Why is GDP per capita useful as a measure of living standards? What are the limitations of GDP per capita as a comparable measure of living standards?
Gross Domestic Product (GDP) measures the monetary value of final goods and services produced in a given year by factors of production within a country. GDP reports are released on the last day of each quarter, reflecting the previous quarter. Therefore, it is measured on a quarterly basis and measures the level of economic growth in different countries.
GDP is commonly expressed as an international currency and is useful because it is widely known, easily calculated and provides a useful statistic for comparison. These figures can help us determine whether a nation’s economy has experienced economic growth or recession through nominal GDP.
The major advantage of using GDP per capita as an indicator of living standards is because it is used widely, frequently and consistently. It is measured widely as GDP is available for most countries in the world, allowing comparisons to be made.
It is measured frequently as most countries provide GDP data on a quarterly basis, allowing trends to be seen quickly. It is measured consistently as GDP is relatively consistent among countries.
GDP is divided by the population of a country to obtain GDP per capita, the amount available to the average person to spend. GDP per capita is a good indicator of living standards, as a rise in GDP per capita signals a growth in the economy and an increase in living standards as people are spending more. GDP per capita is more effective than GDP when measuring living standards as total GDP may not be distributed amongst the population, leading to no improvement of the standard of living of the average citizen.
National input, output and expenditure are generated by the activity of households and firms, through the circular flow of income, which measures GDP. Households provide factors of production (land, labour, capital and enterprise) to firms, whilst firms provide goods and services for households. The factors of production earn an income that contributes to the national income. Land receives rent, labour receives wages, capital receives interest and enterprise receives profit. Households pay for goods and services using the income they receive from selling their factor of production. The output generates income, which is spent on the output. This is the circular flow of income. National income = national output = national expenditure, so the equality of income and output shows the link between productivity and living standards.
Although GDP is used widely, frequently and consistently, there are limitations of GDP per capita as a comparable measure of living standards. GDP is divided by the population to estimate living standards of the citizens in a particular economy; however, the welfare of the society could be an inaccurate reflection as GDP per capita is merely an average. Economic inequality, the gap between the rich and the poor, consists of disparities in the distribution of income within a population. As GDP per capita is a mean value, it does not demonstrate income distribution.
Therefore, each citizen will receive different amounts of GDP depending on their economic status and how much income they gain. If the GDP of a country increases, people would naturally think that the standard of living has increased and people are spending more. However, if there has been a natural disaster in a country, a lot of money would be spent on the damages and infrastructure. This would ultimately lead to a rise in the GDP, but the standard of living for the population would decrease from the damage of the disaster. Additionally, a society with longer working hours (LEDC) will have a higher GDP, but less leisure time and not necessarily greater well-being
Alternatively, a society with a more even income distribution will have a greater level of well-being. Generally, LEDCs, who have little income and weak economies would value $10,000 more than MEDCs. Consequently, GDP per capita is effective when basic needs are not being met (LEDCs), so an increase in consumption of goods and services would lead to greater happiness and greater well-being. Rich societies tend not to be happier than poor societies, which is known as the Easterlin Paradox.
Standard of living is defined as the level of wealth, comfort, material goods and necessities available to a certain socioeconomic class in an area. Standard of living includes social, cultural, environmental and political factors such as income, poverty rate, life expectancy and access to quality health care to name a few. GDP is a factor of standard of living however it is not the solitary constituent. GDP per capita does not take any of the other factors that define ‘standard of living’ into consideration. This is a limitation as true representation of standard of living is not achieved by only evaluating the GDP per capita of a country because there are many other components incorporated in the definition.
Problems that occur when measuring GDP in monetary terms is that it doesn’t show the purchasing power of money. Purchasing Power Parity estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency’s purchasing power. Currencies are traded like any commodity and sometimes they are over or undervalued in different countries. If the common exchange rate was used, a distorted picture of comparable living standards would be the result. Therefore, PPP is used to correct the distortions caused by over or undervalued currencies.
GDP per capita ignores the value of goods and services that are not traded, which may understate the true living standards because of the black economy. In a black/hidden economy, economic activity and the consumption of goods and services are not recorded or included in the GDP. The illegal economy is part of the hidden economy and consists of income produced by violating legal laws, such as criminal activities, drug trafficking and prostitution. Therefore these activities do not show up on tax authorities. Non-market goods and services are not recorded either.
An example of this is babysitting; some parents may put their children in daycare centres, which they pay and therefore the money is included in the economic activity of the country. On the other hand, a parent may ask a neighbor to look after their child whilst they go out, as a favour without paying them. The neighbor is executing the exact same service that a daycare centre would, except they do not receive any money for doing so. The Economist’s latest estimates for the total value of the black economy throughout the world is $9 trillion and Nigeria and Thailand have the world’s largest black economies, both accounting for more than 70% of official GDP. This would understate the standard of living as the increase in GDP is not shown and therefore the GDP per capita would not increase. This could deem that the standard of living is not increasing, when in theory it should be.
There are more limitations than practical factors when measuring standard of living by GDP per capita. Firstly, GDP per capita is just a mean value and does not determine income distribution. Secondly, GDP per capita does not take into account other factors that define ‘standard of living’. Thirdly, purchasing power of money is not shown when measuring GDP in monetary terms, which does not reflect true living standards. Lastly, the black economy throughout the world has a total value of $9 trillion, which has not been recorded and understates the true living standards in a particular area.
Although GDP per capita is a good measure of standard of living because it is easy to compare – it is measured on a quarterly-basis and it is available for most countries in the world – GDP does not measure the standard of living, but the total output of the national economy. When measuring living standards, all social, cultural, environmental and political factors should be included, which would produce an accurate representation of living standards in a specific area.