Limitations of GDP as an Indicator of Welfare

Gross Domestic Product (GDP) is essentially an indicator of aggregate economic activity. In addition to that it is also frequently used to describe social welfare. The idea behind this is that GDP tends to correlate with consumption, which in turn is commonly used as a proxy for welfare. In other words, the more people consume, the happier they are supposed to be.

Now, this line of argument seems a little too simplistic. Assuming causality based on a simple correlation between GDP and welfare may lead to false conclusions which can be highly problematic especially for policy makers. Hence it is important to look at the limitations of GDP as a welfare indicator and to consider possible alternative approaches. 

Limitations of GDP

There are several limitations of GDP as a welfare indicator. Most of them can be traced back to the fact that in essence GDP is not supposed to measure well-being. As a result the concept does not account for various important factors that influence social welfare. To keep things simple the most relevant limitations are listed below:

• GDP does not incorporate any measures of welfare: This is probably the most obvious issue. As mentioned before, GDP only describes the value of all finished goods produced within an economy over a set period of time. There are multiple ways to calculate and measure GDP, but neither of them includes any indicator of welfare or well-being. Even though this does not necessarily mean GDP cannot be a good indicator of welfare, the fact that it is used as a "proxy of a proxy" should be kept in mind as it significantly affects its validity.
• GDP only includes market transactions: As a result, it does not account for domestic or voluntary work, even though these activities have a considerable positive impact on social welfare, as they complement the market economy and thus improve the standard of living. On the other hand GDP does not include black market transactions or other illegal activities that may have a substantial negative impact on overall social well-being.
• GDP does not describe wealth distribution: If there is a high degree of wealth inequality, the majority of people do not really benefit from an increased economic output because they cannot afford to buy most of the goods and services. Thus to accurately describe social welfare it is essential to consider wealth distribution.
• GDP does not describe what is being produced: Since GDP measures the value of all finished goods and services within an economy, it also includes products that may have negative effects on social welfare. Think of a country with an extremely strong armaments industry that represents most of its GDP. If the arms are sold and used within the country itself, overall social welfare will most likely decrease. Of course this also holds true for other goods and services that may have adverse effects on society.
• GDP ignores externalities: Economic growth usually goes hand in hand with increased exploitation of both renewable and non-renewable resources. Due to this overuse, more and more negative externalities arise (e.g. pollution, overfishing) and social welfare will decrease as a result. This effect is not included in GDP at all.

If we look at these aspects, the major issue with GDP as a welfare indicator becomes quite obvious. It suggests that a higher GDP always increases social well-being. However at one point the positive effects resulting from the increase in consumption opportunities may be outweighed by the negative effects associated with the limitations mentioned above. Hence although GDP may on certain occasions be a good proxy for social welfare, it results in a biased description that may lead to unfavorable conclusions.

Alternative approaches

In view of the shortcomings mentioned above there have been various attempts to develop more accurate and reliable indicators in order to measure social well-being. Among others these alternative approaches include the Human Development Index (HDI), the Gross National Happiness Index (GNH), and the Social Progress Index (SPI).

• Human Development Index: An indicator that focuses specifically on people and their capabilities to assess the development and welfare of a country. In particular, it measures achievements in three critical dimensions: health and life expectancy, education, and standard of living. The latter is measured by gross national income per capita. Thus HDI also includes an indicator of economic activity, but it adds two complementary dimensions which results in a more comprehensive description of social welfare.
• Gross National Happiness Index: An index that takes a holistic and psychology based approach to measuring social welfare. It was developed in Bhutan and builds on four pillars: governance, socio-economic development, cultural preservation, and environmental conservation. These four pillars are further classified into nine areas and measured by 33 specific indicators. The large number of distinct indicators used in this concept allows for a very sophisticated analysis.
• Social Progress Index: An extensive framework that is based on three key dimensions: basic human needs, foundations of well-being , and opportunity. Again, social progress for each of those dimensions is measured by a multitude of indicators. Those include but are not limited to: nutrition, medical care, and safety (basic human needs), education, wellness, and sustainability (foundations of well-being), and personal rights, freedom, and tolerance (opportunity).

All these approaches take into account multiple dimensions to provide a more comprehensive description of social welfare. Although it is not feasible to completely replace GDP as a welfare indicator anytime soon, it could be used in conjunction with these alternative approaches to provide more accurate and profound results.

In a nutshell

Despite several shortcomings GDP is commonly used as an indicator of social welfare. Most of the limitations are due to the fact that in essence the concept is not supposed to measure well-being. As a result, GDP fails to account for non-market transactions, wealth distribution, the effects of externalities, and the types of goods or services that are being produced within the economy. To compensate for these issues, different approaches to measuring welfare have been developed, including the Human Development Index (HDI), the Gross National Happiness Index (GNH), and the Social Progress Index (SPI).

Gross Domestic Product (GDP)

The Gross Domestic Product, also known as GDP, is arguably the most common indicator to describe a country's economic performance. Generally speaking it measures the total value of all goods and services produced in an economy over a set period of time (usually one year). It can be measured in nominal or real terms. 

There are three different approaches to calculating GDP: the value added approach, the income approach, and the expenditure approach. They should technically all lead to the same result, however due to estimation errors and minor inaccuracies that will hardly ever be the case in reality. Therefore it is important to be aware of the differences between the three approaches. We will look at them in more detail below.  

Value added approach

The first approach to calculate GDP is the value added approach (also known as production approach). It is the most direct but also the least efficient method as it measures the output of all economic sectors. In particular, GDP according to the value added approach equals the value of all goods produced in all sectors minus the value of all purchased intermediate goods for production (i.e. intermediate consumption). To calculate this the gross value of output resulting from domestic economic activity (VOGS) has to be estimated first. Afterwards, intermediate consumption (IC) can be determined and subtracted from the gross value to obtain GDP. We can illustrate this with a simple formula:

GDP = VOGS - IC

To give an example, we shall look at an imaginary country that only has two factories (factory A and B) that produce wooden tables. Over the course of a year 1'000 tables were produced in factory A and sold at a price of $100 each. The legs required to assemble the tables were produced by factory B and sold to factory A at a price of $10 each, while the tops were imported from a different country at a price of $20 each. In this case, the value  of goods sold adds up to $140'000 (1'000 x $100 + 4'000 x $10) and intermediate consumption adds up to $60'000 (1'000 x $20 + 4'000 x $10). As a result, GDP amounts to $80'000 ($140'000 - $60'000). Note that the value of the table legs is only counted once (for factory B) where it is actually added.

Income approach

Another approach to measure GDP is the income approach. This method focuses on the sum of primary incomes (from labor, capital, land, and profit) to estimate GDP. The idea behind this is that firms need to hire factors of production to create all goods and services, thus the sum of primary incomes can be used as an indicator of economic output. In particular, all incomes from labor (W), rent (R), and interest (i), as well as remaining profits (P) have to be summed up to receive national income. Adding indirect business taxes (IBT) and depreciation (D) to the calculated national income will finally result in GDP. The formula for this looks as follows:

GDP = W + R + i + P +IBT + D

To illustrate this, we can go back to our imaginary economy. Let's assume the workers of the two factories earn a total of $5'000. The rent for all business facilities adds up to $10'000, and the private households earn a total of $5'000 worth of interest payments for lending their money to factories A and B. After paying these expenses, the factories still earn a total profit of $50'000. In this case national income is $70'000 ($5'000 + $10'000 + $5'000 + $50'000). By adding indirect business taxes of $5'000 and depreciation of $5'000, GDP also amounts to $80'000 ($70'000 + $5'000 + $5'000).

Expenditure approach

The last approach to calculate GDP is called the expenditure approach. It can be seen as the counterpart to the income approach, as it measures total spending on final goods and services (as opposed to earnings from them). At this point it becomes quite obvious why the different approaches should result in the same GDP value: according to the circular flow of income, economic expenditure by one party is ultimately always income for a different party. Thus, to calculate GDP according to the expenditure approach, all economic activities that result in the use of goods or services have to be added up. In particular, that includes private consumption (C), total investment (I), government spending (G), and net exports (exports - imports, NX). Again, we can illustrate this with a simple formula:

GDP = C + I + G + NX

Let's revisit our imaginary country again. We assume that private consumption amounts to $50'000. Total investment shall be $30'000, and the government spends $20'000. Last but not least, net exports are -$20'000, because factory A imports intermediate goods worth $20'000 and there are no exports (0 - $20'000). Thus, Once again GDP amounts to $80'000 ($50'000 + $30'000 + $20'000 - $20'000).

Nominal vs. real GDP

Calculating GDP according to one of the three approaches described above will result in a nominal value. That means it is calculated in historical monetary terms without any further adjustments. At this point it is important to note that comparing annual nominal GDPs can be problematic and lead to false conclusions due to changes in the overall price level (i.e. inflation) that are not taken into account. Therefore we generally use the real GDP to compare economic output over multiple years, because it is adjusted for the effects of price level changes. In other words, real GDP uses the prices of a certain base year as a reference to value economic output and thereby eliminates the effect of inflation (or deflation).

To give an example, if the GDP of an economy increased from $80'000 last year to $81'600 this year, it appears as if the economic output had increased by $1'600 (2%). However, if the economy experienced an inflation of 1% over the year, the value of its output increased by $800 even if there had been no increase in actual (real) output. Thus if we adjust for the effect of inflation, real GDP (measured in the prices of the previous year) will only amount to $80'800.

In a nutshell

Gross Domestic Product (GDP) is an important indicator of economic performance. It measures the total value of all goods and services produced in an economy over a certain period of time. It can be calculated in three different ways: the value added approach (GDP = VOGS - IC), the income approach (GDP = W + R + i + P +IBT + D), and the expenditure approach (GDP = C + I + G + NX). If the indicator is used to compare multiple economic outputs within one year, GDP is usually calculated in nominal terms, whereas to compare annual numbers it is most commonly measured in real terms.

Fancy a spendup?

I really like Bill McBride's Calculated Risk blog, a great guide to what's happening to the US economy. Apart from the obvious coverage of the major macro stats, he's also got the gift of presenting the data well - I blogged before about his really impressive graph of the US labour market, and judging by the pageviews lots of others thought it was pretty neat, too - as well as the knack of finding data series that are somewhat off the beaten track but provide interesting insights into what's happening in America.

Here's his latest find, the Restaurant Performance Index produced by the National Restaurant Association and originally published here (where you can see the methodology of the thing). Bill calls it a "minor indicator", and he's right in the sense that it doesn't move markets or get much headline coverage in the business media, but that said, for me this is one of the best summary indicators of the US economy I've seen in ages.

You can see the GFC 'Great Recession', you can see the prolonged period from 2010-12 where double dips, treble dips and jobless recoveries were all in play, and then you see the more recent strong rise (particularly in 2014) where the US economy finally pulls free and starts to grow more strongly on a sustained basis. The Restaurant Performance Index is very closely aligned indeed with turning points in the overall economy, partly (as Bill notes) because it tracks largely discretionary spending decisions, which you'd expect (and you'd be right) would be highly sensitive to the economic cycle.

All of this got me wondering whether the monthly data Stats collects on electronic card transactions (latest example here) couldn't be turned into a roughly equivalent indicator for New Zealand,. One of the card series is electronic card spending on 'hospitality', which includes "accommodation, bars, cafés and restaurants, and takeaway retailing", which again is heavily discretionary and hopefully cyclically sensitive. It's unlikely to be as good a tracker as the American restaurant index, which is built up from a detailed industry survey, but it might show something interesting.

So I downloaded the series (it starts in October 2002 and at time of writing runs to November '14 - you can access it yourself on Stats' Infoshare, it's in the 'Economic Indicators' bit), ran a simple regression to eliminate the long term time trend, and looked at the residuals as a percentage of each month's hospitality spending. What you get is a graph that shows when spending on 'hospitality' is unusually strong or unusually weak, and it looks like this.

It's not too bad. There are oddities: I'm not sure why there's that cyclical weakness in 2003-05, which may be an artefact of how I've calculated the indicator (by construction there will be similar numbers of 'overs' and 'unders' whereas in real life expansion and contractions aren't the same length). But it catches the GFC and post-GFC weakness, and in particular it shows the strength of the current upswing. As far as the consumer is concerned, this is the best time for a bit of a spendup in the past dozen years.