Welfare: From Income to Well- Being Chapter 8 DD202a – Fall Prepared by Maria Frangieh

Objectives Understand the measurement of national income and appreciate its limits as an approach to the measurement of welfare Understand the concept of utility as used in consumer behavior theory and in welfare economics Understand some concepts and evidence associated with well-being

1 Introduction: Socrates and the Pot Noodle This chapter deals with normative questions, i.e. questions about what should be done to improve the well being of people Welfare can be interpreted in many ways: 1- materialistic 2- physical 3- mental 4- spiritual

2 The Economic Wealth of Nations 2.1 The Circular Flow (CF) Model of Income 2.2 Extensions to the CF Model 2.3 Measuring National Income Using the CF Model -Output Measurement -Expenditure Measurement -Income Measurement -Real and Nominal Income 2.4 An Alternative Approach: Sustainable Economic Welfare or Green Income

2.1 The Circular Flow (CF) Model of Income The economy is assumed as comprising a set of exchanges There are two flows, – The first is a physical flow – The second is a money flow in the opposite direction. The physical flow of goods and services is always matched by a financial flow in the opposite direction when people pay for the goods and services they buy. Households Firms Factors of production Incomes Consumption expenditure Consumption goods and services

2.1 The Circular Flow (CF) Model of Income Limitations of this model – Households spend all their income – Omission of the government sector and international trade

2.2 Extensions to the CF Model Households Government Firms Tax less transfers Government Spending Consumption Expenditure Incomes savings imports exports Investment expenditure

2.2 Extensions to the CF Model with Leakages and Injections Households Government Firms Tax less transfers Government Spending Consumption Expenditure Incomes savings imports exports Investment expenditure leakages injections

2.3 Measuring National Income Using the CF Model National income is the value of the goods and services produced over a given period usually a year Calculating national income is based on the identity of income and expenditure Due to the extended model, leakages and injections add some complication to national income calculation.

2.3 Measuring National Income Using the CF Model If we look at the Model we will see there are 3 ways to measure income: – National Output: physical flow of goods and services from firms to households – National Expenditure: measure the money flow moving in the opposite direction – National income: measure the money flow from firms to households, in return for services of factors of production The three should give the same result! Why?

2.3 Measuring National Income Using the CF Model The two money flows, income and expenditure, must be equal. In any transaction there is a buyer and a seller, and the buyer’s expenditure is the seller’s income. The physical flow, output, can be measured or valued in terms of either of the money flows as expenditure incurred in producing it or as income received from selling it.

2.3 Measuring National Income Using the CF Model The more realistic model is the extended model with leakages and injections for two reasons: – Households receive incomes as sellers of labor and other factors of production, but as potential buyers they do not spend all their income on the output of the national economy; some is saved, some is paid to the government in taxes and some is spent on imports. – These withdrawals of expenditure from the circular flow of income are balanced by injections of expenditure on national output by other sectors. Firms buy capital goods; the government buys capital goods; and consumers from overseas buy the nation’s exports.

2.3 Measuring National Income Using the CF Model Output Measurement Gross value added at basic prices + value added taxes (VAT) on products + other taxes on products -Subsidies on products = GDP at market prices The term ‘gross’ means no deduction has been made to reflect depreciation Value added: In order to avoid double counting Basic prices: reflect the cost of the factors of production(exclude taxes, include subsidies)

2.3 Measuring National Income Using the CF Model Expenditure Measurement: Consumer expenditure (consumption) + General government final consumption + Gross capital formation(investment) + External balance(net export) + Statistical discrepancy = GDP at market prices

2.3 Measuring National Income Using the CF Model Income Measurement Income from employment + Profits + Mixed income + taxes on production and imports -Subsidies + statistical discrepancy = GDP at current market price

2.3 Measuring National Income Using the CF Model Measuring Income GNY Gross National Income = GDP + net income from abroad GDP measures income due to factors domestically located (whoever owns them) GNY measures income due to factors nationally owned (wherever they are)

2.3 Measuring National Income Using the CF Model Inflation: refers to a rise in the general level of prices Inflation rate: is expressed as a percentage increase in the general level of prices from one year to the next Inflation index: we can think of the base year prices as equivalent to 100 and consider any change from one year to the next as a percentage change.

2.3 Measuring National Income Using the CF Model Real and Nominal income -Real GDP=money GDP/(GDP deflator)*100 -Per capita output : GDP divided by total population

2.4 An Alternative Approach: Sustainable Economic Welfare or Green Income National income accounting reflects the following problems: – valuable activities are invisible(EX: work in the home) – environmental issues are not handled by national income accounts – there are questions of distribution – changes in human capital are not measured in national income accounts

3 Utility, Welfare and Markets 3.1 Consumption and Diminishing Marginal Utility 3.2 Individual Equilibrium 3.3 Pareto Optimality and the Utility Possibility Frontier 3.4 Welfare Economics: Perfect Competition and Pareto Optimality

3 Utility, Welfare and Markets Utility is a subjective concept Utility: Total utility is the satisfaction derived from consuming a given amount of good Society should maximize the utility enjoyed by consumers in order to maximize welfare Marginal Utility: refers to the change in total satisfaction derived from consuming a good when the amount consumed changes by one unit.

3.1 Consumption and Diminishing Marginal Utility The more units of something that are consumed, the less valuable are successive units to the consumer Cup of coffeeMarginal utility Total number of cups drunk Total utility st515 2nd429 3rd039 4th-247

3.2 Individual Equilibrium Or the marginal utility of the last $ spent on x equals the marginal utility of the last $ spent on y.

3.2 Individual Equilibrium The combination of 5$ for oranges and 8 $ for apples is an equilibrium combination successive dollars paid buying apples and oranges Marginal utility in utils utils 5 Marginal utility of apples Marginal utility of oranges

3.2 Individual Equilibrium Welfare economics is the study of the effect on well-being of different allocation of resources among individuals Allocative efficiency occurs when no reallocation could improve anyone’s welfare without reducing the welfare of someone else.

3.3 Pareto Optimality and the Utility Possibility Frontier Pareto improvements: consist of allocations in which the welfare of everyone improves Pareto improvements with acceptable distributional consequences are supposed to be desirable goals to be achieved. Welfare Economics: is the study of the effect on well-being of different allocations of resources among individuals.

3.3 Pareto Optimality and the Utility Possibility Frontier Utility possibility frontier for Alice and Ben From I to J (Pareto improvements) From J to K (Allocative efficiency) Utility possibility frontier Utility of Alice Utility of Ben U max Alice U max Ben I J K

3.4 Welfare Economics: Perfect Competition and Pareto Optimality Under perfect competition, the common price taken by firms and consumers becomes a mediator which ensures that the worth to the consumer of the last item of each good bought is equal to the marginal cost of producing it. MU = P = MC Once the perfectly competitive market has settled at an equilibrium where these equalities hold, no further improvement is possible by expanding or contracting output.

4 Well-Being According to Amartya Sen, a Nobel laureate, people measure their welfare in terms of their ability to make their own free choices between valued options and that these opportunities are distributed equitably. Human Development Indicator is a measure of well-being originally designed to aid policy makers in assessing development in low- income countries.

countryconsumptionLife expectancyUnemplo- yment suicideEducationHDI rank Canada17363(8) USA20170(4) Japan18918(6) Netherlands15693(9) Finland19364(5) Iceland21685(2) Norway20284(3) France18093(7) Spain11460(10) Sweden23389(1) o Thousand per annum Years from birth Prop of workforce unemployed Annual numbers of male suicides per 0.1 million of population Combined gross enrolment ratio