Whate lower the significance of GDP …

Often GDP (real GDP) is considered as an index of welfare of the people. Welfare means sense of material well-being among the people. This depends upon availability of goods and services per person for consumption. When GDP (or GNP) rises, it shows increase in flow of goods & services. Greater availability of goods and services implies higher standard of living which increases economic welfare. So one may conclude that higher level of GDP is an index of greater well-being of the people. But this may not be correct due to following limitations or reasons.

(i) Distribution of GDP. A mere rise in GDP (or GNP or National Income) may not lead to rise in economic welfare if its distribution results in concentration of income in the hands of very few individuals or firms. A mere increase in GDP does not mean that every individual automatically gets this much of increase. Distribution of GDP might have resulted in making the rich richer and the poor poorer leading to further increase in the gap between rich and poor.

(ii) Non-monetary exchanges or transactions. Many economic activities in the economy are not evaluated in monetary terms. Thus non-market transactions like services of housewife, exchanges through barter, enjoyment from hobbies like painting, gardening, etc. which increase economic welfare are not included in measuring GDP. Hence GDP may not reflect actual productive activities and wellbeing of the country.

(iii)    Externalities. These refer to the benefits or harms which a firm or an individual causes to other in the process of production but for which they are not paid or penalised. For example, negative externalities occur when smoke of a factory pollutes the air or its industrial wastes causes water pollution in the nearby river resulting in loss of social welfare. But nobody is penalised for it nor it is accounted in GDP. GDP does not take into account these externalities. Similarly, positive (beneficial) impact of beautiful garden remains outside of realm of GDP. To that extent GDP is not a correct index of welfare as GDP is then underestimated or overestimated.