Case: Production, Unemployment, And Inflation

Case Assignment

Submit a 5-page paper that addresses the following questions. Be sure to use references within the paper to support your answers.

1. Why is there unemployment even when the economy is at “full employment”? What are some “costs of unemployment”?
2. Is the CPI a biased measure of the inflation rate? Explain your answer.
3. Explain how some government tax revenue and spending can depend on the state of the economy.
4. Explain some limitations of using GDP as an indicator of standard of living (be sure to do some research on your own to find any alternative measures).

Assignment Expectations

Use information from the modular background readings as well as any good quality resource you can find. Make sure you cite all resources you use and provide a reference list at the end of your paper.

Length: 5-typed and double-spaced pages.

In addition to the overall quality, depth, grammar, and organization of the paper, the following will, in particular, be assessed:

1. The level of your understanding of the key concepts of the major macroeconomic indicators.
2. Some in-text references to modular background readings (APA formatting encouraged).

Upload your assignment to the Case 1 dropbox when completed.

• Unemployment at Full Employment and Costs of Unemployment

By definition, full unemployment is a situation where all available labor resources in an economy are being used in the most efficient way possible (Beveridge, 2014). In such a scenario, the number of employed workers equals the number of job vacancies available. However, even when the labor markets are reasonably tight, there is still remains some form of unemployment, usually in the form of structural and frictional unemployment. Frictional unemployment implies that although the quantity of labor needed in an economy equals the quantity of labor supplied, it is not virtually possible to have a situation where all employers are matched with all potential workers (Beveridge, 2014). In any given instance, there will always be some workers looking for employment and some employers looking for potential employees. During this period before the workers are matched with the employers, these workers can be termed as unemployed. For instance, although most of college graduates find a job after completion, it likely takes some time thereby allowing for frictional unemployment.

Structural unemployment is a situation where there is a mismatch between the skills which the workers are offering and those which the employers are seeking for (Beveridge, 2014). For instance, even if a firm has job openings, the qualifications of a given job seeker can fail to be in line with what the firm is looking for. Technological advancements is one of the major causes of structural unemployment. The advancements usually make some skills obsolete and require the workforce to develop new skills. Structural unemployment is also caused by geographic mismatches where an economy activity booms in a given area and slumps in another thereby requiring time for affected workers to move and seek new occupations (Beveridge, 2014).

Full employment has always been a key economic objective. However, achieving the objective has proved to be daunting and employment has posed challenges for many economies. Although there is a certain natural level of unemployment which cannot be done away with, elevated levels of unemployment have implications on the individual, the society, and the economy as a whole (Eardley, 2002).  On the individual level, unemployment causes both economic and non-economic costs. Economic costs become evident when a person’s living standards reduce due to lack of employment (Eardley, 2002). This is especially the case for people who lack savings and live paycheck-to-paycheck. Such individuals can fall into a financial ruin after missing just one paycheck. Non-economic costs entails implications such as emotional and mental stress due to lack of employment.

Although it is difficult to measure the social costs of unemployment, they are no less real. One of the social costs is the apparent link between rising unemployment and rising crime. Unemployed people tend to result to criminal activities such as theft as a means of sustaining themselves. There is also a link between rising unemployment and worsening social dislocation (Eardley, 2002). This social dislocation is usually in the form of aspects such as increasing divorces, worsening health, and lower life expectancy.        

Unemployment also possess challenges to the overall economy. For one, it translates to lost output of goods and services. It leads to the wastage of scarce economic resources thereby reducing the long run potential growth of the economy (Taylor & Saunders, 2002). An economy with low unemployment does not produce within its production possibility frontier, and it is not possible to recover the hours lost by individuals who are not working. Unemployment also translates to extra fiscal costs to the respective governments. It possess costs to the government expenditure, taxation, as well as level of government borrowing. Increased unemployment leads to higher benefit payments and also lowers tax revenues at the same time. When a person is unemployed, they stop paying taxes and still continue using government services. Additionally, the unemployed person’s spending reduces meaning they contribute less to the government in form of indirect taxes. This less contribution to the government through taxes coupled with increased reliance of government benefits can lead to more government borrowing. Lack of employment also leads to loss of investment in human capital. It leads to the loss of the scarce resources which are used in workforce training (Taylor & Saunders, 2002). Moreover, people who remain unemployed for long periods of time tend to get de-skilled due to the rapidly changing job markets thereby requiring even more resources to get them back to the workforce.

• CPI as a Biased Measure of Inflation Rate

Consumer Price Index (CPI), as defined by the U.S Bureau of Labor Statistics, is the measure of the average change in the prices paid by urban consumers for a market basket of consumer goods and services over a given period of time. It is the most widely watched and utilized measure of inflation rate in the country. However, for decades now, economists have noted that this measure tends to overstate inflation, or rather, changes in costs of living. A committee appointed in 1996 found that CPI overstates annual inflation by approximately 1.1 percentage points (Moulton, 1996).

There are various sources of bias in the CPI which makes it tend to overstate inflation. The first bias comes from the way through which the index is constructed. The construction, which is done monthly, starts with a consumer expenditure survey whose aim is to provide information on spending habits. By its very nature, a survey is exposed to biases such as selection and recall bias. Another potential bias in CPI is substitution bias (Moulton, 1996). Whenever the price of a commodity increases, consumers tend to replace it with a cheaper alternative. Being a fixed-weight price index, CPI cannot predict the impact of the price increase on consumer budget accurately. Quality bias is another CPI bias (Moulton, 1996). The durability and usefulness of products tend to increase over time due to factors such as technological advancements. For instance, the useful life of a vehicle’s tire can increase substantially thereby reducing its cost on a per mile basis. However, CPI does not account for such. There is also new product bias which occurs as a result of new products not being included in the index until they are commonplace. As such, significant reduction in prices caused by introduction of new technology products is not reelected in CPI. There is also outlet bias where the CPI fails to represent well the shift of consumers to new outlets such as online retailers and wholesale clubs.

• Government Tax Revenue and Spending Reliance on State of Economy

The state of the economy has significant effects on the government. When the economy is deteriorating, the amount of funds available to the government tends to reduce thereby impacting its spending (Case, Fair, & Oster, 2014). For instance, when an economy goes down, people can lose their jobs which can, in turn, affect their spending power. Loss of jobs will make the government lose on tax revenues while reduced spending will make the affected individuals contribute less to the government in form of indirect taxes. On the other hand, when the economy expands, more people get employed thereby increasing the size of the tax base. A higher tax base translates to more tax revenues without the congress having to raise taxes. Additionally, when the economy expands, the number of people collecting unemployment compensation and those on welfare rolls decreases (Case  et al., 2014). This leaves the government with more money to spend. Government expenditure on things such as welfare and unemployment benefits increases when the economy is in a recession.

• Limitations of Using GDP as an Indicator of Living Standards

In its most basic state, GDP is a measure of total economic activity. Other than that, GDP is usually used as an indicator of welfare, or rather, standards of living. This is because of its correlation with consumption which is also usually used as a surrogate for welfare. However, this line of argument is somewhat faulty. The assumption of casualty based on a simple interrelationship between welfare and GDP can translate to inaccurate conclusions. One of the limitations of using GDP to show living standards is that it fails to incorporate any measures of welfare (Bérenger & Verdier-Chouchane, 2007). It only outlines the value of all finished products within an economy but does not entail any measure of welfare. The indicator treats natural disasters, divorces, and crime as economic gains. GDP accounts for only monetary transactions, and hence, costs of fixing social vices such as crime are added as gains.

Another limitation of GDP is that it does not properly reflect the distribution of income (Bérenger & Verdier-Chouchane, 2007). In the event of a high wealth inequality, the small wealthy percentage can increase the overall GDP while in real sense the overall level of poverty among the poor population is increasing. Another limitation of using GDP is that it ignores non market economy of communities and households. The indicator presumes that all monetary undertakings enhances individual’s well-being, and ignores every activity which occurs beyond the realm of monetary undertakings despite its usefulness to people’s welfare. Alternative indicators of living standards include Gross National Happiness Index (GNHI), Human Development Index (HDI), and Social Progress Index (SPI).

References

Bérenger, V., & Verdier-Chouchane, A. (2007). Multidimensional measures of well-being: standard of living and quality of life across countries. World Development, 35(7), 1259-1276.

Beveridge, W. H. (2014). Full employment in a free society (Works of William H. Beveridge): A Report (Vol. 6). Routledge.

Case, K. E., Fair, R. C., & Oster, S. (2014). Principles of economics. Pearson Higher Ed.

Eardley, T. (2002). Identifying and quantifying the costs of unemployment. The price of prosperity: The economic and social costs of unemployment, 44-64.

Moulton, B. R. (1996). Bias in the consumer price index: what is the evidence? The Journal of Economic Perspectives, 10(4), 159-177.

Taylor, R., & Saunders, P. (Eds.). (2002). The price of prosperity: The economic and social costs of unemployment. UNSW Press.