7  Welfare

Required readings:

Shapiro et al. (2022, ch. 19)

Learning objectives:

Students will be able to:

7.1 Real and nominal numbers in economics

In economics, understanding the distinction between real and nominal values is crucial for analyzing wage levels and currency measurements. Nominal wages refer to the monetary amount received by workers, unadjusted for inflation. For example, if a worker is paid €50,000 per year, that figure represents their nominal wage. However, nominal wages do not account for changes in purchasing power over time due to inflation.

Real wages, on the other hand, provide a more accurate reflection of a worker’s purchasing power by adjusting nominal wages for changes in prices. To compute real wages, economists typically use the CPI. For example, in case of inflation, the real wage controls for the worker can actually afford fewer goods and services than before.

Similarly, this distinction extends to other economic metrics, such as gross domestic product (GDP). Real GDP is adjusted for inflation, providing a clearer picture of an economy’s growth by reflecting the true value of goods and services produced over time. In contrast, nominal GDP represents the raw monetary value without an inflation adjustment.

Exercise 7.1 Nominal vs. real GDP and CPI In this exercise, you calculate nominal and real GDP for a simple economy. You then calculate real GDP growth using two base years and discuss the differences. Suppose an economy consists of only two types of products: computers and automobiles. Sales and price data for these two products for two different years are shown Table 7.1:

Table 7.1: Prices and quantities of cars and PC over time
Year No. of PCs Price per PC (in €) No. of cars sold Price per car (in €)
1990 500,000 6,000 1,000,000 12,000
2000 5,000,000 2,000 1,500,000 20,000

  1. Nominal GDP in any year is calculated by multiplying the quantity of each final product sold by its price and summing over all final goods and services. Assuming that all computers and automobiles are final goods, calculate nominal GDP in 1990 and 2000.

  2. Real GDP in any year is calculated by multiplying that year’s quantities of goods and services by their prices in some base year. Calculate real GDP in 1990 and 2000, using 1990 as the base year.

  3. Calculate the percentage change in real GDP between 1990 and 2000 using 1990 as the base year.

  4. Calculate real GDP in 1990 and 2000, using 2000 as the base year.

  5. Calculate the percentage change in real GDP between 1990 and 2000 using 2000 as the base year.

  6. Explain why your answers to parts 3 and 5 are different. Do you feel there is one that more accurately measures the true growth in GDP? Which one, and why?

  7. Calculate the Consumer Price Index (CPI) and inflation for the economy using 1990 as the base year.

  8. Calculate the Consumer Price Index (CPI) and inflation for the economy using 2000 as the base year.

  9. Compare the CPI results from above. Can you explain the results?

  1. 1990: €15,000,000,000
    2000: €40,000,000,000

  2. 1990: €15,000,000,000
    2000: €48,000,000,000

  3. 220% increase

  4. 1990: €21,000,000,000
    2000: €40,000,000,000

  5. 90% increase

  6. Answers differ because base-year prices are different. Neither measure is clearly superior, but real GDP growth is significantly different. There are ten times as many computers in 2000 compared to 1990 and 50% more cars. Thus, something between 50% and 1000% is appropriate, but how to weight each increase is where prices come in.

\[\begin{align*} 500,000\cdot 6,000+1000,000\cdot 12,000 &= 15,000,000,000\\ 500,000\cdot 2,000+1000,000\cdot 20,000 &= 21,000,000,000\\ CPI_{base=1990} &= 1.4 \end{align*}\] Prices increased from 1990 to 2000 by 40% using 1990 as the base year.

\[\begin{align*} 5000,000\cdot 6,000+1500,000\cdot 12,000&= 48,000,000,000\\ 5000,000\cdot 2,000+1500,000\cdot 20,000&= 40,000,000,000\\ CPI_{base=2000}& \approx 0.8\bar{3}\\ \end{align*}\]
Prices decreased from 1990 to 2000 by approximately \(16\frac{2}{3}\)% using 2000 as the base year.

  1. The contradictory CPI results arise from the use of distinct baskets of goods. With 2000 as the base year, considerable weight is given to PCs, which have declined in price. Conversely, when using 1990 as the base year, greater emphasis is placed on cars, which have risen in price.

7.2 Welfare comparisons

To compare living standards across countries using real GDP, we face several challenges as discussed in greater detail in Shapiro et al. (2022, ch. 19). Let me emphasize two things:

Shapiro, D., MacDonald, D., & Greenlaw, S. A. (2022). Principles of economics (3rd ed.). OpenStax. https://openstax.org/details/books/principles-economics-3e

First, the real GDP of one country must be converted into the same currency unit as the real GDP of another country. This process is straightforward once we have the exchange rates; however, these rates often fluctuate significantly, which can lead to misleading interpretations of GDP when assessed during periods of exchange rate peaks. Additionally, if the prices of goods and services vary considerably between countries, differences in GDP may not solely reflect disparities in living standards.

Second, it is essential that the goods and services in both countries are valued at the same prices. Relative prices can differ across countries, so goods and services should be weighted appropriately. For instance, if prices are generally lower in China than in the United States, this would undervalue China’s production when using its domestic prices. Therefore, if we value all goods and services produced in China using U.S. prices, we can achieve a more accurate comparison of real GDP between the two countries. This comparison, made using consistent pricing, is referred to as purchasing power parity (PPP) prices. The PPP principle is based on the idea that, in the absence of transportation costs and other barriers, identical goods should have the same price when expressed in a common currency.

To calculate PPP-adjusted GDP for a more accurate cross-country comparison, the following steps are typically taken:

  1. Select a representative basket of goods and services for each country.
  2. Determine the respective prices that apply to all countries.
  3. Calculate the exchange rate based on the selected baskets and prices. This rate is known as the PPP exchange rate and reflects the relative price levels between the two countries.
  4. Convert the real GDP of each country into a common currency using the PPP exchange rate.

The resulting adjusted GDP values allow for a more accurate comparison of living standards and play a significant role in international economic analysis and policy formulation.

It is important to note that while the concept of PPP is useful, it is a simplification that does not fully capture the complexities of international trade, market imperfections, and non-tradable goods.

Example: Germany and Indonesia

Let us compare the GDP in PPP for two countries, Germany and Indonesia, using a simplified scenario that assumes a basket of only two goods: bread and milk. Prices are given in local currencies, i.e., Euros for Germany and Rupiah for Indonesia. For this example, let’s say one bread in Germany costs €2 and a liter of milk costs €1.5. In Indonesia, one bread costs 12,000 Indonesian Rupiah (IDR) and a liter of milk costs 10,000 IDR.

Step 1: Basket of goods and services

  • Bread price in Germany: €2
  • Milk price in Germany: €1.5
  • Bread price in Indonesia: 12,000 IDR
  • Milk price in Indonesia: 10,000 IDR

Step 2: Price comparison

  • Bread price ratio: €2 / 12,000 IDR = 0.00016667
  • Milk price ratio: €1.5 / 10,000 IDR = 0.00015

Step 3: Exchange rate calculation

  • Average price ratio: (0.00016667 + 0.00015) / 2 = 0.000158335
  • PPP exchange rate: 1 Euro = 0.000158335 IDR

Now, using the PPP exchange rate, we can convert GDP figures between the two countries to facilitate a more accurate comparison of their economies.

Please note that this is a simplified example for illustrative purposes. Actual PPP calculations involve more comprehensive baskets of goods, data collection, adjustments for non-traded goods, and more sophisticated methods. Real-world PPP calculations are conducted by organizations such as the International Comparison Program (ICP) to provide accurate comparisons of living standards across countries.

7.3 Alternative measures of welfare

Despite its weaknesses the GDP is one of the best measures we have to indicate living standards. Please watch the video of Figure 7.1. However, we should try to also look out for other measures that can complement the GDP.

Figure 7.1: Real GDP per capita and the standard of living

Source: Youtube

Disposable income:
Disposable income is defined as total income minus taxes plus government transfers. It represents the income that households and non-corporate businesses have available after fulfilling their obligations to the government. While GDP includes the value of goods and services produced by the government, such as education, national defense, and law enforcement—factors that contribute to well-being—these are not reflected in disposable income. Thus, GDP per capita can serve as a better measure of living standards than disposable income itself.

Gross National Product (GNP):
The GNP refers to the total income earned by a nation’s citizens, whether generated domestically or abroad. This measure captures the economic contributions of citizens, regardless of location.

Net National Product (NNP)
The NNP is calculated as the total income of a nation’s residents (GNP) minus losses due to depreciation. Depreciation accounts for the decline in value of the economy’s stock of equipment and structures, such as aging vehicles and obsolete computers.

World Happiness Report:
The World Happiness Report primarily utilizes data from the Gallup World Poll, which surveys individuals in over 150 countries (see: World Happiness Report). Each variable measured reflects a population-weighted average score on a scale from 0 to 10 that is tracked over time and compared against other countries. Current variables in the report include:

  • Real GDP per capita
  • Social support
  • Healthy life expectancy
  • Freedom to make life choices
  • Generosity
  • Perceptions of corruption

Human Development Index (HDI)
The HDI is a composite index that incorporates life expectancy, education (mean years of schooling completed and expected years of schooling), and per capita income indicators. Countries are ranked into four tiers of human development based on these metrics. A country attains a higher HDI when it achieves greater longevity, higher education levels, and a higher gross national income (GNI) per capita at purchasing power parity (PPP) (see: Human Development Index).

Exercise 7.2 OECD Better Life Index

Visit the OECD Better Life Index to create your own index by weighting the factors that are important to you. Then, explore what aspects of life matter most, on average, for people in your home country.

7.4 Questions

7.4.1 Single choice questions

Choose the one alternative that best completes the statement or answers the question.

  1. Economics is best defined as the study of…

✗how to run a business most profitably

✗how to predict inflation, unemployment, and stock prices

✗how the government can stop the harm from unchecked self-interest

✓how society manages its scarce resources

  1. Your opportunity cost of going to a movie is…

✗the price of the ticket

✗the price of the ticket plus the cost of any soda and popcorn you buy at the theater

✓zero, as long as you enjoy the movie and consider it a worthwhile use of time and money

✗the total cash expenditure needed to go to the movie plus the value of your time

  1. A marginal change is one that…

✗is not important for public policy

✓incrementally alters an existing plan

✗makes an outcome inefficient

✗does not influence incentives

  1. Adam Smith’s invisible hand refers to…

✗the subtle and often hidden methods that businesses use to profit at consumer’s expense

✓the ability of free markets to reach desirable outcomes, despite the self-interest of market participants

✗the ability of government to benefit consumers, even if the consumers are unaware of the regulations

✗the way in which producers or consumers in unregulated markets impose costs on innocent bystanders

  1. The US Federal government enacted regulation in the 1960s requiring people to wear seatbelts. All of the following resulted from this regulation, EXCEPT:

✗overall deaths due to car accidents changed very little

✗fewer deaths occurred per accident

✓fewer pedestrians were killed in car accidents

✗the frequency of accidents increased

  1. In a market economy, the decisions of what and how much to produce are made by:

✗voters in elections.

✓all producers and consumers.

✗the government only.

✗non-governmental agencies.

  1. Even though markets do a great job in organizing economic activity, governments are needed to do all of the following EXCEPT:

✗establish and enforce property rights.

✗intervene when markets fail due to externalities.

✗intervene when markets fail due to market power.

✓decide what and how much should be produced.

  1. Economics is best defined as the study of how people, businesses, governments, and societies:

✓make choices to cope with scarcity.

✗attain wealth.

✗choose abundance over scarcity.

✗use their infinite resources.

  1. Economists point out that scarcity confronts:

✗the rich but not the poor.

✗the poor but not the rich.

✓both the poor and the rich.

✗neither the poor nor the rich.

  1. Scarcity requires that people must:

✗trade.

✗compete.

✗cooperate.

✓make choices.

  1. As an economic concept, scarcity applies to:

✗neither time nor money.

✓both money and time.

✗time but not money.

✗money but not time.

  1. Which is the most accurate definition of the study of economics? Economics is the study of:

✗the distribution of surplus goods to those in need.

✗affluence in a morally bankrupt world.

✗ways to reduce wants to eliminate the problem of scarcity.

✓the choices we make because of scarcity.

  1. Which of the following is a macroeconomic topic?

✗why plumbers earn more than janitors.

✓the reasons for the rise in average prices.

✗whether the army should buy more tanks or more rockets.

✗the reasons for a rise in the price of orange juice.

  1. Which of the following is a microeconomic topic?

✗the reasons for a decline in average prices.

✓the reasons why Kathy buys less orange juice.

✗the cause of why total employment may decrease.

✗the effect of the government budget deficit on inflation.

  1. Which of the following topics would be studied in a microeconomics course?

✗how a tax rate increase will impact total production.

✗comparing inflation rates across countries.

✗how a trade agreement between the United States and Mexico affects both nations’ unemployment rates.

✓how rent ceilings impact the supply of apartments.

  1. When an economy produces more houses and fewer typewriters, it is answering the what question.

✗where.

✗for whom.

✗how.

✓what.

  1. When firms in an economy start producing more computers and fewer televisions, they are answering the what question.

✗where.

✗when.

✓what.

✗for whom.

  1. The question “Should cars or motorbikes be produced?” is an example of the:

✗how question.

✗who question.

✗where question.

✓what question.

  1. The opportunity cost of any action is:

✗the time required but not the monetary cost.

✗all the possible alternatives forgone.

✓the highest-valued alternative forgone.

✗the monetary cost but not the time required.

  1. The statement that _______ is a positive statement:

✗the price of gasoline is too high.

✗too many people in the United States have no health care insurance.

✓the price of sugar in the United States is higher than the price in Australia.

✗more students should study economics.

7.4.2 Multiple choice questions

Choose the alternative(s) that best completes the statement or answers the question. All or just one answer can be correct.

  1. Which of the following activities are typically excluded from GDP calculations?
    1. Household services like childcare.
    2. Market-based services such as healthcare.
    3. Public infrastructure development.
    4. Industrial production of goods.

a

  1. How does the presence of a black market impact GDP calculations?
    1. It leads to an overestimation of GDP levels.
    2. It might cause GDP levels to be lower than actual economic activity.
    3. It leads to an underestimation of GDP levels.
    4. It doesn’t affect GDP calculations in any way.
  1. and c)
  1. How can increased leisure time affect the economic growth rate and well-being?
    1. It might lead to a lower economic growth rate but enhance well-being.
    2. It always results in higher economic growth and well-being.
    3. It has no impact on either economic growth or well-being.
    4. It leads to lower well-being without influencing economic growth.
  1. How does pollution influence economic growth and living standards?
    1. Pollution directly decreases economic growth.
    2. Pollution might not impact economic growth but can reduce living standards.
    3. Pollution has no effect on either economic growth or living standards.
    4. Pollution enhances both economic growth and living standards.
  1. How is Gross Domestic Product (GDP) typically measured?
    1. By calculating the total monetary value of all imports and exports.
    2. By summing up the value of all assets owned by a country’s citizens.
    3. By computing the total market value of all goods and services produced within a country’s borders during a specific period.
    4. By evaluating the total amount of money circulating within the country’s financial system.
  1. What is the income approach to calculating GDP based on?
    1. The total number of hours worked by the population.
    2. The total value of goods and services produced by households.
    3. The total monetary value of all income earned by individuals in a country.
    4. The average wage rate divided by the number of employed individuals.
  1. How does nominal GDP differ from real GDP?
    1. Nominal GDP does not account for prices, while real GDP does.
    2. Real GDP is measured in current prices, while nominal GDP is adjusted for inflation.
    3. Nominal GDP includes government spending, while real GDP does not.
    4. Real GDP is the total value of goods and services produced, while nominal GDP is adjusted for population growth.

a

  1. What aspect of societal well-being is not addressed by GDP?
    1. Human health and well-being.
    2. Political stability and governance.
    3. Global trade relationships.
    4. The depreciation of goods.

a, b, and d

  1. What aspect of societal well-being is not addressed by GDP?
    1. Economic growth rate fluctuations.
    2. Income inequality within a society.
    3. Equal distribution of public resources.
    4. Long-term sustainability of economic growth.

b, c, and d