Macroeconomic

Theory and Policy

Biswa Swarup Misra

Session-6

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In these Sessions, we look for the answers
to these questions:

▪ GDP at 2011-12 base

▪ Methodological Changes in GDP at 2011-
12 Base
▪ Limitations of GDP

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 GDP of India at
2011-12 Base

MEASURING A NATION’S INCOME B.S.Misra 2

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 GDP in 2012 base
▪ GDP at factor cost=GVA at factor cost=payment to all
factors of production excluding government. In this
concept we don’t use any form of tax or subsidies
for adjustment
▪ GVA at basic price= GVA at factor cost + production
tax-production subsidy.
▪ GDP at market price=Payment to factors of
production + production tax+ product tax-
production subsidy-product subsidy
▪ =payment to all factors of production including
government
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 GDP in 2012 base
▪ Before the product is sold to the consumer, the
distributor or wholesaler purchases the product
from the producer.
▪ The producer charges the distributor not only the
payment to factors of production but also the
amount paid to government on production like
license fee, land revenue, stamp duty and
registration fees .
▪ The retailer while sells the product to the consumer
also collects sales tax for the government from the
consumer.
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 GDP in 2012 base
▪ Production taxes or subsidies are paid or received
with relation to production and are independent of
the volume of actual production. Some examples are:
▪ Production Taxes - Land Revenues, Stamps and
Registration fees and Tax on profession
▪ Production Subsidies - Subsidies to Railways,
Subsidies to village and small industries,
Administrative subsidies to corporations or
cooperatives, etc.

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 GDP in 2012 base
▪ Product taxes or subsidies are paid or received on
per unit of product. Some examples are:
▪ Product Taxes: Excise Tax, Sales tax, Service Tax
and Import and Export duties
▪ Product Subsidies: Food, Petroleum and fertilizer
subsidies, Interest subsidies given to farmers,
households etc through banks, Subsidies for
providing insurance to households at lower rates

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 Methodological Changes in GDP at 2011-12 Base

▪ Two kinds of approaches - establishment and

enterprises- are used in calculating manufacturing
production.
▪ Till now, only establishment approach was used
which means calculating production plant by
plant. On the other hand, in enterprises approach
the activities at headquarters are taken into
account.
▪ For instance, after an item is produced, various
marketing and sales promotion efforts go at
headquarters level.
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 Methodological Changes in GDP at 2011-12 Base

▪ Change in headline to GDP at market prices from GDP

at factor cost.
▪ The headline GDP includes indirect taxes but
excludes subsidies.
▪ Earlier, GDP growth was estimated at factor cost,
which excludes indirect taxes but included
subsidies.
▪ Expenditure on Research & Development (R&D) in
public sector is now considered as part of capital
formation. These were earlier treated as current
expenditure 11
 Methodological Changes in GDP at 2011-12 Base

▪ Corporate Sector-In the 2004-05 series, the Private Corporate

Sector was being covered using the RBI Study on Company
Finances, wherein estimates were compiled on the basis of
financial results of around 2500 companies.
▪ In the new series, comprehensive coverage of Corporate Sector
has been ensured in mining, manufacturing and services by
incorporation of annual accounts of companies as filed with the
Ministry of Corporate Affairs (MCA) under their e-governance
initiative, MCA21.
▪ Accounts of about 5 lakh companies have been analysed and
incorporated for the years 2011-12 and 2012-13, while the
number of common companies (companies for which accounts
are available for the year 2012-13) is around 3 lakh for the
year 2013-14. 12
 Methodological Changes in GDP at 2011-12 Base

➢ The activities, ‘Recycling of metal waste and scrap + non-metal

waste and scrap’, which was earlier part of manufacturing and
‘Sewerage and other waste management services’ have been
clubbed to form the category ‘Remediation and other utility
services’, and will be reflected in the group ‘Electricity, gas,
water supply and other utility services’.
➢ ‘Repair of computers’, which was earlier part of computer
related activities, to be a part of ‘Repair of personal and
household goods” and reflected in ‘Trade & Repair Services’.
➢ ‘Recording, Publishing and Broadcasting Services’ to form a
new category, and reflected in the group ‘Communication &
Services related to broadcasting’.
➢ Sewage activities removed from services sector and made a
part of Electricity, Gas, Water Supply and Utility Services. 13
 GDP and Welfare

MEASURING A NATION’S INCOME B.S.Misra 14

 Shortcomings of GDP
▪GDP can be a useful tool to measure total output in an economy.
Many people go further than this, interpreting GDP as a measure of
the well-being of citizens.
▪However GDP has shortcomings, both in its measure of total
production, and in its usefulness as a measure of well-being.

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Shortcomings of GDP as a Measure of Well-Being
▪GDP per capita (i.e. GDP divided by population) is often used to
represent differences in standards of living from country to country.
However, even if it accurately measured total production, it would not
reflect:
• The value of leisure
• Pollution and other negative effects of production
• Crime and other social problems
• The distribution of income

▪In fact, improvements in many of these will result in lower GDP per
capita.
▪Example: Lower crime would allow lower spending on police,
prisons, and private security. This would decrease GDP, but surely
result in improvements in economic well-being.
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 Making
the Did World War II Bring Prosperity?
Connection

World War II was a

period of extraordinary
sacrifice and
achievement by the
“greatest generation.”
But statistics on GDP
may give a misleading
indication of whether it
was also a period of
prosperity:
• Production was very high, but much of the production was of
military goods-so people weren’t becoming more well-off.
• After the war, GDP fell; but the production of consumption goods
rose rapidly.

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 Limitations of GDP
1. Prices are not values.
2. Nonmarket activities are excluded.
3. The shadow economy is missing.
4. Environmental degradation isn’t counted.
5. Leisure doesn’t count.
6. GDP ignores distribution.

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 Limitation one: Prices are not values.
▪ GDP effectively assigns each good and service a
value equal to its market price.
▪ Price is not a good indicator of value when either
consumer surplus or a market failure is present.

• In a perfectly competitive market, price is equal to the marginal

benefit of a good, therefore price is an indicator of value.

• However, when consumer surplus is present, the total benefit of a

good exceeds the price, making price a poor indicator of value.

• Likewise, when market power or other market failures exist, the price
of a good is not equal to a consumer’s marginal benefit.

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 Limitation two: Nonmarket activities are excluded.

▪ GDP does not measure all productive activity.

▪ Nonmarket activities are omitted from GDP.

• Activities we generally pay for today that our grandparents likely

did for themselves and the implications for GDP. For example,
today people are more likely to eat out, pay for babysitting or dog
sitting services, take an Uber instead of driving, etc.

• On the other hand, there are also some activities that consumers
do for free that were previously paid positions. For example,
restaurant critics have largely been replaced by online user
reviews (which are largely unpaid for), and travel agents have
been largely replaced by people planning their own trips.

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 Limitation three: The shadow economy
is missing.
▪ The shadow economy includes economic activity
purposely conducted out of view of the government.
▪ These activities are unmeasured and therefore are
excluded from GDP.

• a. Percentage of people aged 15 or older who reported having acquired

goods or services in the past12 months that they believed involved
undeclared work;

• b. Percentage of people aged 15 or older who reported having carried out

undeclared paid activities in the last 12 months.

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Interpreting the data: Measuring the
shadow economy

Data from:
Engle,
Dominik H.,
“The Shadow
Economy in
Industrial
Countries.”

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 Making
the Underground Economies in Developing Countries
Connection
▪In developing countries, the
underground economy is often
referred to as the informal sector, as
opposed to the formal sector, in
which output of goods and services
is measured.

• In many developing countries, the

informal sector is very large;
often above 50% of total output.

▪Economists studying economic

development say this often reflects
poor government policies: high
taxes and regulations and low
confidence in the security of private
property from government seizure. 24
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Shortcomings of GDP as a Measure of Total Production
▪ We just discussed the two important types of production are omitted
from the BEA’s measurement of GDP:
▪Household Production
• Household production such as childcare, cleaning, and cooking is
not typically paid for with money. However such contributions are
real-if they were performed by a non-household-member, they
would be paid for and counted in GDP.
▪The Underground Economy
• Buying and selling of goods and services might be concealed from
the government to avoid taxes or regulations, or because the
goods and services are illegal. This constitutes the underground
economy.
• This may be 10% or more of the economy in America, and
substantially more in low-income households.
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 How Important Are These Shortcomings?
▪If we are comparing GDP from year to year, the size of household
production and the underground economy is probably about the same
from year to year, so GDP growth is a reasonable measure of the
growth in total production.

▪However over long periods of time, these shortcomings might be

more serious.
▪Example: As women have entered the workforce in larger numbers,
some household production has been replaced by paid childcare and
restaurant meals. So increases in GDP may exaggerate the increase
in actual total production.

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 Limitation four: Environmental
degradation isn’t counted.
▪ GDP treats natural resources as if they have no
value until they are transformed into something else.
▪ The cost of environmental degradation is ignored.

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 Limitation five: Leisure doesn’t count.
▪ GDP includes the benefit of work, which is more
income.
▪ GDP does not include the cost of work, which is less
leisure.
▪ Working has an opportunity cost – namely,
leisure. GDP will increase if we increase the
number of hours we work, but quality of life may
suffer

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 Limitation six: GDP ignores distribution
Data from: Piketty, Saez and Zucman, “Distributional National Accounts: Methods
and Estimates for the United States

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PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition
 GDP and Economic Well-Being
▪ Real GDP per capita is the main indicator of the
average person’s standard of living.
▪ But GDP is not a perfect measure of
well-being.
▪ Robert Kennedy issued a very eloquent
yet harsh criticism of GDP:

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 Gross Domestic Product…
“… does not allow for the health of our
children, the quality of their
education, or the joy of their play.
It does not include the beauty of
our poetry or the strength of our
marriages, the intelligence of our
public debate or the integrity of our
public officials.
It measures neither our courage, nor our wisdom,
nor our devotion to our country. It measures everything,
in short, except that which makes life worthwhile, and it
can tell us everything about America except why we are
proud that we are Americans.”
- Senator Robert Kennedy, 1968 31
 Then Why Do We Care About GDP?
▪ GDP leaves out a lot, but there is a logic to it.
▪ Having a large GDP enables a country to afford
better schools, a cleaner environment,
health care, etc.
▪ Many indicators of the quality of life are positively
correlated with GDP. For example…

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Table 3 GDP, Life Expectancy, and Literacy

FOR USE WITH MANKIW AND TAYLOR, ECONOMICS 4TH 33

EDITION 9781473725331 © CENGAGE EMEA 2017
 GDP as a Measure of Living Standards
▪ As average income in a country rises, it becomes
easier to invest in things that matter (ex. health and
education of children).
▪ GDP indicates the resources available to pursue
things people value.

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 Higher GDP Is Correlated with Better Life
Outcomes Figure-3

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PRINCIPLES OF ECONOMICS Betsey Stevenson – Justin Wolfers | First Edition
 Higher GDP Is Correlated with Better
Life Outcomes Figure-3
▪ Previous Figure illustrates that people who live in countries
with higher GDP per person tend to enjoy better life
outcomes.
▪ The top left panel shows the results of surveys asking people
to rate how satisfied they are with their lives on a 0–10 scale.
▪ The average score is much higher in countries with high GDP.
▪ Other surveys reveal that people in countries with high GDP
are more likely to rate themselves as being happy, they’re
more likely to smile or laugh a lot, and they’re more likely to
feel that they’re treated with respect.
▪ They’re also less like to experience pain and less likely to feel
depressed

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 Review: Limitations of using GDP as a
measure of standard of living
▪ Market price may be a poor indicator of value.
▪ Not all productive activity in the economy is
measured.
▪ A large shadow economy can result in the value of
GDP being understated.
▪ GDP does not measure environmental impact.
▪ Work is included in GDP, and leisure is not.
▪ GDP measures the size of the pie, not the actual
slice each person receives.

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