Why GDP fails as a measure of well-being

How should we measure changes in an economy's standard of living, or compare living standards across countries? Typically, economists use GDP per capita as a proxy for a country's standard of living, but as International Monetary Fund head Christine Lagarde, Nobel prize-winning economist Joseph Stiglitz and MIT professor Erik Brynjolfsson noted at the recently concluded World Economic Forum in Davos, Switzerland, "GDP is a poor way of assessing the health of our economies and we urgently need to find a new measure."

Using GDP as a measure of welfare has well-known problems, which are among the first things macroeconomics principles courses cover. But the point of the discussions at Davos is that in the digital age, those problems are even deeper. Standard GDP statistics miss many of technology's benefits, so we need to rethink how we measure the typical person's well-being.

The textbooks generally point out five problems with using GDP as a measure of well-being:

• GDP counts "bads" as well as "goods." When an earthquake hits and requires rebuilding, GDP increases. When someone gets sick and money is spent on their care, it's counted as part of GDP. But nobody would argue that we're better off because of a destructive earthquake or people getting sick.
• GDP makes no adjustment for leisure time. Imagine two economies with identical standards of living, but in one economy the workday averages 12 hours, while in the other it's only eight. Which country would you rather live in?
• GDP only counts goods that pass through official, organized markets, so it misses home production and black market activity. This is a big omission, particularly in developing countries where much of what's consumed is produced at home (or obtained through barter). This also means if people begin hiring others to clean their homes instead of doing it themselves, or if they go out to dinner instead of cooking at home, GDP will appear to grow even though the total amount produced hasn't changed.
• GDP doesn't adjust for the distribution of goods. Again, imagine two economies, but this time one has a ruler who gets 90 percent of what's produced, and everyone else subsists -- barely -- on what's left over. In the second, the distribution is considerably more equitable. In both cases, GDP per capita will be the same, but it's clear which economy I'd rather live in.
• GDP isn't adjusted for pollution costs. If two economies have the same GDP per capita, but one has polluted air and water while the other doesn't, well-being will be different but GDP per capita won't capture it.

The Davos discussion, however, is pointed at a different flaw in measured GDP: its inability to fully capture the benefits of technology. Think of a free app on your phone that you rely upon for traffic updates, directions, the weather, instantaneous information and so on. Because it's free, there's no way to use prices -- our willingness to pay for the good -- as a measure of how much we value it.

As a result, GDP statistics won't capture the benefits we gain from free apps, just as it has difficulties accounting for changes in the quality of goods over time.

How can this be fixed? Catherine Rampell provides a nice summary of the alternative measures that have been proposed, including China's "green GDP," which attempts to adjust for environmental factors; the OECD's "GDP alternatives," which adjust for leisure; the "Index of Sustainable Economic Welfare," which accounts for both pollution costs and the distribution of income; and the "Genuine Progress Indicator," which "adjusts for factors such as income distribution, adds factors such as the value of household and volunteer work, and subtracts factors such as the costs of crime and pollution."

Finally, there are more direct measures of well-being such as the Happy Planet Index, Gross National Happiness and National Well-Being Accounts.

However, none of these alternatives deal with the main problem discussed in Davos -- how to measure the full impact of technology on our lives. The problem is that GDP assigns a zero value to goods with a zero price, but those goods aren't valued at zero and as they become more prominent, we'll need to find a way of including the benefits they provide in our measures of the standard of living.

None of the measures proposed so far are perfect, and they won't replace the current GDP yardstick anytime soon.

But there's still something to be gained from this work. When you hear that your standard of living has gone up, ask yourself what has happened to leisure time -- are you working more or less for the same income? How much of technology's benefits might have been missed -- how often do you use Wikipedia? And how was the additional GDP distributed across the population -- did it mostly go to the 1 percent?

In the end, economists -- and the public -- don't care about GDP by itself; they care about the happiness they receive from the goods and services they consume. We've made some progress on measuring the well-being of individuals within an economy, but not enough. More research is needed.