Critique Of GDP As A Measure Of Economic Well-being

The limitations of using GDP as a measure of economic development

Economic growth is a short term view of the physical growth of the economy of a country. It is a pivotal part of the larger goal of the economic development of a country. Economic development of refers to the development of a economy from various aspects and is often measured in qualitative terms. The Gross Domestic Product of a country describes the total amount of goods and services produced within a given country. However, this data does not directly provide an idea of the impact on an individual and provide a limited understanding of the various aspects of development. For example, Gross Domestic Product per capita is an indicator of an increase in the national wealth. Higher happiness can be a result from a higher household income (GDP per capita) as it helps wipe out the stark deprivations such as food supplies. However, a higher income does not necessarily mean more happiness. In some cases, higher incomes can lead to more life style related diseases such as diabetes, eating disorders. (Helliwell, Layard, & Sachs, 2012)

1) Can Growth make us poorer?

The GDP of a country is often measured , as the total value of goods and services produced during a given year. Natural resources and human capital must be invested in order to achieve a given GDP growth. Natural resources are often limited and the production of natural resources , often, cannot be capped.

Figure 1 Total GDP as Aggregate of GDP of Country A and GDP of Country B

Source: Prepared by Author

Adapted from (Samuelson & Nordhaus, 2004)

Let us take an example of two countries, Country A and Country B. Country A has a GDP of $200 billion while country B has GDP of $150 Billion. However, in order to achieve the desired growth, Country A had to sacrifice a large part of its large forest, in order to achieve the desired growth. If the forest had been retained, the value of resources from the forest such as timber, silk and other natural resources would have added $75 billion , in the next five years.

In this calculation, Country A is better off, according to GDP as a measure of wealth. However, this measure did not put a value on the forest as an asset that has been retained. The Gross Domestic Product of a country does not account for goods that do not have a price or are intermediate goods. Moreover, GDP does not account for the negative externalities or net the social costs that were possibly accrued due to the production of the various goods and services in country i.e. it did not account for the intermediate goods that were sacrificed in order to achieve this GDP and possibly led to environmental damage. The GDP also, did not account for the possible social benefits or the possible positive externalities (such as better air quality) that could be achieved from maintaining the forest or natural resources. Country A would be better off only if the social costs of demolishing the forests would be less than the opportunity costs of the total benefits that would have provided by the forests were not cut down. Similarly, Country B would be better off only if the future value projected for the forests is greater than the net gains ie $50billion. (Lipsey & Chrystal, 2011) (Arrow, et al., 2011)

Negative externalities of GDP growth

According to Daly, (2013), “Even if it is theoretically possible that someday the marginal cost of

growth will become greater than the marginal benefit, there is no empirical evidence that this has happened yet.” The concept of Marginal Costs and Benefits can be explained with the help of the concept of negative externalities and deadweight costs.

‘Negative externalities’ are mathematically denoted as the deviation (negative) of Marginal Private Cost or (MPC) from the Marginal Social Costs. Lipsey & Chrystal, (2011) have explained private costs as “Private costs are those costs that are incurred by parties that are involved directly in the Economic activity”. Similarly, social costs have been explained as“Social costs are those costs that are borne by the society” Lipsey & Chrystal, (2011). Hence, Marginal Private Costs refer to the producer’ private s cost of producing the last unit produced or providing services to the last consumer serviced. Producers price goods according to ‘willingness to pay’ of consumers. The ‘Marginal Social Cost’ is the value of the impact that is borne by the society due to the production of that last unit of goods or services. Negative externalities reduce the social good i.e. they have a harmful effect or they cause inconvenience to the general public. (Lipsey & Chrystal, 2011). The diagram given below depicts negative externalities and the ‘loss of social good’ resulting from the producing goods and services. The Marginal Private Costs in the diagram below depict the cost of producing the good or service. Deadweight loss is the difference between the two. (Riley, 2005). The loss of social good is the loss of efficiency and this loss of efficiency is calculated a ‘deadweight loss’.

Figure2 Negative Externalities: Marginal Costs becoming greater than Marginal Benfits

Source: (Riley, 2005)

In figure 2, The Total GDP of a the two countries is reflected as the Total GDP. Although the GDP of the Country A is greater, it diminishes the total value of the GDP because of it’s limited Marginal propensity to save.

The GDP figure captures total value but does not capture the inequality between two countries or it’s overall effect on the world. Similarly, it does not capture the total inequality within the country. To understand the inequality other performance measures must be used.

Economic development for a very long time, had been measured in terms of Gross Domestic Product or the sum total of goods and services produced in a country. However, as economic data began to be available, the short-comings of a system of ranking countries based only on their economic performance within a given year were being noticed. (Bergh, 2008) In order to capture a more qualitative understanding of a nation’s ability to provide for its citizens or its wealth, more and more indicators were being developed. Currently, a bouquet of indicators are available , developed by a host of regional and international organizations, that help measure every aspect of a country’s well being. (Bergh, 2008) These include a plethora of variables including measures of national accounts, measures of inequality (income based, gender based, region based), measures of sustainable development, measures of political institutions etc.

Resource Curse refers to an economic paradox that geographical regions such as towns, villages or even countries that are blessed with greater number of natural resources are often, the most economically backward regions. They are on the negative side of regional imbalances.(Ji K. & W., 2014 )

Measuring qualitative aspects of development

Several researchers have tried to understand the possible reasons for this paradox. It has been observed that these countries are often ridden with conflict and authoritarian regimes. Additionally, they tend to have lower rates of economic growth and economic stability.

One of the possibilities for such a paradox is the assumption that resources naturally, signify greater wealth. However, for resources to be converted into wealth, they have to go through the economic systems of production. The resources must be extracted first. The process of extraction itself has large upfront costs. The consumers of these natural resources , may not, necessarily be the immediate surrounding population. The consumers of these resources must be delinked to the production process. Hence, the transformation from resources to wealth is governed by variety of exogenous factors. The exogenous factors could be related to physical infrastructure or to non-physical factors such as institutions and policies. Institutions may refer to political and social institutions such as democracy, inheritances etc. while policies may refer to governmental policies such as policies on taxation, social spending etc. (Natural Resources Governance Institute, 2015)

The study is a very comprehensive examination od the regional imbalances in China due to the “resource paradox”. The four main contributions of the study are as follows:

Development of a subjective measure to understand institutional quality in china. Most studies relating to institutional qualities study the differences in political factors such as the differences in local governance or social institutions. In China, there is very little difference in the quality of these institutions since China has a Communist system that stresses upon uniformity. This study, therefore, uses the subjective, self reported, metric of quality of the judicial system. This sets the study apart from others because it highlights the fact that imbalances can be a part of the system , even when governance and social institutions are homogenous.. Additionally, the study measures various institutional variables such as the ongoing research and development etc.
The study takes both a stock assessment as well as a flow assessment to measure the wealth of resources. The stock approach describes the availability of natural resources and is more of a comparative measure.
The study takes a time varying approach to the problem by introducing dummy variables for policy shocks and introducing time as a variable.
The study also takes a co-efficient problem. The Co-efficient serves as a weightage to the impact of the resource on the overall estimation. Different resources many have different impacts on the equation. This study uses coefficients to account for that.
- The Data was considered from 28 provinces from Mainland China. The variability of resources was drawn from the statistical handbook and considered mineral resources to measure the resource abundance. The study took stock value as well as the flow of value approach to analyses of data to understand the wealth of resources, although results were presented only for the flow of revenues generated from the resources. The study considered various economy related variables such as economic growth, quality of institutions, the research and development in industries, employment in private sector, foreign investment and initial economic development.

The key differentiating factor, however, that sets this study apart from several others is the assignment of institutional quality. The political institutions of China, being Communist in nature, the institutional quality is uniform all over the country. Similarly, in the absence of religion or caste based differentiation, the social institutional quality is also, very different. Hence, the perceptions like the quality of Courts and justice system was used as a proxy to rate the institutional quality.

The paper examines the effects of the abundance of natural resources in China on growth at the provincial level. The study models an non-linear effct of resources on economic growth while placing an emphasis on the availability of quality of institutions as a determining factor. The study has found that there was a positive co-relation between economic growth and abundance at the provincial level. The co-relation between resource abundance and institutional quality was weak. This implies that the abundance if natural resources This implies that there must be some partial support for the theory of resource paradox. The findings of this study are in contrast with other cross sectional studies conducted in other countries. However, in the short run, the correlation between natural resources and economic growth is not stable.

Policies are shown to play an important role in the relationship between resource abundance and economic growth as policies can act as a catalyst in ensuring that the revenues from the natural resources translate into greater growth for the provinces.

The authors also note that linear models are not good estimators if the linkages between economic growth and resource abundance.

In the two period model, marginal user cost rises steadily. This trend is retained when the two period model is extended to N number of periods. However, the consumption will be slower as the expected demand for future will be higher. Hence, the cost of user curve will tend to be flatter than in the two period.(Tietenberg & Lewis, 2015)

Figure 2 Marginal Extraction Cost for N Periods