Limitations of GDP as Welfare Indicator
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Table of Contents
TOC o “1-3” h z u HYPERLINK l “_Toc413349524” Introduction PAGEREF _Toc413349524 h 2
HYPERLINK l “_Toc413349525” Definition of GDP PAGEREF _Toc413349525 h 2
HYPERLINK l “_Toc413349526” Limitations of GDP and Economic Indicator PAGEREF _Toc413349526 h 2
HYPERLINK l “_Toc413349527” Treatment of “defensive expenditures PAGEREF _Toc413349527 h 3
HYPERLINK l “_Toc413349528” As a measure of household work PAGEREF _Toc413349528 h 3
HYPERLINK l “_Toc413349529” Shadow” or informal economy PAGEREF _Toc413349529 h 3
HYPERLINK l “_Toc413349530” Measures of changes in natural Capital PAGEREF _Toc413349530 h 3
HYPERLINK l “_Toc413349531” GDP and its derivatives are measures of the total output of the economy PAGEREF _Toc413349531 h 4
HYPERLINK l “_Toc413349532” Conclusion PAGEREF _Toc413349532 h 4
HYPERLINK l “_Toc413349533” References PAGEREF _Toc413349533 h 5
Introduction
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 well-being/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.
Definition of GDP
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 islanders 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”) (Fleurbaey & Blanchet, 2013).
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: Each paragraph indicates a limitation
Limitations of GDP and Economic Indicator
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 (Jacobs & Šlaus, 2010).
As pointed out by HYPERLINK “http://graphics8.nytimes.com/images/2008/04/16/business/Easterlin1974.pdf” o “Does Economic Growth Improve the Human Lot? Some Empirical Evidence” t “_blank” Richard Easterlin, who conducted extensive research from the 1970’s through 2000’s, people do not become happier when they grow richer if they crossed some rather low threshold in terms of income (the so-called HYPERLINK “http://en.wikipedia.org/wiki/Easterlin_paradox” t “_blank” 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 (a Jones & Klenow, 2010) 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 HYPERLINK “https://zielonygrzyb.wordpress.com/2012/01/22/social-limits-to-growth/” o “Social Limits to Growth” t “_blank” Fred Hirsch). Both effects make the pursuit of ever-increasing affluence (in terms of GDP) sisyphean and interpretations of the gross domestic product as a welfare indicator flawed.
Treatment of “defensive expendituresAnother 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 HYPERLINK “http://www.guardian.co.uk/business/2012/jul/31/deepwater-horizon-bp-847m-dollars” o “BP adds $847 to Deepwater Horizon costs” t “_blank” 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.
As a measure of household workAlso, 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 HYPERLINK “http://www.nber.org/chapters/c7620.pdf” t “_blank” 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? (Jones & Klenow, 2010)
Shadow” or informal economyA 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.
Measures of changes in natural Capital
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 HYPERLINK “https://zielonygrzyb.wordpress.com/2012/07/09/the-value-of-nature/” o “The Value of Nature” t “_blank” 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 (van den Bergh, 2010), 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 HYPERLINK “http://en.wikipedia.org/wiki/Trickle-down_economics” t “_blank” “trickle-down”, this is a serious limitation of GDP as a welfare indicator (van den Bergh, 2010).
Conclusion
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 HYPERLINK “https://zielonygrzyb.wordpress.com/2012/05/06/stop-debating-growth-and-focus-on-what-is-important/” o “Stop Debating Growth and Focus on What Is Important” t “_blank” 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”.
ReferencesFleurbaey, M., & Blanchet, D. (2013). Beyond GDP: Measuring Welfare and Assessing Sustainability. Oxford University Press.
Jacobs, G., & Šlaus, I. (2010). Indicators of economic progress: the power of measurement and human welfare. Cadmus J, 1, 53-113.
Jones, C. I., & Klenow, P. J. (2010). Beyond GDP? Welfare across countries and time (No. w16352). National Bureau of Economic Research.
van den Bergh, J. C. (2010). Relax about GDP growth: implications for climate and crisis policies. Journal of Cleaner Production, 18(6), 540-543.