By Aidan Hackett. Edited by Arjun Chandrasekar.
Overview
The invention, or at least the popularization of GDP is usually attributed to Simon Kuznets after he devised a more effective way to measure economic welfare in 1934 during the Great Depression. Becoming more and more popular after the Second World War, especially in Europe as their economies were starting to recover and grow once more, in 1993 GDP became the de-facto worldwide standard measure of a country’s economic well-being after China replaced their Marxist accounting principles with a GDP.
GDP Measurement Standard
The definition of GDP according to Investopedia is “the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period.” What this means is nuanced. Firstly, the market value of the goods, which is the dollar amount that they sold for. This changes between time and place, and while attempts are made to standardize this figure, effectively doing this is challenging. Secondly, finished goods, which are goods that are bought by the final consumer. An apple will not be counted if it is going into an apple pie made by a business but would be counted if it is going to be eaten by an individual in the form of the plain apple. Thirdly, the specific time period, which is quite self-explanatory, but it’s important to note that this time period is usually one year.
GDP Formulas
GDP can be calculated in three ways, but all ways lead to the same answer. The first way GDP is calculated is through the expenditure approach. It measures goods and services that are bought by consumers, businesses, and the government, and then adds in net exports (exports subtract imports). This leads to the formula GDP= (consumer spending) +(investment spending) +(government spending) +(exports-imports)=C+I+G+(X-M).
The second way is the income approach. This states that GDP is equal to all income earned in an economy (and these incomes directly link to a different factor of production – land, labor, capital, and entrepreneurship). GDP=(rent)+(wages)+(interest)+(profit), respectively to the factors of production.
The third way is the value-added approach. This states that all the value added to a good each time it is sold is equal to the GDP. This is best described by an example. If I have some wood, I can sell that to a cabinet maker for $50. The cabinet maker then makes a cabinet and sells that cabinet for $150. GDP is equal to the value added both times. I added $50, the cabinet maker added $100, so the sum of that – $150, is the GDP.
Taking the previous example and applying it to the other methods, we should get the same answer, just taking slightly different steps. Method 1 leads us to no investment or government spending, and no importing or exporting (remember, buying something and then selling it on does not count towards GDP), but $150 in consumer spending, meaning a $150 GDP. Using method 2, this $150 could be made up of a number of different combinations of the four factors, but will always equal $150. For the sake of this example, we could assume every last cent went to the entrepreneurs who made the goods: $50 for the initial woods in profit, and then $100 to the cabinet maker in profit too.
So, from this definition, we can answer the original question, “what does GDP measure?”. In short, GDP measures what we can buy as a collective country in the form of goods or services. But what does GDP not account for? And is the measure of material possessions the best way to measure welfare? That leads to the next section.
Arguments against the use of GDP
According to Bobby Kennedy in his speech at the University of Kansas on March 18, 1968, “it [GDP] measures everything in short, except that which makes life worthwhile.” While GDP would measure the cost of a car and the fuel we put into it, it cannot measure the enjoyment we get from the car, or the fossil fuels emitted into the atmosphere every time we start the engine. GDP has many flaws, and in recent times has come under more and more scrutiny.
The first main problem with GDP as a measure of welfare is that it does not account for the number of people sharing these goods consumed. So, while Russia has a GDP of $1.7 trillion, and Australia $1.6 trillion, Australia has about 1/6th of the population of Russia, so the welfare of the nations will naturally have proportional disparities. Australia had a nominal GDP per capita of $53,831, while Russia fares worse at $10,846.
The second problem is the inequality in a nation. While taking the total GDP and dividing it by the population may seem like a reasonable thing to do, if a country is incredibly unequal (say the top 1% have 99% of the wealth, and the other 99% of the people live off $2 per day), then the real standard of living in that country is worse than a poorer country on GDP per capita terms, even though the wealth is spread out more equally.
The third limitation, and one that is becoming more and more pressing, is the environment. GDP measures production and much of this leads to pollution. This causes a blatant perverse incentive to pollute if GDP growth is the country’s main goal. This factor, more than any other, has been the driving force behind reconsidering how we measure economic welfare.
The final major limitation is the underground market: work that is unaccounted for. While this covers horrible things like human and drug trafficking, it also covers amazing things like volunteering or donating. Consider an economy where everything is free, and people work out of the goodness of their hearts. This economy would have a GDP of $0 but would presumably be happier than any country on Earth regardless of its GDP.
Alternatives to GDP
One alternative is the Human Development Index(HDI), which was created by the United Nations to measure life expectancy, education, per capita income, among other things, and ranks countries based on their performance. It is often used in conjunction with GDP.
The second alternative is the Genuine Progress Indicator(GPI), which seems to be the next-in-line to GDP and is generally considered the most comprehensive of all of the popular indicators. It measures economic factors (personal expenditure, underemployment, income inequality, etc.), social factors (volunteer work, higher education, crime, etc.), and environmental factors (ozone depletion, air, water, and noise pollution, the net loss of forest, etc.). It takes all the factors and assigns values to them, adding good ones and subtracting bad ones.
Conclusion
The main goal of all these new indicators and the original goal of GDP is to guide government policy. As Nicholas Oulton put in an article on VoxEU, “above a certain level, a higher material standard of living does not make people happier. This view concludes that we should stop trying to raise GDP and look instead for policies that promote happiness.” By using different indicators, governments are more able to design policies that genuinely increase welfare for citizens, as well as leading to longer-term and more sustainable growth.
For more information, we recommend this video by the LSE and this article by Mark Thoma.
