Welcome to First Year Economics

• 1^st Semester – Introduction and Microeconomics
• Block 1 – (Textbook: The Economy by the CORE Team)
• Block 2 – (Textbook: Economics by Begg et al)

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• 2^nd Semester - Macroeconomics
• Block 1 – (Textbook: Economics by Begg et al)
• Block 2 – (Textbook: The Economy by the CORE Team)

1

Issues to be covered in the first Block

• Week 1 (Introduction to Economics)
• The Capitalist Revolution
• Technology, Population, and Growth
• Week 2 (Introduction to Economics)
• Economic Inequality
• Measuring Economic Inequality
• Week 3 (Microeconomics)
• Scarcity, Work, and Choice
• Week 4 (Microeconomics)
• Social Interactions
• Week 5 (Microeconomics)
• Property and Power: Mutual Gains and Conflict
• Week 6 (Microeconomics)
• The Firm: Owners, Managers, and Employees

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2

Work to be done in Block 1

• Weekly lectures
• Weekly Tutorials
• Tutorial Test
• Formal Test

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• Exam (after Block 2 is completed covering material from Block 1 and Block 2)

3

Background

• These lecture slides are available on the Wits Ulwazi Site as well as on my website at www.kennethcreamer.co.za
• The lectures for Week 1 are drawn from parts of Chapters 1 and 2 of Core’s The Economy
• Core’s The Economy is available free of charge online at www.core-econ.org (on your phone, tablet or computer).
• Read more about how the international Core initiative changing the way that economics is taught
• For a global picture look up CORE Project on Wikipedia at:

https://en.wikipedia.org/wiki/CORE_Project

• For an update on developments in SA read an article on The Conversation at:

https://theconversation.com/south-africa-joins-global-charge-to-overhaul-undergraduate-economics-108267

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Navigation

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https://www.core-econ.org/

Read the book online

Download the app or ePub

• The website offers multimedia with video link, MCQ’s and links to data sources.
• A text-book published by OUP
• Download an Android App or a Windows App version for offline reading
• In SA Apple users cannot access the app / book so an ePub version can also be downloaded at www.core-econ.org for offline reading

ECONOMIC THEORY WEEK 1

The Capitalist Revolution

Technology, Population & Economic Growth

Outline of Week 1 Lectures

• These lectures cover unit 1 and unit 2 of “The Economy” textbook
• Part one:
• Capitalism and the hockey stick
• What caused the industrial revolution?
• What is Gross Domestic Product?
• Capitalism, inequality and the environment
• Part two
• Economics and models
• Modelling the choice of technology to explain the industrial revolution
• The Malthusian model
• Markets, governments and varieties of capitalism

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What is Economics?

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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

• How we come to acquire the things that make up our livelihood: Things like food, clothing, shelter, or free time.
• How we interact with each other: Either as buyers and sellers, employees or employers, citizens and public officials, parents, children and other family members.
• How we interact with our natural environment: From breathing, to extracting raw materials from the earth.
• How each of these changes over time
• Definitions:
• Alfred Marshall (1890) “Economics is a study of mankind in the ordinary business of life”
• Economics is derived from Greek for “Household Management”

Capitalism and the hockey-stick

The hockey stick of history

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There are many hockey sticks!

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Living standards

Labour productivity

Global connectivity

Pollution

What explains the hockey stick?

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?

The capitalist revolution

• 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.
• Under this new way of organizing the economy, advances in technology and specialization in products and tasks raised the amount that could be produced in a day’s work.
• This process, which we call the capitalist revolution, has been accompanied by unprecedented global economic inequalities and by growing threats to our natural environment

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What is Capitalism?

• Capitalism is an economic system characterised by a particular combination of institutions.
• An economic system is a way of organising the production and distribution of goods and services in an entire economy
• Institutions are the laws and social customs that regulate economic relationships in and between families, business and government.
• The combination of institutions that are important in capitalism are:
• Private property
• Market exchange
• Production by firms
• “Free” labour

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Private property

• Private property means you can:
• Enjoy your possessions in a way that you choose
• Exclude others from their use if you wish
• Dispose of them (i.e. hand over ownership to someone else)
• Private ownership is always regulated – it is an institution subject to laws and social conventions like any other.
• Particularly important is the private ownership of property used in production – e.g. capital equipment, land, raw materials, intellectual property – and the output of the production process (i.e. goods and services)

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Markets

• Markets are a way of connecting people who may mutually benefit by exchanging goods and services through buying and selling.
• Market exchange is reciprocal and voluntary: This guarantees mutual benefit.
• Markets mean competition: a seller buying a high price will find that buyers prefer to buy form other competing sellers.
• Markets also enable cooperation: anonymous, decentralised individuals can participate in complex production process.

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Firms

• A firm is a way of organising production with the following characteristics:
• One or more individuals own capital goods that are used in production
• They pay wages and salaries to employees and direct them in the production of goods and services
• The output produced are the property of the owners, which they sell on the market in order to make profit
• A firm is an organisation through which private owners employ others to produce output.
• Firms can be born, expand, contract and die. They can hire additional employees, attract capital for expansion, or go bankrupt and close down.
• There are other types of economic organisation in a capitalist economy: family businesses, non-profits, employee-owned cooperatives and government entities. These are not firms.

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“Free labour” and the capitalist labour market

• In order for firms to operate, labour must be sold on the market – i.e. through a voluntary and reciprocal exchange.
• Before capitalism:
• there were many forms of ‘unfree’ labour (e.g Slavery in the Roman empire, or serfdom in feudal Europe).
• Family labour was also important for production.
• It was common for workers or families to own or have access to land, capital and raw materials – e.g. farmers operating on common land with her own ploughs and cows.
• The creation of a capitalist labour market means ‘freedom’ for labour in two senses: (a) voluntary/reciprocal exchange of labour for wages and

(b) “free” from ownership or access to the means to sustain an independent livelihood.

• The emergence of capitalism also coincided with the intensification of unfree labour in the form of the Atlantic slave trade – but as capitalism developed, unfree forms of labour were abolished.

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Why is capitalism is dynamic?

• Firms can expand or contract
• If the firm fails to generate profit it can be destroyed.
• Firms that are more profitable than their competitors expand.
• Factors of production (i.e. labour and capital) can be shifted towards the most productive or profitable enterprises
• It concentrates power in the hands of owners who direct the process of production
• Firms face competition in decentralised markets
• Innovation is rewarded, but if competition functions properly the rewards are soon dissipated by competition (e.g. an iPhone)
• It has proven to be a dynamic system characterised by:
• Permanent (or continuous) technological revolution.
• Increasing specialisation: Growing markets enable increased productivity thorough “learning by doing”, the concentration of skills and exploiting economies of scale.

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The communist manifesto (1848)

“The bourgeoisie cannot exist without constantly revolutionising the instruments of production, and thereby the relations of production, and with them the whole relations of society.

Conservation of the old modes of production in unaltered form, was, on the contrary, the first condition of existence for all earlier industrial classes.

Constant revolutionising of production, uninterrupted disturbance of all social conditions, everlasting uncertainty and agitation distinguish the bourgeois epoch from all earlier ones.

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Constant revolutionising of production, uninterrupted disturbance of all social conditions, everlasting uncertainty and agitation distinguish the bourgeois epoch from all earlier ones….

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All that is solid melts into air, all that is holy is profaned, and man is at last compelled to face with sober senses his real conditions of life, and his relations with his kind.”

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Measuring livings standards with �Gross Domestic Product

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What does the hockey stick graph show?

• The hockey stick graph was used to represent living standards and show how they suddenly increased.

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• In more technical terms it is:

�real gross domestic product per capita on a PPP basis

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• But what does this graph actually measure?
• It shows a measure of the total goods and services produced in a country (called gross domestic product ) which is then divided by the country’s population.

Gross Domestic Product (GDP)

• GDP measures the market value of the output of goods and services of the economy in a given period (usually one year but often in one quarter)
• GDP ‘adds up everything from nails to toothbrushes, tractors, shoes, haircuts, management consultancy, street cleaning, yoga teaching, plates, bandages, books, and the millions of other services and products in the economy’. (Dianne Coyle)
• How can you add up all these different things to get a measure of output?

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Market prices

• If all these qualitatively different things are exchanged in a market, it is possible to compare them with a common quantity – money!
• Economists use the prices of these items multiplied by the quantity produced (i.e. the volume) to calculate the total market value of production.
• Remember, market exchange is always reciprocal. So, the market price paid for all goods and services is the same as the income received by those producing the goods and services.
• Therefore, by using the market exchange, the value of production corresponds to the total income of everyone in the country.

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GDP = OUTPUT = INCOME

OUTPUT: the value of production sold on the market

INCOME: The sum of all the wages, rents and profits

(all valued at market prices)

What is included and what is excluded?

• What about things of value that are produced but not exchanged on a market? For instance:
• Goods and services that we receive from government but do not buy, such as healthcare, education, policing or defence. (Remember taxes are not voluntary and government services are not reciprocal).
• The value housework mostly performed by women – childcare, cooking, cleaning, which are essential to maintain and reproduced labour.
• Mainly as a matter of statistical convenience government services are included in GDP statistics, but housework is not.
• Government services are valued at the price government pays for them, mainly the salaries of public servants.
• There are many other valuable things in life that are consumed but not produced - the quality of our natural environment, clean air etc. The consumption these things are not included in GDP.
• There still other things that are valuable and important to the quality of life, but which are not counted in GDP: the quality of education or health, culture, language, social life or friends.

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Bobby Kennedy (1968)

“Our Gross National Product … counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage.

It counts special locks for our doors and the jails for the people who break them. It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl.

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It counts napalm and counts nuclear warheads and armoured cars for the police to fight the riots in our cities. It counts Whitman's rifle and Speck's knife, and the television programs which glorify violence in order to sell toys to our children.

Yet the gross national product does not allow for the health of our children, the quality of their education or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials.

It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything in short, except that which makes life worthwhile.”

Nominal GDP vs Real GDP

• “Nominal” generally means in money terms.
• Nominal GDP is calculated like this:

Nominal GDP = (price of a phone)×(number of phones sold)

+ (price of a book)×(number of books sold)

+ (price of … )×(number sold) …

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• Which can be written as:

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• Where p is price, q is quantity (or volume), i is an index number representing a commodity and n is the number of commodities in the economy.

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How do we measure the change in GDP?

• Lets say in year 1 an economy produces 10 phones and 20 books, a phone costs R5,000 and a book costs R200:

NGDP = (10 x R5 000) + (20 x R200)

= R50 000 + R4 000

= R54 000

• In year 2, the economy still produces 10 phones and 20 books, but the price of books increases to 400:

NGDP = (10 x R5 000) + (20 x R400)

= R50 000 + R8 000

= R58 000

• Nominal GDP has increased.
• This is important to know. But it has limits. What if the price of everything doubles?: everybody's income has also doubled (because output = income). Then nothing real has changed?
• But the volume of output is unchanged. The economy is still producing 10 phones and 20 books. In other words Real GDP has not changed!

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Real GDP

• In order to calculate the change in the volume of production, we adjust nominal GDP to eliminate the change in prices in order to get Real GDP.
• To track what is happening to real GDP
• Select a base year: for example, the year 2010.
• The following year, nominal GDP for 2011 is calculated as usual using the prices prevailing in 2011.
• Next, multiplying the 2011 quantities by their prices in 2010
• So using the previous example, multiply the number of books produced in 2011 by the price of books in 2010.
• Using the base year prices:
• If GDP has gone up, we can infer that Real GDP has increased.
• If GDP has not changed it means the overall quantity of output of goods and services has not changed
• Real GDP can also be referred to as GDP at “constant prices”. Nominal GDP is valued at “current prices”

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Calculating real GDP is easier said than done

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Using PPP to compare GDP across countries

• When comparing living standards across countries, we use estimates of GDP per capita in a common set of prices known as purchasing power parity (PPP).
• Why not simply use the exchange rate? i.e. divide South Africa’s nominal GDP by 15 (based on on exchange rate of R/$15.00) and compare the result with USA’s GDP.
• The problem with comparing GDP at market exchange rates is that prices are different in different countries. Prices of certain goods and services are typically lower in poorer countries (and higher in richer countries).
• The key reason for this is that productivity and wages are higher in richer countries, which translates into higher prices. For products that are traded across borders, prices tend to be equalized – but for products that are “non-traded” (i.e. not exported, such as housing, services, haircuts, etc.) prices diverge.
• See the BIG MAC Index (2013) – which is used to indicate that in USD hamburgers are cheaper in South Africa (USD2.45) than in the US (USD4.20). In SA USD100 buys 40 burgers and in the USA 23 burgers. In comparing GDP’s in SA and the USA, taking into account PPP adjusts for this price difference by valuing burgers (and other products) the same in both countries.
• So if you increase the price of burgers in SA to USD4.20 (as well as other traded good to USA price levels) - effectively the PPP GDP for SA will be adjusted upwards.

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Cost of Living

• R:$ ≈ 14
• You would need around 109,710.72R (7,815.52$) in New York, NY to maintain the same standard of life that you can have with 36,000.00R in Johannesburg (assuming you rent in both cities).

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Using PPP to compare GDP across countries

• If you don’t take into account that the prices of many items are lower in SA than the US, and simply divide SA’s GDP by 15 to find out the value of SA’s GDP in US dollars, you will understate the true value of the output that South Africa produces.
• Rather to compare GDP’s you must use a common set of prices known as purchasing power parity (PPP) prices.
• To compare GDP’s of SA and the USA:
• you take South Africa’s GDP divide by 15 to get a USD value
• you adjust the USD value of SA’s GDP by increasing the value of SA’s non-tradable items based on common purchasing power parity (PPP) prices
• this has the effect of increasing the estimated size of South Africa’s GDP so that a true comparison can be made
• This process gives you the SA GDP in USD adjusted for PPP

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So now we know!

• This simply means dividing GDP by the population. Then you get GDP per person.
• This gives us a measure of the average income of the person.
• China’s GDP is vastly larger than South Africa. On a PPP basis

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• Real gross domestic product per capita on a PPP basis
• The only part we’ve left out is “per capita”

GDP Growth

• By the growth rate of GDP or income we mean the rate of change of GDP or income

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• For example in Uganda nominal GDP was USD25.8bn in 2013 and USD27.9bn in 2014.
• So nominal GDP growth over the previous year was

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Using ratio scales to compare rates of growth

• If there is a steady 100% growth rate over 100 year periods:
• Over period 1 GDP per capita grows from USD500 to USD1000
• Over period 2 GDP per capita grows from USD1000 to USD2000
• Over period 3 GDP per capita grows from USD2000 to USD4000
• Over period 4 GDP per capita grows from USD4000 to USD8000
• The growth rate is constant: 100% in every period
• But the absolute value of the increase in GDP is increasing: 500, 1000, 2000, 4000
• If the curve is a straight line (with a constant slope) there is a steady rate of growth (of 100% per each 100 year period)
• If the curve is bending upwards (with an increasing slope) there is an accelerating rate of growth (of over 100% per each 100 year period

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Ratio scales

Whether we want to use a ratio or normal scale depends on the question we are thinking about.

Remember that the underlying data (i.e. the numbers we are looking at) is exactly the same in both graphs – its just the vertical axis that has changed.

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(a) Normal scale

(a) Ratio scale

Normal scale

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The normal scale makes it easier to compare the absolute levels of GDP per capita at different times in history:

We can easily see from that China’s GDP per capita today is about $12 000; Japan’s is about double this at around $24 0000

Ratio scale

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• Its easier to compare growth rates in different periods (the slope of the curve tells us the rate of growth), and the timing growth accelerations or decelerations.
• Also, because the data is more dispersed, it is easier to see that:
• China was once wealthier than Britain
• Indian GDP per capita declined while under British colonial rule

What caused the industrial revolution?

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Overview: Technology, population, and growth

• Economic models help explain the Industrial Revolution, and why it started in Britain in the Nineteenth Century
• Wages, the cost of machinery, and other relative prices all matter when people make economic decisions.
• In a capitalist economy, innovation creates temporary rewards for the innovator, which provide incentives for improvements in technology that reduce costs.
• These rewards are destroyed by competition once the innovation diffuses throughout the economy.
• Population, the productivity of labour, and living standards may interact to produce a vicious circle of economic stagnation.
• The permanent technological revolution associated with capitalism allowed some countries to make a transition to sustained growth in living standards.

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A history of the technology of lighting

• Technological progress in lighting Is measured by how many units of brightness called lumens could be generated by an hour of work. [NB: labour productivity is output per unit of labour input, or average product of labour]
• One lumen-hour is approximately the amount of brightness in a square metre of moonlight lasting for hour.
• Light by a campfire: One hour of labour to produce 17 lm-h
• Animal fat lamps (40 000 years ago): 20 lm-hr / one hour of labour
• Improved sesame oil lamps (about 4,000 years ago): The Babylonians invented lamps that created 24 lm-hr / one hour of labour
• Tallow candles (200 years ago): nine times as much light for an hour of labour as had the animal fat lamps of the past.
• Since then lighting has become more and more efficient with the development of town gas lamps, kerosene lamps, filament bulbs, fluorescent bulbs and other forms of lighting.
• Compact fluorescent bulbs (1992) are about 45,000 times more efficient, in terms of labour time expended, than lights were 200 years ago.
• Today the productivity of labour in producing light is half a million times greater than it was among our ancestors around their campfire.

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Productivity of labour in the production of light

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Zooming in

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The industrial revolution

• Technology: Not a thing, but a process (or recipe) that uses particular inputs (i.e. things) 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.
• The capitalist economic system was brought into being in the course of an industrial revolution which began in Britain in the 1700s and then spread across Europe and the world.
• The Industrial Revolution: A wave of technological and organisational changes starting in Britain in the eighteenth century, which transformed an agrarian and craft-based economy into a commercial and industrial economy.

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New technology in the Industrial revolution

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But why?

• But why did it happen?
• Why did it happen when it did? In the 1800s
• Why did it happen where it did? In Britain
• Later on we will introduce an economic model which focusses the explanation on the impact of relative prices on the choice of technology.
• However, this is one explanation, others have emphasised difference elements in the story.

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It’s science and technology…

• Joel Mokyr, claims that the real sources of technological change are to be found in Europe’s scientific revolution, and the “free thinking” environment created by the Enlightenment.
• For Mokyr, the Enlightenment brought the development of new ways to transfer and transform scientific knowledge into technology that could be used by engineers and skilled artisans to build the machines of that time.

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It’s about political and cultural institutions …

• David Landes, a historian, emphasizes the political and cultural institutions and characteristics of nations as a whole (as opposed Mokyr, who focuses on artisans and entrepreneurs).
• He suggests European countries pulled ahead of China because the Chinese state was too powerful and stifled innovation, and because Chinese culture at the time favoured stability over change.
• Read Gavin Menzies “1421 The Year China discovered the world” which records how the rulers of China decided to scupper their fleet and cease global exploration after they had rounded the Cape decades before Vasco Da Gama in 1497

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It’s about hard work and savings…

• Gregory Clark, an economic historian, also attributes Britain’s take-off to culture. But for Clark, the keys to success were cultural attributes such as hard work and savings, which were passed on to future generations.
• Clark’s argument follows a long tradition that includes the sociologist Max Weber, who saw the Protestant countries of northern Europe, where the Industrial Revolution began, as the particular home of virtues associated with the ‘spirit of capitalism’.

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Its about cheap coal, colonialism and slavery….

• Kenneth Pomeranz, a historian, claims that superior European growth after 1800 was more due to the abundance of coal in Britain than to any cultural or institutional differences with other countries.
• Pomeranz also argues that Britain’s access to agricultural production, produced by slave labour, in its New World colonies (especially sugar and its by-products) fed at low cost the expanding class of industrial workers, thus helping them to escape the Malthusian trap.

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Atlantic Triangular Slave Trade

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• Enslaved people to the America’s (to work on cheap food production)
• Cheap raw materials to Europe from the America’s (stimulating economic growth and growth in manufactured outputs)
• Cheap rum and manufactured to Africa (to trade for enslaved people)

Its about relative prices

Relative to other countries, wages in Britain rose from 1600 and 1700 so there was an incentive for firms to adopt labour-saving technologies.

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The relative prices of labour, energy and capital can help to explain why the labour-saving technologies of the Industrial Revolution were first adopted in England (rather than in other countries).

The relative price of labour was high in Britain

• Wages relative to the cost of energy were high in England, both because English wages were higher than wages elsewhere, and because coal was cheaper in coal-rich Britain than in the other countries
• Labour was more expensive relative to the cost of energy in England and the Netherlands than in France (Paris and Strasbourg), and much more so than in China.

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The graphs shows the wages of building labourers divided by the price of 1 million BTU (British Thermal Units, a unit of energy equivalent to slightly more than 1,000 joules).

Modelling the choice of technology to explain the industrial revolution

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A question

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Is using capital (e.g. machines with the latest technology) more efficient than using human labour?

Economic models can help us think through difficult questions

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• What happens in an economy depends on the actions and interactions of millions of people.
• We use models to see the big picture.
• An effective model identifies the essential features of the economy that are relevant to the question we want to answer. Unimportant details that can be ignored.
• 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

Building a model

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• Capture the elements of the economy that we think matter for our question
• Describe how agents act, and how they interact with each other and the elements of the model
• Determine the outcomes of these actions (an equilibrium)
• Study what happens when conditions change

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• 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.

Key concepts and assumptions for our model

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• Ceteris paribus: Simplification that involves "holding other things (in/outside the model) constant”. Less is more.
• Incentives matter: Economic rewards or punishments, which influence the benefits and costs of alternative courses of action.
• Relative prices matter The ratio of two prices (p_a/p_b) help us compare alternatives; This is more important that the absolute prices themselves.
• Economic rent: the benefit received from a choice, taking into account the next best alternative. When taking some action (call it action A) results in a greater benefit to yourself than the next best action, we say that you have received an economic rent.
• Decision rule:
• If action A would give you an economic rent (and nobody else would suffer): Do it!
• If you are already doing action A, and it earns you an economic rent: Carry on doing it!

Different technologies for producing 100m of cloth

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Suppose we ask an engineer to report on the technologies that are available to produce 100 metres of cloth, where the inputs are labour (number of workers, each working for a standard eight-hour day) and energy (tonnes of coal).

NB: Here we have reduced the idea of technology to different combinations of inputs

Some technologies are just plain better

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• Remember each technology produces the same amount of output (100m of cloth)
• Technology A dominates C (A uses less coal and fewer workers than C)
• Technology B dominates D (B uses less coal and fewer workers than D)

• On a purely technological basis, the firm can eliminate C and D
• But on what basis should it choose between A, B and E? Should it use the more labour-intensive technology E, or the capital-intensive technology A or something in between, like B?
• The answer is not about technology; it is about economy. The firm must evaluate the relative prices of labour and coal

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What about costs?

• The firm’s goal is to make profit. This means producing at least cost.
• The costs it faces are the wages of workers and the price of coal.
• The firm can calculate the cost of any combination of inputs (i.e. of any technology) by multiplying the number of workers by the wage and the tonnes of coal by the price of coal.
• Use the symbols

w for the wage, L for the number of workers

p for the price of coal and R for the tonnes of coal

• The total cost is given by: C =𝑤𝐿 + 𝑝𝑅

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Drawing iso-cost line

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Number of workers

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Tonnes of coal

Cost = £80

• “Iso” is Greek for “the same”
• Suppose that prices are fixed at w = £10 a day and p = £20 per tonne.

P₁ Cost = 2∙£10 + 3∙ £20 = £80

P₂ Cost = 6∙£10 + 1∙ £20 = £80

Joining P₁ and P₂ gives you an iso-cost line – the cost is £80 everywhere along this line.

NB:

The straight line is the line of the equation

C =𝑤𝐿 + 𝑝𝑅

Which can be rearranged as

R = (C/p) – (w/p)L

Where C/p is the vertical intercept and –(w/p) is the slope

If L = 2 R=(80/20)-(10/20)*2

R=3 (i.e. if cost is 80 and L = 2 then R =3)

An iso-cost family with the same relative prices �Slope is –(w/p) in R = (C/p) – (w/p)L i.e. -10/20 = -0.5

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Number of workers

1

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Tonnes of coal

Cost above £80

Cost = £80

Cost = £150

£40

w = £10 a day

p = £20 per tonne

c =𝑤𝐿 + 𝑝𝑅

£120

Bringing relative prices and technology together�

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w = £10 a day, p = £20 per tonne

The table shows the cost of producing 100 metres of cloth with each technology when the wage is £10 and the price of coal is £20. Clearly the B-technology allows the firm to produce cloth at lower cost.

Technological choices

Relative prices

But things change if relative prices change

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w = £10 a day

p = £20 per tonne

w = £10 a day

p = £5 per tonne

Suddenly price of coal falls to £5

but the price of labour remains the same

What happens now?

Slope of iso-cost line

Coal is relatively cheaper

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A

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Number of workers

1

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Tonnes of coal

Cost = £80

B

w = £10 a day

p = £20 per tonne

w = £10 a day

p = £5 per tonne

The iso-cost line swivels up.

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£80 still buys 8 workers,

but it can now but 16 tonnes of coal

16

Cost = £80

It becomes cheaper to produce with B

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w = £10 a day

p = £20 per tonne

w = £10 a day

p = £5 per tonne

Technology B can be used to make 100m of cloth for only £50

But A is now even cheaper still

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w = £10 a day

p = £20 per tonne

w = £10 a day

p = £5 per tonne

But using technology A the firm can make 100m of cloth for only £40

NB: To draw an isocost curve through any point A we calculate the new cost at A (c = wL+pR) then join it to another point like W where c = wL and R= 0

W

What happens next? (the firm)

• The firms profits are equal to revenue it gets from selling output minus the costs of production. Assuming the firm still sells 100m of cloth at the same old price (by ceteris paribus) the change in profit of switching from B to A under the new relative prices is

Δπ = ΔR – ΔC

= 0 – (40 – 50)

= 10

• In this case, the innovation rent for a firm switching from B to A is £10 per 100 metres which is the cost reduction made possible by the new technology. The decision rule (if the economic rent is positive, do it!) tells the firm to innovate
• The first adopter is called an entrepreneur: A person who creates or is an early adopter of new technologies, organizational forms, and other opportunities. When we describe a person or firm as entrepreneurial, it refers to a willingness to try out new technologies and to start new business
• Innovation rents will not last forever. Other firms, noticing that entrepreneurs are making economic rents, will eventually adopt the new technology. They will also reduce their costs and their profits will increase.

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What happens next? (Diffusion)

• What explains the eventual adoption of these new technologies in countries like France and Germany, and ultimately China and India?
• One answer is further technological progress, where a new technology is developed that dominates the existing one in use.
• Technological progress would mean that it would take smaller quantities of inputs to produce 100 metres of cloth.
• We can use the model to illustrate this. Technological progress leads to the invention of a superior energy-intensive technology, labelled A′. Once the A′-technology is available, it would be chosen both in countries using A, and in those using B.

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Diffusion

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Where the relative price of labour is high (England) the energy-intensive technology (A) is chosen.

Where the relative price of labour is low (France) the labour-intensive technology (B) is chosen

Improvements in cloth-making technology occur through “learning by doing” in the new method. This results in a new technology (A’). This technology uses only half as much energy per worker to produce 100 metres of cloth. The new technology dominates the A-technology.

Applying the model to history

Relative to other countries, wages in Britain rose from 1600 and 1700 so there was an incentive for firms to adopt labour-saving technologies.

Technology was labor-intensive before the Industrial Revolution (technology B).Increase in wages relative to price of coal in Britain created the incentive to innovate more capital-intensive technologies (technology A).

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The Malthusian model: explaining the long stagnation

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Malthus and the dismal science

• Writing in the 1800’s Thomas Carlyle called economics the “dismal science”, because drawing on the work of Thomas Malthus it was argued that that humanity could never rise above earning subsistence wages
• Malthus argued that any new technology would result in a rising population and this would push down wages to subsistence levels
• Malthusian economics offered an explanation of the long flat portion of history’s hockey stick
• But, the capitalist revolution disproved Malthus theory, as from the 1700’s onward there was a sustained increase in real wages and in population size in many countries
• Hence, the predictions of economics were not longer so “dismal”

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Malthusian economics

• Land and labour are assumed to be the two key factor of production
• The quantity of land is assumed to be fixed
• The production function tells us that output of grain (Y) is determined by the quantity of land and labour
• Y = f (fixed land and variable labour)
• The more labour that is used on the land the higher will be the amount of grain produced (Y)
• But, each unit of labour added results diminishing average product of labour (Y/size of labour input)

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Diminishing average product of labour

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Production function gives maximum output for a given set of inputs.

If we hold one input (land) fixed, and expand the other input (labour), the average output per worker is going to fall

Malthus’ model

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• Population expands if living standards increase
• 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.
• Malthus’ Model predicts a self-correcting response to new technology.
• In the long run, an increase in productivity (an improvement in technology) will result in:
• increased population, but
• not increased wages

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The Malthus’ Law

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Was Malthus correct?

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The relationship between real wages and population in England between 1280-1600 show evidence of this “Malthusian trap” – population fell and then rose, just as wages fell back to 1280 levels in 1600’s.

The end of Malthus law

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Real wages over seven centuries:

Wages of craftsmen (skilled workers) in London (1264-2001), and the population of Britain.

Escape

Malthusian trap

Malthus

Smith

Population

Real wages

Escaping the Malthusian trap (both population and wages rising)

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Escaping from Malthusian stagnation

• Capitalism meant a shift to permanent technological revolution
• This has mean that productivity has continue to rise and wages have continued to rise (the production function has continued to shift upwards due to new technologies)
• This enabled a rapid rise in living standard (the upward part of history’s “hockey stick”)
• Malthus’s dismal prediction of ongoing subsistence wages (with population increases) was no longer a reasonable description of the world after the mid-1800 (but it was a good explanation of the preceding 10,000 years!)
• Since the 1800’s both population and real wages have increased simultaneously

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Economics models and political-economy

• Economic models help us see the big picture.
• The two models we have looked at help understand the underlying economics of two systems.
• But in both cases there were a range of political, social and institutional features that are not well captured in the economic models, but which are to understanding how the economy evolved.
• Always remember both the power and the limits of modelling framework!
• Do the models we have shown provide compelling explanations of the following puzzles:
• In the Malthusian model rising wages leads population growth. In the 1800s rising wages lead to innovation and labour saving. Why?
• Why did the technological change in the 19^th century become a permanent revolution
• To really answer these questions, we might need to look at institutional, social and political factor that are not fully explained in the models.

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Malthusian era: Labour supply, politics and real wages

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Black Death (1347)

Peasants’ Revolt (1381)

Industrial Revolution: Wages, productivity & social change

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1928 Universal suffrage

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Labour productivity

Real wages

1764 Hargreaves’ spinning jenny

1781: Watt’s’ steam engine

1833: Factor act (no child labour under 9 years)

1844: Factor act (children work only 6.5 hours a day)

1847 Ten Hours Act (Limits work hours for women & children)

1918 Voting rights for all males

Bargaining power

• The permanent technological revolution has meant an increase productivity and in how much is produced - the size of the pie has increased
• The share of the pie going to workers depends on worker bargaining power.
• Factors that influence bargaining power include:
• The supply of labour fell when business owners were stopped from employing children e.g. changes in child labour laws in the UK in the 1830’s and 1840’s
• The power of working people increased as they gained the right to vote and formed trade unions. These workers were able to claim a constant or rising share of the increases in productivity generated by the permanent technological revolution.

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Inequality, the great divergence and the environment

By careful of averages…

• Which group is better off?
• Group A – 10 people all receiving income of R5 000 a month i.e. average income is R5 000 a month
• Group B – 10 people with 5 receiving income of R10 000 a month and 5 receiving income of R500 a month i.e. average income is R5 250 a month ((5 x R10000 + 5 x R500))/10 = R5250
• The average income for Group B is higher then for Group A, but due to a high degree of inequality the average disposable income measure does not accurately describe welfare levels in these groups.
• This shows us that per capita GDP can’t tell us anything about how income is distributed. It is the average income, but cannot indicate the variation in income within the society.

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The great divergence

• An observer at the time would have noticed that people, on average, were better off in Italy, China and England than in Japan or India – but not by much.
• The vast differences between the rich and the poor within countries, were much more striking than these differences across regions.
• According to Angus Deaton, when 300 years of British rule of India ended in 1947: ‘It is possible that the deprivation in childhood of Indians … was as severe as that of any large group in history’. In the closing years of British rule, a child born in India could expect to live for 27 years.

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• We can observe a great divergence between the fortunes of different countries in the world the hockey stick took off.
• In the 14^th century, the Moroccan scholar Ibn Battuta described Bengal in India as ‘A country of great extent, and one in which rice is extremely abundant. Indeed, I have seen no region of the earth in which provisions are so plentiful.’
• At the time of Ibn Battuta’s travels, India was not richer than the other parts of the world. But India was not much poorer, either.

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Living standards in five countries (1750 -2015)

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Living standards in five countries (1750 -2015)

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Divergence (and convergence?) in our neighbourhood

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Performance differs across capitalist economies

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Measuring inequality

• “Across countries” refers to the comparison of income differences between different countries. For this we can compare GDP per capita as we have been doing.
• “Within countries” refers to the comparison of income difference between those within a particular country who are well-off and those who are not well-off
• A handy measure of inequality in a country is called the 90/10 ratio, which we define here as the average income of the richest 10% divided by the average income of the poorest 10%. (It is more commonly defined as the income of the 90th percentile divided by that of the 10th percentile).
• Even in a relatively equal country such as Norway, the 90/10 ratio is 5.4; in the US it is 16 and in Botswana it is 145, 22 in Nigeria, and 20 in India.

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2014

Comparing inequality across and within countries

• In the diagram, countries are arranged according to GDP per capita from the poorest on the left of the diagram (Liberia), to the richest on the right (Singapore). The width of each country’s bars represents its population.
• For every country there are ten bars, corresponding to the ten deciles of income. The height of each bar is the average income of 10% of the population, ranging from the poorest 10% of people at the front of the diagram to the richest 10% at the back, measured in 2005 US dollars.
• Note that this doesn’t mean ‘the richest 10% of income earners’. It is the richest 10% of people, where each person in a household, including children, is assumed to have an equal share of the household’s income.
• The skyscrapers (the highest columns) at the back of the right-hand side of the figure represent the income of the richest 10% in the richest countries. The tallest skyscraper is the richest 10% of people in Singapore. In 2014, this exclusive group had an income per capita of more than $67,000.

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Impact of the capitalist revolution on the environment

• As production has soared so too has the use of our natural resources and degradation of our natural environment.
• Elements of the ecological system such as air, water, soil, and weather have been altered by humans more radically than ever before.
• The most striking effect is climate change.
• Diagrams present evidence that our use of fossil fuels—coal, oil, and natural gas—has profoundly affected the natural environment.
• CO₂ emissions from fossil fuel consumption have risen dramatically since 1800.
• There have been perceptible increases in the northern hemisphere’s average temperatures

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Emission and Atmospheric carbon dioxide

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Global temperature

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Technology as a solution to environmental problems

• The permanent technological revolution—which brought about dependence on fossil fuels—may also be part of the solution to today’s environmental problems.
• For example, in lighting, the permanent technological revolution brought us more light for less heat, which conserved natural resources—from firewood to fossil fuels—used in generating the heat.
• Advances in technology today may allow greater reliance on wind, solar and other renewable sources of energy.

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Markets, institutions, governments and varieties of capitalism

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Economic conditions

• Even though a country is “capitalist”, the economic institutions that make capitalism dynamic may have weaknesses:
• Private property: May not be secure. There is weak enforcement of the rule of law and of contracts, or expropriation either by criminal elements or by government bodies.
• Markets: Might not be competitive. They fail to offer the carrots and wield the sticks that make a capitalist economy dynamic.
• Firms: Might be owned and managed by people who survive because of their connections to government or their privileged birth, not because they are good entrepreneurs. They did not become owners or managers because they were good at delivering high-quality goods and services at a competitive price. The other two failures would make this more likely to occur.
• Combinations of failures of the three basic institutions of capitalism mean that individuals and groups often have more to gain by spending time and resources in lobbying, criminal activity, and other ways of shifting the distribution of income in their favour. They have less to gain from the direct creation of economic value

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Government and dynamic capitalism

• Government is also important:
• Establish, enforce and change the laws and regulations that influence how the economy works. Markets, private property and firms are all regulated by laws and policies.
• Provides essential goods and services such as physical infrastructure, education and national defence.
• A large part of the economy in every modern capitalist economy, accounting in some for more than half of GDP.
• Played a leading role in the capitalist revolution in the “developmental states”.
• In a nutshell, capitalism can be a dynamic economic system when it combines:
• Private incentives for cost-reducing innovation: These are derived from market competition and secure private property.
• Firms led by those with proven ability to produce goods at low cost.
• Public policy supporting these conditions: Public policy also supplies essential goods and services that would not be provided by private firms.
• A stable society, biophysical environment and resource base

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The ”developmental state”

• South Korea’s take-off occurred under institutions and policies sharply different from those prevailing in Britain in the eighteenth and nineteenth centuries.
• The most important difference is that the government of South Korea (along with a few very large corporations) played a leading role in directing the process of development, explicitly promoting some industries, requiring firms to compete in foreign markets and also providing high quality education for its workforce.
• The term developmental state has been applied to the leading role of the South Korean government in its economic take-off and now refers to any government playing this part in the economy. Japan and China are other examples of developmental states. And South Africa aspires to build a developmental state.

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South African Vision of a Developmental State

• The developmental state seeks to provide leadership and guidance to a mixed economy, consisting of private and public sectors, with the aim of changing the structure of the economy to make it more prosperous and inclusive
• The policies of the developmental state seek to:
• Promote inclusive and sustained growth through long-term strategic planning mechanisms, such as, industrial policy and social policies
• Change patterns of wealth, opportunity and income through interventions such as access to public education, land redistribution, competition policies, policies to facilitate new economic entrants and minimum wage policies

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Proper functioning of state and market

• The developmental state facilitates the proper functioning of state and market so that:
• the state can guide and regulate the market to move the economy onto an inclusive growth path
• the market can bring efficiency, decentralisation and through investment see to the introduction of new technologies and new growth opportunities
• The state provides the legal and institutional framework in which the market operates
• the state is the visible hand that guides the workings of the invisible hand of the market
• Economic growth can take many forms – unsustainable growth, jobless growth, futureless growth, undemocratic growth, trickle-down growth, colonial growth, apartheid growth – the developmental state leads and guides the market towards inclusive growth, a growth path that is sustainable and which transforms the underlying unequal and exclusionary structure of the economy
• In South Africa, this means the developmental state should seek to transform inherited patterns of race, gender and class inequality

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Errors avoided by Developmental State vision

• The error of neo-liberalism is to assume that the extension of private, market relations to all spheres of life will lead to efficiency and progress when in fact such policies will entrench inequality and will lack the mechanism achieve structural changes in an economy like South Africa’s damaged by colonialism and apartheid

believing in magical properties of only the invisible hand

• The error of state-ism is to assume that the extension of state ownership and control to all spheres of life will lead to equality and progress when in fact such policies will lead to economic stagnation, corruption and undemocratic governance

believing in magical properties of only the visible hand

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Main points again

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What is Economics?

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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

• How we come to acquire the things that make up our livelihood: Things like food, clothing, shelter, or free time.
• How we interact with each other: Either as buyers and sellers, employees or employers, citizens and public officials, parents, children and other family members.
• How we interact with our natural environment: From breathing, to extracting raw materials from the earth.
• How each of these changes over time

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The capitalist revolution

• 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.
• Under this new way of organizing the economy, advances in technology and specialization in products and tasks raised the amount that could be produced in a day’s work.
• This process, which we call the capitalist revolution, has been accompanied by unprecedented global economic inequalities and by growing threats to our natural environment

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Technology, population, and growth

• Economic models help explain the Industrial Revolution, and why it started in Britain in the Nineteenth Century
• Wages, the cost of machinery, and other relative prices all matter when people make economic decisions.
• In a capitalist economy, innovation creates temporary rewards for the innovator, which provide incentives for improvements in technology that reduce costs.
• These rewards are destroyed by competition once the innovation diffuses throughout the economy.
• Population, the productivity of labour, and living standards may interact to produce a vicious circle of economic stagnation.
• The permanent technological revolution associated with capitalism allowed some countries to make a transition to sustained growth in living standards.

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