Why GDP is not a perfect measure of well being

The article ”We shouldn”t judge wellbeing by GDP alone” gives a clear picture about GDP is not a perfect measurement of wellbeing. Roughly, the article outlines how GDP measure has become become the de facto measure of national welfare among a range of economic indicators, its limitations and shortcomings as measure of national wellbeing, the consequences brought with the flawed measurement and the attempt of shifting in emphasis from economic production to measuring people”s wellbeing together with sustainability.

GDP measure consists of three forms of economic activity over a period, typically one year, which are the value of goods and services produced, the total incomes generated from that production and the total spent on goods and services, plus exports and minus imports. It is only a statistic but it does influence the whole way we run the country and even world. It can be proved when the Reserve Bank decides whether to raise or lower interest rates, none of economic indicators is more important than the quarterly GDP figures. GDP has also become the de facto measure of national welfare when government is framing its annual budget.

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GDP will measure the fall in production from farms, mines and business and the loss of income to individuals, however, will not capture any impact of disasters: the loss in value to business and infrastructure. This shows limitation of it as measurement of wellbeing. And usually, changes in income, which the quarterly GDP measures do not move with changes in wealth in same direction. Increase in GDP may be influenced by inflation but not the rise of wealth since GDP measure value of total production.

GDP measure does not include so many things that do not have monetary value attached to it. It tend to leave out most non-market activities like the broader social importance of voluntary work done by family members or unpaid helpers which not included in GDP. Neither the cost of depleting natural resources nor the health of children, the quality of education or the strength of marriage is being taken in GDP measure. Another view is that weaknesses in the statistics were reasons the global financial crisis took most by surprise. GDP figures with those all shortcomings will give a distorted picture of what is happening in the economy.

A shift in emphasis from economic production to measuring people”s wellbeing, together with sustainability, using a ”dashboard” of indicators, rather than a single measure has been recommended. To illustrate, this approach has been adopted by the Australian Bureau of Statistics, putting out an annual publication, Measures of Australia”s Progress, since 2002 to provide a broader reading on whether life is getting better.

As Albert Einstein put it, ”not everything that counts can be counted and not everything that can be counted counts”.

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2.0 ISSUE: GDP IS NOT A PERFECT MEASURE OF WELL-BEING

Economists measure total production by gross domestic product (GDP). GDP is the market value of all final goods and services produced in a country during a period of time, typically one year. GDP is a central concept in macroeconomics, so we need to consider its definition carefully.

GDP is measured using market values, not quantities. The word value is important in the definition of GDP. In microeconomics, we measure production in quantity terms: the number of shoes produced, the frequency number of services provided and so on. When we measure production in economy, we cannot just add together the quantities of all goods and services because the result would be a meaningless jumble. Instead, we measure production by taking the value, in monetary term, of all the goods and services produced.

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GDP includes only the market value of final goods. We include only the value of final goods in the calculation of GDP. A final good or service is a good and service purchased by it final user and not to be included in the production of any other good or service. A good or service that is an input into another good or service is known as intermediate good or service. For example, flour powder bought by a housewife is a final good while flour powder bought by baker is intermediate good. Therefore, there is important to have it clarified well whether a good or service is final good or intermediate good. If we included the value of intermediate good or service, it would be double counting.

GDP includes only current production. GDP includes only production (goods and services produced) that takes place during the indicated time period. In particular, GDP does not include the value of used goods.

Components of GDP

Equation for GDP: Y = C + I + G + NX

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GDP is made up by 5 elements. They are consumption expenditures, investment, government purchases and net exports. Consumption expenditures are the spending made by households on goods and services, not including spending on new house. Investment is the spending by firms on new factories, office buildings, machinery, and additions to inventories, plus spending by households and firms on new houses. Government purchases are the spending by federal, state, and local governments on goods and services. Net exports are exports minus imports.

Three Approaches to measure GDP

There are three approaches to measuring GDP: expenditures approach, income approach and value-added approach.

1. Expenditures Approach

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The total spending on all final goods and services (Consumption (C) + Gross Investments (I) + Government Purchases (G) + (Exports (X) – Imports (M))

GDP = C + I + G + (X-M)

2. Income Approach (NI = National Income)

Using the Income Approach, GDP is calculated by adding up the factor incomes to the factors of production in the society. These include

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National Income (NI) + Indirect Business Taxes (IBT) + Depreciation (D)

In this approach,

NI = Labor Income (W) + Rental Income (R) + Interest Income (i) + Profits (PR)

3. Value added Approach

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Value added, which is the additional market value a firm gives to a product, is totaled up to calculate the value of GDP.

2.1 Reasons why GDP is not a perfect measure of GDP

Figure 1: Elements of Well-Being

(Source: Deutsche Bank Research, 2007)

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2.11 GDP

GDP is the market value of all final goods and services produced in a country during a given period typically one year. It is widely used to measure an economy”s performance. Nevertheless, GDP only includes value of consumption and net investment.

Disasters can raise GDP

Natural disaster has causes impact on human lives. GDP ignores the cost of destruction-ruined homes, wrecked cars, roads and rail lines washed away, businesses writing off millions of dollars of stock. Reconstruction after disaster or war can greatly boost GDP.

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2.12 Economic Well-Being

Economic well-being is defined as the quality of living standard and the state of wellness of a country. It has a wider range than GDP. We can notice from figure 1 that economic well-being includes parts of GDP, leisure, wealth, underground activity. Economic well-being also includes unemployment and insecurity which may reduce economic well-being.

Underground Economy

Individual and firms tend to conceal the buying and selling of underground economy as this production is not counted in GDP. GDP only include transactions that pass through market with market price. The reasons of conciliation is underground economy are dealing with illegal activities like gambling, smuggling, robbery and prostitution. Individual and firms would like to avoid paying taxes for the income earned and also avoid themselves from government regulations.

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Volunteer and family work

Voluntary work such as those done by family members or unpaid helpers, like child minding, housework, childcare and care for the elderly and the ill have an impact on welfare, however it is not counted in GDP. If volunteer work were to get paid and is included in GDP, GDP will reflect higher value.

Leisure

Leisure can be said to increase people”s welfare. Nevertheless, there”s an ”opportunity cost” arise from leisure which is the lost of increase in GDP. If the working hours of employee are reduced by an addition in increasing sick leaves, casual leaves, it brings relief in people life. The leisure had improved the employee”s performance by working less but unfortunately leisure is not counted in GDP.

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Technology

An increase in technology does not reflect in the value of GDP as it only reflects the value of the end product.

2.13 Living Conditions

Living conditions includes non-material aspects such as the state of environment, health, life expectancy, education and the state of the environment.

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Environmental externalities and depletion of natural resources

Dirty water, chemicals and noise came from the factories will pose negative impact on human. It affects the well-being of individual and reduce the average age limit of human beings. GDP ignores the negative impact on environment and human life. When the money is spent on cleaning pollution, this increases GDP. Additional usage of petrol caused by traffic jams could increase GDP while reducing the quality of life. As GDP does not record the changes in the underlying capital, the deterioration of capital will kept unnoticed for a long time.

Health

The health conditions of societies are only reflected in the increase in costs of health system through GDP. A more expensive health care system will increase the value of GDP. High income also does not reflect the health condition of an individual. A more advanced technique in health care system which causes life-expectancy, inefficiency, lifestyles and prevention is not reflected in GDP. The cost and benefits from health is hard to identify in GDP.

Inequality (Composition and Distribution of Output)

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GDP only measures the size of the pie but not how the pie is divided up. When a country”s GDP increases, this means that the country has more goods and products, however those goods may be unequally distributed as GDP do not provide the compositions of products consumed by a typical person.

Crime and Family Breakdown

Although an increase in crime may increase GDP, it reduces well-being. This is because it will leads to greater spending on police, security guards, and alarm systems. However, it is not adjusted for damages to property or lawyers who manage divorces, drug addiction and family breakdown.

2.14 Happiness

Happiness is determined by family, activities, friends, work satisfaction and community ties. It is the final goal to be achieved to ensure economic well-being. Income is not emphasized in the happiness. Happiness encompasses living conditions, economic well-being and GDP. The income of households does not indicate the happiness. Higher GDP do not guarantee individuals are happy and contented. Thus, understanding the elements of well-being will make it easier to understand the choice of individuals and policymakers.

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2.2 Suggestion: Use other indicators to measure well-being

Different people may have different perspective on the aspect to improve the well-being. An economist should not measure the well-being based on one dimension which is fully describe the economic welfare by only using GDP. They should develop and apply multiple statistics or indicators to describe the various aspects of economic well-being.

In order to measure well-being, many different indicators are developed and applied by many actors such as international organizations (World Bank, UNDP), statistical offices (Eurostat, Destatis), civil-society organizations and campaigns (Sbilanciamoci!) or independent think-tanks (new economics foundation, Redefining Progress). These indicators can be grouped into three different categories: adjusting, replacing and supplementing GDP.

2.21 Indicators ‘adjusting GDP’

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Indicators ‘adjusting GDP’ adjust GDP to incorporate a variety of economic, social or environmental factors which are not included in the conventional measure (Jackson et al.,2005).

Measure of Economic Welfare (MEW) by Nordhaus and Tobin is a measure that shows consumption rather than production. This indicator adjusts for some of the ”bads” and ”regrettables” and adds some nonmarket activities into this measure.

Daly-Cobb Index of Sustainable Economic Welfare (ISEW) and Genuine Progress Indicator (GPI) are indicators that take into account the links between environment, economy and society. But, GPI also consider the elements such as crime, divorce, unemployment and changes in leisure time in its calculation.

Other indicators are Green GDP and Genuine savings. Green GDP incorporates the environmental consequences of economic growth, including the depletion of natural resources and degradation of the environment. Whereas, Genuine savings is a measure of net investment (‘true savings’) in produced, natural and human capital.

2.22 Indicators ‘replacing’ GDP

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The indicators that try to measure wellbeing more directly than GDP are Human development index (HDI), Gender-related Development Index (GDI), Ecological Footprint (EF), Happy Planet Index (HPI), Environmental Sustainability Index (ESI) and Regional Quality of Development Index (QUARS).

Human development index (HDI) is a composite index that combines the levels of life expectancy, education and GDP to measure human development. Similar to HDI, the Gender-related Development Index (GDI) incorporates social issues such as longevity and knowledge. But, GDI also takes note of inequalities between two genders (male and female).

The Ecological Footprint (EF) measures the extent to which the ecological demand of human economies stays within or exceeds the capacity of the biosphere for the supply of goods and services. Happy Planet Index (HPI) is an index of human well-being and environmental impact that incorporates the data on life expectancy, surveys on life satisfaction and the consumption of natural resources.

Environmental Sustainability Index (ESI) tracks a diverse set of socioeconomic, environmental, and institutional indicators that characterize and affect environmental sustainability at the national scale.

Regional Quality of Development Index (QUARS) is an index of variables that represent different dimensions of quality of development.

2.23 Indicators ‘supplementing’ GDP

The indicators that can serve as a complement to GDP are System of Economic Environmental Accounts (SEEA), National Accounting Matrix including Environmental Accounts (NAMEA), German Environmental Economic Accounting (GEEA), System of Economic and Social Accounting matrices and Extensions (SESAME). By using one of them, GDP is not adjusted or replaced by creating new indicators but complemented with additional environmental and/or social information.

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3.0 CONCLUSION

GDP is a simple indicator. It can be used to calculate many relevant economic measures. For example, measures tax revenues and productivity. It also helps estimates the output gaps and inflation. Therefore, it is widely used to measure an economy”s performance.

However, GDP is just a ”gross” concept. It includes depreciation or the replacement of depreciated capital. However, the depreciation will not bring benefits to human. Replacement of the physical capital just brings the economy back to the origin. Besides that, it measures the total product produced in a country, but does not measure the total income received by the people in country. Some of the income included in GDP may produce by and go to foreigners.

There is a strong correlation between GDP levels and components of basic welfare such as high literacy rates, better nutrition and health care, communications technology and life expectancy. Nevertheless, the positive correlation between welfare and GDP is conditional. Other than that, well-being is influenced by many other aspects. Non-economic aspects such as good health and education, a clean environment and safe streets are also contributed to individuals” overall well-being.

Therefore, GDP is still insufficient in measuring well-being. Economists should not rely only on GDP to measure well-being. They should use other indicators to measure well-being in different dimensions.

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