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Gross domestic product refers to the value of the goods and services that are produced by a country over a given period of time which is usually one year (Mankiw 2008:510). The value must be the market value of the goods and services a country produces. Market value of a commodity is taken as the price the customers are willing to pay in order to acquire the good or service. It is the amount the customers are willing to exchange for the goods. In estimation of a country's Gross Domestic Product, all the goods and services of the country are put together and an estimation of their market value is done. All goods of the country and services must be included in calculating the Gross Domestic Product. It is however hard to include some products in calculation for Gross Domestic Product because measuring them is difficult. Examples of such products are illegal goods and goods produced and consumed domestically without going through the process of buying and selling. It is important to note at this point that the goods included in calculation of Gross Domestic Product are only final goods. Unfinished goods are not included.
Gross Domestic product is most of the times used to determine whether a country is advancing or not. This is by comparing the Gross Domestic Product of a country with the Gross Domestic Product of other countries or comparing the Gross Domestic Product of a particular year to that of the previous years.
Gross Domestic Product can also be viewed in terms of consumption of goods and services in a country. This is done by considering the value of elements known as the components of Gross Domestic Product. They are consumption, investment, government expenditure and net exports. Gross Domestic Product is then considered to be equivalent to total of consumption, investment, government expenditure and net exports (Mankiw 2008:512). Consumption is the expenditure by house holds which means individuals and companies. In this component expenditure in goods like food, clothes, cars and in services like hair styling, transport and education is considered. Investment refers to expenditure in goods and services that will be used in the future or in goods that are used to produce other goods. This category includes expenditure in items such as capital goods like machines, building of new houses and all investing activities by individuals and companies. Government purchases are the expenditure of the government in provision of goods and services to its citizens. Examples of government expenditure are in payment of salaries, repair of roads, protection, purchase of government vehicles and offering of administrative services. Transfer payments like funds given to students in colleges and pension given to retirees must be excluded from government expenditure because they do not contribute to the productivity of the economy. Net exports, the last component of Gross Domestic Product is the simply the difference between total exports and total imports of a country.
Gross Domestic Product is in two forms, the nominal Gross Domestic Product and real Gross Domestic Product. According to Carbaugh, nominal Gross Domestic Product is the market value of the goods and services produced in a country at a given year expressed in terms of the prices prevailing at that year (2006:237). Real Gross Domestic Product on the other means the nominal Gross Domestic Product adjusted to reflect the current prices. This is considered to be the best measure of a country's Gross Domestic Product since it puts into consideration changes in the prices of the commodities. This is more realistic because the value of a country's currency changes from time to time due to inflation or deflation. Real Gross Domestic Product is then the value of goods and services produced in a particular year with reference to another year. Adjustment of nominal Gross Domestic Product is done with the use of a Gross Domestic Product deflator. A Gross Domestic Product deflator is a measure of inflation and it measures the change of value of currency in a year with respect to a particular year, called the base year. It is calculated by finding the ratio of the price of goods and services at a particular year to the price of those goods and services at the base year.(Carbaugh 2006:237) According to Weerapana & Taylor, Gross Domestic Product is calculated by dividing nominal Gross Domestic Product with real Gross Domestic Product (2007:534). From this formula, real Gross Domestic Product is then calculated by dividing the nominal Gross Domestic Product of a year with the Gross Domestic Product deflator of that year.
USE OF REAL GROSS DOMESTIC PRODUCT TO MEASURE LIVING STANDARDS
Living standards refer to the state ability of citizens to acquire the goods and services they need in life (Allen, Bengtsson & Dribe 2005:6). It is the measure of the availability of the goods and services to an individual. They also argue that the living standards of people are depicted by the kind of goods they consume or produce. Over the past years, several methods have been use to measure the living standards of people. Such methods include
Gross Domestic Product is usually used to measure the living standards of the citizens of a country. In doing this, the total output per citizen is calculated by dividing the real Gross Domestic Product with the population of productive citizens of a country. This is called real Gross Domestic Product per capita. As Gillespie puts it, real Gross Domestic Product per capita shows how much each citizen earns in a given year (2007:274). Citizens in countries with higher real Gross Domestic Product per capita are considered to be living in better conditions that those of countries with lower real Gross Domestic Product per capita. Similarly, if the real Gross Domestic Product per capita of a country increases, there is an assumption that the living standards of the citizens of that country has improved. The opposite is true and therefore if the real Gross Domestic Product per capita of a country declines with respect to that of another country or that of the previous year, the living standards are considered to have dropped also.
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LIMITATIONS OF USE OF REAL GROSS DOMESTIC PRODUCT TO MEASURE THE STANDARD OF LIVING
Use of real Gross Domestic Product per head to measure standards of living has been found to have several limitations or shortcomings. The first limitation is that the statistical difficulties in estimating the real Gross Domestic Product which might result to non reliable figures. Buultjens notes that there is distortion in the figures of the Gross Domestic Product because there are challenges in calculation. First, it is difficult to differentiate between final products and intermediate products. Such distinction is critical since only finished goods are supposed to be used to calculate the real Gross Domestic Product. There are other difficulties in putting products into their right year of production. This is because some products are finished goods at various stages during production (2005:16). For example, corn that is harvested in 2009 and put in the stores until 2010 when it is milled and sold for consumption would be hard to classify as finished good in either of the two years. Therefore, it is hard to classify the products as finished or raw products in various stages. Real Gross Domestic product is also affected by changes in the exchange rates currencies in the economy and this is not considered in coming up with the figures for real Gross Domestic product per capita. It is thus argued that real Gross Domestic Product per capita is not a reliable figure due to limitations in calculation.
Another shortcoming associated with the use of real Gross Domestic Product per head to measure living standards is the exclusion of some goods and services in the calculation of Gross Domestic Product. As discussed earlier in this paper, some goods and services are not used to calculate Gross Domestic Product. Examples of these goods are those that are not traded in the market but are produced and consumed in the households, illegal goods traded in backstreet markets and all transactions which are not recorded. (Buultjens 2005:16). Goods like illegal drugs and dealings in precious stones in the black markets are not recorded thus not used in calculation of real Gross Domestic Product. Goods manufactured for own consumption like agricultural produce are not captured because they are not traded in the market. The problem of this exclusion is given as the fact that these goods and services that are not captured affect the living standards of citizens.
Another major weakness of use of real Gross Domestic Product per capita to measure living standards is the fact that calculation of Gross Domestic Product ignores social costs. An economy might be producing more goods and services but at the expense of the health of its citizens. Social costs include overwork of citizens leaving them with little or no time for leisure. Such citizens will be living in low standards even though the Gross Domestic Product is high. Other social costs associated with economic growth are pollution of the environment, escalation of crime levels, health problems and degradation of natural resources, all which cause living standards to decline. Gross Domestic Product would be a more reliable figure if it put these social costs into consideration.
Calculation of real Gross Domestic product employs the use of Gross Domestic product deflator which is estimated using the inflation in the economy. Estimation of inflation is hard since many it is affected by many factors in the economy. This may make the real Gross Domestic product not to be exact.
The other problem is that Gross Domestic Product uses a quantitative rather than a qualitative approach in calculation of living standards. This means that all aspects that concern quality are excluded in Gross Domestic Product. Costs incurred to develop new products and improve on the already existing products are also not captured. This is a serious omission since the quality aspects are more important in determining living standards.
Comparison of figure of real Gross Domestic Product per head of different countries is not realistic. This is because countries produce different goods and services and have different prices for their commodities. The methods of production used are different, with some countries using labor intensive methods while others using capital intensive methods. The costs of production are thus different. Therefore, real Gross Domestic Figure is unique for each country and though the figures of two countries may be the same, the people of those countries may be living in different standards due to different prices and production methods.
The major problem cited with this method of measuring living standards is that real Gross Domestic product per capita might be high in a country, but distribution of resources might be poor. This is the most common occurrence in economies where wealth is concentrated in the hands of a few, with the rest living in poverty. If the wealth of these few rich individuals increases, the real Gross Domestic product per head in the country increases, but the state of the poor remains the same. Therefore, real Gross Domestic product per capita does not consider the distribution of income among the citizens; it just gives an absolute figure for the whole economy. Boyes & Melvin support this argument by observing that "Economic growth is considered to be good because it allows people to have a higher standard of living, to have more material goods. But an increase in real GDP or per capita real GDP does not tell us whether the average citizen is better of" (2006: 391)
Because of the above discussed limitations, real Gross Domestic Product per capita is not a reliable way of measuring the living standards. There is need for other methods to be developed to capture the living standards. Some of the methods that have been devised include use of real wage, use of socio-demographic factors and measuring the ability of citizens to overcome economic shocks in the short run. (Allen, Bengtsson & Dribe 2005: 9)
Real wage is a measure of the income of the workers in the economy. It is argued to be more realistic than the real Gross Domestic Product per head since it takes into consideration the distribution of resources to the citizens. This is better than the real Gross Domestic Product per head that considers what each citizen ought to have given the productivity of the nation instead of considering what the citizen actually has. This method is also criticized for using wages only in establishing living standards. It leaves out income generated by land and capital.
Social-demographic indicators were developed to determine the living standards. These indicators are based on research by companies to determine the living standards. This is through consideration of factors such as availability of health care, mortality rates, child health, availability of recreation facilities and levels of literacy among others. These are also called measures of quality of life. They were proposed and developed by the United Nations Organization. It developed the Human Development index (HDI) to measure the living standards using socio-demographic indicators. This is amore reliable indicator but it consumes a lot of time and resources. Research must be conducted to establish the levels of the factors and such research might take long.
The other method cited by Allen, Bengtsson & Dribe is determining the ability of the citizens to deal with economic shocks in the short run. This method is not common because it has some complexities. This method is based on research on how the population reacts and deals with economic shocks such as and abrupt rise or fall in prices of commodities and rise or fall of demand of commodities. If increase of the price of a basic product such as food causes increased death to the population, such population is said to be living in low standards.
Another method in use is the real Gross disposable national income which measures the income available to citizens for consumption. All these were developed to address the inadequacies of the real Gross Domestic Product per capita to measure living standards.