2. (25 points). Suppose that government spending makes...

2. (25 points). Suppose that government spending makes private firms more productive, e.g., spending on roads and bridges might reduce transport costs. (a) Using the production possibilities graph described in chpt. 5 of the text and in Lecture 5, show how an increase productive government spending could increase household welfare. (b) Show that the equilibrium effects on consumption and hours worked are ambigu- ous, but but that output definitely increases. Hint: Consider the induced income and substitution effects.

Transcript

00:01 So here we're talking about a production possibilities frontier, right? so i'm not sure exactly how your production possibilities frontier was drawn, but it sounds like we're making a decision here between consumption and leisure, right? so if i sketch that, it should look something like this.

00:19 Leisure, this is just going to be c for consumption, and we should expect to see some sort of classic concave shape reflecting the, trade off between resources.

00:31 So now we are going to have productive government spending.

00:39 So the key thing is here is that the government spending affects our ability to produce consumption, but not leisure, right? it has no effect on leisure, right? if the government builds better roads, it doesn't give you more hours in the day, but it lets you turn that fixed amount of hours, right, into more consumption.

01:03 So i would say a good way to model that, that would be to say that the curve pivots out around the baseline.

01:11 So the increased productivity doesn't give you much more any more leisure, but as soon as you turn your leisure into consumption via working to produce, you get more bang for your buck, right? so in equilibrium, the equilibrium is the tangency, as usual, right, with the social welfare curve or with the social and curve.

01:38 So that might look something like originally you might get something like this.

01:45 So the effect on output should probably increase, right? because again it says income and substitution effects, for the output, we are now, sorry, so much better to tackle this from the leisure side, right? right? so the idea of leisure is that we are richer...

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