ECON1006 Lecture Notes PDF

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All lecture notes for ECON1006, including everything the lecturer said, everything in the actual uploaded lecture notes, and content on some of the required readings. Obtained an easy HD with these....

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ECON1006 Lecture Notes WEEK 1: INTRODUCTION [Date of lecture: 03/08/2018]  

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The focus of this topic is how economics interacts with the world around us. Economics has bled into everything (economic imperialism), and this has meant that we now analyse the world around us with economic models and analysis. In this course, we will see that a lot of decisions and policy choices are dictated by the simple economic choice model: cost/benefit analysis. Everything we need to know about assessments and dates are in the UoS on Canvas.

1.1 Economic imperialism  Economic imperialism – economics invading other areas of study  Understanding markets – financial, labour goods, services, auctions, kidneys  Business – HR, finance, marketing, strategy  Public policy – Taxation, regulations, law  Everything else - religion, addiction, poverty, environment, discrimination, crime, altruism, beauty 1.2 The basics of economics  Economic analysis  Supply/demand  Economic models: description of relationship between two or more variables  Objective of simplification: 1. Identify principles that are important across a broad range of decision making contexts 2. Make predictions  Disadvantage of simplification: level out rich contextual issues about culture, religion, which may be important for understanding outcomes  Economics is about choice:  Maximisation subject to constraints (scarce resources)  Decision makers have goals and face constraints  Every choice comes with a cost – opportunity cost  Market equilibrium and comparative statics  From a policy perspective: beware of unintended consequences  THREE KEY PRINCIPLES: Underlying all economic analyses are two central assumptions of human behaviour: 1. People (firms) do they best they can (to achieve goals)  I.e. the principle of maximisation  Consumers maximise utility (total satisfaction received from consuming a good or service) and firms maximise profit  Economists assume people act selfishly  If people care about others, economists assume people will make choices with these concerns in mind Utility = f(own consumption) vs f(own consumption + other’s consumption) 2. Nothing is free – the principle of opportunity cost  i.e. constraints on choices  opportunity cost includes not only monetary costs, but includes time, resources, etc  Opportunity cost = lost benefit from the next best alternative use of the resource 3. and ONE guiding prediction about what happens: EQUILIBRIUM

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Positive vs normative statements:  Positive statements are testable statements about cause and effect  E.g. If the government raises the taxes on cigarettes by 50%, 10% less people will smoke  Normative statements: conclusion as to whether something is good/bad and embrace or contain a value judgment  E.g. Australia will be better off if the government raises taxes on cigarettes by 50%  Economists focus on positive statements – based on things we can actually prove

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Markets:  Where buyers and sellers interact, determines market price  Demand:  What affects demand? Price of the good, prices of complements, consumer tastes, information, income, government policy  Demand function: Q=D(price, income, etc)  Demand curve: relationship between quantity demanded of a commodity and its price, ceteris paribus  Law of Demand says demand curve is downward sloping  As price increases, demand decreases, as opportunity cost increases 

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Example demand function: Demand for chicken.  If pt, the price of teriyaki sauce increases, quantity demanded decreases – they are complements – since chicken and teriyaki sauce often go together, if the price of the sauce increases, the demand for the chicken may decrease as well  If y, income increases, quantity demanded increases Movement along the curve:  Price changes lead to movement along demand curve  E.g. changes of quantity Shift of curve:  Change in OTHER FACTORS (i.e. other than price) lead to SHIFT in the demand curve  increase in demand, decrease in demand e.g. income increases lead to increasing demand

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Supply:  Determined by price of good, costs of productive, policies like taxes  Supply function: Q = S(price, other factors..)  Marginal costs get higher and higher  As increases production, gets more and more expensive  This is why there is an upward sloping supply curve  Movement along the curve:  Change in price is movement along curve  Shift of curve:  Change in other factor is shift of supply curve

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Equilibrium: market clear price – no excess supply or demand where the curves meet  EXCESS SUPPLY: If price is greater is greater than P*, then quantity traded equals quantity demanded and there is excess supply, leading to falling prices [see diagram below]

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EXCESS DEMAND: if price less than P*, then quantity traded equals quantity supplied and there is excess demand, leading to price rises [see diagram below]

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Equilibrium is a static prediction  examination of how any chance in the environment affects outcomes as a ‘comparative static’ analysis, i.e. compare one equilibrium outcome to another

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Efficiency:  The point of efficiency would be at the equilibrium between demand and supply.  Where there is an efficient outcome, there are net gains to trade.  Pareto efficient outcomes: where we cannot make one person better off without making someone else worse off i.e. both are better off  Example: Market with 1 Buyer, 1 Seller, 1 car. Buyer values a car at $35,000, Seller values car at $20,000.  Is the sale of the car at $22,000 Pareto efficient? Yes, both parties are better off  $28000? Yes, both parties are better off.  $36,000? No. Buyer worse off, seller better off

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Correlation vs causation  Correlation: increased crime and prevalence of violent video games  Causation: increased in price of ice creams and decrease in quantity ice cream consumed  Often extremely difficult to distinguish between correlation and causation

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Unintended consequences  Substitution effects – overestimation of effects  Complementarities and spill overs – underestimation of effects  Other effects

ECON1006 Lecture Notes WEEK 2: INEQUALITY [Date of lecture: 10/08/2018]

2.1 Introduction + motivation  Inequality is concerned with the relative position of different individuals or households, within a distribution e.g. in terms of wages, incomes, wealth – patterns may be different between these – inequalities growing in certain measures, but not others  Inequality is a major social and economic concern  Over the past 3 decades, dramatic rise in wage (and earnings) inequality  Historical context: rapid change in wage distribution, one of the predominant trends in the last 50 years  Labour market is an important source of increase in inequality in income, consumption and family well-being  Why is inequality important?  Change in wage inequality can indicate fundamental changes in the labour market and in prices for different type of skills e.g. wages going up for one group, demand supply changes, while wages going down for another group  what factors driving this?  Changes in the wage structure will also lead to different incentives for human capital investment  Certain occupations with wages growing faster, impacts what people want to study or pursue  Amount of inequality determines how much taxes collected + how much spent on social programs  Associated with crime, social unrest, violent conflict  Inequality matters in its own right?  Social justice argument  Often argued that should not be a reasonable degree of inequality  Inequality matters for growth?  It used to be argued that a certain amount of inequality was necessary to have economic growth and that initial growth would be expected to increase inequality  Inequality needed for incentive to study, innovate, take risks, etc.  But now not determinative – high costs to ‘social’ problems caused by inequality 

Inequality versus poverty  Poverty only refers to lower end of income distribution n  Absolute poverty is number of individuals below a predetermined cut off based on needs assessment of minimum required income  Relative poverty is number of individuals below a cut off that is some percentage of average or median income or expenditure

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Aspects of inequality  CONSUMPTION  Increasing income inequality approximately replicated by increasing consumption inequality  Inequality of consumption is important because this is what matters to determine utility, which is what economists care about.  MORTALITY  Growing evidence that gains made in reducing mortality rates has not been distributed equally  More educated groups benefiting, other groups actually dying faster  Interestingly, gains in life expectancy at birth have actually been relatively equally distributed between rich and poor areas  CRIME  Not distributed equally across age groups, gender,

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 Poor and minority communities disproportionately experienced HEALTH INSURANCE  Public programs reduce inequality, while private programs raise inequality  The poor are still significantly disadvantaged in terms of health FAMILY STRUCTURE  College graduates – retained more traditional patterns of marriage + parenting  High school educated – increased premarital child bearing  Children of less educated parents more likely to grow up without both biological parents  Instability of childhoods lead to more inequality in income

2.2 Measurement of inequality  Measures of inequality should be insensitive to the absolute number of people or the average absolute value of the measure under consideration  Inequality indices should show a reduction in inequality when a small transfer is made from a richer to poorer individual  Individuals v Households:  Should we look at inequality in terms of individuals or households?  Households are a more meaningful economic decision-making unit  Households experience returns to scale (i.e. it does not cost twice as much to provide for two people as it does for one) – how to make adjustment for this? Equivalency scales  Equivalency scales are used to compare outcomes for different sized households:  Simple scale: householder outcome/n^(1/2)  Per capita: total outcome/n  More complicated scales have differential adjustments for number of adults and number of children  The Generalized Entropy class of inequality indices:  includes three commonly used measures  (1) the standard deviation of log income  (2) the Theil index,  (3) the coefficient of variation.  These indices can be additively decomposed to look at within and between group changes.  The standard deviation is sensitive to income differences at the bottom of the distribution, while the Theil and CV are sensitive to changes at the top of distribution.  Can break up pieces of the equation and looking at what is affecting inequality  Common percentile measures include the 90-10, 75-25 (IQR), 90- 50, 50-10 log income ratio.  These are simple to calculate and quite intuitive.  But, are not decomposable and violate one of the key principles of inequality indices (i.e. money can be transferred from a richer to a poorer household and have no effect on inequality). 

Percentiles (or ‘quartiles’) of the distribution  Compare wages at different points in the distribution  See inequality by the spread of wages between high and low percentages  Can consider whether changes are occurring at the bottom or top (or both) regions of the distribution  This method is popular in empirical studies:  Drawback is that it concentrates on a small number of points in the distribution (ignore what may be happening in other parts of the distribution)

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The Gini coefficient:  Bounded between zero for a perfectly equal distribution and one when only one person has any income.  It is not decomposable by subgroups. It is most sensitive to income changes in the middle of the distribution

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Alternative measures use information from the entire distribution:  An important class of measures are based on the Lorenz Curve  The Lorenz Curve is a transformation of density (“CDF” – cumulative density function)  Intuitively, the LC plots the cumulative proportion of the population (x-axis) by cumulative proportion of total wages (y-axis), after ranking everyone from poorest to richest  A key insight from the Lorenz Curve: fraction of total wages received by bottom x% of workers.

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LCs are very useful for inequality comparisons  LC closer to the line of equality is clearly more equal  In the above diagram, Dist 1980 is more equal  Conceptually can move from Dist 2002 to Dist 1980 by a sequence of transfers from the rich to poor (see two curves above)  BUT, how do you compare LCs for inequality when they overlap? If they overlap, it is difficult to identify which one is more unequal (see curves below)

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To overcome the overlapping LCs issue:  We need a single summary measure  Gini coefficient is a popular summary index of inequality based on the LC  Ratio will be between 0 and 1  The lower the score, the more inequality there is

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If LCs do not cross – the LC and Gini ranking will be the same If LCs do cross – whether the ranking will be the same is debateable, but the Gini coefficient will definitely provide a ranking

Calculating the Gini coefficient: 1. Calculate the area under LC by adding up areas of triangles (orange) and rectangles (blue) 2. Calculate area under the line of perfect equality (45 degree line)  Area is always the same = 0.5 3. Calculate the area of Y (Green)  Y = area under the line of perfect equality MINUS area under LC  I.e. Area in Step 2 minus Area in Step 1 4. Gini Coefficient = Y/Area under line of perfect equality  i.e. Y/0.5

2.3 International trends  Income in Australia:  A person in the top 20% income group has 5 times as much income than someone in the bottom 20% higher than the OECD average  Employment growth reduced inequality by giving people with lower incomes greater access to the workforce, however, unequal wage growth (in particular to skilled and educated workers) has increased inequality also decreasing inequality between genders – reduced overall inequality  Investment income contributes the most to the income gap – superannuation, etc.  Income is not evenly distributed across the States/Territories –people in WA are more likely to be in the top 20%  Wealth in Australia:  A person in the top 20% has around 70 times more wealth than a person in the bottom 20%  The top 10% of wealth holders hold 40% of all wealth. The bottom 40% hold 5% of all wealth  Housing is the most evenly distributed form of wealth, due to high home ownership rates, but this is changing  The average growth in wealth has NOT been equal across people. The average wealth of a person in the top 20% increased by 28% over the past 8 years, while the bottom 20% increased only 3%. 

Based on OECD data, since the late 1970s, broad common findings across countries:  There was a clear increase in wage and earnings inequality beginning in the mid-late 1970s, and throughout the 1980; there was increasing dispersion in bottom the lower and upper halves of the distributions  In the 1980s, there was a pronounced fall in the relative wages and earnings at the very bottom of the distribution (lowest 10-20th percentiles)  Downward pressure on people without skills  From the early/mid 1990s, earnings became less dispersed in the lower half of the wage distribution  At the same time, wages at the top of the distribution (85 th+ percentiles) have pulled away from the median  Forces contributing to growth in the relative wages at the top of the distribution  Especially for US, UK, Australia, NZ, Germany

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Share going to the top 1% for these 3 countries Has come down, but come up in the next diagram

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Common elements to the rise in inequality  Wage structure changes are the predominant source of earnings inequality;  Strong evidence of increased skill differentials in pay  Increasing pay differentials for skilled workers relative to unskilled workers – premium on skills is growing  evident in return to University degree v high school completion (↑ return to schooling, especially high levels of attainment)  suggests increases in the demand for high skill workers (relative to supply)  Also evidence of an increase in the dispersion of skill levels over past 2-3 decades among younger cohorts entering the labor market (along with general rise in average skill);  Rising Within-Group Inequality with evidence that inequality has also risen among workers with the same level of educ. and experience (and within occupations and local regions);  There have also been changes in the industrial and demographic structure of the economy - however these (↓ manufacturing; ageing population; ↑ participation of women) appear to play as small role in the general rise in inequality (with all industries and demographic groups have experienced increasing inequality)

2.4 Sources of growth in inequality The main explanations for this observed rise in inequality can be categorized as: 1. Increase in the Relative Demand for Skilled Workers:  International Trade  Skill-based Technological Change  Importance of relative supply + demand – sets wages in market equilibrium  Examine shifts to determine if supply or demand affecting wages  There is evidence that both D and S of university educated has been shifting to the right, so demand for skill is growing faster than supply, resulting in higher wages. 

Why has demand for skill increased?

1. INTERNATIONAL TRADE:  Rapid expansion for trade, relaxation of restrictions, possible decrease in demand for unskilled labor in industrial economies  BUT, evidence shows that this probably has a small influence on lowering relative wage for unskilled workers.  Also, inequality observed across ALL sectors, not just those exposed to international competition 2. TECHNOLOGICAL CHANGE  Widely seen as a primary factor in the relative shift in demand for high skilled workers, though difficult to measure  From late 1970s – decrease of cost of computing led to widespread adoption of computers in production process  Subsequent improvements in information and communications technology – increasing complexity of jobs  EVIDENCE: upgrades in production processes related to increased employment of skilled workers and decreased employment of low skilled works.  IT raises demand for more highly educate works doing abstract tasks, reduces demand for slightly less educated workers in jobs involving routine tasks 2. Changes in Labor Market Institutions  Changes in Minimum Wages  Decline of Unions  Tax and Transfer Policy 3. Social and economic forces  Rise in intergenerational disadvantage  INEQUALITY IS LINKED TO SOCIAL AND ECONOMIC MOBILITY - Decline in social and economic mobility  Social and economic mobility – inequality increasing distance between moving from bottom of social/economic ladder to the top.  i.e. Rising inequality pulls the rungs of the socioeconomic ladder further apart… reducing intergenerational mobility by making it harder for poor children to avoid becoming poor adults.

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DIAGRAM above: If you know about parent’s income, how much do you know about your income? How closely linked are they?  Takeaway measure: the more inequality you have the closer children’s income is to their own parents, the less social and economic mobility

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Social mobility through Centrelink payment evidence: The story told by the above pictures is that the parents income support levels greatly reflects their children’s requirement for income support. Those with intensive income support (likely to be lower class), result in a greater per...