UNIT 1: THE CAPITALISM REVOLUTION

VOCABULARY
GDP: Gross domestic product = sumatoria pi qi (precio por la cantidad)
Autarky: Producing everything by yourself.

INCOME INEQUALITY
Rich/poor ratio = Income of the richest 10% / Income of the poorest 10%

MEASURING INCOME AND LIVING STANDARDS

GDP corresponds to the total income of the country
GDP per capita is the average income of each person in the country

GNP (Gross National Product): GDP + the output produced abroad attributable to UK
residents - UK output attributable to residents abroad.

Disposable income is the amount of money someone has after the income taxes have
been deducted. It is a good measure of our well being but insufficient because it leaves out
things such as health care, education, free time…

Average disposable income is not a good measurement of well being

VALUING GOVERNMENTS GOODS AND SERVICES

·Those are included in the GDP but not in the disposable income. So GDP is considered a
better measure from that point of view.

·Those are pretty difficult to value because they are free so we usually take the cost of their
production as a reference

COMPARING INCOMES AT DIFFERENT TIMES AND ACROSS COUNTRIES

·Take in account difference in prices over time or across countries you are comparing

Nominal GDP = quantity x prices

Real GDP or GDP = nominal GDP adjusted for inflation

·Across countries we need to use the purchasing power parity (PPP)

HISTORY’S HOCKEY STICK: GROWTH IN INCOME

Ratio scale is used to compare growth rates

Growth rate = change in income/ original level of income x 100

Hockey stick, repeated for:

● gross domestic product per capita

● productivity of labour (light per hour of work)

● connectivity of the various parts of the world (the speed at which news travels)

● impact of the economy on the global environment (carbon emissions and climate
change)

Capitalism is an economic system characterized by some institutions

-Private property (include capital goods) (intellectual property is private property (of your
company, your university or yourself), your skills in general are not disposable to others for
them to become the owners.
-Markets: reciprocated, voluntary and beneficial for both parties
-Firms: make a profit and participate on the labour market (employers: demand side,
workers: supply side)
-Families

Centrally planned economic system is the one in which institution controls production

THE PERMANENT TECHNOLOGICAL REVOLUTION

In economics, technology is a process that takes a set of materials and other
inputs—including the work of people and machines—and creates an output.

THE ECONOMY AND THE ENVIRONMENT

The most important effect humans have had on the environment has been
• Global impacts – climate change
• Local impacts – pollution in cities, deforestation
But the permanent technological revolution—which brought about dependence on fossil
fuels—may also be part of the solution to today’s environmental problems.
CAPITALISM AND SPECIALIZATION OR DIVISION OF LABOUR
·Learning by doing
·Different abilities
·Economies of scale which are more cost-effective

But people will not specialize unless they have a way to acquire the other goods they need.

Absolute advantage means someone can produce more of a good

Comparative advantage means your autarky ratio is lower than the other persons autarky
ratio.

VARIETIES OF CAPITALISM
Developmental state A government that takes a leading role in promoting the process of
economic development through its public investments, subsidies of particular industries,
education and other public policies as South Korea, Japan or China

Capitalism is dynamic when:

-Private property is secure
-There is competition in markets
-Firms are not owned by people because of their relations or privileged birth, they should be
owned by those who can produce at a lower price
-Markets, firms and private property must be regulated by laws
-For innovators to take the risk of introducing a new product or production process, their
ownership of the resulting profits must be protected from theft.
-Avoid monopolies
-Private incentives for cost-reducing innovations
 UNIT 3: SCARCITY, WORK AND CHOICE

VOCABULARY
Ceteris Paribus: all other things being equal ( en igualdad de condiciones). The effect of
one variable on another, provided all the other variables remain the same. (asumir que solo
cambia la variable que nos interesa)

RELATIONS BETWEEN EFFORT AND GRADES

Production function A graphical or mathematical expression describing the amount of
output that can be produced by any given amount or combination of input(s).
If the function becomes flatter, we call it concave

The production function tells us:

1. Marginal product : additional output per labour hour (evaluated at a given

point, holding other inputs constant)
Diminishing marginal product: Studying becomes less productive, the
more you study.

2. Average product: Average output per unit of input. the true marginal product is the slope
of the tangent to the curve.

If we compare the marginal and average products at any point on Alexei’s production
function, we find that the marginal product is below the average product.

e.g.: when he works for four hours his average product is 50/4 = 12.5 points per hour, but an
extra hour’s work raises his grade from 50 to 57, so the marginal product is 7.
PREFERENCES
Your decisions will depend on your [Link] describe preferences we don’t need to
know the exact utility of each option; we only need to know which combinations provide
more or less utility than others.
An indifference curve show all combinations of goods that give the same utility
(satisfaction) (they can not cross)
The marginal rate of substitution (MRS) is the slope of the indifference curve and
represents the tradeoffs that an individual is willing to make. How many units of X would be
considered to be compensation for one less unit of Y.
The utility function: U(xa, xb) for each bundle; this function gives a number representing
the level of satisfaction consumer gets from consumption

OPPORTUNITY COSTS
Choices are limited by constraints and involve tradeoffs (Studying example: higher grades
vs. more free time)

The opportunity cost of an action is the net benefit of the next best alternative action.
The economic cost = out of pocket cost + opportunity cost
If the benefit from an action exceeds the economic costs, you receive an economic rent
from choosing it.

Economic cost = 1000 + 400 = 1400 euros

Economic rent = 1200 -1400 = - 200 euros
THE FEASIBLE SET
The feasible frontier shows the maximum output that can be achieved with a given amount
of input. It is a mirror image of the indifference curves.
The marginal rate of transformation (MRT) is the slope of the feasible frontier, and
represents the tradeoffs that an individual faces.
The budget set is a kind of feasible set which involves income and consumption con two
goods

Both, the MRS and the MRT describe the relationship between two goods in terms of how
many units of one is equivalent to one unit of the other.
However, the MRT focuses on supply and the MRS focuses on demand. The MRT tells
you how many more units of X you could produce if you produce one less unit of Y.

DECISION MAKING AND SCARCITY

Someone can maximize his utility where indifference curve is tangent to the feasible frontier
so that the amount of one good the individual is willing to trade off for the other good (MRS)
equals the actual tradeoff between the two goods (MRT) MRS = MRT .
We have solved a constrained choice problem which is about how we can do the best for
ourselves, given our preferences and constraints.
INCOME AND SUBSTITUTION
w- wage
c- consumption
t- number of hours of free time per week
𝑐=𝑤(24−𝑡)
This is called your budget constraint are the feasible frontiers for consumption choices
which shows what you can afford to buy (it is a straight line)

We can also find 𝑐=𝑤(24−𝑡) + x ; where x: is an extra income. The effect this unearned
money has on your choices is called the income or substitution effect.

If you decide to work less hours getting the same amount of money it is called the
income effect (tendency to want more free time)

If the MRT increases, you will have more incentive to work which is called the
substitution effect. (tendency to work more)
 UNIT 4: SOCIAL INTERACTIONS

VOCABULARY
Altruism: tendency to do well for others without a personal interest. It is most likely to
appear when people know each other.

Free riding: consumidor parásito

Public good: something which benefits everyone

Social dilemmas: occur when people do not take adequate account of the effects of their
decisions on others, whether these are positive or negative.

Tragedy of the Commons: Common resources are often overexploited

ELEMENTS OF THE GAME

1. Players: N agents
2. Strategies: If we consider strategies chosen by all the players together, we talk about
strategy profiles: one strategy per player
3. Payoffs: outcomes of thee game
4. Information: what players know when choosing their strategies

SOCIAL AND STRATEGIC INTERACTIONS

A strategy is an action that a person may take when they are aware of what others are
going to do.
Models of strategic interactions are described as games.
Game theory is a set of models of strategic interactions which explains social dilemmas and
help us make predictions..

- We call a one-shot game a model which assumes that individuals will just interact
once.
- A static / simultaneous-move game (as opposed to a dynamic / sequential-move
game) means that players all make a decision on their action simultaneously.

EQUILIBRIUM IN THE INVISIBLE HAND GAME

The best response is the strategy that will give a player the highest pay off, given the
strategies the other players selected.

Dominant strategy: the actions that yield the higher payoff to a player, no matter what the
other does. (it does not always exist).
Dominated strategy: the strategy that is not the best response independently for other
players’ strategies (it should never be chosen).
If two people have both a dominant strategy we say that there is a dominant strategy
equilibrium.

If they play not choosing their dominated strategies, this strategy is called Iterative
elimination of dominated strategies.

If they play choosing their BR to strategies played by others (taking them as given), this
strategy is called Nash Equilibrium (NE). There can be more than one NE strategy

In most models we have assumed self-interested preferences but people usually also care
about what happens to others. Then we say they have social preferences

We say it is a zero sum game when the sum of the gains and the losses of two people is
equal to zero.

PUBLIC GOODS, FREE RIDING AND REPEATED INTERACTIONS

Everyone's dominant strategy is not to contribute at all (free riding). This is because private
benefits of contribution are lower than private cost of contribution. With altruism this problem
could be solved.
As this problem repeats, individuals have to also think about what others will do in the future
depending on their choice

- Public good experiments show that contribution tend to decrease

- When the punishment is introduced contribution increases

SOCIAL PREFERENCES: BESIDES ALTRUISM

- Inequality aversion: Disliking outcomes in which individual receive more than others
- Reciprocity: Being kind/ helpful to others who are kind/ helpful and vice versa.
GAME TREE FOR THE ULTIMATUM GAME
 UNIT 5: ECONOMIC INSTITUTIONS

INSTITUTIONS
Institutions can take many forms: governments, laws, social norms, etc.
Institutions (the rules of the game) matter for social outcomes; they determine how the
decisions of players lead to who gets what: the allocation
The allocation is the outcome of an economic interaction, a description of who does what,
the consequences of their actions and who gets what as a result.

HOW TO EVALUATE OUTCOMES

An allocation is Pareto efficient if nobody can be better off without making somebody worse
off.
Pareto efficiency is unrelated to fairness. Many allocations that could be unfair are Pareto
efficient
Pesticide example: Pareto dominates (T,T) ; (I,I) , (T,I) , (I,T) are all Pareto efficient.

Fairness evaluates the rules of the game as well as the outcome.

Allocations can be considered unfair for two reasons:

1. Inequality of outcome (e.g. wealth, well-being) Substantive judgement of fairness
2. How they came about (e.g. force vs. fair play, equal opportunity, conforming to social
norms) Procedural judgement of fairness

DETERMIN ALLOCATIONS
e.g.: Angela the farmer

- Angela faces a tradeoff between grain and free time.

 - She farms the land by herself and keeps all the grain
- Recall optimal decision making: allocation is where MRS = MRT

Combine feasible set

- Bruno is not a farmer. He owns the land on which Angela farms. He wants some of
Angela’s profits.
- The combined feasible set shows all possible allocations of production between two
parties.
- The chosen allocation depends on institutions and policies.

Feasible allocation

- The feasible frontier shows all the technically feasible outcomes (limited by
technology).
- The biological survival constraint shows all the biologically feasible outcomes
(limited by survival).
- Feasible allocations are given by the intersection of these constraints.
 Coercion: Imposing allocation by force
- Suppose Bruno can enforce any allocation he wants – in effect, Angela is his
slave.

The allocation that maximises his economic rent is where the slope of the biological
constraint (MRS) equals the slope of the feasible frontier (MRT). MRS = MRT

Voluntary exchange: Bargaining

- How parties divide up the joint surplus (mutual gains) depends on:
1. Each party’s reservation option (what they could get in absent of an
agreement)
2. The relative bargaining power between the parties

The economically feasible set shows all possible allocations that benefit both parties.
Coercion vs. Bargaining
- Under coercion, the allocation chosen is where the slope of the biological constraint
equals the slope of the feasible frontier.
- Without coercion, joint surplus is maximized where the slope of the reservation
indifference curve equals that of the feasible frontier.

The Pareto Efficiency Curve

- Pareto efficiency curve: the set of all Pareto efficient allocations (also called the
contract curve).
- Joins together all points in the feasible set where MRS = MRT.
- The joint surplus is the same, but the distribution of the surplus differs at each point
on the curve.

Pareto-efficient bargaining
The allocation chosen will be on the Pareto efficiency curve (line CD).
- At C, Angela gets all the surplus.
- At D, Bruno gets all the surplus.
- In any other point on the curve, Angela and Bruno split the surplus, and each receive
a rent.
INSTITUTIONS AND POLICIES: LEGISLATION
Institutions and policies affect the size of the surplus and its distribution.
Example: A law that limits working hours and payments to landlords gives Angela a better
reservation value.
But: If circumvention by Angela not allowed => loss in efficiency
MEASURING INEQUALITY
Lorenz curve: Shows the extent of inequality and allows comparison of distributions.
Gini coefficient: Measure of inequality, approximated as the deviation of the Lorenz curve
from the perfect equality line. = A / A+B
Ranges from 0 (perfect equality) to 1 (maximum inequality).
 UNIT 6: THE FIRM: OWNER, MANAGER AND
EMPLOYEES

VOCABULARY
outsourcing/offshoring: deslocalización

THE DIVISION OF LABOUR

We will only say an organization is a firm if:
- Employs people
- Purchase inputs to produce market goods and services
- Sets prices greater than the cost of production

Differences between firms and markets:

RELATIONSHIPS CONTRACTS COORDINATION

MARKETS short term For products sold in Decentralization of

markets power: decisions are
permanently transfer made by the buyers’
ownership of the
and sellers’
goods from the
seller to the buyer autonomous
decisions.
People response to
prices

FIRMS long term For labour Concentration of

temporarily transfer economic power:
authority over a managers direct the
person’s activities
activities of their
from the employee
to the manager or employees.
owner. People response to
orders.
The dashed upward green arrows represent a problem of asymmetric information since
owners or managers do not always know what their subordinates know or do.

In firms, these skills, networks, and friendships are called relationship-specific or

firm-specific assets because they are valuable only while the worker remains employed in
a particular firm.

OTHER’S MONEY: THE SEPARATION OF OWNERSHIP AND CONTROL

When managers decide on the use of other people’s funds, this is referred to as the
separation of ownership and control => conflict of interests => the objective is not always
to maximize the benefits => someone may not make the best decisions when is not his
money => free riding problem

To solve the conflict of benefits:

- They link the managers' pay yo the performance he makes
- monitor the managers’ performance.

OTHER’S LABOUR
Hiring is considered an incomplete contract :
- Some tasks depend on future (unknown events)
- Some aspects of the job are difficult to measure (hidden action problems)

If employers pay employees according to how productive they are, thi is known as
piece rate. This is not used a lot because:
- is difficult to calculate how many units someone produce
- workers do not usually work alone.
EMPLOYMENT RENT
The employment rent is the cost of job loss, which includes:
- lost income while searching for a job
- Costs required to start a new job e.g.: relocation
- Loss of non-wage benefits e.g.: medical insurance
- Social costs (stigma of being unemployed)

This benefits the managers and owners of the firm because:

- They can threaten to fire
- The worker will stay

net utility per hour = wage − disutility of effort per hour =$10
/ wage = 12 ; Disutility = 2

The disutility of effort will increase as the effort required for the job increases

total employment rent = employment rent per hour × expected lost hours of work

There are also many countries where people who lose their jobs get unemployment
benefit.
The wage someone get while being unemployed will be their reservation wage, which is the
lowest wage that would induce her to accept a job in which she did not experience any
disutility of work.

employment rent per hour = wage−reservation wage−disutility of effort

INCREASE THE ECONOMIC RENT
Firms can increase their workers economic rents by offering higher wages

This game is sequantial:

1. The employer first chooses a wage
2. The worker then chooses a level of work effort

Therefore, their strategies will be Nas Equilibrium.

Some possibilities:
- If the wage offered equals the reservation wage, workers best response will be an
effort of 0
- For a higher wage, the BR will be a hisgher level of effort

THE LABOUR DISCIPLINE MODEL

If the worker provides e units of effort => cost per unit of effort = w/e
The employer will try to minimize that cost => efficiency wages (which are set over the
reservation wage so that the employee cares about losing his job).

The cost of effort is the same at all points on an isocost line.

Slope of isocost curve = MRS (the point at which the employer is willing to increase the
wages in order to get higher effort)

The Nash Equilibrium will be the point at which employers and employees curves are
tangent. MRS = MRT
In equilibrium, both wages and involuntary unemployment have to be high enough to ensure
that there is enough employment rent for workers to put in effort.

The position of the best response function depends on:

- the utility of the things that can be bought with the wage
- the disutility of effort
- the reservation wage
- the probability of getting fired when working at each effort level

PRINCIPAL AGENT MODELS

Many contractual relationships are called this way as there is a conflict of interests: the
worker prefers an easy life whereas the employer prefers the employee to work harder

A hidden action (or moral hazard) problem occurs when there is a conflict of interest
between the principal and the agent over some action that may be taken by the agent, and
this action cannot be subjected to a complete contract.

The information about the action may be either asymmetric or unverifiable