WELFARE AND THE GENERAL LEVEL OF PRICES

 

Adam Smith tried to find,

1.     The factors that determine the general price level

2.     The best measure of changes in welfare over time

The second question is more difficult. How do we define welfare in an unambiguous way so that differences in welfare can be measured?

Welfare for the economy can be defined and measured in terms of quantity consumed. Can differences in welfare be defined and measured for an economy of two or more products? Smith tried to answer this question.

If welfare is defined as the total consumption or output of society, then the basic problem to be solved for a multi-product economy is to find a way to aggregate the production or consumption of products. A solution to this problem is to convert all goods into one common step. However, if the relative prices of goods and commodities change as their outputs change, the problem of measuring welfare becomes more complex. In a multi-product economy, the relative prices of goods are usually expressed in a common measure, which is the government's currency. In theory and occasionally in practice, this common measure could be any commodity in the economy.

—for example, cattle, corn, or gold.

In our economy, we measure output by adding the monetary value of each good and to get the GDP. If GDP increases from one year to the next, can we conclude that welfare has increased?

Measuring changes in output in a multi-product economy with this method creates difficulties because the unit of measurement, the benchmark currency, is itself variable. The average price level varies; Therefore, the monetary value of the output may not accurately reflect the actual output. Smith considered the possibility of using gold or silver as a common measure or number, but since the prices of these commodities varied,

They are not satisfied with this work. He then turned to labor but found that the price of labor also changed over time. Ultimately, the only invariant measure he could find to assess differences in welfare was that "equal quantities of labor may be said to be of equal value to the worker at all times and places".

Given Smith's conclusion that labor disorders can be used in calculating a welfare index, the problem of measuring differences in welfare is easily solved. We first measure changes in total output by currency; We then adjust for changes in average price levels based on changes in the price of gold, silver, or corn. By this process, we have converted money income and nominal price into real income and real price.

For example, if the monetary value of output increases by 10 percent and the average price level, as measured by the price of gold, also increases by 10 percent, the real value of output remains the same. If the inactivity of producing this output decreases, welfare increases. If we can produce, and translate into everyday language, the same amount of output with less labor, we will be more rested and better off.

However, measuring changes in welfare is much more complex than Smith thought, and our discussion cannot touch on all the issues involved. Smith did not discuss how to define the inefficiency of labor. One of his assumptions, which was not questioned by orthodox economists until the twentieth century, was that more goods are better than less, or that an increase in production without an increase in labor unrest must always lead to an increase in welfare. An increase in output is an improvement in welfare, even if the increased production includes goods of doubtful benefit to society. Furthermore, Smith and the orthodox economists who followed did not consider the "quality of life" produced by this increased output. Little or no attention was paid to the form of corruption or other harmful external costs that society might pay for large outputs. 

Written by: Tharushi Kanishka Herath

References: Harry Landreth, D. C. (2002). History of Economic Thought (4th ed.). Boston, Toronto: Houghton Mifflin Company.