Question

Discuss the limitations of GDP as a measurement tool.

If the economy runs most efficiently when left on its own (Adam Smith’s invisible hand), then why do we need government involvement? Do you think government should be so heavily involved in our economy?

Answer 1

The limitations of GDP

GDP is a useful indicator of a nation’s economic performance, and it is the most commonly used measure of well-being. However, it has some important limitations, including:

• The exclusion of non-market transactions
• The failure to account for or represent the degree of income inequality in society
• The failure to indicate whether the nation’s rate of growth is sustainable or not
• The failure to account for the costs imposed on human health and the environment of negative externalities arising from the production or consumption of the nation’s output
• Treating the replacement of depreciated capital the same as the creation of new capital

The phrase invisible hand was introduced by Adam Smith in his book 'The Wealth of Nations'. He assumed that an economy can work well in a free market scenario where everyone will work for his/her own interest.

He explained that an economy will comparatively work and function well if the government will leave people alone to buy and sell freely among themselves. He suggested that if people were allowed to trade freely, self interested traders present in the market would compete with each other, leading markets towards the positive output with the help of an invisible hand.

In a free market scenario where there are no regulations or restrictions imposed by the government, if someone charges less, the customer will buy from him. Therefore, you have to lower your price or offer something better than your competitor. Whenever enough people demand something, it will be supplied by the market and everyone will be happy. The seller end up getting the price and the buyer will get better goods at the desired price.

The main reasons for policy intervention by the government are:

1. To correct for market failures
2. To achieve a more equitable distribution of income and wealth
3. To improve the performance of the economy

A regulated economy provides the following advantages:

• It looks out for the safety of consumers.
• It protects the safety and health of the general public as well as the environment.
• It looks after the stability of the economy.

Without large interference by the government the economy would have collapsed years ago. Unlimited power given to the big businesses will ultimately ruin our free market economy because it will not be free anymore and will just be controlled by big businesses that can set their prices as high as they want because there is no other competition and people have to buy from them. The government is also more inclined to protect its people from economic failures then a big business which is solely focused on making a profit.