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The Economy

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Contents THEMES AND CAPSTONE UNITS History, instability, and growth Global economy Inequality Environment Innovation Politics and policy

Preface A note to instructors Producing The Economy List of resources Einsteins Great economists How economists learn from facts When economists disagree Exercises Videos Figures 1—The capitalist revolution Introduction 1.1 Income inequality 1.2 Measuring income and living standards 1.3 History’s hockey stick: Growth in income 1.4 The permanent technological revolution 1.5 The economy and the environment 1.6 Capitalism defined: Private property, markets, and firms

1.7 Capitalism as an economic system 1.8 The gains from specialization 1.9 Capitalism, causation and history’s hockey stick 1.10 Varieties of capitalism: Institutions, government, and the economy 1.11 Economics and the economy 1.12 Conclusion 1.13 References 2—Technology, population, and growth Introduction 2.1 Economists, historians, and the Industrial Revolution 2.2 Economic models: How to see more by looking at less 2.3 Basic concepts: Prices, costs, and innovation rents 2.4 Modelling a dynamic economy: Technology and costs 2.5 Modelling a dynamic economy: Innovation and profit 2.6 The British Industrial Revolution and incentives for new technologies 2.7 Malthusian economics: Diminishing average product of labour 2.8 Malthusian economics: Population grows when living standards rise 2.9 The Malthusian trap and long-term economic stagnation 2.10 Escaping from Malthusian stagnation 2.11 Conclusion 2.12 References 3—Scarcity, work, and choice Introduction 3.1 Labour and production 3.2 Preferences 3.3 Opportunity costs 3.4 The feasible set 3.5 Decision making and scarcity 3.6 Hours of work and economic growth 3.7 Income and substitution effects on hours of work and free time 3.8 Is this a good model? 3.9 Explaining our working hours: Changes over time 3.10 Explaining our working hours: Differences between countries 3.11 Conclusion 3.12 References 4—Social interactions Introduction 4.1 Social interactions: Game theory 4 2 E ilib i i h i i ibl h d

4.2 Equilibrium in the invisible hand game 4.3 The prisoners’ dilemma 4.4 Social preferences: Altruism 4.5 Altruistic preferences in the prisoners’ dilemma 4.6 Public goods, free riding, and repeated interaction 4.7 Public good contributions and peer punishment 4.8 Behavioural experiments in the lab and in the field 4.9 Cooperation, negotiation, conflicts of interest, and social norms 4.10 Dividing a pie (or leaving it on the table) 4.11 Fair farmers, self-interested students? 4.12 Competition in the ultimatum game 4.13 Social interactions: Conflicts in the choice among Nash equilibria 4.14 Conclusion 4.15 References 5—Property and power: Mutual gains and conflict Introduction 5.1 Institutions and power 5.2 Evaluating institutions and outcomes: The Pareto criterion 5.3 Evaluating institutions and outcomes: Fairness 5.4 A model of choice and conflict 5.5 Technically feasible allocations 5.6 Allocations imposed by force 5.7 Economically feasible allocations and the surplus 5.8 The Pareto efficiency curve and the distribution of the surplus 5.9 Politics: Sharing the surplus 5.10 Bargaining to a Pareto-efficient sharing of the surplus 5.11 Angela and Bruno: The moral of the story 5.12 Measuring economic inequality 5.13 A policy to redistribute the surplus and raise efficiency 5.14 Conclusion 5.15 References 6—The firm: Owners, managers, and employees Introduction 6.1 Firms, markets, and the division of labour 6.2 Other people’s money: The separation of ownership and control 6.3 Other people’s labour 6.4 Employment rents 6.5 Determinants of the employment rent 6.6 Work and wages: The labour discipline model 6 7 Wages effort and profits in the labour discipline model

6.7 Wages, effort, and profits in the labour discipline model 6.8 Putting the model to work: Owners, employees, and the economy 6.9 Another kind of business organization 6.10 Principals and agents: Interactions under incomplete contracts 6.11 Conclusion 6.12 References 7—The firm and its customers Introduction 7.1 Breakfast cereal: Choosing a price 7.2 Economies of scale and the cost advantages of large-scale production 7.3 Production: The cost function for Beautiful Cars 7.4 Demand and isoprofit curves: Beautiful Cars 7.5 Setting price and quantity to maximize profit 7.6 Look at profit maximization as marginal revenue and marginal cost 7.7 Gains from trade 7.8 The elasticity of demand 7.9 Using demand elasticities in government policy 7.10 Price-setting, competition, and market power 7.11 Product selection, innovation, and advertising 7.12 Prices, costs, and market failure 7.13 Conclusion 7.14 References 8—Supply and demand: Price-taking and competitive markets Introduction 8.1 Buying and selling: Demand and supply 8.2 The market and the equilibrium price 8.3 Price-taking firms 8.4 Market supply and equilibrium 8.5 Competitive equilibrium: Gains from trade, allocation, and distribution 8.6 Changes in supply and demand 8.7 The effects of taxes 8.8 The model of perfect competition 8.9 Looking for competitive equilibria 8.10 Price-setting and price-taking firms 8.11 Conclusion 8.12 References 9—The labour market: Wages, profits, and unemployment Introduction 9.1 The wage-setting curve, the price-setting curve, and the labour market

9.2 Measuring the economy: Employment and unemployment 9.3 The wage-setting curve: Employment and real wages 9.4. The firm’s hiring decision 9.5. The price-setting curve: Wages and profits in the whole economy 9.6 Wages, profits, and unemployment in the whole economy 9.7 How changes in demand for goods and services affect unemployment 9.8. Labour market equilibrium and the distribution of income 9.9. Labour supply, labour demand, and bargaining power 9.10. Labour unions: Bargained wages and the union voice effect 9.11 Labour market policies to address unemployment and inequality 9.12. Looking backward: Baristas and bread markets 9.13 Conclusion 9.14 References 10—Banks, money, and the credit market Introduction 10.1 Money and wealth 10.2 Borrowing: Bringing consumption forward in time 10.3 Impatience and the diminishing marginal returns to consumption 10.4 Borrowing allows smoothing by bringing consumption to the present 10.5 Lending and storing: Smoothing and moving consumption to the future 10.6 Investing: Another way to move consumption to the future 10.7 Assets, liabilities, and net worth 10.8 Banks, money, and the central bank 10.9 The central bank, the money market, and interest rates 10.10 The business of banking and bank balance sheets 10.11 The central bank’s policy rate can affect spending 10.12 Credit market constraints: A principal–agent problem 10.13 Inequality: Lenders, borrowers, and those excluded from credit markets 10.14 Conclusion 10.15 References 11—Rent-seeking, price-setting, and market dynamics Introduction 11.1 How people changing prices to gain rents can lead to a market equilibrium 11.2 How market organization can influence prices 11.3 Short-run and long-run equilibria 11.4 Prices, rent-seeking, and market dynamics at work: Oil prices 11.5 The value of an asset: Basics 11.6 Changing supply and demand for financial assets 11.7 Asset market bubbles

11.8 Modelling bubbles and crashes 11.9 Non-clearing markets: Rationing, queuing, and secondary markets 11.10 Markets with controlled prices 11.11 The role of economic rents 11.12 Conclusion 11.13 References 12—Markets, efficiency, and public policy Introduction 12.1 Market failure: External effects of pollution 12.2 External effects and bargaining 12.3 External effects: Policies and income distribution 12.4 Property rights, contracts, and market failures 12.5 Public goods 12.6 Missing markets: Insurance and lemons 12.7 Incomplete contracts and external effects in credit markets 12.8 The limits of markets 12.9 Market failure and government policy 12.10 Conclusion 12.11 References 13—Economic fluctuations and unemployment Introduction 13.1 Growth and fluctuations 13.2 Output growth and changes in unemployment 13.3 Measuring the aggregate economy 13.4 Measuring the aggregate economy: The components of GDP 13.5 How households cope with fluctuations 13.6 Why is consumption smooth? 13.7 Why is investment volatile? 13.8 Measuring the economy: Inflation 13.9 Conclusion 13.10 References 14—Unemployment and fiscal policy Introduction 14.1 The transmission of shocks: The multiplier process 14.2 The multiplier model 14.3 Household target wealth, collateral, and consumption spending 14.4 Investment spending 14.5 The multiplier model: Including the government and net exports 14 6 Fiscal policy: How governments can dampen and amplify fluctuations

14.6 Fiscal policy: How governments can dampen and amplify fluctuations 14.7 The multiplier and economic policymaking 14.8 The government’s finances 14.9 Fiscal policy and the rest of the world 14.10 Aggregate demand and unemployment 14.11 Conclusion 14.12 References 15—Inflation, unemployment, and monetary policy Introduction 15.1 What’s wrong with inflation? 15.2 Inflation results from conflicting and inconsistent claims on output 15.3 Inflation, the business cycle, and the Phillips curve 15.4 Inflation and unemployment: Constraints and preferences 15.5 What happened to the Phillips curve? 15.6 Expected inflation and the Phillips curve 15.7 Supply shocks and inflation 15.8 Monetary policy 15.9 The exchange rate channel of monetary policy 15.10 Demand shocks and demand-side policies 15.11 Macroeconomic policy before the global financial crisis: Inflation-targeting policy 15.12 Another reason for rising inflation at low unemployment 15.13 Conclusion 15.14 References 16—Technological progress, employment, and living standards in the long run Introduction 16.1 Technological progress and living standards 16.2 The job creation and destruction process 16.3 Job flows, worker flows, and the Beveridge curve 16.4 Investment, firm entry, and the price-setting curve in the long run 16.5 New technology, wages, and unemployment in the long run 16.6 Technological change and income inequality 16.7 How long does it take for labour markets to adjust to shocks? 16.8 Institutions and policies: Why do some countries do better than others? 16.9 Technological change, labour markets, and trade unions 16.10 Changes in institutions and policies 16.11 Slower productivity growth in services, and the changing nature of work 16.12 Wages and unemployment in the long run

16.13 Conclusion 16.14 References 17—Capstone: The Great Depression, golden age, and global financial crisis Introduction 17.1 Three economic epochs 17.2 The Great Depression, positive feedbacks, and aggregate demand 17.3 Policymakers in the Great Depression 17.4 The golden age of high growth and low unemployment 17.5 Workers and employers in the golden age 17.6 The end of the golden age 17.7 After stagflation: The fruits of a new policy regime 17.8 Before the financial crisis: Households, banks, and the credit boom 17.9 Modelling housing bubbles 17.10 The financial crisis and the great recession 17.11 The role of banks in the crisis 17.12 The economy as teacher 17.13 Conclusion 17.14 References 18—Capstone: The nation and the world economy Introduction 18.1 Globalization and deglobalization in the long run 18.2 Globalization and investment 18.3 Globalization and migration 18.4 Specialization and the gains from trade among nations 18.5 Specialization, factor endowments, and trade between countries 18.6 Winners and losers from trade and specialization 18.7 Winners and losers in the very long run and along the way 18.8 Migration: Globalization of labour 18.9 Globalization and anti-globalization 18.10 Trade and growth 18.11 Conclusion 18.12 References 19—Capstone: Economic inequality Introduction 19.1 Inequality across the world and over time 19.2. Accidents of birth: Another lens to study inequality 19.3 What (if anything) is wrong with inequality? 19.4 How much inequality is too much (or too little)?

19.5 Endowments, technology, and institutions 19.6 Inequality, endowments, and principal–agent relationships 19.7 Putting the model to work: Explaining changes in inequality 19.8 Predistribution 19.9 Explaining recent trends in inequality in market income 19.10 Redistribution: Taxes and transfers 19.11 Equality and economic performance 19.12 Conclusion 19.13 References 20—Capstone: Economics of the environment Introduction 20.1 Recap: External effects, incomplete contracts, and missing markets 20.2 Climate change 20.3 The abatement of environmental damages: Cost-benefit analysis 20.4 Conflicts of interest: Bargaining over wages, pollution, and jobs 20.5 Cap and trade environmental policies 20.6 The measurement challenges of environmental policy 20.7 Dynamic environmental policies: Future technologies and lifestyles 20.8 Environmental dynamics 20.9 Why is addressing climate change so difficult? 20.10 Policy choices matter 20.11 Conclusion 20.12 References 21—Capstone: Innovation, information, and the networked economy Introduction 21.1 The innovation process: Invention and diffusion 21.2 Innovation systems 21.3 External effects: Complements, substitutes, and coordination 21.4 Economies of scale and winner-take-all competition 21.5 Matching (two-sided) markets 21.6 Intellectual property rights 21.7 Optimal patents: Balancing the objectives of invention and diffusion 21.8 Public funding of basic research, education, and information infrastructure 21.9 Conclusion 21.10 References 22—Capstone: Economics, politics, and public policy Introduction 22.1 The government as an economic actor

22.2 Government acting as a monopolist 22.3 Political competition affects how the government will act 22.4 Why an erstwhile dictator might submit to political competition 22.5 Democracy as a political institution 22.6 Political preferences and electoral competition: The median voter model 22.7 A more realistic model of electoral competition 22.8 The advance of democracy 22.9 Varieties of democracy 22.10 Democracy makes a difference 22.11 A puzzle: The persistence of unfairness and market failures in democracies 22.12 Economic infeasibility 22.13 Administrative infeasibility 22.14 Special interests 22.15 Policy matters and economics works 22.16 Conclusion 22.17 References Looking forward to economics after CORE Glossary Bibliography Leibnizes 2.2.1 Introducing the Leibnizes 2.7.1 The production function 3.1.1 Average and marginal productivity 3.1.2 Diminishing marginal productivity 3.1.3 Concave and convex functions 3.2.1 Indifference curves and the marginal rate of substitution 3.4.1 Marginal rate of transformation 3.5.1 Optimal allocation of free time: MRT meets MRS 3.6.1 Modelling technological change 3.7.1 Mathematics of income and substitution effects 4.4.1 Altruistic preferences: Finding the optimal distribution 5.4.1 Quasi-linear preferences 5.4.2 Angela’s choice of working hours 5.7.1 Angela’s choice of working hours when she pays rent 5.8.1 The Pareto efficiency curve 6.6.1 The worker’s best response function 6.7.1 Profit, wages, and effort 7.3.1 Average and marginal cost functions 7.4.1 Isoprofit curves and their slopes

7.5.1 The profit-maximizing price 7.6.1 Marginal revenue and marginal cost 7.8.1 The elasticity of demand 8.4.1 The firm and market supply curves 8.4.2 Market equilibrium 8.5.1 Gains from trade 8.6.1 Shifts in demand and supply 11.8.1 Price bubbles 12.1.1 External effects of pollution 12.3.1 Pigouvian taxes 22.2.1 Expected duration of the dictator or governing elite 22.2.2 How the monopolist sets the rent-maximizing level of taxes 22.3.1 The income and substitution effect of an increase in political competition Copyright acknowledgements

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