How is GDP measured and what are its limitations as a measure of the quality of life?

Gideon Krotosky Macroeconomics coursework Spring 2004 EC1001

Lecturer- John Heaman Tutorial – Peter Wilks BSc Economics and Accountancy

Q. How is GDP measured and what are its limitations as a measure of the quality of life?

A. Gross Domestic Product (GDP) can be defined as the annual value of output produced by factors of production within a nation’s border. In other words, it is the sum of all incomes earned by the country’s residents when producing goods and services with resources located inside that country.

GDP is not to be confused with Gross National Product (GNP), which measures the flow of output produced with resources, which are owned by the nation wherever they might be located. The difference between GDP and GNP is net property income from abroad. The word “gross” in both of these measures of national income, indicates that no account has been taken of depreciation.

There are 3 methods of calculating GDP: the product/output method, the income method and the expenditure method. In theory, because they all claim to measure the same aggregate, they should all give the same total. This is shown below in the circular flow of income:

However, in practice, this is unlikely to be the case. This is because extremely large sums arising out of millions of transactions paid over different time periods are being dealt with and it would therefore be very unlikely if all 3 measures coincided.

The first way of measuring GDP is to add up annually all the value of the goods and services produced in the country, industry by industry. This is known as the output or product method. When accumulating the output of firms, it is crucial to avoid double counting. This occurs because the outputs of some firms are the inputs of other firms causing duplication and an inflated figure for GDP. Double counting can be avoided by either adding together the final value of output produced or by summing the value added at each stage of production. For example, suppose a firm makes £100,000 worth of furniture in a year, but in doing this, it buys supplies worth £40,000 from other firms. Of the total sales of £100,000, the component that our furniture firm is responsible for – the firm’s value added – is £60,000. This is what is added to GDP – the value added from each firm. It generates equivalent amount of factor incomes. Regardless of the method used to obtain the output value, the additions to stock and work in progress must be included in the output figures for each sector.

Other adjustments to the output figures are required in order to obtain a more accurate value of GDP using this method. These include:

Stocks – it is very important only to include the values added in the particular year in question and not to include stocks carried over from previous years. The value of stocks can fluctuate with market forces and an appropriate adjustment should be made.

Public and merit goods –these are provided through the non-market sector and examples include the police service and health care. These types of goods do not have a market price because they are not sold through the market sector even though they are clearly part of the nation’s output. Consequently, the value of output is measured at factor cost i.e. the value of the service is assumed to be equivalent to the cost of the resources used to provide it.
Imports and exports – not all of the nation’s output is consumed domestically, and part is sold abroad as ...

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Public and merit goods –these are provided through the non-market sector and examples include the police service and health care. These types of goods do not have a market price because they are not sold through the market sector even though they are clearly part of the nation’s output. Consequently, the value of output is measured at factor cost i.e. the value of the service is assumed to be equivalent to the cost of the resources used to provide it.
Imports and exports – not all of the nation’s output is consumed domestically, and part is sold abroad as exports. Nevertheless, GDP is the value of domestically produced output and so export earnings must be included in this figure. Correspondingly, the value of imports must be deducted.
Self provided commodities – things like car repairs and home improvements done on a do-it-yourself basis represent output produced, but as they have no market value and must also be omitted in the calculation of GDP.

The second method of calculating GDP is the income method. Using this method, the value of incomes received from production i.e. gross factor incomes are calculated. The most important factor incomes, which contribute to national income, are wages from direct labour and salaries from managerial labour. These payments are in return for the factor of production “capital”. Added to this, is rent-which is in return for land along with interest, dividends and other profits which are in return for the factor of production “entrepreneurship”. The reasoning behind this is that only those incomes paid on return for some productive activity for which there is a corresponding output, are included in national income.

A major problem with measuring GDP using the income method is that care must be taken to avoid including transfer payments. Transfer payments are monies transferred from one person or group to another without any production taking place. Examples include retirement pensions and sickness benefits.

Another adjustment, which needs to be made when using the income method, is that of stock appreciation. This is as explained above in the output method.

As only those incomes generated through the production of a marketed output are included, private transfers of money as well as income not registered with the Inland Revenue e.g. the black market, are also both excluded from the account.

The final way of calculating GDP is the expenditure method. This is the sum of the final expenditure on domestically produced goods and services measured at market prices. In order to avoid the danger of double counting, only expenditure on final output is totalled. GDP at market prices (or aggregate demand) is measured using the following formula:

GDP (at market prices)= C+ I+ G+(X-Z)

Where:

C= consumption expenditure

I= investment expenditure

G=government expenditure

X=exports

Z= imports

As seen, this method adjusts for the balance of trade. This is because export sales represent domestic output and therefore create income in that country. However, expenditure on imports is spending on any goods or services, which are produced in a foreign country, and therefore it creates income for those in the foreign country. As a result of this, it is deducted.

The main adjustments for the expenditure method include:

Taxes and subsidies – the expenditure total is adjusted to factor cost by deducting indirect taxes and adding subsidies. This is done in order to avoid a discrepancy between the income and expenditure totals. Indirect taxes raise total expenditure on goods and services relative to the amount received by the factor of production, and subsidies have the reverse effect.

Additions to stock and work in progress – these represent investment. The factors of production, which have produced this unsold output, will still have received factor payments. By ignoring additions to stock and work in progress, an imbalance between the 3 aggregates of output, income and expenditure would have been created; therefore, additions to stock and work in progress are treated as though firms have purchased them.

Great interest is attached to measured values of GDP. Governments, investors and citizens gauge the success of their economies by how its GDP changes over time. Movements in the national income are often used to indicate changes in the quality of life but care must be taken in using figures for this purpose. It has many limitations:

(1) Economic bads and externalities: some of the undesirable effects of economic growth may actually increase GDP. Examples of economic bads include disease, crime and environmental damage, and economic growth may lead to more of all of three. Increased disease leads to more medical spending; higher crime rates lead to more expenditures on police and increased environmental damage leads to more expenditure on environmental clean-up. These all add to the value of GDP.

Externalities are “spill-over” costs, which are not accounted for in the calculation of national income. Issues like pollution, congestion and the ozone depletion are the by-products of a rising national income, and if they were taken into account, the net benefit of industrial production might be much less.

(2) Income distribution: Two countries may have the same national income figures, but the average quality of life will be very different if in one, the income is evenly distributed while in the other, income distribution is very unequal. A typical feature of many rapidly growing countries is that some people grow very rich, while others get left behind resulting in increasing inequality e.g. Middle East oil sheikhdoms.

(3) The black economy/non-market activity: the black economy consists of illegal and hence undeclared transactions, which are omitted from GDP measurements. The most common example is to work and be paid in cash avoiding income tax. Studies of the scale of the black economy show that its importance has been growing in recent years. Estimates have put the black economy in Britain at about 7% of GDP and according to a survey in the Economist, whilst Nigeria and Thailand have the world’s largest black economy accounting for more than 70% of official GDP. Because such transactions go unreported, they are omitted from GDP hence limiting the accuracy of GDP statistics. Problems arise because many services are performed neither by the government nor the market and therefore do not appear in the national income figures. Examples of these include housewives, nannies and do-it-yourself jobs.

(4) Leisure and working hours: if production increases, it may be due to technological advance. If however, it increases at the expense of leisure time as a result of longer working hours, its net benefit will be less. Leisure and pleasant working conditions are desirable entities but these items are not reflected in the GDP figures.

(5) Consumption and investment: if an economy devotes many resources to satisfying their short term needs and wants of consumers, there may be insufficient resources for investment needed for long term economic development. Conversely, if GDP rises as a result of a rise in investment spending, this will not lead to an increase in current living standards; rather, it will help to raise future consumption. For this reason, GDP can be misleading.

(6) Population changes: as population usually grows over time, using just GDP would be an inaccurate measure of living standards. This is because if for example national income rose by 5% accompanied by an 8% increase in population, it probably means that the average standard of living has fallen in real terms. So, when living standards are being compared, GDP per capita is used (GDP divided by population).

So, in summary, GDP does have many limitations as a measure of the quality of life and is at best a crude approximation of living standards. However if key adjustments are made, its usefulness is enhanced.

There are though, other indicators, which are more useful in measuring the standard of life. One of these is the Human Development Index (HDI). This is an average of three indices based on three sets of variables: life expectancy at birth, education (a weighted average of adult literacy [two thirds] and average years of schooling [one third]), and real GDP per capita, measured in US dollars at purchasing power parity exchange rates. Countries are then placed in one of three groups according to their HDI: high human development (0.8 to 1.0), medium human development (0.5 to 0.799) and low human development (below 0.5).

The HDI has a number of functions. These include:

• To capture the attention of policy makers and the media and to draw their attention away from the more usual economic statistics to focus instead on human outcomes.

• To question national policy choices - asking how two countries with the same level of income per person can end up with such different human development outcomes (HDI levels). For example, Vietnam and Pakistan have similar levels of income per person, but life expectancy and literacy differ greatly between the countries, with Vietnam having a much higher HDI value than Pakistan. Such contrasts stimulate debate on government policies on health and education.

• To highlight wide differences within countries, between provinces or states, across gender, ethnicity and other socio-economic groupings. Highlighting internal disparities along these lines has raised national debate in many countries.

In my opinion though, the HDI alone is not enough to measure accurately a country's level of development or its quality of life. This is because the concepts of human development and quality of life are much broader than what can be captured in the HDI. The HDI, for example, does not reflect political participation and regional or gender inequalities. HDI and the other composite indices only offer a broad proxy on the issues of human development, gender disparity, and human poverty. A fuller picture of a country's level of human development and its quality of life would in my opinion requires the analysis of the HDI in conjunction with a combination of other development indicators and information.

In contrast to the use of HDI measuring living standards, GDP cannot be used to measure human development because of the HDI because it only reflects average national income. It tells nothing of how that income is distributed or how that income is spent - whether on universal health, education or military expenditure. Comparing rankings on GDP per capita and the HDI can reveal much about the results of national policy choices. For example, a country with a very high GDP per capita such as Kuwait, who has a relatively low level of education attainment, can have a lower HDI rank than, say, Uruguay, who has roughly half the GDP per capita of Kuwait.