Is GDP a good measure for the standard of living?
I received this question request on quora. This is a very common question, you can search it on google as well, and I would also like to do my part, by answering it on my blog. Let’s first look at the meaning of GDP: GDP stands for Gross Domestic Product. It refers to the final value of goods and services produced within a country during a particular year.
GDP is of two types:
- Real GDP: When the GDP of a current year is measured on the base year prices. In simple words, Real GDP incorporates the inflation level in the economy.
- Nominal GDP: When the GDP of a current year is measured on the current year prices only. In other words, Nominal GDP ignores the inflation prevailing in the economy.
So, when someone asks is GDP a good measure, they generally mean nominal GDP. So, the answer to the above question is “No”. Now, let’s see why it is not a good measure:
- Nominal GDP can increase even without any increase in physical output because it is affected by a change in prices. It increases without any actual increase in production, but due to the rise in prices affecting nominal GDP.
- Nominal GDP does not reflect the actual distribution of GDP. The rise in nominal GDP could be due to an increase in inequalities in the distribution of income. Thus, the gap between rich and poor increases.
- It ignores non-monetary transactions. Many activities in an economy are not calculated in monetary terms like the services of housewives are not included in GDP. However, they influence the economic welfare.
- Nominal GDP ignores externalities. Externalities mean the benefits and harms of any activity by an individual or a firm, for which they are not paid or penalized. For example, I am running a factory which causes a lot of environmental pollution and I am not paying for the pollution caused by my factory but you are suffering in terms of air quality you breathe. These are externalities, which are not included in the calculation of GDP but they affect economic welfare.
I hope it is making sense, that why GDP is not considered to be a good measure of the standard of living. Now, let’s see what could be a better measure — Its the real GDP. Let’s see why:
- Real GDP reflects the real picture because it includes inflation, so if, real GDP increases then you can assume that actual production of goods and services took place not only increase in prices.
- Real GDP also helps in doing the international comparison, because it includes price differences, we get the true picture that which economy is progressing or growing and which is not.
Read more about the basics of National income.