GDP vs. Social Value

GDP Is Not an Accurate Measure of Well-Being

Has the Internet Been Revolutionary for Well-Being?

Tyler Cowen, an economist at George Mason University, recently published an ebook called The Great Stagnation: How America Ate All The Low-Hanging Fruit of Modern History, Got Sick, and Will (Eventually) Feel Better. 

The basic premise of the book, as summarized by R.A. in The Economist is:

There are two kinds of economic growth possible in this world. One can take good ideas already in use elsewhere, adopt them, and make use of underused stocks of people and capital. That's what China and India are currently doing, and we shouldn't mistake their rapid growth for something it's not. Or one can come up with new ideas and apply them in ways that allow the economy to grow.

The rich world has been stuck doing the latter for most of the last century, and lately they haven't been doing it as well. Mr. Cowen looks at growth rates of output and median income over the last few decades and notes that there's a steady downward trend. And this trend is due, he says, to the exhaustion of the supply of low-hanging economic fruit…

But the big setback for society, according to Mr. Cowen, is the end of the exploitation of the major innovations of the last two centuries. The 1700s and 1800s yielded revolutionary innovations in industry, chemistry, and electricity. Rich countries spent the 1800s and 1900s figuring out how to exploit those innovations to their fullest, and as recently as the 1950s and 1960s, these experiments were producing products that utterly changed the way people lived. During the lifetime of those born in the 1930s and 1940s, household technology changed fantastically: refrigerators, laundry machines, dishwashers, radios, televisions, electric light, air conditioning, cheap automobiles, and so on. But with a few exceptions (among them computers, on which more later) today's households don't look that much different from their 1970s counterparts. Products have improved, but the development of revolutionary new technologies has slowed substantially. The progress of technology has plateaued…

The internet, on which he has a lot to say, has had enormous benefits, but a striking amount of online activity is free and internet businesses create few new jobs (and displace lots of others). The result is growth in utility without much of a contribution to GDP, which would be fine except that countries and people have bills to pay, on things like health care, pensions, and government debt. Complicating matters is the fact that the fastest growing contributors to measured GDP—the government, education, and health sectors—deliver returns that are very difficult to measure. This suggests, he says, that rich world GDPs are likely overstated; we're poorer than we thought. And that, Mr. Cowen concludes, will make it very difficult for us to make good on the many, many obligations accumulated while we assumed that our previous growth trajectory would continue.

The book has induced a frenzy of media discussions.  The discussions I’ve read tend to focus on the issue of stagnation in GDP, and they conclude that innovations in computers and the Internet during the past few decades have simply not been as revolutionary as many thought they would be.

I believe the focus of discussions has been misplaced.  Wealth (GDP) is being used as a measure of population well-being, and writers are concluding that because wealth has stagnated, this means that people’s well-being has stagnated, in which case computers and the Internet have not been revolutionary innovations.  I believe these arguments are flawed because growth in people’s wealth, as measured by growth in GDP, is not an accurate proxy for growth in people’s well-being.

GDP vs. Social Value

In economics, there is a social value associated with every activity.

The social value of an activity is defined as:

The total value to society of having a person (consumer) engage in that activity,

Less

The total costs to society associated with having that person engage in that activity.

We can further subdivide the social value of an activity as (also see visual below):

The Total Value to Society

Is the Sum of the Benefits

Consumer Value: The total value accruing to the consumer of the activity, measured as the price the consumer would be willing to pay to engage in the activity

Producer Value: The total value accruing to the producer of the activity, measured as the price the consumer actually pays to the producer of the activity

Excess Social Value: Any excess value to society associated with the activity, but not captured by the consumer or the producer, usually intangibles, such as additions to the knowledge base, beauty, good health, etc.

Less the Costs of

Consumer Costs: The total costs (money, time, resources) incurred by the consumer of the activity

Producer Costs: The total costs (money, time, resources) incurred by the producer of the activity

Excess Social Costs:  Any excess costs to society associated with the activity, but not incurred by the consumer or the producer, usually intangibles, such as congestion, pollution, etc.

When a consumer engages in an activity,

• We know the price the consumer actually paid to engage in that activity (the transaction price, plus any time and resource costs);
• We know the costs the producer incurred to make the activity available to the consumer; and
• We can (sort of) estimate any excess costs or benefits captured by society associated with the activity.

The problem is that while we know how much the consumer actually paid to engage in that activity, we do not know how much he would have been willing to pay above the price he actually did pay.  That is, we cannot really get a good objective measure of the consumer surplus.

If take all the activities a population engages in throughout the year and add up all the consumer surplus, producer surplus, and net social value, we get the total social value, or total social welfare, of the population.

GDP provides a reasonable estimate of the producer surplus in which its population engages.  However, GDP does not capture consumer surplus, and GDP does not capture many (if any) of the excess costs and benefits to society associated with it’s population’s activities.  Therefore, GDP does not provide an accurate measure of a population’s total social welfare.

GDP Is Not an Accurate Measure of Well-Being

The social welfare of a population's activities might be considered a measure of the society's well-being.  However, in the last section I illustrated how GDP fails to capture the total social welfare of its population's activities.  This section provides additional evidence that GDP is not an accurate measure of a society's well-being.

A recent (2008) study, “An Integrative Approach to Quality of Life Measurement, Research, and Policy” by Robert Costanza et al indicates that

In the popular press, quality of life is also a critical element in the ongoing discourse on economic prosperity and sustainability, but it has often been subsumed under the heading of “economic growth” under the assumption that more income and consumption equates to better welfare. This equation of consumption with welfare has been challenged by several authors, notably Sen (1985) and Nusbaum (1995) and is now also being challenged by recent psychological research (Diener and Lucas, 1999; Easterlin, 2003).

Similarly, a 2006 OECD study, “Alternative Measures of Well-Being” by Romina Boarini, Asa Johansson and Marco Mira d’Ercole notes

Survey-based data on happiness and life-satisfaction across OECD countries are only weakly related to levels of GDP per capita.  Research on these subjective measures suggests that there are several distinct domains – such as joblessness, family and community ties – that contribute to overall life-satisfaction and that their influence cannot be reduced to a single dimension of economic resources.

Deutsche Bank Research published a wonderful analysis in 2006 called “Measures of Well-Being: There is more to it than GDP”. The analysis notes

GDP has four major limitations which restrict its use as a measure of well-being.

First, it includes the replacement of depreciated capital: it is a “gross” concept. However, depreciation does not boost welfare and the replacement of old capital just takes the economy back to square one…

The second difficulty with GDP is that it measures income produced in a country but not how much income people in that country receive. Some income may go to foreigners…

Third, since GDP only counts monetary transactions … it misses many other activities that people value ... GDP also ignores the value of leisure time…

Finally, GDP includes many items that do not boost human well-being. If a hurricane or an earthquake destroys an entire region, the reconstruction effort is counted as a boost to GDP – even if it only replaces something that was there not long before.

The analysis provides other elements of well-being to supplement GDP:

The starting point is the well-known concept of GDP. Capital consumption, income going to foreigners and production of items that cause damage (e.g. pollution) are subtracted. What is then left of GDP (or even a subset of it) is the starting point for measures of economic well-being. These add non-market activity, the value of leisure and wealth, and subtract the cost of unemployment and income insecurity.

But well-being also has non-economic dimensions: good health and education, a clean environment and safe streets all contribute to individuals’ overall well-being...

Finally, the ultimate goal of humans appears to be happiness (or life satisfaction). For good reasons, the US constitution lists as unalienable rights: life, liberty and the pursuit of happiness. Although happiness is inherently difficult to measure, surveys provide valuable insights on the levels and determinants of individuals’ overall satisfaction with life.

Has the Internet Been Revolutionary for Well-Being?

Thus far, I have concluded that from an economic perspective, the well-being of a population may be measured as its total social welfare, which is the sum total of all consumer plus producer plus net social surplus associated with all of the populations' activities.

To the extent that a person’s well-being is affected by more than simply the sum total of all activities he engages in, then the economic measure of social welfare will fall short of the population’s well-being.

A more expansive perspective than the economic one is the psychological or sociological perspective, which measures the well-being of a population as the sum total of the value of various economic, social, and psychological environments in which its population resides.

Regardless of which measure, economic or psychological/sociological perspective is used, it is clear that a population’s GDP does not provide a complete measure of the populations’ social welfare or social well-being.

Now return to Tyler Cowan’s conclusion that because GDP has been stagnant, computers and the Internet cannot be considered revolutionary innovations.

My proposition here is that instead of asking

“What is the impact of computers and the Internet on increasing GDP?”

and concluding that computers and the Internet have not been revolutionary innovations because they have not dramatically increased GDP, the question we should be asking is

“What is the impact that computers and the Internet have had on people’s social welfare or well-being?”

From an economic perspective, this questions translates into

“What is the impact that computers and the Internet have had on creating producer, consumer, and excess social surplus?”

Producer surplus is generally captured in GDP, much social surplus eventually translates into consumer surplus, and it is consumer surplus that is not captured in GDP.  As such, the question we should be asking is reduced to whether or not computers and the Internet have had a revolutionary impact on generating consumer surplus:

“What is the impact that computers and the Internet have had on creating consumer surplus?”

The globalization of the world’s economies has increased the degree of competition the producers face.

The advent of computers and the Internet have vastly decreased communication and transportation costs.

The combination of vastly greater competition, together with vastly lower costs of communication and transportation has led to a monumental increase in

• the quality of existing products, services, and activities
• the availability of new products, services, and activities

Two examples of quality enhancements associated with the advent of computers and the Internet are:

1. Over time, the price of a decent home computer has remained about the same, but what you get for your money now when you buy a computer has vastly more power and capabilities than what you got when you paid the same amount for a computer a decade ago.
2. The enormous increase in access to information that computers and the Internet provide enable people to make better decisions, or otherwise have greater peace of mind about the decisions they make.  So while the value of the resources being exchanged in a transaction might not have increased, the consumer surplus has.

Increases in competition mean that prices of new or improved activities are driven down towards costs, which suggests that most of the surplus associated with the increases in quality and availability of products, services, and activities is consumer surplus.

Based on the proposition that computers and the Internet have vastly increased consumer surplus, I claim that Tyler Cowen is wrong, and that computers and the Internet have, in fact, been revolutionary innovations.