However, lost output can be an inaccurate measure of the economic costs of voluntary unemployment, as it can easily overstate the costs. Labour in voluntary unemployment, have as the term suggests, chosen to be unemployed. They consider the leisure time gained to be worth more than the wage they would receive in employment.

As with GDP, lost output is an inaccurate measure because it fails to account for ‘home production’, activities that may be performed by the unemployed that would otherwise need to be paid for: housework, DIY, caring for relatives etc.

Consider the mathematical representation of the Classical Model for a closed economy.

Which macroeconomic phenomena are the model attempting to explain? Interpret these relations. Which are the exogenous and endogenous variables? Which relative price ensures market clearing in the three markets?

The model claims that national income consists of three main components, consumption, investment and government expenditure, and summarises the interaction of demand and supply. Using substitution, the model becomes

Y=C(Y-T)+I(r)+ G where Y, G and T are fixed. That is, consumption is now a function of income minus taxation and investment is a function of interest rates. The consumption function (Y-T) gives disposable income, which determines effective demand by consumers. The investment function, where investment is a function of interest rates, gives an inverse relationship between investment and interest rates. That is, if interest rates rise, investment will fall. Government expenditure, taxation and national income are all assumed to be at some fixed level. Together, the equation states that the supply of output equals its demand.

The model also states that aggregate national income (Y) is a function of the factors of production; capital and labour, where both these factors are fixed. By extension income is also fixed. This relationship exists because all production is reliant upon either capital or labour (or both), and so national output must be a function of the two. Interestingly, the model also implies that output = income through this function. Both labour and capital are assumed to be fixed (and fully utilised) in order to simplify the model.

Finally, the marginal product (the amount added by one additional unit) of both labour and capital are given as W/P and R/P respectively. In each case the marginal product is the rent paid to the factor divided by the price of the product.

The exogenous factors for this model are government expenditure, taxation, consumption, labour, capital and national income (all these factors are fixed). Only investment will be determined within the model, and is therefore endogenous.

If only investment is endogenous, then the relative price will be determined by changes in the interest rate (the only non-fixed variable in the model). The interest rate has an effect on consumption, as well as investment, by increasing or decreasing the cost/reward of borrowing/saving, and as such is a major determinant of the marginal propensity to consume. The interest rate will therefore adjust to equilibrate the markets.

What happens if the government increases government spending financed by an increase in taxes of equal size. What is the overall effect on the interest rate and investment? Does your answer depend on the marginal propensity to consume?

An increase in government spending would act to increase aggregate demand, whilst an increase in taxation would reduce it by decreasing the disposable income of consumers and the funds for investment available to firms. If the increase in government expenditure is concentrated solely in transfer payments, then there will be no change in the economy, as the reduction in disposable income caused by taxation will be exactly matched by the increase occasioned by the transfer payments.

The extent to which taxation affects investment is dependant largely upon the marginal propensity to consume. Funding expenditure through an equal increase in taxation will have a neutral effect if, and only if, the marginal propensity to consume is 1. Consumption demand is a function of disposable income (Y-T), and so increasing taxation obviously reduces consumption demand. If we assume that the marginal propensity to consume (consumption demand) is 0.7, then pre taxation consumption demand will equal 0.7 of national income. However, following taxation, consumption demand will fall to 0.7(1-t)Y where ‘t’ is the net rate of tax. (Taxes minus transfer payments, as these increase disposable income) If we assume a 0.2 rate of taxation, this means that post tax the MPC will fall to 0.56. This is important when considering investment because it means that the funds available for investment (in this model, savings) will fall.

Prior to the tax, there was a marginal propensity to save of 0.3. With the introduction of a marginal tax rate of 0.2 however, this will change. The ratio shifts from 0.7/0.3 to 0.56 MPC, 0.2 t and therefore 0.24 MPS. The reduction in saving rates grows as MPC tends towards 0. A reduction in saving means a decreased supply of loanable funds, increasing the interest rate and leading to a fall in investment – one of the components of aggregate demand. So an increase in government expenditure financed by increased taxation is likely to lead to a fall in output, dependent upon the size of the MPC.

What happens to GDP and its components if the labour force is reduced?

A reduction in the labour force will see consumption fall as both income and the number of consumers has fallen. This has a knock-on effect, reducing government revenue from indirect taxation and investment by reducing the revenue of firms. Government revenue would suffer further from a decrease in the direct taxation revenue, whilst investment would also fall further due to a decreased supply in the loanable funds market, raising the interest rate, or price of borrowing. According to the circular flow model, the decrease in income would also mean a decrease in output and employment, and GDP would also fall.

“The plague is a blessing for those who survive it” Discuss this statement with a reference to the neoclassical theory of distribution.

The plague experienced by medieval Europe reduced the population by a third. However, those of the labour force who survived would reap substantial benefits. In England, the plague broke the feudal system, and throughout Europe it increased real wages.

This occurs because of the theory of marginal productivity, and also that of diminishing returns. Neoclassical economists believe that, following Euler’s theorem, constant returns to scale will be achieved so long as both factors of production (capital and labour) are increased simultaneously. The plague, by reducing the population also reduced the labour force. There was now an imbalanced ratio of capital (at this time, mainly land) to labour. This caused diminishing returns to scale for capital, as there were now fewer workers to maximise productivity, with the end result being that less productive land was abandoned. Labour, however, greatly increased its marginal product simply because the quantity of labour had been so drastically reduced.

According to the neoclassical theory of distribution, in perfect competition the factors of production will be paid its marginal contribution. So the plague increased the real wage of the majority of the workforce by increasing their marginal productivity. A rise in the real wage meant a rise in the standard of living, and so the poor who survived the plague benefited substantially in financial terms. Furthermore, a sudden fall in demand (as would be caused by a drastic reduction in population) would not be matched by an equal fall in supply – land and other factors would remain at their pre-plague levels – and so prices would fall for many goods.

Furthermore, the labour shortage caused by the plague (as with any labour shortage) saw an increase in workers’ rights, reducing the absolute power held by employers and increasing that of the employees. They were now in a position to bargain for better wages and better working conditions, as they were not easily replaceable.

However, as mentioned, the marginal product of capital was reduced by the plague, substantially decreasing the real rent afforded by land. As a consequence, the landed classes suffered reduced incomes, in addition to which they were now paying higher wages. It is possible that the plague in this way might have increased social mobility, decreasing the cost of land and allowing the lower middle classes to enter the landed classes.

All of this, however, is based on the assumption that the mortality age distribution is fairly even. If it was the case that only the working population were affected, even the surviving labourers would have a mixed blessing. It could result in an economy with large numbers of dependents and only a small proportion of the populace in employment, leading to shortages of many goods and rapid inflation. This is not entirely implausible – the Spanish influenza of the early 20th century was such a disease, accounting for more deaths than the World War which preceded it in Europe, and mainly amongst the young adult population. Due to the further shortages that arose, rationing had to be prolonged.

Malthus believed that plague was one of many ‘positive checks’ that existed to keep population within sustainable levels, and to some extent he was right. The plague, and events like it, greatly alleviated many of the problems associated with an unsustainably large population – falling real wages, a reduction in labour rights, overcrowding. But at the same time it is important to remember that not all the survivors benefit; the diminishing returns of capital can prove costly to the richer portion of society.