GDP is among such economic concepts that even a layman with no economics knowledge knows. For many decades, GDP has been considered a reliable source to measure the economic prosperity of a country.
But, tell me, when you hear that the GDP of your country has declined by 30%, does your lifestyle also drop by 30%? Do you feel 30% poorer than the prior year?
It raises a question, is this indicator as useful as we think?
Let’s discuss a few shortcomings of this indicator. Then, we can finally give our take on GDP’s usefulness as a measure of productivity, success, and the overall standard of living in an economy.
What Are Some Shortcomings of GDP?
GDP (Gross Domestic Product) refers to the market value of all final goods and services produced in a country. GDP is an important indicator to measure the economic success and growth of a nation.
The common approach to calculating GDP is via the Consumption method. Here, GDP is the aggregate of total consumption, investment, Government expenditures, and Net exports during a period in a country.
GDP has a few shortcomings that make it a less-than-perfect indicator to measure economic growth in a country. Let’s find them out.
Shortcoming #1: There’s a Lot of Confusion About What Should Be in the GDP Calculation
As you know, GDP is the total value of all the final output produced in the country. So, GDP should not reflect the value of intermediate goods.
For example, if you buy wood to produce a table, only the final output “table” should be part of GDP, not the wood. The rationale is that the table value would include the value of wood or other materials used to produce it.
Now, it seems straightforward and perfect!
In real life, it is not easy as an example of table and wood. Sometimes the lines between intermediate and final goods are so blurry that it is difficult to dissect. So, the double counting of intermediate goods can exaggerate the GDP.
Similarly, there are other confusions.
For example, the engine is a part of the car. So, GDP will include the car (with engine and other components value automatically accounted for). Now, what if your engine breaks down, and you install a new one?
Does this new engine installation need to be recorded in GDP?
What about repair works on it? Should this be included in GDP calculations?
There are so many unanswered questions that GDP ignores.
Another confusing thing is to exclude the used or second-hand items from GDP calculation. Though these items were produced in past and reflected in GDP then, still they were repurchased this year. GDP simply ignores this expenditure.
Shortcoming #2: GDP Does Not Reflect Informal Economy
The problem with the informal economy is that it is hard to track them. The government cannot track and tax such an economy, so they do not reflect in GDP. These economies are a big part of the world’s workforce, especially in third-world countries. So, not including them in GDP makes GDP less representative of all the economic activities in a country.
It is worth noting that the informal economy includes illegal activities like selling drugs or contraband. Similarly, legal activities like cleaning windshields of cars at signals, fruit carts on street, or other street hawkers, etc.
Shortcoming #3: Complications of Foreign Operations
As we all know many big corporations like Apple, Tesla, Amazon, and others have manufacturing facilities outside the US where the cost of production is cheaper with cheaper labor. As per GDP, the goods produced domestically can only become part of the GDP. So, if Apple creates its iPhone in China, China’s GDP should reflect the production of the iPhone in it and not the USA.
Now, what if the foreign company produces goods in your country and sends back the profit to its origin country? Is it fair to include it in the GDP calculation when besides creating jobs in the host country the foreign company did not contribute more?
That’s where GNP comes into play. GNP takes into account all the output produced by the factors of production of a country anywhere in the world. GNP calculations include net foreign income. Net foreign income is the difference between the income generated by the citizens of a country from their overseas investment and income earned by foreign citizens.
Let’s take an example to understand the difference between GDP and GNP well.
If a US-based ABC Company produces $20 million worth of output through its operations in China and reverts $10 million back to the USA. As per GDP, this $20 million should become part of China’s GDP. On the other hand, the GNP calculation will only include $10 million, as the other $10 million company reverted back to its own country.
Shortcoming #4: GDP Is Not The True Reflection of Living Standards of a Country
Generally, it is assumed the higher the GDP, the higher the economic growth and prosperity. With higher GDP, the living standards of people in a country also improve. It is the reason countries strive to improve their GDP.
In reality, producing more and more goods may make a few selected groups of people richer and richer and not everybody. GDP simply ignores the distribution of wealth. The income disparity affects the living standards of a country.
To have better living standards in a country more things needed to be accounted for than having excessive production.
GDP ignores the kinds of goods produced in a country. For example, any country producing more arms and ammunition can have a strong GDP, but the living standard might not improve. It is because the product produced does not have a positive impact on people’s welfare.
On the contrary, if another country produces more high-tech gadgets or superior-quality products can have a lower GDP than the country with excessive ammunition production. But, in this country, the living standard will be far better because of the kind of output generated here.
Besides, GDP takes into account economic activities, not other welfare activities that actually improve living standards in a country e.g. education, health care, happiness, and environmental and sustainability issues.
It is time to look beyond GDP to measure the economic prosperity of a country. Though GDP is significant, it can aid in measuring the living standard and economic growth of a country, but heavy reliance on it should be avoided. Other indicators like Human Development Index (HDI) or Genuine Progress Index (GNI) should also be considered to understand the living standards situations of a country.
What do you think about GDP? Do we need to look beyond GDP?