- Economics
- Answering Challenges to Advanced Economies
Is the Gross Domestic Product (GDP) of a country a good measure of economic wellbeing? No, it’s not.
Many economists have given their reasons for that. For example, the late Paul Samuelson noted in his textbook that if a man married his paid housekeeper and she quit paid work to become a full-time wife, that marriage would make GDP lower than otherwise. Other economists have noted that the quality of our physical environment, measured by air and water pollution, has grown—and yet that improvement doesn’t show up in GDP. That’s all true.
But GDP fails to measure wellbeing for another even more important reason: GDP completely omits what economists call consumer surplus. It is true that to the extent that GDP over time has a consistent bias in omitting consumer surplus, the growth of GDP may still give a reasonable estimate of the growth in economic wellbeing. But at every point in time, GDP dramatically understates wellbeing.
What is consumer surplus?
In my almost forty years of teaching economics, one thing I enjoyed teaching most was the concept of consumer surplus. I managed to get at least some of the students to see the power of consumer surplus in giving us an appreciation of the free market.
And what exactly is consumer surplus? The idea itself is straightforward. The consumer surplus that you get when you buy an item is the maximum amount you would have been willing to pay for the item minus what you actually pay. So, for example, if you would have been willing to pay $50 for a shirt, but actually pay $30, your consumer surplus on that purchase is $20. Another way of saying that is that the consumer surplus is a measure of the consumer’s gain from a particular trade.
Why consumer surplus matters
One of the hardest ideas for non-economists to accept is that both sides gain from trade. The good news is that when I gave examples in class, most students got the point quickly.
Indeed, one of my students gave an example that I hadn’t previously considered but that I have since used in speeches to illustrate the concept of consumer surplus. It goes like this: You go to a store and find a shirt with a price tag of $50. You try it on and decide you like it. You go to the cash register to pay. The salesperson points out something you hadn’t noticed: the shirt is on sale for 40 percent off and so the price is actually $30. My student pointed out that a minimum estimate of your consumer surplus is $20 because you would have been willing to pay $50 but instead paid only $30. Of course, that’s a minimum estimate because you probably would have been willing to pay at least somewhat more than $50. How do we know? Because you probably weren’t indifferent between buying the shirt at $50 or keeping your money.
Once you understand and really appreciate consumer surplus, you can start looking around and appreciating what you have.
Life without a microwave
Years ago, I wrote an article titled “Life Without a Microwave.” Our microwave had gone on the blink, and it had taken about a week to get a new one installed. No big deal, right? Wrong!
Being without a microwave made me appreciate two of its regular uses that had become part of my weekly, and occasionally daily, life. Every morning, I would drink my cup of coffee slowly. After about fifteen minutes, I would pop it into the microwave for about fifteen seconds. Without a microwave, I couldn’t do that. And there was no other good option.
Also, I would often eat leftovers for dinner. Those leftovers, especially the ones from my favorite Mexican restaurant, were much better when heated up. I could have popped them in the oven, but that would have changed a one-minute task to a ten-minute task: heating the oven for about seven minutes and then warming the food for about three minutes.
In that article I also pointed out how much time and sleep my wife (and occasionally I) saved from finally buying a microwave when our daughter was about two months old. I wrote:
We had been saving for a house on the expensive Monterey peninsula, so we didn’t want to “waste” money on a microwave. But Karen [our daughter] regularly woke us up in the middle of the night to be fed. One of us, usually my wife, had to get up, go into the kitchen, fill a bottle with formula, get some water boiling on the stove, and warm the bottle. After a month or two of this, we decided to get a microwave. It saved valuable time every night and allowed my wife to be less awake while heating the bottle, which made it easier for her to get back to sleep. The microwave, which had seemed like a luxury to us, turned out to be one of the most valuable things we had ever bought.
We paid about $150 in 1985 dollars for that microwave. Once we understood its value, we probably would have been willing to pay at least $400.
The value of indoor plumbing
The consumer surplus that my wife and I got from having a microwave pales by comparison with the consumer surplus my family gained, when I was seven years old, from having indoor plumbing installed in our house in 1958. I grew up in a small town in rural Manitoba. In case you think we were poor, think again. It’s just that indoor plumbing had not yet come to the particular street where our house stood.
There were five people in our family: my parents, my older brother and sister, and I. Saturday was bath day, with a big tub in the middle of the kitchen that my mother filled with hot water from the stove. We took turns using the same bath water and there was very little privacy. That was something that my sister, born in 1946, did not appreciate when she was eleven.
Of course, we used an outdoor “biffy.” In the middle of the winter, when the temperature outside could often be well under zero degrees Fahrenheit, if you got up in the middle of the night to go to the bathroom, you used a pot. And my mother had the unenviable task of emptying and washing those pots every morning.
Think of the consumer surplus you gain from indoor plumbing. Let’s estimate that installing a modern bathroom and a functioning kitchen sink with running water would cost about $40,000.
Retrofitting would cost more. So, imagine that you’re looking at plans for building a house and trying to decide whether to have one bathroom and a kitchen sink. Let’s say that you can get about twenty years of relatively trouble-free use from the bathroom and kitchen sink. How much would you be willing to pay per year? I would bet, that if you’re anything like me, you would be willing to pay at least $15,000 per year. So, the value of indoor plumbing to you –using a real interest rate of four percent – would be about $204,000. You would get a consumer surplus of about $164,000. That’s a lot of money.
Consumer surplus from the internet and cell phones
You don’t have to think about a hypothetical house with indoor plumbing to realize that consumer surplus can be immense. In the last forty-five years, we’ve had three revolutions in technology, not counting AI: (1) the personal computer, which had become widespread by the mid-1980s; (2) the internet and the web; and (3) the smartphone.
With the personal computer, we could write articles and edit more easily, even starting in the middle instead of the beginning; and we could run spread sheets and skip the laborious process of recalculating when one variable changed.
With the internet and the web, we could get in touch easily with friends, check facts with Google, shop online, and do our banking.
With the smartphone, we could be in touch with anyone, could play music, could find our way around strange cities, could take pictures, and even watch movies. Last, but not least, we can share videos of our favorite people and our favorite cats. Could we abuse the web and the smartphone by getting into nasty arguments? Of course. But there’s an easy way to avoid a nasty argument: don’t do it.
Economist Timothy Kane, who is a visiting fellow with Hoover, often writes about the value of these modern inventions. He does so by asking various people how much they would need to be paid to do without, say, a cell phone for a year.
He gets answers that are often in the five digits. You can buy a moderately expensive cell phone for under $1,000, and it would easily last five years. That makes it only about $200 per year. The monthly charges often end up totaling under $1,000 for a year. The total cost over that year would be $1,200. So, someone who would have to be paid $5,000 to give up his cell phone for a year, is getting consumer surplus of about $3,800 in one year.
Thinking about economic growth
Does the fact that GDP undermeasures economic wellbeing mean that the growth rate of wellbeing exceeds the growth rate of GDP? Not necessarily.
Let’s say that in a particular year that we could estimate all of the consumer surplus people would gain from that year’s GDP. Let’s say it’s 40 percent of GDP, which would mean that economic wellbeing would be 1.4 times GDP.
If the following year, real GDP grows by, say, 3 percent, but if consumer surplus is still 40 percent of that year’s GDP, then economic wellbeing would have grown by 3 percent.
To make it more concrete, start with plausible numbers. Say US GDP in 2026 is $30 trillion. Adding in the 40 percent consumer surplus adjustment, we get economic wellbeing of $42 trillion.
Now assume that we have 3 percent real growth so that real GDP in 2027 is $30.9 trillion. But also assume that consumer surplus in 2027 is again 40 percent of the year’s real GDP. So economic wellbeing in 2027 would be $30.9 trillion times 1.4, which equals $43.26 trillion. That $43.26 trillion is exactly 1.03 times the $42 trillion, meaning that economic wellbeing grew by 3 percent.
In short, if consumer surplus over time is a constant percentage of GDP, then the growth of GDP is a good measure of the growth of economic wellbeing.
The wonder of consumer surplus
What I like most about consumer surplus is not all the technical details and measurements, however important they are. What I love is that consumer surplus is a way of making us realize just how lucky and fortunate we are as Americans. Even those in the bottom 20 percent of the income distribution enjoy modern conveniences that make everyday life easier than it was for our parents—and considerably easier than it was for our grandparents.
I could have titled this subsection “Pinch Me.”
