Problems with GDP and GNP as development indicators Alternative indicators addressing sustainability

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1 Measuring Sustainability Problems with GDP and GNP as development indicators Alternative indicators addressing sustainability Net or Genuine Saving Human Development Index (HDI) Environmental Performance Index (HPI) Gross National Happiness (GNH) Issues, concepts, measurement Precautionary principle GDP/GNP Indicator Gross Domestic Product Gross National Product Definition An estimated value of the total worth of a country s production and services, within its boundary, by its nationals and foreigners, calculated over the course on one year. An estimated value of the total worth of production and services, by citizens of a country, on its land or on foreign land, calculated over the course on one year. Formula for Calculation GDP = consumption + investment + (government spending) + (exports imports). Layman Usage Total value of Goods and Services produced within the territorial boundary of a country. GNP = GDP + NR (Net income inflow from assets abroad or Net Income Receipts) - NP (Net payment outflow to foreign assets). Total value of Goods and Services produced by all nationals of a country (whether within or outside the country). Country with Highest Per Capita Qatar ($10,785) Luxembourg ($45,60). (US$) Country with Lowest Per Capita Malawi ($4). Mozambique ($80). (US$) Country with Highest (Total) USA ($17.4 Trillion in 014). USA (~ $11.5 Trillion in 005). 1

2 Problems with using GDP/GNP Distribution of income How is the income distributed does a small proportion of the population earn a high percentage of the income or is income more evenly spread? Quality of life Can changes in economic growth measure changes in the quality of life? Does additional earnings power bring with it additional stress, increases in working hours, increased health and family problems? Impact of exchange rate Difference in exchange rates can distort the comparisons need to express in one currency, but which one and at what value? Problems with using GDP/GNP Informal economy Some economic activity not recorded subsistence farming and barter activity, for example Some economic activity is carried out illegally cash in hand, drug dealing, etc. Work of the non-paid may not be considered but may contribute to welfare charity work, housework, etc. Indiscriminate Makes no distinction between beneficial and harmful economic activity. Gun sales, oil spills, and demolitions all generate economic activity and all count as additions to GDP. Accelerating the depletion of precious nonrenewable resources like oil and coal accelerates GDP growth even as it destroys the essential resource on which that growth depends.

3 Desirable characteristics for sustainable development indicator Sound underlying framework Numeraire / aggregation rules Clear interpretation regarding sustainability Linkage to policy levers through aggregates or sub-aggregates Internationally comparable, available for many countries Alternative indicators Net or Genuine Saving Human Development Index (HDI) Environmental Performance Index (HPI) Gross National Happiness (GNH)

4 Net (Genuine) Saving Rate of savings after taking into account investment in human capital, depletion of natural resources and damage caused by pollution. Principles of Net (Genuine) Saving Asset accounts in monetary units provide a consistent framework and yardstick for measuring development prospects. The components of net saving (gross saving, depletion, damage) can be affected by policy, permitting tradeoffs in the pursuit of sustainability. The saving measure is related to a loose definition of sustainability: non-decreasing present value of social welfare. Positive genuine saving indicates rising social welfare; negative genuine saving suggests that social welfare will fall in the future. Negative net saving implies unsustainability. 4

5 Representative Composition of Net Saving Negative terms Positive term Gross Consump- Net Carbon domestic tion of fixed Energy Mineral forest dioxide Education Adjusted net savings capital depletion depletion depletion damage expenditure savings Low income Middle income Low & middle income High income East Asia & Pacific Europe & Central Asia Latin America & Carib Middle East & N. Africa South Asia Sub-Saharan Africa Net (Genuine) Saving Comparisons GNI is the GDP along with the income obtained from other countries (dividends, interests). 5

6 Adjusted Net Saving vs GDP/cap Adjusted net saving, % of GDP GDP per capita Net (Genuine) Saving Looking at an extended but incomplete range of assets may produce a result further from the truth What s Missing? Health Literacy Education 6

7 Human Development Index (HDI) Summary measure of three basic dimensions of human development: A long and healthy life, as measured by life expectancy at birth Knowledge, as measured by adult literacy rate (/) and combined primary, secondary & tertiary gross enrollment ratio (1/) A reasonable standard of living (GDP/capita) Human Development Index (HDI) The HDI is an index just as vulgar as GDP but it stands for better things (Amartya Sen) Human-centered vs. commodity-centered 7

8 Goalposts for calculating HDI* *UNDP(005): Human Development Report Indicator Max. value Min. Value Life expectancy at birth 85 5 Adult literacy rate (%) Combined gross enrollment ratio(%) GDP per capita (PPP US$) , HDI Calculation HDI = 1/ (D1+D+D) where: D1=longevity index; D= knowledge index D= standard of living index. Individual indices are calculated as: D1 = (actual min) / (max min) D = / adult literacy index + 1/ gross enrollment index D = (log actual log min) / (log max log min) HDI>0.8 represents high 0.5<HDI<0.8 represents medium HDI<0.5 represents low 8

9 17 HDI Trends by Region HDI Rankings (006) 1 Iceland (.968) 11 Finland (.951) Norway (.968) 1 United States (.951) Australia (961) 1 Spain (.949) 4 Canada (.960) 14 Denmark (.949) 5 Ireland (.959) 15 Austria (.948) 6 Sweden (.956) 16 United Kingdom (.946) 7 Switzerland (.955) 17 Belgium (.946) 8 Japan (.95) 18 Luxembourg (.944) 9 Netherlands (.95) 19 New Zealand (.94) 10 France (.95) 0 Italy (.941) 9

10 GDP Rankings (006) 1 Luxembourg ($80,471) 11 United Kingdom ($5,051) Ireland ($44,087) 1 Finland ($4,819) Norway ($4,574) 1 Belgium ($4,478) 4 United States ($4,444) 14 Sweden ($4,409) 5 Iceland ($40,77) 15 Qatar ($,049) 6 Switzerland ($7,69) 16 Australia ($,98) 7 Denmark ($6,549) 17 Singapore ($,867) 8 Austria ($6,01) 18 Japan ($,647) 9 Canada ($5,494) 19 Germany ($1,095) 10 Netherlands ($5,078) 0 Italy ($0,7) 0 Comparison of Indicators GDP per capita HDI Net Saving 10

11 Is the HDI Enough to Measure a Country s Level of Development? According to the UNDP, the answer is: Not at all. The concept of human development is much broader than what can be captured in the HDI, or any other composite indices The HDI and the other composite indices can only offer a broad proxy on some of the key the issues of human development A fuller picture of a country's level of human development requires analysis of other human development indicators and information. What s Missing? Environmental impacts on health Depletion of water resources Depletion of biodiversity Depletion of stocks of fish Climate change... 11

12 Environmental Performance Index (EPI) Based on 0 variables 9 issues objectives: Reduce environmental stress on human health and promote ecosystem vitality and sound natural resources management EPI measures proximity-to target for each indicator (established by international agreements, national standards or scientific consensus with a range of 0-100), which does not vary by country. Scores are calculated as average of the score of the objectives 4 1

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14 7 What s Missing? Psychological well-being Community vitality Cultural diversity Good governance... 14

15 Gross National Happiness (GNH) 0 Gross National Happiness (GNH) 15

16 Three Issues to Consider When Evaluating Indexes 1) Validity ) Reliability ) Parsimony Validity What is the index supposed to measure? What indicators make up the index? Are these the best indicators for this index? How are the indicators calculated? Are there better ways to calculate these indicators? In short, how well does the index actually measure what it is supposed to be measuring? 16

17 Reliability Who or what organization collected the data? How were the data collected? In short, if you or someone else were to try to replicate the index would you end up with more or less the same results? Parsimony The whole point of an index is to simplify the measurement of a particular phenomenon. In short, does the index rely upon as few indicators as reasonably possible without undermining its validity? 17

18 5 Break Decisions under Ignorance I am eating at a new restaurant, for which I don t have any information about the chef. Good lobster Terrible Hungry Hungry 18

19 Decisions under Ignorance Good lobster Terrible 4 1 Hungry Hungry Having a dominates. So there is no reason to choose. Weak Dominance: a a if and only if v( a, s) v( a, s) for every state s. i Strong Dominance: a a if and only if v( a, s i j j ) v( a, s ) for every state s and there is some state s such that v( a, s ) v( a, s ). n i i m j j m i n j n m Dominance Probabilities are not required to assess dominance. However, dominance often fails to single out a particular decision alternative. So, it is not an entirely sufficient decision criterion. 19

20 Maximin Good lobster Terrible 4 1 Hungry Hungry If we are pessimistic, we might want to maximize the worst possible outcome. Maximin criterion: a a if and only if min( a ) min( a ) i j So what should we order? Again, probabilities are not required. i j over all states s. Precautionary Principle The precautionary principle states that if an action has a suspected risk of causing harm to the public or to the environment, then the burden of proof that it is not harmful falls on those taking an action. The principle implies that there is a social responsibility to protect the public from exposure to harm, when scientific investigation has found a plausible risk. In some legal systems, as in the law of the European Union, the application of the precautionary principle has been made a statutory requirement in some areas of law. Practically, the precautionary principle implies a maximin decision criterion. 0

21 Maximax Good lobster Terrible 4 1 Hungry Hungry If we are optimistic, we might want to maximize the best possible outcome. Maximax criterion: a a if and only if max( a ) max( a ) i j So what should we order? Again, probabilities are not required. i j over all states s. Minimax Regret Good lobster Terrible 4 1 Hungry Hungry What if we order the lobster and it turns out to be terrible? What if we order the, and we find out that the lobster is good? 1

22 Minimax Regret Regret Table Good lobster Terrible Hungry Hungry 1 What if we order the lobster and it turns out to be terrible? What if we order the, and we find out that the lobster is good? Minimax regret criterion: Will we actually learn whether the lobster was any good? Minimax Regret What if the waiter now tells us that the special of the day is Thermidor? Thermidor Good lobster Hungry Outstanding! Terrible Hungry Horrible!

23 Minimax Regret Regret Table Thermidor Thermidor 0 1 So what meal is preferred option now? Minimax regret is sensitive to irrelevant alternatives. Principle of Insufficient Reason If one has no reason to think that one state of the world is more probable than another, then all states should be assigned equal probability. This transforms a decision problem under ignorance into a decision problem under uncertainty (or risk). This implies that we should maximize expected utility. 4 1 Thermidor 10-10

24 Principle of Insufficient Reason Extremely sensitive to delineation of states. What if we divided into Excellent chef and Mediocre chef? Excellent chef Mediocre chef Thermidor Which meal is preferred now? In general, why favor equal probabilities over anything else? Ellsberg s Paradox I have an urn containing 90 balls: 0 are red The remaining 60 are either black or yellow or a mix. Which would you prefer? Gamble 1: Receive $100 if a red ball is chosen Gamble : Receive $100 if a black ball is chosen Gamble : Receive $100 if a red or yellow ball is chosen Gamble 4: Receive $100 if a black or yellow ball is chosen 4

25 Ellsberg s Paradox It is inconsistent to prefer G1 and G4 (or G and G), yet that is what most people state. Rather than certainty principle, it seems that people want to avoid ambiguity. Perhaps we should add ambiguity aversion to risk aversion. Remainder of Term: No class on Tuesday, June Help session on Thursday, June 4, :00-:00 PM TA office hours (Time and Location TBA) Prof. Borsuk office hours (C11) Thursday, June 4, :00-5:00 PM Friday, June 5, :00-5:00 PM Final Exam: Sunday, June 7, 11:0 AM 5