The Uses and Limitations of Real gdp
One measure of the standard of living over time is real GDP per person, or real GDP divided by the population. Real GDP per person tells us the value of goods and services that the average person can enjoy. The value of real GDP when all the economy’s labor, capital, land, and entrepreneurial ability are fully employed is called potential GDP. Potential GDP grows at a steady pace because the quantities of the factors of production and their productivity grow at a steady pace.
Fluctuations in the pace of expansion of real GDP is denoted the business cycle, periodic but irregular increases and decreases in the total production and other measures of economic activity. Each cycle is categorized by: trough, expansion, peak, recession. Real GDP can be used to compare living standards across countries. But two problems arise in using real GDP to compare living standards:
First, the real GDP of one country must be converted into the same currency unit as the real GDP of the other country.
Second, the goods and services in both countries must be valued at the same prices. Relative prices in countries will differ, so goods and services should be weighted accordingly. For example, if more prices are lower in China than in the United States, China’s prices put a lower value on China’s production than would U.S. prices. If all the goods and services produced in China are valued using U.S. prices, than a more valid comparison can be made of real GDP in the two countries. This comparison using the same prices is called purchasing power parity (PPP) prices.
Limitations of Real GDP
Some of the factors that influence the standard of living are not part of real GDP. Omitted from GDP are:
Household Production: As more services, such as childcare, are provided in the marketplace, the measured growth rate overstates development of all economic activity.
Underground Economic Activity: If the underground economy is a reasonably stable proportion of all economic activity, though the level of GDP will be too low, the growth rate will be accurate.
Health and Life Expectancy: Better health and long life are not directly included in real GDP.
Leisure Time: Increases in leisure time lower the economic growth rate, but we value our leisure time and we are better off with it.
Environmental Quality: Pollution does not directly lower the economic growth rate.
Political Freedom and Social Justice: Political freedom and social justice are not measured by real GDP.
Economic Growth
Economic growth leads to large changes in standards of living from one generation to the next.
Economic growth rates vary across countries and across time.
There are different economic theories to explain these variations in growth rates.
I. The Basics of Economic Growth
The economic growth rate is the annual percentage change of real GDP. This growth rate is equal to:
Real
GDP growth rate =
The standard of living depends on real GDP per person, which is real GDP divided by the population. The growth rate of real GDP per person can be calculated using the formula above, though substituting real GDP per person.
The growth rate of real GDP per person also approximately equals the growth rate of real GDP minus the population growth rate.
Economic Growth Trends
How Potential GDP Grows
Potential
GDP is the amount of real GDP that is produced when the quantity of
labor employed is the full-employment amount. To determine potential
GDP we use the aggregate production function and the aggregate labor
market. 
The aggregate production function is the relationship between real GDP and the quantity of labor employed when all other influences on production remain the same. The figure shows an aggregate production function.
The additional real GDP produced by an additional hour of labor when all other influences on production remain the same is subject to the law of diminishing returns, which states that as the quantity of labor increases, other things remaining the same, the additional output produced by the labor decreases. The production function in the figure shows the law of diminishing returns because its shape demonstrates that as additional labor is employed, the additional GDP produced diminishes.