Briefly but clearly and fully explain three limitations to G

Briefly, but clearly and fully, explain three limitations to GDP as a measure standard of living in an economy.

Solution

GDP is often taken as a measure of standard of living in an economy. Increase in GDP is generally taken as the increase in standard of living.

However, such generalization is not correct due to following three limitations –

1. Composition of GDP – GDP figures only provides for the total quantity of goods and services produced within an economy. These figures do not provide for the composition of the GDP. In case, GDP is increasing but such increase is on account of increase in production of defense-related products then such increase in GDP cannot be associated with any improvement in standard of living. In such scenario, to take increase in GDP as increase in standard of living is not a correct assumption.

2. Externalities – Externalities refers to the harm or benefit accruing to a third person or society as a whole due to activity undertaken by a firm or individual and for which such individual is not paid or penalized. GDP does not take into account such externalities. For example, pollution is a massive externality that impacts the standard of living. However, as GDP does not take into account such externality, it may point towards rising standard of living whereas in reality opposite may be happening.

3. Rate of population growth – GDP does not take into account the rate of population growth. However, rate of population growth is an important element impacting standard of living in an economy. If rate of population growth is higher than the GDP growth rate then in such scenario per capita availability of goods and services declines leading to decline in standard of living. So, even though increase in GDP is pointing towards rising standard of living, however, in reality opposite is happening.