Introduction to Economics and Business

Reading questions: Week 2

Utrecht University School of Economics

ECB1IEBE
 Main question

What is the subject of economics?

Economics is a study of how people interact with each other and with their natural surroundings in producing
their livelihoods, and how this changes over time:
▪ How we acquire the things that make up our livelihood (e.g., food, clothing, housing or free time).
▪ How we interact with each other (e.g., buyers and sellers, employees and employers)
▪ How we interact with our natural environment (e.g., extracting raw materials from the earth, producing
externalities)
▪ How each of these changes over time

In the lecture:
▪ How we manage national and international economic policy, how we respond to economic fluctuations
 Question 1

What is GDP supposed to measure?

• GDP (gross domestic product) is an estimate of the

living standard (or wellbeing) in the economy. Its value
corresponds to the total income of everyone in the
country:

Nominal 𝐺𝐷𝑃 = ෍ 𝑝𝑖 𝑞𝑖 =
𝑖
𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑔𝑦𝑚 𝑙𝑒𝑠𝑠𝑜𝑛 × 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑔𝑦𝑚 𝑙𝑒𝑠𝑠𝑜𝑛𝑠
+ 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑏𝑜𝑜𝑘 × 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑏𝑜𝑜𝑘𝑠 + ⋯
+ 𝑝𝑟𝑖𝑐𝑒 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑓𝑜𝑟 𝑜𝑡ℎ𝑒𝑟 𝑔𝑜𝑜𝑑𝑠 𝑎𝑛𝑑 𝑠𝑒𝑟𝑣𝑖𝑐𝑒𝑠

• GDP per capita is a measure of the total goods and

services produced in a country, divided by the country’s
population.

Source: CORE. The Economy (2018),

GDP per capita (levels)
 Question 1

What is GDP supposed to measure?

GDP per capita corresponds to the average income of people in a country, but it ignores:
• Payments from the government (e.g., unemployment or disability benefits)
• Payments from others (e.g., gifts)
• Transfers that individual made to others (e.g., taxes paid to the government).

Disposable income accounts for these and captures the maximum amount goods and services that the person can buy
without having to borrow (i.e., food, housing, clothing). However, wellbeing is often not related to what we can buy:
• The quality of our social and physical environment (e.g., friends and clean air)
• The amount of free time
• Goods and services provided by a government (e.g., healthcare and education)
• Goods and services produced within the household (e.g., meals and childcare)
 Question 2

Does GDP measure inequality?

▪ For Group 1, an increase in income of both individuals Group 1 2

will increase the average wellbeing Individual 1 $5,000 $10,000
▪ For Group 2, an increase in income of both individuals Individual 2 $5,000 $500
will not matter much to the rich people, but the poor half Average $5,000 $5,250
would think their poverty was a serious deprivation
Wellbeing ? ?

• People care about their relative position in the income distribution and consider they wellbeing lower
if they find they earn less than others in their group
• Average income fails to reflect how well off a group of people is by comparison to some other group
 Question 3

What should GDP, according to you, measure?

“What you measure affects what you do. If you don't measure the right thing, you don't do the right thing”
Joseph Stiglitz (2001), Nobel Memorial Prize in Economic Sciences

“it [GDP] measures everything in short, except that which makes life worthwhile.”
Robert Kennedy (1981), election speech in University of Kansas

• From the 1950s till the 1970s – GDP became the main measure of the success of an ideology (namely
capitalism vs socialism)
• Focus on higher productivity ignores negative externalities that such productivity creates (e.g., inequality
and environmental damage)
• It does not capture more subjective factors of wellbeing (e.g., quality of life, happiness)
 Question 4

What is economic growth?

• Economic growth is the increase of GDP and hence

the increase of production
• We calculate the growth rate of the economy
(i.e., income) by the following formula:
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 =
𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑖𝑛𝑐𝑜𝑚𝑒
𝑦2001 − 𝑦2000
=
𝑦2000

• Hockey stick: Sustained growth did not occur for a

long time, and it began at different times in different
countries, creating divergence in the living standards
around the world Source: CORE. The Economy (2018),
GDP per capita (ratio scale)
 Question 5

What is considered to be the main driver of economic growth?

• Technology is a process that takes a set of materials and other inputs – including the work of people
and machines – and creates an output

• Industrial Revolution sparked a permanent technological advance because the amount of time
required for producing most products fell with each generation

Technological revolution → Increased labor productivity

→ Increase in economic growth and living standards
 Question 6

What are the limits to economic growth?

• The permanent technological revolution brought about dependence on fossil fuels
• Humans have regarded natural resources as freely available in unlimited quantities

The human causes and the reality of climate change are no longer widely disputed in the scientific community,
so that economic growth can no longer be equated with an increase of welfare.

Source: CORE. The Economy (2018),

Carbon dioxide in the atmosphere and
global carbon emissions from burning
fossil fuels
 Question 7

How is capitalism defined?

Capitalism is:
• A class of economic systems (i.e., way of organizing the production and distribution of goods and services)
• Characterized by a particular combination of institutions (i.e., sets of laws and social customs regulating
production and distribution)

Source: CORE. The

Economy (2018),
Capitalism: Private
property, markets and
firms.
 Question 7

How is capitalism defined?

▪ Private property: capital goods (inputs used in production, such as equipment or buildings) are privately
owned (e.g., by individual, family or business)
▪ Markets: reciprocated, voluntary and competitive means of transferring goods or services from one person
to another
▪ Firms: organizations that can hire additional employees (for wage) on the labor market and attract funds to
finance the purchase of the capital goods they need for production

Combining all institutions results in:

• Production taking place in firm → using private capital goods → that are operated by workers who are paid
wages
• Output sold on markets → in which consumers purchase at a price → and this price covers the production
costs
• And to minimize the production costs → firms having strong incentives to innovate and specialize
 Question 8

What is ‘the economy’?

The economy is part of society, which in turn is part of the biosphere. In the economy, firms combine labor
with structures and equipment, and produce goods and services that are used by households and other firms.

Source: CORE. The Economy (2018),

A model of the economy: Households and firms.
 Question 9

Why did the Industrial Revolution start in the eighteenth century?

Malthusian trap (Malthus 1872, “An Essay on the Principle of Population”):

Increase in
productivity of labor

Technological Increase
improvement in population

Decrease in income and

living standards

A sustained increase in income per capita is impossible: in the long run the workers would earn enough from their
jobs or their farms to keep them alive, and no more.
 Question 9

Why did the Industrial Revolution start in the eighteenth century?

Industrial Revolution broke Malthus’ vicious

circle:
▪ Advances in technology and the increase in
use of coal raised the amount that a person
could produce in a given amount of time
▪ Labor productivity allowed incomes to rise
▪ Rapid and continued improvement in
technology outpaced the population growth
that resulted from the increased income
▪ Living standards increased

Source: CORE. The Economy (2018),

Real wages over seven centuries: Wages of skilled
workers in London and the population of Britain.
 Question 10, 11 and 12

Why did Industrial Revolution first occur in Britain only? What kind of economic or non-economic conditions
contributed to or caused the Industrial Revolution?
Some would try to explain its origin through:
▪ General (economic) mechanism: Britain’s high cost of labor coupled with the low cost of local energy
sources
▪ Combination of favorable (historic) factors: scientific revolution, political and cultural attributes of a
nation, access to the resources, military power and geographical reach
Yet, this change happened only once, which makes it more difficult to explain or model.

The answer to the question “Why are we so rich and they are so poor?” (Landes, 1990) remains a matter of
debate. Still, the recent research highlights 3 fundamental causes of the overall economic growth:
• Institutions
• Geography
• Trade
 Question 13

What makes a model a good model?

A good economic model:
▪ Includes the essential features of the phenomena that are relevant to the research question
▪ Is clear, omits unimportant details and focuses on a simple description of the relationship
▪ Makes justified assumptions and hypotheses about the real world
▪ Predicts accurately and is confirmed by empirical evidence
▪ Improves communication, helps us to understand what we agree and disagree on
▪ Is a useful tool for policy advice and forecasting

▪ In the lecture: its quality depends on the questions for which the model is built