Class2solution

Page 1: GDP Calculation and Welfare Measures

(a) GDP Calculation Methods

• Production Approach:

  • GDP is calculated by summing the value of all final goods produced, minus the value of intermediate goods used in production:

    • Firm A (apples):

      • Total Revenue: £15,000 + £30,000 = £45,000.

      • Intermediate Goods: £0 (no intermediate goods used).

    • Firm J (apple juice):

      • Final Goods Production: £50,000.

      • Intermediate Goods: £30,000 (purchase) + £10,000 (other) = £40,000.

  • GDP = £45,000 + £50,000 - £40,000 = £55,000.

• Expenditure Approach:

  • GDP is total spending on final goods and services:

    • Total Expenditure = C + I + G + NX;

      • C = £15,000 (Firm A) + £50,000 (Firm J) - £10,000 (imports) = £55,000.

      • Investment (I) = £0; Government Spending (G) = £0; Net Exports (NX) = £10,000.

  • Total GDP = £55,000.

• Income Approach:

  • GDP is the sum of all income received by economic agents:

    • Firm A:

      • Wages: £20,000

      • Profits: £15,000

      • Rent: £10,000

    • Firm J:

      • Wages: £10,000

  • Total Income = £20,000 + £15,000 + £10,000 + £10,000 = £55,000.

(b) GDP and Welfare Intuition

• GDP measures market transactions:

  • Reflects the total output produced, total income, and total expenditure.

  • GDP does not equate to welfare, which concerns individual or collective well-being.

• Limitations of GDP as a Welfare Measure:

  • Does not account for:

    • Non-market transactions (e.g., home care, leisure).

    • Underground economy transactions (black markets).

    • Distribution of income (high GDP per capita does not guarantee equitable welfare, as seen in Qatar vs. UK statistics).

• Conclusion:

  • GDP is a useful approximation for economic activity but falls short as a comprehensive welfare measure.

Page 2: Product Exhaustion and Returns to Scale

Production Function: Y = F(K, L) = K^α L^β

• Product Exhaustion Theorem:

  • Applicable under constant returns to scale in competitive markets.

  • When α + β > 1, increasing returns to scale imply that factor payments exceed output value.

Explanation of Theorem.

• Homogeneous Functions:

  • A function is homogeneous of degree k if scaling all inputs results in scaling the output by r^k.

• Cobb-Douglas Production Function:

  • Degree: α + β.

  • Application of Euler’s Theorem shows:

    • Under increasing returns, total income (P*Y) < total payments (rK + wL).

Implications of Increasing Returns to Scale

• Positive externalities may lead to extra value creation not captured in payments.

• In competitive markets, firms should earn zero economic profit in the long-run but increasing returns contradict this, necessitating constant returns to maintain income distribution equilibrium.

Page 3: National Accounting Identity and Twin Deficit Hypothesis

National Accounting Identity

• Identity: Y = C + I + G + NX.

Aggregate Saving and Investment Relation

• Definition of Aggregate Saving (S):

  • S = S_pr + S_pub;

    • S_pr = Y + NFP - T - C (private saving).

    • S_pub = T - G (public saving).

• Derivation of Savings Relationship:

  • S = Y + NFP - C - G;

  • Substitute Y: S = I + NX + NFP.

Twin Deficit Hypothesis

• If the government runs a deficit (T < G), leading to:

  • CA < 0 (Current Account Deficit).

• Explanation:

  • Domestic savers invest privately, while government deficits are financed by foreign borrowing, correlating fiscal with current account deficits.