The modern economic society evolves in a very fast pace. The overwhelming globalization, as well as internationalization process brings new competitors and new challenges every day, creates new markets and reveals new possibilities. However, not every country experience equal benefits from the internationalization process. This inequality displays in disproportionate economic development of different regions and countries.
There are many methods to define and evaluate the progress of the country on the world trade arena. Some techniques show only financial onward, but some of them demonstrate the pervasive development of the society. It compounds life quality, inflation, social inequality, ease of doing business and many others. One of these possible methods to estimate the economic development is by heeding attention to gross domestic product. Country’s gross domestic product often is referred to as a major indicator of economic growth. The use of it has become a defining indicator of the country’s power and potential. However, everything is not as plainly as it seems to be. So is GDP de facto so important element of economic evaluation or its role is somewhat hyperbolical?
The objective of this work is to inquire into the gross domestic product idea and demonstrate three primary methods of GDP evaluation. This paper also deeply outlines the actual case and importance of the primary indicator of the national production in the analysis of country’s economy as a whole. In addition, there is a great deal of additional information concerning GDP to show itself. With all these points being taken into account the structure of the work consist of two major chapters:
- GDP as a major indicator of national production and economic growth. Its history and role in the modern business society;
- GDP calculation methodology. Three basic methods of calculating GDP.
GDP as Major Indicator of National Production and Economic Development
Gross domestic product (abbreviated GDP) can be defined as an index to value all final goods and services produced in a particular country within one year or other time period.
The GDP history began in early 1930th, in the United States of America. The famous economist and scientist Simon Smith Kuznets was being chosen to elaborate GDP for the report of U.S. Congress in 1934. The very idea of the index creation was to seize all the economic production inside the country and measure it (Kuznets 1934). The production activity compounds manufacturing by individuals, residential companies and the government sector. Naturally, when the market situation in the country is worsening, then GDP measure will fall and vice versa. After establishing institutions such as the World Bank and the International Monetary Fund during the 1944 Bretton Woods conference, gross domestic product has become the main instrument to appraise the economy of a specific state (Dickinson 2011). Further on, in 1959 the business world was questioned if the GDP measures the overall well-being.
In 1962 famous American economist Arthur Okun stated that 2% increase in the country’s GDP will decidedly lead to approximately 1% decrease in the unemployment. Today this theory is known as “Okun’s Law” (Investopedia. Com n.d.).
In 1978 few economists compiled GDP per capita for more than 100 countries all over the world. Per capita GDP is the aggregate gross domestic product divided by the country’s population (Investopedia.com n.d.).
Thereafter, having launched the Human Development Index in 1990, the United Nations organization choose it to be an overwhelming index to take into account different aspects of human life that cannot be economically measured – gender equality, health, education, etc. (Economictimes.com n.d.).
The last but not least point is forming of the “green GDP”. This index is considered to be the partial interpretation of GDP. The difference is that “green GDP” takes into account environmental factors thus making it possible to see the dependence between environment and GDP (Dickinson 2011).
The next big thing in this paper is GDP limitations and peculiarities. Despite the fact that GDP is highly considered to be the main indicator of economic growth and the country’s standard of living, it is greatly criticized (Davies 2009).
As it has been mentioned before when comparing the relative production of different countries, the GDP per capita growth is considered to be a straight giveaway. However, is that truly so? The concept of GDP per capita is that so it does take into account the size of the nation in contrast to GDP. It is efficient because of its simplicity, frequency and consistency. It has the same accounting principles almost in every country of the world as well as the data for measurements. Moreover, it allows international comparison among different countries, so it is possible to measure the development of different countries through their GDP increase. However, at the very same time GDP has some serious drawbacks.
To begin with, it does not differentiate the economic output and business drawbacks. The economic output brings the real benefits to the economy while business drawbacks such as welfare expenses, pollution-producing industries and others only worsen the situation (SU-BC.com n.d.).
Another GDP drawback is that it includes only reported activities. Unreported ones such as illegal trading pass through. This point is highly pressing in undeveloped and poor countries, where illegal trading and underground economy are exceedingly developed (SU-BC.com n.d.).
The next shortcoming of gross domestic product is the fact it does not reflect non-market activities. For instance, when ones are looking after their elderly at home, the care will not be included in the GDP account. It also does not consider country’s infrastructure conditions, the overall education level and fuel consumption efficiency (SU-BC.com).
Further on, GDP makes the distribution of wealth over the country to be disproportionate. The point of this is in distribution inequality. When the small group of people inside the country has immense wealth, and the rest of the country’s population is relatively poor, the average income may still be high. However, the country’s nation majority standards of living still remain low. Index just secrets the real situation. It makes everyone more or less similar. In this case it is much better to use Gini coefficient which does show the actual distribution of income (Gini 1936).
As it has been stated before, gross domestic product does not take into account the quality of life of every individual, as it measures the overall material standard of living. The essential point concerning this problem is that the quality of life perceived by different individuals cannot be strictly standardized. It also ignores any other form of capital except financial: human capital, technological capital, organizational capital, ecological capital and both cultural and social ones (SU-BC.com n.d.).
There is a vital need to outline that gross domestic product ignores qualitative changes. For example, when computers become more powerful and advanced, GDP simply does not take it into account and the product quality improvement will simply pass unrecorded. One more interesting point about GDP is that the wealth concept in the accounting process is quite relative and unsure. For example, people in cold climate regions usually tend to spend more fuel or energy on heating. More fuel/energy means more money spending. However, does it make these people wealthier or more satisfied? Obviously it does not.
The next in turn deficiency of GDP is employment decrease. As the production process becomes more effective because of technological background standing in need of less working force, the employment rates are likely to reduce in appreciable manner (SU-BC.com n.d.).
Finally, the last but not least disadvantage of GDP is inadequate accounting of income allocation. This drawback may be similar to one mentioned before, but it is slightly different. In this case, the working force is the subject of the problem. The question is that if there are too many elderly people in a particular country, the working force of this country will have to support these people. (SU-BC.com n.d.) The employment rate tends to downfall as well as the standard of living, thus causing the downgrade of the whole economy. Another example can be the health care industry. The rising costs in health care sector make pretty tough pressure on families but at the same time they increase gross domestic product. Alius point broadly discussed among experts is the interconnection of GDP and employment. A certain country must have an enormous GDP growth rate to increase the employment. So, is high GDP per capita so important to the country’s well-being? Considering all the information provided above and the obvious fact that more income makes a person more satisfied it is not that hard to conclude that higher GDP is always desirable. However, higher per capita GDP does not enhance everything else. Despite more disposable income and wealth, the problem of social and income inequality as well as other problems mentioned before still remain topical.
GDP Calculation Methodology
In this chapter will be described the basic methods of GDP calculation. To begin with, there are three rules before starting the calculation of GDP:
- In GDP calculation ones do not count worn products;
- Non-production financial operations (public transfer payments and private transfer payments) are not included;
- All the products and services produced in one year period should be used in accounting only once (AmosWEB n.d.).
Having stated three compulsory rules-to-remember, the three basic GDP evaluation methods are as follows: production approach, income approach and expenditures approach.
The first approach is production method. In simple words, it can be defined as the sum of the market value of all goods and services produced during one year period (Kiara n.d.). To use this method ones should obtain three statistics: gross value added, intermediate consumption and the value of output. Gross value added can be defined as the gross value of all economic activities inside the country. Intermediate consumption takes into account cost of materials used in a production, supplies and labor force to manufacture products. Finally, the value of output is excluding intermediate consumption from gross value added. The number received is GDP.
GDP = GVA – IC,
where GVA stands for gross value added and IC means intermediate consumption.
The second method is called income method. The concept of this method is to achieve the better control of economic activities. In this case four kinds of income are used: labor income, rental income, interest income and personal profits (EconPort.com). Labor income consists of different kinds of wage, salary, unemployment and health insurance, retirement payments and other payoffs. Rental income is the income received from the private property. This division also includes royalties, copyright payments and other assets. The next is interest income. It is money received from household’s lending to banks and other business institutions. Finally, personal profit is the amount of money that companies have left after paying all taxes and interests.
However, to get GDP two additional adjustments must be made. First, to get from costs to market prices one should subtract subsidiaries from indirect taxes. Second, to receive gross domestic product it is necessary to add depreciation on hard assets (e.g. equipment, warehouses, etc.) (Kiara n.d.).
The last but not least approach to GDP evaluation is expenditures approach. Likewise the previous two methods, this approach consists of several elements. First of all it is consumption. It includes purchases of different goods (both durable and non-durable) and services. It is the biggest component of expenditures approach method (Kiara n.d.). The second part of the approach is the investment. This is a little tricky part. The point is that it is not investment in a traditional meaning (capital funds, stocks, etc.). It means capital investment, which includes equipment, computer software and hardware, new lands mastering and similar kinds of things. Government spending is another part of the expenditures method. This section means the total sum of the government expenditures on different goods and services. It includes infrastructure costs, military purchases, government employee salaries and other costs. Finally, the last component is the net export. It can be determined by subtracting the gross value of imports from the gross value of exports.
GDP = C + I + G + (X-M),
where C is consumption, I stands for investments, G is government expenditures, X and M stands for export and import respectively (EconPort.com n.d.).
One more important point about GDP is that there are two types of GDP: nominal and real. The matter is that if compare GDP year-to-year ones should take into consideration the inflation (or deflation) rate. Nominal GDP is expressed in current year prices, while real GDP takes into account the value of money. The mode used to convert real GDP into nominal one is called GDP deflator (HM Treasury). For example, assume that in 1995 GDP was $100 million, and in 2005 it was $300 million. Assume also that the inflation halved the currency value. To compare 2005 GDP to 1995 GDP ones should divide $300 by one-half and get $150 million. Now it is clearly seen that GDP has grown only by 50 percent not 200 as it might appear. People often confuse GDP with GNP. In some aspect, it cannot be called “confusion”. However, this can be only in a global context (HM Treasury n.d.). The difference between GDP and GNP is that GDP is based on the factor location while GNP concentrates on the ownership (Investopedia.com).
GNP = GDP + Income from the rest of the world – payments to the rest of the world (Lequiller 2006).
All the foreign factors in the domestic economy will not be used in GDP accounting because of foreign ownership. Suppose that a company has more companies registered abroad than foreign companies within national borders. Then country’s GNP will be higher than GDP. However, if all companies are located within domestic borders, then GDP is equal to GNP.
Concluding the paper it is important to point out that, despite all substantial drawbacks and limitations of GDP, it is still considered to be the best way of country’s economic evaluation. GDP is simple and consistent and in spite of the fact that there are many “more advanced” and useful ways to measure economic progress or downgrade, GDP still remains the primary indicator.