Lecture Business economics - Lecture 14: Measuring a Nation’s Income - II

After completing this chapter, students will be able to: Learn how gross domestic product (GDP) is defined and calculated, see the breakdown of GDP into its four major components, learn the distinction between real GDP and nominal GDP, consider whether GDP is a good measure of economic well-being.

• Gross domestic product (GDP) is a measure of the income and

expenditures of an economy

• It is the total market value of all final goods and services produced within a country in a given period of time

• Nominal GDP values the production of goods and services at current prices.

• Real GDP values the production of goods and services at constant prices.

• Some things that contribute to well-being are not included in GDP

 The value of leisure

 The value of a clean environment

 The value of almost all activity that takes place outside of markets, such

as the value of the time parents spend with their children and the value

of volunteer work

Measuring a Nation’s Income - II

Instructor: Prof.Dr.Qaisar Abbas

Course code: ECO 400

1 Shortcomings of GDP

2 Supply side of the model

•Some productive activities don't take place in the market, and as the GDP only measures the market value of output, these activities don't show up in the GDP

•Thus, GDP understates a nation's total output

•Example of such activities are labor of carpenters who repair own homes,

black markets

•One exception: Portion of farmers' output that the farmers consume

themselves is included in the GDP

Leisure:

•GDP only takes the market value of output, therefore, LEISURE (paid

vacation, holidays, leave time), which shows increase of well-being,

satisfaction, and 'psychic income' is excluded in the GDP

Improved product quality:

•GDP is a quantitative measure, and thus does not capture the value of improvements in product quality

•Example a $200 dollar phone costs the same as a $200 dollar phone 10 years ago technological improvements such as greater memory capacities, viewing screens, and enhanced capabilities is not included in GDP

The Underground Economy ("black market"):

•Embedded in the economy is a flourishing and productive underground sector include gamblers, smugglers, drug dealers, etc

•However most participants engage in perfectly legal activities, but choose illegally not to report their full incomes and therefore is not counted in the GDP

• Most of these transactions would help to increase a countries GDP as they would increase the money flow; thus, this is a downfall.

• Example: A woman who tutors a student in math is earning money legally, but she doesn't report it to the government and therefore the money involved in the transaction is not counted in GDP On the other hand, a factory employee,

whose economic status is chartered, has an income counted in GDP

• Value of underground transactions in a country is often very large

GDP and the environment

• The growth of GDP is inevitably accompanied by "gross

domestic by-products" (i.e dirty air, polluted water, toxic waste, congestion, and noise)

• The social cost of the negative by-products reduce our economic well-being.

• Costs of environmental harm are not deducted from GDP

• Therefore GDP overstates national well-being in this aspect

• Ironically, costs of cleaning up the environment are included in the

GDP

• Negative and Positive Externalities are misrepresented or ignored

Composition and Distribution of output

•GDP does not tell us what mix of goods and services benefit or harm society because it assigns equal weight to products of the same price some goods/ services are enriching, or potentially detrimental to society

•Ex As long as they are of the same price Assault Rifle = Book

• GDP does not reveal anything about how output is distributed (therefore, GDP does not tell us the well-being of a society because distribution makes a big difference)

• Society better off if there is less gap between wealthy and poor, but GDP does not represent this aspect of well-being

Per capita output

• GDP itself does not reflect the well being of people in the nation, it is the GDP per capita that is important

• E.g China's GDP in 2004 was $1938 billion and Denmark's

$220 billion, but Denmark's GDP per capita was $40,750 while China's was $1500 The living standards in Denmark are

superior to those in China, since the average income for each person in Denmark is much higher

• An increase in GDP could actually be accompanied by a

decrease in GDP per capita, and vice versa, depending on

population growth

Non economic sources of well-being

• Just as a household's income does not measure its total happiness, a nation's GDP does not measure its total well-being

• There are many things that could make a society better off without necessarily raising GDP, e.g crime reduction,

peaceful international relations, greater civility among the people, less drug & alcohol abuse, etc

• GDP merely reflects the trade going on in the country's markets

Outline of model

A closed economy, market-clearing model

Supply side

 factor markets (supply, demand, price)

 determination of output/income

Demand side

 determinants of C, I, and G

Equilibrium

 goods market

 Factors market

K = capital, tools, machines, and structures used in production

L = labor, the physical and mental efforts of workers

The production function

•denoted Y = F (K, L)

•shows how much output (Y ) the economy can produce from K units of capital and L units of labor

•reflects the economy’s level of technology

•exhibits constant returns to scale.

• Returns to scale: a review

Initially Y1 = F (K1 , L1 )

Scale all inputs by the same factor z:

K2 = zK1 and L2 = zL1

(If z = 1.25, then all inputs are increased by 25%)

What happens to output, Y2 = F (K2 , L2 ) ?

If constant returns to scale, Y2 = zY1

If increasing returns to scale, Y2 > zY1

If decreasing returns to scale, Y2 < zY1

Output is determined by the fixed factor supplies and the fixed state of

technology:

The distribution of national income

determined by factor prices, the prices per unit that firms pay for the factors

of production

The wage is the price of L ,the rental rate is the price of K

Notation

,

= ( )

W = nominal wage

R = nominal rental rate

P = price of output

W /P = real wage

(measured in units of output)

R /P = real rental rate

W = nominal wage

R = nominal rental rate

P = price of output

W /P = real wage

(measured in units of output)

R /P = real rental rate

•Factor prices are determined by supply and demand in factor markets

•Supply of each factor is fixed

•What about demand?

Demand for labor

•Assume markets are competitive: each firm takes W, R, and P as given

•Basic idea:

A firm hires each unit of labor if the cost does not exceed the benefit

• cost = real wage

• benefit = marginal product of labor

Marginal product of labor (MPL)

def:

The extra output the firm can produce using an additional unit of labor (holding other inputs fixed):

MPL = F (K, L +1) – F (K, L)

The MPL and the production function

•As a factor input is increased, its marginal product falls (other things equal)

•Intuition:

L while holding K fixed

fewer machines per worker

lower productivity

MPL and the demand for labor

•We have just seen that MPL = W/P

•The same logic shows that MPK = R/P :

•diminishing returns to capital: MPK as K

•The MPK curve is the firm’s demand curve for renting capital

•Firms maximize profits by choosing K such that MPK = R/P

The Neoclassical Theory of Distribution

• states that each factor input is paid its

marginal product

• accepted by most economists

• states that each factor input is paid its

marginal product

• accepted by most economists

• Shortcoming of GDP

• Factor prices are determined by supply and demand in factor markets

• As a factor input is increased, its marginal product falls (other things equal)