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31410ps1sol_Fall2011 - Economics 3140 Fall 2011 Problem Set...

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Economics 3140 Fall 2011 Problem Set 1: Suggested Solutions Question 1: a. Value added by each person is the value of the good produced minus the amount the person paid for the materials needed to make the good. Therefore, the value added by the farmer is $2.00 ($2.00 – 0 = $2.00). The value added by the miller is $1: the miller sells the flour to the baker for $3 but paid $2 for the flour. The value added by the baker is $4: she sells the bread to the engineer for $7 but paid the miller $3 for the flour. GDP is the total value added, or $2 +$1 +$4 = $7. Note that GDP equals the value of the final good (the bread). b. When a woman marries her gardener, GDP falls by the amount of the gardener’s salary. This happens because measured total income, and therefore measured GDP, falls by the amount of the gardener’s loss in salary. If GDP truly measured the value of all goods and services, then the marriage would not affect GDP since the total amount of economic activity is unchanged. Actual GDP, however, is an imperfect measure of economic activity because the value of some goods and services is left out. Once the gardener’s work becomes part of his household chores, his services are no longer counted in GDP. As this example illustrates, GDP does not include the value of any output produced in the home. Similarly, GDP does not include other goods and services, such as the imputed rent on durable goods (e.g., cars and refrigerators) and any illegal trade. c. The advantage Real GDP is the ease and speed with which it can be calculated. (The value of real GDP is related to the level of employment which does concern many people.) However, strictly speaking real GDP is not a welfare measure. First, it only measures market transactions and second bigger is only better if it improves welfare. When increases in output cause pollution, increases in crime, or increases in sickness, etc., welfare is not improved. In addition, GDP ignores the imputed rent on durable goods such as cars, refrigerators, and lawnmowers. Also, welfare would be better measured by a per capita statistic than an aggregate measure. Moreover if the per capita measure increases over time but the imperfections in the measure stay approximately constant as time progresses then the increase in the measure would represent an increase in welfare.
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