GDP as a measure of welfare and its limitations

Overview

Defensive expenditure, GDP take no account of leisure time and purchasing power parity conversion improve international comparisons of GDP.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Why is GDP an incomplete measure of a country's standard of living even though it measures output accurately?

   Model answer

   GDP records the market value of goods and services produced, but welfare depends on much more than the quantity of output. It says nothing about how the output is shared out, how many hours people had to work to produce it, what environmental damage was caused, or what the output actually consists of. A rise in GDP is therefore consistent with living standards staying still or falling.

2. 2

   How does the distribution of income limit what GDP tells us about living standards?

   Model answer

   GDP is a total, and totals conceal how the output is shared. An economy in which the gains from growth accrue mainly to those already well off can record rising GDP while the incomes of the majority stagnate, so the typical household feels no improvement. Two economies with identical GDP per head can have very different levels of poverty and very different average welfare.

3. 3

   Why does unpaid work carried out within households cause GDP to understate the value of what an economy produces?

   Model answer

   Childcare, cooking, cleaning and care for elderly relatives are genuine services, but because no market transaction takes place they are not recorded. An economy in which such work is done at home therefore shows a lower GDP than one in which the same services are bought from firms. Paradoxically, GDP rises when a household starts paying for childcare it previously provided itself, even though no extra service is being consumed.

4. 4

   How does the hidden economy affect the reliability of GDP as a measure of activity?

   Model answer

   Cash-in-hand work, undeclared trading and illegal activity generate real output and real income, but they are deliberately concealed from the tax and survey systems that produce the statistics. GDP therefore understates true activity, and the size of the understatement varies between countries and over time. Comparisons are distorted whenever the hidden economy is larger in one country or one period than another.

5. 5

   Explain, with an example, how GDP can rise while welfare falls because of negative externalities.

   Model answer

   Output that generates pollution, congestion or resource depletion is valued in GDP at its market price, but the external costs it imposes on third parties are not deducted. An expansion of heavy industry that raises output while worsening air quality raises GDP and lowers the health of the population at the same time. GDP counts the benefit and ignores the cost, so it overstates the improvement in welfare.

6. 6

   What is defensive expenditure, and why does its inclusion make GDP a flattering measure of welfare?

   Model answer

   Defensive expenditure is spending undertaken to repair or protect against harm, such as clean-up after flooding, extra policing after a rise in crime, or medical treatment for pollution-related illness. It adds to GDP because services are being bought and sold, yet it only restores a position that has been lost rather than making anyone better off than before. An economy that suffers more damage can therefore record higher GDP.

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