Core: Chp 1 - THE CAPITALIST REVOLUTION

GDP and economic growth

Since the 1700s, increases in average living standards became a permanent feature of
economic life in many countries, this was associated with the emergence of a new
economic system called capitalism, in which private property, markets and firms play a
major role. Advances in technology and specialization in products and tasks raised the
amount that could be produced in a day’s work.

Economics​ is the study of how people interact with each other, and with the natural
environment, in producing their livelihoods.

To compare living standards in each country, we use a measure called​ GDP​ per capita.
People obtain their incomes by producing and selling goods and services.

GDP​ (gross domestic product) is a measure of the total goods and services produced in
a country in a given period such as a year, which is then divided by the country’s
population.

A thousand years ago the world was flat, economically speaking. There were differences
in income between the regions of the world. The countries that took off economically
before 1900—UK, Japan, Italy—are now rich.

● 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
countries, leading to vast differences in living standards around the world.
Disposable income​ is the amount of wages or salaries, profit, rent, interest and transfer
payments from the government (such as unemployment or disability benefits) or from
others (for example, gifts) received over a given period such as a year, minus any
transfers the individual made to others (including taxes paid to the government).
Received - given = disposable income

The​ ratio scale​ is used for comparing growth rates.

Growth rate​ = change in income / original level of income
GR = y1- y2 / y2 * 100

The industrial revolution

The Industrial Revolution.​ As late as 1800, traditional craft-based techniques, using

skills that had been handed down from one generation to the next, were still used in
most production processes. This marked the beginning of a permanent technological
revolution because the amount of time required for producing most products fell
generation after generation. ​PRODUCTIVITY

● gross domestic product per capita

● productivity of labour (light per hour of work)
● connectivity of the various parts of the world (the speed at which news travels)
● impact of the economy on the global environment (carbon emissions and climate
change)

Technology ​is a process that takes a set of materials and other inputs—including the
work of people and machines—and creates an output.

Capitalism
Capitalism​: an economic system where the main institutions are private property,
markets, and firms.
Institutions​ are the laws and social customs governing the production and distribution
of goods and services.

Private property​ (people owning things), markets (where goods could be bought and
sold) and familie
Markets​ are a means of transferring goods or services from one person to another. In
most markets there is competition.
Firms​ organizations that use inputs to produce outputs and set sales prices
o Input and outputs are private property
o Firms use markets to buy/sell inputs and outputs
o The aim is to make profits
They are different from family businesses due to the fact that they be born, expand and
die fast.

Capitalism implied
● impact on technology: firms competing have incentives to adopt and develop
new technologies
● specialization: growing firms and markets link the entire world. Allows for
specialization in tasks and production
Massive increase of worker productivity.

The gains from specialization

We become better at producing things when we focus on a limited range of activities
• learning by doing
• use differences in skill and talent
• economies of scale
 Comparative advantage

Absolute advantage​ A person or country has this the production of a good if the inputs it
uses to produce this good are less than in some other person or country.
Comparative advantage​ A person or country has comparative advantage in the
production of a particular good, if the cost of producing an additional unit of that good
relative to the cost of producing another good is lower than another person or country’s
cost to produce the same two goods.

- Greta has absolute advantage in production of both crops 1250>1000, 50>20

- Greta has a comparative advantage in wheat bc 1250/50= 25 (uno de trigo renuncia 25 manzanas), 1000/20=
50, 25<50
- Carlos has a comparative advantage in apples = he is least disadvantaged in
production of apples. bc 50/1250=0,04 (una manzana renuncia 0,04 de trigo), 20/1000=0,02
0,02<0,04

Did capitalism cause the hockey-stick growth

 Divergence in growth

Negative effects of growth

Within and between country inequality

1,000 years ago there was almost no difference.
Today: large differences both within and across countries.
- Inequality across countries:​ massive increase
- Inequality within countries:​ moderate increase

Environmental consequences
Increased production and population growth affects the environment
• Global impacts – climate change
• Local impacts – pollution in cities, deforestation

Negative effects on the environment are results of both

• the expansion of the economy (illustrated by the growth in total
output)
• the way the economy is organized (what kinds of things are valued
and conserved, for example).
 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​.

Summary
1.​ Important trends in economic variables over time
● Income inequality across regions has increased a lot over time
● “Hockey-stick” growth in GDP, and its negative consequences
● Technological progress helped bring about these trends
2​. The adoption of capitalism was another key factor
● Capitalism = Private property + Markets + Firms
● Failure of these institutions can explain divergence in economic growth across
countries
Core: Chp 3 - SCARCITY, WORK, AND CHOICE

KEY CONCEPTS
Ceter paribus​: holding everything as it is and changing one sole thing
Incentives: w​ hat makes us do things (rewards/punishments)
Labor:​ an input in the production of goods and services

New technologies​ raise the productivity of goods and services, for example from
1870 to 2000 the Netherlands had a GPD growth of 704% and the working hours
descended -54%

To help explain the relation economists set up models

Models
What happens in an economy depends on the actions and interactions of millions of
people. We use models to see the big picture.
We should capture
• the​ essential features​ of the economy that are relevant to the
question we want to answer,
• unimportant details should be ignored
Models necessarily omit many details. This is a feature, not a bug.

1.​ Capture the elements o

​ f 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 c ​ onditions 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 p ​ redicts w ​ ell: its predictions are consistent with evidence
• It i​ mproves 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​.
 Production function

Production functions s​ how how inputs (e.g. labour) translate into outputs (e.g. goods
and services), holding other factors constant (e.g. production environment)

1. ​Marginal product​: Change in output per unit change in input (evaluated at a given
point, holding other inputs constant)
Example: how much does the grade increase when I study one more hour.
4h= 5
5h= 5,7
Increasing 1 h (5-4) means a marginal product of 0,7 (5,7-5)

2.​ Average product​ Average output per unit of input

Example: 4 hours of study means a grade of 5 so (5/4=1.25 of grade per hour)
but if you study 12 hours your grade would be n 8,6 ( 12/8.6= 1,39 grade per
hour)
 Indifference Curves
- Choices depend on preferences

trade-off ​(there are two things we like so we have to balance them against
each other, the more we get form one good the less we get from the other)

Indifference curves s​ how all combinations of goods that give the same utility
(satisfaction)
The marginal rate of substitution​ is the slope of the indifference curve and represents
the tradeoffs that an individual ​is willing​ to make.
Example: Passing from 15 to16 free time hours (Af - Bf) would generate a trade off of
-0,9 on his grade (Ag-Bg) so 1h free time = -0.9 grade
 Opportunity cost
Choices are limited by constraints and involve tradeoffs (Studying example: higher
grades vs. more free time)

The​ opportunity cos​t of an action is the net benefit of the next best alternative action

Economic cost =
​ out-of-pocket costs + opportunity costs

If the benefit from an action exceeds the economic costs, you receive an e
​ conomic rent
from choosing it.

The Feasible Frontier

The feasible frontier shows the maximum output that can be achieved with a given
amount of input. We are not taking off what we want but what is possible to us.

The marginal rate of transformation (MRT) is the slope of the feasible frontier,
and represents the tradeoffs that an individual faces .
 Optimal Decision Making
The utility-maximising choice is where the amount of one good the individual is willing to
trade off for the other good (MRS) equals the actual tradeoff between the two goods
(MRT)
MRS = MRT
(slope of indifference curve = slope of the feasible frontier)
WHERE THE CURVES TOUCH
What happens when the feasible frontier
changes?

Technological progress affects both

dimensions. Choice of free time depends on
relative preferences and willingness to
substitute one good for another.

E. g.​ Budget constraints​ (wage) are the

feasible frontiers for consumption choices.
Wage changes affect the slope of the budget constraint (MRT).
A wage increase will have 2 effects:
- The​ opportunity cost​ of free time ​increases
(substitution effect → tendency to work less) more
- You can afford a ​greater number of
combinations​ between consumption
and free time.
(income effect → tendency to want
more free time and consumption)

​ ross-country differences
C
Differences in working hours can be explained by preferences that differ across
countries. Other explanations?

• Differences in culture (norms)

• Politics (legal limits on hours)
• Social preferences (e.g.
‘Keeping up with the Joneses’)
 Is this a good model?

- Not realistic:​ People don’t do MRS/MRT calculations. Most people cannot

choose their working hours.
- BUT still a g
​ ood approximation:​ Over time, people learn what combination of
working hours and free time suits them best. Working hours can change due to
culture and politics (indirect choice); people can choose which jobs to apply for.
- Helps us u​ nderstand real-world phenomena​: preferences and
income/substitution effects can explain differences in working hours across
countries and over time​.
Chp 4: Social Interactions
KEYWORDS
Free Riding
Altruism

A social dilemma

A situation in which actions taken independently by self-interested individuals result in a

socially suboptimal outcome e.g. traffic jams, climate change. Social dilemmas occur
when people do not fully account for the effects of their actions on others.
● Tragedy of the Commons: Common resources are often overexploited
● Free riding: One person/party bears all the costs while others enjoys the benefits

Strategic Interaction

A situation involving more than one person/party, where one’s actions affect both their own
and other people’s outcomes and people are aware of the ways that their actions affect
others.
Strategy​: Action(s) that people can take when engaging in a social interaction.

Game ​• A game describes a social interaction:

1. Players​ – who is involved in the interaction

2. Strategy​ – a detailed plan of action for each player
3. Payoffs​ – outcomes for every possible combination of actions
4. Information​ – what each player knows when choosing their action

Best response​:​ Strategy that yields the highest payoff, given the other player’s strategy

Dominant strategy​: A best response to all possible strategies of the other player (does not
always exist!)

Dominated strategy: a​ strategy that is NOT a best response independently of other player’s
strategy. - A
​ dominated strategy should never
be chosen

- If Bala chooses Rice, Anil’s ​best

response​ is to choose Cassava.

- Whatever Bala’s choice, Anil’s best

response is to choose Cassava.
Cassava is a d
​ ominant strategy​ for
Anil.
If dominant strategy exists for every player: ​dominant strategy equilibrium

- Prisoner’s dilemma
A game with a dominant strategy equilibrium Playing the dominant strategy
yields lower individual and total payoffs compared to other strategies.

Why can we predict this outcome?

(1) Players care about their own payoffs only
(2) Nobody could make players pay for the consequences of their actions on
others
(3) Players could not coordinate their actions beforehand

Altruistic preferences​: People care about the well-being of others (for some reason or
the other)
Chapte: 4.6 to 4.8 of the textbook.Lecture 4: Public Goods
Elinor Ostrom

Social preferences

Inequality aversion:​ Disliking outcomes in which some individuals receive more than
others R
​ eciprocity:​ Being kind/helpful to others who are kind/helpful, and vice versa

We evaluate whether others have been ‘kind’ or ‘helpful’ according to ​social norms
(common understanding of how to act in situations when one’s actions affect others).

Learning about preferences

1. Lab experiments:
• Can control available actions and outcomes.
• Can create a control/treatment group for comparison.
• Results can be replicated.
• Can control for other variables.

2. Field experiments (Randomized Control Trials):

• More realistic context than lab experiments
• More expensive/complicated to design
• Potentially more confounding factors

3. Natural/Social experiments:
• Real-world observations that look like a designed experiment
• Even more realistic but very rare

Public goods
We can distinguish the following characteristics in a public good
- Non-rival
- Impossibility of exclusion

Private benefits​ of contribution are ​lower​ than ​private cos​t of contribution, this
generates makes being a f​ ree rider​ (not contributing) a​ dominant strategy

Repeated Games

Better outcomes​ can arise in repeated interactions due to s

​ ocial norms, reciprocity, and
peer punishment.
 - Behaving selfishly​ in one period has consequences in future periods, so it may
no longer ​be a d
​ ominant strategy

Repetition, Reciprocity, and Social Norms Peer Punishment

Contributions differ according t​ o social ​The ability to identify and punish

norms free-riders also increases individual
contributions.
Lecture 5: remainder of chapter 4, Figure 4.13.

Actions and Strategies Revisited

Negotiations​: When there is a social dilemma, people may sit and talk. So we need to
understand the negotiation process.

- A sequential game where players choose how to divide up economic rents, The
proposer’s offer may be motivated by altruism, fairness (50-50 split), inequality
aversion, social norms, or reciprocity...

Proposer: t​ he one who makes the offer

Responder​: the one who takes/leaves the offer
Action:​ The player’s (observable) move
Strategy:​ A detailed plan of action (e.g. reject whenever offer is below some minimal
acceptable offer)

Sequential games
On which players choose how to act after the other player has already acted.
Sequential games are composed of subgames
- The entire sequential game is considered a subgame itself
- Additional subgames: whenever we can observe previous decisions
In sequential games the Nash equilibrium is called: subgame perfect Nash equilibrium
the player that starts has a benefit

Nash Equilibria

N​ash equilibrium:​ each individual plays best-response to the strategies

he/she expects others to use and expectations are correct.
- In a Nash equilibrium, no player has an incentive to deviate
unilaterally
- No player will want to change their strategy unilaterally. However, if another
player
changes strategies they will have to change to in order to play the most beneficial
strategy for them given the situation.

Every dominant strategy equilibrium is a Nash equilibrium (no one wants to change their
strategy), but not every Nash equilibrium is a dominant equilibrium strategy.
Nash equilibrium is when the dominant strategy for both is the same

When there is m
​ ore than 1 Nash equilibrium​ and individuals make their choices without
coordination, there is a good chance that the option selected is not the optimal one. And
since there is not really a method to solve the problem society could be stuck at a bad
place forever.

Summary
1. Social interactions can be modeled as ​games
● Players ​choose​ best responses t​ o others’ ​strategies
2. S
​ ocial dilemmas e​ .g. prisoner’s dilemma can be resolved by social preferences, peer
punishment, or binding agreements
● The rules of the game also matter for outcomes
3. Multiple Nash equilibria can cause coordination problems
● Economic and political institutions can help achieve socially optimal outcomes
Lecture 6: Economic Institutions
Chapter 5 of the textbook. Before the lecture, you should know what an allocation is.
Also, find out how, way back in the end of the 17th century, the rules for sharing
booty differed between a pirate ship like the Royal Rover and a ship of the royal navy
like the Favourite

Introduction

Institutions: t​ he rules of the game are often determined long before playing, they can
take many forms such as governments, laws, social norms, etc.

● Institutions determine how the decisions of players lead to who gets what: t​he
allocation.

To evaluate these allocations we use the ​Pareto-efficiency condition​ and ​fairness

criteria

Evaluating outcomes

Pareto Efficiency: ​this allocation takes place if nobody can be better off without making
somebody worse off. This criteria does not help us choose among the allocations. Pareto
efficiency is unrelated to fairness. Many allocations that could be unfair are Pareto efficient

Pareto dominant​: an allocation where the outcome is better than in other allocation

- (​ I,I) ​Pareto-dominates​ (T,T); ​because it has a better outcome.

- (I,I), (I,T),​ and​ (T,I) ​are all Pareto efficient, we cannot tell which is better, there is
no pareto dominant.
Fairness: ​Evaluate the rules of the game as well as the outcome.Allocations can be
considered unfair for two reasons:
● Substantive judgement of fairness: ​ Inequality of outcome (e.g. wealth,
well-being)
● Procedural judgement of fairness:​ How they came about (e.g. force vs. fair play,
equal opportunity, conforming to social norms)

Fairness and Economics​ Economics does not provide judgements about what is fair,
they look for Pareto efficiency.
But economics can clarify:
- How institutions (rules of the game) affect inequality
- Tradeoffs in the fairness of outcomes e.g. giving up equality of income for
equality of opportunity
- Which public policies can address unfairness, how can they do it, and what are
the consequences.

Determining allocations

We can find different allocations such as G , E, F,

that imply distinct outcomes. Angela would prefer
F than G, as well as Bruno would prefer G rather
than E so all that allocations are pareto efficient
because there is no dominant one.

Feasible allocations
● T ​ echnically feasible outcomes ​(limited by
technology).
● biological survival constraint ​shows the
biologically feasible outcomes (limited by
survival).
Coercion: Imposing Allocations by Force

Bruno can enforce any allocation he wants,the allocation that maximises his economic
rent is where the slope of the biological constraint (MRS) equals the slope of the feasible
frontier (MRT). MRS = MRT

Voluntary exchange: Bargaining

How parties divide up the joint surplus (mutual
gains) depends on:
1. Each party’s reservation option
2. The relative bargaining power between the
parties

The economically feasible set shows all possible

allocations that benefit both parties.

Coercion vs. Bargaining

● Under​ coercion​, the allocation chosen is where the slope of the​ biological
constraint equals the slope of the feasible frontier.

● Without​ coercion, joint surplus is maximized where the slope of the ​reservation
indifference curve equals that of the feasible frontier​.

The Pareto Efficiency Curve:​ the set of all Pareto

efficient allocations (C, G D..)(also called the
contract curve). (​ orange line)
 - Joins together all points in the feasible set where​ MRS = MRT.
- The ​joint surplus ​is the s
​ ame​, but the ​distribution of the surplus​ differs at
each point on the curve.

The allocation chosen will be on the Pareto efficiency curve (line CD).
- At C, Angela gets all the surplus.
- At D, Bruno gets all the surplus.
- In any other point on the curve, Angela and Bruno split the surplus, and each
received a rent. (G)

Institutions and policies: Legislation

Institutions and policies affect the size
of the surplus and its distribution

- Example: A law that limits

working hours and payments to
landlords (IC2) gives Angela a
better reservation value.

- But: If circumvention by Angela

(C) not allowed => loss in
efficiency (E)

Technology and biology determine which allocations are technically feasible. •

Institutions and policies help determine which allocations are economically feasible
(Pareto-improving). • The allocation chosen depends on parties’ preferences (what they
want) and their bargaining power (their ability to get it).