Limitations of GDP as an Indicator of Welfare

Updated Aug 1, 2023

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 in an economy. 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 policymakers. Hence it is important to look at the limitations of GDP as a welfare indicator and to consider possible alternative approaches.

Limitations of GDP

There are several limitations of Gross Domestic Product 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, but economic growth. As a result, the concept does not account for various important factors that influence social well-being. 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 (e.g., income, expenditure), 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 (i.e., non-monetary), 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 income distribution

If there is a high degree of inequality when it comes to income distribution, 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 income distribution and inequality (for more information, see also the Gini index).

GDP does not describe what is being produced

Since Gross Domestic Product measures the value of all finished goods and services within an economy, it also includes products that may negatively affect social welfare. Think of a country with an extremely strong armaments industry that represents most of its economic output. 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 subjective well-being or society as a whole.

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 the ecosystem will decrease as a result. This effect is not included in GDP at all.

If we look at these aspects, the major issue with Gross Domestic Product as a welfare indicator becomes quite obvious. It suggests that a higher GDP always increases social well-being. However, at one point, the positive effects resulting from increased consumption opportunities may be outweighed by the negative effects associated with the limitations mentioned above. Hence although GDP may occasionally be a good proxy for social welfare, it results in a biased description that may lead to unfavorable conclusions.

Alternative Measures and Approaches

In view of the shortcomings mentioned above, there have been various attempts to develop more accurate and reliable indicators in order to measure social well-being. Among others, these alternative approaches include the Human Development Index (HDI), the Gross National Happiness Index (GNH), and the Social Progress Index (SPI).

Human Development Index

The Human Development Index is an indicator that focuses specifically on people and their capabilities to assess the development and welfare of a country (see also human capital). 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 result in a more comprehensive description of economic welfare.

Gross National Happiness Index

The Gross National Happiness Index 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

The Social Progress Index provides 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 Gross Domestic Product as a welfare indicator anytime soon, it could be used in conjunction with these alternative approaches to provide more accurate and profound results.

Summary