In the first blog entry I wrote about the meaning of the word “development” and it led us to an interesting discussion of whether our definitions of development are normative or positive. In the second part of the “Measuring Development” series I would like to talk a bit about an indicator of development: living standards.
Living standards are obviously of utmost importance to economics. Sen (1988, p.11), for instance, points out that “the enhancement of living conditions must clearly be an essential – if not the essential object of the entire economic exercise”. Clearly, we can mean different things when we talk about living standards. To start with a rather simple differentiation, I distinguish between material living standards (MLS) and a broader notion of living conditions (LC), which includes aspects of life that go beyond the material component (i.e. education, health, job satisfaction,… ). The following paragraphs discuss whether GDP per capita successfully measures MLS.
GDP per capita is certainly one of the most widely used measures to assess the level of development or the living standards in a country. There are certainly some good reasons why this is the case: for instance, measures of GDP per capita are available for all countries and are generally quite reliable (or at least more reliable than other indicators). In addition, international standards such as the United Nations System of National Accounts facilitate comparisons across countries. The purpose of GDP is to measure economic activity in a country. It is calculated either as the value added or the sum of incomes or the sum of the value of final products in an economy. Regardless of the way it is calculated, in its core it measures the value of the gross production within a country. Therefore, we could wonder if measuring economic activity and dividing it by the number of citizens really gives us a good picture of living standards in a country.
If anybody cares to dig deeper into this issue, the French government put some of world’s leading economists in charge of investigating this issue. The so called Report of the Commission on the Measurement of Economic Performance and Social Progress that resulted is over 300 pages long, but certainly an interesting piece of work. If you don’t want to read the whole thing, let me give you a short summary of some of the most important arguments.
Firstly, GDP/capita is a flow measure. Thus it does not consider stock variables such as accumulated wealth or the state of the environment. This is problematic, because the material component of living standards relates to individual consumption and not income. Not including measures of wealth can drive a wedge between income and consumption (i.e. if income falls, people could still maintain the same level of consumption by reducing their accumulated wealth). Therefore, by measuring only income, we get an inaccurate measure of the (material) well-being of individuals.
Secondly, GDP does not include services or goods whose market value cannot readily be determined. One important aspect is, for example, that GDP neither values household production nor leisure. Regarding the former, the same good or service can often be produced by the household or by a firm. In the former case it does not enter into GDP, while in the latter case it does. This violates the invariance principle, which states that an equivalent good or service should be valued equivalently no matter who produces it. Excluding leisure is also problematic, because arguably it increases the individual’s non-material welfare. By not including household production and leisure, for example, GDP falls short of providing an accurate picture of MLS as well as LC. In recent decades national accounts have been extended in a variety of ways to address such issues (i.e. in the Sustainable Measure of Economic Welfare by Nordhaus & Tobin (1973)).
Thirdly, it is not quantity of the goods and services produced that matters, but also quality. While there have been attempts to adjust for quality improvements, these are hard to measure and often lead to over- or understatements of inflation and correspondingly real income. This is particularly problematic for evaluating services.
Finally, GDP/capita is an average that doesn’t take into account the distribution of income. Yet income inequality matters for MLS, because if inequality is high, GDP/capita will substantially underestimate the well-being of some and overestimate the well-being of many. It also matters for living conditions, because high income inequality is often tied to other types of inequalities, which lowers well-being beyond the material dimension (see, for instance, Crafts, 2002; Sen, 1988).
The majority of these arguments are related to the shortcomings of GDP in actually measuring the “material well-being” of individuals. They show that particularly the omission of distributional concerns, the focus on production instead of consumption and the omission of non-monetary variables are substantial problems if we want to use GDP/capita as a measure MLS. However, there is a more fundamental problem if we want to get a more comprehensive picture and measure living conditions rather than just their material component. Unless we can assume that all indicators that we consider important for living conditions are positively, significantly (and preferably causally) related to GDP/ capita, we cannot use GDP/ capita as an approximation for LC. But we will take a closer look at these issues in the next blog entry.
CRAFTS, N. 2002. The Human Development Index 1870-1999: Some revised estimates. European Review of Economic History, 6, 395-405.
SEN, A. 1988. The Concept of Development. In: H. CHENERY, H. & SRINIVASAN, T. N. (eds.) Handbook of Development Economics Amsterdam: Elsevier.
STIGLITZ, J. E., SEN, A. & FITOUSSI, J.-P. 2009. Report by the Commission on the Measurement of Economic Performance and Social Progress.