Intro to Econ: Eighth Lecture – What does the Gross Domestic Product (not) measure?

You may recall that the value of anything is really a subjective thing, something may be valuable to someone, but at the same time may be not valuable to someone else. In this post I want to investigate in what way, if any, in what way the gross domestic product (GDP) measures total “market” value.

I feel this is best done by going through a series of (semi)fictitious examples in which we find it relatively easy to judge how much value is really generated and where we can then see how this is reflected in the GDP calculation.

Example 1

Suppose we have two countries A and B. Suppose in country A someone has a monopoly on milk, while in country B the milk market is quite competitive. This means milk prices in country B are more or less such that market supply is equal to market demand. The market price for milk in country A, however, is set not so much by market forces but by the milk monopolist. As we have discussed earlier, this means that the price of milk in country A is likely “too high” and there is likely “too little” milk sold. Now suppose that milk price multiplied with milk quantity sold is nevertheless equal in both countries. In which country does milk contribute more to GDP? In which country would we think people are better off? You may want to think about it for a moment.

Well, one way of calculating how milk enters the GDP (see previous post) is to compute the final value to consumers: that is price (or value) per liter of milk multiplied by how many liters of milk are consumed. As we have assumed that this number is the same for both countries, milk, thus, enters the GDP calculation in exactly the same way in both countries. So according to GDP, if we think of GDP measuring the “market value”, milk provides the same value in both countries. But this is clearly odd, as the value of milk as measured by its price in country A is high probably not because so many people love milk so much more in country A than in country B, but rather because the milk monopolist is able to charge such a high price for milk simply because it is a monopolist. We would therefore think that milk-related welfare is much higher in country B than in country A, even though this does not show up in the GDP calculation.

Example 2

This one is about all the valuable production in a country that do not enter the GDP calculation. Compare the three situations A, B and C. In situation A, I spend a specific Saturday on my couch, doing nothing. In situation B, I instead spend this same Saturday trimming the hedge in my father’s garden. In situation C, I spend Saturday on the couch again, while my father hires a gardening firm to trim his hedge. In which situation is this Saturday’s contribution to GDP the highest? In which situation do we have the highest welfare? You may want to think about it a bit.

Well, situations A and B yield the same GDP. As long as no money changes hands (in such a way that it is recorded somewhere) activities such as me trimming my father’s hedge do not enter the GDP calculation. In situation C, as money does change hands (presumably in a recorded manner), GDP is higher. As to welfare, I don’t know. One could quite possibly argue that situations B and C are similar in total welfare, although one could also argue that I would really enjoy a Saturday on the couch, much more so than my father enjoys a neatly trimmed hedge.

But the point of all this is this. Any, no matter how productive activity that is not officially paid for, cannot enter the GDP calculations. Any work you do at home, cooking, cleaning, gardening, shopping, et cetera, no matter how valuable it is to you and others, does not enter GDP. Nor does any only unofficially paid work, i.e. black market work. If you build a house by yourself, possibly with the help of “friends”, and if you never sell this house, then not much of all this activity enters the GDP calculation.

Example 3

Suppose that football (soccer) games in City A are very peaceful, while in City B they are rather violent affairs. With violent I mean fan violence: they break rear-view mirrors of cars, break windows, fight and injure each other. Because of this, City B requires much more police personnel than City A does. Suppose that this is the only difference between these two cities. Which city has a higher GDP? Where is welfare higher? Think about it for a bit.

Well, City B has a higher GDP as police work certainly enters into the GDP calculation. Yet, I would consider welfare higher in City A. In fact, if the hooligans in city B manage to destroy a few things, GDP will likely be even higher still. Consider the damaging of cars. The car owners might then have to buy new rear-view mirrors and the payment they (or their insurance company) make for that enters the GDP as well. In fact GDP does not at all measure whether anything deteriorates in value. The GDP of a given country in a given year measures the “market value” of anything officially produced in that country in that year. No more and no less. It does not measure the value of everything that is already there (perhaps produced in previous years). A hurricane or volcano eruption might therefore increase GDP as it destroys things that were already there (which does not enter the GDP calculation) and thereby creates a “demand” for having these things rebuilt. Whether or not it does, depends on what exactly is destroyed and how much of it is rebuilt and how much of what was originally planned can now not be done.

Summing up, I think it is fair to say that GDP is no measure of welfare.

 

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s