Why is GDP considered a key measure of economic growth?

A key measure of economic growth is the Gross Domestic Product (GDP). Let’s understand what is GDP, and why is it widely used as an economic metric?

GDP: A key measure of economic growth

Gross Domestic Product (GDP) is an important macroeconomic indicator that measures the economic growth of a country. It is also an easy parameter for comparing the growth of a country with that of other countries in the world. The disadvantage of this measure is that it is an average numerical indicator that does not capture inequalities, unemployment, the rural-urban divide, or income percentiles. Despite these drawbacks, GDP remains a frequently used metric because of the way it is measured. 

GDP is the sum of the market value of all the final goods and services produced within the geographical boundaries of a country each year. If a country produces “n” commodities each year with quantities represented by q₁ to qₙ and their corresponding market prices denoted as p₁ to pₙ, then GDP is calculated by multiplying the price per unit with the total quantity produced and summing it across all goods and services. This is indicated in a mathematical format below:

GDP = (q₁​×p₁​)+(q₂​×p₂​)+(q₃​×p₃​)+…+(qₙ×pₙ​)

Advantages and disadvantages of using market values

However, while using market values provides a standardised and convenient method for economic measurement, it also has advantages and disadvantages. 

Advantages

The market value of goods and services refers to the prices at which they are sold to the final consumer (inclusive of all taxes). Using market value offers certain advantages:

a) Aggregation of goods and services: Prices provide a common unit for adding up the value of different goods and services, which are otherwise measured in different physical units. This enables GDP to be represented as a single value

b) Economic importance: Market prices reflect differences in the relative economic importance of different goods and services.

Disadvantages  

a) Exclusion of non-marketed goods and services: Some goods and services like homemaking, child rearing, and clean air are not sold in the formal market. Therefore, actions taken to improve these aspects, such as to reduce pollution, are not reflected in GDP. If suitable adjustments could be made to include these contributions, the value of GDP would increase and would be more representative.

b) Partial inclusion of non-marketed goods and services: Some non-marketed goods and services are partially incorporated in official GDP calculations. Some of these are: The underground economy or the black economy, which includes both legal and illegal activities.

— Legal activities: Transactions hidden from government records mainly to evade taxes or regulatory compliance.

— Illegal activities: Activities such as drug trafficking, gambling, and prostitution. In a country like India, where the shadow economy is large, not accounting for this in GDP calculations would lead to a gross underestimation of economic output.

c) Government-provided services: One very important component that doesn’t pass through the market is the value of services provided by the government like defense, infrastructure, public health, and education. So, no market values are available for the government’s contribution to GDP. This could also lead to an underestimation of the GDP. The solution lies in valuing these services at their cost of provision –  referred to as “factor cost”.

A similar principle applies to the distinction between final and intermediate goods in GDP measurement. 

Final and intermediate goods 

GDP accounts for the value of only newly produced goods – goods produced during the year for which GDP is being calculated, normally taken as the financial year. For example, the price obtained from the resale of a house is excluded from GDP, as the house was not constructed in the year of estimation. However, the value of the services provided by the real estate agent involved in the sale of the house is included in GDP, as it is new income generated during the year of estimation.

GDP ignores all transactions in which money or goods change hands without the production of new goods or services. Therefore, the sale of bonds and stocks is not counted because they are exchanges of paper assets rather than real physical assets. Similarly, profits from the sale of stocks and bonds are excluded from GDP for the same reason.

Only final goods and services are included in GDP. Intermediate goods — those goods which are used as inputs in the production of other goods — are excluded to avoid double counting. Sometimes, the distinction between final and intermediate goods can be subtle. For instance, a tool purchased by a carpenter is considered an intermediate good, as it is used to produce other final goods. However, if the tool continues to be useful for further production in future years, it is considered a capital good – a special type of final good – due to its continued usefulness. 

Another example is electricity: when consumed by a household, it is considered a final good, but when consumed by a factory during the production process, it is treated as an intermediate good. Similarly, inventory investment — goods produced during the year of estimation but not sold in that year — is also treated as a final good in GDP calculations.

Thus, while reliance on market values ensures a practical and consistent approach to measuring economic activity, the distinction between final and intermediate goods helps maintain accuracy in calculations.

Post Read Questions

Why is GDP considered a fundamental measure of a country’s economic growth?

How does GDP maintain accuracy in economic measurement?

What role does the distinction between final and intermediate goods play in GDP calculations?

What is the main advantage of using market values for economic measurement?

In what ways can the disadvantages of using market values be addressed or mitigated in economic analysis?

(Meera Malhan and Aruna Rao are Professors in economics at Delhi University. In the second part of the article, the authors will anlayse methods of measuring GDP.)

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