ClaSS 1

What is Economics?
AND HOW ECONOMISTS TRY TO UNDERSTAND THE WORLD

The Economy – Unit 2 sections 2.2 and 2.3

!
 What is Economics?
• “Economics is the study of how people interact with each other and with their
natural surroundings in producing their livelihoods, and how this changes over
time” The Economy, The CORE Project

• Economics studies how to use limited resources à trade-off between choices

• We will look at:

• Individuals, decisions and conflicts

• Firms, individuals and institutions

• Markets and the state

 How economists try to understand the world… Models

• Reality is complex: impossible to consider everything simultaneously

• Models:
o Simplify reality: based on simplifying assumptions
o There are several ways to model the same problem
o All models are wrong… Some are useful.
How economists try to understand the world… Models

• Building Models
o Start with a question.
o Look at the evidence
o Build a model that helps you understand what you see.
o Critically evaluate the model
§ Does it provide insight into the question?

§ Does it explain the evidence?

How economists try to understand the world… Models

An example: Should we create/increase

Minimum Wages?

What do you think?

YES NO Don’t Know

 How economists try to understand the world… Models
An example: Should we create/increase Minimum Wages?

• State of the Union Address by President

von der Leyen (September 2020) • A different view on Minimum Wage

https://www.youtube.com/watch?v=KTLZVfJ0cyE https://www.youtube.com/watch?v=edtqrOmL
Minimum _QQ
Wages
Work Minimum
Wages = less
jobs and/or
• Alan Krueger higher prices

https://www.youtube.com/watch?v=VtjnxtHAis8
How economists try to understand the world… Models
An example: Should we create/increase Minimum Wages?

• The standard theory Unemployment

à Workers

o Without a minimum wage employment

level would be Q*

o With the minimum wage

employment level is Q**

o Minimum wage results in à Firms

unemployment: Qs – Q**
Q** Q* Qs Employment
How economists try to understand the world… Models

• So is the Neoclassical labour market model a bad model?

o Not necessarily, when applied to situations in which reality matches its assumptions:
§ Downward sloping labour demand. If these hold, the model is a
§ Upward sloping labour supply. good model. Sometimes they
hold, sometimes not.
§ Curves significantly elastic (responsive to wage).
§ Rational agents.
§ No other labour market institutions.
How economists try to understand the world… Models

• Why is the evidence on the effect of minimum wages so diverse? Because

this simplified model is not always applicable to situations in the real world!
o Maybe MW too low to have impact? Maybe inelastic (non-responsive) behaviour?
Maybe institutions/policies? Firm side? Substitution of other production factors?

• Krueger’s work: for example in the presence of

o Labour market frictions: ex. Expensive for employees to go to interviews, submit
applications
o Imperfect information: employees may not know exactly how much one firm is paying
compared to others
o It can be possible to set/increase minimum wage without harming employment.
How economists try to understand the world… Models
• Examples
1. Minimum wage to low to have an impact

o Q1: number of workers willing to

work
o Q2: number of workers firms want to
hire
o We will converge to Q*, W* W*

o But Q*, W* would be the outcome

even in the absence of the minimum
Wa
wage

Q1 Q* Q2 employment
How economists try to understand the world… Models
• Examples
2. Different types of workers (ex. Experienced vs No Experience)
wage S0

In this case
W*0 S1
o Workers without experience
would be affected by the Min. W

↑ I
Minimum Wage
o Experienced workers would
not be affected by the minimum
wage W*1
D0
D1

Q*1 Q*0 employment

Technology, Population, Growth
The Economy – Unit 2 sections 2.4 and 2.7 to 2.11
 Historical data: Evolution of Living Standards

• Since the 1700s

the average living
standards
increased in many
countries.

• In particular after
the 1800s.
Lindustrial revolution
 Historical data: Evolution of Living Standards

• Historical data raises the question: why did this upward turn started
around 200 years ago?
1. The emergence of Capitalism
§ A new economic system in which private property, markets and firms
play a major role.
• Economic system: the institutions that organize the production and distribution
of goods and services in an entire economy
• Institutions: the laws and social customs governing the way people interact in
society

§ More info on this: The Economy – Unit 1: Capitalism: Private Property,

Markets and Firms, Recommended reading (not in the slides)
 Historical data: Evolution of Living Standards

• Historical data raises the question: why did this upward turn started
around 200 years ago?
2. Technological progress
§ Changes in technology that reduce the amount of resources (labour,
machines, land, energy, time) required to produce a given amount of
output. Also new products and services introduced over time to satisfy
needs
§ A technology is defined by the way inputs are combined to obtain
outputs
o Inputs or factors of production: The labour, machinery and equipment

O
(usually referred to as capital), land, and other inputs to a production
process. (Physical resources financial resources human Resources)
-
,

I RAW MATERIALS) CFUNDS ITO INVESTI IPEOPLE NEEDED TO RUNA BUSINESS)

o Outputs: quantity that is produced of something

↳goosich ,
services

Intangible
 How do we represent a technology?
• Production Function A
o Maximum amount of output resulting from a given combination of
inputs efficiency
o Describes differing technologies capable of producing the same thing
o Often described as Q = f(K, L), where K is capital and L is labour
§ How much we can produce using a given amount of capital and
labour
 How do we represent a technology?
• ! à Q = f (L)
Example: Q = f(K, L) with K fixed at a specific level "
Q
Q L don't vary directly w/ the production
- statt wages
- rpment Production Functions
insurance

can have different

-

shapes, depending on
the technology they
are describing

Labour Labour

Two different technologies

 How do we represent a technology?
produccion por unidad de trabajo

• Average Product of Labour (APL): Output per unit of labour.

something produced by person-machine industry
!
-

Lamount of

o APL = à Ratio of vertical by horizontal distance of any point of Q=f(L)

"
variacion en la produccion por unidad de variacion de las

unidades de trabajo
• Marginal Product of Labour (MPL): Change in output for unit change in
units of labour.
#!
-point o MPL = #" à Slope of the production function Q = f(L)

or -
!!$!" -> AL
2 pointso MPL = if we have discrete data
"!$""
 How do we represent a technology?

• Example 1: Q = K0,5L0,5 with K = 100

E APL

I
o For K = 100: Q 100%5 .= 10/0 -3

a
=

o APL = G =

1 =
10 .
2- * ↑

-
5

100
0

o MPL =
-

=>

0 ,
3 :
=
5L
DL ↑

* Sk
- 1

g =

Is 10 = L
1
 How do we represent a technology?
Y
B
• Example 2: Discrete data O
L (nr workers) Q APL MPL
20 2000
2004/20 =
100
I
28 =
100 ,

40 3300
3309/40 =
82 , 5 2000
3- =
1
,
60
=

65

50 4000 700

4004/56 =
80 2000 -3300 : =

7
ClaSS 2

Technological Progress
• Technological progress can be described in three equivalent ways

1. A change in technology that allows to produce more output with the

same amount of inputs
or
2. A change in technology that allows to produce the same output using
less inputs
or
3. A change in technology that allows to reduce the costs of production
 Technological Progress
Q
Q2 Q = f2(L)

• Same Q, less inputs

Q1
or Q
Q = f1(L)

• Same inputs, more Q

L2 L1 L
Labour
 Technology, Population, Growth
• Example: Malthusian Economics (Thomas Malthus) – a model
o 1 input 1 output – farmers and grain produced
o Assumptions:
§ Farmers work on a fixed amount of land
§ The more farmers there are, the more grain is produced, at least up to a certain
point
§ Diminishing average product of labour: APL decreases as the number of
farmers increase
§ Population growth is limited by the availability of resources
• Increase if living standards improve
• Decrease if living standards deteriorate
 Technology, Population, Growth
How to check APL “graphically”?

• APL in a point can 732

be inferred from the
angle created by a
straight line 500
connecting the origin
and that point
(orange dashed lines)
• Where is APL higher
A or B?
 a/L

A
B
=

APL :

878
:38
L 1600 PPL 458 C APL
549
=
=
=
=
r

1600

Technology, Population, Growth

• The effect of an improvement in technology
Q2
o Consider we start C
with 1600 farmers 878
732 Q1
and technology Q1
o Technology
500
improves to Q2
§ With 1600 farmers
we are now able to
produce more
grain (point C)

o What happens to
APL? Are farmers
better off?
 Technology, Population, Growth
• The effect of an improvement in technology
Q2
C
o What happens to APL 878
from B to C? 732
Q1

§ APL increases
§ APL in C =
500
878000/1600 = 549
> 458
o Are farmers better off?
§ Yes: on average
each is producing
more
§ Living standards
increase
 Technology, Population, Growth
• The effect of an improvement in technology
D Q2
C
878
o Recall assumption: 732
Q1
population expands if
living standards
increase 500
o From C to D Population Increase

§ Population increases
§ We have more
farmers
§ APL starts
decreasing
 Technology, Population, Growth
• The effect of an improvement in technology
D E Q2
C
o When will population 878
stop increasing? 732
Q1

§ When we return to
the inicial APL
500
o At point E
§ More Population
§ More production
§ Same APL as in B
§ Same living
standards
 Technology, Population, Growth
• Example: Malthusian Economics (Thomas Malthus):

o Malthusian Trap:
improvements in technology
don’t result in better living
standards due to population
growth

o This is a possible
explanation for the absence
of growth until the 1800s
 Technology, Population, Growth
• Escaping the Malthusian Trap
o In Malthus model he didn’t consider that improvements in technology
could happen at a faster rate than population growth
o If technology grows faster than population the diminishing average
product of labour effect can be offset
o If technology grows faster than population we expect economic growth
(increase in living standards)
§ This can be one explanation for the upward trend started in the 1800s
 Technology, Population, Growth
• Escaping the Malthusian Trap E

D Q2
C
878
Q1
732

500