Introduction to Economics PDF

03/10-21/11 2023 Introduction to Economics Overview of World Economic History The “hockey stick of growth” ○ Economic growth is flat till 18th century ○ Around 1750 income suddenly grows (industrial revolution) Agricultural Revolution ○ 11.000 years ago = change from hunter-gatherer to...

03/10-21/11 2023 Introduction to Economics Overview of World Economic History The “hockey stick of growth” ○ Economic growth is flat till 18th century ○ Around 1750 income suddenly grows (industrial revolution) Agricultural Revolution ○ 11.000 years ago = change from hunter-gatherer to sedentary society ○ Independent occurrences in different parts of the world Measuring Economic Development: GDP per Capita ○ GDP per Capita = used to measure economic development and compare living standards in each country ○ GDP = Total Value of Goods and Services Produced in an Economy in a year = total income (same thing) ○ GDP per Capita = GDP divided by number of residents The World in 1000 ○ China = richest economy around that time World Distribution of GDP per Capita ○ 1000 = World is quite poor (small differences between countries) ○ 1500 = Italy becomes wealthier ○ 1700 = most of the world is still very poor, shift of economic growth in England and the Netherlands too ○ 1820 = Europe (and countries that were colonies) becomes wealthier, and also the US ○ 1870 = growth began in Japan, standards declined in India and China ○ 1950 = US, Northern Europe are wealthier than Africa and other areas in Asia ○ This diversion is still very much present World in 1500 ○ Few developed civilisations (15) ○ Before 1500 = more isolated world ○ World becomes global (people of different parts of the world get to know one another) ○ China = less poor than other civilisations Reversal of Fortune ○ Relatively poor places in 1500 → rich in the modern day  03/10-21/11 2023 ○ Countries that were relatively developed, declined (improvements in living standards occurred only when they gained independence from colonial rule) Distribution of World Manufacturing ○ 1750 = e.g. porcelain ○ China = largest manufacturer ○ Industrial revolution hits → change in 1800 ○ Remarkable number of scientific and technological advances → upward kink in the income hockey stick ○ New technologies, ideas, discoveries, methods and machines ○ Technology = process that takes a set of materials and other inputs (e.g. work of people, machines) and creates an output ○ Technological progress revolutionised production ○ England becomes the largest manufacturer (1800) ○ Steam engine (used in textiles, manufacturing, railways and steamships) World GDP per Capita 1820-2018 ○ Pretty much the same in 18th century ○ 19th-20th century = grows in certain areas World GDP per Capita 1950-2018 ○ Qatar = grows, falls, and grows again ○ Because price of natural resources changes Adam smith ○ Founder of modern economics ○ “An Inquiry Into the Nature and Causes of the Wealth of Nations” (1776) ○ Asked himself why some countries prospered and others did not The Global Economy Globalisation ○ Growing interconnections between the economies of different countries ○ Of trade (= growing movement of goods between countries) ○ Imports and exports ○ Of factors of production (= inputs into production process) ○ Migration (movement of labour) ○ International capital flows A Potted History of Globalisation ○ Long history of international trade and explorations ○ Expansion of trading routes in 15th-17th centuries ○ 3 waves of globalisation  03/10-21/11 2023 ○ Mid 19th century to WW1 ○ WW2 to 1970s ○ Post 1970s to now Globalisation over Five Centuries World Trade before 1500 ○ Extensive trade = centred around Indian Ocean, not Europe ○ Major drivers of trade = China and “India” ○ Polycentric (= not controlled by central power) The 15th Century World System ○ Trade routes would overlap, so goods would pass from one trader to another ○ Because cities were not self-sufficient, they needed to trade with each other The First Globalisation ○ “The great divergence begins with the first globalisation” - Allen ○ New trade routes and products (coming from the New World) ○ Development of European empires Age of Discovery ○ Diaz (sails around Cape of Good Hope - 1488) ○ Di Gama (rounds Africa -1499) ○ Columbus ○ Magellan (sails around South America - 1519) ○ Cortés conquers Aztecs (1519-1521) ○ Pizarro conquers Incas (1530s) New developments in shipbuilding ○ Change in sails (allowed sailing across the wind) ○ Reduction in manpower ○ New navigation techniques (e.g. compass) ○ Developed in Europe, not a lot in China ○ Reduction in transport costs Innovation and shipbuilding ○ Galleys → Caravels → Carrack Improvements in navigation ○ 16th-18th centuries maps Why are these changes happening in Europe and not in China (wealthiest place at that time)?  03/10-21/11 2023 Mercantilism ○ Economic nationalism that seeks to limit the competition faced by domestic producers ○ Use of national strength to promote trade ○ Monopolies on trade, supported by the state Fortified Trading Posts European Expansion ○ Europe controlled 35% of the world by 1800 ○ Why Europe and not somewhere else? Not all exploration was European ○ Voyages of Zheng He ○ Ibn Battuta Summary: Globalisation before 1800 ○ Rise of settled societies explained by agricultural suitability ○ Geographical features can (perhaps) explain why Europeans expanded and built empires ○ Living standards = similar around the world throughout most of history ○ Have risen rapidly since 1750 (in some countries) ○ Rapid technological progress A lot of Variation by Country ○ UK exports more than 10% of its GDP = small open economy ○ US exports less than 10% of its GDP = large closed economy Decline of (European) Empires in 1914 Explaining Economic Development Causality ○ The way economists think about problems ○ Economics studies why things happen ○ Want to understand how to change things for the better ○ Distinguish between cause and effect ○ Correlation is NOT causation Economic Methods  03/10-21/11 2023 ○ 2 sets of tools ○ Theoretical methods = mathematics to provide simplified version of human interactions ○ E.g. “demand and supply” to identify market forces ○ Tools of game theory ○ Empirical methods / econometrics ○ Test whether there are causal relationships between variables ○ E.g. does getting a degree cause individuals to receive higher incomes? Causal Analysis ○ Causal = direction from cause to effect, establishing that a change in one variable produces a change in another ○ Distinguish between ○ Exogenous = determined outside the model/system, makes it easier to identify causality ○ Endogenous = determined within the model/system ○ Causal chains ○ Proximate (immediate) causes = immediate cause before some event (e.g. heart attack causing death) ○ Ultimate (root) cause = deeper cause (e.g. eating too much pizza) ○ Intermediate cause = between the two (e.g. blocked arteries) Global Economic Development: Ultimate vs. Proximate Causes ○ Why did European nations develop before other parts of the world? ○ Proximate causes ○ European conquest before 1800 ○ Industrial Revolution happened in Europe ○ Explanations ○ Culture ○ Geography ○ Institutions ○ Are these ultimate or proximate causes? Geography and Economic Development Why did European nations develop before other parts of the world? ○ Proximate causes ○ European conquest before 1800 ○ Industrial Revolution happened in Europe ○ Explanations ○ Culture ○ Geography  03/10-21/11 2023 ○ Institutions ○ Are these ultimate (root) or proximate (immediate) causes? Causality in European Expansion Causes ○ Cultural differences ○ Geographical differences ○ Institutional differences ○ Disease immunity ○ Firearms technology Outcome ○ European control of the world in 1800 Geography and the Wealth of Nations Geography and Long Run Development ○ Some parts of the world are geographically favoured ○ Natural resources ○ Access to the sea ○ Advantageous conditions for agriculture ○ Advantageous conditions for human health ○ There is some extent to how some situations can better Contrast with Nomadic Cultures ○ Today = almost none ○ Geography itself determines how societies form ○ Barren desert or steppe = not suited to settled agriculture ○ Important differences between different groups of nomads in terms of flexibility and warrior nature (moving target can move away from dangers, while people settled in a city are more of an easier target) Why does agriculture matter? ○ Settled societies have growing population density ○ This allows specialisation (everyone specialises in different field) ○ More technological development ○ More productivity ○ Can produce more than needed, goods can be stored ○ More people can be supported ○ Allows tax ○ Strong centralised government ○ Infrastructure development ○ Support to religion ○ Wealth of towns based on taxes and tithes on rural peasantry  03/10-21/11 2023 ○ Writing = needed for taxes and accounting, to create calendars for agricultural purposes Is settled agriculture beneficial? How does geography affect trade? ○ What products do you have? ○ Climate and land controls crop availability (different areas = different crops) ○ Mines and resources are not movable ○ Differentiated climate = differentiated products → development of trade ○ Location and accessibility ○ Shipping lanes and overland trade routes ○ Waterways allowed trade of bulk products ○ Distance = higher cost ○ Settled agriculture allows for development of manufacturing and more complex society ○ Access to the sea = important Summary ○ Direct link between geographic characteristics and agricultural development ○ Crop type ○ May change over time (like it is today, climate is changing) ○ Settled agriculture allows development of more complex societies ○ Geography also affects trade ○ Determines available goods ○ Also transport access / costs Geography and European Conquest European Expansion ○ Europe colonised the world by 1750 European Conquest ○ Why did Europe control 35% of the world’s surface before 1800? ○ What are the factors that drive exploration? ○ Profit? Culture? Are these distinct? ○ Why were the Europeans the explorers? ○ Differences from other Empires? ○ Technology? Geography? Culture? Government? Not all exploration was European ○ China - Voyages of Zheng He  03/10-21/11 2023 Why was it Europe that kept expanding? ○ A lot of potential geographical explanations ○ Other Empires turned inwards, Europeans expanded ○ Europe is not an empire, it is constituted by different states and that means there’s competition between them ○ Political competition (between states) due to geographic fragmentation ○ E.g. Columbus could go elsewhere to receive fundings ○ Chinese focused taxation on fighting Mongols, not overseas explorations ○ Western Europe was closer to the Americas so got there first Ultimate versus Proximate Causes ○ 2 proximate causes for European conquest ○ Disease (immunity) ○ Gunpowder technology ○ Social scientists want to know ○ How important were these 2 factors? ○ What explains differences between Europe and elsewhere: what are the ultimate causes? Proximate Cause I: The Columbian Exchange (of diseases) ○ Exchange of diseases from Europe to Americas after 1492 ○ Population declines of up to 85–90% (at least partly due to diseases they did not know before - no biological resistance to them) ○ European conquest was assisted by the spread of these diseases (less people to fight against, …) Smallpox ○ One of the main killers at the time ○ Evidence of it goes back to the Egyptian mummies ○ First recorded in 1st century in AD in China/India ○ Probably endemic in Europe in 10th century AD ○ 1 in 10 deaths in England in 18th century ○ Fatal up to 30% of cases ○ Eradicated through vaccination The Role of Geography Is disease exogenous (why Eurasia)? ○ The rise of agriculture and infectious diseases ○ Higher population densities → easier transmission (in cities) ○ Settler societies have faecal matter / irrigation ○ Domestication of animals → diseases (start from animals and move to humans)  03/10-21/11 2023 ○ People were more likely to live close to animals in Eurasia, which is why diseases spread more in that area But why Eurasia? ○ Agricultural revolution not solely a Eurasian phenomenon ○ Jared Diamond: But type of agriculture also matters (25:01–36:00) The Fertile Crescent ○ World distribution of large-seeded grass species ○ Mostly in the Mediterranean zone Europe vs elsewhere ○ Why Eurasia? ○ Easy transmission of disease between centres ○ Fewer domestic animals in Mesoamerica The Fertile Crescent: animals matter too! ○ Domesticated animals provide food, transport, energy and other goods ○ Not every animal can be domesticated Smallpox (Proximate Cause I): A Gunpowder Substitute? ○ Disease used as a means to reduce the Mesoamerican populations Relative Importance of Disease? ○ Effects on allies as well as opponents Summary ○ Spread of disease (“the Columbian Exchange”) played a major role in the European conquests of the Americas → a proximate cause ○ European advantage in disease immunity may be explained by ○ Agricultural allowing large population centres ○ Domestication of animals ⇒ Geography an ultimate cause Proximate Cause II: European Advantages in Gunpowder Technology ○ What advantage did Europe have? ○ Guns but also piercing weapons, armour ○ Boats (with guns) and naval technology ○ Tactics and military discipline ○ Fortifications Why Europe (within Eurasia)? ○ Competition?  03/10-21/11 2023 ○ Competitive markets lead to innovation ○ But why in the military in particular? Not in porcelain, mathematics, etc. A History of Gunpowder Technology ○ First mentioned ○ China (800s) ○ Europe (1267) European History ○ Italian cities were the largest in Europe moving into the 14th century European History: Struggle for Supremacy ○ Importance of competition between countries ○ Series of wars marked a struggle to unite the continent The Military Revolution ○ Series of wars taxed the capacity of the warring powers ○ Massive increase in size and expense of war ○ Technological changes lead shift away from cavalry to infantry ○ Necessitated much larger numbers of troops Military advances ○ Artillery and defence ○ Guns ○ Firearms on ships ○ Tactics (e.g. volley fire) Learning-by-doing and Military Advance ○ “Learning-by-doing” = technological improvement through trial and error ⇒ No learning by doing in peace because firearms are not being used (e.g. China) ○ Likelihood of technological improvement depends on amount of resources spent ○ More spending on war → higher chance of technological progress Learning-by-doing in practice ○ Italy invaded by France in 1494 → develop new fortifications ○ French lose 7 years war (1763) → design lighter field artillery ○ English and French learn Spanish organisational techniques during 16th century fighting ○ Much of this due to experimentation, not theory Learning-by-doing in action ○ Captures inflation (that's why the price of spades is mentioned and is particularly relevant - comparison is needed)  03/10-21/11 2023 ○ Price of guns < price of spades ○ Same resources and elements to produce them, so that doesn’t matter in the end prices ○ What matters is the improvement in technology What Does This Have to do with Geography? ○ Aztecs do not learn about gunpowder due to geographic isolation ○ Europeans fight a lot because Europe is fragmented ○ Develops advanced technology through learning-by-doing ○ China on other hand, only fights the mongols (who fought on horseback) ○ Firearms = less effective against enemy on horseback Tournament Model I-II (Hoffman) ○ Europe: fragmented, culturally prized glory (kings want to fight because they want to win) → frequent fighting, high spending on firearms ○ China: ○ Hegemonic, with main military threat the nomads, high cost of raising tax ○ Frequent war, relatively low expenditure → low firearms development ○ Difficult to copy Europe ○ Ottoman Empire: ○ Location meant prioritised cavalry and galleys (used to cross small distances) ○ Institutions hindered development of fiscal capacity ○ Mughal Empire: ○ Frequent fighting, but small prize and difficulties in tax raising ○ Relatively low expenditure ○ Japan: ○ Fights a lot in the beginning, starts developing firearms ○ Early unification brought period of firearms development to an end ○ Presence of nearby hegemon precluded continued warfare ○ Russia: ○ Location meant prioritised cavalry and galleys ○ Could copy Europe, and eventually does catch-up ○ Big empires = no competition → no technological development → no gunpowder development Tournament Model III ○ Europe could have been united ○ Succession after Charlemagne could have avoided splitting the Empire ○ China could have been fragmented ○ Without Mongol conquest China could have remained divided ○ China may have developed gunpowder and been strong enough to fight off European powers  03/10-21/11 2023 ○ Non-Europeans could have taken different paths and established different institutions Summary ○ Agricultural suitability explain rise of settled vs. nomadic societies ○ Europe on periphery of system until 1500, then expands outward ○ Non-Europeans also explored, but did not build empire (in the same way) ○ Geographical features can (perhaps) explain why it was Europeans emphasised expansion ○ Disease advantage ○ Fragmentation of states ○ Not constrained by need to fight Mongols ○ Need for expansion to gain access to new products ○ Access to Atlantic ○ Ultimate cause: geographical differences (exogenous) ○ Proximate causes: firearms and disease immunity (endogenous) ○ Outcome: Europeans’ control of the world by 1800 (endogenous) ○ Geography, guns, germs and steel = strongest forces to shape the history of our world The role of “institutions” Part I: What are institutions? What are institutions? ○ Rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction ○ Humanly “devised” = made by humans and is deliberate, it was not an accident ○ Institutions constrain and incentivise behaviour ○ Political institutions (e.g. government structure, separation of powers) ○ Economic institutions (e.g. patent system, contract enforcement) ○ Culture and social norms (maybe) The Rules of the Game ○ A set of rules to organise the division of economic outcomes ○ E.g. 2 games = The Dictator Game and The Ultimatum Game ○ Everything here (the total payoff) is the same but the rules are different, dynamics of interaction change → different outcomes ○ Institutions may also affect the size of the pie  03/10-21/11 2023 Institutions at Society-Level ○ Organisation of society ○ Formal institutions (government system, laws) ○ Informal institutions (social norms) ○ Include both ○ De jure (e.g. a constitution) ○ De facto (how it works in practice) Evaluating Institutions ○ Do institutions maximise the “size of the pie”? ○ E.g. economic growth ○ Are the outcomes “fair”? ○ Pareto Criterion = no-one can be made better off without someone being made worse off ○ Low poverty and/or inequality ○ Procedurally acceptable (e.g. fair trial, equal rights) Good Institutions and Economic Growth ○ Countries with low constraint on executive = poor countries ○ Corrupted countries = poor countries ○ Chances that government comes along and takes my property (expropriation) = poor countries ○ Government comes along and takes money through taxes too, but those are predictable and planned in advance ○ Expropriation instead is a risk Good and bad institutions ○ Good institutions ○ Protect and encourage economic activity ○ (protect) Trade and development of contracts ○ Incentivising investment and innovation ○ Bad institutions ○ Discourage productive economic activity ○ Encourage resources to be used unproductively Property Rights ○ One particularly important institution is the protection of property rights ○ Legal protection of ownership (ownership is well defined and protected) ○ Right to exclude others (from my possessions) ○ Benefit from or sell the thing owned ○ Intellectual property rights (...) Institutions to Protect Property Rights  03/10-21/11 2023 ○ Clearly-defined laws ○ Effective legal systems ○ Patents = giving the owner of an invention exclusive ownership (a monopoly) for a specific length of time ○ Private vs. Public Ownership (e.g. neighbours fighting over common land) Glorious Revolution ○ England = key example of good institutions as a result of the Glorious Revolution in 1689 ○ Representative government (Parliament is given more power) ○ Protection of property rights ○ Patent system ○ All of these help investment ○ Credit markets can flourish because lenders will be repaid ○ Inventors will research because they can claim the rewards from their inventions Bad institutions ○ Extract resources from one group to another rather than supporting productive activity ○ Corruption ○ Expropriation of property or profits ○ High tax ○ Rent-seeking (attempts to gain wealth without economically beneficial activities) (spending resources without getting economical benefits) (e.g. government lobbying) ○ Divert resources to non-productive ends ○ Internal wars (if it were external then it could have benefits, but internal wars only destroy resources) Mediaeval vs. Modern Institutions So good institutions mean high growth, right? ○ Maybe institutions are endogenous ○ Maybe rich places can afford good institutions? ○ Perhaps something else causes both (geography? culture?) ○ Institutions are perhaps context-specific Something might work in a specific country at a specific time and not in another Modernisation Theory ○ “Perhaps the most widespread generalisation linking political systems to other aspects of society has been that democracy is related to the state of economic development.  03/10-21/11 2023 ○ Strong correlations between democratisation and ○ Wealth/income ○ Urbanisation ○ Industrialisation ○ Education (within country) More general criticisms of institutional theories ○ Richer countries tend to be democracies; is that because ○ Democracies support growth? ○ Growth leads to democratisation? Part II: Political Institutions: Democracy and Autocracy Political Institutions and Economic Growth ○ Political institutions are important both in deciding the size of the pie, and how fairly it is distributed ○ Determining legal framework ○ Economic management: fiscal and monetary policy ○ Deciding tax system and rates ○ Efficiency vs equity ○ Corruption and expropriation Feudalism and Serfdom ○ Medieval Europe involved series of decentralised territories only loosely bound into realms (no central state) ○ Power split between different allegiances, between Church and King and nobility and monarchy ○ Little intergenerational mobility between classes Absolutism ○ Monarch was top of the feudal pyramid, this grows into “absolutism”: development of centralised authority ○ Absolute monarchy = power of monarch is absolute; “divine right” ○ Monarch is personification of the state ○ Stage in development of nation-state ○ Associated with development of unified market and direction of national economy ○ Commerce controlled by government: mercantilism ○ Helped the growth of countries and economical markets Absolutism and Capitalism ○ Absolute rule can aid development of trade ○ e.g. Support for voyages of discovery  03/10-21/11 2023 ○ But also an inherent tension between capitalist freedom and absolute rule, particularly in international sphere where activities take place beyond “jurisdiction” ○ Expropriation risk deters investment ○ Absolute rulers can constrain capitalism (e.g. by banning trade or helping uncompetitive firms) ○ Early capitalist states also those that established representative assemblies earlier Representative Assemblies ○ Representative assemblies begin to emerge in Europe after 1000 AD ○ Some governed should give some form of consent to governors ○ Unique to Europe compared to China, Abbasid Caliphate, etc at same point in development ○ Associated particularly with early Italian city states (e.g. Florence) ○ Also early Parliaments where nobles gave consent to monarchs, although not clear whether was a true constraint Alternatives to Representative Assemblies ○ No similar assemblies elsewhere ○ Song dynasty in China ○ Similarly Abbasid Caliphate had well developed bureaucracy (Political Equality: Types of democracy ○ Illiberal democracy ○ Not free and fair elections ○ Regimes deprive citizens of basic rights and freedom ○ Formal (procedural) democracy ○ Free and fair elections, multi-party system and universal suffrage ○ Few other political rights ○ Liberal democracy ○ All characteristics of formal democracy ○ Citizens have civil rights and freedoms protected by law) Summary: Political Institutions ○ Vast range of possible political institutions ○ Autocracy = can focus on desires autocrats/elites/”selectorate” to understand policy-making ○ Democracy = more power for poor/minorities/non-elites ○ Positive correlation between democratisation and economic growth Part III: Political Institutions and the Rise of Europe Why do Europeans Develop Representative Assemblies? ○ Simplest theory: different ideas  03/10-21/11 2023 ○ Development of Athenian democracy and Roman law ○ But Aristotle’s works emerged in Latin after development of city republics ○ Also well-known among Abbasids and Byzantines ○ Roman law does offer plausible connection, but re-shaped: not a deterministic relationship ○ Differences in economic development ○ Within Europe it was the richest areas that developed representative assemblies: first Italian city republics, then Netherlands ○ Causality difficult to show because works in both directions ○ Cross-regional comparisons suggest that perhaps high GDP is not enough to cause development Why Europe II? ○ Back to warfare(!) ○ Early rulers needed revenue to fight wars ○ In return for tax revenue, they granted nobles certain rights ○ But...other regions also fought wars? ○ Difference: they already had a strong, centralised government and bureaucracy ○ Had “capacity” to raise tax revenue without needing consent ○ Ability to enforce tax collection Recap: European history ○ For 150 years after 1500 a series of wars marked a struggle to unite Europe ○ The Hapsburgs were the dominant power but unable to consolidate control ○ Europe develops advantage in military technology ○ Hoffman’s tournament model argues amount spent on war drives “learning-by-doing” ○ Warfare was not unique to Europe, but the scale of warfare was The Military Revolution ○ A series of wars taxed the capacity of the warring powers (extremely long) ○ Massive increase in size and expense of war ○ Majority of government spending devoted to warfare ○ France and Spain both declare bankruptcy in the same year (1557) ○ Cost of war increased from millions of pounds to hundred million pounds / per year ○ Technological changes lead shift away from cavalry to infantry ○ Necessitated much larger numbers of troops ○ Expansion in size and cost of shipping ○ Upward spiral in war costs Warfare and Financial Constraints  03/10-21/11 2023 ○ High spending particularly problematic for the Hapsburgs because they were always at war ○ Big difficulty due to trouble raising tax money at home The Financial Revolution ○ Countries began to develop sophisticated systems of banking and credit ○ Driven by needs of warfare ○ Expansion of trading networks and trade volume allowed bills of exchange and credit ○ Amsterdam = financial centre of Europe ○ Huge war cost necessitated huge borrowing ○ Required good system for raising loans ○ Government needed to have good credit “rating” ○ United Provinces and Britain particularly effective at raising loans (back to Glorious Revolution) ○ Representative assemblies allowed repayment of debt ○ Classic example of “good” institutions How do Governments Finance Spending? ○ Governments can finance spending in two (main) ways: ○ Taxation = taking money today from firms and households (ability to use force for taxation) ○ Borrowing = taking money today with promise of repayment in future ○ Taxation can be done by force: ○ Relies on state capacity ○ Strong tax system and/or norms of tax compliance ○ Borrowing relies on individuals being willing to lend ○ And so they must believe they will receive some return ○ i.e., Must expect they will be repaid Representative Assemblies and Property Rights ○ For investment in an economy to occur, strong property rights are needed ○ BUT not enough to establish property rights ○ Sovereign can still expropriate all property or not repay the debt (what happened with the Hapsburgs and France) ○ Need “credible commitment” to enforce the mechanism ○ Institutions can be a mechanism to solving this problem The Glorious Revolution ○ James II is replaced by his daughter and her husband ○ Largely bloodless revolution ○ Glorious Revolution established era of “Parliamentary sovereignty”; ○ Parliament  03/10-21/11 2023 ○ Was permanent (King could not dismiss it) ○ Held sole right to raise taxes ○ Could monitor royal expenditure ○ Had credible threat of removing King after the Civil War/ GR ○ Creation of a politically independent judiciary Why did this matter? ○ Before GR, King had issues raising money because borrowers couldn’t believe he would repay ○ Any promise made today, could be reneged on in future ○ Could not credibly commit to repaying loans ○ Parliament provide a credible commitment ○ Merchants in Parliament had incentive for low regulation / taxes ○ Plurality of voices prevented private interests being imposed ○ Multiple “veto players” North and Weingast (1989) ○ Results of institutional changes through looking at credit markets ○ Before GR, Crown raised money through forced loans, often not repaid ○ Afterwards, Parliament raised new taxes to pay for each new long-term loan Understanding Interest Rates Slides 109-111 (explanation) The noble is only willing to lend if the interest rate is “high enough” Will the noble lend? No Why don’t all countries choose good institutions? ○ Why did England and Netherlands have representative institutions and Portugal and Spain did not? ○ Culture? ○ (Maybe) poorer crown means more merchant freedom, meaning wealth from growing Atlantic trade ends up in hands of merchants ○ Wealthier merchants have more bargaining power… they can negotiate for representation ○ Circular effect (fascinating and infuriating): economic institutions → economic outcomes → political power → economic institutions What About Countries That Can’t Choose? ○ Many countries’ institutions are shaped by colonial legacies ○ Are these good or bad institutions? ○ Maybe it depends on the coloniser ○ An influential set of theories argues that British legal origin superior to French  03/10-21/11 2023 ○ Argument: common law (British) protects investors more than civil law (French) ○ Other work has pointed to the role of slavery or forced labour has having “persistent” negative effects on economies Institutional Persistence ○ Historical events have long term effects on institutions, although still not always clear why or how ○ Many of these studies criticised for not identifying the mechanism very clearly ○ Most countries haven’t been colonies for 70+ years now, but often haven’t managed to remove bad institutions ○ Some colonies did well: Australia, New Zealand, Argentina (until 1913)...what is the difference? ○ More generally, institutions may work for a while but then hold back progress when the world changes Summary ○ Institutions are often argued to be a major source of differences in development: ○ European representative institutions, and archetypal example of Glorious Revolution ○ Constraints on rulers + higher status of merchants ⇒ favourable conditions for trade and economic growth ○ Bad institutions: remove incentives for investment and undermine productive activity ○ Concept of “institutions” can be vague, and exogeneity not always clear ○ Institutions are often developed for a reason ○ Institutions can be shaped by history: ○ Persistent effect of forced labour institutions Economic Growth and The Malthusian Trap Several factors that have shaped long run human development: ○ Geography ○ Disease ○ Institutions ○ Innovation Malthusian Theory (explaining fluctuations before 1750) ○ No (permanent) change in average incomes from the palaeolithic to the Industrial Revolution ○ Fluctuations more noticeable than significant upward trend  03/10-21/11 2023 ○ Mankind caught in same “trap” as other species: size of population adjusts to amount of resources available ○ This pattern changed during (because of?) the Industrial Revolution Understanding Economic Growth Introduction - Economic Growth ○ = Growth of GDP per capita ○ There’s lots of variety ○ Worst economies of the world = southern hemisphere Real vs. Nominal Quantities ○ Real = physical, something that actually counts the quantity of goods and not their price ○ Nominal = monetary value of wages (GDP, etc, in terms of the currency at the time) ○ Real = accounts for “purchasing power”, by adjusting for differences in price levels ○ We care about the quantity of goods/service produced and consumed, not their prices Real vs. Nominal II-III ○ The difference between real and nominal is important when comparing across time or place ○ We measure nominal quantities, and then adjust for price differences ○ Across time: inflation/deflation ○ Across places: “purchasing power parity” ○ Nominal value = price x quantity ○ Real value = nominal value : price (only cares about quantity) ○ Example = growth in nominal salary vs. growth in real salary (income could go up and prices go up more, so the income could actually go down) Measuring Real GDP ○ GDP deflator = price index measuring the average prices of all goods and services in the economy, it is a measure of inflation ○ Real GDP = nominal GDP : GDP deflator UK Real vs. Nominal GDP ○ Real GDP = much more continuous line Measuring Economic Growth ○ Conceptually economic growth is quite straightforward ○ In practice it can be complicated ○ We can still measure GDP growth even if we can’t measure everything (such as black market)  03/10-21/11 2023 A Simple Model of the Macroeconomy ○ Aggregate production function: Y = F (K, L, Z) ○ Y = aggregate output (GDP) ○ F() = production function (general mathematical function) ○ 3 factors of production ○ L = stock of labour ○ Z = land ○ K = capital stock ○ Amount produced = function of the amount of the factors used ○ How do we produce the most outcome? Factors of Production ○ What is labour? ○ Number of workers ○ Work patterns (people may not work for different reasons - e.g. parental leave) ○ What is capital? ○ Machines ○ Buildings ○ IT ○ What is land? ○ Agricultural land The Cobb-Douglas Production Function ○ A = multiplying the capital, labour and land (this is how we think of technology) ○ A measures the technological progress of society (“multifactor productivity”) ○ Technology = how we use the 3 factors ○ Measuring technology is much harder Modelling Economic Growth: Concepts and Assumptions ○ Non-redundancy: ○ More of any input always means more production ○ Adding more people to the working force = more production ○ Marginal returns / product: ○ Margin = changing one thing very slightly ○ What happens if we add 1 more unit of land, of labour? ○ Slight change in the marginal return = how much production changes by adding just one factor, keeping the amount of all others constant ○ Nearly always assumed to be diminishing (law of diminishing marginal returns) ○ Economies of scale:  03/10-21/11 2023 ○ How production changes as we add more of all factors by the same proportion, all at once (e.g. double all factors) ○ Can be constant, increasing or decreasing Competitive Markets and the Macroeconomy ○ The amount of factors of production are determined endogenously ○ Normal assumption (because it is an assumption, it has its limitations) = there is a competitive market (free market) with firms and workers ○ Firms choose how much labour and capital to use ○ Individuals choose how much to work ○ The amount of land is fixed Output per Capita ○ We care about GDP per capita, not just GDP ○ How much is economic growth about capital, land and technological progress The “Fundamental Equation of Growth” (Clark) ○ Formula to determine the sources of economic growth ○ Gy = growth rates of output per worker ○ Gk and gz = growth rates of capital and land per worker ○ GA = growth of technology What is gA? ○ “total factor productivity” (TFP)* or “Multi factor productivity” ○ Measures how effectively all the inputs are used in production ○ Referred to as the “Solow residual” since it is what is left after accounting for the change in the stock of capital and land (and labour when looking at GDP) ○ Since it is calculated as a residual it often been referred to as a “measure of our ignorance” ○ It is hard to measure directly or to analyse ○ How do you capture “innovation”? Which cause is more important? ○ Z (land) can be ignored for the most part ○ We have to add “human capital” (skilled labour) ○ Share of capital in income tends to be quite constant over time ○ Technological growth is what matters (gA) Economic Growth Before the Industrial Revolution: The Malthusian Trap Understanding Economic Growth ○ Industrial Revolution marks start of persistent economic growth (there was growth before IR, but it is not sustained, it was not persistent)  03/10-21/11 2023 ○ Economic growth mainly explained by technological improvement and growing productivity ○ More is produced for a given amount of input (labour, capital) ○ To understand economic growth we need to understand innovation and invention An Introduction to Malthus ○ Thomas Malthus: An essay on the Principle of Population (1798) ○ Claims population growth undercuts sustained economic growth Malthusian Logic in Malthus’ Own Words ○ Two laws: ○ Food is necessary to the existence of man ○ The passion between the sexes is necessary and will remain nearly in its present state A Modern Interpretation ○ The model depends on three assumptions: ○ Population ↑ → real wages ↓ ○ Real wages ↑ → birth rate ↑ ○ Real wages ↑ → death rate ↓ The Race between Mortality and Fertility Malthusian Scissors (Graphs) ○ Income (X axe) birth/death rate (Y axe) ○ Called scissors because they cross ○ Assumptions ○ Birth rate increases with real wages ○ Death rate decreases with real wages ○ = population grows ○ Equilibrium income (also called subsistence income) ○ Where death rate = birth rate (= income that keeps population constant) ○ Can technological improvements increase living standards? ○ Technological improvement means producing more from the same amount of inputs ○ Higher output from the same amount of labour ○ Short run = technology means higher income ○ Long run = technological improvement is not as positive, it only increases population but not living standards ○ Technological improvement allows a higher real wage, but only temporarily since population will adjust ○ Better technology allows higher population, but not a higher standard of living  03/10-21/11 2023 ○ → Malthusian “trap” ○ Technological improvements only increase population, but do not improve living standards (in the long run) ○ As long as births exceed death rates (population grows), wages go down ○ Birth rates will then equal death rates again, but population will be higher then ○ → new equilibrium with same income but higher population (Graph) Law of Marginal Returns ○ Concave ○ Marginal product ○ How much extra output every unit added gives (how does production change adding labour?) ○ Only changing one factor, not all at the same time ○ Every unit of labour added, the line goes up a bit less (each person is adding less to the economy, everyone is worth less (economically), so they are paid less - curve is not as steep as in the beginning) Malthusian Policy Recommendations ○ Birth rate ↑ → population ↑ → subsistence wage ↓ ○ Population control allows a higher standard of living ○ Death rate ↑ → population ↓ → subsistence wage ↑ ○ War and famine allow a higher standard of living Why does higher population mean lower wages? ○ Amount of production added by one more unit of labour = marginal product of labour (MPL) ○ Nearly always assumed that marginal returns are diminishing ○ Each additional unit of labour is less productive ○ Marginal increment decreases in scale The Malthusian Mechanism in Practice Data on Mortality and Fertility ○ Used to be very high until 18th-19th century, now = much smaller A Crude History of World Population up to 1700 ○ Small & chaotic population growth, but positive (n = 0.1%) ○ Not complete Malthusian stagnation: world population tripled between 0 and 1700 ○ Remember: small differences in growth rates matter a lot when they persist over centuries The Black Death as a Malthusian Shock  03/10-21/11 2023 ○ The effect of population on real wages is relatively uncontroversial both theoretically and empirically ○ 1/3 of Europe’s population is killed ○ Wages almost double How can we measure living standards in the long run? ○ Main measure used by economic historians is real wages ○ Actual wage (w) divided by the price of goods that are bought (purchasing power of the wage) Malthusian model assumptions ○ Inverse relationship between population and wages (diminishing marginal returns) ○ Higher wages means lower mortality ○ Higher wages means more births Summary ○ Living standards rose very slowly in the millenia before 1800 ○ Malthusian processes (population fluctuations) played a large part in this ○ Black Death provides stark example of how reduced population affects real wages ○ Dispute about whether this was because of Malthus’s “checks”, or exogenous shocks ○ But clear that this link was broken after 1750 (if not before) in North-Western Europe with wages continually increasing Innovation and the Industrial Revolution The (British) Industrial Revolution What was the Industrial Revolution? ○ 1760-1830 ○ Set of changes that irreversibly altered Britain’s economy and society The Four Industrial Revolutions ○ British Industrial Revolution ○ Textiles and steam ○ Late 19th to early 20th century ○ Mass production ○ Electrification ○ Late 20th century ○ Automation ○ Information Technology (IT)  03/10-21/11 2023 ○ Early 21st century (still debated) ○ Robotisation ○ Artificial Intelligence (AI) What was the (British) Industrial Revolution? ○ Economic changes ○ Transition from economy dominated by land to an economy dominated by “capital” (machines) ○ Development of capitalist labour relations ○ Start of first consistent and permanent productivity improvements ○ Series of important technological breakthroughs ○ Social changes ○ Family make-up and fertility decisions ○ Status of women and children in the home and workforce ○ Development of skills and mass education ○ Interactions with political and religious institutions What was the industrial revolution? ○ Multiple reinforcing revolutions ○ Technological revolution ○ Demographic revolution ○ Rapid growth in population (related to Malthus) ○ Urban revolution ○ Population percentage that lived in towns and cities increased ○ Agricultural revolution ○ Farms had to supply more food with smaller proportion of labour force (because of urban and demographic revolution) ○ Better crop rotation and selective breeding ○ Commercial revolution ○ Exports and imports became increasingly important ○ Rapidly growing manufacturing exports ○ Transportation revolution ○ Reduction in transportation costs due to improved ships and navigation ○ Inland shipping costs fell due to new canal system and improved roads ○ Steam power reduced costs further through railway and steamships ○ Financial revolution ○ Growth in commerce required an expansion of trade credit ○ Legal changes allowed land to be used as security to raise long term loans (mortgages) ○ Establishment of the Bank of England allowed refunding of national debt  03/10-21/11 2023 ○ Energy revolution ○ Coal industry developed ○ British manufacturing had access to low cost coal ○ Many of these processes began before 1760, others take up afterwards ○ Together they show the construction of many elements of the modern economy Technological revolution ○ Huge range of technologies advanced ○ Cotton = spinning jenny, flying shuttle ○ Transport = steam engine and steamboats ○ Energy = puddling and rolling ○ Manufacturing = factory system and division of labour Inventions of the industrial revolution: textiles ○ Most prominent part of the industrial revolution ○ Britain was a small producer in mid-18th century ○ How to make cotton (video) Inventions of the industrial revolution: cotton ○ Many attempts made to improve how to make cotton ○ Spinning Jenny = by pushing a wheel, various threads are spun ○ Raised capital-labour ratio 70-fold ○ Water frame ○ Wheel is pushed by water ○ Cotton Mule ○ Less labour needed to produce more ○ Combination of best of water frame and mule Change in cost of cotton over time ○ Over 76 years costs halves, even though the cost of raw cotton remains almost the same ○ Capital increases (because machines have to be built), but in the end it decreases because people spend more in total in capital (beginning of economy in scale), by getting big enough you spend less per unit (?) Inventions of the industrial revolution: weaving (videos) Inventions of the industrial revolution: steam power Economic growth during the Industrial Revolution ○ Technological improvement was not necessarily associated with rapid economic growth ○ Income per capita was estimated to be slowly but constantly increasing  03/10-21/11 2023 How can we think about this? ○ 2 sectors of the economy ○ Industrial (growing rate = 4% per annum) ○ Agricultural (growing rate = 1% per annum) ○ If at the beginning of the Industrial Revolution the industrial sector is small, the overall growth will be small ○ It will take 74 years for the 2 sectors to be of equal size ○ Much of the story of the Industrial Revolution is of advance in a few small sectors Why did it start in England? The Industrial Revolution and the Malthusian Trap The Industrial Revolution and the Malthusian Trap ○ Inverse relationship between population and wages (increasing technology leads to more people, and that leads to lower wages) ○ Post-IR technological change is now consistent (not an exogenous shock) ○ Move to economy based on capital (K) and not land (Z) ○ Land is fixed, it becomes a not very important part of the economy (diminishing marginal returns) ○ Capital is not constraint (it is unlimited) ○ Development policy has focused on increasing (human) capital and stimulating technological take-up Law of diminishing marginal returns ○ Output increases as we use more of any factor, keeping everything else fixed ○ What happens as we add more labour (keeping everything else constant)? ○ I see the marginal product of labour ○ Marginal increment decreases in scale (adding more and more units of labour, the output continues to increase but always in a smaller percentage) The Industrial Revolution and Economic Growth ○ Technological development has several parts: ○ Creation of new product/process (invention) ○ Introducing and improving those ideas (innovation) ○ Imitating and implementing existing ideas (diffusion) Why did the IR happen in Britain? ○ 3 groups of explanations ○ “Idealist” / cultural = associated with cultural changes (Mokyr) ○ Incentives / real wages (Allen) ○ Hybrid accounts / endogenous values (Clark)  03/10-21/11 2023 ○ Alternative categorisation = demand vs supply for inventions “Supply-side” Theories of the Industrial Revolution Idealist accounts ○ Roots of the IR can be found in the Scientific Revolution of the 16th century (Mokyr) ○ Enlightenment includes revolutions in science, politics and philosophy ○ Industrial Enlightenment = belief that material progress and economic growth could be achieved through increasing human knowledge of natural phenomena Idealist accounts: Industrial Enlightenment ○ Creation of social networks = correspondence (letters) between scientists and industrialists ○ Application of scientific method to technology through experimentation ○ Enlightenment = movement from above (elite), rather than from below Idealist accounts: Clark’s criticism ○ Enlightenment was a European-wide phenomenon ○ Then why did it happen in Britain? ○ Why did it take so long (c. 100) years for the Scientific Revolution to lead to technological change? Changes in Education ○ High wages are an incentive to get educated ○ Commercial economy necessitates more correspondence → higher returns to education ○ Development of printing press reduces cost of learning Institutions and incentives to innovate ○ An alternative theory emphasises England’s institutions ○ Culture is often thought of as an institution ○ Institutions constrain and incentivise behaviour ○ Important (good) institutions ○ Protection of property rights ○ Representative government ○ Patent system ○ Inventors will research because they can claim the rewards from their inventions ○ Criticisms: Many were not able to protect their patents, Profits remained low Theories of the IR: Induced innovation (incentives / real wages) Induced Innovation: Firm-Level Choices ○ Firm-level decisions to understand economy-wide use of capital  03/10-21/11 2023 ○ Firms aim to ○ Maximise profit ○ Minimise costs ○ Firms’ choices ○ Set prices and quantities ○ Hire workers and capital ○ Firms choose which different factors of production to use Firm-level decisions: production (isoquants) ○ Firms want to see how much capital and how much labour are needed in order to produce a fixed amount of output ○ Isoquant = capital-labour combinations that produce the same amount of output ○ Always downward sloping (if I use less capital, I will have to use more labour) ○ Using more capital and more labour, I will produce more (higher output) Firm-level decisions: cost ○ Total cost of production of a single unit ○ C (total cost) = rK (cost times amount of capital) + wL (cost times amount of labour) ○ Isocost = capital-labour combinations that produce the same total cost (amounts of capital and labour used that cost a fixed amount) ○ If I use more capital and more labour, it must cost more ○ If gradient changes, it tells us something ○ Line gets steeper ○ Labour is more expensive (relative to capital) ○ Cost of capital is the same, but labour is more expensive - I can afford less labour Firm-level decisions: what capital-labour ratio will they use? ○ How do firms maximise? ○ (choose capital-labour combination where) Isocost is tangent to isoquant (minimum cost for producing the amount of output we want to achieve) Firm-level decisions: what happens when real wages change? ○ Real wages went up ○ Switch away from labour and turn towards using more capital ○ (firms care about relative factor prices - e.g. cost of labour compared to capital) Induced innovation (slide 65) ○ Macro-inventions require committing to research and experimentation, which requires incentives  03/10-21/11 2023 ○ Most focus will be given to inventions that are most desirable to firms “Induced innovation” ○ England was special ○ Had high wages ○ Had cheap coal ○ Development of capital-intense and coal-intense technology Induced Innovation: Criticisms ○ Why the sudden change? ○ Other countries had access to coal as well (through trade) De Vries: the Industrious Revolution ○ Focus on demand side of revolution ○ Shift in household behaviour due to growing aspiration and changing tastes ○ Harder and more work ○ Aspirations for new consumer goods Theories of the IR: Endogenous Growth Theories ○ Often very complicated mathematically ○ “Endogenous” because growth is driven by events within the system, not outside of it Summary ○ Many different theories of Industrial Revolution ○ Distinguish between ○ Changing incentives: relative prices, institutional changes ○ Differential response to same incentives: behavioural change ○ England became the industrial leader, but this led to changes in the world economy too ○ Implications for other countries ○ Why did some countries catch up to England and others did not? ○ Industrial Revolution = start of sustained technological progress ○ Most famously in cotton, but affected a wide range of industries ○ The demand vs supply of inventions: ○ Demand: factor prices and induced innovation ○ Supply: Culture and the Industrial Enlightenment ○ Cannot easily disentangle them: e.g. high wages affect both Modern Economic Growth Which countries developed after GB?  03/10-21/11 2023 Convergence in the 21st century Industrialization After the Industrial Revolution ○ How did other countries develop after Britain? When? ○ The Great (nineteenth-century) Divergence ○ The original success stories: Northern Europe, United States ○ The original “losers”: China, India, Africa ○ The Late (twentieth/twenty-first century) Convergence ○ Some factors ○ Incentives to take-up new technologies ○ Role of government and colonisation ○ Effect of globalisation (the dog that didn’t bark) Convergence, Divergence, and The Neoclassical Growth Model What happens? ○ England becomes rich, then other countries begin to take up technology and catch-up ○ In practice, only a few countries catch up with England ○ United States surpasses England ○ North-western Europe largely stays in touch with England ○ Elsewhere little effect either in modern developing countries but also most of Europe ○ More countries catch up in the 20th and 21st century Long Run Outcomes ○ (Nearly) everyone gets richer but at very different rates ○ Europe and the United States grow, rest of the world languishes ○ Gap between rich and poor expands ○ Poorest economies today are poorer than the average economy before the Industrial Revolution ○ In the 20th century the “periphery” begins to catch-up ○ USSR, East Asia, India (eventually) Post Malthusian: World Production Function ○ Aggregate per capita production function ○ Industrial world = possible to ignore land ○ Income = driven by technology World Production Function ○ Ability to use more and more capital ○ More capital is added per worker Human Capital  03/10-21/11 2023 ○ Becomes increasingly important in the world production function ○ In modern “post-industrial” economies the production function incorporates human capital ○ Distinguish between “skilled” and “unskilled” workers ○ What determines human capital? ○ Education (e.g. literacy rates) ○ Experience, work ethic, culture The Neoclassical Growth Model ○ Standard economic growth model = everything is based on competitive markets ○ The model predicts that differences in national income per capita in the long run (“steady state”) are a result of: ○ Differences in saving rates (=investment) and hence capital per worker (k) ○ Differences in education and hence human capital per worker (h) ○ Differences in technology (A) ○ Differences in population growth rates ○ Conditional on these features, countries should catch-up ○ “Absolute” or “unconditional” convergence = poor countries should catch-up (no conditions) ○ “Conditional” convergence = there can be differences in income levels across countries if these key features vary across countries ○ If there are no differences in these features, poorer countries will grow faster and catch-up with richer ones (that’s what happens for many countries in the 20th century) Converging on Convergence? ○ Relatively flat until 1990 ○ From 2000 on, countries catch up (inverted line) Conditional - Absolute Convergence? ○ Argument: “the world has converged to absolute convergence because absolute convergence has converged to conditional convergence” ○ Convergence in policies across different countries ○ World has become more stabilised ○ Countries become more similar and poorer countries close the gap with richer ones ○ Globalisation has meant policies/institutions are more similar and so they “matter less” Summary ○ Neoclassical growth model predicts conditional convergence: countries should catch up if they have the same underlying economic characteristics (technology, savings rates, etc)  03/10-21/11 2023 ○ Countries should not necessarily catch-up “unconditionally” ○ So why don’t poorer countries simply copy the policies, technology, etc. of the rich? Technical Change Technological Change and Economic Growth ○ Importance of technical change in driving economic development (IR) ○ Neoclassical growth model suggests that if countries all have the same policies and technology then they should have the same long-run growth Technological Change: Key Concepts ○ Invention: Creation of new product/process ○ Innovation: Introducing and improving those ideas ○ Learning-by-doing: productivity improves because workers repeat a task ○ Diffusion: Imitating and implementing existing ideas ○ Labour (Capital) Productivity: Output produced per unit of labour (capital) ○ Capital-saving: less capital needed to produce same amount of output ○ Labour-saving: less labour needed to produce same amount of output ○ Unbiased technical change: increases productivity of all factors of production equally ○ Biased technical change: increases productivity of some factors more than others ○ Capital-biased: productivity of capital increases more than other factors ○ Machines become more efficient, and that helps need less labour ○ Skill-biased: productivity of high-skilled workers increases more than low-skilled Technology as a Public Good ○ Neoclassical model takes technology as “manna from heaven” ○ It arrives from nowhere, all countries have it ○ Conceptually, we can ask whether is technology a public or private good? ○ A pure public good is ○ “non-rival”: one person using a good does not prevent others from using the public good (and it has no implication, it does not affect how much they can use it) ○ “non-excludable”: impossible (or prohibitively costly) to prevent others from using the public good (I cannot stop others from using it) ○ If technology is a public good then all countries should have the same technology (it is a public good in the world) (A in the production function) ○ Firms / governments should simply copy technology ○ Inventors cannot claim rewards from their inventions ○ → we need a model of technical change which does not require private incentives ○ (If technology is a private good then ownership defined by clear property rights  03/10-21/11 2023 ○ Inventors can gain financial rewards from their inventions ○ → we need a model of technical change driven by private incentives) Population Growth and Technological Change ○ Economists believe we should never invest in public good because we cannot get any money back ○ The model of technology as a public good is a bit limiting ○ Start with Malthusian relationship between population and growth ○ BUT: technological change is driven by population growth (it is endogenous) ○ Specifically, Kremer’s model predicts: ○ Growth rate of population defined by available technology (a la Malthus) ○ Growing population → more ideas ○ Growing population → better technology → growing population → better technology →...etc etc ○ Overall: large population density → high growth ○ This model predicts industrialization (at the world level) endogenously ○ Once the world became dense enough, there were more ideas Innovation and Agglomeration Economies ○ Another source of technology as public good are “agglomeration economies” ○ Innovation is often spatially concentrated (e.g. Hollywood in movie industry) ○ Locating together can lead to “spillover effects” (= more people together = more ideas and exchanges) ○ Co-location helps sharing of goods, workers, and knowledge ○ Governments often seek to stimulate high-tech “development clusters” to benefit from these spillover effects Technology as a Private Good: Incentives to Invent ○ Institutions: patent system/property rights increase returns from innovation ○ Stimulates investment in Research & Development ○ Market scale: larger market means higher rewards: ○ A 1 cent profit on a billion sales is a lot of money, on 10,000 it is not a lot ○ BUT this is irrelevant if technology is non-excludable ○ Also: cheaper to produce at large scale (economies of scale) ○ Relative factor prices: Firms demand for inventions that save on the expensive factor Recap: “Induced Innovation” ○ England was special because: ○ It had high wages (cheap capital) ○ It had coal (not peat) Back to Induced Innovation ○ Distinguish between “macro-inventions” and micro-improvements  03/10-21/11 2023 ○ Macro-inventions: “set in train long trajectories of advance that resulted in great increases in productivity” ○ e.g. steam power, spinning jenny ○ Often applying ideas from other fields (e.g. steam power used ideas from natural philosophers) ○ Micro-improvements: “all the improvements in the trajectory of advance that elaborated macro-inventions and realised their possibilities” ○ Improvements to existing ideas ○ They require smaller investments, since they involve local changes ○ Often developed through “learning by doing” rather than inspiration Take-up and invention of new technology (other ppt) ○ Low-wage country (red line) ○ High-wage country (green line) ○ T = capital-intensive, labour saving invention (new technology) ○ High-wage countries take up new technologies faster, manage to move to isocost 2 ○ Technology improves, uses less labour and capital ○ As technology becomes cheaper, even low-wage countries take them up (over time) Induced Innovation ○ Macro-inventions will be developed in economies with sufficiently high wages ○ The technology won’t be taken up in low-wage economies even when it exists ○ Micro-inventions happen through learning-by-doing ○ Eventually producers in all economies will take-up the new technology (the technology diffuses) “Elevator of growth” ○ Growth of world economy has reflected increasingly capital-intensive production ○ Technological progress has evolved enabling more capital per worker ○ Largely driven by inventions in “rich” economies, via R&D investment ○ High-wage economies → demand for labour-saving technology→ more capital per worker → labour is scarce → wages are high →... ○ ⇒ An initial headstart is persistent ○ If you can get started on a cycle you can continue to grow, but starting is pretty hard Induced Innovation: Theoretical Criticisms ○ Theoretically, the induced innovation story is a bit more complicated ○ Inventors cannot look ahead, otherwise they would understand the benefits from learning-by-doing ○ Must be the case that labour-saving devices are more beneficial  03/10-21/11 2023 ○ Could reflect differential efficiency (productivity): wages can be high because EITHER labour is scarce or because labour is productive ○ Remember: real wages = marginal product of labour Summary: Sources of Technological Development ○ We can think of technology as having BOTH public and private good aspects ○ To the extent it is a private good, the predictions of the basic neoclassical model might not work ○ Countries cannot simply copy / adopt technology from elsewhere ○ Theory of induced innovation suggestions countries’ patterns of invention may be due to differential incentives Government, Convergence and Divergence Government and the Great Divergence ○ Why do some countries end up on the Elevator of Growth and others do not? ○ US grows to become world economic leader (early 19th century) ○ Exemplifies a “standard model” ○ Creation of mass market, with investments in capital and education ○ Importance of market scale ○ We need to understand differences in investment in capital, investments in human capital, and innovation Endogeneity of Factor Prices ○ Induced innovation = relative prices of production inputs shapes both innovation and diffusion Incentives to Invent in the U.S. ○ Natural resources were an abundant factor ≡ labour was an expensive factor ○ Demand for resource-intensive, labour-saving technological change ○ Large market due to large, homogenous, population ○ Citizens with similar incomes (low inequality) ○ Allowed for design of specialised machines producing standardised products and interchangeable parts Government Involvement and US Economic Growth ○ Mass market created by government policy ○ Removal of internal tariffs (taxes on trade between states) ○ Transportation improvements to create mass market (e.g. Erie Canal) ○ Open to immigration until early twentieth century ○ Mass education leading to high skilled workforce ○ National banks to stabilise currency and ensure credit → supported investment ○ External tariffs protected US industry post-1815  03/10-21/11 2023 ○ Encouraged investment in US textiles industry by protecting from competition by UK firms ○ Protecting “infant industry” The Standard model of 19th-century economic development ○ Key components: ○ Abolishing internal trade barriers ○ Develop transport links to increase market size ○ Use tariffs to keep out British manufactures ○ Tariff = tax on imports ○ Makes domestic production more competitive ○ Investment banks channel capital to industry ○ Mass education to create high skilled workforce ○ Exact implementation varies across countries Imperialism and the Great Divergence ○ There is a relationship between imperialist powers and industrialisation ○ Countries that industrialised early tended to be powerful before 1800 ○ Many countries were forced to accept 0 or low tariff trade ○ Forced “deviation” from the standard model Japan and China ○ Relatively sophisticated societies ○ Cannot impose tariffs on their manufacture goods to Western countries ○ Western countries seeked favourable treaties Russian Twentieth-Century Catch-Up ○ Standard model during USSR = GDP per capita grows ○ Collapse of USSR = GDP per capita goes down ○ GDP per capita starts going back up Big Push Industrialization: Russia (USSR) ○ Coordinated attempt to build all the elements of an industrial society ○ USSR = forcible reallocation of resources from agriculture towards industry ○ Planners set both prices and production prices ○ Attempt to control development through, for instance, subsidising urban living conditions ○ Shrinking of consumption in order to support growth Socialism in Soviet Russia ○ A series of 5 year plans is implemented: the classic example of big push industrialization ○ Soviet economy was transformed from rural to industrial nation  03/10-21/11 2023 ○ Vast industrial production, although living standards did not increase in the same way ○ Collectivization of agriculture ○ Forced low prices → peasants forced into cities: cheap source of labour ○ Widespread food shortages and starvation (famine) The Development State ○ Attempts to boost capital development, encourage technological development ○ Typical elements of “Standard model”, but with added features ○ Central government planning ○ State-owned (or nationalised) industries ○ Export promotion / import substitution ○ Some success, with rapidly developing urban areas, but not catch-up ○ Markets were too small, so they could not reach efficient capacity The Development State: Successes ○ Post WWII: Japan: invest heavily in advanced technology, wait for factor prices to catch up ○ Benefited from ability to sell into large US market, justifying large factories ○ High wages due to company culture also boosted ability to purchase and hence a large domestic market ○ Korea, Taiwan: similar path to Japan, with high investment in education, advanced technology and heavy industry ○ China: ○ Large scale Soviet-style investment in 1960s and 1970s, but only limited growth ○ Reforms in 1970s allowed local production and sales in free market ○ BUT still widespread state ownership and state planning of investment ○ State-owned banks, undervalued exchange rate (implicit subsidy) ○ Large focus on international trade: manufacturing dependent on global market The Development State: State-Owned Enterprises ○ Theoretically state-owned enterprises may be bad since: ○ Soft-budget constraints (no property rights) ○ Poor incentives for managers (agents) ○ BUT similar criticisms can be laid at private companies (“too big to fail”), shareholder control ○ Many successes ○ e.g. Renault (and other French companies) used to be SOEs ○ Where beneficial? ○ Overcome capital market difficulties due to (e.g.) short-term private-sector investment horizons: “kick-start” capitalism  03/10-21/11 2023 ○ Potential for natural monopoly Summary: Post WWII Convergence ○ The period since WWII has seen convergence between the “West” and other parts of the world ○ Most notably East Asian “Tigers”, China ○ Alongside era of decolonization: e.g., an independent Middle East increasingly powerful as a source of fossil fuels ○ In contrast to 19th century, governments taking a more interventionist role ○ Governments increasingly responsible for managing the economy worldwide ○ Attempts to incentivize (force) savings and capital accumulation, later human capital ○ Particularly extreme in the Soviet Union, but also in various versions of the “Development State” ○ 1990s see increasing consensus on the importance of free markets, and openness to international trade Summary ○ The British Industrial Revolution was followed by a period of global divergence ○ Manufacturing expanded in the West and its offshoots, declined in China/India ○ Europe and the US caught up with (and exceeded) Britain, other areas remained poor ○ The second half of the 20th century saw the period of divergence draw to a close ○ Convergence has continued in the 20t -century: China is now the world’s largest economy ○ Government has played a major role in shaping and enabling industrialization (or not) ○ ⇒ lessons for building economic growth more generally Producers and Consumer Decision-Making Economics ○ Distinguish between: ○ Macroeconomics ○ Study of the overall economy ○ Microeconomics ○ Study of individual economic agents (firms, households) and markets Governments aim to encourage or force economic development Pattern has changed over time, convergence has been happening in the last decades Because of globalisation, institutions and policies have become more similar, so they “matter less”  03/10-21/11 2023 After WW2 = governments have become more and more involved in the economy (more interventionists) Analysing markets What is a Market? ○ An institution for allocating goods and services ○ Involves voluntary exchange (to what extent is one going to work voluntary? it’s a necessity most of the time) ○ Not necessarily involving money (e.g. barter) ○ Distinct from government control / central planning ○ Underpinned by existence of private property (one cannot buy stuff if it’s not someone else’s property) ○ Capitalist Economic Production: production based in firms Firms and Economic Production ○ When and how will economic agents engage in voluntary exchange? ○ What will they produce and sell (market supply)? ○ What will they want to buy (market demand)? ○ How much will they buy/sell? At what price? (Market equilibrium, Demand and Supply) Consumer Decision-Making and Market Demand Consumers ○ The counterpart of the producer problem is the consumer problem ○ Consumers have to decide how much to buy, of which goods, at different prices ○ Consumer decision-making underpins market demand Consumer Preferences ○ Consumers have preferences over different goods and services ○ We can represent those preferences by a “utility function” ○ Utility functions are underpinned by over rational decision-making ○ Simple additive utility function: ○ U (apples, bananas) = number of apples + 3 × number of bananas ○ “Budget constraint” = consumers trained by the income they have available ○ Consumers’ problem = how much of each good to buy Indifference Curves ○ The consumer problem can be studied using similar methods to firm-level production choices ○ Indifference curves (similar to isoquants): trade-offs between different goods giving same level of utility  03/10-21/11 2023 ○ = gives the combination of different goods that produce same utility ○ Perfect complements = the more I have of one thing, the more I want of another (e.g. no need of having more erasers if I don’t have more pencils) (more of one good increases the value of another) ○ Perfect substitutes = having more of one thing compensates for less of another ○ Budget constraint (similar to isocost): affordable combinations of goods ○ Budget line further away from the origin = larger budget (consumer can afford to buy more) ○ Optimal consumption bundles depends on relative good prices, and on income ○ Consumer wishes to choose the bundle that will maximise their utility, subject to their budget constraint (a mix of the two) Consumer Problem: Price Increases ○ Consumer’s budget stays the same but price increases ○ They can no longer reach the previous indifference curve ○ Utility is now lower ○ Consumes fewer apples and more bananas (substitution effect) ○ Bananas are not perfect substituted though ○ We cannot tell in advance ○ Trade-off between: ○ Substitution effect (relative prices) (product is more expensive relative to other products, so the consumer switches) ○ Income effect (lower real income) ○ Apples = only affected by income effect ○ Quantity consumed will go down ○ As price of a product goes up, a consumer will consume less of it Consumer (Individual) Demand Curve for Apples ○ Downward sloping ○ Change in price is reflected along the curve ○ Price increases ○ Quantity of apples consumed for each price goes down ○ Changes in other aspects of the market will shift the curve ○ E.g. price of apples goes down → demand for bananas goes down Consumer Demand: Income Changes ○ Income increases ○ Budget increases, with no change in relative prices ○ Can afford more than before ○ Leads to consuming more of both goods  03/10-21/11 2023 ○ We don’t know in advance: can either buy more or afford more quality goods Individual Level and Market Demand Curves ○ Using utility functions, we can construct individual-level demand curves ○ Relationship between product’s own-price and individual’s consumption of that product ○ How much would each individual buy of each product, at each price ceteris paribus? (= keeping incomes and prices of other products constant) ○ Then we can sum these together to construct market-level demand curves ○ Individual-level demand curves are downward sloping → market demand curves are downward sloping ○ Higher market prices → lower market demand ○ More people → higher market demand Firm Decision-Making and Market Supply Firm-level Choices ○ Firms bring together factors of production to produce output ○ Firms aim to maximise profits ○ Profit (pi) = Total Revenue (R) - Total Cost (C) ○ Q = quantity produced ○ P = selling price ○ Higher prices mean that firms will sell fewer products ○ Firm’s problem: trade-off price and quantity to maximise profits ○ Firms would like as high a price, and a low a cost as possible ○ But they face constraints ○ Costs are constrained by their production function and factor markets ○ Prices are constrained by the demand for their product ○ Firms also face choices over which products to produce, how to market, how to invest, etc ○ We are considering the simplest version: a firm producing a single good (no variation, brands, etc) with an established technology What affects Demand? ○ Consumer preferences ○ How much do they want (need) a product? ○ Consumer income ○ How much can they afford a product? ○ Market environment ○ What options does a consumer have? Markets and price-setting  03/10-21/11 2023 ○ In a competitive market firms are price-takers ○ In practice they cannot set the price ○ They do not have “market power” ○ The quantity they produce does not affect the market ○ They have to sell at the “market price” ○ If they set the price above the market price, consumers will leave ○ So we can take the price as exogenous to the firm ○ This is true in a competitive market: at the extreme “perfect competition” ○ Not true if firms have monopoly power (e.g., due to strong branding) What affects Firm Costs? ○ Available technology / production function ○ How much capital/labour/etc is needed? ○ Depends on scale of production ○ Factor prices ○ What is the price of capital/labour? Technology and firm-level production functions ○ We can represent firm-level production function through isoquants ○ Combining with the isocost identifies the minimum cost for every level of production ○ The tangent point between the isocost and isoquant give the cost-minimising combination of capital and labour ○ Relative factors prices affect the tangent point, and so the cost of the firm Returns to Scale ○ Often large firms can be more profitable simply because they produce more ○ One reason is that production functions may exhibit “returns to scale” ○ Constant of Scale = increasing all inputs by a fixed proportion increases output proportionally ○ Increasing Returns to Scale = increasing all inputs by a fixed proportion disproportionally increases output ○ Decreasing Returns to Scale = increasing all inputs by a fixed proportion increases output by less than proportionally The Cost Function ○ To understand the optimal quantity, we need to understand how the costs of producing vary according to the quantity produced ○ Total Cost = Total Fixed Cost + Total Variable Cost ○ Fixed costs: do not vary with amount produced ○ Start-up costs, cost of buying a machine ○ Overhead costs, such as management ○ Research and development ○ Advertising, lobbying  03/10-21/11 2023 ○ Variable costs: costs for every unit produced ○ Hourly wage, or production input Average vs. Marginal Cost ○ Marginal Cost = additional cost from one more unit of output (closer to a variable cost) ○ Marginal costs are generally increasing (each additional unit of productions costs more to produce) ○ Average Cost = total cost divided by the quantity Marginal Cost and Marginal Revenue ○ Marginal Revenue = additional revenue from selling one more unit ○ Marginal Cost = additional cost of selling one more unit (how much it costs me) ○ Firms will ALWAYS want to produce where MC = MR ○ If MC > MR, then an additional unit of sales will lose money (loss on the extra unit) ○ If MC < MR, then an additional unit of sales means more profit (I’d do it) Marginal Cost, Marginal Revenue, and Price ○ Firms will ALWAYS want to produce where MC = MR ○ But be careful: MR does not necessarily equal the price ○ The price is the Average Revenue (AR) = the revenue per unit sold ○ But a higher price has two possible effects: ○ Higher revenue per unit sold (average revenue) ○ Lower demand and hence fewer units sold ○ Marginal revenue incorporates both of these effects Producers ppt Cost Functions … By producing more I sell more and production costs lower Allocatively efficient Competitive market For the exam: learn competitive market and monopoly Practice ○ Can produce more but will sell less ○ Revenue = Q x P (producing more will not lead to more and more revenue, it’s not linear) ○ Find Cost ○ Find Profit ○ Answer: B Market Supply  03/10-21/11 2023 ○ Understanding firm-level decision-making allows us to understand the supply of goods to a market ○ In a competitive market, each firm’s supply will be determined by their marginal cost curve ○ Upward sloping due to assumption diminishing marginal returns ○ Market supply is the sum of all the firm-level supply curves ○ → also upward sloping ○ If firms have market power (the market is not competitive) the situation is more complicated ○ Firms set BOTH price and quantity: their optimal choice will depend on demand conditions (price choice will affect the overall market demand) ○ Their decision will be determined on how sensitive consumers are to price (“price elasticity of demand”) ○ Profit = Average Revenue (R) - Average Total Cost (ATC) Economies of Scale ○ Idea that larger scale production leads to cost advantages ○ Minimum Efficient Scale (MES) = smallest quantity at which firm achieves lowest possible cost What Quantity Should Firms choose? ○ Price-taking firms only set quantity ○ They will receive the same revenue for every unit they sell ○ Marginal revenue (MR) = price (P) ○ Each additional unit they sell will increase their revenue by P, but it will increase their profit only if MC < P ○ Profit-maximising output will be where P = MC = MR Consumer and producer decisions are the basis for market supply and demand curves Demand and Supply Firms and Economic Production ○ To understand the economy we need to understand market allocations ○ When and how will economic agents engage in voluntary exchange? ○ What will they produce and sell (market supply)? ○ What will they want to buy (market demand)? ○ How much will they buy/sell? At what price? (Market equilibrium, Demand and Supply) ○ We focus on the market for goods and services: firms sell, consumers buy ○ But market interactions underpin a range of other economic outcomes ○ Price of factors of production (e.g. wages)  03/10-21/11 2023 ○ Level of investment ○ Technological take-up, research, investment Goal: Understand Market Equilibrium ○ We want to understand market prices and quantities Competitive Markets Market Equilibrium ○ In economics we want to predict outcomes ○ In markets: price and quantities ○ Often we use the concept of “equilibrium”: a point at which nothing is expected to change ○ Absence of exogenous / external shocks, everything will remain the same ○ The system is in balance ○ Idea: an equilibrium point is where the (market) system will end up eventually ○ Economists model competitive markets using model of demand and supply ○ Markets are in equilibrium when demand =supply ○ The market clears ○ Gains from trade are fully realised ○ Law of One Price: All transactions carry out at same price (one market) ○ Does not work for every market (e.g. plane tickets) ○ Then we can analyse how shocks to demand or supply change market outcomes: ○ Demand shocks: change in preferences, changes in income, changes in prices of other goods ○ Supply shocks: changes in costs (input prices, technology), changes in structure of market ○ Predict the effect of policy changes: e.g., introducing taxes What is a Competitive Market? ○ Economic models commonly focus on competitive markets ○ At an extreme “perfect competition” ○ Major characteristics ○ Very large number of independent buyers and sellers (there’s not someone that has more power than others) ○ Products are identical (homogenous) (e.g. Pepsi and Coca Cola) ○ Price information easily available (I need to know who else is selling the same product and at what price) ○ Low transaction costs (does