History’s hockey stick

• After many centuries of stable (low) living standards, living standards have risen sharply over the past two hundred years or so – at different times in different countries
• Economic theories were developed:
• to explain the long period of stable (low) living standards (the theory of the Malthusian trap) and
• to explain the sharply rising living standards (theories that explain the continuous technological change associated with the Industrial Revolution)

Comparative advantage, specialisation, and �the division of labour

• In 1600, the great manufacturing centres in the world—for textiles and other goods not produced on farms—were in Asia. The Industrial Revolution in Britain, and later in the rest of Europe and the US, changed this.
• By 1900, Europe and its offshoots had come to specialize in manufacturing, benefiting from rapid changes in technology that raised their output per worker.  The rest of the world specialized in farming, where technology improved slowly and populations were caught in a Malthusian trap.
• To understand how these events came about, we need three concepts:
• comparative advantage,
• specialisation, and
• the division of labour.

Effects of Specialisation and Trade

• We become better at producing things when we each focus on a limited range of activities. This can happen for three reasons:
• Learning by doing: We acquire skills as we produce things.
• Difference in ability: Because of skill, or the characteristics of the natural surroundings (such as soil quality, for example), some people are better at producing certain things than others – they are said to enjoy a comparative advantage in the the production of that item.
• Economies of scale⁠: Producing a large number of units of a good is often more cost-effective than producing a smaller number.
• People do not typically produce the full range of goods and services that they consume in their daily lives. Instead we specialise and trade - some producing one good, others producing other goods.
• During the upturn in the hockey stick, global trade improved the scale opportunities for specialisation.
• Specialisation increased productivity by allowing people produce goods for which they have a comparative advantage and then trade.

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Advantage of specialisation and trade based on comparative advantage

• Factual situation if 100% of time and resources is spent producing one good:
• Greta will produce 1250 apples or 50 tons of wheat
• Carlos will produce 1000 apples or 20 tons of wheat
• So Greta can produce more wheat and apples than Carlos. Greta has an absolute advantage in both goods.
• However, for specialization and trade , we are more interested in the concept of comparative advantage
• Calculation of relative prices and Comparative advantage
• For Greta the relative price of producing 1 ton of wheat is calculated as follows: 1250 apples / 50 tons of wheat = 25 apples per ton of wheat (ie if she dedicated all her resources to wheat she would give up all apples 1250 so the cost would be 25 apples forgone per ton of wheat
• For Greta the relative price of producing an apple = 50 tons of wheat /1250 apples = 0,04 tons of wheat forgone per apple produced.
• For Carlos the relative price of producing 1 ton of wheat = 1000/20 = 50 apples per ton of wheat
• For Carlos the relative price of producing apples = 20 / 1000 = 0,02 tons of wheat per apple produced

Advantage of specialisation and trade based on comparative advantage

• If there is specialization in production based on comparative advantage:
• If Greta and Carlos each specialize in producing the good that they can produce at lowest relative price (i.e. the good for which they have a comparative advantage)
• Greta will produce 50 tons of wheat as for her the relative price of wheat is 25 apples per ton of wheat (vs 50 for Carlos)
• Carlos will produce 1000 apples as for him the relative price of apples is 0,02 tons of wheat per apple (vs 0,04 for Greta)

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• Outcome with specialization and trade:
• After they trade both Greta and Carlos will be better off than if they were self-sufficient.
• Greta will consume 600 apples (>500) and 35 tons of wheat (>30) and
• Carlos will consume 400 apples (>300) and 15 tons of wheat (>14).
• Most important for the hockey stick is that when there is specialisation and trade overall production is greater than if Great and Carlos choose self-sufficiency (50 tons of wheat vs 44 tons of wheat are produced and 1000 apples v 800 apples)

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If self sufficiency:

Greta can choose to produce 500 apples and 30 tons of wheat (as she reduced apples from 1250 by 750 at a relative price of 25 apples per ton of wheat and 750/25 = 30)

Carlos can choose to produce 300 apples and 14 tons of wheat (as he reduces apples from 1000 by 700 at a relative price of 50 apples per ton of wheat and 700/50 = 14)

Explaining the sharply rising part of history’s hockey stick – rising living standards due to Continuous Technological Change

• Advances in technology and the increased use of non-renewable resources raised productivity (output per person) more rapidly.
• As long as technology improved fast enough, it could outpace the population growth that resulted from the increased income, and break out of the Malthusian vicious circle.
• Real wages and Living standards could then rise.
• What caused this to take place first in the United kingdom – there are various theories, but the lecture will focus on a model that shows the process was driven by falling energy (coal) prices.

Explanations of the industrial revolution…

• 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 codify, transfer and transform scientific knowledge into technology that could be used by engineers and skilled artisans.
• Political and Cultural institutions - David Landes, a historian, emphasizes the political and cultural institutions and characteristics of nations as a whole. 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.
• Hard work and savings - for Gregory 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 as the particular home of virtues associated with the ‘spirit of capitalism’.

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It’s about cheap energy (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

• 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)
• Guns, textiles and manufactured to Africa (to trade for enslaved people)

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Understanding how Britain’s colonial domination contributed to the industrial revolution

• The industrial revolution in Britain resulted from interactions with the rest of the world.
• Textiles were at the heart of these interactions: the taste for cotton textiles in Europe—and especially Britain—came from Indian imports
• Much of the new technology came from Continental immigrants
• The main raw material—cotton—came from the Americas, where it was largely produced by enslaved Africans
• The incentive to mass-produce textiles would have been greatly diminished had it not been for Britain’s overseas markets.

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Key question?

• If the colonies and enslaved labour were not been available, the Industrial Revolution would most likely not have occurred when and where it did.
• Counterfactual - Where would the calories and raw materials for the textile industry have come from if not from slave plantations in the North American colonies?
• It has been estimated that producing, on British farms, the quantity of calories provided by slave-produced sugar would have required between 11 and 15% of all of the arable land in Britain. The effect would have been to raise the price of food substantially, which would have required an equivalent increase in wages to allow British workers to be sufficiently well nourished to do their jobs.
• When cotton exports to Britain were halted during the US Civil War, finding substitutes for US cotton—in Egypt, India, and elsewhere—proved to be very difficult. Had American plantations not provided cotton as a raw material, it is likely that the textile industry would have produced woollen rather than cotton textiles. The amount of wool equivalent to the cotton imported from North America would have required more than all of Britain’s crop and pasture land combined.
• So the access to the resources of slavery and the colonies was necessary for the Industrial Revolution to take place in Britain. Even if other sources of inputs could have been found, it is likely that they would have been substantially more expensive, especially given the quantities required to sustain the levels of increasing output achieved by the Industrial Revolution.

The Answer

• Concerning markets, most of the demand for British-made textiles and other manufactured goods came from British buyers, but sales to the rest of the world were nonetheless important.
• If colonial markets did not exist in South Africa, India, Burma, Australia and South America, the price at which the ever-increasing output of the Industrial Revolution could have been sold would have been lower, further reducing the profits of the new firms and their ability to invest and grow.
• Conclusion: The institutions that contributed to the Industrial Revolution in Britain include those frequently stressed - such as private property, markets and firms competing for profits, that jointly make up capitalism, but also other institutions: colonial domination and the enslavement of people.

Economic concepts to explain the impact of cheap energy (coal) costs

• To understand the economy, we need to understand how people make decisions
• Models help us to ‘see more by looking at less’ i.e. economic models try to isolate how changes in a few important variables can be shown to lead to the expected changes in other variables. Lack of realism is an intentional feature of models, not a shortcoming.
• Economists do not claim that people actually think through the model’s calculations each time we make a decision. 
• Rather models works “as if” people make such calculations – like a pool player does not calculate the physics and use geometry to calculate the angles, but when he or she sinks the ball it ‘as if’ he or she is doing the calculations
• Economists use models to predict choices by firms or individuals ‘as if’ those firms or individuals are doing the calculations or using the model that the economists have developed

Model-building

When we build a model, the process follows these steps:

1. We begin with a well-defined question.
2. We construct a simplified description of the conditions under which people take actions.
3. We describe in simple terms what determines the actions that people take.
4. We determine how each of their actions affects each other.
5. We determine the outcome of these actions. This is often an equilibrium (something is constant).
6. Finally, we try to get more insight by studying what happens to certain variables when conditions change.

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Key ideas in a model

• Equilibrium – a situation that is self-perpetuating, meaning that there is no tendency for the situation to change unless an external force for change is introduced
• Endogenous variables – variables whose values are determined by relationships built into the mode
• Exogenous variables – variables whose values are determined outside the model
• Ceteris paribus – holding other things equal
• To understand how people make decisions we need to use concepts such as opportunity costs, economic rents, and incentives

Decision making model – it is ‘as if’ we make decision like this

• Imagine the the ticket for a soccer match cost R250 and you value your enjoyment of the soccer match at R550, then:

Net benefit of the attending the soccer match is R550 – R250 = R300

• If your neighbour offers to pay you R400 to babysit their child at the same time as the soccer match and the effort involved in babysitting is valued at R180, then:

Net benefit of babysitting is R400 – R180 = R220

• You will decide to attend the soccer match as:

Net benefit of attending the soccer match rather than babysitting is R300 – R220 = R80

• Opportunity cost of attending the soccer match is the loss of the R220 of net benefit that you would have received from babysitting (the opportunity cost is the loss of not taking the next best alternative)
• This next best alternative is sometimes referred to as the Reservation Option

Decision making model (cont.)

• Economic cost = direct costs incurred by taking an action plus the opportunity cost

Economic cost = R250 cost of ticket plus opportunity cost of R220 = R470

• As you value the enjoyment/benefit of going to the soccer match at R550 and this is greater than the economic cost of R470 then you will decide to go to the soccer match

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• If the net benefit of going to the soccer match R550 – R250 = R300 is greater than the opportunity cost i.e. the net benefit of baby sitting R400 – R180 = R220 then you will decide to go to the soccer match as you gain an economic rent of R80

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economic rent =

net benefit from option taken − net benefit from next best option (reservation option), or

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economic rent = net benefit from option taken − opportunity cost�

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Innovation rent and relative prices

• Innovation rents – a form of economic rent. The extra profits made by being the first to adopt a new technology or exploit an invention. Provide incentives for taking action and is a key driver in the model to explain the industrial revolution.
• Relative prices – the price of one option relative to another, often expressed as a ratio of the two prices. An important factor in determining economic incentives.
• Relative prices are simply the price of one option relative to another, often expressed as the ratio of the two.
• In the explanation of the Industrial Revolution, the falling ratio of energy prices (the price of the coal) to the wage rate plays an important part in incentivising the decisions of people running firms as the new relative prices create the opportunity for innovation rents (extra profits) by early adopters of new energy-intensive technologies.

Technology choice

Suppose there are 5 possible technologies for producing 100 metres of cloth – A, B, C, D and E.

A is the most energy intensive technology (6:1) and E is the most labour intensive technology (1:10).

Which technology should a firm choose? We can see immediately that the firm will not choose C or D as they are dominated by A and B respectively. Why?

But to choose from A, B and E the firm will need to know the costs of labour and energy (coal) – if labour is relatively cheap the firm will choose E, if energy is relatively cheap the firm will choose A

Technology choice – isocost curves

• Assume the motive of the firm is to maximise profit. This means they will want to minimise the cost. Profit = Revenue minus cost
• Assume the cost of labour (the wage, w) is £10 and the cost of coal for energy is p = £20 per tonne.
• Cost is calculated as:
• C = wage (w) x number of workers (N) + Price of coal (p) x tonnes of coal (R)
• C = (w x N) + (p x R)
• An isocost curve joins all the points with equal costs eg isocost curve C = 80 can be made up by joining the intercepts (y intercept (80/20=4), (x intercept (80/10 = 8):
• C = 80 = (w x N) + (p x R) = (10 x 0) + (20 x 4)
• C = 80 = (w x N) + (p x R) = (10 x 8) + (20 x 0)
• And all points in between e.g.
• At p1 C = (10 x 2) + (20 x 3) = 80
• At p2 C = (10 x 6) + (20 x 1) = 80

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Slope of isocost curve

(0,4)

(8,0)

Intuition: At any point, if you increase the number of workers by one, your costs rise by £10 (the wage). But the price of coal is £20, so if you decrease the coal input by 0.5 tons at the same time, costs will stay the same.

There is a large family of isocosts curves with same slope -w/p

• If the ratio w/p does not change and more (less) workers and coal are used then this will be on higher (lower) isocost curves with the same slope e.g. isocost curve with w = 10 and P = 20 and passing through points Q1 (3,6) and Q2 (5,5)
• At Q1 C= 150 = (w x N) + (p x R) = (10 x 3) + (20 x 6)
• At Q2 C= 150 = (w x N) + (p x R) = (10 x 5) + (20 x 5)

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Which technology will the firm choose A, B or E?

• Given the family of isocost firms with slope (-w/p) the isocost line closest to the origin or the lowest isocost line that passes through one of the technology options A, B and E will be chosen as this will be the isocost line with the lowest cost and highest profit for the firm.
• In this example, the least cost technology is technology B where cost is 80, at A the cost is 130 and at E the cost is 120.

Impact of a change in relative prices (energy prices fall)

• Suppose the price of coal falls from £20 to £5 and the wage remains at £10, all else being equal.
• Slope of isocost curves get steeper as –w/p changes from -10/20 (-0,5) to -10/5 (-2)
• At B when the cost of coal is 20 and the wage is 10 the total cost is 80
• At B’ after the cost of coal falls to 5 and the wage is 10 the total cost is 50
• But B is no longer the lowest cost technology as with technology A which requires 6 units of coal and 1 unit of labour it will cost the following to produce 100m of cloth: (1 x 10) + (6 x 5) = 40

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• Profit = revenue – costs or Profit = R - C
• If is assumed the Revenue (R) is initially unchanged, then
• R - 40 > R - 50 i.e. profit is greater by 10 for firms that adopt technology A
• As more profit can be made given the changed costs of the inputs and firms that don’t adopt the lowest cost technology maybe forced to close
• An entrepreneur can be someone who is first to adopt the new technology.
• Schumpeter’s description of capitalism’s dynamics as involving a process of Creative Destruction: This analysis shows that firms have an incentive to switch to technology, firms that use technology A will be more profitable and will survive, firms that continue with technology B are likely not so survive. Overall, this process increases productivity in the economy.
• In the longer run prices may fall as more as all firms adopted technology A, and entrepreneurial / innovation / first mover rents will be eroded

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Differences between labour intensive technologies (like B) and capital or energy intensive technologies (like A)

Is the theory supported by facts?

• In Britain, in the 1600s, the relative price of labour to energy and capital (-w/p) was low and technology B on isocost line HJ was used. B was cheaper than A.
• In the 1700’s, when the relative price of labour to energy and capital (-w/p) was high, A was cheaper. Firms switched to the energy-intensive and capital-intensive technology A on isocost line FG
• Support for the theory that the industrial revolution happened first in Britain due to a change in relative prices, as the absolute value of the ratio (-w/p) increased

The spread of new technologies around the world

• Assume that for a country X where energy is relatively cheap technology A is being used and for another country Y where labour is relatively cheap technology B is being used
• if there was effective trade between the two countries we know that technology A would prevail as it is more competitive
• Then a new technology A’ is discovered which is superior to A for country X with relatively low energy costs, in that it produces 100m of cloth with half the energy (1 worker and 3 units of energy (not 6)) (it lies below isocost curve GF, -w/p = -2)
• Technology A’ is also superior to B even for country Y with relatively low wages (it lies below isocost curve JH, -w/p = -0,5)
• So both country X and Y will adopt technology A’ – and there will be a spread or diffusion of this technology across the world
• NOTE: it is possible that in country Z with very low labour costs (and relative energy cost was very high) that technology B would be superior to technology A’, if the slope of the iscosts curve (-w/p) was so low that the isocost line is flatter than HJ (slope = -0,5), so that it goes through B but below A′ eg if –w/p = 0,25 (y intercept 3 and x intercept 12)(if wage was 5 and cost of energy was 20)

What happens to wages during process of technological change?

• The story of the continuous technological revolution demonstrates that there are two influences on wages.
• How much is produced: We can think of this as the size of the pie to be divided between workers and the owners of other inputs (land or machines).
• The share going to workers: This depends on how wages are determined (individually, or through bargaining by trade unions with employers, for example).

Escaping the Malthusian trap

Capitalism + carbon = hockey-stick growth + climate change

• The Industrial Revolution marked the transition to an energy-rich economy based on fossil fuels.
• It led to unprecedented increases in per capita income.
• It also led to unprecedented increases in the surface temperature of the Earth.
• The ongoing reduction in global poverty cannot be accomplished by the same carbon-plus-capitalism

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How can the process of climate change be contained?

• The world faces two energy problems:
• most of our energy still produces greenhouse gas emissions
• hundreds of millions lack access to energy.
• Solution: to raise incomes and global access to electricity will have to be based on non-carbon or renewable energy sources
• How quickly this happens and at what cost depends critically on the policies that governments pursue; and these differ across countries.

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Link between rising living standards and CO₂ emissions

• Countries where GDP per capita is higher tend to have higher CO₂ emissions as well.
• The greater income per capita is the result of a higher level of production of goods and services per capita, involving greater use of fossil fuels
• In low-emitting countries like France and Sweden, a substantial share of electricity is generated by non-fossil fuel sources (92% and 99% respectively) (such as nuclear power and hydropower)

Falling prices of renewable energy allows the decoupling of growth from environmental destruction

• A transition to low-carbon electricity could occur simply by governments ordering it, but it would be more likely to happen—either by government order or by private decisions—if the energy from these sources is cheaper than from fossil fuels.
• In most parts of the world, power from new renewable facilities is cheaper than from new fossil fuel ones.
• The technological progress in renewables is a sign that a path to higher living standards without fossil fuels may be possible. 
• There is a need to decouple growth from environmental destruction (see example of Sweden)

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Summary

1. Used models for insights on the technological revolution - Model of a firm: high wages (relative to capital, including energy) showed role of entrepreneurial rents as a motivation for technological innovation

2. Located the Industrial Revolution in context of Britain’s colonial domination both in terms of access to cheap input and to markets for sales

3. Looked at how wages were influenced by labour market institutions after escape form Malthusian Trap

4. Examined the link between industrial revolution and climate change and a possible way out via a new wave technological innovation linked to falling renewable energy prices that are likely to cause the displacement of uncompetitive fossils fuels

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5. Next week: An economic model of decision making under constraints

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