This document contains the necessary material for the course Microeconomics, Institutions and Welfare. The document includes the lectures and the necessary literature.
Microeconomics, Institutions & Welfare – all material
Microeconomics, Welfare and institutions - Week 1 (Unit 1-3):
I. Economic Development since 1000 AC (Unit 1)
Measures of living standards:
1) GDP
= Gross Domestic Product → all the goods and services that are produced in a country → the
output of the economy in a given period → aggregate production → measured per capita
GDP does not take into account inequality.
2) Happiness
does not measure well-being accurately.
→ Self-reported Life Satisfaction (2018) → Correlation: a high GDP usually means higher
scores on Life Satisfaction → equal countries score high
3) Disposable income
= income available after paying taxes and receiving transfers from the government
is thought to be a good measure of living standards because it is the maximum amount of
food, housing, clothing and other goods and services that the person can buy without having
to borrow. → However, disposable income leaves out many aspects of wellbeing that are not
related to what we can buy like free time, health care etc.
GDP is a better measure of living standards than the disposable income, since it includes goods and
services produced by the government (e.g. schooling), which contribute to wellbeing but are not
included in the disposable income.
‘Hockey-stick’ growth: sustained rapid growth in GDP per capita happened at different times in
different countries
For a very long time, living standards did not grow in any sustained way.
When sustained growth occurred, it began at different times in different countries, leading to
vast differences in living standards around the world.
Technology: A process that uses inputs to produce an output
Remarkable scientific and technological advances occurred around the same time as the
upward kink in the hockey stick in Britain in the middle of the 18th century.
Technological improvements allowed for improvements in living standards by reducing the
amount of work-time it takes to produce the things we consume.
The Industrial Revolution: A wave of technological advances starting in Britain in the 18th century,
which transformed an agrarian and craft-based economy into a commercial and industrial economy.
Technological progress improved:
a. productivity of labour
b. the speed at which information travels (communication revolution)
Markets are:
a way of connecting people who may mutually benefit
by exchanging goods and services
through a process of buying and selling
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,Capitalism: an economic system in which private property, markets, and firms play an important
role.
Economic system: The institutions that organize the production and distribution of goods and
services in an entire economy.
Institution: The laws and social customs governing the way people interact in society.
The capitalist revolution → Capitalism led to growth in living standards because of:
• Specialization: the growth of firms and the expansion of markets linking the entire world allowed
historically unprecedented specialization in tasks and production
- specialization is possible when people can acquire other goods via the market
• Impact on technology: firms competing in markets had strong incentives to adopt and develop
new technologies
- Learning by doing: We acquire skills as we produce things.
- Taking advantages of natural differences in skill and talent: Some people are better at
producing some things than others – difference in ability.
- Economies of scale: Producing a large number of units of some goods is often more cost-
effective than producing a smaller number.
Together with the technological revolution, this increased worker productivity.
Differences in capitalism’s success (divergence in growth) due to:
1. ownership/property laws
2. competitiveness of markets
3. quality of institutions
Conclusion Unit 1:
Throughout most of history, living standards were similar around the world and changed little from
century to century. Since 1700 they have risen rapidly in some countries. This upturn coincided with
rapid technological progress, and with the advent of a new economic system, capitalism, in which
private property, markets and firms play a major role. The capitalist economy provided incentives
and opportunities for technological innovation, and gains from specialization.
Countries differ in the effectiveness of their institutions and government policy: not all capitalist
economies have experienced sustained growth. Today, there are huge income inequalities between
countries, and between the richest and poorest within countries.
II. Economics and Models (Unit 2)
Economics is the study of how people interact with each other and with their natural surroundings in
producing their livelihoods, and how this changes over time.
Economics is about how economic agents allocate scarce resources to maximize their
utility/profit/output.
Why do we need theories and models?
To understand the causes and consequences of: the industrial revolution, firm growth,
unemployment, the financial crisis, the digital revolution, etc.
To guide us to decide what we (governments, firms, individuals) should do if we want to
reach our goals: short-term profit maximization, continuity, equality, becoming a millionaire,
spending time with your family and friends, an inhabitable planet, etc.
Equilibrium: A model outcome that is self-perpetuating in this case, something of interest does not
change unless an outside or external force is introduced that alters the model’s description of the
situation. One or more things in the model are constant. It does not need to mean that nothing
changes.
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,Subsistence level: The level of living standards (measured by consumption or income) such that the
population will not grow or decline.
→ An income at subsistence level is an equilibrium, because movements away from subsistence level
are self-correcting: they automatically lead back to subsistence income as population rises.
Ceteris paribus: Setting aside things that are thought to be of less importance to the
question of interest → ‘holding other things constant’
Incentive: Economic reward or punishment, which influences the benefits and costs of
alternative courses of action
Relative price: The price of one good or service compared to another → usually expressed as
a ratio
Economic rent: A payment or other benefit received above and beyond what the individual
would have received in his or her next best alternative (or reservation option). When taking
some action (call it action A) results in a greater benefit to yourself than the next best action,
we say that you have received an economic rent.
Economic rent = benefit from option taken – benefit from next best option
Reservation option: The alternative action with the next greatest net benefit (action B), is
often called the ‘next best alternative’, your ‘reservation position,’ ‘fallback option’ or
‘reservation option.’ → It is ‘in reserve’ in case you do not choose A.
III. Technology and Production Function (Unit 2)
General-purpose technologies: Technological advances that can be applied to many sectors, and
spawn further innovations. E.g. ICT and electricity
Why did the Industrial Revolution happen first in the 18th century in Britain, on an island of the
coast of Europe?
There are many alternative explanations:
• relatively high cost of labour and cheap local sources of energy
• Europe’s scientific revolution and Enlightenment
• political and cultural characteristics of nations as a whole
• cultural attributes such as hard work and savings
• abundance of coal and access to colonies
• English wages were higher than wages elsewhere, and coal was cheaper in Britain than in the other
countries.
• The combination of capacity to innovate and changing relative prices of inputs les to a switch to
energy-intensive technology.
Change in relative prices in Britain → technology was labour-intensive before the industrial
revolution → increase in wages relative to price of coal in Britain create the incentive to innovate
more capital-intensive technologies
Firms choose between technologies (specific combinations of inputs) to produce outputs.
Some technologies are dominated by other technologies.
Isoquant: all input combinations that yield the same output (= minimum required quantity of inputs)
Marginal Rate of Technical Substitution (MRTS): amount by which the quantity of an input can be
reduced when one extra unit of another input is used, so that output remains constant. → the ease
with which one input can be replaced by one or more units of the other input while holding
production constant reflected in the slope of the curve. → - change in capital / change in labour =
marginal product of labour / marginal product of capital
→ MRTS of labour for capital is the amount by which capital can be reduced when one extra unit of
labour is used
3
, Derivative → how does a function f(x) change as a function of a change of x? → how fast changes the
curve
Firm’s choice → minimizing cost
Firms aim to maximize profit, which means producing at the least possible cost
This is why the firm’s choice of technology depends on economic information about relative
prices of inputs
Cost = (wage x number of workers) + (cost of capital x quantity of capital)
c = (w x L) + (p x R)
R = (c/p) – (w/p)L
Isocost lines: combinations of inputs that give the same cost (slope = relative price of inputs) → A
line that represents all combinations that cost a given total amount → Slope of the isocost line -(w/p)
Producing a given output at minimum cost
→ Optimization problem: given the desired level of q, find the lowest possible level of C → find the
tangent point where the slopes of the two curves are equal: MRTS = change in K / change in L =
-(w/r)
IV. Stagnation in population and living standards before the 18th century (Unit 2)
Production function gives maximum output for a given set of inputs → Describes the relationship
between the amount of output produced and the amounts of inputs used to produce it.
• If we hold one input, and expand the other input, the average output per worker is going to
fall. This is the law of diminishing average product of labour. A situation in which, as more
labour is used in a given production process, the average product of labour typically falls.
Malthus’ model → key ideas:
Population expands, if living standards increase.
But the law of diminishing average product of labour implies that as more people work on
the land, their income will inevitably fall.
In equilibrium, living standards will be forced down to subsistence level. Population and income will
stay constant. → Malthusian trap
3 conditions are required to stay in the Malthusian trap:
Diminishing average product of labour
Rising population in response to increases in wages
An absence of improvements in technology to offset the diminishing average product of
labour
The permanent technological revolution meant that the third condition no longer holds, and explains
why Britain was able to escape the Malthusian trap. → Both population and real wages
simultaneously increasing.
V. Consumer choices over labour (Unit 3)
For most countries, living standards have greatly increased since 1870, but there are disparities in
free time and income across countries.
→ Use a model of individual choice to explain the differences in work hours across countries and
over time.
A production function shows how inputs translate into outputs holding other factors constant. It is a
graphical or mathematical expression describing the amount of output that can be produced by any
given amount or combination of input(s). The function describes differing technologies capable of
producing the same thing.
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