Gross Domestic Product-Meaning, Uses & Limitations

# Gross Domestic Product-Meaning, Uses & Limitations

Gross Domestic Product (GDP) is the market value of the products made in an economy over a particular time period. It is usually published quarterly or yearly. GDP comprises the output made by both indigenous and foreign-owned producers operating within the country’s geographical boundary.

Nominal GDP and real GDP

Nominal GDP is GDP in money terms, i.e. goods and services are valued at the prevailing prices in the relevant year. Real GDP, on the other hand, is nominal GDP that has been adjusted for inflation. The GDP can increase if only prices rise, only quantities rise or both prices and quantities rise. Real GDP measures the change in the output produced in a country more accurately than nominal GDP since it removes the effect of rising prices on the value of a country’s output. An adjustment has to be made because the GDP can increase due to rising prices of goods and services in a country even though output has not increased. The goods and services in a particular year are priced at the base-year prices to eliminate the effect of inflation. Nominal GDP is also known as money GDP or GDP at current prices. Real GDP is also called GDP at constant prices.  In Table 1 below, nominal GDP increased from \$620,000 in year 1 (base year) to \$774,000 in year 2. Nominal GDP for year 1 is obtained by using year 1 prices and nominal GDP for year 2 is obtained by using year 2 prices. If rising prices were ignored in year 2, GDP actually decreased from \$620,000 to \$465,000 since the base period, year 1. The goods in year 2 are valued at the base year (year 1) prices to obtain the real GDP of \$465,000.

Table 1: Calculating real GDP using the prices in the  base year

 Year 1 (base year) Year 2 (current year) Quantity Price Quantity Price Petroleum 4,000 \$5 3000 \$8 Cars 2,000 \$300 1500 \$500

Nominal GDP in year 1 (using year 1 prices) = (4,000 x \$5) + (2,000 x \$300) = \$620,000
Nominal GDP in year 2 (using year 2 prices) = (3,000 x \$8) + (1,500 x \$500) = \$774,000
Real GDP in year 2 (using year 1 prices) = (3,000 x \$5) + (1,500 x \$300) = \$465,000

Alternatively, real GDP can be computed from the division of the nominal GDP by the GDP deflator. The GDP deflator removes the effect of inflation and shows how prices have increased compared to a base or reference period.

Real GDP = Nominal GDP
————————–
GDP deflator

where
GDP deflator = Price index in the current year
—————————————————
Price index in the base year

Therefore,
Real GDP = Nominal GDP   X     Price index in the base year
—————————————————
Price index in the current year

Calculating real GDP using GDP deflator

The nominal GDP of country X is £5,000,000. Calculate the real GDP if prices of goods and services have risen by 5% from the base year.

GDP deflator = 105       (current year index is 100 + 5)
——–
100    →   (base year index is 100)

= 1.05

Real GDP = £5,000,000
——————
1.05

= £4,761,905

GDP at current prices and GDP at constant prices

GDP at current prices is the economy’s output valued at the prices obtainable in the year under consideration. For instance, GDP at current prices for year 1 is the output obtained when the goods and services are measured at year 1 prices.

GDP at constant prices is the GDP that has been adjusted for inflation. For example, GDP at constant prices for year 1 is obtained when the goods and services of year 1 are valued at the ruling prices in a base year.

GDP at factor cost and GDP at market price

GDP at market price is measured using prices at retail outlets. The market price includes indirect tax but excludes subsidies.

GDP at market prices = GDP at factor cost + indirect taxes – subsidies

GDP at factor cost is GDP valued using incomes paid to factors of production. It adjusts for indirect taxes and subsidies. GDP at factor cost is also known as GDP at basic prices.

GDP at factor cost = GDP at market prices – indirect taxes + subsidies

Other national income statistics
GDP is the most common national income statistic. Other measures of economic performance derived from the GDP include Gross National Product (GNP), Net National Product (NNP) and Net Domestic Product (NDP).

GNP, also known as Gross National Income (GNI), is the total output produced by the country’s citizens and businesses irrespective of where they are located. It is derived from the addition of net property (factor) income from abroad (NPIFA) and the GDP.

GNP = GDP + NPIFA

Net property income from abroad is the difference between incomes earned by a country’s residents on their assets abroad and incomes on assets held in the country by foreigners.

NNP is GNP minus capital consumption allowance or depreciation (D). NNP considers the output of the indigenous entities after adjusting for a fall in the value of the economy’s capital. Capital consumption allowance is a provision made for the replacement of an economy’s capital that has fallen in value from wear and tear. Capital consumption allowance is subtracted from gross investment (IT) to give net investment (IN). Gross investment is the total amount spent on capital; net investment represents the addition to the economy’s capital or productive capacity having adjusted for capital consumption.   NNP is the most realistic figure for national income.

NNP = GDP + NPIFA -D

NDP is GDP minus capital consumption. It considers the total output of the economy after adjusting for a fall in the value of capital from wear and tear.

National Income (NI) can be defined as the total value of the goods and services produced by an economy or the total sum of incomes paid for the use of an economy’s productive resources in a given period. It can be determined by subtracting indirect business taxes from the NNP. Alternatively, it is obtained by adding rents, wages, interests and profits.

Personal Income (PI) is the sum of the incomes individuals receive in a country before the deduction of direct taxes. It includes employees’ compensation (wages, salaries and income from self-employment), rent, interest and profit, transfer payments, and dividends received by individuals. The items deducted include undistributed or retained corporate profit and employees’ contributions to social security.  PI minus income tax produces Personal Disposable Income (PDI)

The usefulness of  the GDP
For ascertaining the direction of the economy
The output or GDP of an economy is useful in determining the direction the economy is headed. Increasing output is an indication that the economy is growing while a fall in output for two consecutive quarters shows that the economy is in a recession. The government would need to know the state of the economy in order to formulate policies that can address any problem discovered.

For determining the performance of specific sectors of the economy
Apart from the general state of the economy, GDP can reveal the state of different sectors of the economy. This will determine the policies or actions that government would take in repositioning a troubled sector. For example, if the output in the agricultural sector is declining, the government can decide to grant subsidies to farmers or deal with specific problems faced by farmers such as lack of access to finance, fertilisers or high-yield seeds.

For determining average income
Average income is obtained by dividing the GDP of a country by its population. This can then be compared with the previous year to show how the living standard has changed over time or compared with another country’s figure. In comparing countries, the GDP has to be converted to a common currency such as the dollar.

Attracts foreign aids
Aids from richer countries or multilateral institutions can be based on a country’s need as obtained from the GDP figures. This will help to direct aid to an ailing sector in the economy as revealed by the official statistics.

Attraction of investment
The GDP  is a common way of estimating the expected level of demand for products in an economy. If the GDP is rising, it means more people are employed to produce these goods. These people earn incomes and demand for goods is expected to rise. A decrease in GDP will make investors cut their investments in the country as demand would be expected to fall.

Limitations of the GDP
The GDP is a quantitative measure of how much has been produced in an economy, it does not measure many things that affect living standards or quality of life. Some problems associated with the use of GDP are explained below.

Distribution of income
The GDP shows the size of the economy; it does not reveal how GDP or the national income is distributed among the citizens of a country. The bulk of the income may be concentrated in the hands of a few individuals, thereby causing income inequality in the economy.

Environmental damage
The GDP does not record the value of the damage caused to the environment in an attempt to produce the country’s output. Air pollution and the destruction of wildlife habitats are examples of damage from production. These costs have a negative effect on the quality of life of the people.

Leisure time is ignored
Leisure time improves the quality of life of the workers. It can improve the mental health and physical health of the workers. GDP does not account for this as increasing output might come at the expense of leisure as workers have to spend long hours at work.

Underground economic activities are omitted
Some activities are not covered by the official statistics. This leads to an understatement of the GDP of a country. Those activities may not be declared due to their illegality, e.g. smuggling, dealing in hard drugs and prostitution. People may also understate their incomes in order to avoid paying taxes. The size of the underground economy is larger in developing countries than in developed countries. This could be due to the existence of many informal activities that are not registered with the government. The underground economy is also known as the hidden or shadow  economy,

Non-marketed activities
These are activities that are not included in the measurement of the GDP because they are provided either free of charge or at prices below clearing or market prices, e.g. volunteer work, services rendered by charities, public education, government services, etc.

Data accuracy
Data availability and accuracy pose a challenge to accurately determining the GDP of a country. This is more pronounced in developing countries because of weak data-capturing systems.

GDP fails to measure happiness
It excludes many factors that promote the happiness and well-being of the people such as health, education, safety, political participation and fundamental rights. These factors are captured in the Gross National Happiness Index.