11175 Introduction to Economics

Answers to exam review questions module 10

Compare your responses to those provided below.

Question 1
What are the three approaches of calculating GDP? Discuss.

Three approaches of calculating GDP:

i. Expenditure approach: The sum of total expenditure on final goods and services by
households, investors, government and net exports (exports minus imports)

GDP= C + I + G + NX

C: sending by households on goods and services. This includes spending on services

such as medical care, education and haircuts; expenditures on non-durable goods,
such as food and clothing; and expenditures on durable goods, such as cars and
furniture. Spending in new houses isn’t included in C.

I: Spending by firms on new factories, office buildings, machinery and inventories plus
spending by households on new houses.

G: Spending by federal, state and local governments on goods and services, such as
education, roads and aircraft.

NX: Net exports (Exports – Imports)

ii. Value added approach: Measures GDP by adding up the value added to products at
each stage of their production up until final consumption. Value added equals the
value of a firm’s production minus the value of the intermediate goods it uses in
production.

The text book also refers to this approach as “The production method” – and defines it
as – the sum of the value of all goods and services produced by industries in the
economy in a year minus the cost of goods and services used in the productive
process, leaving the value added by the industries. This simply means adding the
value added by all industries in the economy.

For example: Value of Bread = value added by a farmer (in growing wheat grains) +
value added by flour mill (in converting wheat grains into flour) + value added by baker
(in converting flour mill into bread)

iii. The Income approach: The sum of the income generated in the production of goods
and services; which includes profits, wages and other employee payments, income
from rent and interest earned. The income approach calculates GDP by how much it
cost to produce it [by adding the incomes of the factors of production used in
producing GDP].

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 Wages and Salaries – goes to Labor used in producing GDP.

Rent – goes to the land used in producing GDP.

Interest- goes to the capital used in producing GDP.

Profit- goes to the entrepreneur who owns the business.

Question 2
What are the shortcomings of GDP as a measure of wellbeing?

The shortcomings of GDP as a measure of wellbeing are:

1. GDP and GDP per capita figures do not tell us how income is distributed among the
population in a country. When measuring the wellbeing of a country’s population, what
is important is not only the level of GDP but also how the income or output is
distributed. If the income generated from production is concentrated among only a
small part of the population, economic wellbeing may be unchanged or become
relatively worse for other sections of the population. This is an issue of economic
equality and social justice.

2. The value of leisure is not included in GDP. The increased leisure time available to
workers in industrialised countries- which allows them to pursue many worthwhile
activities, including being with family and friends, participating in sports and hobbies,
and pursuing cultural and educational activities – is a major benefit of living in a
wealthy society. But these extra hours of leisure are not reflected in GDP.

3. GDP doesn’t show us the level and quality of health care and education in a country.
This is because GDP measures the market value of a country’s production and it takes
no account of the composition of the goods and services produced. For example,
production levels may be high, but the availability of health care may be limited, or
too expensive for many people to afford. Any measure of wellbeing must include
measures of access and affordability of essential goods and services.

4. GDP is not adjusted for pollution and other negative effects of production. When a dry
cleaner cleans and presses clothes, the value of this service is included in GDP. If the
chemicals used by the dry cleaner pollute the air or water, GDP is not adjusted to
compensate for the costs of the pollution. Similarly, the value of cigarettes produced
is included in GDP without no adjustment for the costs of the lung cancer that
smokers develop.

5. GDP doesn’t reflect other indicators of good life such as low crime rate, minimal
traffic congestion, active civic organisations and open space. GDP is also not
adjusted for changes in divorce rates, drug addiction or other factors that may affect
people’s wellbeing.

Question 3
Explain the three reasons the aggregate demand curve slopes downward?

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The three reasons are the wealth effect, the interest-rate effect, and the international-trade
effect. In the wealth effect, an increase in the price level decreases the real value of
household wealth, which decreases consumption. In the interest-rate effect, an increase in
the price level raises interest rates, which decreases investment spending and consumption
spending, particularly on durable goods. In the international-trade effect, an increase in the
price level makes Australian exports relatively less profitable to produce and foreign imports
less expensive, which decreases net exports.

Question 4
Why does the short-run aggregate supply curve slope upward?

The short-run aggregate supply curve slopes upward because, as the prices of final goods
and services rise, the prices of inputs rise more slowly ('sticky' prices). The higher price
level increases profits and the willingness of firms to supply more goods and services. A
secondary reason the SRAS slopes upward is that, as the price level rises, some firms are
slow to adjust their prices. A firm that raises prices slowly when the price level increases
may find that its sales increase and therefore will increase production.

Question 5
What variables will shift the short-run aggregate supply curve?

Expected changes in the future price level; adjustments by workers and firms to errors in
past expectations about prices; unexpected price changes of important natural resources
that are used as production inputs; changes in technology; changes in the quantity of the
labour force; changes in the quantity of capital. [Discuss these factors if you get this
question in an exam setting].