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# Real Income

MEANING AND ORIGIN OF THE CONCEPT

REAL INCOME AS A MEASURE OF WELL-BEING

BIBLIOGRAPHY

Many societies strive to improve the well-being of their members by increasing their incomes. But an increase in ones income (wage, pension, and so forth) does not necessarily mean that he or she is better off unless inflation is appropriately factored in. This is because inflation reduces purchasing power, the amount of goods or services that one can afford with a given amount of income, thus eroding some or all of ones nominal income gains. In order to make an accurate assessment of the effect of an income change on well-being, it is important to consider real income (income in constant dollars), which takes inflation into account, instead of nominal income (income in current dollars), which does not.

## MEANING AND ORIGIN OF THE CONCEPT

Real income could be viewed in two equivalent ways. Again suppose that your nominal income rises by 50 percent (from \$200 to \$300) this year over last year but the price per bottle of your favorite drink rises by 25 percent (from \$2.00 to \$2.50) over the same period. First, with the \$200 you could afford \$200/\$2.00 = 100 bottles of the drink at last years price (\$2.00). However, to buy the same 100 bottles of the drink at this years price (\$2.50), you require \$250. Because your income has increased from \$200 to \$300, your real income has increased by only \$300 \$250 = \$50, a 25 percent increase from your original income of \$200 last year (i.e., less than the 50 percent increase in your nominal income). Second, because your nominal income increases by 50 percent (from \$200 to \$300) and the price of the drink increases by 25 percent (from \$2.00 to \$2.50), your real income increases by 50 25 = 25 percent, which also amounts to \$50.

As noted above, adjusting nominal income to maintain some desired level of real income requires information about the inflation rate. However, practical difficulties arise in the measurement of inflation. In practice, the inflation rate is computed from a price (or cost-of-living) index, a summary measure describing relative price changes between some reference (base) period and another (current) period. For purposes of indexing wages, pensions, and so on, the inflation rates are commonly derived from a Consumer Price Index (CPI). The CPI is based on the prices of a representative basket of goods and services purchased by households. The economists M. C. McCracken and E. Ruddick (1980) provide a simple exposition of the nature and practical difficulties associated with CPI as an inflation measure. The economic statistician Roy Allen (1975) describes some applications of price index numbers in the measurement and international comparisons of real incomes. Given the aforementioned connection among real income, prices, and purchasing power, the origin of the real income concept can be linked to that of price index numbers, which the economic statistician Wesley Mitchell (1938) traced as far back as the 1700s.

The concept of real income is used in national income accounting to refer to real gross domestic product (GDP), the real value of all final goods and services produced in a country during a specific time period. In evaluating real GDP, the output for different years is evaluated using a common set of prices, thus eliminating the contamination of the value of actual output by inflation. Real GDP is obtained by deflating nominal GDP by a special price index called the GDP deflator, which measures changes in the average price of a broader basket of goods and services than does CPI. The usage of real income to mean real GDP is commonplace in the literature on economic growth and the measurement of human well-being, among others.

## REAL INCOME AS A MEASURE OF WELL-BEING

Because real income takes into account the actual physical quantity of goods and services that can be consumed with the income, it is a better measure of human well-being than its nominal counterpart. It is therefore not surprising that real income has been incorporated into several measures of human well-being developed by the United Nations Development Program (UNDP) in its annual issues of the Human Development Report. UNDP (2006) describes these measures, including the Human Development Index (HDI), the Gender-Related Development Index (GDI), and two human poverty measures (HPI1 and HPI2).

Amartya Sen, winner of the 1998 Nobel Prize in Economics, has raised some philosophical issues surrounding the appropriateness of real (or nominal) income as a measure of well-being. Sen (1985) argues that functional capabilities (i.e., what a person can do or can be) are more important than income improvements. This view, which has come to be known as the capabilities approach, emphasizes the removal of obstacles to what a person can be or can do. Such obstacles include illiteracy, poor health, lack of access to resources, and lack of civil or political freedom, among others. The ideas underlying the capabilities approach have been incorporated in UNDPs human development and poverty measures.

The link between real (or nominal) income and happiness has been the subject of empirical investigations by economists and sociologists. There is evidence that higher incomes may not necessarily translate to greater happiness. The economist Mathias Binswanger (2006) has reviewed several explanations for the failure of (real) income growth to increase happiness.

SEE ALSO Economic Growth; Happiness; Inflation; Mitchell, Wesley Clair; Money Illusion; Nominal Wages; Price Indices; Sen, Amartya Kumar; Welfare Economics

## BIBLIOGRAPHY

Allen, Roy G. D. 1975. Index Numbers in Theory and Practice. London: Macmillan.

Binswanger, Mathias. 2006. Why Does Income Growth Fail to Make Us Happier? Searching for the Treadmill behind the Paradox of Happiness. Journal of Socio-Economics 35 (2): 366-381.

McCracken, M. C., and E. Ruddick. 1980. Towards a Better Understanding of the Consumer Price Index. Hull, Canada: Minister of Supply and Services Canada.

Mitchell, Wesley C. 1938. The Making and Using of Index Numbers. New York: Sentry.

Sen, Amartya. 1985. Commodities and Capabilities. Amsterdam and New York: North-Holland.

United Nations Development Program. 2006. Human Development Report 2006: Beyond Scarcity: Power, Poverty, and the Global Water Crisis. New York: United Nations Development Program. http://hdr.undp.org/.

Tomson Ogwang