Review of the previous lecture

For an economy as a whole, income must equal expenditure.

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.

Lecture 14

Measuring a Nations Income - II

Instructor: Prof.Dr.Qaisar Abbas
Course code: ECO 400

Lecture Outline

1. Shortcomings of GDP
2. Supply side of the model

Shortcomings of GDP
Non market transactions:
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.

Shortcomings of 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

Shortcomings of 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.

Shortcomings of GDP
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

Shortcomings of GDP
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.

Shortcomings of GDP
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 wellbeing.
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

National Income: Its Production, Distribution and Allocation

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

Supply side
Factors of production
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 economys level of technology.
exhibits constant returns to scale.

Supply side

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

Supply side
Determining GDP
Output is determined by the fixed factor supplies and the fixed state of
technology:

Y F (K , L)

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
W

R
R
P
P
W /P
W /P
R /P
R /P

= nominal wage
= nominal wage
= nominal rental rate
= nominal rental rate
= price of output
= price of output
= real wage
= real wage
(measured in units
(measured in units
of output)
of output)
= real rental rate
= real rental rate

Supply side
How factor prices are determined
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)

Supply side
The MPL and the production function

Supply side
Diminishing marginal returns
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

Supply side
Determining the rental rate
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 firms demand curve for renting capital.
Firms maximize profits by choosing K such that MPK = R/P .
The Neoclassical Theory of Distribution

states
statesthat
thateach
eachfactor
factorinput
inputisis
paid
paidits
itsmarginal
marginalproduct
product
accepted
acceptedby
bymost
mosteconomists
economists

Supply side
How income is distributed

Summary

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).