I am starting to have difficulty believing that it indicates more productivity. I considered two cases where productivity of the worker doubles, and consider its long term influence on the GDP.
Case 1: Limited demand for item: In this extreme, the demand for the item is completely limited at the current or lower price. Influence of higher price is not relevant here. Let the demand be satisfied by 100 people making $50k average. Assuming wages match product cost, together, they contribute $5M to the GDP.
Now, imagine productivity of the workers producing this item suddenly doubled. Instead of needing 100 people being paid $50k, we need just 50 people making $50k to satisfy demand. What is the influence on the GDP?
50 people suddenly are unemployed because we assume constant demand. We assume the 50 unemployed people find other jobs paying the same amount. Thus they contribute $2.5M to the GDP from the outside.
In this industry, the same 50 people now are able to produce twice as much leading to a halving of price. As demand does not change, same number of items contribute half as much to the GDP: $2.5M.
So the total GDP should not change despite a doubling of efficiency for a particular item.
Case 2: Unlimited demand, limited money: This is the other extreme where the people will pay a limited amount of money for the item, but can consume it in unlimited quantities. Again, consider 100 people working for $50k average.
After the productivity increase, 100 people can make twice as much goods for the same half price adding up to the same total - $5M, all of which will be produced and consumed. The contribution to the GDP by this 100 people again remains the same - $5M.
I think most practical situations will fall between these two extremes. As there should be no GDP growth in either of the extremes, I find it hard to believe the combined situation would increase the GDP.
When can GDP increase?
I can also provide a scenario where GDP increases after being adjusted for inflation.
Inflation is measured based on the purchasing habits of a typical consumer. However, GDP is the total product, most of which is consumed by the rich consumer, given the current state of wide income and spending disparity.
If you print money, and give it to rich people, it would influence your inflation metric only a bit because the typical consumer does not have more money and cannot drive up the prices on the things he needs. But there would be a substantial increase in prices and product for the rich people contributing substantially to the overall GDP.
For example, Japan has had languishing GDP growth for over a decade. But they increased their productivty over time along with other nations as they have remained competitive.
I am trying to understand what is the flaw in my reasoning. I will update with interesting answers.
TL;DR: May be productivity increase does not cause GDP growth. Increase in spending inequality does.
EDIT: By real GDP, I mean nominal GDP after adjusting for inflation. I am using it as a technical term and I think that is its definition.
Case 1: You nailed it. In a productive economy, GDP would go down.
Case 2: I don't get the math. If they are making twice as much, and selling at the same price, why is GDP the same?
Doesn't typical mean average, meaning half the country has less money than him, and half have more? So that when we talk about the typical consumer, one way or the other we are talking baout half the country?
In any case, you are contradicting yourself. At first you write that most of GDP is rich people consuming, meaning the rich spend most of the money. Then in the next paragraph you write that if you give rich people more money that won't do anything. But they account for most of GDP, you said, meaning they do most of the buying. So if what they buy goes up in price, as you said it would, that would be price inflation.
But the truth is that you are right. An increase in GDP can only occur if there is inflation [=increaase of money supply]. So that if there was a true adjustment for inflation, the GDP could not rise [given that velocity of money changes only very slightly in a large economy]. The increases in GDP that happen despite their being "adjusted for inflation" can only happen because the adjustment for inflation was flawed.
All this is layed out in Kel Kelly's brilliant article.
Look for his article on Japan to explain what's happening there. And for his critique of GDP in both articles.
Bottom line: You are on to something. Needs polishing, though. Have you studied any AE?
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It's easy to refute an argument if you first misrepresent it. William Keizer
The first step should be to accurately define what GDP is. I would call it Circulating Money Supply or some such. Gross Domestic Product is a joke of a misnomer. After you filter out that "product" mental trap it becomes easy to answer the question.
I fixed the post to make case 2 clearer. I think it answers your question.
Yes, "typical" means half the country spends (slightly better than has) less than him and the other half spends more than him. Consequently, what it does not mean is that half the money spent is by people poorer than him and the other half is being spent by people richer than him.
In fact, the people richer than the "typical" consumer contribute a lot more than half the spending power. The point is that the inflation metric weights spending patterns by vote, while the GDP weighs spending patterns by, well... spending!
Consider the top 5% of the population. If only their income went up by 10%, their items would become 10% costlier (very rough prediction). But that would contribute only 10% * 5% = .5% to inflation. But if the top 5% were responsible for 50% of all spending, there would be a 10% * 50% = 5% increase in GDP. Consequently, there would be a 4.5% increase in "real" GDP. By printing money.
AE was introduced to me by a friend some years ago. I read it for quite a while. To be honest, recently, I have been developing certain radically alternative explanations. As they become clearer, I will present some of them here.
When there is a discrepancy between what GDP should be showing and what the method used to calculate inflation is showing, how do you know the error lies in GDP? Maybe it lies all in the way you you are calculating inflation, or maybe both things are wrong. In any case you haven't provenn that GDP is inherently incorrect.
I saw the new Case 2. It is very similar to case 1, an increase in productivity leading to a fall in prices. Indeed that is Kel Kelly's insight as well, that increase in productivity with a fixed money supply will not change GDP.
Gautham, I don't understand what you mean by "limited/unlimited demand for item". Can you please explain?
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I am characterizing extremes of types of demand for an item. When the price falls because of increased productivty, demand could increase, or not increase.
The "limited demand" case reflects the situation where halving of prices produce absolutely no change in the demand for an item.
The other "unlimited demand" extreme is where a halving of prices doubles the demand for the item.
The argument that doubling is an extreme case needs some justification. I understand it is feasible that the demand can more than double. The only possible explanation for this that I can think of is possible indivisibility of the item. But if the item is assumed to be infinitely divisible, because of marginal utility, a doubling of demand is (probably) the extreme case.
Hope this makes it clear. I have been known to have great difficulty guessing other people's confusion. Specific questions allows me to produce more focused answers.
I am not suggesting that GDP is incorrect. I will gladly stipulate that given the definition of GDP, the economists do a fairly good job of estimating it.
Instead, I am questioning the GDP's relevance as a metric of economic progress, given that increase in productivity does not increase GDP.
In fact, an argument could be made that targeting real GDP growth could actually be harmful because, due to the disconnect between inflation metric and GDP, policies that result in real GDP growth by increasing income disparity may appear artificially beneficial and be forced upon the public.