Economic Analysis

Module 6. National income

Lesson 28
IS GNP A GOOD MEASURE OF ECONOMIC WELL BEING?

28.1 Introduction

Advocates of the existing economic and social system often argue that market economies have produced a growth in real output because of the genius of free market. But GDP includes many questionable entries and omits many valuable economic activities.

Isn’t it true the GDP includes government production of bombs and missiles along with salaries paid to prison guards? Doesn’t an increase in crime boost sales of home alarms, which adds to the GDP? Doesn’t GDP fail to account for environmental degradation such as global warming?

In recent years, attempt to extend the boundaries of the traditional accounts by including important non market activities as well as correcting for harmful activities that are included as part of national output.

Many household activities valuable “nice-market” goods and services such as meals, laundering, and child-care services. Recent estimates of the value of unpaid household work indicate that it might be almost 50 percent as large as total market consumption. Perhaps the largest omission from the market accounts is the value of leisure time. Yet the value of leisure time is excluded from our official national statistics.

In addition to omitting activities, sometimes GDP omits some of the harmful side effects of economic activity. An important example is the omission of environmental damages. Our measure of output should not only add in the value of the electricity (which GDP does) but also subtract the environmental damage caused by the pollution (which GDP does not).

Considerable progress has been made in recent years in developing augmented national accounts, which are accounts designed to include both nonmarket and market activities. The general principle of augmented accounting is to include as much of economic activity as is feasible, whether or not that activity takes place in the market. Example of augmented accounts include estimates of the value of non-market investments in human capital, the value of unpaid home production, the value of forests, and the value of leisure time.

1. The national income and product accounts contain the major measures of income and product for a country. The gross domestic product (GDP) is the most comprehensive measure of a nation’s production of goods and services. It comprises the rupee value of consumption (C), gross private domestic investment (I), government purchases (G), and net exports (X) produced within a nation during a given year.

GDP = C+I+G+X

This will sometimes be simplified by combining private domestic investment and net exports into total gross national investment (I^T = I+X):

GDP = C+I^T+G

2. The flow-of-cost approach uses factor earnings and carefully computes value added to eliminate double counting of intermediate products. And after summing up all (before-tax) wage, interest, rent, depreciation, and profit income, it adds to this total all indirect tax costs of business. GDP does not include transfer items such as interest on government bonds or welfare payments.

3. By use of a price index, we can “deflate” nominal GDP (GDP in current prices) to arrive at a more accurate measure of real GDP (GDP expressed in rupees of some base year’s purchasing power). Use of such a price index corrects for the “rubber yardstick” implied by changing levels of prices.

4. Net investment is positive when the nation is producing more capital goods than are currently being used up in the form of depreciation. Since depreciation is hard to estimate accurately, statisticians have more confidence in their measures of gross investment than in those of net investment.

5. National income and disposable income are two additional official measurements. Disposable income (DI) is what people actually have left−after all tax payments, corporate saving of undistributed profits and transfer adjustments have been made−to spend on consumption or to save.

6. Using the rules of the national accounts, measured saving must exactly equal measured investment. This is easily seen in a hypothetical economy with nothing but households. In a complete economy, private saving and government surplus equal domestic investment plus net foreign investment.

7. Gross domestic product and even net domestic product are imperfect measures of genuine economic welfare. In recent years, statisticians have started correcting for nonmarket measure such as unpaid work at home and environmental externalities.

Inflation occurs when the general level of prices is rising (and deflation occurs when it is falling). We measure the overall price level and rate of inflation using price indexes−weighted averages of the prices of thousands of individual products. The most important price index is the consumer price index (CPI), which traditionally measured the cost of a fixed market basket of consumer goods and services relative to the cost of that bundle during a particular base year. Recent studies indicate that the CPI trend has a major upward bias because of index-number problems and omission of new and improved goods, and the government has undertaken steps to correct some of this bias.