Question

Consider a conventional neoclassical economic model, where workers value both leisure and consumption and are willing to make entirely conventional tradeoffs between those two goals. Output is produced via a conventional production function with diminishing returns to labor. For simplicity, entirely ignore the role of capital. If purely wasteful government purchases increase, and the government purchases are financed via lump-sum taxes, what will be the effects of this increase in the size of government on:

Real GDP

Real wage (per hour of work)

Total hours worked

Consumption

Be clear about your predictions: Will these values rise, fall, remain unchanged, or are the effects theoretically ambiguous?

Answer 1

UNDERLYING CONCEPTS:-

• Tradeoff- Possible alternatives or the opportunity cost
• Production function- Functional relationship between inputs and outputs in production.
• Diminishing returns to labor- Fall in Marginal product when one more labor is added to work.
• Real GDP- Valuation of GDP based on constant prices.
• Real wage- Wages that builds effective purchasing power among workers.

According to the Question :-

The Neo-Classical models are backed by the fact of Rationality and Strong emphasis of market forces for price detremination. They suggest the porpotionate production functions which are simultaneously related with Diminishing returns to Labor in the short run.

Effect of Rise in Government's wasteful expenditure and lump sum increase in Taxes would be as such;

1. Real GDP- It may possibly rise as the valuation of current year output is subjected to change because of the Government's policy but the price level will not show significant fluctuations.
2. Real Wages- They will rise after the increased Government spending.
3. Total hours work- It may also rise corresponding to Government's expenditure.
4. Consumption- The consumption will possibly rise.