Principles of Economics

Table of Contents

Budget constraint:

Optimal income-leisure tradeoff.

Wage cut by 20%...

Adding the second indifference curve.

Income and substitution effects:

Opportunity costs and wage decrease:

How effective is GDP to be an indicator of economic activity in the light of Covid-19?.

Consequentialist perspective about the payments to support

Deontological perspective about the payments to support

Perspective of substantive and procedural judgements of fairness.

References:

Budget Constraint

For a typical worker like Jordan, who earns daily wages at the rate of $30 per hour and assuming he can work up to 24 hours per day and earn 720 dollars per day, he would have a money income which he can spend on consumption goods and services plotted on the vertical axis. Similarly, the labour-leisure hours is plotted on the x-axis or the horizontal axis which shows his hours of free time from the origin to the right whereas labor hours is measured from the 24 hour point to the origin as shown in the diagram below(Mankiw, 2016).

Assuming that he would work for 24 hours a day and earn $720, the vertical intercept is at $720 on the y-axis and if we assume that he would spend all of his day in leisure, the horizontal intercept is at 24 representing 24 hours of a day. The graph below shows the labor leisure tradeoff of the laborer Jordan at the wage rate of $30 per hour.

The total number of hours is given by T or 24 hours /day

The number of leisure hours is L

The number of working hours is T-L = h

The wage per hour is at w or $30

The budget constraint is at

wh= w(T-L) = wT-wL

since the income from working is used to buy either consumption or leisure, we have

wT-wL = C (assuming the P price of consumption is at 1).

Since w is at 30, we have

30T-30L= C

Optimal Income-Leisure Tradeoff

We can use indifference curve to explain Jordan’s choice between his daily wage measured as consumption in the y-axis and the leisure in the x- axis. The income earned by Jordan is earned by scarifying his leisure time to do the work for daily wages. When the leisure is sacrificed by a greater amount, the greater would be the work done and greater would his income which can be spent on consumption goods(Nicholson & Snyder, 2008). While income represents the person’s ability to purchase goods and services, leisure is yet another normal commodity which is enjoyed by the individual. In this regard, drawing an indifference curve IC1 as shown in the figure, we can see that it would provide satisfaction to the individual at point E where he works 14 hours per day and uses 10 hours of leisure as shown in the following diagram. Two assumptions about the optimal income-leisure combination for Jordan would be that he is free to work as many hours a day as he likes (24 hours maximum) and wage rate is the same $30/hour irrespective of the number of hours Jordan chooses to work. Assuming that he works for 14 hours and earns $420, we can see the equilibrium at a point where his budget constraint in Q1 and the indifference curve are tangent to each other as shown in the following diagram.

The budget constraint and the indifference curve are tangent to each other to make the optimal consumption level at

$30 * 14 = $420; where income = consumption at $420

Wage Cut by 20%

Due to the pandemic of Covid-19, the employers all around the world are facing hardship. So does the Jordan’s employer faces hardship and cuts the wages by 20%. This means that his wage is now at $24 per hour (and not $30 per hour) and he can earn a maximum of $576 dollars with his 24 hours per day(Mankiw, 2016).

The total number of hours is given by T or 24 hours /day (this is the same as above)

Number of leisure hours is L (this would change according to substitution and income effect)

The number of working hours is T-L = h (this would also change)

The wage per hour is at w (this has changed to $24 due to the wage cut by 20%)

The budget constraint is at

wh= w(T-L) = wT-wL

wT-wL = C (assuming the P price of consumption is at 1).

24T-24L = C

In the above diagram, DB is the new budget line, where with the given budget line, Jordan can earn $576 maximum per day which is the intercept in the y-axis and x-axis intercept is the same at 24 (as he has 24 hours per day).

Adding the Second Indifference Curve

Now we add a second indifference curve in the model developed in the previous sections. And we have IC2 as that second indifference curve. This indifference curve IC2 has a much lower utility than the IC1. This is one of the properties of indifference curves where the farther away the indifference curves are from the origin, the greater utility they have. Since IC1 is farther than the IC2, we can say that the utility that Jordan derives from the labor-leisure tradeoff that results in consumption has decreased due to the wage cut.

Income and Substitution Effects

To find out the income and substitution effects of the wage decrease, we have drawn an imaginary line that is parallel to the original budget line AB but is tangent to the new indifference curve IC2 and this is the blue line shown in the following figure

In the above diagram, Jordan chooses point e before the wage cut where the original indifference curve IC1 is tangent to the budget line (AB). When there is a tax cut by 20%, the budget constraints moves inward to DB shown by the brown line in the figure and Jordan chooses a point g where the new budget line DB is tangent to a new indifference curve IC2. This choice by Jordan can be decomposed into the income effect which is shown by the movement from e to f and the substitution effect which is a movement from f to g. Point f is the income effect which is the combination of consumption and leisure that would have been chosen by Jordan if income that is reduced would have left Jordan with the same level of utility (IC2) (assuming that there has been no relative changes in the prices of consumption and leisure)(Investopedia, 2019). However, the movement from f to point g in the following figure represents the relative changes in prices of leisure vs. consumption, which having the same utility (utility held constant) which is referred to as substitution effect. We can see that the substitution effect is larger than the income effect which has resulted in Jordan increasing the amount of leisure (which is now relatively cheaper compared to his other good consumption).

Opportunity Costs and Wage Decrease

The opportunity costs concept is defined as the income foregone in the next best alternative available. In the particular situation above, we can see that the substitution effect (movement from f to g) is larger and the result is that Jordan increases the amount of leisure he was enjoying previously despite the fact that his wages has decreased. This is because, Jordan considers leisure to be relatively cheaper when compared to consumption. The opportunity costs of decreasing wages is the additional time he can enjoy in leisure activities(Nicholson & Snyder, 2008).

How Effective is GDP to be an Indicator of Economic Activity in The Light of Covid-19?

With the increasing spread of coronavirus across various nations, many governments across the world have taken various unprecedented measures to control the pandemic. The measures first focus of health as it is of primary importance. These governmental measures -particularly that of lockdown has resulted in widespread restrictions to go for work and has affected the mobility of workers, there has been financial market disorder, an erosion of confidence among businesses and households and also uncertain situations(The_Economist, 2020). The GDP measure as an economic indicator would certainly lower after the lockdown period in various countries. Though GDP is a easier measure of economic activity and can be calculated easily to reflect the aftermath of Covid-19, it is a very narrow indicator that would not show the quality of life and turmoil faced by people after Covid-19. It does not show the health care facilities created for Covid-19 prevention and treatment and unemployment created by this pandemic and it also does not account of inequalities faced by the pandemic. Though GDP is an good indicator of telling the policy makers whether their policies have been effective in creating employment and value for the economy; However, it could also be misleading based on the population of a country like China or India which might show a high value of GDP due to the vast number of people involving themselves in economic activity(The_Treasury, 2020).

Consequentialist Perspective About the Payments to Support

According to the consequentialist perspective, the purpose of the payments support system is to ensure that the actions of these payments to support the families should avoid the bad consequences and maximize the good consequences for all. In this regard the payments support system by the government based on consequentialist perspective could be used to justify the resource allocation that would do the maximum good for the people (or minimise the harm created by lockdown) and an example would be to allocate the scarce resources that are available to save maximum lives possible(WHO, 2020). This is appropriate in allocating the scarce resources that would confer different benefits to the people (different groups of people).However the allocation principle should be justified to have different perspectives at different stages of scarce resources. For example when the allocation of ventilators on a first come first serve basis on a ethical value of equality would be justified at a time of little scarcity. However, as the resource of ventilators or even payment supports become increasingly scarce, it would be justified in the lines of prioritizing those who require it the most and when it becomes even more scarce the principle that would justify would maximise the benefit is more apt(Mandal et al., 2016).

Deontological Perspective About the Payments to Support

According to the deontological perspective, any harm that would be created by the payments to support the families and old people is not unacceptable irrespective of the consequences it would create. The consdierations through which these measures and payment support systems are implemented are different for different people(Aus_Govt, 2020). However there needs to be equality which considers interests of each person equally unless there are good reasons to justify the different prioritizations of resources. In this context irrelevant characteristics such as race, ability, ethnicity, ability or creed should not be considered for these allocations of resources. Such allocation on the basis of deontological perspective may be appropriate in guiding the scarce resource allocation to groups of people who expect to derive the dame benefit from that payments for support provided by the government(Mandal et al., 2016).

Perspective of Substantive and Procedural Judgements of Fairness

A fair process for the allocation of scarce resources would promote certain values like inclusiveness, transparency, consistency and accountability. In this transparent process of providing payment support systems to households, businesses and other vulnerable groups, the Australian government has provided the fact sheet in which it has announced about the first payment and the second payment from the Australian government and it has also provided the eligibility criteria for the same which will make it more transparent about the schemes announced by the government(WHO, 2020). Similarly those getting affected by the allocation decisions generally should be able to exert influence on the decision making process and this is not evident from the fact sheet whether those affected by the payment decisions were allowed to participate in the decision making process. Consistency signifies that those people from the same categories should be treated in the same way and favoritism should be avoided due to political or religious reasons. And from the fact sheet, those vulnerable groups are treated equally and consistently without any favoritism. And above all accountability suggests that those making these decisions should be made accountable for these decisions. Since the actions of the government are transparent enough, it could be taken that they are also accountable and answerable to the public in general about the payment support system they are providing(Aus_Govt, 2020).

References for Principles of Economics

Aus_Govt. (2020). Payments to support households. https://treasury.gov.au/sites/default/files/2020-03/Fact_sheet-Payments_to_support_households_0.pdf

Investopedia. (2019). Understanding Income Effect vs. Substitution Effect. https://www.investopedia.com/ask/answers/041415/whats-difference-between-income-effect-and-substitution-effect.asp

Mandal, J., Ponnambath, D. K., & Parija, S. C. (2016). Utilitarian and deontological ethics in medicine. Tropical Parasitology, 6(1), 5–7. https://doi.org/10.4103/2229-5070.175024

Mankiw, G. N. (2016). Principles of Microeconomics (8th Editio). CENGAGE Learning Custom Publishing.

Nicholson, W., & Snyder, C. (2008). Microeconomic Theory: Basic Principles and Extensions. In Thomson South-Western (10th ed.). Thomson:South-Western. http://www.sidalc.net/cgi-bin/wxis.exe/?IsisScript=CIMMYT.xis&method=post&formato=2&cantidad=1&expresion=mfn=047436

The_Economist. (2020). A grim calculus - Covid-19 presents stark choices between life, death and the economy | Leaders | The Economist. The Economist. https://www.economist.com/leaders/2020/04/02/covid-19-presents-stark-choices-between-life-death-and-the-economy

The_Treasury. (2020). Economic Response to the Coronavirus | Treasury.gov.au. https://treasury.gov.au/coronavirus

WHO. (2020). Ethics and COVID-19: resource allocation and priority-setting. https://www.who.int/blueprint/priority-diseases/key-action/EthicsCOVID-19resourceallocation.pdf

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