Introduction to Economics ALL UNITS

Evidence people care about inequality

• Dictator Game

• Public Goods Game

• MRI (2010)

• Possible reasons

  • signalling to others we are prosocial

  • reciprocity preference

  • fear that inequality leads to bad social consequences

• Probably evolutionary process → human survival

Inequality

Occurs when there’s a difference between groups of individuals on one or more dimensions (height, income, food)

inequality ≠ inequity

inequity when inequality is deemend inequitable (unfair, unjust)

inequity → inequality

inequality is necessary, but not sufficient for inequity

• ex. grades in class

relative view

inequality is about proportional differences between incomes

• T10/B50

Implications: global inequality decreased in the world since 1980’s because income ratios between rich and poor have fallen, even though everyone got richer

absolute view

inequality is about absolute income gaps

• T10-B50

Implications: global inequality has increased over the past 40 years, because the absolute income gap has grown

3 measures of inequality

1. Income share ratios

2. Income gap

3. Gini coefficient derived from the Lorenz Curve

Lorenz Curve

plots the share of total income held by the poorest percent of the population

• the lower the curve, the more unequal distribution

• 45* = perfect equality

Limited/incomplete view from focusing only on income inequality

people find inequalities from circumstances UNFAIR, and from ambition FAIR

• Income is only one dimension of inequality

  • Wealth

    • wealth > income

  • Health

  • Education

  • Life chances

  • Opportunities

  • Access to public goods and services

GDP =

market value of the output of final goods and services in the economy in a given period

GDP as informative

high GPD = high production, correlation with other measures of wellbeing

GDP as incomplete

inequality + natural resources + free time + household activities

Malthusian theory

low living standards → technology improves → avg. output per farmer improves → population rises → less land per farmer → avg. output per farmer falls → larger population but living standards come back to the original level

Malthus stance

improvements in technology will not raise living standards in long term

Economic system

way of organizing the production and distribution of goods and services in an entire economy

Capitalism

PRIVATE PROPERTY | MARKETS | FIRMS

Private property

you can… enjoy however you choose, exclude others, dispose by selling or gifting

Markets

way of connecting the people for exchanging/transferring of goods and services

Firms

way of organizing production one or more people owning a set of capital goods that are used in production. Firms pay wages, they sell their goods in an intention of making a profit

Capitalism accelerates technological progress

competition, adoption, development

Capitalism accelerates specialization

allows production on large scale, more productivity

Capitalism accelerates flexibility

firms can be born, expand, die

Capitalism & industrial revolution

Capitalism emerged at the same time, or just before the industrial revolution

Rational individual

Has to make a tradeoff between free time and consumption. Makes decisions under scarcity and to maximalise their utility.

individuals make choices to maximize their utility given constraints such as income, time, and prices. This is a simplifying assumption that allows us to build models and analyze behavior under scarcity

Budget constraint

all combinations of goods and services that can be acquired using the entire budget

Indifference curves

all combinations of goods and services that provide a given utility to the individual

Optimal choice

combination of free time and consumption which gives the highest utility within the feasible set (all combinations of goods and services that can be acquired using the all or part of the budget)

Income effect

MORE FREE TIME CHOSEN change in income → expansion of feasible set you are richer, you can consume more

Substitution effect

LESS FREE TIME CHOSEN change in price → change in opportunity cost you consume more, you have less free time as OC is higher

Decrease in working hours in 20th cenury

• share of income by the rich → increase

• lavish consumption of the rich → higher bar of standard for anyone else

• people higher value on the goods their wages can buy to fit in

• conspicuous consumption

• working more to afford more expensive goods

Empirical test: avg. annual working hours vs. % share of money of the top 1%

Conspicious consumption

Social status, Velben effect, working more as you the rich is getting richer and you want to be like rich so you are more likely to pay more for services and goods

Gender pay gap

• unpaid work

• constraints from unpaid work

• allocation of better paid man work to men

• culture expectations

Social dilemmas

actions taken by individuals in the pursuit of their own benefis leave everyone worse off comparing to if everybody would cooperate

Private solutions to social dilemmas

• Altruism → social preference in which individual’s utility is increased by benefits to others. Inequality aversion meaning preference for fairness.

• Repeated interactions → individuals cooperating now to incentivise other’s behaviour tomorrow. Repeated prisoners dilemma = 50% more cooperation probability from players

• Social norms → shared understanding of a community about how people should behave. Trust and reciprocity > social exclusion, disapproval. Eleanor Ostern → rules and social norms impacting sustainable use and maintenance of common property resources

Governmental solutions to social dilemmas

• Government policies

  • regulation → eg. fishing quotas, pollution limits

  • legal constraints and standards → prohibiting harmful actions

  • punishment and enforcement → fines and penalties, discouraging free-riding

• International agreements

  • eg. climate change

  • individual governmental actions are not enough

  • reaching outcomes better than the non-cooperative nash equilibriums

  • difficulty in realisation

Pareto criterion

test or rule for judging changes: a change is a Pareto improvement if it makes someone better off and no one worse off, thus increasing social welfare.

Pareto efficiency

• no one can be made better off without making someone else worse off; it's the outcome or condition achieved when all Pareto improvements are exhausted.

• an allocation that is not pareto dominated by any other allocation

• there is no allocation in which at least one party is better off without making nobody worse off

accounting profit

only includes direct payments in the total cost

economic profit

includes direct payments, and the opportunity cost

economic profit > accounting profit

Numerical example of economic vs. accounting profit

giving up the job for a startup = 100k lost each year

if you don’t choose to invest = 5k each year lost

economies of scale

when the avg. cost decreases with the quantity produced

causes: technological improvements, cost advantages

firm with market power

• they have a downward sloping demand

• the ability to set a high price without loosing all customers to competitors

causes of market power

• perception of a unique, special product by the customers

• firms using marketing/advertising

• technological advancements

• economies of scale as it is cheaper to produce the product anyway

downward-sloping demand curve

• to sell more units (one more unit), the company needs to lower the price of all units sold

elasticity of demand

• measure of responsiveness of customers to a price change

• demand = elastic → MR positive, increases when output increases

  • >1

• demand = inelastic MR negative, decreases when output decreases

  • <1

consumer surplus

Willingness to pay - Price they actually pay

producer surplus

Price they get per each unit sold - Marginal Cost of each unit

• it ignores the Fixed Costs

  • when FC are high, the Producer Surplus might be high, while the Profit is low

total surplus

• total welfare

Maximalization of gains from trade

• efficient allocation

• total surplus maximized

• all transactions for which WTP>MC

• caveats

  • not take into account the fairness, monetary gains don’t mean the same for everyone

why firm with market power chooses to produce less than the quantity that maximizes gains from trade?

• profit maximization doesn’t mean maximization of gains from trade

• (max. gains from trade = WTP> MC)

• firms want to maximize their own profit, not the total economic welfare

• a firm chooses the quantity at the intersection between MR and MC

Deadweight loss

• loss of total surplus because of the choice that a firm with market power is making

• monopoly: loss of total surplus caused by producing less than the efficient quantity. It represents the mutually beneficial trades that do not occur because the monopolist restricts the output to keep prices above the MC

oligopolistic markets

• decision of one firm impacts the other firms

• small number of firms in a market

public policies towards firms with market power

• competition policy

  • as firms with market powers are not pareto efficient and have DWL

  • EU at EU and national level encourages efficiency

• competition authorities

• the government being the monopoly

Economic theory = competitive markets are (pareto) efficient

• when there is pareto efficiency (S&D cross)

  • gains from trade are maximized

• gains from trade are measured by the surplus obtained by buyers and sellers

• pareto efficiency → resources are optimally allocated

• conditions for the efficiency

  • many buyers and sellers

  • buyers and sellers have no market power

  • market is at equilibrium

  • trade in the market has no external effects

• even if efficient, not necessarily fair

• in non-competetive markets, there is DWL because they stop production at a point where P>MC

decrease in demand causes

• decrease in consumer income

• negative change in consumer perception of benefits of the product

• a decrease of price of a substitute good

• shift to the left on the demand = price go lower

increase in supply causes

• cheaper inputs

• better technology

• rise in the price

• shift to the left of the supply

tax effect

consumers

• demand to the left

producers

• supply to the left

total surplus

• total surplus falls, welfare is lower

• there is DWL

• prevent buyers and sellers to make mutually beneficial trade

• effects are the same on price

• enchance the wellbeing of the population

subsidy effect

consumers

• demand goes right

• pay more money

producers

• supply goes left

• recieve more money but costs more to produce due to demand going up

total welfare

• increase of number of transactions → welfare losses

  • quantity increases beyond the efficient level.

• effects are the same on quantity sold

assuming there are no + or - externalities

negative externalities

when the impact on the bystanders is adverse

negative production externalities

noise, inadequate safety measures, deforestation

the marginal cost of production doesn’t take into the account the other costs because its not the products that get affected

negative consumption externalities

heating/travelling → Co2, plastic bags → waste

markets failure

when firms don’t maximize gains from trade

market failure in presence of negative externalities

cost of producing the good for the society + direct production cost

the optimum = social cost with the demand

(new disturbed “equilibrium”)

the equilibrium = supply with the demand

solutions to market failure in presence of negative externalities

• private, coesian barganing

  • government interventions (regulation, taxation)

positive externalities

when the impact on the bystanders is beneficial

positive production externalities

beekeeper’s bees pollinating nearby, Research & Design

positive consumption externalities examples

vaccination, education, security systems

market failure in presence of positive externalities

the social benefit is higher than the private profit

consumers don’t take into account these other benefits

the optimum = social benefits with the supply

(new disturbed “equilibrium”)

the equilibrium = supply with the demand

solutions to market failure in presence of positive externalities

• subsidies → it would not create DWL

• patents → firms enjoying monopoly → more profit

GDP

The monetary value of all final goods produced by an economy in a given time period

GDP measurements

• Output → value added

• Income → wages, profits

• Expenditure → changes in inventories, gov. expenditures, intl. trade

GDP = C + I + II + G + (X-M)

• C → by household on consumer goods and services

• I → gov. investment in: bachinery, buildings, housing

• II → firms on changes in inventories

• G → gov. on goods and services

• X → exports

• M → imports

GDP does not include

leisure time, quality of social and physical environment, inequality, depletion of resources, household or volunteer work

Purchasing Power Parity

• to compare various countries → expression in the same currency

  • using PPP exchange rate

PPP exchange rate

rate at which the currency of one country would have to be converted into that of another to purchase the same amount of goods and services in each country

nominal GDP

good’s prices sold in year T are multiplied by quantities sold in year T

• princes and quantities in the same year

• current prices

real GDP

1. estimate the nominal GDP

2. pick a base year

• analysis of GDP growth across years across countries

• adjusts for inflation thus the base-year

nominal GDP

actual amount of money in a given currency received by worker as a payment for work

Consumer Price Index

metric tracking the total price of shopping basket containing goods&services commonly purchased by goods

Recession

significant decline in economic activity that is spread across the economy and that lasts for more than a few months

Central Bank

manages the money supply and interests rates

Monetary Policies

how a country’s bank manages the money supply and interest rates to influence the economy

Expansionary monetary policies

• have a positive effect on GDP

• Tend to decrease unemployment and/or increase wages through a higher demand for labour

• Policies used during economic downs or recessions

• decrease in interest rates

Expansionary monetary policy example from the European Central Bank

Interest rate historically low during COVID-19

• easier for people and companies to borrow money supporting spending and investment

• Additionally:

  • Bought bonds from private banks → more funds for banks to lend to businesses and households

  • Bought bonds from the companies → additional source of profit

  • Make it easier for the banks to borrow from the ECB

Fiscal policies

How government uses spending and taxation to influence the economy

Expansionary fiscal policies

increasing government spending or decreasing taxes

Example of expansionary fiscal policy

Fiscal stimulus packages like COVID-19

• increased investments in R&D, innovation, infrastructure, digitalisation, climate

• + public expenditure + investment + consumption = job creation

• Additionally:

  • job training and upskilling

  • job search assistance

  • subsidized employment

  • unemployment benefits

Inflation

general increase of prices in an economy

Contractionary monetary policies

• have a negative impact on the GDP

• tend to increase unemployment and/or lower wages

• Decrease in demand for labour

• Tend to slow down the inflation

Example of contractionary monetary policies by European Central Bank

• Before 09’/09’ economic crisis → strong economic growth in Europe, prices were rising

• ECB increased interest rates several times between 2005-2008