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AP®︎/College Macroeconomics
Course: AP®︎/College Macroeconomics > Unit 2
Lesson 2: Limitations of GDPLesson summary: The limitations of GDP
AP.MACRO:
MEA‑1 (EU)
, MEA‑1.B (LO)
, MEA‑1.B.1 (EK)
In this lesson summary review and remind yourself of the key terms and concepts about the limitations of GDP.
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 Terms | definition |
|---|---|
| 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 transactions | economic 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 inequality | when a disproportionate share of a nation’s income is earned by a small minority of households; for example, when the top 10, percent of households earn 80, percent 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. |
| sustainability | the 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 bads | any 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 capita | the 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 capital | the 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
- Do higher incomes and more output always equal a higher quality of life for the people experiencing such growth? Explain.
- 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?
- Choose an alternative measure of well-being and describe what it includes.
Want to join the conversation?
Discussion Question 1: Higher incomes and more output does not always equal a higher quality of life for the people experiencing such growth. For example, if more cars own cars, although the peoples' quality of life might be better, there might be more pollution in the air, affecting their health.
Discussion Question 2: If the top 10% of wealthy peoples' incomes go up, that would increase the nation's average income but not increase the income of the typical, median household.
Discussion Question 3: Happy Planet Index (HPI) is 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(6 votes)
Surely depreciation of capital is more a symptom of low growth rather than something that needs to be measured by GDP? In a growing economy, depreciating capital is replaced. This doesn't have to be directly, it can be replaced with newer technology or by the firm expanding into more profitable sectors. However, I would think that if GDP is increasing, capital investment will be being renewed, and vice versa. Thoughts?(1 vote)
Depreciation of capital is a symptom of the fact that things wear down. Whether an economy is growing or not, equipment wears out. Economic growth means that not only is equipment that is wearing out is being replaced, but even more equipment is being added on top of that replacement.(10 votes)
1. Higher incomes will not always equal a higher living standards because it highly depends on where you are spending your money and which tax bracket you are in. For example if 30% of your £50,000 annual income is spent on just taxes and an extra 15% is spent on necessity, then you barely got anything left to pay rent on time let alone buy yourself some normal or luxury goods. More outputs will also have the adverse effect on a nation if those goods and services are being purchased too quickly or they are being produced with a neglect on the environment.
2) If majority of the nation's wealth is held by the top 5% earners, then an increase in a nation;s average income will not lead to an increase in the income of the typical, median household.
3) An alternative measure of wellbeing would be the MPI. This is an international measure of acute multidimensional poverty covering over 100 developing countries. It complements traditional monetary poverty measures by capturing the acute deprivations in health, education, and living standards that a person faces simultaneously.(4 votes)- Aren't all the indices(indexes) like measures of economic development, not GDP and hence why would they be taken as limitations?(0 votes)
- GDP is not, strictly speaking, a measure of economic development. Its just a measure of how much stuff gets made. Other indices try to take a more holistic approach in measuring economic development, but none is perfect.(4 votes)
- How come the summary includes many key terms which have never been mentioned in previous lessons? Such as "real GDP", "Human Development Index", "Genuine Progress Indicator", "Happy Planet Index"(1 vote)
- these terms have been mentioned in the previous videos and hence not re-explained here.(1 vote)
- Can sb explain what is depreciation of capital please and maybe an example(1 vote)
- Do higher incomes and more output always equal a higher quality of life for the people experiencing such growth? Explain.
Ans : It is not always the higher incomes is, the higher quality of life will be. Based on the statistics , even the highest GDP of USA is not the highest quality of life that we could determine. Therefore the total GDP is not the absolute measurement of quality of life.
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?
Ans :
Choose an alternative measure of well-being and describe what it includes.
Ans : The Happy Planet Index (HPI) includes location , quality , severity , duration , timing , context , modifying factors , and associated signs and symptoms.
The Human Development Index (HDI) includes health, knowledge and standard of living.
The Genuine Progress Indicator (GPI) includes GDP + environmental and social elements ,such as pollution, crime , volunteerism.(1 vote) 
1. 50/50. In this video, quality of life is defined by the standard of health, happiness, security, and material comfort of an individual, a group of people, or a nation. A higher income can support people in terms of security and material comfort by purchasing inferior goods such as Tesla and Apple products. By producing more output, consequences such as the waste produced by factories need to be considered to ensure good health of the individual, groups or a nation.
2. Market inflation.
3. Happy Planet Index includes the measurement of quality of life.(0 votes)- Higher incomes and outputs do not always equal a higher quality life because those do not account for important factors such as the environment, health, and stress/community, and happiness.
If the increase incomes is as a result of goods and services not registered through the government like illegal activity or under the table payments, then the median household is not affected.
The Happy Planet Index measures the well being of people in different. On top of economic factors, they factor in things lie the environment, health, stress, and community.(0 votes) - Why are household production and the underground economy not included GDP calculations? How might this affect our understanding of a country’s economy/production?(0 votes)
- They're not included because they're not reported.
The non-reporting will result in the official GDP being lower than one which included such items.(0 votes)
