PRINCIPLES OF ECONOMICS
UNIT 1
To compare living standards in each country, we use a measure called GDP (Gross
Domestic Product) per capita → average annual income.
1.1 INCOME INEQUALITY
A handy measure of inequality in a country is called the 90/10 ratio, which we define
here as the average income of the richest 10% divided by the average income of the
poorest 10%. Even in countries such as Norway, where the people are most equal to
each other, the ratio is still 5.4. Therefore there is much inequality in the world.
1.2 MEASURING INCOMING AND LIVING STANDARDS
GDP per capita = the total goods and services produced in a country divided by the
country’s population. It measures the output of the economy in a given period.
Disposing income (income available after paying taxes and receiving transfers from
the government) is not the same as the average income that GDP per capita
measures. Disposable income is therefore a good measure of living standards
because it is the maximum amount of goods and services that the person can buy
without having to borrow. However, to measure someone’s well-being, it is not
suitable because it leaves out…
• The quality of our social and physical environment such as friendships and clean
air.
• The amount of free time we have to relax or spend time with friends and family.
• Goods and services that we do not buy, such as healthcare and education, if they
are provided by a government.
• Goods and services that are produced within the household, such as meals or
childcare (predominantly provided by women).
Since income distribution (verdeling) affects wellbeing, and because the same
average income may result from very different distributions of income between rich
and poor within a group, average income may fail to reflect how well off a group of
people is by comparison to some other group.
GDP per capita is a better measure in comparison to disposing income because it
involves the goods and services produced by the government.
EINSTEIN
Statisticians and economists must try to solve three problems;
• We need to separate the thing we want to measure—changes or differences in
amounts of goods and services—from things that are not relevant to the
comparison, especially changes or differences in the prices of the goods and
services.
• When comparing output in one country at two points in time, it is necessary to take
into account differences in prices between the two points in time.
• When comparing output between two countries at a point in time, it is necessary to
take into account differences in prices between the two countries.
The starting point: Nominal GDP
Nominal GDP = price x quantity, for all goods and services
Real GDP = the price changes over time, is also mentioned as GDP at constant
prices (prices corrected for increases in prices (inflation) or decreases in prices
(deflation), so that unit of currency (valuta) represents the same buying power in
different periods of time.
We also have to mention the price difference between countries;
,Purchasing Power Parity (PPP) = A statistical correction allowing comparisons of
the amount of goods people can buy in different countries that have different
currencies.
1.3 HISTORY’S HOCKEY STICK: GROWTH IN
INCOME
Growth rate = change in income/original level in
income
A steeper (steiler) line in a ratio scale chart means a
faster growth rate.
Growth of rate of 100% means that the level
doubles.
In the history’s hockey stick, you can see that…
• For a very long time, living standards did not
grow in any sustained (ononderbroken) way
• When sustained growth occurred, it began at
different times in different countries, leading
to vast differences in living standards around
the world
Adam Smith = ‘intends only his own gain, and he is in this, as in many other cases,
led by an invisible hand to promote an end which was no part of his intention’. Smith
did not think that people were guided entirely by self-interest.
1.4 THE PERMANENT TECHNOLOGICAL REVOLUTION
Industrial revolution → The introduction of new technologies in textiles, energy and
transportation.
Technology (economy) → a process that takes a set of materials and other inputs –
including the work of people and machines – and creates an output.
As technology progress (a change in technology that reduces the amount of
resources required to produce a given amount of the output) revolutionized
production, the amount of time required for producing most products fell generation
after generation.
By reducing the amount of work-time it takes to produce the things we need,
technological changes allowed significant increases in living standards.
1.5 THE ECONOMY AND THE ENVIRONMENT
As production has soared (gestegen),
the use of our natural resources and
degradation (gaat verloren) of our
natural environment have too. The most
striking effect is climate change.
Climate change is a global change, but
many of the environmental impacts of
burning fossil fuels are local. These
effects are results of both the
expansion of the economy (growth in
total output) and the way the economy
is organized (what kind of things are
valued and conserved, for example).
,1.6 CAPITALISM DEFINED: PRIVATE PROPERTY, MARKETS, AND FIRMS
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 key economic institutions (in the past) were private property (people owning
things), markets (where goods could be bought and sold) and families. In other
countries the government is seen as the institution → centrally planned economic
system. In a capitalist 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. Some things that we value are not private
property, such as air.
Markets are
• A way of connecting people who may mutually (onderling) benefit
• By exchanging goods and services
• Through a process of buying and selling
They are reciprocated (wederzijds). It is good/service against good/service.
They are voluntary, because both transfers are private property.
The exchange must be beneficial in the opinion of both parties.
Firms
• One or more individual own a set of capital goods that are used in production
• They pay wages and salaries to employees
• They direct the employees (through the managers they also employ) in the
production of goods and services.
• The goods and services are the property of the owners.
• The owners sell the goods and services on markets with the intention of
making a profit.
Family-businesses are not firms, because they do not make profit, or because the
owners are not private individuals who own the assets (middelen) of the firm and
employ others to work there. Note: a firm pays wages or salaries to employees but, if
it takes on unpaid students interns, it is still a firm.
Labour market → in this market, employers offer wages to individuals who may
agree to work under their direction. Economists say that employers are on the
demand side of this market, while employees are on the supply side.
Firms can grow because they are able to hire additional employees on the labour
market, and attract funds to finance the purchase of the capital goods they need to
expand production. Firms can die because they are not making enough profits to
continue employing and producing.
1.7 CAPATALISM AS AN ECONOMIC
SYSTEM
Markets and private property are essential
parts of how firms function for two reasons:
• Inputs and outputs are private property
• Firms use markets to sell outputs
Ownership = the right to use and exclude
others from the use of something, and the
right to sell the thing that is owned.
, 1.8 THE GAINS FROM SPECIALIZATION
As Smith explained, we become better at producing things when we each focus on a
limited range of activities. This is true for three reasons;
• Learning by doing: we acquire skills as we produce things
• Difference in ability: for reasons of skill people are better at producing some
things than others
• Economies of scale (doubling all of the inputs to a production process more
than doubles the output): producing a large number of units of some good is
often more cost-effective than producing a smaller number.
People will not specialize (division of labour) unless they have a way to acquire the
other goods they need.
When people differ in their ability to produce different goods, markets allow them to
specialize. All producers can hereby benefit by specializing and trading goods. This
means that one producer specializes in a good that another could produce at lower
cost.
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.
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.
1.9 CAPITALISM, CAUSATION AND HISTORY’S HOCKEY STICK
We want to make causal (establishing that a change in one variable produces a
change in another) statements in economics, for example to determine if capitalism
caused the upward kink in the hockey stick. However, economics has to do with a lot
of interactions whereby experiments are not possible.
Natural experiment: An empirical study exploiting naturally occurring statistical
controls in which researchers do not have the ability to assign participants to
treatment and control groups, as is the case in conventional experiments. Instead,
differences in law, policy, weather, or other events can offer the opportunity to
analyse populations as if they had been part of an experiment. The validity of such
studies depends on the premise that the assignment of subjects to the naturally
occurring treatment and control groups can be plausibly argued to be random.
Using the natural experiment we were not able to discover if capitalism caused the
upward kink in the hockey stick.
1.10 VARIETIES OF CAPITALISM: INSTITUTIONS, GOVERNMENT, AND THE
ECONOMY
Both Botswana and Nigeria are rich in natural resources, but differences in quality of
their institutions – the extent of corruption and misdirection of government funds, for
example – may help explain their contrasting trajectories.
Developmental state → a government that takes a leading role in promoting the
progress of economic development through its public investments, subsidies or
particular industries, education and other public policies.
The varieties of capitalism that replaced central planning in the countries that had
once made up the Soviet Union did not work so well either.
The lagging performance of some economies proves that the existence of capitalist
institutions is not enough, in itself, to create a dynamic economy. There are two sets
involved;
• Economic conditions
Where capitalism is less dynamic, the explanation might be that…
