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.
What are the Limitations of Using GDP?
Some of GDP’s limitations 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 varies 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 can face severe fines and penalties.
However, many developing economies rely on high output to support the growth of their own economies and are less concerned with environmental issues. Nonetheless, there is a consensus that such environmental damage should be counted against a country’s GDP since it is 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 this 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.
Alternatives to Gross Domestic Product
Gross National Income (GNI)
GNI is a similar measure to GDP, except that it focuses on 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. This would in turn cause GNI to rise by $100 million. The equation to calculate GNI is:
Where:
GDP – Gross Domestic Product
FIAin – Factor Income from Abroad “In” (i.e., receivables from abroad business)
FIAout – Factor Income from Abroad “Out” (i.e., payables to abroad business)
(FIAin – FIA out) – Net Factor Income from Abroad (NFIA)
Green Gross Domestic Product (GGDP)
GGDP essentially penalizes a country for employing manufacturing practices that harm the environment. Such practices are seen as being unsustainable and, thus, many believe that they should be counted against a country’s GDP.
Where:
GDP – Gross Domestic Product
g – Negative environmental impact ($)
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 CFI resources:
