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Shortcomings of GDP

Understanding the shortfalls of GDP and exploring alternative metrics

What is Gross Domestic Product (GDP)?

Gross Domestic Product (GDP) refers to the total economic output achieved by a country over a period of time. While GDP is generally a good indicator of a country’s economic productivity, financial well-being and standard of living, it does come with shortcomings.

 

Gross Domestic Product

 

What are the Limitations of Using GDP?

Some of GDP’s shortcomings as an economic indicator are below:

 

Underground Economy

The underground economy (or black market) refers to cash and barter transactions that are not formally recorded and are often used to support the trade of illegal goods and services (i.e., drugs, weapons, prostitution, etc.). The scale of underground economies vary greatly between nations, and in some cases, they make up a substantial percentage of a country’s economic output.

The underground market is almost impossible to keep reliable accounts on and due to its illegal nature, it is rarely incorporated into a nation’s published GDP figure. Thus, some nations’ economic output may be understated by GDP.

 

Environmental Abuses

Often, producers can increase their output by giving less consideration to the environment. In developed countries, production is strictly regulated and companies that violate environmental laws could face severe fines and penalties.

However, many developing economies rely on this high output to support the growth of their own economies. Nonetheless, there is a consensus that such environmental damage should be counted against a country’s GDP since they are not conducive to achieving a sustainable production situation.

 

Increases in Product Quality

As technology advances, producers are able to offer increasingly better products for the same amount of money. For example, smartphone manufacturers may be producing phones with better cameras, more advanced processors and higher quality displays. Thus, consumers experience higher utility than before without being faced with proportionately inflated prices. Such advancements are not counted in GDP since relative utility gains are difficult to quantify.

 

Non-Market Production

Non-market production refers to goods and services that are produced for private consumption, and for which exist no official record of production. For example, consider people who grow their own food or manufacture their own electricity.

Similar to the black market economy, it is almost impossible to keep reliable accounts on the size of the sector. The sector’s size also varies greatly between countries. For instance, the GDP of countries with many subsistence farmers will be understated, whereas, in economies with less subsistence farming, GDP wouldn’t be as affected.

 

Gross Domestic Product Limitations

 

Alternatives to GDP

 

Gross National Income (GNI)

GNI is a similar measure to GDP, except that it factors in net national income. Net national income is the total net income that a country earned over a certain time period from other countries. The figure is referred to as the Net Factor Income from Abroad (NFIA).

For instance, if Country A is home to a major multinational’s headquarters (i.e., reports earnings in this country), and that company oversees operations that generate profits of $100 million in Country B, then Country A’s NFIA would be $100 million. It would in turn cause GNI to rise by $100 million. The equation to calculate GNI is:

 

 

Where:

GDP – Gross Domestic Product

FIAin – Factor Income from Abroad “In” (i.e., receivables from abroad business)

FIAout – Factor Income from Abroad “Out” (i.e., payables from abroad business)

(FIAin – FIA out) – Net Factor Income from Abroad (NFIA)

 

Green Gross Domestic Product (GGDP)

GGDP essentially penalizes a country for employing manufacturing practices that harm the environment. Such practices are seen as being unsustainable and thus many believe that they should be counted against a country’s GDP.

 

 

Where:

GDP – Gross Domestic Product

g – Negative environmental impact ($)

 

More Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

  • Economic Indicators
  • Gross National Product
  • Inflation
  • Supply and Demand

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