1. 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.

2. Lecture 14 Measuring a Nation’s Income - II Instructor: Prof.Dr.Qaisar Abbas Course code: ECO 400

3. Lecture Outline 1.Shortcomings of GDP 2.Supply side of the model

4. 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.

5. 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

6. 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..

7. 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

8. 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.

9. 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 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

10. 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

11. 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 economy’s level of technology. exhibits constant returns to scale.

12. 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

13. Supply side Determining GDP 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

14. 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)

15. Supply side The MPL and the production function

16. 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

17. 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 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 states that each factor input is paid its marginal product accepted by most economists accepted by most economists states that each factor input is paid its marginal product states that each factor input is paid its marginal product accepted by most economists accepted by most economists

18. Supply side How income is distributed

19. 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).