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Principles of Economics - UC3M COMPLETE COURSE NOTES
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Principles of Economics UC3M. Introductory course. Whole theory summarized from the slides.
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PRINCIPLES OFECONOMICS
Course 17585 –Bachelor’s in Management and Technology
Fernando Alfayate Fernández
2022/2023
,Tabla de contenido
1. CAPITALIST REVOLUTION, TECHNOLOGY, POPULATION AND GROWTH ..................................................................................5
1.1 WHAT IS ECONOMICS? .....................................................................................................................................................5
1.2 GDP AND ECONOMIC GROWTH .......................................................................................................................................5
1.3 ECONOMIC MODELS .........................................................................................................................................................5
1.4 MALTHUSIAN MODEL .......................................................................................................................................................6
1.4.1 ESCAPE: EXPLAINING THE I.R. .......................................................................................................................................6
1.4.2 ISOCOST LINE ................................................................................................................................................................6
1.5 ECONOMIC RENT ..............................................................................................................................................................7
1.6 CREATIVE DESTRUCTION ..................................................................................................................................................7
2. SCARCITY, WORK AND PROGRESS ............................................................................................................................................8
2.1 INTRODUCTION. A MODEL OF WORK AND LEISURE TIME. ..............................................................................................8
2.1.1 PRODUCTION FEASIBILITY FRONTIER (Frontera de Posibilidades de Producción o Frontera Factible) ........................8
2.1.2 PREFERENCES & INDIFFERENCE CURVE ........................................................................................................................9
2.2 DECISION TAKING & SCARCITY .........................................................................................................................................9
2.3 INCOME & SUBSTITUTION EFFECT ................................................................................................................................ 10
2.3.1 EFFECT OF AN ADDITIONAL RENT.............................................................................................................................. 10
2.3.2 EFFECT OF A VARIATION IN WAGE ............................................................................................................................ 11
2.4 MODEL APPLICATION .................................................................................................................................................... 11
3. STRATEGY, ALTRUSIM AND COOPERATION ........................................................................................................................... 12
3.1 GAME THEORY ............................................................................................................................................................... 12
3.2 RESOLVING SOCIAL DILEMMAS ..................................................................................................................................... 13
3.3 DYNAMIC GAMES .......................................................................................................................................................... 14
3.4 JUDGING GAME SOLUTIONS: EFFICIENCY ..................................................................................................................... 14
3.5 JUDGING GAME SOLUTIONS: FAIRNESS (equidad)........................................................................................................ 15
3.6 MEASURING INEQUALITY .............................................................................................................................................. 15
4. THE FIRM. OWNERS, MANAGERS AND EMPLOYEES .............................................................................................................. 17
4.1 OWNERS vs MANAGERS. CONFLICT OF INTERESTS WITHIN THE FIRM ......................................................................... 17
4.2 WORKERS vs MANAGERS. CONFLICT OF INTERESTS WITHIN THE FIRM ....................................................................... 17
4.2.1 INDUCING EFFORT: PIECE RATES ............................................................................................................................... 17
4.2.2 RISK OF BEING FIRED ................................................................................................................................................. 18
4.2.3 EMPLOYMENT RENTS (renta económica del trabajo) ............................................................................................... 18
4.3 THE LABOR DISCIPLINE MODEL ..................................................................................................................................... 18
4.3.1 WORKER´S SIDE ......................................................................................................................................................... 19
4.3.2 FIRMS´S SIDE .............................................................................................................................................................. 19
4.3.3 EQUILIBRIUM ............................................................................................................................................................. 20
4.3.4 INVOLUNTARY UNEMPLOYMENT .............................................................................................................................. 20
4.3.5 CHANGES IN THE EQUILIBRIUM ................................................................................................................................ 20
4.4 PRINCIPLE-AGENT MODEL ............................................................................................................................................. 20
5. THE FIRM AND ITS CUSTOMERS............................................................................................................................................. 22
5.1 COSTS ............................................................................................................................................................................. 22
5.1.1 AVERAGE COSTS ........................................................................................................................................................ 22
5.1.2 MARGINAL COSTS ...................................................................................................................................................... 22
5.1.3 AVERAGE vs MARGINAL COSTS ................................................................................................................................. 23
5.1.4 ECONOMIES OF SCALE & SCOPE ................................................................................................................................ 23
5.2 REVENUE ........................................................................................................................................................................ 23
5.3 PROFITS.......................................................................................................................................................................... 24
5.3.1 PROFIT MAXIMIZATION ............................................................................................................................................. 25
5.4 GAINS FROM TRADE ...................................................................................................................................................... 25
5.5 PRICE ELASTICITY & PROFITS ......................................................................................................................................... 26
5.6 PRICE ELASTICITY POLICY ............................................................................................................................................... 26
5.7 COMPETITION POLICY.................................................................................................................................................... 27
Fernando Alfayate Fernández – fernandoalfayate.apuntes@gmail.com
,6. SUPPLY & DEMAND. PRICE TAKING COMPANIES AND COMPETITIVE MARKETS ................................................................... 28
6.1 PRICE SETTING vs PRICE TAKING ................................................................................................................................... 28
6.2 DEMAND & SUPPLY ....................................................................................................................................................... 28
6.3 PRICE-TAKING FIRMS ..................................................................................................................................................... 28
6.4 COMPETITIVE EQUILIBRIUM .......................................................................................................................................... 30
6.4.1 CHARACTERISTICS ...................................................................................................................................................... 30
6.5 CHANGES IN EQUILIBRIUM ............................................................................................................................................ 30
6.5.1 EXOGENOUS DEMAND & SUPPLY SHOCKS ................................................................................................................ 30
6.5.2 TAXATION AND MARKET DISTORTIONS .................................................................................................................... 31
6.5.3 CHANGES IN EQUILIBRIUM: TAXES ............................................................................................................................ 32
6.5.4 EQUILIBRIUM PRICE ................................................................................................................................................... 32
6.6 PERFECT COMPETITION ................................................................................................................................................. 32
7. MARKETS, EFFICIENCY & PUBLIC POLICY ............................................................................................................................... 34
7.1 IMPERFECT COMPETITION............................................................................................................................................. 34
7.2 EXTERNALITIES ............................................................................................................................................................... 34
7.2.1 MEASURING EXTERNALITIES ..................................................................................................................................... 35
7.2.2 WHY DO EXTERNALITIES EXIST? ................................................................................................................................ 35
7.2.3 HOW TO ADRESS EXTERNALITIES? ............................................................................................................................ 35
7.3 BARGAINING .................................................................................................................................................................. 36
7.3.1 ADVANTAGES vs DISADVANTAGES ............................................................................................................................ 36
7.4 GOVERNMENT POLICIES ................................................................................................................................................ 36
7.4.1 PIGOUVIAN TAX ......................................................................................................................................................... 36
7.4.2 COMPENSATIONS ...................................................................................................................................................... 37
7.5 IMPERFECT INFORMATION ............................................................................................................................................ 37
7.5.1 EXAMPLE OF PRIVATE HEALTH INSURANCE – hidden attribute ................................................................................ 37
7.5.2 EXAMPLE OF CAR INSURANCE – hidden action ......................................................................................................... 38
7.5.3 EXAMPLE OF BANKING COMPANY ............................................................................................................................ 38
7.6 PUBLIC GOODS............................................................................................................................................................... 38
7.6.1 AS A MARKET FAILURE............................................................................................................................................... 38
7.7 LIMITS TO MARKETS ...................................................................................................................................................... 39
8. THE LABOR MARKET .............................................................................................................................................................. 40
8.1 INTRODUCTION.............................................................................................................................................................. 40
8.2 PRICE-SETTING, WAGE-SETTING, EMPLOYMENT AND REAL WAGE.............................................................................. 41
8.1.1 THE FIRM´S DECISION PROCESS................................................................................................................................. 41
8.1.2 WAGE-SETTING CURVE .............................................................................................................................................. 42
8.1.3 PROFIT-SETTING CURVE............................................................................................................................................. 43
8.1.4 LABOR MARKET EQUILIBRIUM .................................................................................................................................. 44
8.1.5 THE ROLE OF LABOR UNIONS .................................................................................................................................... 46
8.1.6 LABOR MARKET POLICIES .......................................................................................................................................... 47
9. BANKS, MONEY, AND CREDIT MARKET .................................................................................................................................. 49
9.1 INCOME, BORROWING AND SAVING ............................................................................................................................ 49
9.1.1 MODELING BORROWING DECISIONS ........................................................................................................................ 49
9.1.2 MODELING SAVINGS DECISIONS ............................................................................................................................... 51
9.1.3 MODELING BORROWING AND SAVINGS: RESERVATION OPTION............................................................................. 51
9.1.4 MODELING INVESTMENT: EQUILIBRIUM .................................................................................................................. 51
9.2 INDIVIDUAL´S BALANCE SHEET ...................................................................................................................................... 52
9.2.1 LENDING, BORROWING AND BALANCE SHEET .......................................................................................................... 52
9.3 BANKS & MONEY ........................................................................................................................................................... 52
9.3.1 INTRODUCTION.......................................................................................................................................................... 52
9.3.2 CENTRAL BANK .......................................................................................................................................................... 52
9.3.3 COMMERCIAL BANKS & BANK MONEY ..................................................................................................................... 52
9.3.4 DEFAULT, LIQUIDITY RISK & BANKING CRISES........................................................................................................... 52
9.3.5 MONEY MARKET ........................................................................................................................................................ 53
Fernando Alfayate Fernández – fernandoalfayate.apuntes@gmail.com
, 9.3.6 FINANCIAL SYSTEM .................................................................................................................................................... 53
9.3.7 BANK´S BALANCE SHEET ............................................................................................................................................ 53
9.3.8 POLICY RATES AND THE ECONOMY ........................................................................................................................... 54
9.4 CREDIT RATIONING ........................................................................................................................................................ 54
9.4.1 INEQUALITY IN ACCESS TO BANKING SYSTEM........................................................................................................... 55
10. ECONOMIC FLUCTUATIONS & UNEMPLOYMENT .............................................................................................................. 55
10.1 BUSINESS CYCLES ........................................................................................................................................................... 55
10.1.1 OKUN´S LAW .............................................................................................................................................................. 56
10.2 MEASURING AGGREGATE ECONOMY (GDP) ................................................................................................................. 56
10.2.1 GDP APPROACHED TO SPENDING ............................................................................................................................. 56
10.2.2 GDP APPROACHED TO PRODUCTION (AGGREGATE VALUE) ..................................................................................... 57
10.2.3 GDP APPROACHED TO INCOME................................................................................................................................. 57
10.2.4 MEASUREMENT ISSUES ............................................................................................................................................. 58
10.3 ECONOMIC FLUCTUATIONS AND CONSUMPTION ........................................................................................................ 58
10.3.1 LIMITATIONS TO CONSUMPTION SMOOTHING: CREDIT CONSTRAINS ..................................................................... 59
10.3.2 LIMITATIONS TO CONSUMPTION SMOOTHING: WEAKNESS OF WILL ...................................................................... 59
10.4 ECONOMIC FLUCTUATIONS AND INVESTMENT ............................................................................................................ 59
10.4.1 VOLATILITY OF INVESTMENT ..................................................................................................................................... 59
10.4.2 INVESTMENT COORDINATION ................................................................................................................................... 60
10.4.3 INVESTMENT AND THE AGGREGATE ECONOMY ....................................................................................................... 60
10.5 ECONOMIC FLUCTUATIONS AND OTHER COMPONENTS .............................................................................................. 61
10.5.1 NET EXPORTS AND GOVERNMENT SPENDING .......................................................................................................... 61
10.6 ECONOMIC FLUCTUATIONS AND INFLATION ................................................................................................................ 61
10.6.1 MEAUSRING INFLATION ............................................................................................................................................ 61
10.6.2 INFLATION FORECASTS .............................................................................................................................................. 62
11. UNEMPLOYMENT & FISCAL POLICY ................................................................................................................................... 63
11.1 AGGREGATE DEMAND: MULTIPLIER MODEL ................................................................................................................ 63
11.1.1 PRIVATE CONSUMPTION FUNCTION ......................................................................................................................... 63
11.1.2 PRIVATE INVESTMENT FUNCTION ............................................................................................................................. 64
11.1.3 GOODS MARKET EQUILIBRIUM ................................................................................................................................. 65
11.1.4 EXAMPLE OF GOODS MARKET EQUILIBRIUM: 1929 CRASH ...................................................................................... 66
11.2 AGGREGATE DEMAND MODEL: ROLE OF THE GOVERNMENT ...................................................................................... 66
11.2.1 STABILIZING ROLE OF THE GOVERNMENT ................................................................................................................ 66
11.2.2 FISCAL STIMULUS ....................................................................................................................................................... 67
11.2.3 MULTIPLIER IN PRACTICE........................................................................................................................................... 67
11.2.4 GOVERNMENT´S FINANCES ....................................................................................................................................... 68
11.3 AGGREGATE DEMAND MODEL: FEEDBACK MECHANISMS ........................................................................................... 68
11.3.1 PRIVATE SECTOR, GOVERNMENT ACTIONS AND OUTPUT (DE)STABILIZATION ........................................................ 68
11.4 AGGREGATE DEMAND MODEL & FOREIGN TRADE ....................................................................................................... 69
11.5 AGGREGATE DEMAND MODEL & UNEMPLOYMENT..................................................................................................... 69
12. INFLATION, UNEMPLOYMENT & MONETARY POLICY........................................................................................................ 70
12.1 INFLATION...................................................................................................................................................................... 70
12.1.1 HOW MUCH INFLATION IS GOOD? ............................................................................................................................ 70
12.1.2 CAUSES OF INFLATION ............................................................................................................................................... 71
12.2 THE PHILLIPS CURVE ...................................................................................................................................................... 71
12.2.1 BARGAINING GAP ...................................................................................................................................................... 72
12.2.2 OVER TIME CHANGES. PHILLIPS CURVE..................................................................................................................... 74
12.3 CHANGES IN INFLATION ................................................................................................................................................ 74
12.3.1 SUPPLY SHOCKS ......................................................................................................................................................... 74
12.4 MONETARY POLICY ........................................................................................................................................................ 74
12.4.1 POLICY INTEREST RATE AND MONETARY POLICY TRANSMISSION MECHANISMS .................................................... 75
12.4.2 MARKET INTEREST RATES .......................................................................................................................................... 75
12.4.3 ASSET PRICES AND PROFIT EXPECTATIONS ............................................................................................................... 75
Fernando Alfayate Fernández – fernandoalfayate.apuntes@gmail.com
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