National Income – Limitations of using GDP as an Index of Welfare of a Country

# Limitations of using GDP as an Index of Welfare of a Country

@ Many goods an services contributing economic welfare are not included in GDP or Non-Monetary Exchanges –

1. There are many goods and services which are left out of estimation of national income due to practical estimation problems.

E.g. – the services of housewives and other members, productive activities for own self satisfaction and work, such as growing vegetables in house backyard for consumption purpose, doing other works at home which should be done by professional, such as fixing small electrical problems etc.

2. These are left on account of non availability of data and problem in valuation.

3. It is generally agreed that these items contribute to economic welfare.

4. So, if we depend only on the GDP, we would be underestimating economic welfare.

@ Externality –

When the activities of somebody result in benefits or harms of others with no payment received for the benefit and no payment made for the harm done, such benefits and harms are called externalities.

1. Activities resulting in benefits to others are  positive externalities and increases welfare, and those resulting in harm to others are called negative externalities, which causes decrease in welfare.

2. GDP does not take into account these externalities.

For example – Construction of a flyover or a highway reduces transport cost and journey time of the people who have not contributed anything towards its cost. Expenditure on construction is included in GDP but not the positive externalities coming from it. GDP and positive externalities both increase welfare. So, taking only GDP as an index of welfare understates welfare. Welfare is much more than what is indicated by GDP.

3. Similarly, GDP does not take in account negative externalities.

For example – factories produce goods but at the same time creates pollution of water, air and other types of pollution. This pollution harms people. The factories are not required to pay anything for harming people. Producing goods increases welfare but creating pollution reduces welfare. So, taking only GDP as an index of welfare overstates welfare. In this case, welfare is much less than indicated by GDP.

@ Change in the distribution of the income (GDP) may affect welfare –

1. All people don’t earn the same amount of income. Some earns more and some earns less, so there is an unequal distribution of income.

2. In case of rise in ‘per capita real income’ all people are not better off equally. ‘Per Capita’ is only an average. Income of some may rise less and of some by more than the national average (per capita). In some cases it may even fall.

3. It means that the inequality in the distribution of income may increase or decrease.

4. When it increases rich becomes even more richer and poor becomes more poor.

5. Utility of a unit (one rupee or one dollar) of income is more to the poor than the rich. Suppose, the income of the poor declines by one unit and that of the rich increases by one unit. In this case, decline in the welfare of the poor will be more than the increase in welfare of the rich.

6. So, if the rise in per capita real income unequally increases, it may lead to a decline in welfare.

@ All products may not contribute equally to economic welfare –

1. GDP includes different types of goods and services such as houses, clothes, food, law and order, defense services, police services etc.

2. Some of these goods and services contribute more to the welfare of the people such as food, houses, clothes etc. Other goods and services such as police services, military services etc, may contribute comparatively less and may not directly affect the standard of living of the people.

3. Economic welfare depends less on how much of goods and services are produced, but more on what kind of goods and services are being produced in the economy.

4. It means if the GDP rises, the increase in welfare may not be in the same proportion.

@ Contribution of some products may be negative –

1. GDP includes all the final goods and services whether it is milk or liquor.

2. Milk may provide immediate and ultimate satisfaction to consumers. While liquor may provide some immediate satisfaction, but because of its harmful effects on health it may lead to decline in welfare.

3. GDP includes only the monetary values of the products and not their contribution to welfare.

4. Economic welfare depends less on the volume of goods and services are consumed, but more on what kind or type of goods and services are being consumed in the economy.