Why might a given increase in real GDP not accurately reflect an increase in living standards?

In brief, measuring the Gross Domestic Product (GDP) of a country is a way of calculating economic activity in the region. There are three ways a government can take the GDP of its country; by measuring the monetary value of its income, output or expenditure. However, the value of the normal ‘nominal GDP’ depends on not only the actual quantity of goods but the prices of goods as well, and this can largely be affected by inflation or deflation. Therefore, adjustments are made to the nominal GDP based on price changes to make the ‘real GDP’, a more accurate measure of economic activity. It is a common misconception that the real GDP is an indicator of not only economic well being but also of standards of living. Unfortunately, inflation and deflation are not the only reasons why the GDP might not reflect how a society is faring and even real GDP might not indicate actual standards of livings in a country.

The reported growth in real GDP largely depends on the government and the accuracy of their statistics and calculations and even if a government is extremely careful in their data collection and calculations, there will be economic activity that will not be measured. Shadow economies, also known as underground economies or black markets, are extremely prominent especially in countries in which production taxes are high. Markets in these economies do not declare their economic output usually either to avoid being taxed or because its goods have been banned. If there are markets that the government are not aware of and thus cannot measure, the real GDP that the government declares will not be accurate. Often there is also non marketed output in an economy, where there is no official transaction between suppliers and consumers and therefore, no record of economic activity. For example, if a person cuts firewood and gives some firewood to his friend. There is still a transition of goods from suppliers to consumers but it is not official or recorded and there are often no prices on part of the consumers. Similarly to the consequences of a shadow economy, if economic transactions are not recorded and declared, the government cannot report an accurate representation its country’s economic activity.

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Real GDP also does not take into account the composition of output, only the monetary value of it, and also disregards its region’s purchasing power parity (PPP) compared to other regions. Measuring output based on its prices is a problem simply because an expensive good might not represent a useful good. In fact, many expensive goods are luxuries while some goods with less monetary value are needs. It is possible that a country has a high real GDP value, perhaps due to its specialisation in luxury items, and yet also has substandard living conditions because of lack of output in necessities. On the other hand, another region could have a low GDP and but good living conditions because the necessities of its citizens are met. Countries with a relatively low GDP can also have higher standards of living than countries with higher GDP because of differences in PPP. Purchasing power parity is an equilibrium at which the price of a good in one region is the same as the price of the same good is in another. Sometimes, exchange rates between countries do not reflect the PPP and so it is cheaper or more expensive to buy certain goods and services in certain countries. For example, the GDP of the United States (in 2010) was 14,620,000, almost three times that of China, but the price of a Big Mac hamburger in China is less than half the price of a Big Mac in the United States. Even more shocking is the differences in the prices of taxi rides. The price of a taxi ride in Los Angeles can be up to five times more expensive than a taxi ride of the same length in Beijing, depending on the distance traveled. Naturally, in a region in which living costs are relatively lower than other regions, a lower real GDP does not indicate lower standards of living.

In addition, a growth in real GDP might not reflect a rise in living standards because the GDP also does not take into account the population of the region or the income disparity. It is not by coincidence that the two countries, namely the U.S. and China, with the largest populations have the highest GDP. That there will be more economic activity in regions with more people than in regions with less people is to be expected. A more accurate representation of a country’s living standards would be if the GDP was then divided by the region’s population to make the GDP per capita. Unsurprisingly the countries with the highest GDP per capita are not the U.S. or China, but Qatar, Liechtenstein, Luxermbourg and Norway. However, even then, a high GDP per capita might not reflect high living standards in the country depending on the income disparity. For example, China has a real GDP growth rate of 10.1 per cent which is very high considering its large population. Yet, China has only ‘medium human development’ according to the United Nations and more than 212 million people are living below US$1.25 a day. Here it shows that the Chinese government has not redistributed income among its citizens and that China’s capitalist economic policies and many corrupt officials stop the nation’s growth in wealth from being shared. China’s rise in real GDP has not so far reflected a correlating rise in standards of living for every citizen.

Finally, there is also the notion that “money cannot buy happiness”. The real GDP is a measure of the economic and therefore monetary growth and activities. The amount of money and the material goods owned are determinants of living standards, as are stress levels, health, crime rates, political freedom and countless of other externalities. Surveys have shown that though the purchasing power of the average Hong Kong citizen is higher than that of an average European citizen, the average European citizen is more content with his life than the average Hong Kong citizen, because of the long working hours and high stress levels in Hong Kong. Some say that the real indicator of standards of living is the level of satisfaction with a person’s own life, not GDP. As Robert F Kennedy says, the GDP “measures, in short, everything except that makes life worthwhile”.

In conclusion, a growth in real GDP might not accurately reflect a rise in living standards for numerous reasons, some of which are demonstrated above, thus the GDP should not be used to judge human development.

Munglok Wong 12 LZ

Economics HL: Mr. Parkinson