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GDP is the single most useful number for describing the size and growth of a country's economy. However, even real, inflation-adjusted GDP has its shortcomings as a measure of economic performance. Some of the shortcomings relate to transactions that get left out of the GDP calculation. Others relate to externalities and other cost-like factors that are related to a nation’s overall economic wellbeing but don’t count toward GDP. Finally, GDP does not account for the consumer surplus achieved through trade.
Omitted Activity
Not all economic activity gets logged and reported for inclusion in the GDP calculation. For one thing, there’s an underground economy where money changes hands, but the activity is not reported. This covers a wide range of transactions: sales of illegal drugs, wages paid to undocumented workers, unreported tips collected by food servers, cash-and-a-handshake deals where the seller wants to avoid paying sales tax, and so on. In addition, there is nonmarket activity where no money changes hands. This category includes unpaid housework, gardening, owner-performed home- and vehicle repairs, and barter transactions (lawn mowing in exchange for fresh-caught fish—that sort of thing). In a developed economy, omitting such activities does not greatly impact the calculation of GDP. But in an economy where households grow their own food or in some other way live off the land, the standard GDP calculation will significantly underestimate the amount of economically productive activity going on.
Externalities and Externality-like factors
The calculation of GDP is based on money that flows from buyers to sellers, but it doesn’t account for non-monetary effects on third parties. In other words, it doesn’t account for negative externalities. So, for example, the GDP contributed by a local track where people can pay to race gasoline-powered go-karts is measured entirely in ticket sales. It doesn’t account for the air pollution from the go-kart engines, which is a non-monetary cost the economic activity imposes on the community. (GDP-as-ticket-sales also doesn’t account for positive externalities, such as the enjoyment non-paying spectators might get out of watching a friend or family member zip around the track.)
In addition, GDP doesn’t account for the impact of work on leisure time. Suppose that the go-kart track, which has been open 7 days a week, starts closing on Mondays. As far as GDP is concerned, this is nothing more or less than a loss of 1 day’s worth of ticket sales every week. For the track owner, however, being closed on Mondays means the recovery of a day of leisure time—a chance to go boating with their family, maybe. Although leisure does not generate income, it contributes to quality of life, so much so that people will sometimes forgo income in favor of leisure time (as discussed in the chapter on Labor).
Finally, GDP tracks how much money changes hands but is blind to issues of equity. That is, GDP doesn’t have anything to say about whether the income generated through economic activity is distributed evenly or fairly. As far as the calculation is concerned, it’s all the same whether nearly all the money goes to just a few people or whether it is more equally distributed.
Gains from Trade Ignored
In a typical economic transaction, value is created, because each party values what they receive more than what they give up. For example, a restaurant patron who pays $45 for a meal might have been willing to pay as much as $52. Meanwhile, the meal might have cost the restaurant only $39 to prepare and serve. The consumer surplus of $7 plus the producer surplus of $6 add up to $13 in total surplus. That is value created by the transaction. The GDP calculation does not “see” the surplus value. It only sees a fair exchange: a $45 meal in return for $45 in cash.
