Question

1. Describe major problems with CPI as an indicator inflation, give examples of each.

2. What divergences arise between equilibrium quantity and efficient quantity when (a) negative externalities and (b) positive externalities are present? How might government correct these divergences? Cite an example (other than the text examples) of an external cost and an external benefit.

3. How is the labor force defined and who measures it? How is the unemployment rate calculated? Does an increase in the unemployment rate necessarily mean a decline in the size of the labor force?

4. Contrast the ideas of nominal GDP and real GDP. Why is one more reliable than the other for comparing changes in the standard of living over a series of years? What is the GDP price index and what is its role in differentiating nominal GDP and real GDP?

Answer 1

1. Following are the major problems with Consumer Price Index( CPI) as an indicator inflation.

A) Substitution Bias: Consumer substitute towards goods that become relatively cheaper, mitigating the effect of price increases. Like we substitute tea with coffee. CPI misses this Substitution because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living.

B) Quality adjustment bias: Changes in prices assumed to be from inflation may just reflect changes in the quality of goods. For example, in 2007 you purchased a brand new car of $20000 and 2017 you purchased a another new car of $40,000. In 10 years we can see doubling of price which amount to 10% inflation. But our purchasing power is also increased and the quality of car must be improved in 2017.

C) Introduction of New goods: The introduction of new products increases variety, allows consumers to find products that more closely meet their needs.In effect, dollars become more valuable. Like in this technological time, each day new mobile sets are launched with a variety of models available to everyone accordingly their needs. The CPI misses this effect because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living.

2. Equilibrium quantity is when supply equals to demand for a product. When there is no shortage or surplus in the market which results optimal level of production. But this equilibrium level is disturbed when there are externalities.

Negative Externalities: When negative externalities are present, it means the producer does not bear all costs, which results in excess production. If the negative externalities is taken into account, then the cost of production would be higher. This would result in decreased production and a more efficient equilibrium. Government can discourage negative externalities by taxing goods that generate external costs. This taxation effectively increases the cost of production of such goods. A steel plant that produces steel is an example of negative externalities because it pollutes the environment during the production process. The cost of the production is not borne by the plant, but instead shared by the society in form diseases( due to inhaling the dangerous gases coming out of the plant and by drinking the polluted water)

Positive externalities when positive externalities present the buyer does not get all the benefits of goods, resulting in decreased production. Government can encourage positive externalities by subsidizing goods and services that generate external benefits. For example an educated and intelligent person increased tax revenues from better-paying jobs, less crime and more stability. All these factors positively correlate with education levels. So government should give subsidies for higher education.

3. Labor Force: The labor force is defined as the majority of the population who are able and willing to work.

Labor Force =Number of employed +Number of Unemployed.

The U.S. Bureau of Labor Statistics (BLS) measures the labor force.

Unemployment rate is the percentage of labor force that is unemployed. No, an increase in the unemployment rate does not mean a decline in the size of labor force. For example, students graduating from college start looking for a job and increased labor force. Iin this case, the number of unemployed also increases as they are willing to work now. This increases the labor force and unemployment rate also.