Limitations of GDP as an Indicator of Welfare

Gross Domestic Product (GDP) is essentially an indicator of aggregate economic activity. In addition to that it is also frequently used to describe social welfare. The idea behind this is that GDP tends to correlate with consumption, which in turn is commonly used as a proxy for welfare. In other words, the more people consume, the happier they are supposed to be.

Now, this line of argument seems a little too simplistic. Assuming causality based on a simple correlation between GDP and welfare may lead to false conclusions which can be highly problematic especially for policy makers. Hence it is important to look at the limitations of GDP as a welfare indicator and to consider possible alternative approaches. 

There are several limitations of GDP as a welfare indicator. Most of them can be traced back to the fact that in essence GDP is not supposed to measure well-being. As a result the concept does not account for various important factors that influence social welfare. To keep things simple the most relevant limitations are listed below:

• GDP does not incorporate any measures of welfare: This is probably the most obvious issue. As mentioned before, GDP only describes the value of all finished goods produced within an economy over a set period of time. There are multiple ways to calculate and measure GDP, but neither of them includes any indicator of welfare or well-being. Even though this does not necessarily mean GDP cannot be a good indicator of welfare, the fact that it is used as a "proxy of a proxy" should be kept in mind as it significantly affects its validity.
• GDP only includes market transactions: As a result, it does not account for domestic or voluntary work, even though these activities have a considerable positive impact on social welfare, as they complement the market economy and thus improve the standard of living. On the other hand GDP does not include black market transactions or other illegal activities that may have a substantial negative impact on overall social well-being.
• GDP does not describe wealth distribution: If there is a high degree of wealth inequality, the majority of people do not really benefit from an increased economic output because they cannot afford to buy most of the goods and services. Thus to accurately describe social welfare it is essential to consider wealth distribution.
• GDP does not describe what is being produced: Since GDP measures the value of all finished goods and services within an economy, it also includes products that may have negative effects on social welfare. Think of a country with an extremely strong armaments industry that represents most of its GDP. If the arms are sold and used within the country itself, overall social welfare will most likely decrease. Of course this also holds true for other goods and services that may have adverse effects on society.
• GDP ignores externalities: Economic growth usually goes hand in hand with increased exploitation of both renewable and non-renewable resources. Due to this overuse, more and more negative externalities arise (e.g. pollution, overfishing) and social welfare will decrease as a result. This effect is not included in GDP at all.

Alternative approaches

• Human Development Index: An indicator that focuses specifically on people and their capabilities to assess the development and welfare of a country. In particular, it measures achievements in three critical dimensions: health and life expectancy, education, and standard of living. The latter is measured by gross national income per capita. Thus HDI also includes an indicator of economic activity, but it adds two complementary dimensions which results in a more comprehensive description of social welfare.
• Gross National Happiness Index: An index that takes a holistic and psychology based approach to measuring social welfare. It was developed in Bhutan and builds on four pillars: governance, socio-economic development, cultural preservation, and environmental conservation. These four pillars are further classified into nine areas and measured by 33 specific indicators. The large number of distinct indicators used in this concept allows for a very sophisticated analysis.
• Social Progress Index: An extensive framework that is based on three key dimensions: basic human needs, foundations of well-being , and opportunity. Again, social progress for each of those dimensions is measured by a multitude of indicators. Those include but are not limited to: nutrition, medical care, and safety (basic human needs), education, wellness, and sustainability (foundations of well-being), and personal rights, freedom, and tolerance (opportunity).

All these approaches take into account multiple dimensions to provide a more comprehensive description of social welfare. Although it is not feasible to completely replace GDP as a welfare indicator anytime soon, it could be used in conjunction with these alternative approaches to provide more accurate and profound results.

Despite several shortcomings GDP is commonly used as an indicator of social welfare. Most of the limitations are due to the fact that in essence the concept is not supposed to measure well-being. As a result, GDP fails to account for non-market transactions, wealth distribution, the effects of externalities, and the types of goods or services that are being produced within the economy. To compensate for these issues, different approaches to measuring welfare have been developed, including the Human Development Index (HDI), the Gross National Happiness Index (GNH), and the Social Progress Index (SPI).