Chapter 2: MEASURING THE NATIONAL INCOME ACCOUNTS

National income is commonly defined as the total value of goods and services
produced annually in a country. In other words, the total amount of income accruing to a
country from economic activities in a year‘s time. It includes payments made to all resources in
the form of wages, interest, rent and profits.
The national income has been defined countless times by economists. From the modern
point of view, Simon Kuznets has defined national income as “the net output of commodities
and services flowing during the year from the country’s productive system in the hands of the
ultimate consumers.”. On the other hand, in one of the reports of United Nations, national
income has been defined on the basis of the systems of estimating national income, as net
national product, as addition to the shares of different factors, and as net national expenditure in
a country in a year’s time. In practice, while estimating national income, any of these three
definitions may be adopted, because the same national income would be derived, if different
items were correctly included in the estimate.
In this chapter, topics will primarily focus on how National Income Accounts are
measured, with emphasis on Gross Domestic Product (GDP) as the most common measure of
national income.

LEARNING OUTCOMES:

After learning this module, the student will be able to:

1. Learn how National Income is derived
2. Understand comprehensively the concept of Circular Flow Model as it relates to the flow
of income
3. Familiarize with GDP as a common measure of National Income
4. Identify the different components of GDP
5. Illustrate the Flow of Income based on the different components of GDP
6. Distinguish the difference between Nominal and Real GDP
7. Discern if GDP is an accurate measure of economic well-being
 Lesson 1
TOTAL INCOME = TOTAL EXPENDITURE

In the previous chapter, we have learned the use of Circular Flow Model or the Circular
Flow Diagram which explains the exchange of goods and services in an economy, the value of
aggregate output (the national product) which should equal the value of aggregate income
(national income).
A Circular Flow Diagram describes a very simple economy. The economy is composed
of two distinct groups: households and firms. Firms produce all the final goods and services in
the economy using factor services (labor and capital) supplied by the households. The
households, in turn, purchase the goods and services supplied by the firms. Thus goods and
services move between the two groups in the counterclockwise direction. Exchanges are
facilitated with the use of money for payments. Thus when firms sell goods and services, the
households give the money to the firms in exchange. When the households supply labor and
capital to firms, the firms give money to the households in exchange. Thus money flows
between the two groups in a clockwise direction.

National product measures the monetary flow

along the top part of the diagram—that is, the
monetary value of goods and services produced
by firms in the economy.

National income measures the monetary flow

along the bottom part of the diagram—that is, the
monetary value of all factor services used in the
production process. As long as there are no
monetary leakages from the system, national
income will equal national product.

Expenditure Equals Income

Because firms pay out as income everything they receive as revenue from selling goods and
services, total income, Y , equals total expenditure.
 Y = C + I + G + NX

For a firm, the value of its production is the cost of the production, which equals the
income generated by the production. So, the value of production equals income equals
expenditure, or

GDP = Y = C + I + G + NX

Households use their income on consumption expenditure, saving, and paying net taxes.
Therefore, it is the case that:
Y = C + S + NT

If everything is measured correctly, adding depreciation would yield GDP. But there
often is a statistical discrepancy, the difference between the expenditure approach and the
income approach. The difference is measured as the expenditure approach minus the income
approach, so any statistical discrepancy is added to the sum to yield the income approach GDP

.Three ways economic growth is measured

1. Gross Domestic Product (GDP) measures the economic activity within the
physical borders of a country (whether the producers are native to that
country or foreign-owned entities)
2. Gross National Product (GNP) is a measurement of the overall production
of persons or corporations native to a country, including those based abroad.
GNP excludes domestic production by foreigners.
3. Gross National Income (GNI) is another measure of economic growth. It is
the sum of all income earned by citizens or nationals of a country
(Regardless of whether or not the underlying economic activity takes place
domestically or abroad)
 GDP GNP GNI

Focuses on the income, It is calculated by adding the It is derived from the sum
output and expenditure net property income from value of resident producers
considering that these abroad to the country‘s GDP. which is added to net
factors taken place within Net property income from receipts of all incomes
the confines of the abroad is also earned by abroad (e.g. OFW
country—regardless if you owning property (e.g. buildings, remittances), added as well
are Filipino or a foreigner shops, factories, financial are the product taxes (e.g.
as long as you have a assets like bonds and shares in sales taxes, property
company situated in the foreign countries) earning taxes). Considerations
Philippines or resides in thereby rent and interest. include depreciation of
the country materials used for
production or
manufacturing.

The gross national product (GNP) and the gross domestic product (GDP) are two of the
most frequently used economic indicators when assessing the status of the Philippine economy

Concepts of National Income

A. Gross Domestic Product (GDP):

 GDP is the total value of goods and services produced within the country during
a year.
  This is calculated at market prices and is known as GDP at market prices.
 There are three different ways to measure GDP:
1) Product Method
2) Income Method
3) Expenditure Method.
 These three methods of calculating GDP yield the same result
National Product = National Income = National Expenditure.

The Product Method:

 In this method, the value of all goods and services produced in different
industries during the year is added up.
 This is also known as the value added method to GDP or GDP at factor cost
by industry of origin.
 The following items are commonly included as products: agriculture and allied
services; mining; manufacturing, construction, electricity, gas and water supply;
transport, communication and trade; banking and insurance, real estates and
ownership of dwellings and business services; and public administration and
defense and other services (or government services).
 In other words, it is the sum of gross value added.

The Income Method:

 The people of a country who produce GDP during a year receive incomes from
their work. Thus GDP by income method is the sum of all factor incomes:
Wages and Salaries (compensation of employees) + Rent + Interest + Profit.

Expenditure Method:
 This method focuses on goods and services produced within the country during
one year.
 GDP by expenditure method includes:
1) Consumer expenditure on services and durable and non-durable goods
(C),
2) Investment in fixed capital such as residential and non-residential
building, machinery, and inventories
3) Government expenditure on final goods and services (G),
 4) Export of goods and services produced by the people of country (X),
Less imports (M). That part of consumption, investment and government
expenditure which is spent on imports is subtracted from GDP. Similarly,
any imported component, such as raw materials, which is used in the
manufacture of export goods, is also excluded.
 Thus GDP by expenditure method at market prices = C+ I + G + (X – M),
where (X-M) is net export which can be positive or negative.

If you want to check the current data of National Accounts of the Philippines, you may copy the
link below and search in your browser
https://www.ceicdata.com/en/country/philippines
 Lesson 2
Gross Domestic Product (GDP)

Gross Domestic Product (GDP) is the total value of goods and services produced within
the country during a year. This is calculated at market prices and is known as GDP at market
prices. Dernberg defines GDP at market price as “the market value of the output of final goods
and services produced in the domestic territory of a country during an accounting year.”

A. Three approaches used in GDP Calculations

1. The Expenditure Approach

 The expenditure approach, also known as the spending approach,
 Calculates spending by the different groups that participate in the economy.
 The U.S. GDP is primarily measured based on the expenditure approach.
This approach can be calculated using the following formula:

GDP = C + G + I + NX
Where: C= Consumption
G= Government Spending
I= Investment
Nx= Net Exports (Total Export – Total Import)

Consumption (C) includes all that we pay for in terms of goods and services;
Government Spending (G) includes payroll for government employees and
infrastructure;
Investment (I) fixed capital such as residential and non-residential building,
machinery, and inventories; and
Net exports (Nx) which can be derived from subtracting total import from
total export.

 The expenditure approach, meanwhile, sums up personal consumption

expenditures of households, government consumption, investment or capital
formation, and exports less imports.
  This approach yields GDP by type of expenditure. Common sources of these
data are household expenditures surveys, retail and wholesale trade surveys,
producer surveys, customs records, government accounts, and special
surveys done by the statistical centers

2. The Production or Outcome Approach

 It is essentially the reverse of the expenditure approach.
 Instead of measuring the input costs that contribute to economic activity, the
production approach estimates the total value of economic output and
deducts the cost of intermediate goods that are consumed in the
process (e.g. materials and services).
 In comparison, the expenditure approach projects forward from costs, the
production approach looks backward from the vantage point of a state of
completed economic activity.

The finished product minus

the labor cost and the cost
of production

 The production approach calculates the GDP based on industrial origin

wherein the domestic economy is divided into three productive sectors:
a) Agriculture, fishery, and forestry;
b) Industry; and
c) Services.
 This approach sums up the value added contribution of each sector to obtain
the total contribution to the economy. Data on the value added of these
sectors may be obtained from producer surveys like agricultural surveys, crop
and livestock statistics, manufacturing surveys, surveys of the trade sector,
and others ([PIDS], 2006)

3. The Income Approach

  The income approach represents a kind of middle ground between the two
other approaches to calculating GDP.
 The income approach calculates the income earned by all the factors of
production in an economy, including the wages paid to labor, the rent
earned by land, the return on capital in the form of interest, and corporate
profits.
 The income approach factors in some adjustments for those items that are
not considered a payments made to factors of production. For one, there are
some taxes—such as sales taxes and property taxes—that are classified as
indirect business taxes. In addition, depreciation–a reserve that businesses
set aside to account for the replacement of equipment that tends to wear
down with use–is also added to the national income.

B. Types of Gross Domestic Product

1) Nominal GDP: GDP evaluated at current market prices

2) Real GDP: Real GDP is an inflation-adjusted measure that reflects both the
value and the quantity of goods and services produced by an economy in a given
year. Inflation is the rate at which the general level of prices for goods and
services is rising and, consequently, the purchasing power of currency is falling
3) GDP Growth Rate: The GDP growth rate compares one quarter of a country's
GDP to the previous quarter in order to measure how fast an economy is
growing.
4) GDP Per Capita: GDP per capita is a measurement of the GDP per person in a
country's population; it is a useful way to compare GDP data between various
countries.
 Lesson 3
COMPONENTS OF GDP

The Components of GDP

We can divide the goods and services produced during any period into four broad
components, based on who buys them, namely:
1. Personal Consumption (C)
2. Gross Private Domestic Investment (I)
3. Government Purchases (G)
4. Net Exports (Xn).

GDP = Consumption (C) + Private Investment ( I ) + Government Purchases (G) + Net Exports (
X n ), or GDP = C + I + G + X n

Two types of variables:

1. Stocks. A stock variable is a variable that is independent of time
(Example: Balance in a checking account)
2. Flows. A flow variable is a variable that is measured over a specific period of
time (Example: Income)

Components of GDP

1. Personal Consumption
 A flow variable that measures the value of goods and services purchased by
households during a time period.
 Purchases by households of groceries, health-care services, clothing, and
automobiles—all are counted as consumption.
 The production of consumer goods and services accounts for about 70% of total
output.
 Because consumption is such a large part of GDP, economists seeking to
understand the determinants of GDP must pay special attention to the
determinants of consumption.
 Personal consumption represents a demand for goods and services placed on
firms by households.
  "Personal Consumption in the Circular Flow" presents a circular flow model for
an economy that produces only personal consumption goods and services.
Spending for these goods flows from households to firms; it is the arrow labeled
―Personal consumption.‖ Firms produce these goods and services using factors
of production: labor, capital, and natural resources. These factors are ultimately
owned by households.
Factor Incomes
 The income that flows from firms to households brought about by the
production of goods and services which generates income to households,
Personal Consumption in the Circular Flow.

Personal Consumption in the Circular Flow

Personal consumption spending flows from households to firms. In return, consumer
goods and services flow from firms to households. To produce the goods and services
households demand, firms employ factors of production owned by households. There is
thus a flow of factor services from households to firms, and a flow of payments of factor
incomes from firms to households.
  In exchange for payments that flow from households to firms, there is a flow
of consumer goods and services from firms to households.
 Example: When you buy a soda, for example, your payment to the store is
part of the flow of personal consumption; the soda is part of the flow of
consumer goods and services that goes from the store to a household—
yours.

Factors of production
1) labor,
2) capital,
3) natural resources

 This factors flows from households to firms. If you work for a firm, your labor is
part of this flow. The wages you receive are part of the factor incomes that flow
from firms to households.

Because our focus now is macroeconomics, the study of aggregates of economic

activity, we will think in terms of the total of personal consumption and the total of
payments to households.

2. Private Investment
 Gross private domestic investment is the value of all goods produced during a
period for use in the production of other goods and services. Like personal
consumption, gross private domestic investment is a flow variable.
 It is often simply referred to as “private investment.”
 Examples of investments: A hammer produced for a carpenter is private
investment. A printing press produced for a magazine publisher is private
investment, as is a conveyor-belt system produced for a manufacturing firm.
Capital includes all the goods that have been produced for use in producing other
goods; it is a stock variable. Private investment is a flow variable that adds to the
stock of capital during a period.
Heads Up!
The term “investment” can generate confusion. In everyday conversation, we use the term
“investment” to refer to uses of money to earn income. We say we have invested in a stock or
invested in a bond. Economists, however, restrict “investment” to activities that increase the
economy’s stock of capital. The purchase of a share of stock does not add to the capital stock; it
is not investment in the economic meaning of the word. We refer to the exchange of financial
assets, such as stocks or bonds, as financial investment to distinguish it from the creation of
capital that occurs as the result of investment. Only when new capital is produced does
investment occur. Confusing the economic concept of private investment with the concept of
financial investment can cause misunderstanding of the way in which key components of the
economy relate to one another.

Private Investment in the Circular Flow

Private investment constitutes a demand placed on firms by other firms. It also

generates factor incomes for households. To simplify the diagram, only the spending
flows are shown—the corresponding flows of goods and services have been omitted
 Gross private domestic investment includes three flows that add to or maintain
the nation‘s capital stock:
1) Expenditures by business firms on new buildings, plants, tools,
equipment, and software that will be used in the production of goods and
services;
2) Expenditures on new residential housing;
3) Changes in business inventories.

 Any addition to a firm‘s inventories represents an addition to investment; a

reduction subtracts from investment. For example, if a clothing store stocks 1,000
pairs of jeans, the jeans represent an addition to inventory and are part of gross
private domestic investment. As the jeans are sold, they are subtracted from
inventory and thus subtracted from investment.
 By recording additions to inventories as investment and reductions from
inventories as subtractions from investment, the accounting for GDP records
production in the period in which it occurs.
 For example, that Levi Strauss manufactures 1 million pairs of jeans late in 2011
and distributes them to stores at the end of December. The jeans will be added
to inventory; they thus count as investment in 2011 and enter GDP for that year.
Suppose they are sold in January 2012. They will be counted as consumption in
GDP for 2012 but subtracted from inventory, and from investment. Thus, the
production of the jeans will add to GDP in 2011, when they were produced. They
will not count in 2012, save for any increase in the value of the jeans resulting
from the services provided by the retail stores that sold them.
 Private investment accounts for about 15% of GDP—but, at times, even less.
 Private investment plays a crucial role in the macroeconomy for two reasons:

1) Private investment represents a choice to forgo current

consumption in order to add to the capital stock of the economy.
Private investment therefore adds to the economy‘s capacity to
produce and shifts its production possibilities curve outward.
Investment is thus one determinant of economic growth, which is
explored in another chapter.
 2) Private investment is a relatively volatile component of GDP; it
can change dramatically from one year to the next. Fluctuations in
GDP are often driven by fluctuations in private investment. We will
examine the determinants of private investment in a chapter devoted
to the study of investment.

3. Government Purchases
 Government agencies at all levels purchase goods and services from firms. They
purchase office equipment, vehicles, buildings, janitorial services, and so on.
 Many government agencies also produce goods and services. Police
departments produce police protection. Public schools produce education. The
National Aeronautics and Space Administration (NASA) produces space
exploration.

 Government purchases are the sum of purchases of goods and services

from firms by government agencies plus the total value of output produced
by government agencies themselves during a time period.

 Government purchases make up about 20% of GDP.

 Government Purchases in the Circular Flow

Purchases of goods and services by government agencies create demands on

firms.
As firms produce these goods and services, they create factor incomes for
households.

 Government purchases are not the same thing as government spending. Much
government spending takes the form of transfer payments, which are payments
that do not require the recipient to produce a good or service in order to receive
them. Transfer payments include Social Security and other types of assistance to
retired people, welfare payments to poor people, and unemployment
compensation to people who have lost their jobs. Transfer payments are certainly
significant—they account for roughly half of all federal government spending in
the United States. They do not count in a nation‘s GDP, because they do not
reflect the production of a good or service.

4. Net Exports

 Sales of a country’s goods and services to buyers in the rest of the world
during a particular time period represent its exports.
 Example: A purchase by a Japanese buyer of a Ford Taurus produced in the
United States is a U.S. export. Exports also include such transactions as the
purchase of accounting services from a New York accounting firm by a shipping
line based in Hong Kong or the purchase of a ticket to Disney World by a tourist
from Argentina. Imports are purchases of foreign-produced goods and services
by a country‘s residents during a period. United States imports include such
transactions as the purchase by Americans of cars produced in Japan or
tomatoes grown in Mexico or a stay in a French hotel by a tourist from the United
States.
Subtracting imports from exports yields net exports.

Exports ( X ) − imports ( M ) = net exports ( X n )

 In 2011, foreign buyers purchased $2,087.5 billion worth of goods and services from the
United States. In the same year, U.S. residents, firms, and government agencies
purchased $2,664.4 billion worth of goods and services from foreign countries. The
difference between these two figures, −$576.9 billion, represented the net exports of the
U.S. economy in 2011. Net exports were negative because imports exceeded exports.
Negative net exports constitute a trade deficit. The amount of the deficit is the amount by
which imports exceed exports. When exports exceed imports there is a trade surplus.
The magnitude of the surplus is the amount by which exports exceed imports.

 Goods and services produced for export represent roughly 14% of GDP
 When there is a trade surplus, net exports are positive and add spending to the circular
flow. A trade deficit implies negative net exports; spending flows from firms to the rest
of the world.

Net Exports in the Circular Flow

Net exports represent the balance

between exports and imports. Net
exports can be positive or
negative. If they are positive, net
export spending flows from the
rest of the world to firms. If they
are negative, spending flows from
firms to the rest of the world.

Spending in the Circular Flow Model

  The production of goods and services for personal consumption,
private investment, government purchases, and net exports makes
up a nation’s GDP.
 Firms produce these goods and services in response to demands
from households (personal consumption), from other firms (private
investment), from government agencies (government purchases),
and from the rest of the world (net exports).
 All of this production creates factor income for households.

Spending in the Circular Flow Model

GDP equals the sum of production by firms of goods and services for personal
consumption (1), private investment (2), government purchases (3), and net exports (4).
The circular flow model shows these flows and shows that the production of goods and
services generates factor incomes (5) to households.
 Lesson 3
REAL GDP & NOMINAL GDP
Classifications of GDP

1. Nominal GDP (GDP at current prices)

 When GDP is measured on the basis of current price

2. Real GDP (GDP at constant prices)

 When GDP is calculated on the basis of fixed prices in some year

Nominal GDP is the value of goods and services produced in a year and measured in terms of
Pesos (money) at current (market) prices.
 In comparing one year with another, we are faced with the problem that the
Philippine Pesos is not a stable measure of purchasing power.
 GDP may rise a great deal in a year, not because the economy has been
growing rapidly but because of rise in prices (or inflation).
  On the contrary, GDP may increase as a result of fall in prices in a year but
actually it may be less as compared to the last year. In both 5 cases, GDP
does not show the real state of the economy. To rectify the underestimation
and overestimation of GDP, we need a measure that adjusts for rising and
falling prices.

Real GDP is the value of goods and services in terms of constant market prices and using the
prices on the base year.
 Real GDP can be used to compare the standard of living over time, to track
the course of the business cycle, and to compare the standard of living
among countries.
 To find out the real GDP, a base year is chosen when the general price level
is normal, i.e., it is neither too high nor too low. The prices are set to 100 (or
1) in the base year.
 Now the general price level of the year for which real GDP is to be calculated
is related to the base year on the basis of the following formula which is
called the deflator index (which will be discussed in the next chapter):

Calculation of General Price Level

Suppose 1990-91 is the base year and GDP for 1999-2000 is Php 6,000,000 and the price
index for this year is 300.
Thus, Real GDP for 1999-2000 =Php. 6,000,000 x 100/300 = Php 2,000,000
 Lesson 5
GDP: MEASURE OF ECONOMIC WELL-BEING?

GDP is probably the most widely reported and closely monitored aggregate statistic.
 GDP is a measure of the size of an economy.
 It tells us the total amount of ―stuff‖ the economy produces.
 Since most of us, as individuals, prefer to have more stuff rather than less, it is
straightforward to extend this to the national economy to argue that the higher the GDP,
the better off the nation.
 For this simple reason, statisticians track the growth rate of GDP. Rapid GDP growth is a
sign of growing prosperity and economic strength. Falling GDP indicates a recession,
and if GDP falls significantly, we call it an economic depression.
 For a variety of reasons, GDP should be used only as a rough indicator of the prosperity
or welfare of a nation. Indeed, many people contend that GDP is an inadequate measure
of national prosperity. Below is a list of some of the reasons why GDP falls short as an
indicator of national welfare.

Reasons Why GDP is NOT an Accurate Measure of Economic Well-Being

1. GDP only measures the amount of goods and services produced during the year.
It does not measure the value of goods and services left over from previous years. For
example, used cars, two-year-old computers, old furniture, old houses, and so on are all
useful and provide welfare to individuals for years after they are produced. Yet the value
of these items is only included in GDP in the year in which they are produced. National
wealth, on the other hand, measures the value of all goods, services, and assets
available in an economy at a point in time and is perhaps a better measure of national
economic well-being than GDP.
2. GDP, by itself, fails to recognize the size of the population that it must support. If
we want to use GDP to provide a rough estimate of the average standard of living
among individuals in the economy, then we ought to divide GDP by the population to get
per capita GDP. This is often the way in which cross-country comparisons are made.
3. GDP gives no account of how the goods and services produced by the economy
are distributed among members of the economy. One might prefer a lower GDP with
 a more equitable distribution to a higher GDP in which a small percentage of the
population receives most of the product.
4. Measured GDP growth may overstate the growth of the standard of living since
price level increases (inflation) would raise measured GDP. Thus even if the
economy produces exactly the same amount of goods and services as the year before
and prices of those goods rise, then GDP will rise as well. For this reason, real GDP is
typically used to measure the growth rate of GDP. Real GDP divides nominal (or
measured) GDP by the price level and is designed to eliminate some of the inflationary
effects.
5. Sometimes, economies with high GDPs may also produce a large amount of
negative production externalities. Pollution is one such negative externality. Thus one
might prefer to have a lower GDP and less pollution than a higher GDP with more
pollution. Some groups also argue that rapid GDP growth may involve severe depletion
of natural resources, which may be unsustainable in the long run.
6. GDP often rises in the aftermath of natural disasters. Shortly after the Kobe
earthquake in Japan in the 1990s, economists predicted that Japan‘s GDP would
probably rise more rapidly. This is mostly because of the surge of construction activities
required to rebuild the damaged buildings. This illustrates why GDP growth may not be
indicative of a healthy economy in some circumstances.
7. GDP measures the value of production in the economy rather than consumption,
which is more important for economic well-being. As will be shown later, national
production and consumption are equal when a country‘s trade balance is zero; however,
if a country has a trade deficit, then its national consumption will exceed its production.
Ideally, because consumption is pleasurable while production often is not, we should use
the measure of national consumption to measure economic well-being rather than GDP.

REFERENCES
Measures of Income. Lumen Learning
https://courses.lumenlearning.com/atd-fscj-macroeconomics/chapter/measures-of-income/

Measuring Total Output and Income.

https://saylordotorg.github.io/text_principles-of-economics-v2.0/s24-measuring-total-output-and-
inc.html

Dynan, K. & Sheiner, L. (2018). GDP as a Measure of Economic Well-being.Hutchins Center

Working Paper #43. https://www.brookings.edu/research/gdp-as-a-measure-of-economic-well-
being
 READ/

DIGEST

THE ECONOMICS OF WELL-BEING

Justin Fox
Harvard Business Review
From the Magazine (January–February 2012)

Money isn‘t everything. But for measuring national

success, it has long been pretty much the only
thing (other than, of course, sports). The specific
metric that has prevailed since World War II is the
dollar value of a country‘s economic output,
expressed first as gross national product, later as
gross domestic product. This is an improvement
over ranking by military victories—the most time-
honored gauge. And the era of GNP and GDP
has been characterized by a huge global rise in living standards and in wealth.
At the moment, though, GDP is embattled. Economists and national leaders are
increasingly talking about measuring a country‘s status with other metrics and even with a
squishy-seeming concept like ―happiness.‖ A 2009 study on alternatives to GDP, commissioned
the year before by French president Nicolas Sarkozy and led by the economists Amartya Sen,
Joseph Stiglitz, and Jean-Paul Fitoussi, has become a global wonk sensation. In October 2011
the Organisation for Economic Co-operation and Development (OECD)—a club of the world‘s
wealthy nations—followed with a ―How‘s Life?‖ report on ―well-being‖ in its member countries.
Each year since 2007 the private Legatum Institute has published a global Prosperity Index, a
sophisticated mix of economic and other indicators. Individual nations are getting into the game,
with Prime Minister David Cameron of the UK making the biggest waves by unveiling plans to
measure national well-being. There are decades-old challenges to GDP as well, such as the
United Nations‘ Human Development Index and the Kingdom of Bhutan‘s insistence that it is out
to maximize not GNP or GDP but GNH—―gross national happiness.‖
As everyone in business knows, you manage what you measure. So although the
replacing-GDP discussion may seem a little airy, its growing credibility in important circles could
give it a real impact on economic policy. And it parallels efforts in some boardrooms to use new
metrics to measure overall success. So it‘s worth exploring where the movement is coming from
and where it might be headed. (For more on how the expansion of performance metrics leads to
new management priorities, see ―Runaway Capitalism,‖ by Christopher Meyer and Julia Kirby,
HBR January–February 2012.)
From Happiness Calculus to GDP
The story usually begins with Jeremy Bentham, an Englishman who in 1781 outlined a
philosophy of utility that assessed the merits of an action according to how much happiness it
produced. This was during the Enlightenment, when thinkers sought to replace religion-based
rules with rational, scientific guides to decision making and life. Bentham suggested creating a
sort of happiness calculus for any action by balancing 12 pains (the pains of the senses, the
pains of awkwardness, and so on) and 14 pleasures (the pleasures of amity, the pleasures of
wealth).
Although the basic idea of utility took off, Bentham‘s approach to it did not. Calculating
pleasure and pain in a way that could be compared from person to person was too difficult and
messy. Economists, the most enthusiastic adopters of the concept, came to focus instead on
the tangible expression of people‘s needs and desires: what they were willing to spend money
on.
This work reached an apotheosis in the 1930s, with Paul Samuelson‘s attempt to explain
welfare economics in purely mathematical terms. At about the same time, the economists
Simon Kuznets, in the U.S., and Richard Stone, in the UK, were developing the systems of
national accounting from which GNP and GDP are derived. They were not really concerned with
utility; the main goal was to make it easier for policy makers to manage a national economy
through financial crises and wars. But the combination of a straightforward metric, the belief
among economists that spending patterns revealed all, and the rise in economists‘ clout and
prestige was a powerful one. In the 1940s GNP was adopted by the newly formed International
Monetary Fund and World Bank as the key indicator of economic growth, and over the years it
took on deeper connotations of success and well-being.
For its original purpose—measuring short-term economic fluctuations—GDP is not likely
to be supplanted anytime soon. It may even be gaining ground: A major discussion is under way
concerning whether the U.S. Federal Reserve and other central banks should in times of crisis
focus not on inflation but on GDP growth.
When one moves beyond short-term ups and downs, though, things get more
complicated. ―Our gross national product…counts air pollution and cigarette advertising and
ambulances to clear our highways of carnage,‖ Robert F. Kennedy said on the presidential
campaign trail in 1968. ―It counts special locks for our doors and the jails for the people who
break them. It counts the destruction of the redwood and the loss of our natural wonder in
chaotic sprawl.…Yet the gross national product does not allow for the health of our children, the
quality of their education, or the joy of their play.‖
Although Kennedy‘s critique got little attention at the time, it has since become famous, and
deservedly so, because it gives succinct voice to almost all the major criticisms of GDP. The
three main strands have been these: (1) GDP is, even on its own terms, a faulty measure; (2) it
takes no account of sustainability or durability; and (3) progress and development can be better
gauged with other metrics. Let‘s look at these points in detail.

Measurement error.
Compiling GDP involves making a lot of choices, and even reasonable choices can lead
to skewed results. Statisticians understandably favor goods and services that are bought and
sold—and thus easily valued by market price—over economic activities whose value must be
estimated. Such things as unpaid household work, although clearly of great economic
importance, are left out of the calculations. And the value of government programs, including
health care provision, is generally underrepresented, as is the value of leisure. Yet the anti-
estimate bias is inconsistent: For example, ―imputed rent‖—an estimate of how much
homeowners would pay if they didn‘t own their homes—makes up about 10% of the United
States‘ GDP.
Another element of the inevitable arbitrariness of GDP was introduced with the switch
from GNP in the 1980s and early 1990s. GNP counted the income of a country‘s citizens
wherever in the world it was earned. As global trade and investment grew, this measure
became harder and harder to square with domestic indicators such as employment and
industrial production. It made sense to switch to GDP, which measures only domestic
production. The change, though, altered the growth trajectories of many countries. Developing
nations with lots of foreign direct investment saw GDP grow much faster than GNP would
have—but didn‘t necessarily reap the benefits, because the investments‘ profits went mostly to
multinational corporations.

Sustainability.
As Kennedy‘s comments make clear, GDP can‘t distinguish between economic activities
that increase a nation‘s wealth and ones that eat into its natural endowments (cutting
redwoods), result in sickness and future cleanup costs (pollution), or merely ameliorate
disasters whose costs are never accounted for (ambulances). Measuring the sustainability
(environmental or otherwise) of economic growth requires making estimates, of course. Joseph
Stiglitz, a leading proponent of what‘s usually called green GDP, doesn‘t think sustainability
estimates are any more speculative than some of the estimates now included in GDP. ―Taking
into account resource depletion and some aspects of sustainability is fairly easy,‖ he told me
recently.
It‘s true that the challenges of tracking energy use or pollution aren‘t huge. But the politics are
extremely tricky. In its early days the Clinton administration pushed the Bureau of Economic
Analysis—the agency that measures U.S. GDP—to develop a green GDP. A West Virginia
congressman put a halt to the effort, fearing it would hurt his state‘s coal mining industry. A
green GDP initiative in China got much further, but it, too, was eventually derailed by
opponents.

Other metrics.
Many things of value in life cannot be fully captured by GDP, but they can be measured
by metrics of health, education, political freedom, and the like. In the 1980s Amartya Sen began
to distinguish between ―commodities,‖ which show up in GDP, and ―capabilities,‖ which do not.
A few years later, in a project spearheaded by Mahbub ul Haq, a friend from his university days,
Sen was able to put the idea into practice. The result was the most successful effort thus far to
supplant GDP.

Many things of value in life cannot be captured by GDP, but they can be measured
by metrics of health, education, and freedom.

Ul Haq was a top adviser to Robert McNamara at the World Bank in the 1970s, served
as Pakistan‘s finance minister in the 1980s, and joined the UN Development Programme in
1989. He had long been frustrated by how hard it was for Pakistan and other poor nations to
make rapid progress as measured solely by GDP, so he concocted a project to better track
development, roping in Sen and several other prominent economists to help. The group decided
to supplement GDP with data on life expectancy and educational attainment, which were readily
available worldwide. And—this was ul Haq‘s essential contribution—they combined the numbers
into a simple index that allowed them to rank countries.
 ―I told Mahbub, ‗Look, you are a sophisticated enough guy to know that to capture
complex real­ity in one number is just vulgar, like GDP,‘‖ Sen recalled in a 2010 interview with
the UNDP. ―And he called me back later and said, ‗Amartya, you‘re quite right. The Human
Development Index will be vulgar. I want you to help me to do an index which is just as vulgar
as GDP, except it will stand for better things.‘‖
The first HDI, published in 1990, put the U.S.—at the time far in the lead in terms of per
capita GDP—in 10th place, behind Japan, Canada, Australia, and several small European
countries. It also identified a few nations—Sri Lanka, Vietnam, and China were the standouts—
that with respect to living standards were punching well above their economic weight. The HDI
is now a dominant metric in development circles. And although the main index hasn‘t changed
much, the annual Human Development Report spotlights various other metrics, such as
sustainability and income distribution. In the most recent report, the U.S. comes in fourth on the
HDI but is just 23rd on the ―inequality-adjusted‖ index.
The HDI has spawned legions of imitators, from single-issue rankings such as the
Heritage Foundation‘s Index of Economic Freedom and Transparency International‘s Corruption
Perceptions Index to broad measures of well-being such as the Legatum Prosperity Index
mentioned earlier. Anybody with enough statistical skills and time on her hands can now
construct national rankings to match her priorities. In fact, the OECD‘s website lets those
without statistical skills join in, giving visitors the option of deciding which indicators are the most
important and then spitting out a personalized country list (Australia is number one on mine).

Measuring Happiness
An alternative to crunching data sets to produce a ―vulgar‖ index is to find better ways of
presenting them. In the late 1990s, after decades of practicing medicine in the developing world,
Hans Rosling began teaching a course in global health at Sweden‘s Karolinska Institute. As he
struggled to convey the complex story of the progress he had witnessed, he enlisted his son
and daughter-in-law—both artists—to help. The result was software, since acquired by Google,
that animates the movement of different indicators over time. Complete with Rosling‘s unhinged-
sports-announcer narration, it makes an improbably compelling alternative to GDP rankings.
How compelling? A talk Rosling gave at the 2006 TED conference has been viewed more than
3.8 million times.
The idea that economic and other data can be better presented with a dashboard of
indicators than as a single number or ranked list is very much in the air among experts and
policy makers. In Sarkozy‘s 2009 report on alternatives to GDP, the word ―dashboard‖ appears
78 times. But the notion of dashboards hasn‘t captured the public‘s imagination. What has is a
word that shows up just 29 times in the Sarkozy report (mostly in the bibliography): ―happiness.‖
Perhaps this isn‘t so surprising. After all, happiness is what Jeremy Bentham was out to
maximize way back when. In the 1950s and 1960s psychologists and sociologists reopened the
question of whether it could be quantified. Opinion polls, then entering their heyday as
measurers (and in some cases determiners) of the public mood, were an obvious vehicle for the
attempt.
The economist Richard Easterlin imported the happiness discussion to his discipline with
a 1974 paper pointing out that the results of national happiness polls did not correlate all that
well with per capita income. Rich people were generally happier than poor people in the same
country, but richer countries weren‘t necessarily happier than poorer ones; and beyond a certain
level, rises in income over time failed to increase happiness.
It took quite a while for the so-called Easterlin paradox to garner much attention from
other economists. But the recent emergence of behavioral economics, which takes
psychological research seriously, has caused an explosion of surveys about happiness and
well-being. The trend has been fueled by the example of Bhutan, where the former king Jigme
Singye Wangchuck began talking about gross national happiness in the 1970s, shortly after he
came to power. A 1987 interview with the Financial Times alerted the world to his views—
sending a long parade of happiness pilgrims to Bhutan and spurring the king to eventually
convert GNH
into something tangible enough to measure with development indicators and polling data.
The interest in happiness surveys has also led to critical scrutiny of the Easterlin
paradox. After reevaluating decades‘ worth of polling data, the economists Betsey Stevenson
and Justin Wolfers made headlines in 2008 by refuting the paradox—at least the part that said
people in wealthy nations weren‘t happier than those in poor nations. They were unable to
conclusively debunk the argument that rises in income over time fail to deliver increased
happiness, but the evidence they marshaled certainly muddied the waters. Meanwhile, other
researchers have begun to distinguish between happiness surveys that ask people to evaluate
how satisfied they are with their lives and ones that focus on emotional states at specific times.
The first quality is closely linked to income; the second is not.
The psychologist and behavioral economics pioneer Daniel Kahneman has been working with
the economist Alan Krueger (now the head of President Obama‘s Council of Economic
Advisers) on creating ―national time accounts‖ in the U.S. These would combine time-use
surveys conducted by the Bureau of Labor Statistics since 2003 with measures of economic
value and maybe even happiness. The concept applies its own number-crunching precision to
the study of well-being, but it uses different numbers—minutes. What‘s more, there‘s no obvious
reason for interest groups to oppose it.
There are limits, though, to how far the Bureau of Economic Analysis is willing to go. A
2010 paper by several BEA officials concluded that any GDP expansion should ―focus on
economic aspects of non-market and near-market activities…and not attempt to measure the
welfare effect of such interactions.‖ Even then, they warned, ―it is critical that such an expansion
of the scope of the accounts not occur at the expense of funds needed to maintain, update, and
improve the existing GDP accounts.‖
Money can’t buy happiness. But it could perhaps buy the ability to measure it.

Link to the article

https://hbr.org/2012/01/the-economics-of-well-being

To read related literature on the topic, you may visit and download the link
below (To download, copy the link to your browser)
https://www.brookings.edu/wp-content/uploads/2018/08/WP43-8.23.18.pdf
https://www.brookings.edu/research/gdp-as-a-measure-of-economic-well-being