1.

SOME MACROECONOMIC IDENTITIES

Gross Domestic Product measures the aggregate production of final goods and services taking
place within the domestic economy during a year. But the whole of it may not accrue to the
citizens of the country. For example, a citizen of India working in Saudi Arabia may be earning
her wage and it will be included in the Saudi Arabian GDP. But legally speaking, she is an
Indian. Is there a way to take into account the earnings made by Indians abroad or by the factors
of production owned by Indians? When we try to do this, in order to maintain symmetry, we
must deduct the earnings of the foreigners who are working within our domestic economy, or the
payments to the factors of production owned by the foreigners. For example, the profits earned
by the Korean-owned Hyundai car factory will have to be subtracted from the GDP of India. The
macroeconomic variable which takes into account such additions and subtractions is known as
Gross National Product (GNP). It is, therefore, defined as follows
GNP GDP + Factor income earned by the domestic factors of production employed in the
rest of the world Factor income earned by the factors of production of the rest of the
world employed in the domestic economy .
Hence, GNP GDP + Net factor income from abroad
(Net factor income from abroad = Factor income earned by the domestic factors of production
employed in the rest of the world Factor income earned by the factors of production of the rest
of the world employed in the domestic economy).
Depreciation: Short Discussion
A part of the capital gets consumed during the year due to wear and tear. This wear and tear is
called depreciation. Naturally, depreciation does not become part of anybodys income. If we
deduct depreciation from GNP the measure of aggregate income that we obtain is called:
Net National Product (NNP).
Thus, NNP GNP Depreciation
National Income

It is to be noted that all these variables are evaluated at market prices. Through the expression
given above, we get the value of NNP evaluated at market prices. But market price includes
indirect taxes. When indirect taxes are imposed on goods and services, their prices go up.
Indirect taxes accrue to the government. We have to deduct them from NNP evaluated at market
prices in order to calculate that part of NNP which actually accrues to the factors of production.
Similarly, there may be subsidies granted by the government on the prices of some commodities
(in India petrol is heavily taxed by the government, whereas cooking gas is subsidised). So we
need to add subsidies to the NNP evaluated at market prices. The measure that we obtain by
doing so is called Net National Product at factor cost or National Income.
Thus,
NNP at factor cost National Income (NI ) NNP at market prices (Indirect taxes
Subsidies) NNP at market prices Net indirect taxes
(Net indirect taxes Indirect taxes Subsidies)
Personal Income
We can further subdivide the National Income into smaller categories. Let us try to find the
expression for the part of NI which is received by households. We shall call this Personal
Income (PI). First, let us note that out of NI, which is earned by the firms and government
enterprises, a part of profit is not distributed among the factors of production. This is called
Undistributed Profits (UP). We have to deduct UP from NI to arrive at PI, since UP does not
accrue to the households. Similarly, Corporate Tax, which is imposed on the earnings made by
the firms, will also have to be deducted from the NI, since it does not accrue to the households.
On the other hand, the households do receive interest payments from private firms or the
government on past loans advanced by them. And households may have to pay interests to the
firms and the government as well, in case they had borrowed money from either. So we have to
deduct the net interests paid by the households to the firms and government. The households
receive transfer payments from government and firms (pensions, scholarship, prizes, for
example) which have to be added to calculate the Personal Income of the households.
Thus,

Personal income (PI) NI Undistributed profits Net interest payments made by

households Corporate tax + Transfer payments to the households from the government
and firms.
Personal Disposable Income (PDI):
Even PI is not the income over which the households have complete say. They have to pay taxes
from PI. If we deduct the Personal Tax Payments (income tax, for example) and Non-tax
Payments (such as fines) from PI, we obtain what is known as the Personal Disposable Income.
Thus,
Personal Disposable Income (PDI) PI Personal tax payments Non-tax payments.
Personal Disposable Income is the part of the aggregate income which belongs to the
households. They may decide to consume a part of it, and save the rest. The Fig. below presents
a diagrammatic representation of the relations between these major macroeconomic variables.

2. GOODS AND PRICES

2.1 GDP Deflator

One implicit assumption in all this discussion is that the prices of goods and services do not
change during the period of our study. If prices change, then there may be difficulties in
comparing GDPs. If we measure the GDP of a country in two consecutive years and see that the
figure for GDP of the latter year is twice that of the previous year, we may conclude that the
volume of production of the country has doubled. But it is possible that only prices of all goods
and services have doubled between the two years whereas the production has remained constant.
Therefore, in order to compare the GDP figures (and other macroeconomic variables) of different
countries or to compare the GDP figures of the same country at different points of time, we
cannot rely on GDPs evaluated at current market prices. For comparison we take the help of real
GDP. Real GDP is calculated in a way such that the goods and services are evaluated at some
constant set of prices (or constant prices). Since these prices remain fixed, if the Real GDP
changes we can be sure that it is the volume of production which is undergoing changes.
Nominal GDP, on the other hand, is simply the value of GDP at the current prevailing prices.
Example
For example, suppose a country only produces bread. In the year 2000 it had produced 100 units
of bread, price was Rs 10 per bread. GDP at current price was Rs 1,000. In 2001 the same
country produced 110 units of bread at price Rs 15 per bread. Therefore nominal GDP in 2001
was Rs 1,650 (=110 Rs 15). Real GDP in 2001 calculated at the price of the year 2000 (2000
will be called the base year) will be 110 Rs 10 = Rs 1,100. Notice that the ratio of nominal
GDP to real GDP gives us an idea of how the prices have moved from the base year (the year
whose prices are being used to calculate the real GDP) to the current year.
In the calculation of real and nominal GDP of the current year, the volume of production is
fixed. Therefore, if these measures differ it is only due to change in the price level between
the base year and the current year.
The ratio of nominal to real GDP is a well known index of prices. This is called GDP Deflator.
Thus if GDP stands for nominal GDP and gdp stands for real GDP
then, GDP deflator = GDP/gdp .
Sometimes the deflator is also denoted in percentage terms.

In such a case, deflator = [GDP/gdp] 100 per cent.

In the previous example, the GDP deflator is 1,650 /1,100 = 1.50 (in percentage terms this is 150
per cent). This implies that the price of bread produced in 2001 was 1.5 times the price in 2000
which is true because price of bread has indeed gone up from Rs 10 to Rs 15. Like GDP deflator,
we can have GNP deflator as well.
2.2 Consumer Price Index
There is another way to measure change of prices in an economy which is known as the
Consumer Price Index (CPI). This is the index of prices of a given basket of commodities
which are bought by the representative consumer. CPI is generally expressed in percentage
terms. We have two years under consideration one is the base year, the other is the current year.
We calculate the cost of purchase of a given basket of commodities in the base year. We also
calculate the cost of purchase of the same basket in the current year. Then we express the latter as
a percentage of the former. This gives us the Consumer Price Index of the current year vis-avis the base year.
Example
Let us take an economy which produces two goods, rice and cloth. A representative consumer
buys 90 kg of rice and 5 pieces of cloth in a year. Suppose in the year 2000 the price of a kg of
rice was Rs 10 and a piece of cloth was Rs 100.
So the consumer had to spend a total sum of Rs 10 90 = Rs 900 on rice in 2000. Similarly, she
spent Rs 100 5 = Rs 500 per year on cloth. Summation of the two items is,
Rs 900 + Rs 500 = Rs 1,400.
Now suppose the prices of a kg of rice and a piece of cloth has gone up to Rs 15 and Rs 120 in
the year 2005. To buy the same quantity of rice and clothes the representative will have to spend
Rs 1,350 and Rs 600 respectively (calculated in a similar way as before).
Their sum will be, Rs 1,350 + Rs 600 = Rs 1,950.
The CPI therefore will be 1,950/1,400 100 = 139.29 (approximately).

2.3 Retail and Wholesale Prices

It is worth noting that many commodities have two sets of prices. One is the retail price which
the consumer actually pays. The other is the wholesale price, the price at which goods are traded
in bulk. These two may differ in value because of the margin kept by traders. Goods which are
traded in bulk (such as raw materials or semi-finished goods) are not purchased by ordinary
consumers. Like CPI, the index for wholesale prices is called Wholesale Price Index (WPI). In
countries like USA it is referred to as Producer Price Index (PPI). Notice CPI (and analogously
WPI) may differ from GDP deflator because
2.4 Differences between CPI and WPI
1. The goods purchased by consumers do not represent all the goods which are produced in
a country. GDP deflator takes into account all such goods and services.
2. CPI includes prices of goods consumed by the representative consumer; hence it includes
prices of imported goods. GDP deflator does not include prices of imported goods.
3. The weights are constant in CPI but they differ according to production level of each
good in GDP deflator.

2.5 GDP AND WELFARE

Can the GDP of a country be taken as an index of the welfare of the people of that country? If a
person has more income he or she can buy more goods and services and his or her material wellbeing improves. So it may seem reasonable to treat his or her income level as his or her level of
well-being. GDP is the sum total of value of goods and services created within the geographical
boundary of a country in a particular year. It gets distributed among the people as incomes
(except for retained earnings). So we may be tempted to treat higher level of GDP of a country as
an index of greater well-being of the people of that country (to account for price changes, we
may take the value of real GDP instead of nominal GDP). But there are at least three reasons
why this may not be correct

1. Distribution of GDP how uniform is it:

If the GDP of the country is rising, the welfare may not rise as a consequence. This is
because the rise in GDP may be concentrated in the hands of very few individuals or firms.
For the rest, the income may in fact have fallen. In such a case the welfare of the entire
country cannot be said to have increased. For example, suppose in year 2000, an imaginary
country had 100 individuals each earning Rs 10. Therefore the GDP of the country was Rs
1,000 (by income method). In 2001, let us suppose the same country had 90 individuals
earning Rs 9 each, and the rest 10 individual earning Rs 20 each. Suppose there had been no
change in the prices of goods and services between these two periods. The GDP of the
country in the year 2001 was 90 (Rs 9) + 10 (Rs 20) = Rs 810 + Rs 200 = Rs 1,010.
Observe that compared to 2000, the GDP of the country in 2001 was higher by Rs10. But this
has happened when 90 per cent of people of the country have seen a drop in their real income
by 10 per cent (from Rs 10 to Rs 9), whereas only 10 per cent have benefited by a rise in
their income by 100 per cent (from Rs 10 to Rs 20). 90 per cent of the people are worse off
though the GDP of the country has gone up. If we relate welfare improvement in the country
to the percentage of people who are better off, then surely GDP is not a good index.

2. Non-monetary exchanges:
Many activities in an economy are not evaluated in monetary terms. For example, the
domestic services women perform at home are not paid for. The exchanges which take place
in the informal sector without the help of money are called barter exchanges. In barter
exchanges goods (or services) are directly exchanged against each other. But since money is
not being used here, these exchanges are not registered as part of economic activity. In
developing countries, where many remote regions are underdeveloped, these kinds of
exchanges do take place, but they are generally not counted in the GDPs of these countries.
This is a case of underestimation of GDP. Hence GDP calculated in the standard manner may
not give us a clear indication of the productive activity and well-being of a country.

3. Externalities:
Externalities refer to the benefits (or harms) a firm or an individual causes to another for which
they are not paid (or penalised). Externalities do not have any market in which they can be
bought and sold. For example, let us suppose there is an oil refinery which refines crude
petroleum and sells it in the market. The output of the refinery is the amount of oil it refines. We
can estimate the value added of the refinery by deducting the value of intermediate goods used
by the refinery (crude oil in this case) from the value of its output. The value added of the
refinery will be counted as part of the GDP of the economy. But in carrying out the production
the refinery may also be polluting the nearby river. This may cause harm to the people who use
the water of the river. Hence their utility will fall. Pollution may also kill fish or other organisms
of the river on which fish survive. As a result the fishermen of the river may be losing their
income and utility. Such harmful effects that the refinery is inflicting on others, for which it does
not have to bear any cost, are called externalities. In this case, the GDP is not taking into account
such negative externalities. Therefore, if we take GDP as a measure of welfare of the economy
we shall be overestimating the actual welfare. This was an example of negative externality. There
can be cases of positive externalities as well. In such cases GDP will underestimate the actual
welfare of the economy.

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 welfareusually 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 ofpurchasing 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.

Macroeconomics - Limitations of GDP

and Alternative Measures
There are many limitations to using GDP as a way to measure current income
and production. Major ones include:
Changes in quality and the inclusion of new goods - higher quality and/or new
products often replace older products. Many products, such as cars and medical
devices, are of higher quality and offer better features than what was available
previously. Many consumer electronics, such as cell phones and DVD players,
did not exist until recently.
Leisure/human costs - GDP does not take into account leisure time, nor is
consideration given to how hard people work to produce output. Also, jobs are
now safer and less physically strenuous than they were in the past. Because
GDP does not take these factors into account, changes in real income could be
understated.
Underground economy - Barter and cash transactions that take place outside of
recorded marketplaces are referred to as the underground economy and are not
included in GDP statistics. These activities are sometimes legal ones that are
undertaken so as to avoid taxes and sometimes they are outright illegal acts,
such as trafficking in illegal drugs.

Harmful Side Effects - Economic "bads", such as pollution, are not included in
GDP statistics. While no subtractions to GDP are made for their harmful effects,
market transactions made in an effort to correct the bad effects are added to
GDP.
Non-Market Production - Goods and services produced but not exchanged for
money, known as "nonmarket production", are not measured, even though they
have value. For instance, if you grow your own food, the value of that food will not
be included in GDP. If you decide to watch TV instead of growing your own food
and now have to purchase it, then the value of your food will be included in GDP.
Alternative Measures of Domestic Income
Other than GDP and GNP, there are alternative measures of domestic income,
such as national income, personal income and disposable personal income.
National Income
National income is computed by subtracting indirect business taxes, the net
income of foreigners, and depreciation from GDP. It represents the income
earned by a country's citizens. National income can also be computed by
summing interest, rents, employee compensation (wages and benefits),
proprietors' income and corporate profits.
Personal income represents income available for personal use. It is computed by
making various adjustments to national income. Social insurance taxes and
corporate profits are subtracted from national income, while net interest,
corporate dividends and transfer payments are added.
Disposable personal income (or disposable income) is income available to
people after taxes; i.e., it is personal income less individual taxes.

What are the advantages and disadvantages of

Gross Domestic Product?
Gross Domestic Product (GDP) is an economic measure of a nation's total income and
output for a given time period (usually a year). Economists use GDP to measure the
relative wealth and prosperity of different nations, as well as to measure the overall
growth or decline of a nation's economy.

The most common way to measure GDP is the expenditure approach. With the
expenditure approach, GDP is the sum of the following elements:

Total domestic consumption: This is the total amount spent on domestically

produced final goods and services. Final goods are items that will not be resold or
used in production within the next year milk, cars, bow ties, and so on.
Total domestic investment expenditures: This measurement includes not
only investments in stocks and bonds, but also investments in equipment such
as bulldozers, computer servers, and commercial buildings that will be useful
over a long period of time. It also includes inventory goods final goods

waiting to be sold that a company still has on hand.

Government expenditures: This includes everything from paying military

salaries to building roads and maintaining monuments, but does not include
welfare and social security payments.
Net exports: Net exports is the total of goods and services produced
domestically and sold to foreigners minus goods and services produced by
foreigners but sold domestically (imports).

Using GDP as a measure of a nation's economy makes sense because it's essentially a
measure of how much buying power a nation has over a given time period. GDP is also
used as an indicator of a nation's overall standard of living because, generally, a
nation's standard of living increases as GDP increases.
But there are a number of shortcomings to using GDP. Here are just a few:

GDP doesn't count unpaid volunteer work: GDP doesn't take into account
work that people do for free, from an afternoon spent picking up litter on the
roadside to the millions of man-hours spent on free and open source software
(such as Linux). In fact, volunteer work can actually lower GDP when volunteers

do work that might otherwise have gone to a paid employee or contractor.

Disasters can raise GDP: Wars require soldiers, oil spills require cleanup, and
natural disasters require health workers, builders, and all manner of helping

hands. Rebuilding after a disaster or war can greatly increase economic activity
and boost GDP.
GDP doesn't account for quality of goods: Consumers may buy cheap, lowquality, short-lived products repeatedly instead of buying more expensive, longerlasting goods. Over time, consumers could spend more replacing cheap goods
than they would have if they had bought higher-quality goods in the first place,
and GDP would grow as a result of waste and inefficiency.

Although economists are constantly working on other ways to measure an economy,

GDP is still the best indicator of a nation's overall economic health, in spite of its
shortcomings.

Limitations of Gross Domestic Product (GDP)

The standard measure of human wellbeing today is Gross Domestic Product (GDP).
This measures no more than the size of an economy. GDP as a general measure of
wellbeing is so deeply woven into the collective unconscious that our political leaders
generally need do no more than announce at the end of every year the rate by which
our economy has grown to assure the public that all is well.
The common acceptance of GDP as our principal indicator and measure of wellbeing has
helped define us as consumers. By increasing consumption, so the story goes, the
economy grows and collective wellbeing grows with it.
There is however, growing recognition of the limitations of GDP as a true measure of
wellbeing. Are there not many things included in GDP that can scarcely be described as
adding to the sum of happiness? Consumption of cigarettes, traffic jams, ecological
disasters that require major clean-up operations and war all could be said to have an
adverse effect on human wellbeing while being good for the economy.
Similarly, there are many things that clearly do make us happy but that are not
included in the measure of GDP: love, friendships, a vibrant and supportive community,
volunteering, free time.the list is almost endless.
To truly measure the wellbeing of individuals, communities and ecosystems, we need
something more nuanced.
Quote
GDP includes air pollution and advertising for cigarettes and
ambulances to clear our highways of carnage. It counts special
locks for our doors and jails for the people who break them.
GDP includes the destruction of the redwoods and the death of
Lake Superior. It grows with the production of napalm, and

missiles and nuclear warheads... it does not allow for the health
of our families, the quality of their education, or the joy of their
play. It is indifferent to the decency of our factories and the
safety of our streets alike. It does not include the beauty of our
poetry or the strength of our marriages, or the intelligence of
our public debate or the integrity of our public officials. It
measures everything, in short, except that which makes life
worthwhile Robert Kennedy

GDP: An Imperfect Measure of

Progress
33

JAN 30, 2013 6:30 PM EST

By The Editors

Which is better for a countrys well-being: $10 million spent

constructing a jail, or $10 million spent producing a line of
smartphones? How about clear-cutting rain forests to produce $10
million in lumber? Or a storm that requires $10 million in repairs?
Using todays most common shorthand of national welfare, gross
domestic product, all of the above are equal. GDP measures only
output, and makes no claims on the quality of that output, let alone on
subjective concepts such as social progress or human happiness. It
does what it was intended to do -- offer a value of marketed goods and
services produced in a country in a given time frame -- and does it
reasonably well.
Unfortunately, as youll probably gather from the reaction to this
weeks announcement that U.S. GDP unexpectedly declined in the last
quarter of 2012, politicians have increasingly come to rely on this
measure as a singular tool for calibrating public policy. This is a
mistake.
As useful as GDP is, it has some crucial flaws. It can obscure growing
inequality and encourage the depletion of resources. It cant

differentiate between spending on good things (education) and terrible

things (cigarettes). It doesnt measure the economic services that
nature provides, such as the dwindling wetlands that once protected
New Orleans from storms, or those that dont come with a market
price, such as raising children. It fails to account for the value of social
cohesion, education, health, leisure, a clean environment -- in other
words, as Robert Kennedy once put it, GDP measures everything
except that which makes life worthwhile.

SOME IMPROVEMENTS
This is why more and more economists and activists are pushing to
update GDP. The risk, though, is trying to incorporate too much into
one indicator -- particularly when it comes to subjective measures such
as happiness or well-being. A far better approach would be to improve
some of the measurements used in national accounts, and develop a
wider range of individual indicators of welfare to inform public policy.
In doing so, here are four guidelines to keep in mind.
First, economists need faster access to accurate information about
growth, especially during recessions. Consider that the original
estimate of GDP growth for the fourth quarter of 2008 was a
contraction of 3.8 percent. Over several years that figure was revisedto
8.9 percent -- suggesting a much more severe recession than most
people realized in early 2009 when Congress was debating
PresidentBarack Obamas stimulus bill. Several researchers,
notably Jeremy Nalewaik of the Federal Reserve, have said that gross
domestic income had suggested the onset of the recession earlier and
with greater accuracy than GDP had. Nalewaik and several coauthorsargued that a combined GDP-GDI measure would be more
accurate, helping to offset some of the measurement errors that inhere
in GDP and ideally giving policy makers a better economic picture
when it most counts.
Second, we should take better account of non-market production -- like
household work -- that affects the economy. The Bureau of Economic
Analysis, which compiles the national-income accounts of the U.S., has

done an admirable job in recent years of using satellite accounts to

take a more comprehensive snapshot of the economy. These enable
experimentation with what data the bureau collects, without
jeopardizing the credibility of the existing national accounts.
For instance, a recent study calculated a satellite account for
household production -- including non-market domestic services such
as gardening and housework, returns on consumer durable goods, and
return on government capital -- and found that GDP would have been
26 percent larger in 2010 if it had included such criteria. The study also
found that the historical annual growth rate of GDP would have been
slower and measures of income inequality would have been lower.
Although such data necessarily entail uncertainty, they can still offer
illuminating detail thats missing from traditional measures.

EDUCATION, HEALTH
The use of satellite accounts should be expanded prudently (note to
Congress: that means giving BEA more money), especially to better
account for education and health care. As a 2005 National Research
Council study pointed out, non-market measures should be consistent
with existing national accounts and, where possible, should use market
analogs to determine value -- for instance, by estimating the value of
parental care using the cost of private child care or the income a
parent would forgo by staying home.
Third, because GDP measures average income, it can obscure
important discrepancies at the household level. When incomes rise
disproportionately for the well-to-do, for instance, mean income can
increase even though many regular workers see their paychecks cut.
As a report from the think tank Demos recently noted, although U.S.
GDP more than doubled over the past 30 years, median household
income grew by only 16 percent. One possible solution, which the
authors support: Create new measures of household data for
disposable income to better capture families welfare and buying
power.

Fourth, economists are generally converging on the idea that some

measurement of environmental impact could be added to GDP. The
current system doesnt account for pollution, the depletion of natural
resources or the economic benefits nature can provide. Fortunately,
data on environmental accounting are improving, and its possible,
statistically if not politically, to place a monetary value on
environmental depletion that could be subtracted from GDP. One way
to begin might be to experiment with satellite environmental accounts.
What about measures of social well-being? This information is
important, but measures proposed as a replacement or improvement
to GDP, such as the Genuine Progress Indicator, typically suffer by
including ideological or subjective criteria. Better to collect such data
as part of a limited dashboard of additional indicators -- on health, the
environment, social cohesion and so on -- that is separate from GDP.
This is the approach recommended by the Stiglitz Commission, which
did exhaustive work on this subject for the French government.
GDP is a universal, objective and very useful measurement. But we
should recognize its limitations. Increasing GDP shouldnt be
governments only objective. Nor should GDP be considered a
definitive measurement of human welfare. For that, well have to
expand our data. And, ultimately, hold our politicians to better account.

LIMITATIONS OF GDP AS WELFARE INDICATOR

GDP (and its derivatives) is a measure of economic activity, actually. Narrowly
understood economic activity, one should add. However, this does not prevent
economists and policy makers from making welfare comparisons across countries and
across time on its basis. The argument goes as follows: GDP is a good proxy of the
consumption possibilities people have, and consumption is a good proxy of wellbeing/welfare. Therefore, we allegedly can use GDP per capita for comparing welfare
between countries and GDP growth as an indicator of social progress within a society.

This may sound compelling to many and, indeed, we are used to this rhetoric from
authorities and the media. But it is wrong to assume that GDP or any of its common
derivatives provides a measure of social welfare, for a number of reasons.

Let us begin with some basic definitions. GDP (gross domestic product) is computed as
the sum of all end-use goods and services produced in an economy during a period of
time, weighted by their market prices. There are at least two derivatives of GDP that are
in usage, too: GNP and NNP. GNP (gross national product) is GDP plus income earned by
inlanders abroad minus income earned by foreigners in the inland. For most economies,
the difference between these two is small, but it can be significant in some cases (e.g.
in Ireland before the crisis, where much of the GDP was owned by foreign corporations).
NNP (net national product) is GNP minus depreciation of capital, sometimes including
estimates of natural capital depreciation (green NNP).

From the definitions it is clear that these accounting quantities measure primarily the
economic activity and, in the case of the NNP, the sustainability thereof (although in a
very limited sense only). They could potentially be used as welfare indicators under
some ideal conditions. But these conditions are nonexistent. To use GDP and its
derivatives as a welfare indicator means to ignore its limitations, and there are many of
them:

First of all, GDP (I will stick to this base measure, but I mean its derivatives as
well, if not else indicated) is computed at market prices which means that it
ignores externalities, particularly (but not only) environmental ones. To a limited
extent, this limitation can be overcome by computing the measure using
accounting prices, which try to correct for market externalities. However, this is
a difficult procedure, since many accounting prices are more or less best guesses
with limited reliability. In most cases, market prices are used.

As pointed out by Richard Easterlin, who conducted extensive research from the
1970s through 2000s, people do not become happier when they grow richer if
they crossed some rather low threshold in terms of income (the socalled Easterlin Paradox). There are many possible explanations of why this is so
e.g. the fact that there is some threshold beyond which we have no more time
to enjoy the fruits of our affluence (as suggested by Staffan Linder) or the
correlation between increasing affluence and increasing competition for
positional goods that can be attained by anyone, but not by everyone (this
theory was suggested by Fred Hirsch). Both effects make the pursuit of everincreasing affluence (in terms of GDP) sisyphean and interpretations of the gross
domestic product as a welfare indicator flawed.

Another argument against using GDP as a welfare indicator is its treatment of

defensive expenditures: a category that includes items from expenditures on
the military, through money spent on building dams to protect human
settlements from flooding, to clean-up costs after, say, an oil-spill in the Gulf of
Mexico. These expenditures contribute positively to the GDP, but they clearly do
not contribute to well-being. Therefore GDP overestimates what it is thought to
approximate, i.e. social welfare.

Also, GDP does not include a meaningful part of the economy household work -,
as was pointed out by William Nordhaus and James Tobin in their famous paper Is
Growth Obsolete?. Beside of its importance for the proper functioning of the
economy and society, unaccounted for household work makes welfare
comparisons based on GDP both across time and across countries difficult. E.g.,
the US is known for its culture of outsourcing of household work (which may at
least partly explain why US-Americans work more hours and why the US
unemployment rates are systematically lower than in Europe) many things that

Europeans do on their own, outside of the market (and therefore unnoticed by

GDP statistics), e.g. cooking, washing etc., an average US-Americans lets do
others against payment. This makes the US-American GDP higher by trend but
it is very difficult to interpret the welfare consequences of these differences,
especially because they root deeply in cultural specifics. Also, the tendency
toward household work changes within societies over time how should the
resulting change in GDP be interpreted in welfare terms?

A similar point to the one made above can be made about the shadow or
informal economy, which is especially important in developing countries (but also
in many developed ones, particularly in Southern Europe) being informal, its
activities are not included in GDP statistics, even though they may have a
tremendous influence on the welfare specifically of the poorer parts of the
society.

A subject that this blog is often concerned about is that GDP does not include any
measures of changes in natural capital. Nor does the normal NNP. Since natural
capital and ecosystem services (including renewable and nonrenewable natural
resources, water purification, climate regulation, pollination, flood protection and
many, many more) more often than not has no market prices, it is not included in
GDP-like statistics that deal with marketed goods and services only. Also, the
already mentioned environmental external effects remain unaccounted for (and,
furthermore, there is evidence suggesting that rapid GDP growth is correlated
with environmental destruction). However, ecosystem services are tremendously
important for the well-being of people in developing and developed countries
alike (although in the short term the former depend relatively more on them). Or
could you get by without clean water, a stable climate or pollinated fruits? These

things have to be included in any meaningful measure of social welfare, even

though their valuation may be problematic.

GDP and its derivatives are measures of the total output of the economy they
do not in any way account for distributional or equity effects of it. However, as
suggested among others by Fred Hirsch and Richard Easterlin (see above),
people evaluate their lives not in absolute terms, but rather in comparison with
those whom they live among. So, the distribution of wealth is very important, in
many cases (particularly when basic needs of the population are satisfied, as is
the case in most developed countries) it may be more important than the general
(average) level of wealth. GDP does not capture this crucial aspect of human
well-being at all. Unless one believes in some kind of trickle-down, this is a
serious limitation of GDP as a welfare indicator.

A more general point was made by Partha Dasgupta and Karl-Gran Mler, who
analysed formally the ability of NNP (including green NNP) to provide a glimpse
at changes in social well-being across time and differences across countries.
Their result was that NNP can only help evaluate the welfare effects of policy
changes in the short-term within an economy, but not in the long-term and
across countries. The reason is quite simple, actually GDP and its derivatives
are all measures of income, not of wealth. The difference between these two
terms that are often used interchangeably in everyday speech is significant. If
our income is high, it may be due to the fact that we live on tick: after having
accumulated some wealth in the past, we are consuming (producing)
unsustainably, i.e., in a way that cannot be sustained over a longer period of
time. Unless income is defined in Hicksian terms (i.e., as the amount of money
that can be consumed within a period of time without compromising the ability to

consume at least as much in the next) and GDP is not -, it cannot be used as a
true, sustainable measure of welfare.

Many of the points made above can be summarized within the notion
of capabilities, which goes back toAmartya Sen. He and other researchers dealing
with this subject pointed out that human (or social) well-being does not depend
solely on commodities (as captured by the GDP statistics), but on the capability
of people to actually use them in a way they wish to. This understanding of
welfare requires much more than just a simple statistic of economic activity
GDP leaves too much of the good things out and includes too much of the
bad ones.

Given all the limitations of GDP and related measures as welfare indicators (as listed
above), it is clear that the practice of (implicitly or explicitly) using GDP statistics as a
welfare proxy is deeply flawed and should be abandoned. There is no ready-made
alternative that would give us a glimpse at social well-being and require just one single
number. Most likely, it is impossible to create such a simple indicator. Instead, welfare
has to be assessed on the basis of many different indicators, as I suggested recently.
GDP may have the attracting characteristic of being relatively simple, but it is also
flawed in the role as a welfare indicator. We should, using a quote attributed to Albert
Einstein, make things as simple as possible, but not simpler.