Question

'GDP as an index of welfare may understate or overstate welfare'. Explain the statement using examples of a positive and a negative externality.

Answer 1

GDP does not account fpr externalities. Externalities refer to the benefits or harms which a firm or an individual causes to another but for which they are not paid or penalised.

Negative externalities: Example, pollution from factories decreases welfare which is not considered while measuring GDP which therefore, overstates the actual welfare.

Positive externalities: Example, Saving of commuting time due to construction of a fly-over increases welfare which is not considered while measuring GDP, would imply that GDP as an index understates welfare.