Gross Domestic Product (GDP): A Meaningful Measure of Well Being?
Gross Domestic Product (GDP) Calculation
(courtesy of Wikipedia)
GDP was first developed by Simon Kuznets for a US Congress report in 1934. After the Bretton Woods conference in 1944, GDP became the main tool for measuring a country’s economic performance and has become a number much loved by governments and the media to summarise ‘how we are doing’.
The generally favoured formula in investment and economic media is
GDP = private consumption + gross investment + government spending + (exports − imports), or
GDP = C + I + G + (X – M)
But does it tell us anything meaningful about the well-being of a country’s economy?
1. Determining GDP
GDP can be determined in three ways, all of which should, in principle, give the same result. They are the product (or output) approach, the income approach, and the expenditure approach.
The most direct of the three is the product approach, which sums the outputs of every class of enterprise to arrive at the total. The expenditure approach works on the principle that all of the product must be bought by somebody, therefore the value of the total product must be equal to people’s total expenditures in buying things. The income approach works on the principle that the incomes of the productive factors (“producers,” colloquially) must be equal to the value of their product, and determines GDP by finding the sum of all producers’ incomes.
1.1 GDP by the Production Approach
This is defined as:
” Market value of all final goods and services calculated during 1 year . ”
The production approach is also called Net Product or Value added method. This method consists of three stages:
a). Estimating the Gross Value of domestic Output out of the many various economic activities;
b). Determining the intermediate consumption, i.e., the cost of material, supplies and services used to produce final goods or services; and finally
c). Deducting intermediate consumption from Gross Value to obtain the Net Value of Domestic Output.
Symbolically,
Net Value Added = Gross Value of output – Value of Intermediate Consumption.
Value of Output = Value of the total sales of goods and services + Value of changes in the inventories.
Subtracting intermediate consumption from gross output, we get Gross Value Added (GVA) at factor cost. Then add total sector gross value to get GDP at factor cost. Adding indirect tax minus subsidies in GDP at factor cost, we get GDP at Producer Prices.
1.2 GDP by the Income Approach
This is defined as:
” The sum total of incomes of individuals living in a country during 1 year .”
GDP calculated this way is sometimes called Gross Domestic Income (GDI), or GDP(I). GDI should provide the same value as the expenditure method described below. (By definition, GDI = GDP. In practice, measurement errors make this impractical when reported by national statistical agencies.)
This method measures GDP by adding incomes that firms pay households for factors of production they hire- wages for labour, interest for capital, rent for land and profits for entrepreneurship.
Two adjustments must be made to get to GDP:
a). Indirect taxes minus any subsidies are added to get from factor cost to market prices.
b). Depreciation (or Capital Consumption Allowance) is added to get from net domestic product to gross domestic product.
Total income can be subdivided according to various schemes, leading to various formulae for GDP measured by the income approach. A common one is:
GDP = compensation of employees + gross operating surplus + gross mixed income + taxes less subsidies on production and imports, represented as:
GDP = COE + GOS + GMI + TP & M – SP & M
Where;
- Compensation of employees (COE) measures the total remuneration to employees for work done. It includes wages and salaries, as well as employer contributions to social security and other such programs.
- Gross operating surplus (GOS) is the surplus due to owners of incorporated businesses. Often called profits, although only a subset of total costs are subtracted from gross output to calculate GOS.
- Gross mixed income (GMI) is the same measure as GOS, but for unincorporated businesses. This often includes most small businesses.
The sum of COE, GOS and GMI is called total factor income; it is the income of all of the factors of production in society. It measures the value of GDP at factor (basic) prices. The difference between basic prices and final prices (those used in the expenditure calculation) is the total taxes and subsidies that the government has levied or paid on that production. So adding taxes less subsidies on production and imports converts GDP at factor cost to GDP(I).
1.3 GDP by the Expenditure Approach
This is defined as:
” All expenditure incurred by individuals during 1 year . ”
The expenditure method of calculating GDP is based on measuring the total expenditure of money used to buy things as a way of measuring production.
Activity such as non paid work at home does not get counted as GDP because it is never sold.
Similarly, if there is a long term shift from non-market provision of services (for example cooking, cleaning, child rearing, do-it yourself repairs) to market provision of services, then this trend toward increased market provision of services may mask a dramatic decrease in actual domestic production, resulting in overly optimistic and inflated reported GDP. This is particularly a problem for economies which have shifted from production economies to service economies.
Within this method, there are variations on the theme. One example is:
GDP = private consumption + gross investment + government spending + (exports − imports), or
GDP = C + I + G + (X – M)
Where:
- “Gross” means that GDP measures production regardless of the various uses to
which that production can be put.
- “Domestic” means that GDP measures production that takes place within the
country’s borders.
- Private consumption (C) is normally the largest GDP component in the economy,
consisting of private (household final consumption expenditure) in the economy. These personal expenditures fall under one of the following categories: durable goods, non-durable goods, and services. Examples include food, rent, jewellery, fuel, utility bills and medical expenses. The figures do not include the purchase of new housing. The private investment and trade portions of the economy are ultimately directed (in mainstream economic models) to increases in long-term private consumption.
- Government Consumption (G), is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments, such as social security or unemployment benefits.
- Investment (I) covers new fixed assets or inventories, or depreciated fixed assets
replacement.
- Exports (X) represents the amount a country produces, including goods and services
produced for other nations’ consumption, therefore exports are added.
- Imports (M) represents gross imports and are subtracted since imported goods will be
included in the terms G, I, or C, and must be deducted to avoid counting foreign supply as domestic.
2. Limitations and Criticisms
Simon Kuznets, the economist who developed the first comprehensive set of measures of national income, stated in his first report to the US Congress in 1934, in a section titled “Uses and Abuses of National Income Measurements”.
“The valuable capacity of the human mind to simplify a complex situation in a compact characterization becomes dangerous when not controlled in terms of definitely stated criteria. With quantitative measurements especially, the definiteness of the result suggests, often misleadingly, a precision and simplicity in the outlines of the object measured. Measurements of national income are subject to this type of illusion and resulting abuse, especially since they deal with matters that are the centre of conflict of opposing social groups where the effectiveness of an argument is often contingent upon oversimplification.
All these qualifications upon estimates of national income as an index of productivity are just as important when income measurements are interpreted from the point of view of economic welfare. But in the latter case additional difficulties will be suggested to anyone who wants to penetrate below the surface of total figures and market values. Economic welfare cannot be adequately measured unless the personal distribution of income is known. And no income measurement undertakes to estimate the reverse side of income, that is, the intensity and unpleasantness of effort going into the earning of income. The welfare of a nation can, therefore, scarcely be inferred from a measurement of national income as defined above.”
In 1962, Kuznets stated:
“Distinctions must be kept in mind between quantity and quality of growth, between costs and returns, and between the short and long run. Goals for more growth should specify more growth of what and for what.”
Austrian School economist Frank Shostak has argued that:
“GDP is an empty abstraction devoid of any link to the real world, and, therefore, has little or no value in economic analysis.”
Says Shostak:
“The GDP framework cannot tell us whether final goods and services that were produced during a particular period of time are a reflection of real wealth expansion, or a reflection of capital consumption. For instance, if a government embarks on the building of a pyramid, which adds absolutely nothing to the well-being of individuals, the GDP framework will regard this as economic growth. In reality, however, the building of the pyramid will divert real funding from wealth-generating activities, thereby stifling the production of wealth.
So what are we to make out of the periodic pronouncements that the economy, as depicted by real GDP, grew by a particular percentage? All we can say is that this percentage has nothing to do with real economic growth and that it most likely mirrors the pace of monetary pumping. We can thus conclude that the GDP framework is an empty abstraction devoid of any link to the real world.”
