Limitations of GDP
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.
If we look at these aspects, the major issue with GDP 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 the increase in consumption opportunities may be outweighed by the negative effects associated with the limitations mentioned above. Hence although GDP may on certain occasions be a good proxy for social welfare, it results in a biased description that may lead to unfavorable conclusions.