Principles of Economics

27/02/20
The Capitalist Revolution
Inequality

 1,000 years ago, the world was “flat”. Today, there are large differences both within and
across countries.
 While both types of inequality seemed to have increased, differences in average income
between countries are much larger today than they were in the past.
 For a very long time, living standards did not grow in any sustained way. When sustained
growth occurred it began at different times in different places.
 The countries that took off economically a century or more ago—UK, Japan, Italy—are now
rich.
 The countries that took off only recently, or not at all, are in the flatlands.

Measuring income and living standards

 Gross Domestic Product (GDP) = A measure of total income and output of the economy in a
given period.
 Usually expressed in per-capita terms (as an average income).
GDP per capita ≠ Disposable income
 Disposable income = Total income – taxes + government transfers
 GDP is an imperfect measure of well-being. However, it is highly correlated with other
measures of well-being, such as life expectancy at birth and the infant mortality rate, both of
which capture some aspects of quality of life.

“Hockey Stick” Growth

Timing of Growth

 Growth take-off occurred at different points in time for different countries:

o Britain was the first country to experience sustained economic growth. It began
around 1650.
 o In Japan, it occurred around 1870.
o The kink for China and India happened in the second half of the 20th century.
 In some economies, substantial improvements in people’s living standards did not occur
until they gained independence from colonial rule or interference by European nations.

The Technological Revolution

 Technology = A process that uses inputs to produce an output.

 By reducing the amount of work-time it takes to produce the things we need, technological
changes allowed significant increases in living standards.
 Remarkable scientific and technological advances occurred more or less at the same time as
the upward kink in the hockey stick in Britain in the middle of the 18th century.
 The technological revolution is ultimately driven by the scarcity of time: • Time is a scarce
resource
 Only 24 hours per day to allocate between work (and hence enjoy consumption) and leisure
activities
 Technological changes help to ease this trade-off
 Opportunity to spend less time working in exchange for more leisure time, or to work the
same amount of time but get more consumption
 Industrial Revolution = a wave of technological advances starting in Britain in the 18th
century, which transformed an agrarian and craft based economy into a commercial and
industrial economy.

A Connected World

 Technological progress also greatly improved the speed at which information travels, making
the world more connected.

Environmental Consequences

 Increased production and population growth affects the environment

o Global impacts – climate change
o Local impacts – pollution in cities, deforestation Technology may provide the
solution
 These effects are results of both
o The expansion of the economy (illustrated by the growth in total output)
o The way the economy is organised (what kinds of things are valued and conserved,
for example).
 The permanent technological revolution may also be part of the solution, by making it
possible to use less resources to produce more output.

Capitalism

 Institutions are the laws and social customs governing the production and distribution of
goods and services.
 Capitalism – an economic system where the main institutions are private property, markets,
and firms.
 Private property = ownership rights over possessions
 An important type of private property is capital goods = the non-labour inputs used in
production.
  Does not include some essentials, e.g. air, knowledge Markets = a way for people to
exchange products and services for their mutual benefit. Unlike other types of exchange,
markets
o are reciprocated transfers
o voluntary
o usually there is competition
 Firms = business organisation that uses inputs to produce outputs, and sets prices to at least
cover production costs.
o Inputs and outputs are private property
o Firms use markets to sell outputs
o The aim is usually to make profit
 This pursuit of profit provides an incentive for firms to innovate and adopt new technologies,
as witnessed during the Industrial Revolution.

The Capitalist Revolution

 Capitalism led to growth in living standards because of:

o Impact on technology: firms competing in markets had strong incentives to adopt
and develop new technologies
o Specialisation: the growth of firms and the expansion of markets linking the entire
world allowed historically unprecedented specialisation in tasks and production
 Together with the technological revolution, this increased worker productivity.

Gains from Specialisation

 Specialisation increases productivity of labour because we become better at producing

things when we each focus on a limited range of activities
o Learning by doing
o Taking advantage of natural differences in skill and talent
o Economies of scale
 People can only specialise if they have a way to acquire the other goods they need. In a
capitalist society, this is done via markets.

Comparative Advantage

 All producers can benefit by specialising and trading goods, even when this means that one
producer specialises in a good that another could produce at lower cost.
 Markets contribute to increasing the productivity of labour by allowing people to specialise.

Divergence in growth

 Not all capitalist economies are equally successful

o The right incentives must be in place in order to promote growth
o Economic conditions: firms, private property, or markets may fail
o Political conditions: capitalist institutions are regulated by the government
o The government also provides essential goods and services (infrastructure,
education)

Political Systems

 Capitalism coexists with many political systems.

  A political system determines how governments will be selected, and how those
governments will make and implement decisions.
 In most countries today, capitalism coexists with democracy
o Individual rights of citizens (e.g. freedom of speech)
o Fair elections But capitalism has coexisted with non-democratic systems, too.

5/03/20

Technological change, population, and growth

Economic Models

 3 main agents in economy

o Government
o Firms/businesses
o Consumers

Why do we need models?

 What happens in an economy depends on the actions and interactions of millions of people.
 We use models to see the big picture.

Building a model

 To create an effective model we need to distinguish between

o the essential features of the economy that are relevant to the question we want to
answer, which should be included in the model
o unimportant details that can be ignored
 Models necessarily omit many details. This is their feature, not a bug.

Building a model

1. Capture the elements of the economy that we think matter for our question
2. Describe how agents act, and how they interact with each other and the elements of the
model
3. Determine the outcomes of these actions (an equilibrium)
4. Study what happens when conditions change
 Equilibrium of a model = situation that is self-perpetuating. Something of interest does not
change unless an external force is introduced that alters the model's description of the
situation.

What is a good model?

 It is clear: it helps us better understand something important

 It predicts accurately: its predictions are consistent with evidence
 It improves communication: it helps us to understand what we agree (and disagree) about
 It is useful: We can use it to find ways to improve how the economy works

Key Concepts

 Less is more: Ceteris paribus = simplification that involves "holding other things (in/outside
the model) constant”.
  Incentives = economic rewards or punishments, which influence the benefits and costs of
alternative courses of action.
 Relative prices help us compare alternatives.
 Economic rent = the benefit received from a choice, taking into account the next best
alternative (reservation option)
o Forms the basis of how we make choices.

Explaining growth

Explaining the industrial Revolution

 Why did the Industrial Revolution happen first in the 18th Century, on an island off the coast
of Europe?
 There are many alternative explanations
o Access to colonies
o Relatively high cost of labour
o Europe’s scientific revolution and Enlightenment
o Political and cultural characteristics of nations as a whole
o Abundance of coal

Firms choice: inferior technologies

 Firms choose between technologies (specific combinations of inputs) to produce outputs.

 Some technologies are dominated by other technologies.

Firm’s choice: minimising cost

 Firms aim to maximise their profit, which means producing cloth at the least possible cost.
 This is why the firms’ choice of technology depends on economic information about relative
prices of inputs
Explaining Stagnation

Mathus Model
 Key ideas:
o Population expands if living standards increase
o But the law of diminishing average product of labour implies that as more people
work on the land, their income will inevitably fall
 In equilibrium, living standards will be forced down to subsistence level.
 Population and income will stay constant.
 12/03/20

Scarcity, Work and Choice

Key concepts
Decision-making under scarcity