Tuesday, September 05, 2006

On International Comparisons of GDP

A student emails me some praise and a question about comparing the Gross Domestic Product of different countries:

Hey Greg,

I'm an International Relations student in Montevideo, Uruguay. My class used your "Principles of Economics" book in the course of the same name, and it was simply amazing. A definite keeper and a true mind-opener, it has attracted me quite strongly to economics--whereas before, I was almost purely focused on international politics. That book plus your blog have encouraged me, for example, to read Milton Friedman's "Capitalism and Freedom" and to watch "Free To Choose". Anyway, there goes the much-deserved praise.

Now to a question I was hoping you would address in your blog. Every country's GDP varies when measured with nominal exchange rates and via purchasing power parity. However, the variation in China's GDP is immensely more significant than in other countries. For example, China's economy is the fourth in size when measured with nominal rates, but the second with PPP. The difference is several trillion Dollars. My question is, would you mind discussing this? If a writer for an article or a thesis had to pick one or the other, what would you advise?

Thanks in advance and don't let up on the blog, which is a daily must-read. Economists can be rock stars without being smug and arrogant -- and you know which ones I mean.

[name withheld]

As all students of macroeconomics know, GDP measures the total income earned from the goods and services that a nation produces within a given period of time. Comparing the GDP of the United States with the GDP of China requires some way of dealing with the units, because US GDP is in dollars whereas China's GDP is in yuan. There are two ways to change China's GDP into US dollars:

1. Use the market exchange rate to convert China's GDP from yuan into dollars.

2. Compute the GDP of China as if the goods and services produced in China were sold in the United States at US prices.

If all goods and services were traded in world markets without any frictions (such as transports costs or tariffs), prices would be the same everywhere after correcting for the exchange rate, and the two methods would produce the same answer. In practice, however, many goods and especially services are not traded, and as a result the two methods give different answers.

Imagine that China produces a large quantity of some nontraded good or service that commands a low price in China compared with its price in the United States. Because its Chinese price is low, each unit contributes only slightly to Chinese income and also to GDP computed using the exchange rate. But because the US price of this good or service is high, each unit of the good contributes more to Chinese GDP when measured using US prices.

When thinking about nontraded production, a good example is a personal service like haircuts. Haircuts are produced with roughly the same process everywhere: 20 minutes of a barber's time and a pair of scissors. In nations where wages are low, haircuts are cheap. So when computing Chinese GDP in US dollars, does it make more sense to convert the low income of a Chinese barber at the exchange rate or to compute his income as if he sold his services at US prices? Both are artificial constructs. The barber is neither converting his income in foreign exchange markets to buy goods in the United States nor selling his services at US prices.

Is one construct better than the other? To help you answer that question for yourself, I finish up with an exercise:

Suppose two countries--call them China and the US--each have 100 units of labor. A unit of labor sell for $1 in the US and 1 yuan in China.

The US can produce a TV with one unit of labor and a haircut with one unit of labor. China can produce a TV with 3 units of labor and a haircut with one unit of labor. In each country, the number of TVs produced equals the number of haircuts produced.

TVs are traded in world markets, so the a US-made TV sells for the same price as a Chinese-made TV (once the prices are expressed in the same currency). Haircuts are not traded.

What are the prices of TVs and haircuts in each country? What is US GDP? What is China's GDP? What is the exchange rate between dollars and yuan? What is China's GDP converted into dollars using the exchange rate? What is China's GDP computed using US prices? Which measure, in your judgment, better captures the relative size of the Chinese economy?

Readers are encouraged to post and debate the answer in the comments section.