Real GDP is certainly a useful indicator of how well an economy is performing. This does not necessarily mean that it tells us about the welfare of those who live there. Some countries, such as China or India, have a large real GDP simply because they have large populations. Living standards in these countries are nonetheless relatively low because the large GDP must be shared by a very large number of people. To correct for this, we look at real GDP per person, which measures how much GDP would be available if we shared it equally across the entire population.
If two countries have substantially different levels of real GDP per person, we can fairly reliably infer that the richer country, by this measure, is also the country with higher living standards. Real GDP per person in Germany is about 25 times greater than real GDP per person in Kenya. Even a few minutes spent in the streets of Nairobi and Berlin would confirm that Germany enjoys much higher material living standards. However, when we compare countries with similar levels of real GDP per person, it is rash to assume that a richer country necessarily enjoys a higher standard of living. This is because there are several ways in which real GDP per person is flawed as an indicator of economic welfare.
Remember, first, that GDP measures market transactions only. National income accounts can measure activities that are traded only in markets. If people clean their own homes, tend their own gardens, repair their own cars, or cook their own meals, these activities are not included in our measurement of GDP. (There are a few exceptions. Most notably, GDP statistics impute a value to owner-occupied housing: GDP statistics effectively pretend that homeowners rent their houses from themselves.)
This leads to some unfortunate inconsistencies in GDP accounting. Suppose you and your neighbor both work as auto mechanics. If you each maintain and repair your own cars, these activities do not show up in GDP. But if you hire your neighbor to maintain your car, and she hires you to repair her car, then GDP does include this economic activity. Yet another possibility is that you barter with your neighbor, so she looks after your car and you look after hers but no money changes hands. Again, this work goes unrecorded in national accounts. Barter is more prevalent in developing countries than in developed countries and causes more of a problem for measurement of GDP in poorer countries. It is a particular source of difficulty when we want to compare economic activity in different countries.
People also value their leisure time. GDP measures the goods and services that people consume but does not tell us anything about how much time they must give up to produce those goods. For example, people in the United States are richer, on average, than people in Spain. But people in the United States work longer hours than people in Spain, and Spanish workers also enjoy much longer vacations. If we use measures of GDP to compare welfare in the United States and Spain, we will capture the fact that Americans can afford more DVD players, but we will miss the fact that they have less time to watch DVDs. GDP measures material well-being rather than overall welfare.
The economic activity that goes into the production of GDP also often has negative consequences for economic welfare that go unmeasured. A leading example is pollution. Coal-generated power plants generate sulfur dioxide as a by-product of the production of electricity. When sulfur dioxide gets into the atmosphere, it leads to acid rain that damages forests and buildings. This damage is not accounted for in GDP. Emissions from automobiles contribute to the buildup of greenhouse gases in the atmosphere, contributing to global climate change. They also generate smog (technically, particulate matter) that is damaging to health. These adverse effects are not accounted for in GDP. 1
Critics sometimes argue that GDP not only fails to measure negative effects from production but also erroneously includes measures taken to offset those measures. This criticism is misplaced. Consider the 2010 oil spill in the Gulf of Mexico. The environmental damage from that spill is not included in GDP, which is indeed a problem with using GDP to measure welfare. The costs of cleaning up the gulf are included in GDP, and the inclusion of cleanup costs does make GDP a better measure of welfare. To clean up means to produce a cleaner environment from a dirty environment, which increases economic welfare. The problem is the failure to include the original environmental damage, not the inclusion of the cleanup costs.
Finally, real GDP is an aggregate measure. It does not reflect the ways in which goods and services are distributed across the many households of an economy. In comparing two economies, we may feel differently about an economy in which resources are distributed relatively equitably compared to one in which some people are very rich and others are very poor, even if overall real GDP per person is the same. Similarly, we may feel quite differently about changes in real GDP depending on who is reaping the benefit of those changes.
In summary, real GDP is far from a perfect measure of economic welfare, but then again it is not designed to be. It is designed to measure economic activity, and it is—at best—an imperfect measure of material well-being. Nevertheless, when we want to understand what is happening to overall economic well-being or get an idea of comparative welfare in various countries, we begin with real GDP per person. For all its flaws, it is the best single indicator that we have.
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