What is GDP?
Let’s do a quick review of what Gross Domestic Product (GDP) is.
G= Government spending
(X-M)= Net Exports (exports minus imports)
GDP represents the total dollar value of all goods and services produced within the economy. Typically it is used to assess the overall health of the economy by comparing changes in GDP from the previous year or quarter. For example, you might hear a headline like “GDP is up 3% compared to last year”.
GDP is also used to give us a relative measure of how bad things might be going. Economists define a recession as two consecutive quarters of negative economic growth, as measured through GDP.
GDP has become the most widely accepted measuring stick for how the economy is doing. But GDP has its shortcomings.
A poor measure of well being
GDP remains a good measurement of the total dollar value of the production of goods and services in the economy. However, it is a very poor indicator of the total welfare of a country or its citizens. One of my economics professors summed up how meaningless GDP can be with the following example.
If the government of any country was to pay people to continually dig holes and then immediately fill them back up, this would represent a positive contribution to national GDP. It would not, however, increase the well being of anyone living in the country (with the possible exception of the hole diggers and the hole fillers who now have employment).
GDP also fails to capture the impacts of income inequality. If we were to hear a headline that said “GDP increased by 15% this year, compared to last” we might come away with the assumption that the well being of the average citizen has increased significantly. However, that is not always the case.
To illustrate, consider an extreme example where 100% of the increase in GDP was the result of the government contracting one mega-corporation to dig and refill holes throughout the entire country, all year. The mega-corporation and to a small extent, its hole diggers, would enjoy the benefits of increased GDP while the rest of us would be no better off.
Increased GDP does not always mean that everyone in the economy is doing better. However, as I have written previously if everyone in the economy was doing better, it would have tremendously positive impacts on GDP.
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Environmental factors and other negative externalities
Negative externalities are the costs suffered by an unrelated third party resulting from an economic activity.
To illustrate let us once again return to the example of the government paying people to dig holes. Imagine instead, a hypothetical world where the people were paid to dig holes, dump toxic waste inside the holes, and cover the hole back up. As we have learned, this would represent a positive contribution to national GDP.
This activity could lead to severe health consequences for people living near these toxic waste-filled holes. The health consequences (the cost) suffered by the people living near the holes (the unrelated third party) would represent a negative externality not accounted for in the calculation of GDP. As we can see GDP is an imperfect measure of welfare.
GDP falls short in the digital economy
GDP’s shortcomings to represent people’s well being do not need to be as dramatic as contracting an illness from a hole filled with toxic waste. A much more subtle failure of GDP is its inability to fully account for how technology increases the welfare of consumers.
At the end of the day, GDP is simply a counting stat. Its usefulness is limited to our ability to measure the value of the goods within the economy. As explained in The Economist:
“That equation (GDP) worked pretty well when the economy was still mostly farms and factories, producing things of similar quality that could easily be counted. But GDP is less suited to the task of measuring modern, service-led economies that are geared towards the quality of consumer experience, rather than consumption of greater quantities”
In today’s economy, online companies such as Google do not (directly) charge the consumer for using their service. You can open a Gmail account for free and communicate with people all around the world. You could send 1,000 emails a day and there would still be no cost. Compare this to communications 100 years ago, the costs (and time) associated with sending physical letters to people.
While buying stamps and paying a delivery charge to send a letter does register in GDP, opening your browser and quickly sending an email does not register in GDP. The benefits the consumer receives from many online services are not captured by GDP. Our lives are made easier and more productive by the many online services we have available to us today, but that is not fully captured by GDP.
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