Externalities both positive and negative are the limitations of the GDP as an indicator of the welfare, because GDP does not take them into account.
- Taking an example of introduction of metro rail , as an latest means of transport , reduces transport cost, travel time of its commuters who have not directly contributed anything towards its cost. Expenditure on its construction is included in GDP but not the positive externalities flowing from it.
- Similarly , GDP does not take into account negative externalities. Taking an example of factories producing goods , they exercise welfare on one hand but on the other hand create pollution of air, water and noise, which in turn harms people , so as the pollution created by the factories reduces welfare.
- Thus taking only GDP as an index of welfare overstates welfare. In this case welfare is actually lesser indicated by GDP.
