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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 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 in GDP 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 estimate or value, 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 polluting or damaging the environment. In developed countries, production is better 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 sustainable production and may impact future growth.

 

Increases in Product Quality

As technology advances, producers are able to offer increasingly better products for reduced production costs. 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 exists 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 estimate the amount of this sector. The sector’s size also varies greatly between countries. For example, the GDP of countries with many subsistence farmers will be understated, whereas in economies with less subsistence farming will more accurately record GDP.

 

Gross Domestic Product Limitations

 

Alternatives to Gross Domestic Product

 

Gross National Income (GNI)

GNI is a similar measure to GDP, except that it includes net national income. Net national income is the total net income that a country earned over a specific 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 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 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:

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

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Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!