Lesson overview

Alas, nothing is perfect. And GDP is no exception. As much as economists like to use GDP as a measure of output, or even as a measure of a country’s well being, GDP has some limitations when trying to answer those questions. GDP leaves out some production in an economy, such as the squash your mom might grow in the backyard, or other non-marketed goods. Even though GDP is frequently used to capture the wellbeing of a society, it was never intended to do that, and as a result it leaves out important aspects of well-being like pollution or even happiness.

Key terms

Key Termsdefinition
quality of life(sometimes called “well-being”) the standard of health, happiness, security, and material comfort of an individual, a group of people, or a nation
non-market transactionseconomic activity that takes place in the informal sector (from babysitting, to lawn mowing, to illegal drug sales), sometimes called the gray market or the black market economy; non-market transactions are not recorded, taxed, or officially monitored by the government. Because of this, the output and income generated is not included in the calculation of a nation’s GDP.
income inequalitywhen a disproportionate share of a nation’s income is earned by a small minority of households; for example, when the top 10%10\% of households earn 80%80\% of the total income in a country, there is a high degree of income inequality; GDP does not account for income distribution in any way.
sustainabilitythe ability of a system to endure indefinitely into the future; an increase in GDP will only be sustainable as long as it does not deplete natural resources too rapidly nor exploit the environment in a way that diminishes the quality of life of the nation’s households over time.
economic badsany outcome from economic activity that creates negative value for society, such as air pollution from cars that harms human health and the environment; unsustainable economic growth may diminish the quality of life of a nation’s people.
real GDP per capitathe real gross domestic product of a nation, divided by the nation’s population; this measure is an indication of the average income of a nation’s people
depreciation of capitalthe decrease in the value of a nation’s capital stock over time; GDP accounts for investment in new capital but does not subtract the lost value of depreciated capital. Because of this, GDP may overstate the amount of economic activity in nations with rapidly depreciating capital stocks.
Human Development Index (HDI)a composite measure of nation’s social and economic development developed by the United Nations that includes measures of health, wealth, and education
Genuine Progress Indicator (GPI)a measure of a nation’s quality of life that includes the income and output measured by gross domestic product. This measure subtracts out the costs of negative effects related to economic growth such as crime, environmental degradation, resource depletion, and the costs of climate change. GPI nets the positives and negatives of economic activity to provide a more accurate measure of a nation’s quality of life than GDP alone.
Happy Planet Index (HPI)a measure of a nation’s quality of life that includes survey results on happiness, life expectancy at birth, the degree of inequality across society, and the ecological footprint

Key takeaways

The limitations of GDP

GDP is a useful indicator of a nation’s economic performance, and it is the most commonly used measure of well-being. However, it has some important limitations, including:
  • The exclusion of non-market transactions
  • The failure to account for or represent the degree of income inequality in society
  • The failure to indicate whether the nation’s rate of growth is sustainable or not
  • The failure to account for the costs imposed on human health and the environment of negative externalities arising from the production or consumption of the nation’s output
  • Treating the replacement of depreciated capital the same as the creation of new capital
Alternative indicators have been developed to provide a more well-rounded measure of a nation’s quality of life by different national and international organizations. These include:
  • The Human Development Index (HDI)
  • The Genuine Progress Indicator (GPI)
  • The Happy Planet Index (HPI)
Each of these indexes is a composite measure weighing both income and non-income variables such as life expectancy, literacy rates, environmental indicators, measures of inequality and so on. By including these variables, they provide a measure of life quality that goes beyond the narrowness of a nation’s GDP value.

Common misperceptions

  • Some people mistakenly think a higher income (and larger GDP) is correlated with a higher quality of life and more happiness, but only up to a certain income level. Some studies have actually found that beyond a certain income level, additional increases in income are no longer correlated with higher quality of life. Instead, other, non-income factors (such as the equity of income distribution and access to education and health-care) are more closely correlated with a happier, healthier society.
  • Some of the poorest countries in the world may actually appear poorer than they really are if we only consider their official GDP figures. If a large percentage of the workforce is employed in the informal sector, then their incomes will not be reflected in the nation’s GDP. As a result, the nation’s GDP will appear smaller than it would be if all economic activity were included.

Discussion questions

  1. Do higher incomes and more output always equal a higher quality of life for the people experiencing such growth? Explain.
  2. Under what circumstances would an increase in a nation's average income not lead to an increase in the income of the typical, median household?
  3. Choose an alternative measure of well-being and describe what it includes.
    The Human Development Index is a measure that was developed by economist Mahbub ul Haq with the goal of shifting attention away from measures like GDP to a more people-centric measure of well-being. Its uses measured that are meant to capture three dimensions of well-being: a long and healthy life, knowledge, and a decent standard of living.