Key Aspects of Economics - Assignment Example

1. ‘Since Country A has a higher GDP than Country B then this must mean the residents of Country A are better off in terms of economic welfare’. Discuss. Gross Domestic Product or GDP is defined as the sum of values added by all producers’ values, or in other words, the total value of goods and services produced in a particular year by the residents operating within the geographical boundary of the country. National Income or GDP is a quantitative aspect whereas economic welfare is a qualitative aspect as economic welfare takes into account the fulfillment of the basic amenities of life like food, clothe, shelter, and education. In the modern times health and sanitary facilities and gender empowerment are also considered to be good indicators of economic welfare. (GDP: What is it all about?, February 2001) Traditionally the income index i.e. national income or per capita income of a country was considered to be a good measure of economic progress of a country. It was assumed that the higher is the level of national income or per capita income of any country, the greater is the level of its economic development. (What is GDP and why is it so important?, 2008) But multiple instances can be cited which go on to show that a mere increase or a high level of national income does not necessarily lead to an increase in economic welfare. Thus if Country A has a higher GDP as compared to Country B, this does not necessarily mean that the residents of Country A are better off in terms of economic welfare. High national income if co-exists with certain maladies it is of no good rather it damages the economy in the long run. 1. Inflation: The GDP might be high due to inflation (i.e. a rising rise in the general price level). For example the amount of goods produced in Country A in a particular year may be equal to that produced in Country B. However since the prices of all commodities are higher in Country A due to inflation, the national income or GDP of Country A will also is higher as compared to Country B. In such a situation despite high levels of GDP, Country A will face hardships due to the evil effects of inflation and economic welfare is hampered. 2. Unemployment: Rise in national income demands improved productivity and hence increased production. However this is only possible through technological improvement. Production can be increased to a great extent by implementing advanced machines and equipments or in other words, by using labour saving techniques. Thus, in the process of achieving a higher national income, a country often has to face the problem of unemployment. 3. Production of luxury items: National income may increase as a result of an increase in the production of commodities that have nothing to do with the welfare of the common man or masses. For example income generated from the production of luxury items or weapons or military hardware. 4. Ecological disbalance: Higher national income means higher production that further indicates rapid industrialization. Rapid industrialization may lead to large-scale environmental pollution that, in turn, may lead to serious health hazards in the country and also may disrupt the ecological balance in the long run. 5. Inequality of income: A country cannot be said to have economic welfare even when it has high national income, if it has at the same time a high degree of inequality of income distribution. For example in the late 1970s the per capita income of Kuwait was higher that of USA. This was achieved due to the fabulous earnings of the ruling families of Kuwait through the sale of oil. However at the same time two thirds of the total population of Kuwait lived in extreme distress. Thus under such circumstance, Kuwait inspite of having high GDP ranks low when it comes to welfare of the citizens. Similarly if Country A has high GDP registered in a particular year compared to Country B, but also has wide scale inequality in the economy, it does no good to the common people of the country. And it might so happen that Country B despite having lower GDP has better facilities for its citizens. 6. Unfavorable BOP position: It might also happen that high national income coexists with unfavorable Balance of Payment position. 7. Others: If in Country A exists poor health condition, illiteracy, social unrest and political unrest then inspite of having high levels of GDP, there will be no welfare for the people. (Bhola G., September 2007) Thus it is seen that an increase in national income does not necessarily lead to an increase in economic welfare. Or in other words the residents of Country A might not be better off in terms of economic welfare than Country B despite having a higher GDP. In more recent times it is the real per capita income that is used to decide the level of a country’s economic development or welfare. Real per capita income is a better measure than per capita income because it takes into account the price factor. Reference: Bhola G., (September 2007), GDP: Gross Domestic Product Fails as an Indicator of Economic Welfare - Part 1, retrieved November 30, 2008, from http://www.gimmiethescoop.com/gdp-gross-domestic-product-fails-as-an-indicator-of-economic-welfare GDP: What is it all about?, (February 2001), Special Report, retrieved November 30, 2008, from http://www.equitymaster.com/DETAIL.ASP?story=7&date=2/5/2001 What is GDP and why is it so important?, (2008), Investment Question, retrieved November 30, 2008, from http://www.investopedia.com/ask/answers/199.asp 2. Provide a detailed account of each of the following concepts: a. Own price elasticity of demand b. Cross-price elasticity of demand c. Income elasticity of demand Discuss how each of the above can be calculated and the information they provide. Demand is defined as ‘desire for a commodity backed by purchasing power’. There is a fine line of difference between want and demand. Effective demand for a commodity is generated only when a person has the want for the commodity and also has the money to buy it (i.e. purchasing power). From the definition of demand it is clear that demand depends on purchasing power. However there are certain factors on which purchasing power depends, for example, income of a person and the price of the commodity. If price is taken to be constant, the higher is a person’s income, the higher will be his purchasing power. If income is taken to be constant, the higher the price of the commodity, the lower will be the purchasing power and vice versa. Apart from income and price of the commodity in concern, demand for a commodity also depends on the prices of the other related goods. For example when the price of tea goes up, the demand for coffee might go up as people will substitute coffee for tea. On another instance if the price of sugar falls, demand for tea might go up as tea and sugar complement each other. Thus a consumer’s demand for a commodity depends mainly on his income, the price of the commodity and prices of the related goods like complements and supplements. The law of demand states that keeping all other factors constant, the price of a commodity is inversely related to the quantity demand of the commodity. When price of a commodity increases, the demand for it falls and conversely, when price falls, demand rises. The concept of elasticity of demand is used to determine the sensitivity of demand for any commodity in response to a change in its own price or a change in the income of the consumer or a change in the price of a related commodity. 1. Price Elasticity of demand – As stated above the law of demand states that price of a commodity and the quantity demanded of the commodity move in opposite direction. However this does not say anything about the amount or degree to which demand varies with change in the commodity’s price. Price elasticity of demand is the ratio between the percentage change in demand for a commodity and percentage change in the price of the commodity. (Moffatt M., n.d.) Price elasticity or own price elasticity of demand is thus expressed as, e = (-) Percentage change in quantity demanded Percentage change in it’s own price Since demand and price moves in opposite direction, to make the ratio positive a minus sign is put before the ratio. If it is less than one then demand is relatively inelastic and greater than one implies demand is relatively elastic. If this ratio is equal to one then it is said to be unit price elasticity of demand i.e. the rate of change in quantity demanded is equal to the rate of change in the price of the commodity. If this ratio happens to be equal to zero, then demand for the commodity is perfectly inelastic, i.e. even with an increase or decrease in the price, the demand is not affected. Lastly, if the ratio tends to infinity then demand is considered to be perfectly elastic i.e. a small change in the price leads to an infinite change in the quantity demanded for the commodity. (Price Elasticity of Demand, n.d.) 2. Income Elasticity of Demand – As seen earlier demand for a commodity apart from price also depends on the income of the consumer. Income elasticity of demand measures the sensitivity of quantity demanded with respect to income of the consumer. It is a ratio between the percentage change in quantity demanded to the percentage change in income. Income elasticity of demand for a commodity can be expressed as, e = Percentage change in quantity demanded Percentage change in income Usually the demand for a commodity rises as the income of the consumer rises and vice versa. Therefore, the ratio between percentage change in demand and percentage change in income is usually positive. However in case of inferior goods income elasticity of demand is negative because rise in the income leads to a fall in the demand for such goods (i.e. the ratio is less than zero or negative). In case of normal goods, the income elasticity of demand can be elastic (i.e. ratio is more than one), unit elastic (i.e. ratio equal to one) or inelastic (i.e. ratio is less than one). Income elasticity of demand is important in forecasting demand for a good or service and thus in making production plans. Necessary consumption items have low-income elasticity of demand while luxury items have such as luxury cars have high-income elasticity if demand. 3. Cross Elasticity Of Demand – Cross elasticity of demand measure the sensitivity of demand for a commodity with respect to the process of other commodities. For example the demand for tea changes when the price of sugar changes because tea and sugar are complementary goods. It is a ratio of the percentage change in demand for a commodity X and percentage change in the price of a related commodity Y. It is expressed as, e = Percentage change in quantity demanded for X Percentage change in price of Y Theoretically nothing can be said about the sign of the ratio as it will depend on the relationship between X and Y. If X and Y are complementary goods then a rise in the price of Y will reduce the consumption of X and thus, cross elasticity of demand for X will negative (i.e. the ratio is less than zero). If X and Y are substitutes then a rise in the price of Y will result in a rise in the demand for X hence cross elasticity of demand for X will be positive (i.e. the ratio will be more than zero). (How Elasticity of Demand Affects Total Revenue, n.d.) Thus it is seen that elasticity of demand depends on nature of the commodity, existence of substitutes, income of the consumer, habits or addiction to a certain commodities, durability of a commodity and importance of a commodity in a consumer’s budget. Elasticity of demand is a very important concept used in making economic decisions. It is used national and international price setting wage bargaining by trade unions, framing tax policies by the Government and also in devaluation policy. Reference: How Elasticity of Demand Affects Total Revenue, (No Date), Chapter 9, retrieved November 30, 2008, from http://www.businessbookmall.com/Economics_19_How_Elasticity_of_Demand_Affects_Total_Revenue.htm Moffatt M., (No Date), Price Elasticity of Demand, retrieved November 30, 2008, from http://economics.about.com/cs/micfrohelp/a/priceelasticity.htm Price Elasticity of Demand, (No Date), retrieved November 30, 2008, from http://www.netmba.com/econ/micro/demand/elasticity/price/ Read More