CFA Level 1

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Macroeconomics - Limitations of GDP and Alternative Measures

There are many limitations to using GDP as a way to measure current income and production. Major ones include:

·Changes in quality and the inclusion of new goods - higher quality and/or new products often replace older products. Many products, such as cars and medical devices, are of higher quality and offer better features than what was available previously. Many consumer electronics, such as cell phones and DVD players, did not exist until recently.
·Leisure/human costs - GDP does not take into account leisure time, nor is consideration given to how hard people work to produce output. Also, jobs are now safer and less physically strenuous than they were in the past. Because GDP does not take these factors into account, changes in real income could be understated.

·Underground economy - Barter and cash transactions that take place outside of recorded marketplaces are referred to as the underground economy and are not included in GDP statistics. These activities are sometimes legal ones that are undertaken so as to avoid taxes and sometimes they are outright illegal acts, such as trafficking in illegal drugs.

·Harmful Side Effects - Economic "bads", such as pollution, are not included in GDP statistics. While no subtractions to GDP are made for their harmful effects, market transactions made in an effort to correct the bad effects are added to GDP.

·Non-Market Production - Goods and services produced but not exchanged for money, known as "nonmarket production", are not measured, even though they have value. For instance, if you grow your own food, the value of that food will not be included in GDP. If you decide to watch TV instead of growing your own food and now have to purchase it, then the value of your food will be included in GDP.

Alternative Measures of Domestic Income
Other than GDP and GNP, there are alternative measures of domestic income, such as national income, personal income and disposable personal income.

National Income
National income is computed by subtracting indirect business taxes, the net income of foreigners, and depreciation from GDP. It represents the income earned by a country's citizens. National income can also be computed by summing interest, rents, employee compensation (wages and benefits), proprietors' income and corporate profits.

·Personal income represents income available for personal use. It is computed by making various adjustments to national income. Social insurance taxes and corporate profits are subtracted from national income, while net interest, corporate dividends and transfer payments are added.

·Disposable personal income (or disposable income) is income available to people after taxes; i.e., it is personal income less individual taxes.

Components of Marginal Product and Marginal Revenue
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