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Summary of all prescribed chapters of the book, Principles of Economics IBL, Leiden Universiteit,
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PRINCIPLES OF ECONOMICS — BookWeek 1
Economics and the economy
Chapter 1 and Sections 2.2 and 2.3 of Chapter 2.
For measuring living standards we use the term GDP (Gross Domestic Product). GDP measures the
market value of the output of final goods and services in the economy in a given period. The GDP
corresponds to the total income of everyone in the country.
GDP per capita measures average income, but that is not the same as the disposable income of a
person.
Disposable income is the amount of wages or salaries, profit, rent, interest and transfer
payments form the government or from others received over a given period. It is a good measure
because: it is the maximum amount of goods that a person can buy without having to borrow.
Income is a major influence on wellbeing because it allows us to buy the goods and services
that we need or enjoy. But it does not cover every aspect of our wellbeing, for example:
● The quality of our social and physical environment such as friendships and clean air
● The amount of free time
● Goods and services that we do not buy
● Goods and services that are produced within the household
GDP includes the goods and services produced by the government, such as schooling, national
defence and law enforcement. They contribute to wellbeing, but are not included in disposable
income.
But government goods and services are difficult to value. They are typically not sold, and the
only measure of their value to us is how much it costs to produce them.
In economics, technology is a process that takes a set of materials and other inputs and creates an
output.
Technological progress is a process where the skills and time needed to produce a product are slowly
changed in a more effective way. By reducing the amount of work-tme it takes to produce the things
we need, technological changes allowed significant increases in living standards.
Global climate change is a result of the expansionof the economy and the way economy is organized.
The relationship between the economy and the environment is two-way:
● We use natural resources in production
● This may cause a turn in the environment we live in and its capacity to support future
production.
Capitalism is an economic system (= a way of organizing the production and distribution of goods
and services) characterized by a particular combination of institutions.
Private property
Goods were usually produced by families working together, rather than by firms with owners and
employees. Private property means that you can:
● enjoy your possessions in a way that you choose
● exclude others from their use if you wish
,PRINCIPLES OF ECONOMICS — Book
● dispose of them by gift or sale to someone else
● … who becomes their owner
Centrally planned economic system: societies in which the government has been the institution
controlling production.
Most economies today are capitalist. In this kind of economy an important type of private property
is the equipment, buildings and other durable inputs used in producing goods and services. These
are called capital goods.
Markets are:
- A way of connecting people who may mutually benefit
- By exchanging goods and services
- Through a process of buying and selling
Markets are means of transferring goods or services from one person to another. Markets differ
from these in three aspects:
● They are reciprocated (wederzijds)
● They are voluntary
● In most markets there is competition
Firm: is a way of organizing production with the following characteristics:
1) One or more individuals own a set of capital goods that are used in produciton
2) They pay wages and salaries to employees
3) They direct the employees
4) The goods and serviced are the property of the owners
5) The owners sell the goods and services on markets with the intention of making profit
Labour market:
● Employers are the demand side
● Workers are the supply side
In a capitalist system, production takes place in firms. Markets and private property are essential
parts of how firms function for two reasons:
● Inputs and outputs are private property
● Firms use market to sell outputs
Most production takes place using privately owned capital goods (= the durable and costly non-
labout inputs used in production).
Capitalism is an economic system that combines centralization with decentralization. It concentrates
the power in the hands of owners but limits it, because they face competition to buy and sell in
markets.
How could capitalism lead to growth in living standards?
1) Technology
2) Specialization
,PRINCIPLES OF ECONOMICS — Book
We become better at producing things when we each focus on a limited range of activities for three
reasons:
● Learning by doing
● Difference in ability
● Economies of scale
The division of labout possesses a problem for society: how are the goods and services to be
distributed from the producer to the final user? ⇒ Requisitioning and distribution.
Markets accomplish an extraordinary result: unintended cooperation on a global scale.
Comparative advantage: a person or country has comparative advantage in the production of a
particular good, if the cost of producing an additional unit of that good relative to the cost of
producing another good is lower than another person or country’s cost to produce the same two
goods.
Absolute advantage: a person or country has this in the production of a good if the inputs it uses to
produce this good are less than in some other person or country.
Developmental state: a government that takes a leading role in promoting the process of economic
development through its public investments, subsidies of particular industries, education and other
public policies.
The existence of capitalist institutions is not enough to create a dynamic economy. Two sets of
conditions contribute to the dynamism of the capitalist economic system; economic and the other
one political.
Explanation might be, in situations that capitalism is less dynamic (economic conditions):
● Private property is not secure
● Markets are not competitive
● Firms are owned and managed by people who survive because of their connections to
government of their privileged birth
Capitalism is the first economic system in which membership of the elite depends on a high level of
economic performance.
Political conditions: capitalism can be a dynamic economic system when it combines:
● Private incentives for cost-reducing innovation
● Firms led by those proven ability to produce goods at low cost
● Public policy supporting these conditions
● A stable society, biophysical environment and resource base.
All of the economic system takes place as part of a biological and physical system in which firms and
households make use of our natural surroundings and resources.
How to create an effective economic model:
Fisher’s study of the economics illustrates how all models are used:
1) First he built a model to capture the elements of the economy that hte thought mattered for
the determination of prices
, PRINCIPLES OF ECONOMICS — Book
2) Then he used the model to show how interactions between these elements could result in a
set of prices that did not change
3) He conducted experiments with the model to discover the effects of changes in economic
conditions.
⇒ His study illustrates an important concept in economics: an equilibrium is a model outcome that is
self-perpetuating, meaning that something of interest does not change unless an outside or external
force for change is introduced that alters the model’s description of the situation.
An income at subsistence level (the level of living standards such that the population will not
grow or declin) is an equilibrium, because movements away from subsistence income are self-
correcting: they automatically lead back to subsistence income as population rises.
A good economic model has four attributes:
- It is clear
- It predicts accurately
- It improves communication
- It is useful
For economic modeling we use four key ideas:
● Ceteris paribus: holding other things constant helps us to focus on the variables of interest
● Incentives matter; because they affect the benefits and costs of taking one action as
opposed to another.
● Relative prices; help us compare alternatives
● Economic rent: is the basis of how people make choices
○ Economic rent = benefit from option taken — benefit from next best option
○ Simple decision rule:
■ If action A would give you an economic rent (and nobody else would suffer):
do it!
■ If you are already doing action A, and it earns you an economic rent: carry
on doing it!
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