mechanism that assigns value to the goods and services exchanged. Anything that is not exchanged for money, for example, production outside the market or within the household, is not reflected in the GDP. Since GDP only takes into account the value of production, there is a serious shortfall in the actual value of output in the economy. One of the shortcomings of GDP is that it fails to measure the public and private non-market activities. The exclusion of non-market activities causes GDP to underestimate the true value of the amount of goods and services provided in the economy. In other words, many of the things that people value are not paid for in the market, and GDP is an incomplete index of true income (Carlino and Defina, 1998). This is an important concept for people when using GDP as a measure of social welfare, as it can be used to compare the standard of living over a period of time, determine the rate of economic growth, and make international comparisons. Although non-market activities would not make a significant difference to developing countries which are still increasing their standard of living by market production, it is crucial for developed countries in which the standard of living has peaked to find alternative ways to compare living standards. One such example is Nordic countries where the standard of living is very high, yet they have a low GDP compared to the USA or the United Kingdom. This is a consequence of high tax rates in which a lot of the taxes are returned to the public in the form of free or subsidized non-market activities such as healthcare and education. These European countries are said to be sacrificing current consumption for long-run growth, and hence non-market activities are assigned high value to the welfare of the country.

2.2. Inadequate representation of income distribution

The distribution of income among the citizens is the key factor in determining the level of economic welfare of a nation. The greater the difference in income between the rich and the poor, the lower the level of welfare. As an indicator of average living standards, GDP per capita may give a misleading picture. Suppose a few people become very much richer while the majority see no improvement in their standard of living. In this situation, average living standards, as indicated by GDP per capita, may actually rise. Yet the majority of the population will feel that economic welfare has not improved, which is the case when only a small percent enjoy an improvement. The welfare of the majority has not improved, and there is no reason to believe that the rich will necessarily use their additional income to provide the public goods that would raise the welfare of all. In this way, an increase in GDP may actually be detrimental to economic welfare. Thus, in order to make judgments regarding changes in economic welfare, it is necessary to examine the distribution of income that results from the change. One way to do this is to compare the changes in GDP with changes in the distribution of income. The above example suggests that an increase in GDP accompanied by a more unequal distribution is unlikely to increase economic welfare. Another way is to take the changes in GDP and examine the changes in specific groups or the population. By comparing the welfare changes resulting from changes in GDP, we can determine the extent to which an increase in GDP contributes to economic welfare. Since GDP measures only the market value of goods, it is conceivable that economic welfare can be improved without any increase in GDP. This occurs when non-market goods such as those provided by the public sector increase social welfare, but are not reflected in an increase in GDP.

2.3. Ignoring environmental costs

Environmental costs are much easier to assess. It has been approximated that the burning of one gallon of petrol produces $5 worth of heat and light. However, the environmental costs included in the production are much greater. Now although it is good that the wealth of developed nations has increased through increased production of more goods and services, the environmental costs have been huge. It is shown in figure one that for high income nations with slightly higher than average growth rates the percentage decrease in environmental sustainability between 1990 and 1995 has been great. It is evident that the marginal rate of transformation of environmental quality has been much too high, with the rate of resource depletion also far too great. This means that the welfare of current generations has only increased at the expense of future generations. The costs of earth's diminishing resource base, and continuously escalating waste rates will almost never be included in any GDP statistics. Yet these costs are enormous and future generations will have to pay for the reparations of this generation's damage. High income nations with higher growth rates will have significantly more resource depletion and higher greenhouse gas emissions than other nations. This damage is often irreversible and is a clear indication that GDP is an inadequate measure of economic welfare across both space and time.

3. Alternative Measures of Economic Welfare

The use and importance of GDP as an economic measurement has long been acknowledged. However, in recent years, there has been increasing research and recognition that GDP may not be a valid measure of economic welfare. Should this be the case, then potential new measures must be identified and validated. A variety of measures have been proposed, but no consensus has been reached about which is the most valid and reliable measure to replace GDP. This section of the essay will identify several of the new measures and investigate how and why they differ from GDP. Measures such as HDI, and the more recent measures of GPI, HPI, and CIW all aim to fulfill the void left by GDP and provide a more accurate measure of economic welfare. The HDI, which was first introduced in 1990 by the United Nations Development Programme (UNDP), is a composite index that contains three dimensions: health (life expectancy), education (adult literacy, combined primary, secondary, and tertiary enrollment, and GDP per capita), and standard of living. HDI uses an econometric model to deduce an index that spans from 0-1, with 1 being perfect "development". HDI differs from GDP in that it directly measures welfare by the criterion of development as defined by the index, whereas GDP is seen as an indirect measure of welfare. HDI also takes into account the relative importance of health and education, deviating from GDP and the "health-earnings" confusion, and does so in an approximate manner by giving the two of them a weight of two-thirds to define the HDI from the geometric mean of the dimension indices. A further criticism of GDP is addressed by HDI's consideration of income distribution. While GDP accounts for the total amount of income in a country, it does not consider the distribution of income among its citizens. HDI asserts that development should involve an improvement in the life of the average person and thus income distribution is an important factor in determining development, so that HDI is lowered by income inequality within countries using a redistribution-adjusted income GDI. This is calculated GDI = HDI times (average income/inequality-adjusted average income) and is set equal to the GNI for ideal equality.

3.1. Human Development Index (HDI)

The HDI is a composite index developed by the UNDP to measure development in a country. It provides a composite measure of three dimensions of human development: living a long and healthy life (life expectancy at birth), being educated (mean years of schooling and expected years of schooling) and having a decent standard of living (GNI per capita). The life expectancy and the education attainment indicators are measured by the same indicators used in the Education Index and the Life Expectancy Index. The standard of living is measured by GNI per capita. The income data is discounted using a logarithmic function. A minimum income is needed to attain any or all of the dimensions of the HDI, which is $100 per person and higher for higher dimensions. The maximum discount rate is set at 1, which gives more value to higher income, the level of maximum human development at GNI per capita of $40,000 or more. This depth of the HDI and the income cut off at poverty give more value to the standard of living dimension and less to the income spent to improve access to education and health. The HDI has achieved considerable traction, becoming one of the strongest influences in the policy making process at the United Nations. As of 2006, over 150 countries have used the HDI as a tool to assess their progress and 700 studies have been published analyzing the relationship between the HDI and various economic, social or political factors.

3.2. Genuine Progress Indicator (GPI)

The Genuine Progress Indicator (GPI) was launched in 1995 by Redefining Progress, a team of 5 leading American economists including Clifford Cobb and John Cobb. GPI is a metric that provides a more comprehensive and accurate measure of our well-being and ecological sustainability (Redefining Progress, 2008). It includes economic, environmental, and social factors to measure the net welfare of a nation. The aim of GPI was to do what the HDI was doing in comparison to GDP. It considers welfare over a period of time. As such, if an individual works for low pay, no consideration is given to pay when considering welfare because money is a flow, but rather if it improves life for someone, e.g. time off work, pay rise. It recognizes the net gain of an activity as well as the decay of resources such as environmental factors. The positive values added to welfare are balanced against the social and environmental costs based on the principle of resource accounting. This identifies the sustainability issue: an increase in current welfare now is done at the expense of future welfare through the depletion of resource capital. An example of this is the decline in air quality in New Zealand because of increased burning of fossil fuels. The recent increase in welfare in the form of a better transportation system comes at the cost of future welfare through damage done to STM through a decline in resource capital. This is then reflected by recalculating the value of welfare at a later date based on the costs and depreciation, giving it a more accurate reflection of welfare over time. This concept is very different from the one employed by GDP, which seeks to maximize current welfare without considering future effects.

3.3. Happy Planet Index (HPI)

The Happy Planet Index (HPI) is an index of human well-being and environmental impact. It was introduced by the New Economics Foundation (NEF) in July 2006. The index is based on the concept that "sustainable well-being" should be the ultimate goal of human economic activity. The HPI is a measure of the environmental efficiency of supporting well-being in a certain country. It aims to measure the relative effectiveness with which countries provide long, happy, sustainable lives for the people who live in them. HPI is based on general utilitarian principles in accordance with the definition of well-being established by Lord Richard Layard: "Well-being is a state of mind in which an individual thinks his or her life is going well." Utility is mapped by taking objective life expectancy and the experienced well-being, both ecological and psychological, in a given country, and dividing this by the "Ecological Footprint." This is the amount of land which a country needs in order to produce the resources it consumes and to absorb the waste it produces, using the prevailing technology, irrespective of whether that land is located within the country or outside its borders. By maximizing the utility function, one could in theory gain the greatest possible well-being for the least ecological impact. This is presented as H=E/(EF)*(HPI). The results of the HPI are surprising as they challenge many conventional thoughts on what might be a good and sustainable standard of living. According to the 2006 HPI, the overall world average score came out at 54.3. The country with the highest score was Vanuatu at 68.2, higher than a single country's score on the HDI. The leader board is dominated by small tropical and subtropical nations which have relatively low life expectancy and experienced well-being scores, but very small Ecological Footprints. Vanuatu's HPI thus suggests that by having a very low impact way of life, it is possible to maximize the ratio of well-being to environmental impact. The lowest scoring countries are a mix of African, Middle Eastern and former Soviet nations, with the bottom six spots being held by Iraq and countries of the former Soviet Union. 24 countries were not ranked at all due to a lack of data.

3.4. Composite Index of Wellbeing (CIW)

CIW is the recent version of alternative index that goes beyond the narrow traditional measures of the GDP and takes into account additional indicators relating to both the resources and the use of those resources that societies value. By placing a monetary value on various aspects of wellbeing (positive or negative), CIW identifies the price of non-sustainability and the depth of trade-offs between current and future levels of wellbeing. Similar to the national accounts, CIW maintains balance sheets that show the sustainability of activities by listing the social, economic, human, natural and built and environmental and indicating whether these stocks are being maintained over time. The creation of CIW has been largely driven by dissatisfaction with the indicators used to inform and evaluate progress towards sustainability. Taking inspiration from the genuine progress indicator, there are now a variety of initiatives at the national, regional and local level aimed at creating new indicators or modifying existing ones to better reflect the complex nature of wellbeing and its dependence on the quality and sustainability of the environment and society. This has led to growing interest in using CIW for policy development and evaluation.

4. Conclusion

After discussing the many ways in which the GDP is not an accurate reflection of the economic welfare of a country, it is important to summarize the many points brought forward. It is evident that the GDP is not an adequate representation of a nation's welfare as there are too many aspects it does not measure. There are the informal markets and increased output due to environmental degradation and usage of non-renewable resources, both of which serve only to artificially inflate the GDP. The GDP is also unable to measure the distribution of income among the residents of a country, as well as the leisure time, both of which are crucial factors in determining the welfare of a country. After careful consideration of the limitations of the GDP, it becomes quite obvious that the concerns differ depending on the demographic one is considering. If one is looking from the perspective of a policy maker whose aim is to increase the welfare of a nation, the key concerns are with regard to economic factors. For these people it is important to note that an increase in GDP is not always synonymous with increased welfare. In some cases the GDP has been increased due to such things as the depletion of natural resources and environmental degradation, both of which have long term consequences and serve to reduce the welfare of future generations. On a similar note, the GDP is unable to measure the distribution of income in a country. This is a very important factor as an increase in the national income does not necessarily mean an increase in the standard of living for the citizens of a country. The GDP is also unable to measure income not reported to the tax authorities, which is often the case with the very rich and the very poor. This too is an important factor in income distribution.

4.1. Summary of limitations of GDP

One of the key points made by this essay is that GDP is not a comprehensive measure of the standard of living of a nation. First, it includes only market activity. To the extent that an activity moves from the non-market to the market sphere, GDP is likely to rise - and it may be a change for the worse. For example, if a family takes its meals at home, they are more likely to be eating a variety of nutritious foods. If they shift to eating at fast food restaurants, the quality of their nutrition will likely decline. Any resulting increase in medical expenditures will be added to GDP, but this will be an added cost, not a net gain in human welfare. Similarly, if more of child care and elder care is shifted from the non-market sector (often provided by relatives) to the market sector, GDP will rise. Yet it may well mean a decline in the quality of life for the recipients of care as well as for the family members now forced to pay for those services. A second shortcoming of GDP as a measure is that it captures only the size of the economic pie, not the manner in which it is sliced. A country may have a high GDP, but the living standards of large segments of its population may be quite low. On the whole, a higher GDP does tend to be associated with better living standards than a lower one. Yet there are many exceptions to this rule. For example, the data in "A Portrait of Poor in America" show that in 2003, 37.0 million people in the U.S. were living in poverty – an increase of 1.3 million from 2002. This actually suggests a decline in the economic welfare for the poorest Americans, despite a rise in GDP. Conversely, it is possible for a country to have a low GDP but a high quality of life. This is true of some of the world's very poor countries, where economic activity is sufficient to keep body and soul together, but little remains to show for it after provision for basic necessities.

4.2. Importance of considering alternative measures

Given the extent of its limitations, it is clear that GDP is an unsuitable measure of economic welfare. The significance of these limitations is such that economists and policymakers must consider alternative measures if they are to obtain an accurate understanding of the standard of living within a country. A variety of alternatives to GDP exist, ranging from composite indices that measure various factors thought to contribute to welfare, to 'happy indexes', and they all have their advantages and disadvantages. What is consistent throughout all of these alternatives is the acknowledgement that a high GDP can mask various negative aspects of life within a country, and indeed that in many cases these negative aspects are caused as a result of enacting policies designed to increase economic growth. By identifying and measuring these negative aspects, alternative measures can be very effective in providing a guide of areas in which a country can improve the standard of living for its citizens. One of the most widely used alternative measures to GDP is the Human Development Index (HDI), introduced by the United Nations which aims to "shift the focus of development economics from national economic growth to people centered policies". The HDI is a composite index that takes into account three dimensions of human development: health, education and living standards. It is a vast improvement on GDP for it considers the distribution of economic factors, and the income dimension which it takes from GDP per capita is given a coefficient that alters the affect that income has on the final HDI result, thus illustrating that not all income is spent on improving living standards. Although HDI and other alternatives have their own limitations and are in a continual process of development, it is clear that the consideration of alternative measures to GDP is a vital step in understanding and improvement of the standard of living within a country.

4.3. Call for a more comprehensive approach

The limitations of GDP as an indicator of economic welfare have been addressed from various perspectives. Whether it is the abstraction from the actual well-being of the citizens and the judgment of social welfare, which many citizens are concerned with, or the lack of sustainability for the future generations, there is a consensus that the GDP is not an adequate measure of the standard of living in a nation. Consequently, there has been a call for a more comprehensive approach which aims to consider the terms of well-being of the present and future generations and people in developing and developed nations on a sustainable basis. The study of welfare economics is concerned with the changes in the well-being defined as the utility derived from the goods market or the satisfaction that the individuals in a society attain from a range of services. These utilities can be derived from many different factors and are not solely reliant upon the consumption of goods. The sustainability of well-being is dependent on whether the present generation is capable of providing the similar opportunities for future generations to attain their own utility. We know that GDP measured as the total market value of goods and services is achieved by maximizing production and by doing so, it is not considering the negative externalities that may come from the production process. An example of this is environmental damage. In many cases the opportunity costs of production are greater than the benefits. Combined with the fact that many resource and environmental assets are not being evaluated in the national accounts system, it is obvious that GDP is failing to consider the wealth of the nation and ignoring the implications it may have on the future well-being of the society.

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Limitations of GDP

Limitations of using gdp statistics.

GDP statistics are widely used for comparing economic performance of developing countries, but they can be criticised  for several reasons.

Differences in the distribution of income

Although two countries may have similar GDP per capita, the distribution of income in each country may be very different.

Differences in hours worked

As when comparing a country over time, the number of hours worked to generate a given level of income may be quite different. For example, workers in the UK tend to work longer hours than those in France, and this would falsely inflate the GDP figures in the UK relative to France. Wider  measures of economic welfare  usually include an adjustment of GDP to take into account the value derived from leisure.

International price differences

International prices will also vary, which is significant because purchasing power is based on price in relation to income. To solve this problem, GDP statistics can be re-calculated in terms of  purchasing power . The purchasing power of a currency refers to the quantity of the currency needed to purchase a given unit of a good or common basket of goods and services. Purchasing power is determined by the relative cost of living and inflation rates in different countries. Purchasing power  parity  means equalising the purchasing power of two currencies by taking into account cost of living differences.

For example, if we simply convert GDP in Japan to US dollars using market exchange rates, relative purchasing power is not taken into account, and the validity of the comparison is weakened. By adjusting rates to take into account local purchasing power differences, known as  PPP adjusted exchange rates , international comparisons are more valid.

Difficulty of assessing true values

The true value of public goods such as defence and transport infrastructure and, and merit goods, such as healthcare and education, is largely unknown. This means it is difficult to compare two countries with very different spending on these goods and assets.

Hidden economies

Similarly, the existence of a large  hidden economy  may make comparisons based on GDP very misleading. For example, comparing the official GDP of the UK and Russia may be misleading because of the size of the hidden economy in Russia. To avoid tax, transactions may go unrecorded and excluded from official statistics.

Currency conversion

GDP figures for different countries must be converted to a common currency, such as the US dollar, and this may give misleading figures. Exchange rates against the US dollar may not be accurate for countries whose international trade is relatively small. In such cases converting to US dollars may significantly under-value national output. This is why converting to purchasing power parity is preferable to converting to US dollars.

See:  Measures of Economic Welfare

Banking sector

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19 Limitations of Real GDP

Limitations of real gdp: goods and services omitted from gdp.

GDP measures the value of goods and services that are bought in markets, so it excludes:

• Household Production  : Household production is productive activities at the home that do not involve market transactions. As more services, such as childcare, meals and laundry are provided in the marketplace, the measured growth rate overstates development of all economic activity.
• Underground Production  : Underground production is the part of the economy that is hidden from the view of the government either because people want to avoid taxes and regulations or because the goods and services being produced are illegal. If the underground economy is a reasonably stable proportion of all economic activity, the growth rate will be accurate.
• Leisure Time  : Leisure time is an economic good that does not get measured in the official GDP figures. Increases in leisure time lower  the economic growth rate, but we value our leisure time and we are better off with it. Increased output is not worth very much if we have little or no time to enjoy it.
• Environmental Quality  : Pollution does not directly lower the economic growth rate. If our standard of living is adversely affected by pollution, our GDP measure does not show this fact. The reason is that the devices that we produce to mitigate pollution count as part of GDP but the pollution itself is not subtracted.  (1)

Limitations of Real GDP

Other influences on the standard of living omitted from GDP, but important for the standard of living, is:

• Health and Life Expectancy  : While obviously important factors determining the standard of people’s living, they are omitted from real GDP. Health and life expectancy have improved as infant deaths and death in childbirth have almost been eliminated. Life expectancy has increased from 70 years at the end of WWII to nearly 80 years today. These gains have been checked somewhat by AIDS and drug abuse, which take away from our standard of living.
• Political Freedom and Social Justice  : Political freedom and social justice are not measured by real GDP. A country might enjoy a very large GDP but have limited political freedom and social justice and, hence, have a lower standard of living.  (1)

Self-Check Activity

Economic growth is a sustained expansion of production possibilities. Consider Table 3.4 and answer the question below. Click on the blank space to reveal the answer.  (1)

Table 3.4: Differences in Economic Growth Rates

Do you think an economy will grow dramatically differently if the growth rate is 8% compared to 3%?  (1)  [ Do you think an economy will grow dramatically differently if the growth rate is 8% compared to 3%?(1) Looking at the table, in the first 5 years the change is not substantial ($115.92 is not too different from $146.93), but in 20 years, and especially in 40 years the gap gets wider and wider, thus allowing for a country experiencing an 8% growth rate to have much higher GDP and income per person in 20 years (more than double) or 40 years (about 7 times higher). ].

Principles of Macroeconomics Copyright © by Lumen Learning is licensed under a Creative Commons Attribution 4.0 International License , except where otherwise noted.

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LIMITATIONS OF THE GDP AS A MEASURE OF PROGRESS AND WELL-BEING

• Published 30 June 2016
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Standard of Living - Limitations of GDP as a measure of Wellbeing

Last updated 20 Nov 2023

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This short video looks at some of the limitations of GDP when measuring changes in economic well-being.

GDP, or gross domestic product, is often used as a measure of a country's economic health and prosperity, but it has its limitations when it comes to measuring well-being. Some of the criticisms of using GDP as a measure of well-being include:

• It fails to account for non-market activities like volunteering, caregiving, and household work, which are important to people's well-being.
• It ignores distributional issues, like income inequality and poverty, which can have a significant impact on well-being.
• It doesn't account for environmental degradation and other negative externalities that can reduce well-being.
• It doesn't capture subjective well-being measures like happiness, life satisfaction, or mental health.

While GDP can provide a snapshot of economic activity, it doesn't fully capture the quality of life of a population or the sustainability of economic growth.

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Pros and Cons of GDP as a Macroeconomic Indicator

Advantages of gdp: benefits of using gross domestic product as an indicator of economic success, below are the specific advantages of gross domestic product as a macroeconomic indicator:, disadvantages of gdp: limitations of using gross domestic product as an indicator of economic success.

Another example is Russia. It has the highest gross domestic product in the world at USD 1.77 trillion in 2022 but has a standard of living that is arguably lower than Western countries Income inequality is pervasive because Russian oligarchs control more than 70 percent of the wealth in the country and average adjusted disposable income is substandard.

Below are the specific disadvantages of gross domestic product as a macroeconomic indicator: