Gross Domestic Product, Explained

Gross Domestic Product (GDP) is the most commonly used tool to refer to the size of an economy. It is, in effect, assumed to indicate the well-being of any given country. Born in the manufacturing age, the tool’s failure to count for environmental costs, unpaid work, technology benefits, and the informal economy, have conceded economists’ widespread debate around the dethronement of GDP as an indicator of economic and social success. To understand how this tool fails to paint a comprehensive picture of a country’s well-being, an explanation of GDP as a concept is first necessary.

GDP measures the aggregate value of all final goods and services produced in a specific country during a given period and can be calculated using three different methods: the production approach, the expenditure approach, and the income approach. The first method adds the value-added (total sales value minus the value of intermediate inputs) by all producers; the second method adds all spending on domestically produced final goods and services; and the third method adds all income paid to the country’s factors of production. All approaches are equivalent. The standard formula uses the expenditure approach by summing individual consumption expenditures plus business investment plus government expenditure plus net trade (exports minus imports): C + I + G + (X – M).

There are several ways to report the GDP figure of a country. Those interested in comparing the GDP of an economy by year use real GDP, which calculates the value of all final goods and services produced using the prices of a base year and a price deflator to adjust for inflation. Others interested in the percentage increase in GDP from quarter to quarter refer to the GDP growth rate, which changes with the four phases (peak, contraction, trough, expansion) of the business cycle. Those interested in comparing GDP between countries use real GDP per capita, which calculates the total economic output divided by the number of people of a country using the prices of a base year and a price deflator to adjust for inflation per the real component.

Considering its methodology, the use of GDP as an indicator of well-being is often misleading. A critical limitation from the tool is the fact that it depends on government data and is unable to count for non-organized market transactions like household production, volunteer work, and the informal market. Likewise, GDP cannot differentiate between bad and good expenditure, counting all consumption and investments as equivalent under the welfare assumption. In the case of an extreme weather event, GDP increases besides mitigation and adaptation expenditure regardless of the short-term and long-term damages incurred. And as the tool does not consider the distribution of goods, a significant omission for a welfare indicator, it does not account for the wealth and social equity component of who is most affected. Factors like time for leisure and individual technology benefits, such as the gains from a free app that provides traffic updates or weather forecasts, are also not recognized.

Counting for other factors, indicators like the Human Development Index, the Genuine Progress Indicator, and the Happy Planet Index exist. While none of the alternatives to GDP are perfect, a complete examination of other tools is necessary to paint a more accurate picture of any given country’s well-being.

About Alessandra

Alessandra is a second-year student double majoring in Economics and Environmental Policy & Decision Making with a minor in Global Development Studies. She graphs economic models and curves with crayons.

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