After Studying This Chapter Students Should Be Able To

Chapter 8: OBJECTIVES

After studying this chapter students should be able to:  Understand the measurement of national income, and appreciated 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.

The Circular Flow (CF) Model of Income

 How is it that individuals and societies come to be wealthy in economic or material terms?

 Today, in most economies around the world, most exchanges depend on the use of money.

 CF is a diagram that outlines the flow of resources, products, income, and revenue among households, firms, governments, and the rest of the world.

 Figure 8.1 (page 214) shows the basic circular flow (CF) model of income.

 Figure 8.1 shows that there are two flows: 1. ‘Physical’ flow of goods and services from firms to HHS and of the services of factors of production such as labor from households to firms.

2. ‘Money’ flow in the opposite direction, from firms to HHS in the form of income for the factors of production they supply and from HHS to firms in the form of consumption expenditure for the purchase of goods and services.

 In Figure 8.1 the dotted lines are financial flows, and the solid lines show flows of real goods and services. Extensions to the CF Model

 Figure 8.2 (page 215) shows three extensions of the basic CF model.

 The first extension incorporates savings by HHS and investments by firms.

 Savings reduce consumers’ expenditure below their incomes. Therefore, savings represent a ‘withdrawal’ from household spending.

 Some firms produce capital goods and sell them to other firms. Purchases of these capital (investment) goods are financed by borrowing from financial institutions. This borrowing for investment represents an ‘injection’ of finance into firms.

 The second extension incorporates the government sector. Direct and indirect taxes represent the most important sources of government revenue.

 Tax revenue, minus transfer, is another ‘withdrawal’ from HHS spending. The money that the government spends on goods and services in defence, health, and education is the corresponding ‘injection’.

 The third extension incorporates the foreign trade sector. ‘Imports’ are goods and services we bring into the country and ‘exports’ are goods and services we sell abroad. Imports represent a ‘withdrawal’ from the circular flow of income whereas exports represent an ‘injection’.

Measuring National Income Using the CF Model

 National income is the value of the goods and services available in a national economy over a given period of time, usually a year.

 National income could be measured by using three measures: output measurement, expenditure measurement, and income measurement.

2  Output approach measures the values of the ‘physical’ flow of goods and services from firms to households, that is, national output.

 The Gross Domestic Product (GDP) is the value of all the output produced by factors of production located in the national economy.

 Expenditure approach measures the national (aggregate) expenditure.

Aggregate Expenditure = C + G + I + (X – M)

 Income approach measures the money flow from firms to HHS in return for the services of factors of production, that is, the national income.

 Gross National Income (GNY) is the value of the final output produced by nationally owned factors of production, wherever that production takes place.

 GNY measures income relating to factors nationally owned (wherever they are); GDP measures income due to factors domestically located (whoever owns them).

Real and Nominal Income

 Nominal or money output is the value of output expressed in the prices prevailing at the time it was sold. Nominal GDP is GDP at current prices. Real GDP is GDP at constant prices.

 Suppose that a country’s GDP increased by 25% between 1990 and 2000. Were its consumers 25% better off in 2000 than in 1990? Did they have 25% more goods and services to buy?  Yes, if the inflation rate between 1990 and 2000 is zero.

 No, if the inflation rate between 1990 and 2000 is positive.

 Inflation refers to a rise in the general level of prices in a country.

 The inflation rate measures the rate at which prices are rising, and is expressed as a percentage increase in the general level of prices from one year to the next.

3  Example: Assume the following information:

1995 1996 GDP (millions of $) 400 430

And assume that the inflation rate between 1995 and 1996 was 5 per cent.

What was real income (output) in 1996 expressed in terms of 1995 prices?

1. Consider the 1995 as equivalent to 100; these are the ‘base year’ prices. We derive an index of inflation between 1995 and 1996 expressed in terms of 100. With 5% inflation the price index for 1996 will be 105.

2. We ‘deflate’ the 1996 money GDP of $ 430 million using the inflation index. This is done by dividing 430 by 105 and then multiplying the result by 100.

430 . 100 = 409.5 105  This result is equivalent to dividing 430 by 1.05. So the real vale of 1996 GDP is $ 409.5 million, which is considerably less than the nominal GDP of $ 430 million.

Estimating the Standard of Living

 The standard of living explains welfare in terms of access to material goods and services.

 Assume that GDP of a country for 2000 was $ 943 412 million and the population in 2000 was 59 756 000. What was GDP per head in 2000?

 GDP per head = $ 943 412 000 000 59 756 000

 This means that the average person (woman, man and child) had a share of goods and services worth $ 15 788.

4 Utility, Welfare and Markets  Utility is the satisfaction derived from consuming a given amount of a good. Utility is measured in units called ‘utils’.

 Utility expresses the idea that the welfare derived from consumption is a subjective concept, in the sense that the satisfaction one person gets from consuming a given amount of a particular good may be quite different from the satisfaction another person gets from consuming the same amount of the same good.

Consumption and Diminishing Marginal Utility

 Marginal utility refers to the change in total satisfaction derived from consuming a good when the amount consumed changes by one unit.

 Table 8.8 (page 228) shows that the total and marginal utility are related: in mathematical terms, marginal utility represents the change in total utility. Conversely, total utility is the sum of all the marginal utilities.

 Diminishing Marginal Utility: The marginal utility that a consumer gets from a good decreases as more of the good is consumed.

Individual Equilibrium

 An important use of utility theory is in describing equilibrium conditions for consumers.

 Consumer Equilibrium: The condition in which an individual consumer’s budget is completely spent and the last dollar spent on each good yields the same marginal utility; therefore, utility is maximized.

 Suppose that there are two goods, videos and takeaways. A necessary condition for equilibrium in consumption is that the marginal utility of the last $1 spent on videos equals the marginal utility of the last $1 spent on takeaways.

 The condition for equilibrium is as follows: marginal utility of videos = marginal utility of takeaways

5 price of videos price of takeaways