National income figures, usually GDP at factor cost, are the man figures used to compare living standards. This is because most countries keep and publish detailed national income data.
However, care has to be taken in using national income figures to compare living standards both over time and between countries. It is important to use GDP at constant prices (i.e. real national income) so that a misleading impression is not given because of the effects of inflation. It is also important to take into account differences in population size. A country with a large population is likely to produce more than a country with a small population. However, this output has to be shared out among more people so living standards are not necessarily higher. This is why economist divide output by population and compare real GDP per capita. Even when adjustments have been made for inflation and differences in population size, national income figures as a measure of living standards have to be interpreted cautiously.
A rise in real GDP per capital may have resulted from an increase in the output of capital goods. In the longer run this will increase productive capacity and result in more consumer goods being produced. However, in the short run people may not feel any benefit from more capital goods being made. An increase in weapons will also increase GDP but, again, may not necessarily improve living standards. If more police are employed and crime is reduced, the quality of people’s lives will be improved. However, if more police are employed to keep pace with rising crime, people will be feeling worse off. So economists have to look not only at the amount of goods and services produced but also at the composition of those goods and why the quantity has changed. In addition, the quality of goods and services produced should be examined. The same quantity could be produced this year as last year or five years ago but if the quality of the output has risen, living standards will have improved.
The distribution of income also has to be taken into account. National income may rise but if it is concentrated in the hands of a few, the living standards of the majority may not rise. See graph below from The Economist showing the Gini coefficient of income inequality.
National income figures also fail to take into account some items which affect the quality of people’s lives. A certain amount of economic activity is not declared, either to avoid paying taxes or because it is illegal. If there is an increase in, say, people providing home hairdressing services but not declaring them, people’s living standards may rise, although this increase will not be reflected in the official figures.
Differences in working hours and working conditions are also not taken into account. If output remains constant but working hours fall, people are likely to have a higher quality of life.
National income figures only take into account economic activities for which a payment is made. They do not take into account externalities and non-marketed activities. So, for example, an increase in pollution will reduce living standards while an increase in people decorating the homes of old people, on a voluntary basis, will improve the quality of life of the elderly. Neither of these will be recorded in national income figures.
All of these factors have to be taken into account in using national income figures to make comparisons both over time and between countries. However, some additional factors have to be considered when making international comparisons. Different statistical methods are employed in some countries and the degree of accuracy can vary. Tastes and needs can be different in different countries. For example, people living in a cold climate have to spend more on heating than those in warm countries, merely to enjoy the same standard of living. There is also the problem of selecting a rate of exchange to make the comparison. Exchange rate fluctuate and do not always reflect relative prices in compared using purchasing power parities which compare the cost of a given basket of goods in different countries.