1. When the activities of somebody result in benefits or harms to others with no payment received for the benefit and no payment made for the harm done, such benefits and harms are called externalities. 

2. Activities resulting in benefits to others are positive externalities and increase welfare; and those resulting in harm to others are called negative externalities, and thus decrease welfare. 

3. GDP does not take into account these externalities. 

4. For example, construction of a flyover or a highway reduces transport cost and journey time of its users who have not contributed anything towards its cost. Expenditure on construction is included in GDP but not the positive externalities flowing from it. GDP and positive externalities both increase welfare. Therefore, taking only GDP as an index of welfare understates welfare. It means that welfare is much more than it is indicated by GDP. 

5. Similarly, GDP also does not take into account negative externalities. For examples, factories produce goods but at the same time create pollution of water and air. River Yamuna, now a drain, is a living example. The pollution harms people. The factories are not required to pay anything for harming people. Producing goods increases welfare but creating pollution reduces welfare. Therefore, taking only GDP as an index of welfare overstates welfare. In this case, welfare is much less than indicated by GDP.