Wednesday, August 15, 2007

Issues With GDP as a Measure of Well-Being

GDP measures the total amount of goods and services that are created in an economy. GDP per capita is used as a proxy for standard of living and more generally of well-being. It is used to compare levels of well-being between nations. It is also used as a way to compare how the level of well-being has changed over time in a nation.

While GDP is a good measurement of the size of the formal economy, using GDP per capita as a measure of well-being has 6 issues that impact its accuracy.

1) GDP gives no value to leisure. A society that works more hours will have a higher GDP but not necessarily greater well-being.

2) GDP does not capture the non-paid sector: volunteer work, the informal sector (and black market), raising children, and household duties. GDP can grown by monetizing work that previously was done for free, but this does not necessarily increase well-being.

3) GDP includes 'Regrettables' such as police protection, health care, insurance, and military spending. They are regrettable because if people were more honest, healthier, less prone to accidents and more peaceful, the money could be spent in ways that lead to greater well-being.

Imagine two countries, one with a greater level of honesty such that they can have a smaller police force than the other. The citizens of that country would spend less on fighting crime and have more money to spend in other more pleasurable ways. That society would have greater well-being but it would not be reflected in GDP. Similar scenarios could be constructed for doctors, soldiers, fire fighters or social workers. Not to say that these aren't valuable and rewarding jobs, just that society would be better off if we didn't need as many of them.

Some argue that these regrettables such as the Exxon Valdez oil spill actually increase GDP because jobs are created to clean up the spill. This is not true, but rather an example of the broken window fallacy: that breaking a window helps the economy by creating a job for that glass worker. It is incorrect because the money that is spent fixing the window could have been spent in another way that would have created another job for another person. Likewise, regrettables don't add to GDP, they just redirect spending.

A society that spends less on regrettables will have greater well-being at the same level of GDP as one that spends more.

4) GDP does not take into account assets. Even from a standard economics point of view, this doesn't make sense. It is like judging a company based solely on its income statement without looking at the balance sheet.

Often times after a natural disaster GDP goes up due to the economic activity generated by reconstruction. While no one thinks that destroying houses makes good economic sense, GDP does not take reflect whether assets are being increased or decreased and therefore gives an incomplete view of the economy. It doesn't make sense to look at GDP growth without taking a look at what is happening to a nations assets in the form of real estate, stocks, bonds, and cash and their liabilities such as underfunding of social security and Medicare.

Beyond these standard forms of assets, non-standard assets need to be accounted for as well. Human capital (education, knowledge), societal capital (honesty, security, institutions), health assets (value of being healthy) and environmental assets (fish stocks, forests) all impact the health of the economy and need to be reflected.

The issue of regrettables being misvalued can be taken care of with non-standard assets to reflect their value. An honest society would have less crime and require fewer police. This could be reflected in societal capital.

A nation that is increasing its assets more at a given level of GDP will be in better economic shape in the future than one that isn't.

5) Using GDP per capita as a measurement of well-being assumes that people use their time and income in a way to maximize their own well being. But this in not always the case for 3 reasons.

First, people aren't good at gauging how much happiness they will get from their purchases. For example, people typically don't take into account how quickly they will adapt to the pleasure a product gives when making purchases (hedonic adaptation). People spend their money on larger houses and fancier cars, but they come to take them for granted quicker than they expect. People would get more well-being per dollar if they were to spend money on inconspicous goods that they won't adapt to such as freedom from a long commute or a stressful job. Because of this, knowledgeable people are able to get more happiness and well-being out of each dollar they spend.

Second, people suffer from short term perspectives and lack of control. Those that can plan their spending long term can get more value from each dollar, by making purchases when prices are low or buying in bulk. Lack of control and addictions such as gambling and drugs can lead to a much lower level of well-being at the same level of consumption as someone without these problems.

Third, the value of many goods is not absolute but rather relative to what other people have. Pleasure is derived not by having a large house, but because the house is larger than that of your friends and family. The absolute size of the house doesn't impact well-being, just the relative size. Therefore, much of spending is a zero sum game. It is a consumption arms race that does little to help overall well-being, as there is still only one person in first place. More spending on these goods does not raise well-being as it just raises the absolute not the relative level.

A society that better understands what gives well-being, has a longer term perspective and avoids zero sum spending will have greater well-being at a given level of GDP than one that doesn't.

6) GDP per capita is a mean rather than median average. The more even the distribution of wealth in a society, the more well-being it will lead to.

Money becomes less valuable the more you have of it. $10,000 is more valuable to someone in poverty than it is to Bill Gates. Because of this, well-being is maximized when income is distributed evenly. While GDP per capita might not see a difference between Bill Gates increasing his wealth by $10 billion and 1 million people increase their wealth by $10,000, the second is greater in terms of well-being. A society with a more even distribution of wealth will have a greater level of well-being at the same level of GDP per capita as one that has a less even distribution.

Other issues

1) When comparing a country's GDP over time, you want to take inflation out of the equation (going from nominal to real GDP). The way inflation (GDP deflater) is calculated impacts real GDP, and therefore how much improvement has taken place.

If an identical product goes up in price, for example a dozen eggs, it is easy to calculate inflation on that item. But, other items are more subjective. For example, greater variety of goods makes for better consumption, but how much? How much better is a Netflix with a 20,000 movie library than one with 2,000? 200 channels of cable television vs. 20?

Improved technology makes for better consumption as well, but again how much? How much better is the 4th generation iPod over the 3rd generation? A 10 megabit internet connection vs. a 56k dial up connection?

If the environment used to provides services for free, such as filtering water, but it has deteriorated and now you have to pay for it, is this taken into account? Or if lumber used to be abundant and cheap but due to mismanagement in is now scarce and expensive, is this considered inflationary?

The way inflation is calculated impacts how much real GDP has changed and many of the decisions are subjective judgment calls.

2) When comparing between countries you need a way to convert the GDP of one nation into the others. This can be done via the currency exchange rate, but this fluctuates often for reasons beyond the relative values of goods and services. Another way to do it is the price purchasing parity (PPP) which attempts to normalize the prices of goods between two countries, so a Big Mac in one country costs the same as a Big Mac consumed in another. But how exactly do you do this for all goods and services? Not all goods and services are identical between countries, so again judgment calls have to be made. The way PPP is calculated impacts the comparison of GDPs.

3) Some argue that because prices in an economy are based on the margin that GDP is misleading. It is true that some things that give great value to well-being are abundant (like water) and cheap and therefore show little impact on GDP while others are scarce and expensive (like diamonds) and not at all necessary for life. When comparing between different goods, their price might not reflect their value.

But, in aggregate, this is not a problem. Water is only cheap because it is abundant and everyone can have access to it. If it became scarce, resources would have to be redirected to provide it and it would become expensive. This redirection of resources would take people away from producing some other good or service and therefore lower total GDP. Valuing on the margin does not impact the results of GDP per capita, for $12,000 per capita is always better than $10,000 (assuming the GDP deflater and exchange rates are calculated properly).


While GDP per capita is often used as a proxy for well-being it has many issues. It does not value leisure, or the non-paid sector. It values regrettables just like other goods and services. It doesn't take into account assets. It is a mean average that doesn't take into account distribution of income.

These probably could be accounted for with some tweaks to the system. The value of leisure and non-paid work could be estimated and added in. Regrettables could be subtracted from the total. Asset values (both standard and non-standard) could be calculated and accompany the GDP figure. GDP could be adjusted based on the level of income inequality in a nation.

On the other hand, the fact that some societies can get greater levels of well-being on lower levels of income due to better understanding of well-being, a longer term perspective or fewer zero-sum games means that we cannot just tweak the current system. Instead, we need a new measurement system to do the comparisons. I will look into some different measurements of well-being in an upcoming post.


Audacious Epigone said...

Quite interesting.

Police protection, social services, and the like, don't really bolster GDP however, as other professions that lose potential members to them tend to create more transferable value and salaries as high or higher.

In other words, if I could be a teacher but instead, due to all the thugs in my town, became a social worker, I'd make roughly the same. But as a teacher I'd be planting the seeds for greater economic activity in my town down the road than I would be in simply trying to recoup the damages done by the thugs.

That is, I think GDP does capture this fairly well.

Fat Knowledge said...


If I understand your point correctly, you are saying that regrettables actually reduce GDP and therefore don't need to be handled as a special case.

I actually wrote this point to go against those that say that crime or war or heart attacks actually raise GDP. But, I have to admit I didn't fully considered your point that they actually lower it.

I would definitely agree that crime lowers GDP, as the criminals behind bars would contribute much more to GDP if they were instead honest workers.

But, I am not convinced that all regrettables reduce GDP. If we reduced military spending, would this raise GDP? Would those in the defense industry be able to find jobs that produce a higher level of output? Maybe, but I am not convinced.

As for your example, I basically agree with you (well except that GDP would not go up in that year, as it takes a while for the education to have its value, but the "educational capital" is certainly created). But, what if the teacher was a piano teacher or some other type of training that doesn't really lead to greater GDP? In this case GDP wouldn't go up, but well-being would.

So, I agree with you to the extent that many of the regrettables do actually decrease GDP, but I am not convinced that they all do.

Audacious Epigone said...


I suppose the military spending issue would have to consider not just funding for companies like Lockheed or Boeing, but also the non-US governmental demand for it.

More generally, GDP is a measure more useful for gauging economic health from the perspective of the financial markets. That is, it's helpful for those on Wall Street more so than those on Main Street, where other quality of life issues that are related to economic growth in various degrees (or not at all) are of greater importance.

Still, PPP combined with the gini coefficient proxies pretty well for a lot of other things. Much better than just GDP.

Fat Knowledge said...

I agree that GDP is more important on Wall Street (and in Washington because it determines the tax base) than on main street.

But, most articles I read asking whether Americans are better now than we were 10 years ago look at GDP per capita (or income which is fairly similar). And when they compare between countries GDP per capita is what I usually see. That is why I wanted to throw out some additional things to think about when looking at those comparisons.

Good point on PPP + Gini. That seems like a number that is fairly easily accessible these days and I think would be a more accurate reflection of well-being than just GDP when comparing between countries.

Anonymous said...

Just came across your entry, very nice.

You omit one important point: GDP includes only the FINAL goods and services (or value added). The market value of the piece of paper used to print a paperback book is not included in GDP, since its value is implicitly included in the market value of the finished book.

Also quite interesting is the technical point that housing costs are imputed in the investment account, so while GDP does not include the value of houses that are older than 1 year, it does include a rent-equivalent.


Anonymous said...

one testing point is left,
If a Nation does not Spend but saves and invest in foreign countries, its GDP will be diminished in comparison to one that spends borrowed money.

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