MARKETS AND THE ECONOMY - Assignment Example

? Markets and the Economy (Change if the of your assignment is different) Your Increased federal budget deficit resulting from a recession helps stabilize an economy During a recession the federal budget deficit can increase due to some automatic stabilizers in the economy and/or due to deliberate higher government spending to boost the economy. The factors explaining the increase in budget deficit stabilizers are outlined below: 1) As the economy goes into recession, corporate profits decrease leading to lower corporate tax revenues for the government. Due to lower demand in the economy, companies sell less and have higher cost pressures leading to lower profitability. 2) As corporate profit decrease, companies start firing employees leading to an increase in unemployment in the economy. This further leads to lower income tax revenues for the government. 3) As unemployment increases, the government has to make more payments for unemployment benefits and other welfare programs (transfer payments). These three factors automatically increase the government deficit during recession due to lower revenues and higher spending built into the system. 4) In order to spur demand in the economy, government can spend higher than usual. This spending could be through lowering taxes and/or increasing spending on new/existing projects. All the four factors combined mean that some of the effect of recession on households and companies is mitigated by government spending. Unemployed workers get state benefits and companies get opportunities to invest in new projects. The combined effect is that companies are encouraged to hire more workers to work on those projects thus reducing unemployment and people have more disposable income due to reduced taxes thus increasing consumption. Therefore, the increase in budget deficit during a recession helps stabilize the economy by bringing it back to the equilibrium operating level. Adjustments in wages and prices take the economy from the short-run equilibrium to the long-run equilibrium The price system and wages in the economy do not always change instantaneously. Changes in macro-economic factors like output, demand, supply, interest rates etc do not immediately bring about a change in price levels and wages. Thus, when one or more of the other macro-economic variables changes in the economy, prices and wages are slow to react to this change, therefore the economy comes to operate in a short-run equilibrium where prices and wages are yet to adjust to the other macroeconomic changes. Some of the reasons for this stickiness of prices and wages include contracts for fixed duration like labor union contract for wages fixed for a year, or even market competition prohibiting firms from increasing prices suddenly. However, as time goes (in the long-run), wages contracts get re-negotiated depending on earlier changes in demand and supply, inflation, and other factors. This change in wages leads to change in cost structure of firms and price changes then become necessary. For example, if the labor union re-negotiates to higher wages, the firm must increase its prices in order cover the increased cost of labor. As these adjustments in wages and prices take place, the movements of wages and prices determines the output of the economy. For example, if the firms find it less profitable to produce more, the will reduce their output and the GDP will contract and vice versa. Thus, adjustments in wages and prices take the economy from short-run equilibrium to long-run equilibrium. This is to say that if the prices and wages had changed immediately following a change in the other macroeconomic factors, the long-run equilibrium output would have been seen in the short-run. However, as prices and wages are sticky and adjust to the changes slowly, the economy first settles on a short-run equilibrium where other factors have changed but prices and wages have not and eventually the adjustments in price and wages takes the economy from this short-run equilibrium to the long-run equilibrium where the economic output is based on the new adjusted price levels and wages. Marketable pollution permits system vs. Command-and control system Under the command and control system, the government sets a rigid limit for each company and industry on the level of pollution they are allowed to cause. The government also sets the standards on technology and route to be followed by companies to achieve the pollution within maximum prescribed limit. By doing so, the government forces all the companies in an industry to follow the same technology irrespective of the existing systems or how a company might be able to more effectively and efficiently stay within its pollution level limits. While this system leads to pollution abatement across all industries and geographical areas, however, the corresponding cost is very high for both companies and the government. Companies, irrespective of their existing pollution control systems, must adopt the standard technology specified and/or reduce its production in order to reach the prescribed limit of pollution, and governments must have the right technical know-how for each and every industry in order to formulate the system and must also have a large force of “pollution police” to make sure that companies adhere to the set standards. On the other hand, under the marketable pollution permits system, every company must buy its right to pollute. The government sets a limit for an industry/company and if the company is operating at below the pollution limit it can sell its pollution permit up to the maximum level and if a company is operating at a higher pollution level, it must buy the right to pollute more than the permissible level. This system is much more cost efficient to implement for both companies and the government as it encourages innovative solutions best suitable (efficient and cost effective) for companies to control the pollution. However, this leads to companies deciding on taking pollution control actions based on a cost-benefit analysis i.e. comparing the cost of pollution control systems and the cost of acquiring more pollution permits. As a result, some industries may find it less costly to acquire more pollution permits than actually deploy technology to control pollution. As a result, the geographic pockets hoisting these industries will see an increase in pollution. Therefore, this system would lead to a concentration of high polluting areas. GDP and measuring the well-being of a nation GDP simply adds up all the products and services that are bought and sold. It makes no distinction between transactions that add to the social welfare and those that diminish it. GDP assumes that all monetary transactions add to well-being without separating cost from benefit. For example, as a result of the recent earthquake and Tsunami in Japan, GDP would not take into account the loss caused by it but would actually add up the cost spent in bringing things back to normal. Also, activities that actually are negative for the social welfare are added up in GDP – like lawyer fees in divorces or property damage and medical expenses due to crime. Further, GDP does not take into account some of the most important social welfare work that happens in our everyday lives – childcare, DIY home repairs, or even voluntary work. As an example of the ambiguity of GDP, if we hire someone to do the home repairs, GDP adds the income but if we do it ourselves, the DIY repair goes “unnoticed” in the GDP. Van der Bergh (2009) even suggests that in order to make GDP a better measure of social welfare, we could represent GDP like the balance sheet of a company showing separately the assets (monetary transactions that lead to social welfare and development) and the liabilities (monetary transactions that cause negative impact on social welfare or those that have been made in order to be back to normal after a disaster). The net of these assets and liabilities would then be a good indicator of how much actual social welfare has occurred in the country or over time. Some factors that could be included in measuring GDP in order for it to better reflect well-being of a nation are: 1) Resource depletion: If the activities done to produce goods and services today mean that there will be lesser or fewer resources to reproduce them tomorrow, then these activities would be reducing the well-being rather than increasing. Thus adding this factor to the GDP would reflect the true quality of goods and services produced and how they affect the future well-being. 2) Pollution: Many industrial activities cause pollution which reduces the well-being of people and the nation. Thus adding a pollution index to the GDP would reflect how far the nation is successful in ensuring that the environment we live in is of good quality. 3) Income distribution: It is an old cliche that the rich keep getting richer and the poor keep getting poorer. The true well-being of a nation would be reflected by how far the poor are able to improve their standard of living. Thus adding a factor of the percentage of national income attributable to the poor would truly reflect how far the nation has developed overall. References Bernstein, J. D. (1995). Alternative Approaches to Pollution Control and Waste Management. Washington DC: Urban Management Programme by The World Bank. Bivens, J. (2011). Another consequence of the recession: Rising federal budget deficits. Retrieved August 16, 2011, from Economic Policy Institute: http://www.epi.org/economic_snapshots/entry/another_consequence_of_the_recession_rising_federal_budget_deficits/ O'Leary, S. (2010, November). The Federal Deficit: The Facts. Retrieved August 16, 2011, from West Virginia Center on Budget & Policy: http://www.wvpolicy.org/downloads/IB110410.pdf Van der Bergh. (2009). The GDP Paradox. Journal of Economic Psychology 30 , 117-135. Read More