How well off are we compared to recent years and in comparison with people in other countries? What do we actually mean by the standard of living and can routine information on national income give us a reliable indication of our economic well-being. In this chapter we look at living standards and the development of alternative measures of welfare and the quality of life.

Defining and measuring the standard of living
The standard of living is a measure of the material welfare of the inhabitants of a country. The baseline measure of the standard of living is real national output per head of population or real GDP per capita. This is the value of national output divided by the resident population. Other things being equal, a sustained increase in real GDP increases a nation’s standard of living providing that output rises faster than the total population. 

However it must be remembered that real income per capita on its own is both an inaccurate and insufficient indicator of true living standards both within and between countries.
National income data can be used to make cross-country comparisons. This requires

• Converting GDP data into a common currency (normally the dollar or the Euro)
• Making an adjustment to reflect differences in the average cost of goods and services in each country to produce data expressed at a ‘purchasing power parity’ standard

Problems in using national income statistics to measure living standards
GDP data on its own is an insufficient indicator of our economic well-being. The following quote adapted from an article in the Independent in December 2002 sums up the issue quite well.

The table below provides time series data on per capita national incomes for the twenty five nations of the European Union. Ireland has made huge strides in improving her relative standard of living. In 1994 Ireland’s GDP per capita was just 84% of the EU average but extremely rapid economic growth allowed the Irish economy to surge past the EU15 average in 1999 and this progress has been maintained. In contrast, Germany’s relatively slow growth has seen erosion in her relative advantage in living standards – from a level 10% above the EU average in 1994 to a level only 3% above the average in 2002. In 2004, Britain had a per capita income (adjusted for differences in living costs) some ten per cent higher than the European average.

Average GDP per head of the ten accession countries in the year 2000 was only 46% of the EU average although it should be pointed out that there has been progress in closing this gap over recent years. Many transition economies experienced a deep recession in the early 1990s but have grown more quickly since then. Of the ten accession countries, Cyprus and Slovenia are closest to the EU average in terms of a PPP adjusted income per capita.

GDP and living standards - problems of accuracy

Official data on a nation’s GDP tends to understate the true growth of real national income per capita over time due to the expansion of the shadow (or underground) economy and also the value of unpaid work done by millions of volunteers and people caring for their family members.

Various definitions are used to describe the "shadow economy" but the definition usually embraces a range of illegal activities such as drug production and distribution, prostitution, theft, fraud and concealed legal activities such as tax evasion on otherwise-legitimate business activities such as unreported self-employment income. The scale of the “shadow economy” varies widely across countries at different stages of development. According to the IMF, in developing countries it may be as high as 40% of GDP; in transition countries of central and Eastern Europe it may be up to 30% of GDP and in the leading industrialised countries of the OECD, the shadow economy may be in the region of 15% of GDP.

GDP and living standards – problems of interpretation

Here are reasons why GDP data may give a distorted picture of living standards in a country:

• Regional Variations in income and spending: National GDP data can hide regional variations in output, employment and income per head of the population. The table below provides some evidence for this with household disposable income per head in Inner London over seventy-five per cent higher than the national average and several of our major cities having disposable incomes per head at only three quarters of the average (or less). The Office for National Statistics provides a useful regional snapshot which offers economic and social information on each of the UK’s major regions.

• Inequalities of income and wealth: The Lorenz Curve and the Gini-coefficient are two ways of measuring inequality and relative poverty– an outward shift in the Lorenz Curve would indicate a widening of income and wealth inequality. Since 1979, there has been a rise in inequality as the gap between the rich and poorer sections of society has widened. The distribution of wealth is even more unequal than that for income in the UK.

• Leisure and working hours: An increase in real GDP might have been achieved at the expense of leisure time if workers are working longer hours. Several reports have highlighted the fact that British workers have the longest working week in Europe which can cause stress and damage family life – two social indicators that potentially create some negative externalities for society as a whole.

• Imbalances between consumption and investment: If an economy devotes too many scarce resources to satisfying the short run needs & wants of consumers, there may be insufficient resources for capital investment and over-consumption can lead to an over-exploitation of scarce finite resources thereby limiting future growth prospects.
• Changes in life expectancy: Improvements in life expectancy have a huge impact on people’s living standards but don’t always show through in the GDP accounts. Reductions in infant mortality have been accompanied by the prevention or cure of diseases that might have led to the premature death of even the richest of our ancestors at any time. Putting a monetary value on the benefits of increased longevity is difficult, but surely it must be factored into any overall assessment of living standards and the quality of life.
• The value of non-marketed output including work done in the home

Much useful and valuable work is not produced and sold in markets at market prices. The value of the output of people working unpaid for charities and of housework might reasonably be added to national income statistics.

• Innovation and the development of new products: One of the problems in comparing and contrasting living standards and the quality of life across different generations is that new goods and services become available because of competition, investment, invention and innovation that simply would not have been available to the richest person on earth less than fifty years ago. About half of what we spend our money on now was not invented in 1870. Examples include air travel, cars, computers, antibiotics, hip replacements, insulin and many other life-enhancing and life-saving drugs
• Environmental considerations: Rising output might have been accompanied by an increase in air and noise pollution and other externality effects that have a negative effect on our social welfare. Faster economic growth may cause long term damage to our eco-systems, threatening the long-term sustainability of the economy.
• Defensive expenditures: Much spending in an economy is on defensive expenditure – not spending on tanks and armaments! But spending to defend yourself against an “economic or social bad” e.g. crime, or spending to recover the damage from externalities (e.g. cleaning up the effects of pollution, managing the huge and growing volume of waste; driving long distances to and from work. This spending adds directly to our GDP but does it really add to our material welfare? Some economists believe that adjustments should be made to officially published data for GDP to take into account items of this defensive spending.

Purchasing power - differences in the cost of living between countries

Data on relative standards of living is normally adjusted to reflect estimates of purchasing power parity to take account of differences in the cost of living – so that each unit of currency has (approximately) the same purchasing power. One Euro of income in each country may not have the same real purchasing power because of differences in the average cost of living. For example, relative prices of a basket of goods and services for consumers in Britain are estimated in 2003 to be 18% higher than the EU15 average.
The Scandinavian countries have significantly higher prices whereas Mediterranean countries have relative price levels less than four fifths of the EU average. As the following passage makes clear, movements in the exchange rate also have an effect on the relative cost of living in different locations around the world.

Limitations of the purchasing power parity adjustment

At any given time, the current exchange rate for a country is unlikely to be at PPP levels. Currency speculation or other factors may have driven the exchange rate above or below its estimated PPP level. The PPP calculation/estimation is also constrained by the fact that:

• Not all output is traded internationally – some goods and services are produced only for domestic consumption and do not find their way onto international markets
• Price differences in different countries may reflect product differentiation
• Differences in degree of competition in local and national markets affect relative prices – for example the high level of new car prices in the UK compared to most other countries in the EU is partly a result of oligopoly power among leading UK car retailers
• Local indirect taxes and tariffs cause differences in the cost of living
• Central bank intervention in the currency markets can take the actual exchange rate out of PPP alignment because they are trying to manage the value of the currency

Alternative measures of economic and social welfare
Having focused on income as a key measure of living standards, we briefly consider some of the alternative approaches.

One of the simplest ways of judging whether we are better off materially than we were a few years ago is to track ownership of consumer durables. The table above draws on some of the information provided over the years 1990 – 2004. Ownership levels are affected by the trend in price levels, household incomes, changes in tastes and preferences, the emergence of new general purpose technologies and factors such as consumer borrowing and confidence.

The Human Development Index (HDI)
The Human Development Index (HDI) has been published by the United Nations each year since 1990. The HDI is the average of three indices based on three different variables:

• Life expectancy at birth
• Education – a weighted average of adult literacy (two-thirds) and average years of schooling (one third)
• Real GNP per capita – measured in US dollars, at purchasing power parity exchange rates.

Clearly, this index gives us a better way of estimating standards of living than just GNP taken on its own. However, it is still far from perfect. Economists have recently been looking at ways to include other factors in the measurement, such as income distribution (perhaps using the Gini coefficient), gender inequalities, and inequalities by region or by ethnic group. Since 2001, Norway has come top of the international rankings for human development. Canada held the top spot from 1996 to 2000. Iceland and Australia also figure prominently at the top of the Human Development Index with Niger and Sierra Leone at the bottom.

The Human Poverty Index (HPI)

The Human Poverty Index (HPI) published annually by the United Nations focuses on four basic dimensions of human life -– longevity, knowledge, economic provisioning and social inclusion. The latest published data shows the UK ranked only 15th out of 17 leading industrialised countries with only Ireland and the United States below us. The most recent data for the Human Poverty Index is shown in the table below together with the factors that go into creating the Human Poverty Index ranking.

The Measure of Domestic Progress

The Measure of Domestic Progress (MDP) is published by economists at the New Economics Foundation and is supposed to reflect progress in Britons' quality of life and progress towards a sustainable economy by factoring in the social and environmental costs of economic growth, and benefits of unpaid work such as household labour, that are currently excluded from official GDP.

Key Points

• The basic measure of the standard of living refers to per capita real GDP. It is found by dividing real GDP by the size of the population.
• This figure is an average and gives no indication of the distribution of income
• To ensure purchasing power parity between countries, the current exchange rate is adjusted so that a basket of goods and services can be bought for the same amount of dollars. GDP data can then by expressed at purchasing power standard (PPS)
• There are limitations in the use of purchasing power parity estimates
• Omissions and inaccuracies suggest that officially published GDP figures are a debatable guide to the quality of life and the standard of living
• A range of alternative “composite” measures of economic welfare and the quality of life have been developed – happiness is now a firm part of the agenda of public policy!
• These include the Human Development Index, the Human Poverty Index, the Index of Sustainable Economic Welfare and the newly established Happy Planet Index!