Shortcomings of GDP - Online Tutor, Practice Problems & Exam Prep

Gross Domestic Product (GDP) measures total production and well-being but has limitations. It excludes household production, like a homemaker's services, and the underground economy, which includes illegal transactions and tax evasion. While GDP per capita suggests higher well-being with increased output, it overlooks leisure value, environmental impacts, crime-related costs, and income distribution equity. Thus, GDP is not a comprehensive measure of citizens' well-being, as it fails to account for these critical factors affecting quality of life.

Shortcomings as Measure of Production

So we've been using GDP to measure the productivity in an economy, but it's not a perfect measure like most things in this world. Let's go ahead and check out some of the shortcomings of GDP. So when we use GDP as a measure of statistical variable, we use it to measure two things: the total production in an economy, but we also use it as a measure of the well-being of its citizens. We tend to think that the higher the production, the higher the output, well, that leads to a higher standard of living. More things are available for the citizens, okay? Let's go ahead and see how it's not perfect. First, let's start here with total production in the economy.

There are some things that do not contribute to the GDP calculation, but they arguably should. Right? They arguably should even though they're not included. So what are some of these things? The main ones here are household production. So if someone creates something for their own use, well, it's not going to be included in GDP. The value of goods produced for own use, we'll say here, for own use. So let's assume there's a carpenter that builds bookshelves and sells bookshelves all the time, but then he also builds a bookshelf at home. Well, if he hadn't built that bookshelf, he would have had to go out and purchase it. Right? So this should technically be included in our GDP, but there's not really a way to measure it and include it in the calculation. So the one he produced at home, the ones he used at home is not in GDP, but it arguably should be, right? Because it was production during this year. Another thing is the services of a homemaker, right? So if there's a stay-at-home parent, a stay-at-home mom or stay-at-home dad, well, what they do doesn't get included in GDP. However, if they had a job and they had to hire a babysitter to take care of the kids, the babysitter's services would have been included in GDP. However, since they're doing it themselves, they're producing this homemaker service themselves, it's not included in the GDP calculation. So household production are things that should arguably be included in GDP and are not.

Next, is the underground economy, so this is the buying and selling of goods that is hidden from the government. There are a few reasons why people might hide transactions from the government. The first one is obviously if they're trading illegal goods, right? You don't want the government to know if you're selling drugs or if you're a prostitute, you're going to get sent to jail for that. So you buy and sell on the underground market and there's clearly a product being sold here. There's value being created when you sell drugs or something like that that's not, included in GDP. So these values should be included in GDP, but since they're illegal, they're not being tracked. Right? Other things in the underground economy, well, people are avoiding taxes. So if you hire someone under the table, hiring under the table, well, that doesn't get included in GDP because it's being hidden from the government. They're not going to be able to include it in their calculation. And avoiding government regulations, people avoid government regulations. They hide things to avoid certain regulations. Maybe they sell some sort of asset but they don't want to pay taxes on the sale, so they hide that information from the government. So whatever it might be, those underground economy transactions are not included in GDP, but they arguably are creating value and they're being produced, right? There are final goods and services being produced there.

So does the exclusion of these two main things, underground economy and household production, significantly affect GDP's usefulness? Well, in the short run, we're going to see that it's generally pretty constant. So we could think that the underground economy is not changing too much. The amount of drugs that are being sold year to year is relatively constant or the amount of household production year to year is generally pretty constant. So in the short run, since we're leaving out about the same amount each year, it's not going to incredibly affect the calculation. However, in the long run, there are social changes that can have drastic effects, such as the amount of homemakers. So when we're talking about household production, the homemakers weren't being included in GDP although they were producing something significant, right? They're producing the equivalent of a babysitter, nanny service, house cleaning service, but in the 1970s, a lot of these women who were stay-at-home moms entered the workforce and their production was included in GDP now. Even though before they were technically still producing as a homemaker, now they're producing as something that was being recorded by the government and included in GDP. So they were producing before and not being included and now producing after and being included. This is going to affect the GDP calculation and make it seem like, wow, something happened in the 1970s. Although, they were producing before and producing after, that exclusion could have altered those calculations, right? So let's pause here and then in the next video, let's discuss the other side of GDP, the well-being of citizens.

Shortcomings as Measure of Well-Being

So GDP per capita is generally used to measure the well-being of citizens. When we say per capita, we mean per person. Right? Per person in the population. So we say if there's more GDP per person, well, that means there's more output per person, and we can say that there's more production available per person and tends to lead to an increase in the well-being. However, this shouldn't be the only measure of well-being. Right? Because there are things that are not included in GDP that definitely account for the well-being of the citizenry. So what about the value of leisure? Imagine if everyone worked all the time, no one took any breaks, everyone works 168 hours a week, 12 hour days. Well, GDP would be higher, wouldn't it? If everyone worked all the time, but would the citizens be happier? Probably not, right? They'd be exhausted. They probably get sick more often from overwork and it wouldn't benefit the citizens although GDP would be increased, right? It wouldn't necessarily translate to happier, better citizens. So the value of leisure is not included in GDP because the idea that if everyone just worked more, GDP would increase, meaning the well-being would increase that doesn't really follow.

Next is environmental effects. GDP would be higher if without environmental regulations as well. So if there were no environmental regulations, there would be a lot more production, there wouldn't be restrictions on production and there would be a higher GDP, but does that necessarily lead to the well-being of citizens? Probably not. Right? As a well-being, this GDP should probably be reduced for these health hazards and pollution and things like that. There should be some sort of measure of these pollutions that kind of adjust GDP for that.

Next is crime and social problems. If there was more crime, there would be more government spending. Right? Because more crime would lead to more police, higher government spending. We know government spending is part of GDP. Well-being of the citizens? I don't think so. Right? So you could see that these social issues can play a part in GDP as well.

Finally, one more issue with GDP is the equity in GDP. GDP is just measuring the total amount of production and saying there's this much per citizen, but is it really split evenly? There's not really a perfectly even split of GDP. Right? It measures what we say the size of the pie, right, the GDP pie. But how is it split? I don't think everyone's getting equal slices. Right? We're not getting equal slices for each citizen. Maybe we'll have some really small slices here and some really big slices. Right? Maybe we've got a little tiny slice here and then a really big slice for someone else. So it measures the size of how much is being produced but not how it's split between the citizens. So that's not a perfect measure of well-being as well.

So remember, the two problems here with GDP is that it doesn't necessarily include all production and it doesn't necessarily perfectly measure the well-being of the citizens. Cool? Alright. Let's go ahead and move on to the next topic.

Here’s what students ask on this topic:

What are the main shortcomings of GDP as a measure of economic well-being?

GDP has several shortcomings as a measure of economic well-being. Firstly, it excludes household production, such as homemaker services, which contribute to the economy but are not monetized. Secondly, the underground economy, including illegal transactions and tax evasion, is not captured in GDP. Additionally, GDP per capita does not account for the value of leisure, environmental impacts, crime-related costs, and income distribution equity. These factors significantly affect the quality of life but are not reflected in GDP, making it an incomplete measure of well-being.

Why is household production not included in GDP calculations?

Household production is not included in GDP calculations because it involves goods and services produced for personal use rather than for sale in the market. For example, a homemaker's services or a carpenter building a bookshelf for personal use are not monetized and thus not tracked in GDP. Although these activities contribute to the economy, there is no straightforward way to measure and include them in GDP calculations, leading to an underestimation of total economic production.

How does the underground economy affect the accuracy of GDP?

The underground economy affects the accuracy of GDP by excluding transactions that are hidden from the government, such as illegal activities and tax evasion. These transactions create value and involve the production of goods and services, but they are not recorded in official statistics. As a result, GDP underestimates the true economic activity, leading to an incomplete picture of the economy's total production and well-being.

What are the limitations of using GDP per capita as an indicator of well-being?

GDP per capita has several limitations as an indicator of well-being. It does not account for the value of leisure, meaning that increased work hours may boost GDP but not necessarily improve quality of life. It also overlooks environmental impacts, as higher production can lead to pollution and health hazards. Additionally, GDP per capita does not consider crime-related costs or the equity of income distribution, meaning it does not reflect how wealth is shared among citizens. These omissions make GDP per capita an incomplete measure of well-being.

How do environmental effects impact the reliability of GDP as a measure of well-being?

Environmental effects impact the reliability of GDP as a measure of well-being because GDP does not account for the negative externalities of production, such as pollution and resource depletion. Higher GDP might indicate increased production, but if this comes at the cost of environmental degradation, it can harm citizens' health and quality of life. Therefore, GDP may overstate economic well-being by ignoring the environmental costs associated with production.