If you subscribe to my substack, you’ve probably spent (or wasted) enough time on economics-adjacent topics that you’ve heard that GDP is not a good metric. Sure, income matters, but GDP does not account for inequality. Yeah, more money might be good, but after a certain point it has minimal effects on life expectancy.
These rants are usually followed by a proposal for an alternate metric such as HDI or the happiness index. My goal with this post is something unusual. I’m not going to try and defend the honor of GDP versus these alternate metrics, but rather explain an often neglected rationale for why GDP is a useful number.
And for that, we’ll have to start with a very basic microeconomics lesson. Imagine you have two goods, coffee and beer (in other words, you’re in college). Coffee costs $3 a cup and beer costs $5 a glass. Question: assuming that you consume both coffee and beer, how much do you value an additional cup of coffee relative to an additional glass of beer?
Let’s back up. Economists have a concept called “willingness to pay”, which measures…how much you’re willing to pay for something, which, in turn, is a pretty good measure of how much you *value* something. If you value coffee at more than $3, then you’ll buy coffee. If you value it at $2, then you won’t. Same for beer.
So, how many cups of coffee will you buy? Well I have no idea, but I know that you’ll stop buying coffee after your willingness to pay hits around $3. What about beer? Will you consume more beer than coffee or less? Again, I have no idea. But I do know that you’ll keep consuming beer until you’re willing to pay about $5 for it.
So, you’ll ultimately end up consuming an amount of coffee and beer such that you value coffee at $3 and beer at $5. And it doesn’t matter how much you liked one or the other! This condition will hold for *everyone who consumes both goods*.
Think about that. For any two goods, everyone values them at their price. If they valued the goods at more than their price, they would buy more of them. If they valued them at less than their price, they would buy less of them. And they would keep doing this until they valued the good at just below its price. This condition holds for everyone.
So, when thinking about the value that society generates for individuals, we would generally want to take what we create, and weight each good by its price (because a buyer *must* be valuing the good at around its price). We can then add these numbers up and get a good estimate of how much value we generated for people.
In other words, the sum of the prices of all final goods and services produced within a country in a given timespan - GDP.
But…I’m ever so slightly oversimplifying here. Because people will value good at this price on the margin. They will value an additional cup of coffee at $3, but not an average cup of coffee at $3. So can we really measure the value of these goods with their prices? Maybe not. But consider this, what is a marginal rise in GDP? Well, that’s economic growth. In other words, when calculating economic growth rates, we are at the margin. Therefore, valuing goods in proportion to their prices and calculating standard GDP growth is a fairly good measure of how much welfare has improved. Take that HDI.