What is Economic Growth?

One of the things that I find frustrating about reading the news or watching politicians give speeches is that the language of economics is often used in a way that assumes everyone listening will know what it means. Terms like ‘GDP’, ‘growth’ and ‘recession’ are dropped into the conversation without ever explaining what they mean.

This can lead people to feel like these are very complicated concepts which would be very difficult to understand, and therefore it might be better to just leave it to the experts to decide. This is definitely how I felt before I started reading about economics.

However, once I started learning about economics, I realised that a lot of these concepts are actually surprisingly simple. It is just that the unfamiliar language makes it hard to follow.

One of the things I like to do in my free-time is to play the video-game Fortnite (yes, I am a grown adult, thanks for asking). Fortnite has a lot of its own language. If someone who wasn’t familiar with the game walked in when I was playing it with a friend and heard me say, “Put this big pot on and then let’s tunnel to the zone before the storm starts ticking for five. I’m max brick and metal so let me know if you need mats”, they probably wouldn’t know what I was talking about.

But none of the unfamiliar words there are especially complex. There are millions of children in the UK who would happily explain any of them to you in five minutes. It’s just that being bombarded with words you don’t know makes a subject seem very complicated. (If this Fortnite example doesn’t work for you, then think about football, tennis, driving a car, fashion, your job, music – all have their own terminology which can be baffling to someone not familiar with it).

Many concepts in economics are much simpler than watching the news would make you think. You don’t need to have a degree in economics to be able to have a valid opinion – in the same way that you don’t need to have a science degree to have an opinion about climate change. You just need to understand some of the basic concepts and know what the commonly used words mean.

In this post I want to go through some common economics terms and explain the concepts behind them. My aim is that anyone who reads this will have enough understanding to be able to form their own opinion when they read the news.

Good and Services

A lot of economics is about the way that goods and services are produced and distributed, so understanding what these two words mean is a good place to start.

Goods are physical objects or substances that a person might own, buy, want or need. Rather than trying to give a really detailed definition, the easiest thing is to just see some examples. All of the following things are goods:

  • A sandwich
  • A pair of shoes
  • A computer
  • A bottle of fruit juice
  • A car
  • A book
  • A jumper
  • A tube of toothpaste

A service is like a good, but rather than being a physical item, it is something that happens. For example, all of the following are services:

  • A haircut
  • A bus, train or taxi journey
  • A delivery (of a letter or package)
  • An internet connection
  • A concert or show
  • Medical treatment (such as an operation or a GP appointment)
  • Cleaning

Basically, a service is something that someone does for you.

Gross Domestic Product (GDP)

Gross Domestic Product (GDP) is a way of measuring the total amount of goods and services produced in a particular place during a particular period of time.

GDP is usually measured for a particular country and for a particular year. For example, we might talk about the GPD of the UK in 2018, or the GDP of France in 1995. However, we could measure the GDP for any area, such as a particular region of the UK, or a whole group of countries, and we could measure it for any time period, such as a month.

GDP is calculated by adding up the prices of all the goods and services produced. For example, imagine a company in the UK that makes chairs. To keep things simple, let’s imagine that the company only makes one type of chair, which it sells for £40. Every time the company produces a chair, the UK’s GDP goes up by £40.

If the company produced 10,000 chairs in 2018, then its contribution to that year’s GDP would be found by multiplying the number of chairs produced by the price, which would give £400,000. By doing this process for all of the different goods and services produced in the UK that year, and adding all the numbers together, you get the GDP of the UK.

(In case you’re curious, the GDP of the UK in 2018 was £2.11 trillion, or £2,110,000,000,000).

GDP is not actually calculated by recording every single good or service produced in the entire country. Instead, samples of data are taken from a range of different sources and used to come up with an estimate which is used as the GDP value. In fact, as more data comes in over time, previously published GDP values are updated to make them more accurate estimates.

What counts towards GDP?

There are a couple of important points to note about what does and what doesn’t count towards GDP.

GDP measures the amount produced, not the amount sold

GDP counts all the goods that are produced, even if they are not sold. In the chair company example above we counted the total number of chairs that the company produced. At the end of the year, some of those chairs may still be sitting in a warehouse waiting to be sold, but they still count towards GDP because they have been produced. Therefore, the most accurate way to describe GDP is to say that is a measure of the total amount of goods and services produced, not the total amount of goods and services sold.

Only final goods count

Some goods that are produced are then used to make other goods. For example, one company might make fabric which it then sells to another company, who use it to make t-shirts, which they then sell to consumers.

Only final goods (ones that are intended to be sold to consumers) are counted as part of GDP. So in the example above, the t-shirts would be included in GDP but the fabric would not. This is because the price of the t-shirts already includes the cost of fabric, so if both the fabric and the t-shirt were included in GDP then the fabric would be counted twice. By only counting final goods, GDP is measured in a way that ensures that each item is only counted once.

Also, because of this goal of only counting each good once, GDP does not include second-hand goods. For example, a company might sell a t-shirt to someone and a couple of years later that person might donate it to a charity shop, where it gets sold again. However, the t-shirt will only be counted towards GDP once. This makes sense if we remember that goods count towards GDP when they are produced, not when they are sold.

Ways of interpreting GDP

Although the thing that GDP actually measures is the amount of goods and services produced in a particular place during a particular time period, it can also be used as a rough measure of various other things. This is because there are many things that affect or are affected by the amount of goods and services produced, meaning that we can take the amount of goods and services produced to be a rough indicator of these other things.

GDP as a measure of sales

GDP measures the amount of goods and services produced, even if they are not sold. However, we can still think of GDP as a rough measure of the amount of goods and services sold, because in practice the difference between the amount produced and the amount sold is likely to be small.

In fact, for services, there is usually no difference between the amount produced and the amount sold. For example, if you are a hairdresser, then you ‘produce’ each haircut as you cut the hair. You don’t have a warehouse full of haircuts waiting to be sold.

And even for goods, the difference between the amount produced and the amount sold is likely to be small. It is true some of what a company produces this year will still be in the warehouse at the end of the year. However, it is also true that some of last year’s unsold goods will be sold this year. So these effects will largely cancel each other out, making the difference between the amount produced and the amount sold pretty small.

Also, even though GDP measures production, it is important to note that sales are generally what drive production. If businesses find that they are selling a lot of a certain good or service then they will increase the production of it so that they can make more money. If they find that a good or service is not selling well, then they will decrease production of it so that they don’t lose money. In other words, production responds to demand.

Therefore, it can often be helpful to think of GDP as an indicator of how much demand there is for goods and services, which could be an indicator of things like how much money people have to spend.

GDP as a measure of consumption

In everyday life, when we talk about ‘consuming’ things we usually either mean eating them or using them up. However, in economics, to consume just means to receive a good or service.

For example, if you go to a shop and buy a pair of shoes then you have consumed a pair of shoes. This is true even if you keep them in a cupboard and never wear them (or eat them). Similarly, if you travel somewhere by bus then you have consumed one bus journey.

We can think of GDP as a rough measure of the amount of goods and services consumed with a particular country or region. At first, this might sound like the same thing as the amount of goods sold, however it is not quite the same thing because of imports and exports.

Some of the goods and services that are sold in the UK are actually sold to people in other countries (they are exports). This means that although they are produced and sold in the UK (and count towards the UK’s GDP), they are not consumed by people in the UK. On the other hand, there are some goods and services sold by people in other countries to people in the UK (these are imports). This means that they are not produced or sold here (and don’t count towards the UK’s GDP), but they are consumed by people in the UK.

However, we can still think of the GDP of a country or region as a rough measure of the amount of goods and services consumed there. For example, if the GDP of the UK increases, then it is likely that people in the UK are consuming more goods and services (although it might also be the case the UK is just exporting more goods and services).

GDP as a measure of ‘the size of the economy’

Economists, politicians and journalists often talk about ‘the economy’, however, they rarely explain what they mean by this. The concept of ‘the economy’ is actually pretty vague and could be thought of as including all kinds of different things such as all of the people and businesses in the country or region, the goods and services produced, the distribution of work and resources, and so on.

Because ‘the economy’ is such a vague concept, we should not take economists too literally when they talk about ‘the size of the economy’. Instead we should think of it a rough way of collecting several different concepts together into one idea. These concepts include:

  • The number of people in the country or region (the population size).
  • The wealth of the people in the country (how rich are they?).
  • The level of technological advancement of the country.

GDP can be thought of as representing all of these concepts. If the population size is greater then GDP will be higher, since there will be more demand for goods and services and more workers to produce them. If the people are wealthier then GDP will be higher because they will have more money to spend on goods and services. If the country has more advanced technology then GDP will be higher because more goods and services can be produced for a given amount of input.

As long as we remember not to take it too literally, this idea of GDP as a measure of the ‘size of an economy’ can actually be very useful.

For example, imagine that we wanted to compare the amount of government spending in different countries. Our aim is to see which countries’ governments spend the most freely and which governments have the most restricted spending.

One way that we could do this is to just compare the actual amount of money spent by each government in a given year (after converting all the amounts into the same currency for comparison, of course). If we did this we would find that the country with the highest government spending is the USA, which spent $6 trillion ($6,000,000,000,000) in 2017.

This is far higher than the amount spent by any other government. For example, the government of Serbia only spent $16.9 billion ($16,900,000,000) in that same year – about 355 times less than the government of the USA.

So does that mean that the USA has the most generous government in the world? Are the US Government more committed to using taxation and borrowing to fund investment in public services and the nation’s infrastructure than any other country?

They are not. Just comparing the total amount of spending is not a fair comparison because the countries have different ‘sizes of economies’. The USA has a much bigger economy than any other country, because it has a large population and a lot of wealth. Because there is a large population, more government spending is needed to maintain the same quality of life. And because of their bigger economy the Government gets more money from taxes. Even if they had the same rates of tax as a smaller country, the Government would get more money from tax due to there being more people and more money.

So what we really want to know is how much the governments of different countries spend relative to sizes of their economies. Since GDP is a rough measure of the size of the economy, government spending is usually expressed relative to the GDP of the country.

In other words, GDP can be used to scale the public spending figure to the size of the economy, in order to allow more meaningful comparisons between countries (or between the same country in different years).

When we look at government spending as a percentage of GDP we find very different results to the ones we got from just looking at the total amount spent. The USA’s government spending is 38% of its GDP, which is actually pretty low. For example, Serbia’s is 41% of its GDP. The country with the highest level of government spending relative to GDP is France, at 56%.

GDP per capita

GDP per capita is the GDP of a country or region divided by the amount of people living there. As mentioned above, the UK’s GDP in 2018 was £2.11 trillion. To find the UK’s GDP per capita for 2018 we have to divide this by the amount of people living in the UK that year, which was 66.4 million:

£2,110,000,000,000 ÷ 66,400,000 = £31,777

This gives us a GDP per capita of £31,777.

Since GDP measures the total amount of goods and services produced in the country that year, GDP per capita shows the amount each person would receive if all of these goods and services were shared out equally.

In other words, if all of the goods and services produced in the UK in 2018 had been shared out equally between everyone in the country, we would have each received £31,777 worth of stuff. (Note that these are not the exact figures for 2018, I’m just trying to give an illustration of how it works).

GDP per capita can be more useful than GDP when making comparisons between countries or between different years in the same country. This is because it takes the population size into account.

For example, New Zealand has a much lower GDP than Colombia. This tells us that New Zealand produces a smaller amount of goods and services than Colombia. However, when we consider that New Zealand only has a population of 4.8 million, while Colombia has a population of 49.1 million, we realise that this isn’t a particularly interesting fact.

GDP per capita allows us to compare the amount of goods and services produced per person living in the country, which is likely to tell us much more about the differences in people’s lives in the two countries. It turns out that New Zealand’s GDP per capita is much higher than Colombia’s, which tells us that the average person in New Zealand consumes many more dollars’ worth of goods and services in a year than the average person in Colombia.

GDP per capita on its own doesn’t tell us much about prosperity

Prosperity is when people have the things that they need and want. This include basic needs like food, shelter, clothes, warmth, clean water and medical care, as well as the less essential things that we might want like mobile phones, holidays, cinema trips and so on. It could also include things that aren’t necessarily goods and services, like having time to spend with your friends and family, or being able to enjoy nature.

GDP per capita is often treated as if it is a measure of prosperity. This is based on the idea that if a country is producing a large amount of goods and services per person, then the people in the country must be benefiting from that. After all, most of what is produced get sold, so most of those goods and services are going to the people in the country. The argument says that people will only pay for things that they want or need, and it is this demand that determines which things are produced. So if more goods and services are being produced, then people must be getting more of the things they want and need – which means there is more prosperity.

However, there are a lot of problems with this logic. And when we look a bit more closely it becomes clear that higher GDP per capita doesn’t necessarily mean more prosperity.

Firstly, the argument assumes that people always benefit from the things that they buy, however we all know from our own experience that this isn’t true. A smoker who wants to quit but hasn’t been able to might spend thousands of pounds per year on cigarettes, even though they know that this is actively making their life worse. At a less extreme level, we have all bought things that we thought would make us happy (perhaps after being attracted by advertising) but later realised that we should have saved our money. In fact, many of us suspect that we might be happier if we had less stuff.

Secondly, it is important to note that the more something costs, the more it counts towards GDP (since GDP is calculated using the prices of things). This is based on the idea that the more someone is willing to pay for something, the more value it must have to them. While this might be true for one person, it isn’t necessarily true when the things are being bought by different people. For example, a millionaire might be willing to pay £1200 for a luxury watch, while a homeless person might only be willing to pay £12 for a night in a hostel. But that doesn’t mean that producing a luxury watch contributes 100 times more to the country’s prosperity than providing a person with shelter for the night does.

Thirdly, GDP per capita doesn’t tell us anything about the way that the goods and services are distributed. GDP per capita is the amount we would each get if the goods and services were shared equally, but of course they are not. GDP per capita might increase simply because a small group of very rich people are buying more luxury goods and services, without any change in the lives of the majority of people.

Fourthly, GDP per capita doesn’t take account of any negative effects that the things we buy have on other people or the environment. These negative effects might actually outweigh the benefits that we get from the goods and services, meaning that the overall prosperity of the country has gone down even though GDP per capita went up.

Also, GDP only counts things that are either sold or are intended to be sold. For example, if you have elderly parents, you might go round to their house on your way home from work each day and look after them for a couple of hours. Or you might pay a carer to do this. If you pay someone else to do it then it is considered a service and it counts towards GDP, but if you do it yourself it isn’t counted.

In fact there are loads of things that we do in our daily lives that could be paid for. For example, cleaning your house rather than paying a cleaner to do it, growing your own vegetables rather than buying them, looking after your kids rather than paying for a babysitter. If we pay for these things then they count as goods and services, but if no money changes hands suddenly they don’t count. Using GDP per capita as a measure of prosperity ignores the fact that there are many activities that we benefit from that aren’t counted as part of GDP.

Another problem with using GDP per capita as a measure of prosperity is that it doesn’t include some of the more abstract things that we might need or want. For example, one thing that most people want is free time to see friends and family, work on their own projects, do their hobbies, or just relax and do nothing. If we all started working less and had more time for the things we enjoy, then the amount of goods and services produced might decrease, meaning that GDP per capita would go down, even though, in a way, we might be more prosperous, since we would have more of what we want.

Another thing that most people want is a sense of connection to other people. In the UK today, many people living in cities and towns don’t know their neighbours. For people who don’t have family or friends living nearby, this can lead to loneliness. If the Government or a local council introduced policies to help people get to know their neighbours, this would lead to more social connection, and since this is a thing that people want, it could be described as an increase in prosperity. However, this wouldn’t necessarily show up in GDP per capita, because it may not affect the amount of goods and services being produced.

How should we measure prosperity?

The problem with using GDP per capita as a measure of prosperity is that it assumes that a complex, abstract concept like prosperity can be reduced down to a single number. Since there are so many different aspects to prosperity, this just doesn’t make sense.

A better approach to measuring the prosperity of a country is to look at a range of different indicators. For example, some of the things that we might look at are:

  • Measures of health – life expectancy, rates of illness, infant mortality rates, and so on.
  • Measures of emotional well-being – do people report that they are happy? What percentage of people have depression or anxiety issues?
  • Measures of income – How much money does the average person have coming in each month? How much can this buy?
  • Measures of inequality – are incomes evenly distributed or is most of the money going to the wealthiest people? What is the distribution of wealth?
  • Measures of poverty – what percentage of people do not have the basic things that they need like food, shelter, clothes and so on?
  • Measures of how well public services are working – How long do people have to wait for a GP appointment or an operation? How are schools performing?
  • Measures of our impact on the environment – What are the concentrations of greenhouse gases in the atmosphere? How polluted in the air? How much biodiversity is there?

Some economists and social scientists have suggested that we should have a ‘dashboard‘ of different indicators, such as the ones above, that we can look at to see how a country is doing.

GDP per capita could be included as part of that dashboard, since it does tell us some useful things. If we found that GDP per capita (the amount of goods and services produced per person) was increasing, and life expectancy was increasing, and inequality was reducing, and environmental indicators were improving, and so on, then we might conclude that this increase in GDP per capita was genuinely a good sign.

Economic Growth vs Recession

An increase in GDP per capita is called ‘economic growth’ and a decrease in GDP per capita is called ‘recession’ (people also use these two terms to talk about increases and decreases in GDP rather than GDP per capita).

The graph below shows how the UK’s GDP per capita has changed over time from 1960 to 2018 (hover over or touch a datapoint to see its year and value). The values are in US dollars. Even though we use pounds in the UK, GDP per capita data is usually published in dollars so that countries can be compared.

To account for the fact that the value of money changes over time (one pound today is worth less than it was 30 years ago, for example), the amounts have all been converted into how much they would have been worth in 2010. It doesn’t matter which year you use as the standard, it is just important that you adjust the numbers in this way to make the comparison meaningful.

As you can see, the general pattern over time is economic growth (an increase in GDP per capita). Almost every year has had a higher GDP per capita than the previous year. There are only a few years where there has been a recession (a decrease in the GDP per capita).

The last time there was a recession was in 2008 and 2009, which was due to the global financial crisis.

This pattern of almost constant increases in GDP per capita is mainly due to advances in technology which allow us to produce more goods and services per worker per hour. Also, over time, businesses accumulate more of the things that they need to produce goods and services (like machines) and this allows them to produce more.

Because GDP per capita tends to go up most of the time, economists and politicians tend to focus on the rate of growth. In other words, by what percentage has GDP per capita increased from the previous year? A high growth rate means that GDP per capita is increasing quickly. If there has been a recession then the growth rate will be negative.

The graph below shows the growth rate of GDP per capita in the UK since 1961. You can see that the growth rate is almost always positive but in some years it is bigger than in others.

Summary

GDP is a measure of the amount of goods and services produced in a particular place during a particular time period.

It can also be thought of as a rough indicator of the amount of goods and services sold, or the amount of goods and services consumed.

It can also be thought of as a rough measure of the ‘size of an economy’. This can be useful for scaling things like the amount of government spending, so that we can see what it is relative to the size the economy – which can often allow more meaningful comparisons.

GDP per capita is the GDP of a country or region divided by the number of people living there. It is often used as a rough measure of prosperity, although there are a lot of reasons why, on its own, it is not a good measure of this, and it would be better to look at a range of different indicators.

Economic growth is an increase in GDP per capita (or GDP) over time, while recession is a decrease in GDP per capita (or GDP) over time. Economic growth occurs almost every year, so it is often more useful to look at the rate of growth, which tells us how quickly GDP per capita is increasing (or decreasing).

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