PRINCIPLES OF

ECONOMICS
Course 17585 –Bachelor’s in Management and Technology

Fernando Alfayate Fernández

2022/2023
Tabla de contenido
1. CAPITALIST REVOLUTION, TECHNOLOGY, POPULATION AND GROWTH ..................................................................................5
1.1 WHAT IS ECONOMICS? .....................................................................................................................................................5
1.2 GDP AND ECONOMIC GROWTH .......................................................................................................................................5
1.3 ECONOMIC MODELS .........................................................................................................................................................5
1.4 MALTHUSIAN MODEL .......................................................................................................................................................6
1.4.1 ESCAPE: EXPLAINING THE I.R. .......................................................................................................................................6
1.4.2 ISOCOST LINE ................................................................................................................................................................6
1.5 ECONOMIC RENT ..............................................................................................................................................................7
1.6 CREATIVE DESTRUCTION ..................................................................................................................................................7
2. SCARCITY, WORK AND PROGRESS ............................................................................................................................................8
2.1 INTRODUCTION. A MODEL OF WORK AND LEISURE TIME. ..............................................................................................8
2.1.1 PRODUCTION FEASIBILITY FRONTIER (Frontera de Posibilidades de Producción o Frontera Factible) ........................8
2.1.2 PREFERENCES & INDIFFERENCE CURVE ........................................................................................................................9
2.2 DECISION TAKING & SCARCITY .........................................................................................................................................9
2.3 INCOME & SUBSTITUTION EFFECT ................................................................................................................................ 10
2.3.1 EFFECT OF AN ADDITIONAL RENT.............................................................................................................................. 10
2.3.2 EFFECT OF A VARIATION IN WAGE ............................................................................................................................ 11
2.4 MODEL APPLICATION .................................................................................................................................................... 11
3. STRATEGY, ALTRUSIM AND COOPERATION ........................................................................................................................... 12
3.1 GAME THEORY ............................................................................................................................................................... 12
3.2 RESOLVING SOCIAL DILEMMAS ..................................................................................................................................... 13
3.3 DYNAMIC GAMES .......................................................................................................................................................... 14
3.4 JUDGING GAME SOLUTIONS: EFFICIENCY ..................................................................................................................... 14
3.5 JUDGING GAME SOLUTIONS: FAIRNESS (equidad)........................................................................................................ 15
3.6 MEASURING INEQUALITY .............................................................................................................................................. 15
4. THE FIRM. OWNERS, MANAGERS AND EMPLOYEES .............................................................................................................. 16
4.1 OWNERS vs MANAGERS. CONFLICT OF INTERESTS WITHIN THE FIRM ......................................................................... 16
4.2 WORKERS vs MANAGERS. CONFLICT OF INTERESTS WITHIN THE FIRM ....................................................................... 16
4.2.1 INDUCING EFFORT: PIECE RATES ............................................................................................................................... 16
4.2.2 RISK OF BEING FIRED ................................................................................................................................................. 17
4.2.3 EMPLOYMENT RENTS (renta económica del trabajo) ............................................................................................... 17
4.3 THE LABOR DISCIPLINE MODEL ..................................................................................................................................... 17
4.3.1 WORKER´S SIDE ......................................................................................................................................................... 18
4.3.2 FIRMS´S SIDE .............................................................................................................................................................. 18
4.3.3 EQUILIBRIUM ............................................................................................................................................................. 19
4.3.4 INVOLUNTARY UNEMPLOYMENT .............................................................................................................................. 19
4.3.5 CHANGES IN THE EQUILIBRIUM ................................................................................................................................ 19
4.4 PRINCIPLE-AGENT MODEL ............................................................................................................................................. 19
5. THE FIRM AND ITS CUSTOMERS............................................................................................................................................. 20
5.1 COSTS ............................................................................................................................................................................. 20
5.1.1 AVERAGE COSTS ........................................................................................................................................................ 20
5.1.2 MARGINAL COSTS ...................................................................................................................................................... 20
5.1.3 AVERAGE vs MARGINAL COSTS ................................................................................................................................. 21
5.1.4 ECONOMIES OF SCALE & SCOPE ................................................................................................................................ 21
5.2 REVENUE ........................................................................................................................................................................ 21
5.3 PROFITS.......................................................................................................................................................................... 22
5.3.1 PROFIT MAXIMIZATION ............................................................................................................................................. 22
5.4 GAINS FROM TRADE ...................................................................................................................................................... 23
5.5 PRICE ELASTICITY & PROFITS ......................................................................................................................................... 23
5.6 PRICE ELASTICITY POLICY ............................................................................................................................................... 24
5.7 COMPETITION POLICY.................................................................................................................................................... 24
6. SUPPLY & DEMAND. PRICE TAKING COMPANIES AND COMPETITIVE MARKETS ................................................................... 25
6.1 PRICE SETTING vs PRICE TAKING ................................................................................................................................... 25
 6.2 DEMAND & SUPPLY ....................................................................................................................................................... 25
6.3 PRICE-TAKING FIRMS ..................................................................................................................................................... 25
6.4 COMPETITIVE EQUILIBRIUM .......................................................................................................................................... 27
6.4.1 CHARACTERISTICS ...................................................................................................................................................... 27
6.5 CHANGES IN EQUILIBRIUM ............................................................................................................................................ 27
6.5.1 EXOGENOUS DEMAND & SUPPLY SHOCKS ................................................................................................................ 27
6.5.2 TAXATION AND MARKET DISTORTIONS .................................................................................................................... 28
6.5.3 CHANGES IN EQUILIBRIUM: TAXES ............................................................................................................................ 29
6.5.4 EQUILIBRIUM PRICE ................................................................................................................................................... 29
6.6 PERFECT COMPETITION ................................................................................................................................................. 29
7. MARKETS, EFFICIENCY & PUBLIC POLICY ............................................................................................................................... 31
7.1 IMPERFECT COMPETITION............................................................................................................................................. 31
7.2 EXTERNALITIES ............................................................................................................................................................... 31
7.2.1 MEASURING EXTERNALITIES ..................................................................................................................................... 32
7.2.2 WHY DO EXTERNALITIES EXIST? ................................................................................................................................ 32
7.2.3 HOW TO ADRESS EXTERNALITIES? ............................................................................................................................ 32
7.3 BARGAINING .................................................................................................................................................................. 33
7.3.1 ADVANTAGES vs DISADVANTAGES ............................................................................................................................ 33
7.4 GOVERNMENT POLICIES ................................................................................................................................................ 33
7.4.1 PIGOUVIAN TAX ......................................................................................................................................................... 33
7.4.2 COMPENSATIONS ...................................................................................................................................................... 34
7.5 IMPERFECT INFORMATION ............................................................................................................................................ 34
7.5.1 EXAMPLE OF PRIVATE HEALTH INSURANCE – hidden attribute ................................................................................ 34
7.5.2 EXAMPLE OF CAR INSURANCE – hidden action ......................................................................................................... 35
7.5.3 EXAMPLE OF BANKING COMPANY ............................................................................................................................ 35
7.6 PUBLIC GOODS............................................................................................................................................................... 35
7.6.1 AS A MARKET FAILURE............................................................................................................................................... 35
7.7 LIMITS TO MARKETS ...................................................................................................................................................... 36
8. THE LABOR MARKET .............................................................................................................................................................. 37
8.1 INTRODUCTION.............................................................................................................................................................. 37
8.2 PRICE-SETTING, WAGE-SETTING, EMPLOYMENT AND REAL WAGE.............................................................................. 38
8.1.1 THE FIRM´S DECISION PROCESS................................................................................................................................. 38
8.1.2 WAGE-SETTING CURVE .............................................................................................................................................. 39
8.1.3 PROFIT-SETTING CURVE............................................................................................................................................. 40
8.1.4 LABOR MARKET EQUILIBRIUM .................................................................................................................................. 41
8.1.5 THE ROLE OF LABOR UNIONS .................................................................................................................................... 43
8.1.6 LABOR MARKET POLICIES .......................................................................................................................................... 44
9. BANKS, MONEY, AND CREDIT MARKET .................................................................................................................................. 45
9.1 INCOME, BORROWING AND SAVING ............................................................................................................................ 45
9.1.1 MODELING BORROWING DECISIONS ........................................................................................................................ 45
9.1.2 MODELING SAVINGS DECISIONS ............................................................................................................................... 46
9.1.3 MODELING BORROWING AND SAVINGS: RESERVATION OPTION............................................................................. 47
9.1.4 MODELING INVESTMENT: EQUILIBRIUM .................................................................................................................. 47
9.2 INDIVIDUAL´S BALANCE SHEET ...................................................................................................................................... 47
9.2.1 LENDING, BORROWING AND BALANCE SHEET .......................................................................................................... 47
9.3 BANKS & MONEY ........................................................................................................................................................... 48
9.3.1 INTRODUCTION.......................................................................................................................................................... 48
9.3.2 CENTRAL BANK .......................................................................................................................................................... 48
9.3.3 COMMERCIAL BANKS & BANK MONEY ..................................................................................................................... 48
9.3.4 DEFAULT, LIQUIDITY RISK & BANKING CRISES........................................................................................................... 48
9.3.5 MONEY MARKET ........................................................................................................................................................ 48
9.3.6 FINANCIAL SYSTEM .................................................................................................................................................... 49
9.3.7 BANK´S BALANCE SHEET ............................................................................................................................................ 49
9.3.8 POLICY RATES AND THE ECONOMY ........................................................................................................................... 50
 9.4 CREDIT RATIONING ........................................................................................................................................................ 50
9.4.1 INEQUALITY IN ACCESS TO BANKING SYSTEM........................................................................................................... 50
10. ECONOMIC FLUCTUATIONS & UNEMPLOYMENT .............................................................................................................. 50
10.1 BUSINESS CYCLES ........................................................................................................................................................... 51
10.1.1 OKUN´S LAW .............................................................................................................................................................. 51
10.2 MEASURING AGGREGATE ECONOMY (GDP) ................................................................................................................. 51
10.2.1 GDP APPROACHED TO SPENDING ............................................................................................................................. 52
10.2.2 GDP APPROACHED TO PRODUCTION (AGGREGATE VALUE) ..................................................................................... 52
10.2.3 GDP APPROACHED TO INCOME................................................................................................................................. 52
10.2.4 MEASUREMENT ISSUES ............................................................................................................................................. 53
10.3 ECONOMIC FLUCTUATIONS AND CONSUMPTION ........................................................................................................ 53
10.3.1 LIMITATIONS TO CONSUMPTION SMOOTHING: CREDIT CONSTRAINS ..................................................................... 54
10.3.2 LIMITATIONS TO CONSUMPTION SMOOTHING: WEAKNESS OF WILL ...................................................................... 54
10.4 ECONOMIC FLUCTUATIONS AND INVESTMENT ............................................................................................................ 54
10.4.1 VOLATILITY OF INVESTMENT ..................................................................................................................................... 55
10.4.2 INVESTMENT COORDINATION ................................................................................................................................... 55
10.4.3 INVESTMENT AND THE AGGREGATE ECONOMY ....................................................................................................... 56
10.5 ECONOMIC FLUCTUATIONS AND OTHER COMPONENTS .............................................................................................. 56
10.5.1 NET EXPORTS AND GOVERNMENT SPENDING .......................................................................................................... 56
10.6 ECONOMIC FLUCTUATIONS AND INFLATION ................................................................................................................ 56
10.6.1 MEAUSRING INFLATION ............................................................................................................................................ 56
10.6.2 INFLATION FORECASTS .............................................................................................................................................. 57
11. UNEMPLOYMENT & FISCAL POLICY ................................................................................................................................... 58
11.1 AGGREGATE DEMAND: MULTIPLIER MODEL ................................................................................................................ 58
11.1.1 PRIVATE CONSUMPTION FUNCTION ......................................................................................................................... 58
11.1.2 PRIVATE INVESTMENT FUNCTION ............................................................................................................................. 59
11.1.3 GOODS MARKET EQUILIBRIUM ................................................................................................................................. 60
11.1.4 EXAMPLE OF GOODS MARKET EQUILIBRIUM: 1929 CRASH ...................................................................................... 61
11.2 AGGREGATE DEMAND MODEL: ROLE OF THE GOVERNMENT ...................................................................................... 61
11.2.1 STABILIZING ROLE OF THE GOVERNMENT ................................................................................................................ 61
11.2.2 FISCAL STIMULUS ....................................................................................................................................................... 62
11.2.3 MULTIPLIER IN PRACTICE........................................................................................................................................... 62
11.2.4 GOVERNMENT´S FINANCES ....................................................................................................................................... 62
11.3 AGGREGATE DEMAND MODEL: FEEDBACK MECHANISMS ........................................................................................... 63
11.3.1 PRIVATE SECTOR, GOVERNMENT ACTIONS AND OUTPUT (DE)STABILIZATION ........................................................ 63
11.4 AGGREGATE DEMAND MODEL & FOREIGN TRADE ....................................................................................................... 64
11.5 AGGREGATE DEMAND MODEL & UNEMPLOYMENT..................................................................................................... 64
12. INFLATION, UNEMPLOYMENT & MONETARY POLICY........................................................................................................ 65
12.1 INFLATION...................................................................................................................................................................... 65
12.1.1 HOW MUCH INFLATION IS GOOD? ............................................................................................................................ 65
12.1.2 CAUSES OF INFLATION ............................................................................................................................................... 65
12.2 THE PHILLIPS CURVE ...................................................................................................................................................... 66
12.2.1 BARGAINING GAP ...................................................................................................................................................... 67
12.2.2 OVER TIME CHANGES. PHILLIPS CURVE..................................................................................................................... 68
12.3 CHANGES IN INFLATION ................................................................................................................................................ 68
12.3.1 SUPPLY SHOCKS ......................................................................................................................................................... 69
12.4 MONETARY POLICY ........................................................................................................................................................ 69
12.4.1 POLICY INTEREST RATE AND MONETARY POLICY TRANSMISSION MECHANISMS .................................................... 69
12.4.2 MARKET INTEREST RATES .......................................................................................................................................... 70
12.4.3 ASSET PRICES AND PROFIT EXPECTATIONS ............................................................................................................... 70
12.4.4 EXCHANGE RATES ...................................................................................................................................................... 70
12.4.5 MULTIPLIER MODEL................................................................................................................................................... 71
12.4.6 LIMITATIONS .............................................................................................................................................................. 71
12.5 DEMAND SHOCKS .......................................................................................................................................................... 72
 12.6 DISCRETIONARY POLICIES vs INFLATION TARGETING ................................................................................................... 72
12.6.1 CENTRAL BANK CREDITIBILITY ................................................................................................................................... 72
12.7 INLATION AND LOW UNEMPLOYMENT ......................................................................................................................... 73
13. TECHNOLOGICAL PROGRESS, INSTITUTIONS, UNEMPLOYMENT AND LIVING STANDARDS IN THE LONG-RUN ................ 74
13.1 TECHNOLOGICAL PROGRESS AND LIVING STANDARDS................................................................................................. 74
13.1.1 TECHNOLOGICAL PROGRESS AND CAPITAL INTENSITY ............................................................................................. 75
13.2 JOB CREATION AND UNEMPLOYMENT .......................................................................................................................... 75
13.2.1 BEVERIDGE CURVE ..................................................................................................................................................... 76
13.3 LONG-RUN LABOR MARKET MODEL.............................................................................................................................. 77
13.3.1 REAL WAGE ................................................................................................................................................................ 77
13.3.2 REAL WAGES AND LONG RUN UNEMPLOYMENT...................................................................................................... 78
13.3.3 SHORT vs LONG-RUN ................................................................................................................................................. 79
13.4 THE ROLE OF INSTITUTIONS AND POLICIES ................................................................................................................... 80
13.4.1 INCLUSIVE AND EXCLUSIVE UNIONS: DIFFERENCES BETWEEN COUNTRIES ............................................................. 80
13.4.2 CHANGES OVER TIME ................................................................................................................................................ 81
14. ECONOMIC INEQUALITY .................................................................................................................................................... 83
14.1 TRENDS IN INEQUALITY ................................................................................................................................................. 83
14.1.1 GLOBAL INEQUALITY ACROSS TIME........................................................................................................................... 83
14.1.2 CATEGORICAL INEQUALITY ........................................................................................................................................ 84
14.1.3 INTERGENERATIONAL INEQUALITY ........................................................................................................................... 84
14.1.4 CROSS-SECTIONAL INEQUALITY ................................................................................................................................. 85
14.2 EVALUATING INEQUALITY ............................................................................................................................................. 85
14.2.1 MODELLING PREFERENCES OVER INEQUALITY ......................................................................................................... 86
14.3 EXPLAINING INEQUALITY ............................................................................................................................................... 87
14.3.1 SOURCES OF ECONOMIC INEQUALITY ....................................................................................................................... 87
14.4 ADDRESSING UNFAIR INEQUALITY ................................................................................................................................ 88
14.4.1 GOVERNMENT POLICIES ............................................................................................................................................ 88
14.5 TRENDS IN INCOME INEQUALITY................................................................................................................................... 89
14.6 INEQUALITY AND ECONOMIC GROWTH ........................................................................................................................ 90
14.7 A GLIMPSE ON POVERTY ............................................................................................................................................... 90
1. CAPITALIST REVOLUTION, TECHNOLOGY, POPULATION AND GROWTH
1.1 WHAT IS ECONOMICS?
A science that focuses on two main areas: financials and human behavior. Moreover, it cares about sources and their
allocations. However, it is a trend science (see example of most repeated concepts).

The study of how people interact with each other and with their natural surroundings in providing
their livelihoods, and how these change over time.

 How we come to acquire the things that make up our livelihood: Things like food, clothing, shelter, or free time.
 How we interact with each other: Either as buyers and sellers, employees or employers, citizens and public
officials, parents, children, and other family members.
 How we interact with our natural environment: From breathing, to extracting raw materials from the earth.
 How each of these changes over time.
History

• Adam Smith considered that economics is an “inquiry into the nature and causes of the wealth of nations”. He
wanted to investigate economics on a financial basis and analyze economics with the mathematical
perspective. Alfred Marshall was the one who inserted mankind inside the concept of economics.
• Lionel Robbins stated the idea of scarcity, of infinite needs and limited sources. He said “science which studies
human behavior as a relationship between ends and scarce means which have alternative uses”. Milton
Friedman highlighted with “in economics we say that there are no free lunches”, stating that we are always
choosing and that everything has a cost.

1.2 GDP AND ECONOMIC GROWTH

Hockey-stick growth: GDP per capita since year 1000.
GDP is an estimation that accounts for means produced in the country (regardless of who owns the production factors),
that is which marks the difference between GDP and GNP.
GDP measures the sum of the output of final goods and services in the economy in each period. Intermediate goods
are excluded to avoid double counting. The second way is to calculate the value added of each phase of the chain.
The Nominal GDP is the output measured at current prices and current quantities: ∑𝑛𝑖=1 𝑝𝑖 𝑞𝑖. To account
𝑝𝑖𝑡 ∗𝑞𝑖𝑡
inflation´s effect, we use Real GDP/GDP at constant prices: ∑𝑛𝑖=1 . The symbol below is a price index, which
𝑝0𝑡
measures change in prices between base (0) and current period.
If we wish to compare countries’ GDP, we need to hold constant the price levels in different countries. We can achieve
a correct analysis measuring with the Purchasing Power Parity (poder de compra afectado por el valor de la moneda)
𝐺𝐷𝑃
When we wish to measure economic growth, we use GDP per Capita ( ).
𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛

1.3 ECONOMIC MODELS

What happens in the economy depends on the actions and interactions of millions. Economic models allow us to look
at the big picture. Models incorporate essential features and ignore unimportant details.
What makes a good model?

 It is clear: it helps us better understand something important.

 It predicts accurately: its predictions are consistent with evidence
 It improves communication: it helps us to understand what we agree and disagree about
 It is useful: we can use it to find ways to improve how the economy works.

1. Economic models allow to look at the big picture

2. Used to describe how agents act and interact
3. Allow to find outcomes:
a. An equilibrium in a model is a situation from which no agent has incentive to move from;
b. Often challenged by external forces shocks that change conditions
4. Ruled by ceteris paribus which means everything remains the same;
a. Models include explanatory variables (independent) to explain one of interest (dependent)

1.4 MALTHUSIAN MODEL

The Malthus model explains that technological advances lead to gains in average living conditions, which lead to
increased population that in turn diluted the average improve in living conditions. The impact of increasing inputs
diminishes with time and stagnates.
Malthus proposed an economic model which predicted a certain development pattern consistent with the flat part of
GDP per capita hockey-stick graph. In accordance with his theory, even if the increase in population generates a
higher production, average production decreases.
i. + tech => + living standards => + population => - living standards.
ii. Diminishing returns. The tool used is the Production Function.
iii. There is an incentive of the population to increase while there are gains to be exploded from the technology
increase. Average living conditions are not really
increasing or getting better, because it is a repeating
cycle.
iv. The Malthusian Model is positive for slight
Technological Advances.
In conclusion, the Malthusian Model is not perfect to study
economic growth after Industrial Revolution, because of the
effect of Ceteris Paribus. This does not mean the Model is
useless, but that there are better ways to explain the escape
of the Industrial Revolution.

1.4.1 ESCAPE: EXPLAINING THE I.R.

During the I.R., there was a change in the cost structures. This change made that including new technologies was
cheaper than paying more and more workers.
• Malthus´s economic model, which describes a vicious circle in which population growth neutralizes the
temporary increases in earnings, could explain the stagnation in living standards that extended before I.Rev.
Industrial Revolution came with the introduction of new technology, which allowed GDP to growth at a much higher rate,
and that provoked an increase in the result of GDP/POP. Finally, this provoked an escape of the Malthusian Trap.

1.4.2 ISOCOST LINE

Iso-cost lines represent all possible combinations of inputs with the same cost. However, it just considers the economic
cost. The slope is defined as the wage - capital ratio. With this parameter, we are trying to find the ratio between the
price of wage and the price of capital:
𝑤 𝐶
The total cost is given by: 𝐶 = 𝑤𝐿 + 𝑝𝐾 ⇔ 𝐾 = − 𝑝 𝐿 + 𝑝

Conclusion: after the Industrial Revolution, capital-intensive schedules were more desirable, because the capital cost
was much lower than labor cost.

1.5 ECONOMIC RENT

An economic rent is the difference between earnings obtained with an alternative, and the earnings that could be
obtained with the next best alternative. Therefore, there is an economic rent whenever the benefit extracted from one
option is larger than the benefit from the next best alternative.

• Companies decide to innovate and adopt new technologies when they estimate a positive economic rent.
𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑟𝑒𝑛𝑡 = 𝐵𝑒𝑛𝑒𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝑜𝑛𝑒 𝑜𝑝𝑡𝑖𝑜𝑛 − 𝐵𝑒𝑛𝑒𝑓𝑖𝑡 𝑓𝑟𝑜𝑚 𝑛𝑒𝑥𝑡 𝑏𝑒𝑠𝑡 𝑜𝑝𝑡𝑖𝑜𝑛

1.6 CREATIVE DESTRUCTION

Creative Destruction is Joseph Schumpeter´s
name for the process by which old technologies
(and firms that do not adapt) are swept away by
the new ones, because they cannot compete in
the market. In his view, the failure of unprofitable
firms is creative, because it releases labor and
capital goods for use in new combinations.
2. SCARCITY, WORK AND PROGRESS
2.1 INTRODUCTION. A MODEL OF WORK AND LEISURE TIME.
The increase in living standards had impact on the time devoted to work and leisure. After all, leisure time is also an
important component of living standards. The model used to analyze is one of work and leisure time, which consists in
two major ingredients:

Production function: relation between quantity

used (inputs) and production obtained (output).
Diminishing Marginal Product: increase in the
output’s quantity when an additional unit of
input is used.
It is usually decreasing (the more time
dedicated to work, the less productive work is)
In the graph it is the slope of the funt.
Average Product of Labor: quantity of output
that is obtained per each work unit.
For example, to model the decision of a student in terms of hours
of study time and its impact on the grade, we are going
to use the Production Function: y = f(x).
Where y = exam grade and x = study time.
The student is the technology that turns effort into grade.
With 15 hours of study per day, the student reaches max.
capacity, 90. If he studies more time, the grade will
continue to be the same. Following the marginal and
average product theories, the graph will carry on
flattening more and more.
This shows the theory of the Diminishing Marginal
Product. <=> Decreasing Returns.
Decreasing Marginal Effect => Marginal product is
the last product and its effect on the consumer.
How, on average, an output changes when
introducing an input => Avg Change.
The change that happens when introducing one
more unit of input => Marg.Change

2.1.1 PRODUCTION FEASIBILITY FRONTIER

(Frontera de Posibilidades de Producción o
Frontera Factible)
After having in mind the scarcity of resources we find ourselves with,
the next task is to identify a set of feasible possibilities. The PFF
shows, graphically, the maximum quantities of production an
economy can achieve in a determinate period using all its available
resources. Have a look at the graph.
The slope of PFF is the Marginal Rate of Transformation. It
represents the trade-offs the student gets, which in this case is the
Opportunity Cost of free time.

 As free time increases, MRT does too (effect of diminishing

marginal returns). From A to E, student will get 1 extra hour of free time; but will also lose 3 grade points; then
∆𝑦 ∆ 𝑔𝑟𝑎𝑑𝑒𝑠
(opportunity cost) MRT = 3. [𝑀𝑅𝑇 = = ∆ 𝑟𝑒𝑠𝑡 𝑡𝑖𝑚𝑒]
∆𝑥

There is also an Economic Cost of an alternative. It is the result of a monetary quantity + opportunity cost.
  If benefit obtained is higher than economic cost → positive economic rent → choose the alternative.
 If benefit obtained is lower than economic cost → negative economic rent → not choose the alternative.
2.1.2 PREFERENCES & INDIFFERENCE CURVE
When an individual decides, it should consider preferences and consumption possibilities. Indifference curves show all
combinations of goods that give the same utility (satisfaction). Preferences over two goods of a person are represented
with an indifference map, which groups all indifference curves; and in this map there are no upper bounds.
Indifference curves are characterized by four things:

• Negative slope to reflect that whichever alternative has more

quantity of a good, will have less quantity of the other.

• The farther from the origin, the more utility they give.

• They do not transect each other (transitivity)

• They usually reflect small changes in the quantity of goods,
which do not generate great variations in utility.
The Marginal Rate of Substitution (slope of the indifference
curve) measures the trade-off that the student is willing to accept
between test scores and free time.
In other words, how much grade the student renounces to, in order
to have one more unit of free time but maintaining the same utility.
Over time, Indifference Curves get flatter and flatter because the
higher the quantity, the easier it is to renounce to the good.

2.2 DECISION TAKING & SCARCITY

Given the feasible set, an individual chooses the best alternative, which is the one that provides higher utility. The
individual´s decision will be the combination of feasible set which accounts for MRT = MRS (combination where
indifference curve is tangent to the feasible set).

• The MRS:
o additional points in the grade that the student must
be given to give up at least one hour of leisure.
o the maximum points that the student would give up
to have one more hour of leisure.

• The MRT:
o additional points that the student gets if he gives up
an hour of leisure.
o the points the student loses you lose if you enjoy an
extra hour of leisure

Given the graph, in a combination such as point C, utility can be increased by reaching to higher indifference curves.

 If MRS>MRT, as in B or D, free time can be increased in one hour as the student chooses to give up more
grade points than those, he would lose for having that additional free time hour.
 If MRS<MRT, as in A, free time can be reduced in one hour, as it has a higher result in terms of grade.

 Then, the optimal point is at E, where the student does not want to lose or gain any extra hour or points, ans
also where MRS = MRT.
When a positive technological advance takes place, production for any nº of work hours would also increase. As the
new production function is concave, it has more slope than the original (marginal product of labor). This, in the end,
implies that consumption odds increase.
 New and old New and old
production production
functions functions

For example,
an individual
who produces
the food he
consumes.

Given the new consumption odds, there is a possibility to consume more and to enjoy more free time. However, the
result can vary depending on the preferences on both goods and the predisposition to substitute one another.
Two opposite effects happen:
• Technological change allows to produce and consume more given the same free time.

• Technological change provokes an increase in Marginal Product, which implies that opportunity cost is also
greater, which in the end is an incentive to work more.

2.3 INCOME & SUBSTITUTION EFFECT

Any individual has a budget constrain, which shows what the individual can consume given the rent obtained with
work (which is also the consumption odds). If an individual has 24 hours available and enjoys (t) free time hours, the
work hours are defined as 24 – t.
If the individual is paid a wage (w) per work hour, the maximum consumption (c) of the individual is defined by the
function: 𝑐 = 𝑤 ∗ (24 − 𝑡).The slope of this constrained budget is the MRT, and it equals the wage.
Income effect is the change in optimal choice when income changes,
keeping opportunity costs constant (budget constraint slope) fixed.

Substitution effect
is the change in
optimal choice when
the opportunity cost
changes at the new
level.
Given the feasible set, the person chooses the
combination between free time and consumption that maximizes its
utility (best indifference curve possible).
In the graph, this would be the case with point A, which is where the I.Curve is tangent to the feasible set and we achieve
MRT = MRS.

2.3.1 EFFECT OF AN ADDITIONAL RENT

If the person receives an additional rent (M), it could be destined to consume, and the feasible set would be:
𝑐 = 𝑤 ∗ (24 − 𝑡) + 𝑀. This would provoke an upwards displacement (opportunity cost does not vary), and this translates
in enjoying one more hour of free time implying that the person renounces to collect one hour of wage, as well as
renouncing to consume what it could buy with that extra wage.
 Depending on the preferences (indifference curves), the person could choose to keep working the same and
consume the additional rent or increase consumption a bit less and take more free time.
The income effect is the effect produced on the election of free time as an increase in rent.
2.3.2 EFFECT OF A VARIATION IN WAGE
If, instead of giving an additional rent, the person is given a raise in its salary, the feasible set would increase upwards
as well, and this has two main effects:

 Higher wage per work hour. For each level of free time, the person can consume more, and would be more
disposed to sacrifice consumption to get more free time (in other words, higher MRS).
o This would correspond to a income effect that could lead the person to want more free time, as the
consumption would remain the same, or even working less hours.

 Higher Opportunity Cost of enjoying one more hour of free time. This happens because the person
renounces to a higher wage (in other words, higher MRT).
o This would correspond to substitution effect, where the person has incentive to work more and reduce
its free time, since now it costs more.
In the graphic, the rent effect implies going from A to C
(without changing slope, only increasing rent).
The substitution effect implies going from C to D (in reality,
slope does change).
The total effect of the wage increase is the sum of both
effects, and in terms of the graph, means going from A to
D.

2.4 MODEL APPLICATION

We have applied a model based in preferences and consumption possibilities to decide how many work hours should
be done in three scenarios: a student, a producer, and a worker. In the three cases, the model has shown that the best
selection is the quantity or combination of quantities where an Indifference curve is tangent to the feasible set (that is,
where MRT = MRS).
To explain growth during 20th century, data seems to reflect a continuous increase in wages and reduction in work
hours. According with the model, this could be an example of a situation where income effect dominates over
Substitution effect. In that way, we conclude the total effect made an increase in free time and a reduction in work hours.
Moreover, we must consider the possibility that
preferences also change.
Data from some countries indicates that in the late
20th century, work hours increased but wages did
not.
This could have happened because population
started to value more consumption and less free
time.

Differences in preferences can also explain differences among countries.

In the graph we see that free time in Mexico and Sout Korea are almost the
same, even if wages in Korea are much higher.
In point Q, where IC from Korea and USA cross, the IC from USA has a
steeper slope. This means that the mean USA citizen is open to renounce
to more consumption to get more free time (MRS is higher) than the Korean
citizens.
3. STRATEGY, ALTRUSIM AND COOPERATION
In the decision taking model, results do not depend on the actions of others. Individuals take decisions to obtain the
best possible outcome, and the optimal decision depends on its own decision.
We use Game Theory to model social interactions in which individuals´ decisions affect others, and also to analyze
social dilemmas.
Social Interaction: Situation involving more than one party, where one’s actions affects both their own and other
people’s outcomes.

 The phenomenon of “tragedy of the commons” (Garret Hardin) can be described as an overexploitation of
common resources – grazing, fish, air, climate…
Social dilemma. A social dilemma takes place when individuals decide taking into account only its own interests (they
do not think on the effects of their actions on others). What is best for an individual may be worst for society.

 This way, a suboptimal result is achieved from the social point of view (a better result could have been
achieved if people had acted collectively)
The two most important social dilemma are:

• Tragedy of common resources: in certain goods that are not owned by anyone (atmosphere, for example)
the trend is overexploitation of resources, unless that access to those is controlled in some way.

• Problem of free riding in public goods: one contributes, and the rest is benefited from the work of the first
person.
o For example, when there is a group task, effort costs are individual, but earnings (grade) are in group.

3.1 GAME THEORY

IMPORTANT TERMINOLOGY
 Social interaction. Situation involving more than one person/party, where one´s actions affect both them and
other people´s outcomes.

 Strategic interaction. Social interaction where people are aware of the ways that their actions affect others.

 Strategy is defined as an action (or a course of action) that indicates what decision may a person take in each
and every of the cases in which it would correspond for the player to act.
 Game theory is a set of models of strategic interactions. It is widely used in economics and elsewhere in the
social sciences.
o Game. Formal model of strategic interaction in which some people are involved in a social interaction,
and are conscious on how actions affect each of them. Three fundamental elements:
▪ Players
▪ Feasible strategies (actions)
▪ Payoffs that each player can receive
 Equilibrium: analyst´s prediction for a solution of the game (more than one may exist, or not).
o Adam Smith talked about the invisible hand as the market leading to an equilibrium.
o He thought that supply and demand interact in a way which they reach an equilibrium, which is good
for the individuals who interact and for society.

 Models of strategic interactions are described as games.

➔
To find the solution to the game, we need to find the best response: strategy that gives the highest possible payoff,
given a strategy from the other player. Some games can be solved identifying two types of strategies:

 Dominant strategy: a strategy is dominant if it is always the best strategy for a player, regardless of what the
rest players do. If a player has a dominant strategy, he will always play it.

 Dominated strategy: a strategy is dominated if the player always obtains less outcome than with any other
strategy, regardless of what the rest players do. If a player has a dominated strategy, he will never play it.
The objective of each player is too look what is more convenient to maximize benefits, given what is expected for the
other players to do. By doing this, each player chooses and equilibrium strategy.

• In order to do this, each player looks for their best response (response that achieve the highest outcomes
given a strategy chosen by the rest of the players)
Nash equilibrium: result obtained where none of the players wants to deviate from their strategies of equilibrium.
Strictly dominant = best response // Strictly dominated  best response
If there is more than one Nash equilibrium, and if people choose actions independently, then an economy can get
“stuck” in a Nash equilibrium in which all players are worse off than they would be at the other equilibrium.
When two players take decision simultaneously and without knowing what the other chooses, the game is represented
through a Payment matrix.

3.2 RESOLVING SOCIAL DILEMMAS

Prisoner´s dilemma: game with a dominant strategy equilibrium in which
playing the dominant strategy results in lower individual and total payoffs
compared to other strategies.
In this example, there is a dominant strategy, which is choosing terminator, and
with it, socially optimal outcome is not achieved.
We predict the prisoner´s dilemma game because:
1 – players only care about their payoffs, here if we introduce social preferences
things will change
2 – nobody can make players pay for the consequences of their actions on
others. If the game was repeated, things could change.
3 – player couldn´t coordinate actions beforehand (change the rules of the
games
INTRODUCING SOCIAL PREFERENCES
Economists use experiments to learn about preferences.
1. Lab experiments
a. Control participant´s decisions and outcomes
b. Create a control group
c. Results can be replicated
d. Control other variables
2. Field experiments
a. Lab experiments may not predict real world decision making
b. More realistic context in which people make decisions
SELFISHNESS
Up until now, we have considered that persons have selfish preferences. But, people do not usually care only to what
happens to themselves, but also what happens to the rest. This is the case of social preferences, in which envy,
altruism or resentment are examples.
 ALTRUISM
Some social dilemmas arise when players only care about own payoffs. In
such cases, players have an incentive to choose an otherwise dominated
strategy. Intuitively, we introduce a social component into their preferences,
which now accounts for more than self-interest.
With altruistic preferences, a person could assume a certain cost to benefit
another party because it gives more utility.

REPEATED GAMES
In one-shot games you play the game once and collect the payoff. In real life, this does not happen.
 Repeated games are those played more than once.
 Repeated games may lead to better outcomes, due to social norms, reciprocity, and peer punishment.
 This is because behaving selfishly in one period has future consequences, so it may no longer be dominant.

3.3 DYNAMIC GAMES

In dynamic games, players adopt decisions in a sequential way, instead of simultaneously. To represent them, we use
a model known as game trees.
A common dynamic game is the ultimatum game. In this game, there is a proposer, offer and receiver. The proposer
does an offer, and the receiver must accept it or decline it.
Any type of distribution is allowed, but if the receiver declines the offer, none of the two receive (take it or leave it). The
game tree would look something as:
Some concepts:
Nodes: players need to make a choice.
Edges/lines: actions available at decision nodes.
Final nodes: payoffs.

The proposer´s action depends on what the receiver does, so he must ensure or at least try to guess the possible
answer of the receiver. If the offer is too low, the receiver could want to “punish” the proposer by rejecting the offer.
When the proposer makes any offer, it must think about the minimum acceptable offer (offer in which the benefit from
obtaining the object is equal to the satisfaction of rejecting the offer and not obtain anything).

3.4 JUDGING GAME SOLUTIONS: EFFICIENCY

An allocation or a game result is pareto efficient if there is not any other response in which at least one person improves
its situation without damaging others. There are some limitations to Pareto criteria:

• There can be various Pareto efficient allocations and Pareto criteria does not tell which one is best.
• A Pareto efficient allocation does not imply everyone will be satisfied with the transaction
Pareto criteria does not guarantee equity. A Pareto allocation can be considered unfair on two grounds:

• Inequalities in the result (income, wellbeing…)

• Way in which that result was obtained (imposed, cheat…)
3.5 JUDGING GAME SOLUTIONS: FAIRNESS (equidad)
When speaking of equity, we can consider two perspectives:

• Substantial fairness: equality towards physical and non-physical results.

• Procedural fairness: institutions are not biased.
It is understood that nobody has privileges. Good behavior when in a transaction may be rewarded. However, to
guarantee fairness, we use the veil of ignorance:

 An institution is fair if we accept it before knowing the role we are going to play in the game/transaction.
In the ultimatum game, the veil of ignorance implies reflecting on the distribution proposal that would be considered as
fair without the individual knowing if the role is going to be proposer or receiver.

3.6 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. It ranges from
0 (perfect equality) to 1
(maximum inequality).

Government policies:

 Taxes and transfers are a common way of government redistributive policies. They can lead to a more equal
distribution of disposable income.
o The difference between inequality with disposable income, and without market income, depends on
how effective the policies and institutions are.

 Reforms. Policies do not have to be restricted to taxes and transfers. Land tenure reforms allowed farmers to
keep a greater share of crops.
o The reform was not Pareto efficient (it made landowners worseoff) but decreased income inequality,
and productivity also increased.
4. THE FIRM. OWNERS, MANAGERS AND EMPLOYEES
Work is an important part of economics. In models of economic interactions, bargaining determines the division of social
surplus. All parties gain from these interactions but have conflicting interests over how these gains (profits) are shared:

 How are wages determined within firms?

 What are the economy-wide effects of firm interactions?
Markets and firms differ in many aspects:

• Whereas firms represent a concentration of economic power (owners and managers decide), markets
(theoretically) work through demand and supply law, therefore decentralizing market power.

• Social interactions inside a firm can be permanent, but in markets these are usually momentaneous through a
buy/sell model.
A fundamental question raised is the type of contracts established inside firms. In the market, these are easy (buy-sell
contract = transfer or proprietorship), but inside firms contracts suppose the employee temporarily grants the authority
to a manager or an owner to be directed by him in its labor activities.

 The main problem with these contracts, is that the firm cannot write an enforceable employment contract that
specifies the exact tasks employees should perform to get paid.
This phenomenon is known as an incomplete contract: contract which does not specify, in an enforceable manner all
the aspects that affect the interests of the parties involved.

4.1 OWNERS vs MANAGERS. CONFLICT OF INTERESTS WITHIN THE FIRM

A firm is a business organization which employs people, purchases inputs to produce market goods and services, and
tries to set prices greater than the cost of production. Within the firm, several individuals interact:

 Owners decide on long-term strategy.

 Managers implement their strategy to execute the vision of the owners.
 Workers are assigned tasks and monitored by managers.
There are asymmetric information issues between different hierarchical levels. A firm´s profit legally belongs to the
owners of a firm. Managers actions have impact on profits, but in general they will not benefit automatically from this.
This creates a conflict of interest between managers and owners:

 Managers particularly when in commission, may care more about revenue

o A manager may be happy increasing costs to maximize revenue, but the owner not.
Alternatives to solve this conflict are:

 Link manager´s pay to the performance of the company´s share price

 Create mechanisms to measure manager´s performance.

4.2 WORKERS vs MANAGERS. CONFLICT OF INTERESTS WITHIN THE FIRM

We use a model of interactions to explain how wages are determined, and how this influences unemployment. In the
table you can see the problem of hidden action:

Uncertainty Employment contracts cannot predict all contingencies – the firm does not know what it
might need the employee to do in the future.
Incomplete
Measurement It is very costly for the firm to observe worker´s effort. contracts
issues
Moreover, in case of litigation, the employer cannot show clearly if the employee did not
comply with certain aspects of a job, like being sufficiently nice to customers.

Even if the firm could predict the future and observe efforts, a truly enforceable contract, covering all aspects of the
exchange between the parties, would be impossible to write. For example, if an employee is not satisfied with his current
labor situation, he can start what we know as quiet quitting.

4.2.1 INDUCING EFFORT: PIECE RATES

Observing effort is difficult, but we can measure output. If we assume output is positively related with effort, then we
can incentivize effort by providing compensation based on outputs.
 POTENTIAL PROBLEMS OTHER INCENTIVES INTRINSIC MOTIVATIONS OF WORKERS

Method of measuring output and its Fringe benefits Work ethic.

accuracy.

Measuring the real worker´s contribution Promotion opportunities. Feeling of responsibility.

to the output.

Measuring quality of the output. Adequate working conditions. Fear of being fired.

Life-work balance.

More responsibilities to workers.

4.2.2 RISK OF BEING FIRED

Risk/fear of being fired appears when the worker is paid more than the reservation option (Employment rent = cost of
job loss). This cost of job loss may include:
• Lost income while searching for a job
• Costs required to start a new job
• Loss of non-wage benefits
• Social costs (stigma)
A Reservation wage is the amount of money that makes a worker indifferent between working or not.

4.2.3 EMPLOYMENT RENTS (renta económica del trabajo)

The employment rent is the difference between the net value of a job minus the value of the next best option (which in
this case is being unemployed and looking for a job).
𝑬𝒎𝒑𝒍𝒐𝒚𝒎𝒆𝒏𝒕 𝑹𝒆𝒏𝒕 = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐽𝑜𝑏 𝐿𝑜𝑠𝑠
= 𝑊𝑎𝑔𝑒 − 𝐷𝑖𝑠𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝑜𝑓 𝐸𝑓𝑓𝑜𝑟𝑡 − 𝑅𝑒𝑠. 𝑊𝑎𝑔𝑒
i. Depends on what you lose monetarily, and the
duration unemployment period.
ii. The reservation wage is the wage that would
be obtained in an alternative job or the
unemployment benefit that would be earned.
The factor of unemployment benefits is very
relevant, as they also take part in the matter, and
help take decisions. There are two main
problems with them: 1) if too generous, they may
provide an incentive to not work; 2) if too low, we
risk people suffering from poverty.

4.3 THE LABOR DISCIPLINE MODEL

Model that describes the social interaction between firms and employees, that is sequential and repeats each and every
period of time.
The analysis of employment rents highlights that large rent is associated to large cost of job loss, and so, it can
stimulate higher effort from the worker. Thus, firms may induce more effort by increasing wages:

 This will increase the opportunity cost of losing the job/not working.
How much wage is adequate? => Wages represent a cost for profit maximizing firms.
To discuss this, we introduce the employment game or Labor discipline model.

 In this model, the employer chooses wage, and if the worker works, then the person keeps the job at the offered
wage; or the worker chooses level of effort, in which case we assume the costs of losing the job is too low.
Payoffs: employers – worker output (wages) // workers – employment rent. In this model, workers are supply (will to
sell labor) and firms are the demand (will to buy labor).
4.3.1 WORKER´S SIDE
The worker decides the effort given the wage rate. Maria´s feasible set of choices can be represented in a graph.
Maximum possible effort. Worker´s best response curve when expected
unemployment duration is 44 weeks.

 Feasible wages are those above the reservation wage:

• Worker prefers not to work below the RW.

 Points inside the feasible set (not at the boundary) are inefficient
• Worker is exerting low effort for the wage

 Points at the boundary are efficient

• Best response curve of the worker
The slope of this best response is the MRT.

The worker´s best response curve has two main characteristics:

▪ Increasing. If firm offers higher salary, the employment rent increases, and the worker is incentive to work more.
▪ Concave. It flattens out more and more as wage and effort increase. When the wage is low, and a little raise is
given, it incentives more effort than when wage is already high.
From the firm´s point of view:
▪ Being increasing, paying higher wages can result in more effort. Thus, more production and income.
▪ Being concave, however, shows that productivity of effort decreases.

4.3.2 FIRMS´S SIDE

To maximize profits, firms want to minimize production costs:
𝑃𝑟𝑜𝑓𝑖𝑡𝑠 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐶𝑜𝑠𝑡𝑠
= (𝑜𝑢𝑡𝑝𝑢𝑡 ∗ 𝑝𝑟𝑖𝑐𝑒) − [(ℎ𝑜𝑢𝑟𝑠 𝑜𝑓 𝑤𝑜𝑟𝑘 ∗ 𝑤𝑎𝑔𝑒) + 𝑜𝑡ℎ𝑒𝑟 𝑐𝑜𝑠𝑡𝑠]
= [𝐹(𝑒𝑓𝑓𝑜𝑟𝑡 ∗ ℎ𝑜𝑢𝑟𝑠 𝑜𝑓 𝑤𝑜𝑟𝑘) ∗ 𝑝𝑟𝑖𝑐𝑒] − [(ℎ𝑜𝑢𝑟𝑠 𝑜𝑓 𝑤𝑜𝑟𝑘 ∗ 𝑤𝑎𝑔𝑒) + 𝑜𝑡ℎ𝑒𝑟 𝑐𝑜𝑠𝑡𝑠]
The formula above highlights the trade-off between wages and effort. Wages represent a cost, but they are also
associated to effort levels, which affects output produced and revenue.
Thus, firm should find feasible combination of effort and wages that minimize the cost per unit of effort.
We represent all combinations of effort and wages that cost the same using isocost lines.

• More vertical lines represent combination with a lower cost [(+)effort (-)wage)]
The slope of each curve is the MRS, this is, the rate at which employer is wiling to increase wages to get higher effort.
4.3.3 EQUILIBRIUM
Profits are maximized at the steepest iso-cost line which represents the lower cost for the firm. But this is subject to
the worker´s best response curve (maximal effort per wage level).
This implies, that in equilibrium, MRS = MRT.
[tangency of iso-cost/best response]
In this example, 12€/hour represents the equilibrium wage: less costly option to guarantee maximum effort.

4.3.4 INVOLUNTARY UNEMPLOYMENT

The labor discipline model assumes a certain period of unemployment in case the job is lost. Thus, it implies involuntary
unemployment will always exist:

 Involuntary unemployment means being out of work, but preferring to have a job, given the wages/working
conditions that employee has.
Imagine the person unemployed finds a job immediately after being fired, with the same wage and working conditions,
then his employment rent = 0, as he is indifferent between keeping and losing the job. In this case, his best response
is to exert zero effort, but this cannot be an equilibrium.
The employer will not pay a wage to an employer that does not work. Then, in equilibrium both wages and involuntary
employment must be high enough to ensure employment rent is high enough for workers to put in effort.

4.3.5 CHANGES IN THE EQUILIBRIUM

The equilibrium depends crucially in the relation wages/effort – best response of the worker. The best response (and
the equilibrium) may change in reaction to changes in:
- Utility of things that wage can buy
- Disutility of effort
- Reservation wage
- Probability of getting fired at each effort level

4.4 PRINCIPLE-AGENT MODEL

There are several economic interactions where contracts are
incomplete. These appear when:

 Information is unverifiable: a contract is enforceable if

information is observable by both parties and verifiable by third part
(e.g.: judicial forces). Sometimes it´s impossible to comply with.

 Uncertainty and duration: a contract is usually executed through a period of time. For example, specifying
that A does X and then B does Y. However, what B does can depend of factors that can be sometimes not
considered in the contract. It is unlikely that people can anticipate each and every event.

 Measurement difficulties: many goods and services are difficult to describe or measure with enough precision
to mention in contracts.

 Judicial system has shortcomings: for some transactions, there are not judicial institutions that can make
parties involved to comply with contracts.

 Not inclusion of certain aspects: even with the nature of the goods or services to be exchanged allows for a
very complete and specific contract, it can happen that parties do not want to detail so much.
These economic interactions with incomplete contracts can be modeled with the principle-agent model. The principle-
agent relation is the relation existing when one part (principle) wants the other (agent) to act in a certain way that
cannot be done through a contract.

• In these relations, there is a conflict of interest, and the agent can act in a way that does benefit the principle.
The problem surges when the principle cannot easily observe nor control that way of acting from the agent => problem
of hidden action, which implies a moral risk. Inside the contracts within firms, principal = owners and agent = employee.
5. THE FIRM AND ITS CUSTOMERS
Profitability: measure of success of a firm: today´s profits can be reinvested. To study profitability, we model the way
firms decide output levels/prices.
Profitability is a common way to measure the success of a firm: today´s profits can be reinvested tomorrow. To study
profitability, we need to model the way firms decide output levels/prices.
In a simplified version of the firm´s problem, we assume that firms want to maximize profits only, given by the equation:
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑄 ∗ (𝑃 − 𝐴𝑣𝑔. 𝐶𝑜𝑠𝑡) Where Q= units at price P.
The firm´s problem is constrained problem, as feasible combinations of prices and quantities depend on demand.

5.1 COSTS
Managers must know cost management to maximize profits, so they need to know cost functions to make pricing and
production decisions. Total cost C(Q) depends on the amount of output produced Q.
C(Q) is increasing in Q.
Total costs C(Q) can be decomposed into two parts:

 Fixed costs: FQ do not change with Q.

 Variable costs: VC change with Q.
This is not inconsistent with the total cost definition C=wL+rK. There are also two important concepts:

 Average costs: AC(Q) measure how much it costs in average to produce one unit.
𝐶(𝑄)
o 𝐴𝐶 (𝑄) = 𝑄
 Marginal costs: additional cost by increasing production:
𝐶(𝑄2)−𝐶(𝑄1) ∆𝐶(𝑄)
o 𝑀𝐶 (𝑄) = =
𝑄2−𝑄1 ∆𝑄
o If ∆𝑄 = 𝑄2 − 𝑄1 =≫ 𝑡ℎ𝑒𝑛 𝑀𝐶(𝑄) = 𝐶(𝑄2 ) − 𝐶(𝑄1 ) = ∆𝐶(𝑄)

5.1.1 AVERAGE COSTS

Geometrically, the Average Cost is the slope of the line that
connects the origin to a given point of the Total Cost function.
By collecting all these slopes, we can build the average cost
𝐶(𝑄)
function: 𝐴𝐶(𝑄) = .
𝑄

 Usually, U-Shaped
o Decreasing for low values of Q
o Increasing for higher values of Q
 For a given Q, the profit per unit goes as: 𝐴𝑃 = 𝑃 −
𝐴𝐶(𝑄).
From the figure, we conclude that there are decreasing
average costs at low production levels (AC curve slopes
downwards), but at higher production levels average cost
increases (AC curve slopes upwards).

5.1.2 MARGINAL COSTS

Geometrically, the Marginal Cost is the slope of the line
tangent to the total cost function in a specific point. By
collecting all of these slopes, we can build the marginal cost
∆𝐶(𝑄)
function: 1) 𝑀𝐶(𝑄) = ∆𝑄
2) 𝑀𝐶(𝑄) = 𝐶𝑀(𝑄) = 𝐶(𝑄 + 1) − 𝐶(𝑄) = ∆𝐶(𝑄 => when Q increases by 1 unit.

 Mostly upward slopping

 Increasing production impacts on total costs. It helps determine the level of profit maximizing.
5.1.3 AVERAGE vs MARGINAL COSTS
It is always true that:

 If AC > MC, then AC is decreasing

o Additional units cost less than previous ones, on average
 AC < MC
o Additional units cost more than previous ones, on average
 MC always intersects AC at its lowest possible point.
5.1.4 ECONOMIES OF SCALE & SCOPE
The degree of returns to scale indicates rate at which production increases, when the firm also increases production
factors in the same proportion.

 A technology has increasing returns to scale if, when increasing all production factors, the quantity of output
also increases, in an even higher rate.
o This means that the firm can produce the double its amount, incurring in less than the double cost
(average costs decrease) and scale economies appear.

 A technology presents constant returns to scale if, when increasing all production factors in the same
proportion, the output quantity increases in the same proportion.
o For the firm to produce two times, the firm must double its cost (average cost is constant) and do not
exist scale economies.
 A technology presents decreasing returns to scale if, when increasing all production factors in the same
proportion, the output quantity increases in the same proportion.
o To produce double its units, firm needs to incur in more than double the cost (average cost increases)
and Scale economies exist.
Firms can also have economies of scope. This means that there exists a cost savings when two or more prodcucts
are produced in the same firm instead of separate ones (e.g.: if a University offers both undergraduate studies and
postdoctoral studies, the average cost per student will decrease overall)

5.2 REVENUE
To make pricing and production decisions, managers need to know how Revenue evolves. In general, total revenue
can be obtained from multiplying unit price by quantity: 𝑅 = 𝑃 ∗ 𝑄.

 In a market economy, however, the price level is determined by the market (supply & demand), thus we assume
that: 𝑅 = 𝑃(𝑄) ∗ 𝑄, where P(Q) is the inverse demand function.
Marginal revenue measures the impact of changing quantities on the total revenue, but also reflects the dual effect of
increasing Q: increase in quantity boosts revenue & decrease price:
∆𝑅
𝑀𝑅 = = 𝑅(𝑄2 ) − 𝑅(𝑄1 ).
∆𝑄

DEMAND CURVE
It measures the quantity that consumers will buy at
each possible price. Firms estimate it using surveys.
This is the constraint that firms face in the profit
maximization process. The willingness of consumers to
buy output at a given price limits the feasible
combinations of prices and quantities.
In the case of the graph, it shows that 60 consumers
are willing to pay 3200€. Then, the demand of product
at a price of 3200€ is 60 people.
Low price = more consumers willing to buy, so demand
is higher. Demand curves are drawn straight often, but
there is no reason to expect them to be as so in reality.
  We do expect them to slope downwards (as price rises, consumer´s willing to buy decreases). In other words,
low quantity = high price. This relationship is known as Law of Demand.
PRICE ELASTICITY OF DEMAND
Firm´s pricing decisions depend on the slope of the demand curve
and the position along the curve. The Price elasticity of demand,
measures the degree of responsiveness of demand to a price change:
∆𝑄
−% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑒𝑚𝑎𝑛𝑑 𝑄 𝑃 ∆𝑄 1 P
𝜀𝑝 = = =− ∗ = ∗
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 ∆𝑃 𝑄 ∆𝑃 𝑠𝑙𝑜𝑝𝑒 Q
𝑃
Suppose you are at point A and want to increase output by one unit
(∆𝑄 = 21 − 20 = 1)
𝑄1 = 20 ⟹ 𝑃 = 6400 𝑎𝑛𝑑 𝑅 = 20 ∗ 6400 = 128.000
𝑄2 = 21 ⟹ 𝑃 = 6320 𝑎𝑛𝑑 𝑅 = 21 ∗ 6320 = 132.720
Then,
However, the impact of changing output, on revenue, is not always the
𝑃 ∆𝑄 6400 1 same. Taking the graph, while at points A and B the marginal revenue is
𝜀𝑝 = − ∗ =− ∗ =4
𝑄 ∆𝑃 20 −80 positive, at point C, increasing output by one unit, decreases revenue.
𝑀𝑅 = 𝑅(𝑄2 ) − 𝑅(𝑄1 ) = 4720
Goods with near substitutes (butter and margarine) tend to have more elastic demand; if price for one increases,
demand for the other increases too. Elasticity of demand is related to the slope of demand curve.

 The higher the slope; the more consumers react to a change in price; demand is more elastic.

5.3 PROFITS
For any enterprise, profits are the difference between Revenue and Costs of production.
𝑷𝒓𝒐𝒇𝒊𝒕𝒔 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡𝑠 = 𝑃 ∗ 𝑄 − 𝐶(𝑄)
𝐶(𝑄)
𝑨𝒗𝒈. 𝑪𝒐𝒔𝒕 = ⟶ 𝐶(𝑄) = 𝐴𝑣𝑔. 𝐶𝑜𝑠𝑡 ∗ 𝑄
𝑄
When substituting in the profit profits equation: 𝑷𝒓𝒐𝒇𝒊𝒕𝒔 = 𝑄 ∗ (𝑃 − 𝐴𝑣𝑔. 𝐶𝑜𝑠𝑡)
 Slope of isoprofit depends on the cost structure.
𝑀𝐶−𝑃
o 𝑆𝑙𝑜𝑝𝑒 = .
𝑄

o MC = C´(Q), which is the derivative.

 To keep profit constant, as we increase quantity,

𝑃−𝑀𝐶
P must decrease by: 𝑄

5.3.1 PROFIT MAXIMIZATION

FINDING THE QUANTITY AND PRICE WHICH MAXIMIZE
PROFIT
To optimize profits, firms must target the highest isoprofit
curve, which includes at least one feasible bundle in terms
of consumer demand. In the case of the next graph:
• Demand curve = Firm´s Feasible Frontier [slope
= MRT]

• Isoprofit curves = combinations with same profit

[slope = MRS]
• In equilibrium, MRS = MRT
o Point E is the last feasible point in the
highest isoprofit.
 Profit maximization can also be described in terms of
revenues and costs.
As the demand curve defines the feasible set of P & Q, when
the firm maximizes profits, he chooses the demand point that
belongs to the best isoprofit curve
When firms change output, revenue and costs also change,
which in the end (in equilibrium) means Marginal Revenue
= Marginal Cost.

5.4 GAINS FROM TRADE

In a market economy, both firms and consumers affect
equilibrium outcome (quantities and prices).

 Consumer willingness to pay constrains the firm´s

profit maximization targets.
Additionally, participating in a market generates gains for both consumers and firms: Consumer surplus is the
difference between willingness to pay and market price. Producer surplus is the difference between revenue and
marginal cost.
Total surplus is the sum of both. The maximum total surplus is attained under the equilibrium in competitive markets:
[𝐷 = 𝑀𝐶] − 𝑃𝑎𝑟𝑒𝑡𝑜 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑎𝑙𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛

In some cases, the efficient allocation cannot be attained, (reducing potential gains) and generating a Deadweight
loss. If DWL > 0, there are unexploited gains from trade. This is common when firms have market power.

5.5 PRICE ELASTICITY & PROFITS

The Markup of a firm (profit margin as a proportion of the price) is inversely proportional to price elasticity of demand.
A firms profit margin depends on the elasticity of demand, which is determined by competition:

 Demand is inelastic if there are few substitutes. (Substitute goods can be used to satisfy the same need)
Firms with market power can set prices above marginal cost (bargaining power) without losing customers. This is a form
of market failure, as it generates a Deadweight loss. Some firms with market power are:

 Firms selling specialized products; Monopolistic firms -natural monopolies (common in utilities)-
Independent authorities must regulate competition (limit collusion of firms to control prices or market entry) or impose
maximum prices.
One of the manifestations of market power is product differentiation. Similar goods have different prices. Market
power in the shape of product differentiation may stem from innovation or advertising.

5.6 PRICE ELASTICITY POLICY

The effect of good-specific taxes depends on the elasticity of demand for those goods. Governments raise more revenue
taxes by levying taxes on price inelastic goods.

 In these goods, consumers are less sensitive to price changes (demand is more vertical). Thus, an increase of
price induced by a tax increase is less likely to lead to a drop in demand.
TAX POLICY
If government establishes a tax over a particular good, that burden will make price that consumers pay to increase, so
the effect of the tax will depend on the elasticity of demand.

• If demand es highly elastic (too sensible), a tax could greatly reduce sales. For instance, the government could
tax tobacco to discourage tobacco consumption because it is harmful to health.

• If a tax causes a significant drop in sales, it also reduces government collect share. Consequently, a
government that wishes to raise funds through taxes must choose to tax products with elastic demand.

5.7 COMPETITION POLICY

Government can be worried that firms have few competitors. This type of firms can exploit its dominant position (count
with a market power that allows them to fix high prices and generate big benefits at the expense of consumers)

 Potential consumer surplus is lost because few consumers buy, and those who do, pay a high price.
A special cause for concern in markets where there are few companies, is the formation of cartels. A cartel is a group
of companies that act together to keep high prices. By behaving like monopolies, instead of competing with each other,
they can increase their profits.
Competition policies (or antitrust laws) aim to limit market power of companies and prevent formation of cartels.
6. SUPPLY & DEMAND. PRICE TAKING COMPANIES AND COMPETITIVE MARKETS
A market is a situation in which buyers and sellers exchange goods or services. Buyers determine, jointly, demand of
the product and sellers determine offer.
In the last topic, we saw firms had market power, and that allowed them to fix their own prices (price maker) above
marginal cost (e.g.: when a monopoly or differentiated firms). In this type of markets the result is inefficient and occurs
a lost of efficiency.
There are many markets in which we assume that firms do not have market power. In a competitive market:

 The same product is being sold.

 There are various buyers and sellers that exert an insignificant influence in market price.
In these markets, we assume a perfect competition (buyers & sellers are price takers-they must accept the price
determined by market)
In competitive markets, prices transmit information and allow to allocate scarce resources.

6.1 PRICE SETTING vs PRICE TAKING

Firms with market power can set their own prices. In general, this does not happen because of consumer demand
(and competition), which restrict the possible outcomes. Other firms are price takers, which means that they take the
price of products as given (they do not have market power).
¿How does the behavior of price-taking firms differ from price-setting? ¿Does competition improve market outcomes?
The aim is to model profit maximizing decisions in price taking firms: perfect competition is a special case of the
model; we use the model to discuss similarities and differences between price-taking and price-setting firms.

6.2 DEMAND & SUPPLY

The price that each individual firm takes as given is determined by the interaction of two market forces:
DEMAND
 Demand curve: measures the total quantity all consumers are willing to buy at any given price
 Demand is negatively related to prices.
 The demand curve also represents the willingness to pay (WTP) of buyers.
SUPPLY
 Supply curve: measures the total quantity all firms are willing to sell at any given price
 Typically, supply is positively related to prices.
 It represents the willingness to accept (WTA) of sellers.
Note that different sellers may have reservation prices: if the reservation price is above the market price, they will not
participate in the market.
EQUILIBRIUM PRICE
At the equilibrium (market-clearing) price, P*, supply =
demand.
Any other price is not a Nash equilibrium, as there will be
gains from unilateral deviation:
a. If P > P* there is excess supply, so some
suppliers could benefit from charging a lower
price.
b. If P < P* there is excess demand.
Note that we are assuming products are identical, so buyers would we willing to buy from any seller.

6.3 PRICE-TAKING FIRMS

Price-taking firms are stuck with the price determined by the market. They cannot benefit from choosing a different
price. They cannot influence in prices. Finally, if they try to charge higher prices, they will sell nothing (consumers will
start to buy from suppliers with P = P*).
There are two requirements:

 There is competition and other suppliers in the market have capacity to fulfil demand.
 Consumer is indifferent about which supplier he buys from – products are identical.
This does not mean that firms have no say. It means that given the price, the firm´s problem is reduced to choosing
quantity. It may be optimal to choose zero quantity and leave the market.
If firms are price takers: the feasible set (demand curve) is completely flat. Firms maximize profits when P = MC.
Notice, at this point: slope of iso-profit (MRS) = slope of demand (MRT) = 0.
𝑀𝐶−𝑃
The slope of the iso-profit curve is given by: 𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 𝑖𝑠𝑜𝑝𝑟𝑜𝑓𝑖𝑡 = . But, as we saw, if the price is determined by
𝑄
the market: P = P*, and the slope of the iso-profit tangent to an horizontal demand is zero.
𝑀𝐶−𝑃 ∗
Then: 0 = ⟺ 𝑃 ∗ = 𝑀𝐶 = 𝐶´(𝑄)
𝑄

SUMMARY
 INDIVIDUAL SUPPLY FUNCTION AGGREGATE SUPPLY FUNCTION

Overall, for each possible price level, the firm is willing to supply The aggregate supply function is obtained by summing
the amount that maximizes profit MC = P. individual quantities at each price level:
This amount that the firm is willing to supply is given by: 𝑆(𝑄) = ∑ 𝑆𝑖 (𝑄)
Si(Q) = MC(Q). 𝑖

Then, the price determined by the whole market will identify the In our example, if the market has 50 firms with the same cost
equilibrium quantity supplied by each firm. structure: 𝑆(𝑄) = 50 ∗ 𝑠𝑖 (𝑄)

6.4 COMPETITIVE EQUILIBRIUM

1. All buyers are price-takers
2. All sellers are price-takers
3. Contracts are complete
4. Transactions only affect buyers and sellers.
The equilibrium in a competitive market is obtained when
Supply=Demand. This equilibrium is Pareto Efficient (A
in the graph)

6.4.1 CHARACTERISTICS
Importantly, in this equilibrium all the gains from trade are
exploited. This means that there is no deadweight loss,
and that the total surplus is at its maximum level.
Pareto efficient does not imply fairness. In the graph, the
consumer surplus is much larger than producer surplus.
The distribution of total surplus depends on the shape
of demand and supply curves. The share of total surplus
is inversely related to elasticity.

6.5 CHANGES IN EQUILIBRIUM

6.5.1 EXOGENOUS DEMAND & SUPPLY SHOCKS
Exogenous shocks lead to shifts in curves. Buyers and
sellers adapt and a new equilibrium is attained, so that
markets clear again.
Suppose that in the market of second-hand books, the school incentivizes students to buy more books.
Demand for books increases (curve shifts to the right). At the initial price, there is excess demand. Consumers and
producers move along their respective curves and a new equilibrium is achieved: 𝑄1 > 𝑄0 𝑎𝑛𝑑 𝑃1 > 𝑃0 – quantity
increases & price also increases. We do not know if it is desirable or fair.
 Another example, in the market of bread, technology increases and
improves productivity of bakeries.
The supply increases at every price, and at the initial price there is
excess supply. Consumers and producers move along their
respective curves, and a new equilibrium is achieved.
Suppose now that in this market, new bakeries start opening in the
area.
This is known as market entry. If new firms enter, the supply shifts
rightwards. New entrants are more likely when firms have positive
economic rents and costs of entry are not too high.
In the end: (+) quantity » (-) price » (-) profits.

6.5.2 TAXATION AND MARKET DISTORTIONS

Taxes are an important source of revenue for governments. Taxes on suppliers or consumers shift the supply/demand.
Suppose we are in the market of salt.
Government imposes a sales tax of 30% per kilo. Firms collect the tax and transfer it to the government. The impact
on the equilibrium is that firms will see taxes as an increase in marginal costs => supply shifts leftwards.
 Then, we would have a new equilibrium such that: 𝑄1 < 𝑄∗ 𝑎𝑛𝑑 𝑃1 > 𝑃 ∗ , where quantity is (Q) and price (P)
 Tax per unit: 𝑡 = 𝑃1 − 𝑃0
Importantly, compared to the initial equilibrium, tax induces a
reduction in gains from trade. This means that it generates
a Deadweight Loss.

 Supply function without taxes ---- Q(P) = c +dP

 Supply function with taxes ---- Q(P) = c+d(P-t)

 Supply function with ad-valorem tax ---- Q(P) = c+d(P-tP)

 Inverse Supply function with taxes ---- Q(P) = (C/d+T) +

(1/dQ)
When using a specific tax, the supply curve will shift parallel
upwards. In the case of ad-valorem tax, the curve shifts to the
left and the slope goes steeper as price increases.
The consequence of this tax is inefficiency. There must be a new equilibrium. Demand will decrease as well as price,
so a new competitive equilibrium will appear. Taxes on suppliers/consumers shift the supply/demand curve because
the price is higher at each quantity.

INITIAL EQUILIBRIUM AFTER TAX EQUILIBRIUM

The fall in total surplus is positively related to elasticity of demand (how sensitive consumers are to price changes).
Moreover, government appropriates part of the surplus, (government revenue obtained from taxes). Tax incidence
shows who bares the cost of the tax, which typically is the less elastic group. The impact of taxation on welfare depends
on what the government does with tax revenue.

6.5.3 CHANGES IN EQUILIBRIUM: TAXES

Taxes are used to induce consumer behavior changes.
A real example was Denmark, which in 2011 introduced a
tax on saturated fat, which in the end made the average
butter price to increase by 22%.
The result was that consumption on butter and related
saturated fat products fell by 15%, but this is not always the
case. The process goes as: supply reduced => lower
quantity => higher price => demand reduced

6.5.4 EQUILIBRIUM PRICE

6.6 PERFECT COMPETITION

 Homogenous products.

 Many buyers and sellers who act independently.

 No entry barriers or also to leave the market.

 Information on price is accessible.

As a result:

 Law of one price: all transactions take place at one single price, which clears the market (demand = supply)

 Buyers and sellers are price takers

 Gains from trade are realized
Perfect competition is used as a benchmark, as in reality, although some markets are very close to perfect competition,
some of the assumptions above may not be (totally) present.

Price setters (e.g.: monopolistic market) Price takers (perfect competition)

MC < Price MC = Price

Deadweight losses (Pareto inefficient) No deadweight losses (can be Pareto efficient)
Owners receive economic rents in long and short run No economic rents in the long run
Firms advertise their unique product Little advertising expenditure
Firms invest in R&D and seek to prevent copying Little incentive for innovation
7. MARKETS, EFFICIENCY & PUBLIC POLICY
7.1 IMPERFECT COMPETITION
Under a completely competitive efficient market we reach a Pareto efficient equilibrium, but this is not always the case,
and we need to know what inefficiency is and what can the government do to solve it. Examples of market failure (no
need to learn by heart, just for understanding:
1. Pesticides in the Caribbean
a. Banana plantation owners used harmful pesticides to reduce costs and increase their profits.
b. The chemicals leaked into the rivers and contaminated fisheries, damaging fishermen livelihood and
causing residents to fall seriously ill.
2. Overuse of antibiotics
a. People often overuse antibiotics when other treatments would be better, which creates bacteria-
resistant pathogens.
Markets fail when property rights are missing, incomplete, or are difficult to enforce with a contract.
Firm´s market power may arise because:

 There is limited competition

 Patents or other market-entry barriers
 Products are differentiated
 Long run average costs are lower due to economies of scale (natural monopolies)
Deadweight Losses can be eliminated mainly through price discrimination and competition policy.

7.2 EXTERNALITIES
Positive/negative effect of production, consumption or other economic decision on another person or people, that is not
specified as a benefit/liability in a contract.
Negative externalities (MSC > MPC). They occur because the agent who makes the decision does not bear the full
costs of their decision. To measure the extent of a negative externality, we distinguish between three concepts:

CONCEPT MEANING EXAMPLE

Marginal Private Marginal Cost for the decision All marginal costs involved in the use of pesticides for the farmers who
Cost (MPC) maker. use it.

Marginal External Marginal Cost imposed by the Marginal cost supported by fisherman, whose activity will be harmed and
Cost (MEC) decision maker on others. by the residents.

Marginal Social Total marginal for society: MSC -

Cost (MSC) = MPC + MEC
7.2.1 MEASURING EXTERNALITIES
Marginal costs are in the vertical axis. Output produced
is in the horizontal axis.
Marginal external cost is below marginal private cost for
low amounts of output; but increases faster than MPC.
In the yellow area, the costs imposed on fishermen by
plantations of banana are represented.
Knowing market price, we can compute the equilibrium
quantity produced by firms and calculate the
corresponding external and social costs:

 Farmers produce where Price = MC = MPC

 Pareto efficient level is where Price = MSC
The presence of negative external costs leads to overproduction
and overuse of pesticides.

 Producing 80k units is not Pareto efficient

 At this level, the marginal external cost amounts for
270€/unit (social cost 400€ + 270€ = 670€).
This means fishermen are willing to pay up to 270€ to farmers for
them to reduce production by 1 unit.

7.2.2 WHY DO EXTERNALITIES EXIST?

External costs cause market failure because of incomplete contracts:

 Incomplete contracts do not specify all aspects of the exchange and effects on affected parties

 Building contracts that reflect all external costs is very complicated, because relevant information is
asymmetric or not variable.
 Property rights:
o Define legal ownership of resources (patents, right to silence, to make noise)
o Parallel market where parties interact to define a price for the externality.

 Still, the simple imposition of properties rights or the use of contracts is often not enough to guarantee all social
costs/benefits are included in the decision-making process.

7.2.3 HOW TO ADRESS EXTERNALITIES?

There are various ways to address externalities:

 The purpose is that agents who make decisions include the external cost in the decision-making process.
This would bring the private cost close to the social cost.

 We discuss four possible alternatives:

o Bargaining => private agents. Theorem of Ronald Coase.
o Regulation of production => governments. Cap at socially optimal amount. It may be difficult to
determine and enforce the right quota for each polluter.
o Pigouvian tax/subsidy => governments. Tax/subsidy on firms generating negative/positive external
effects, in order to correct an inefficient market outcome
o Compensations => government. For affected parties.
All options have advantages and disadvantages, and some are more suitable in specific contexts.
7.3 BARGAINING
Whenever there is a net social gain of addressing an externality, bargaining is a possibility:

 It requires private sector agents reach an agreement about the decision to be made, allowing for the
incorporation of previously external costs into it.
 Typically requires that property rights are assigned to the externality.
o E.g.: in the pesticides example, the right to pollute or the right to clean air.

 Private bargaining between the parties involved will lead to a Pareto-efficient allocation, regardless of which
party owns the property rights, in the absence of transaction costs.
o Transaction costs (e.g.: acquiring necessary information, enforcing the contract, collective action…)
may lead to asymmetries in the bargaining power and thus, a non-efficient allocation.
The first economist to study the role of property rights as a solution for the correction of externalities was Ronald Coase.

7.3.1 ADVANTAGES vs DISADVANTAGES

Bargaining may be more effective than government information, as private agents generally have more and better
information. But this also has limitations:
 Impediments to collective actions: finding a representative and reaching an agreement
 Missing information: calculating the exact costs imposed on each fisherman and each plantation´s
contribution to pollution

 Enforcement: it may be difficult for judiciary authorities to determine if farmers have complied or not
 Limited funds: fisherman may not have enough money to pay the required compensation.
In the pesticides example:

 The loss in farmer´s profit in the Pareto efficient allocation (in pink) is smaller than the net social gain (in green).

 The farmer´s accept an offer for their property rights to pollute that at least matches the lost profits – minimum
acceptable offer.

 Fishermen´s are willing to pay at most the amount of social gains (sum of pink and green areas) – reservation
option.
 Actual compensation will depend on relative bargaining power.

7.4 GOVERNMENT POLICIES

Governments have tools to mitigate externalities. One of those, is regulating production. Governments ideally restrict
maximum allowed output (production quotas – see graph above).
The ideal amount of allowed production = the social optimal amount [where P (production) = MSC (marginal social
cost)]. This would reduce external costs, but amount would be difficult to determine and enforcing quotas as well.
7.4.1 PIGOUVIAN TAX
Governments can also impose taxes or subsidies to correct for externalities. A subsidy is simply a negative tax. Such
fiscal policy measures are often known as Pigouvian Taxes.
To correct for a negative externality, one may impose per-unit tax that reduces price received by decision makers. In
the pesticides example, this is a tax that reduces the amount farmers get per unit of product.

 Tax reduces the benefit from pesticide use; but force producers to face the full cost of their decision.
How much should the Pigouvian Tax be? => Equal to the MEC when at the Pareto efficient quantity. Farmers, will
choose quantity such that price net of tax equals Marginal Private Cost.
If determined properly, this ensures Pareto efficient quantity is implemented.

7.4.2 COMPENSATIONS
Governments may also require producers to pay a compensation for the external costs. In the pesticides example, this
implies farmers paying fishermen a monetary amount. Compensation represents an additional cost to farmers and
should be equal to the difference between the MSC and MPC (grey area).
Fishermen are fully compensated, and producers choose the socially optimal production.
 There is a similar effect on profits with Pigouivan Tax, but in this case fishermen are better off, as they receive
the compensation directly
As with private bargaining, government policies that try
to correct externalities have limitations.
Missing information: it is difficult to determine the
exact compensation needed.
Measurement: MSC are difficult to measure as well.
Lobbying: government may favor powerful groups,
which could impose a pareto efficient outcome, but
unfair.

7.5 IMPERFECT INFORMATION

When information is asymmetric, one party knows something important for the transaction that the party does not. There
are essentially two forms of asymmetric information:

SOURCE MEANING EXAMPLES

Hidden action The action taken by one party is not perfectly Employer cannot know (or verify) how hard the worker
known to the other. It is associated to a moral has worked.
hazard problem.
Voters cannot know for sure if politicians are doing
their best.

Hidden attributes One or more characteristics of one of the parties Buyers of second cars do not know all the attributes of
is not know to the other parties. It is associated the cars (sellers more likely do.
to an adverse selection problem.

When a potentially mutually beneficial exchange could be implemented, but is not due to information asymmetries, we
say we have a missing market.

7.5.1 EXAMPLE OF PRIVATE HEALTH INSURANCE – hidden attribute

There is an asymmetry of information. Customers know their health status and will probably buy insurance of they have
worse health. Insurance companies do not [hidden attribute]. To keep business profitable, company must charge high
enough prices, however this will make it more costly for healthy people to buy the insurance

 This creates an adverse selection problem: the people more likely to buy the insurance are those who already
have a health problem.

 Missing market. Many (healthier) people who would like to buy insurance will remain uninsured.
7.5.2 EXAMPLE OF CAR INSURANCE – hidden action
In the example of car insurance there is also an asymmetry of information. Insurance companies do not observe the
day-to-day behaviour of drivers [hidden action]. Insured drivers may have an incentive to be less careful.

 This is particularly the case with full coverage policies. Driver has a larger incentive to be risky.
Insurance companies mitigate this by imposing limits on the contract, but it cannot enforce different behaviour from
drivers.

 Moral hazard problem. We can also think about external effects. Careful drivers impose a positive externality
on the insurance companies (and the society).
7.5.3 EXAMPLE OF BANKING COMPANY
The credit market is one plagued with principal-agent problems. We discuss two. On the one hand, borrower’s
decisions have external effects on the lender.

• Some clients may be less financially prudent, which limits their ability to repay debts;
• Banks impose conditions on access to credit to limit non-compliance or credit defaults;
• As a result, poor borrowers are often credit-constrained (or even excluded) leading to a credit market failure
(missing market)
On the other hand, banks and investors may experience external effects due to the behaviour of other financial
institutions:

• Some banks may impose less lending restrictions, this will make their asset portfolio more risky.
• If they go bankrupt, this is likely to represent a systemic risk for the other institutions.

• When Governments bail out banks that are “too big to fail”, they incentivize risk.
During the financial crisis of 2010, many EU countries bailed banks to avoid bankruptcies.

• It is true that market conditions were complicated for banks at the time: A crisis generally leads to
unemployment which makes previously solvent customers turn into risky clients.

• Still, if banks believe they have a safety net on the government, they have an incentive to be riskier:
• After all, they make money from interest payments, and can charge higher interest rate to more risky borrowers.

• Taxpayers face a negative externality from this risky behavior.

7.6 PUBLIC GOODS

To distinguish between public and private goods we rely on the concept of rival and excludable goods.

 Non rival: the good is used by one person and can be used by others aswell.
 Non excludable: no one can be excluded from having access to it.
We classify goods in four categories:

RIVAL NON-RIVAL

EXCLUDABLE Private goods (food, clothes, houses) Public goods artificially scarce (cable TV,
uncongested tollroads, knowledge under int.rights)

NON-EXCLUDABLE Common pool resources (fish stock in a lake, Public goods and bads (view of lunar eclipse, public
common grazing land) broadcasts, mathematics, national defense, noise)

Public goods must be non-rival but can be or not excludable.

7.6.1 AS A MARKET FAILURE

Markets are generally used to allocate private goods (rival & excludable). For the other cases, market allocation is likely
to fail, or is simply not possible:
  Non rival goods have a marginal cost = 0. Then, we cannot set P = MC (where P is price), unless provision is
completely subsidied. Non excludable goods cannot be priced because price is a tool for excluding people who
have not paid, but in this case exclusion is not possible.

7.7 LIMITS TO MARKETS

Markets are used as a mechanism to allocate goods across individuals. This is very necessary given the unlimited
needs vs limited resources. They have several advantages, as they can deliver Pareto efficient allocations.

 Unregulated markets may also deliver Pareto inefficient outcomes (market power, externalities…); or other
institutions could be more effective than the existing market.
Market mechanisms may crowd out norms of social preferences (e.g.: paying students for high grades). Repugnant
markets: market for goods and services that would violate ethical/social norms (e.g.: slavery). Merit goods: should be
provided regardless they could pay or not (e.g.: education, health)
8. THE LABOR MARKET
8.1 INTRODUCTION
We discuss how the labor discipline model can inform on aggregate wages, employment and unemployment. How are
they determined, and if we can improve upon these market outcomes.
Real wages, output prices and unemployment are related.
1. Output prices + => Employment + & Unemployment –
2. Outprices - => Employment & Unemployment = (stagnates)

Where there is more competition in a job position, the wage will be higher. Where there is less competition in a position,
the wage will be lower. It is also important to know what an unemployed person is:
Unemployed are those who:

• Not in paid employment 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 =
• Available for work 𝑙𝑎𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒
• Actively seeking work.
The unemployment rate should not be confused with two other concepts:
𝑙𝑎𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒
 Share of people who actively seek work: 𝑃𝑎𝑟𝑡𝑖𝑐𝑖𝑝𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑎𝑔𝑒
𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
 Share of working age population who is working: 𝐸𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 = 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑎𝑔𝑒

We can illustrate the difference between these concepts with this diagram:

Two countries with the same unemployment rate can differ substantially in their employment rates, depending on the
participation rate. The labor market structure differs widely across countries.
8.2 PRICE-SETTING, WAGE-SETTING, EMPLOYMENT AND REAL WAGE
Profit maximizing firms interact with two agents to set prices:

• Firms and employees: firms set an enough high wage to induce effort and make job loss costly.
• Firms and customers: firms set a markup above production costs, subject to demand.
• Thus, firms decide: price and quantity of outputs, wages and how many employees they hire.
We consider real wage to account for inflation´s effect. Workers care about their nominal wage and real wage.
𝑤
• 𝑅𝑒𝑎𝑙 𝑊𝑎𝑔𝑒 = 𝑝

Real wage is obtained by dividing nominal wage (w) by the price level of the goods purchased (p). In aggregate terms,
employment is the sum of the total number of workers hired by all firms in an economy; real wages are the average of
the real wages of all these individual workers.

• The evolution of real wages differs substantially across economies

Real wage/hour has increased in the UK (and to a
smaller extent in the US).
In Japan, real wage exhibits a decreasing trend.

8.1.1 THE FIRM´S DECISION PROCESS

Profit maximizing firms determine wages, prices, output quantity and number of workers in a sequence of steps:
1. Nominal Wage = F(other´s firms prices and wages, unemployment rate)
2. Price = F(own nominal wage, demand for own product)
3. Output = F(optimal price, demand curve)
4. Number of employees = F(output, production function)
As all firms proceed analogously, we can determine the equilibrium wage and employment in the economy. The
aggregate labor market equilibrium (equilibrium between real wage and employment) determines economy-wide:

Equilibrium (real) wage and employment

Wage-setting Price-setting

Both of these are curves, and we are looking for the point where they cross.

Wage and employment Wage implied by firms´ profit-maximizing

combinations that maximize effort decision about the price of output

How firms identify combinations Firms want profit and wage is a cost, so
that motivate workers to work. they look for profit maximization
8.1.2 WAGE-SETTING CURVE
We can summarize the relation between the real wage
(wage that makes people work) and unemployment with
the wage-setting curve.

• Vertical axis: Real wage

• Horizontal axis: Employment rate
The wage setting curve shows the real wage necessary
at each level of employment to provide workers with
incentives to work hard and well.
The vertical dashed line represents labor force. The
unemployment rate is the horizontal distance between
the labor force and the employment rate, for each real
wage level.

How can we rationalize the positive relation between economy-wide employment and real wage?

Firm aims at steepest iso-cost line, given the worker´s best response function. In the first graph, firms are looking for
the most vertical lines. Changes in reservation wage shift the worker´s best response function. In the second graph,
workers look for the best response curve.
If, for the same labor force, employment increases, then: Notes on wage-setting curve:

• Worker´s best response function shifts rightwards: Higher reservation wage = higher wage
firms must offer.
o Job loss cost declines
The more employment = the higher wages
o Reservation wage increases demanded.
• In the end, this leads to a new equilibrium (B), where:
o Real wage is higher (and at the same time, firm´s costs as well)
Thus, higher employment leads to higher equilibrium wages.
Regarding the interpretation, we find that the points inside
and above the wage setting curve are feasible.
Below the wage-setting curve, workers choose not to work,
because real wage is too low for that level of employment.

We can estimate the wage-setting curve with administrative

data on unemployment rates and wages. In the graph we see
data from the US, and we can notice that the positive slope is
empirically validated. Notice that unemployment increases as
we move to the left on the horizontal axis. This is the same as
employment increasing to the right (just as what happened in
the previous graph).

8.1.3 PROFIT-SETTING CURVE

PROFIT-MAXIMIZING PRICE
Firms decide an optimal price for their outputs, in the
point where demand is tangent to an iso profit curve.
This determines optimal output level, and the number
of workers that is necessary to produce it.

 Firms choose higher possible iso-profit given a

demand curve
o B equilibrium: optimal price (p*) & quantity
(q*).
Given the technology available, this determines
necessary employment. Moreover, the labor is the only input, and 1 hour of labor produces 1 unit (n*=q*).
DISTRIBUTION OF OUTPUT
The firm´s choice of profit-maximizing price and quantity, also determines the optimal markup (difference between the
price charged and the marginal cost). The unitary optimal price can be divided into two components:
𝑃𝑟𝑜𝑓𝑖𝑡 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑤𝑎𝑔𝑒
 𝑃𝑟𝑖𝑐𝑒 = 𝑂𝑢𝑡𝑝𝑢𝑡 + 𝑜𝑢𝑡𝑝𝑢𝑡

o where (profit/output) is the unitary profit; and (nominal wage/output) is the unitary cost.
For the economy, this translates into how revenues are distributed between firm owners and workers.
𝑟𝑒𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡 𝑟𝑒𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑤𝑎𝑔𝑒
 𝑃𝑟𝑖𝑐𝑒 = = +
𝑤𝑜𝑟𝑘𝑒𝑟 𝑤𝑜𝑟𝑘𝑒𝑟 𝑜𝑢𝑡𝑝𝑢𝑡

o where (real profit/worker) is the share of revenues that goes to owners, (real wage/worker) is the share
of revenue that goes to workers, and (real output/workers) is the average product of labor.
In this last case, we are presented with real variables. These are obtained by dividing the nominal variables by the price
𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑃𝑟𝑖𝑐𝑒∗𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
level. In the case of the real output: 𝑟𝑒𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡 = = = 𝑄.
𝑃𝑟𝑖𝑐𝑒 𝑃𝑟𝑖𝑐𝑒

• Price-setting curve = real wage paid when firms choose profit-maximizing prices. It depends on two factors:
o Competition determines markup and Labor productivity determines real wage for a given markup.
▪ Higher productivity will likely equal higher wage

• The price setting curve is a constant value, that is:

o Real wage is consistent with the markup over labor costs when all firms set price to maximize profit.
o It does not vary with the employment level of the economy.
If we plot a series of points A, B and C:
Notice two things.
At point A:
- Real wage is too high (real markup low)
- Firm increase prices
- Reduce in demand, optimal output, and
real wages
At point C:
- Real wage is too low (real markup high)
- Firms decrease prices
- Increase in demand, optimal output,
and real wages.

8.1.4 LABOR MARKET EQUILIBRIUM

FINDING EQUILIBRUM EMPLOYMENT
We can obtain the labor market equilibrium by combining the
wage-setting and price-setting curves.
For a given real wage, we obtain:
- Employment
- Unemployment = Labor Supply – Unemployment.
At point X: Wage and price-setting curves intercept. This is
the Nash equilibrium of labor market.
Why is it equilibrium? All parties are doing the best they can,
given what everybody else is doing.

 Firms offer lowest wage to ensure effort but cannot reduce it more because it will also reduce effort.

 Highest employment given the wage, there are more workers not willing to work with the actual wage.
o Actual workers also cannot ask for higher wages, as firms will not give them.

 Unemployed people cannot persuade firms to work with a lower wage because of the wage vs worker effort.
INVOLUNTARY UNEMPLOYMENT
Unemployment = excess supply in the labor market. There will always be unemployment in a labor market equilibrium.
It is a feature that is never eliminated. If no employment, there would be no cost of losing the job and no effort.
In some sense, unvoluntary unemployment motivates workers.

 Unemployment is driven by firm´s labor demand

 o Firm´s demand for labor depends on demand for goods/services. The more people want to consume,
the more firms will want to produce, the more people that they will employ, the lower unemployment.

 High unemployment reduces aggregate demand and so, firm´s labor demand.
o Higher unemployment means purchasing power declines, and so does consumption.
o This, further compresses aggregate demand, and likely boosts unemployment.
▪ An increase in unemployment motivated by a reduction in aggregate demand, is known as
demand-deficient unemployment.
In general, during crisis, aggregate demand lowers and naturally, this means lower offer and higher unemployment.
DEMAND-DEFICIENT UNEMPLOYMENT
A low aggregate demand moves economy from the labor market equilibrium in point X to point B, which is not:
1) Firms can lower wages with nor reduction in effort.
2) Lower production costs allow for price reductions
3) Declines in price stimulate demand and output rises
4) To produce more, firms hire more workers
5) Unemployment falls back to equilibrium in X.
Through this model, we can discuss the effect of
intervention in the labor market, as it suggests that
unbalances in the labor market are self-correcting.
However, in real economies, we do not find so
concrete situations, and do not function so smoothly.

 Workers might resist to nominal wage cuts.

o Lower motivation and strikers may occur.
o In many cases, lowering nominal wage is not legally possible.

 With lower wages, people spend less and aggregate demand reduces further.

 Lower prices also may lead consumers to postpone purchases in hope of even lower prices.
o This could lead to deflation.
 The economy may be stuck below equilibrium employment.
THE ROLE OF GOVERNMENT INTERVENTION
One alternative to address this situation could be government intervention.
Governments induce aggregate demand either through
fiscal or monetary policy:
• Increase public consumption
• Reduce taxes
• Devaluate currency
These situations would boost equilibrium output. They will
probably increase employment, and raise profits for firms
without lowering wages.
ROLE OF LABOR SUPPLY
Changes in labor supply also affect labor market equilibrium. Suppose labor supply increases due to innmigration, this
will shift labour supply curve to the right; and it will also increase unemployment. (more unemployment = less reservation
wage)

 Since more people are currently looking for work: employment rents will increase, cost of effort will decrease,
and wage setting curve will shift to the right (higher effort & lower wage // more workers = more production)
Now, initial employment level (point B) is not optimal.
During the process from B to C, firms will hire more
workers and employment will increase.

8.1.5 THE ROLE OF LABOR UNIONS

INEQUALITY IN THE DIVISION OF OUTPUT
The inequality in the division of economy´s output is
measured with the Gini coefficient which rises with:
• ↑ unemployment rate
• ↓ real wage
• ↑ markup
• ↑ productivity (with no changes in wage)

LABOR UNIONS & WAGES

Labor Unions are organizations that represent worker´s interests and demands. They strive to improve wages and
working conditions for their members. The relevance of Labor Unions depends crucially on the share of unionized
employees.
If labor unions are strong (high bargaining power) wages are not unilaterally set by firms.
In some cases, the bargained wage may be above wage-setting curve. Unions can achieve this by threatening with
collective action like strikes.

 How would this change in equilibrium compare to a case without unions?

o The higher wage increases costs for firms => the more shift to the left wage-setting curve
o In equilibrium, this leads to unemployment. However, there are certain risks for labor unions:
▪ Wages do not change
▪ Employment declines
▪ Firms´s profit likely decrease.
Then, can we say there is a positive relation between the power of the union and unemployment? Not really.
 From this graph, we conclude that unions do not affect unemployment
rate, and that a high union power can also lead to high unemployment
(look, for example, at Spain).
This effect has been named as the union voice effect, giving voice to
employees may induce higher effort and involvement:
It might happen that unions fight for a higher involvement of the worker
in the firm, instead of just claiming higher wages.

By looking at the graph to the right, we can see that the

wage-setting curve (bargaining and voice effect) shifts
rightwards.
This means that there will be a higher equilibrium
employment. The overall effect of labor unions on
employment is ambiguous.

8.1.6 LABOR MARKET POLICIES

CHANGES IN PRICE OR WAGE-SETTING OR THE LABOR
SUPPLY CURVE
There are various policies that may affect the equilibrium in the labor market by shifting the curves.

 A shift in the price-setting curve:

o Education and training increase labor productivity (↑ price-setting curve)
o Wage subsidization reduces production costs and prices (↑ price-setting curve)

 A shift in the wage-setting curve

o Lower unemployment benefits decrease reservation wage (← price-setting curve)

 A shift in the labor supply

o More lenient immigration policies increase labor supply (→ labor supply)
o Childcare provision increases female labor participation (→ labor supply
9. BANKS, MONEY, AND CREDIT MARKET
9.1 INCOME, BORROWING AND SAVING

Wealth Stock of things owned or the value of that stock. It is also the result of 𝑮𝒐𝒐𝒅𝒔 + 𝑹𝒊𝒈𝒉𝒕𝒔 − 𝑶𝒃𝒍𝒊𝒈𝒂𝒕𝒊𝒐𝒏𝒔.

Depreciation Reduction in the value of a stock of wealth over time.

Income Amount of money (after tax) one receives over time from market earnings, investment, government.

Net income Maximum amount that one can consume without reducing wealth.
Net income = gross post-tax income - depreciation

Earnings Wages, salaries, and other post-tax income from labor.

Savings Income that is not consumed.

Investment Expenditure on capital goods (above that to cover depreciation)

9.1.1 MODELING BORROWING DECISIONS

There is a trade-off between consuming goods and now later. The opportunity cost of having more goods now is having
fewer goods later. Borrowing and lending allow us to rearrange the capacity to buy goods and services across time.
We are going to model decisions of saving and indebtness with feasible set and indifference curves. In this case, we
sacrifice consume today to be able to consume tomorrow.
The opportunity cost of consuming today is consuming les tomorrow. When an individual goes into debt, it can buy
more today at the expense of buying less tomorrow. Nevertheless, asking for a loan is not free, we must pay interest.

Borrowing Lending

Today Increases income available for consumption today. Decreases income available for consumption today

Later Decreases income (debt + repayment + interest) Increases income (initial funds + interest) available for
available for consumption in the future. consumption in the future.

Decisions about borrowing and lending are affected by various factors: expectations about future income and inflation;
interest rate offered; preferences of consumers.
MODELING BORROWING: FEASIBILITY SET
Focusing on the decision to borrow, let´s put an example:
Suppose Julia has no income today (t) and knows she will get 100€ in the
next period (1+t).

 With no borrowing, she consumes zero today and spends 100€ later.
 If she decides to borrow, she can consume today but will have less
for consumption later.
To borrow, she must pay an interest rate (r) on the amount.
𝐶𝑡+1 = 𝐸𝑡+1 − (1 + 𝑟)𝐶𝑡 ; C = consumption, E = endowment, r = int. rate
MODELING BORROWING: CONSUMER PREFERENCES
The actual combination of consumption today and later she will choose
depends on the preferences over the timing of consumption.
 Consumption smoothing means to avoid big changes in
consumption over time, while Impatience is to prefer consuming
today.
We assume there are diminishing marginal returns to consumption. The
value of an additional unit of consumption declines the more consumption
you have.
At point C or E Julia consumes much more later than now. Point F provides higher utility.
The shape of Julia´s indifference curve reflects the tradeoff between the
value of consumption now and later. The tradeoff depends on
impatience.
Overall, we assume impatience using the discount rate (𝝆):

 A higher 𝜌 means you discount the future a lot (impatient

consumer – favor consumption today)
 A lower 𝜌 means you discount the future much less
(consumption smoothing – balance today and later)
The discount rate depends on two factors:
 Desire to stabilize consumption
o An individual softens consumption to evade consuming too much in a period and too few in other. This
is due to diminishing marginal returns to consumption (the higher consumption, the lesser value an
additional unit has) = MRS of consuming reduces with time.

 Degree of pure impatience

o Pure impatience (there is no softening consumption) comes from
▪ Myopia (short-sightedness): current satisfaction is more valued than the same, but later.
▪ Prudence: people may not be around later, so they favor current consumption.
MODELING BORROWING: EQUILIBRIUM
Equilibrium is obtained by finding the feasible set of combinations of
current and future consumption which yields the highest utility.
Geometrically, this is the tangency point which equates: 𝑀𝑅𝑆 = 𝑀𝑅𝑇 ⟺
1+ 𝜌=1+𝑟 ⟺𝜌 =𝑟
If interest rate is 10%, point E in the graph is equilibrium. At point F, 1 +
𝜌 > 1 + 𝑟 ⟺ 𝜌 > 𝑟. This means that the discount rate is too high, so she
prefers to consume more today.
Having a look at the graph to the right, we can see that with a new interest
rate (78%), consumer´s preferences will change; and a new equilibrium
will be attained.

Since Interest Rate is higher, bringing consumption to today is more

expensive -- she will slightly increase future consumption.

9.1.2 MODELING SAVINGS DECISIONS

Equilibrium in borrowing-consumption model is obtained by finding
the feasible set of combinations of current and future consumption
which yield the highest utility.
We can also adapt this model to study saving decisions:
Suppose Marco has 100€ of grain just harvested (t) and does not
expect any additional income flows at t+1 (see next page)
 The grain can be seen as wealth today (can be sold to obtain income), or
as wealth later (stored or lent). Marco can sell grain and consume 100€
today and nothing later; or save and consume a positive amount later:

• Stores a portion of his grain for future consumption (depreciation

affects negatively, we assume that 20% of the saved grain is going to
depreciate).

• Lends a portion of the income and use repayment and interest to

consume in the future. We assume he charges an I.R. of 10%, and the
loan has no risk.
If Marco finally decides to store the grain to sell in the future and pay
for future consumption, he faces a 20% depreciation. So, if he saves 100€
today, he can only obtain 80€ later. Given his preferences, H is the
equilibrium (see graph in the left).

9.1.3 MODELING BORROWING AND SAVINGS: RESERVATION OPTION

This example of Julia and Marco helps us understand why borrowers and lenders have different indifference curves

 The difference between two lies in the timing endowment:

While Julia´s future endowment is 100€, Marco´s current endowment is 100€. The reservation indifference curve
includes all the points at which the individual would be just as well as at the reservation position.
These are the combinations of current and future consumption that would yield the same utility. Consuming only in the
future for Julia; and consuming only today for Marco.

9.1.4 MODELING INVESTMENT: EQUILIBRIUM

The model can also be used to study investment decisions. Suppose Marco can invest 100€ worth of the grain he
has today, into improving his farming technology to collect 150€ (return of 50%, expansion of feasibility set; new
equilibrium at K.

• Marco borrows at a 10% I.R. today. He can use this opportunity to expand his resources and increase
investment or consumption today.
o He decides to borrow and expands his feasibility frontier.
o Given his preferences, point L is the new equilibrium. He consumes more today and later as well.

9.2 INDIVIDUAL´S BALANCE SHEET

Assets = Liabilities + Net Worth.
A balance sheet summarizes what a household
or firm owns, and what owes to others. If Assets > Liabilities & Net Wort > 0 you own more than you
owe
LIABILITIES
ASSETS If Assets < Liabilities & Net Worth < 0 you owe more than you
NET WORTH own.

9.2.1 LENDING, BORROWING AND BALANCE SHEET

Wealth (or net worth) does not change when you lend or borrow. A loan adds both assets and liabilities to the balance
sheet. The borrowed money = asset; the debt = liability.

9.3 BANKS & MONEY

9.3.1 INTRODUCTION
A bank is a firm that makes profits by lending and borrowing. There are essentially, two types of banks in an economy.
A central bank, which is a sovereign body that issues currency, regulates banking system and defines monetary policy.
In the EU, this is done by the ECB. Local Central Banks have regulatory functions and act on behalf to ECB rules.
A commercial bank is one that interacts with other agents like firms or consumers. They are profit institutions. They
receive deposits from customers, loans from Central Bank or other commercial banks, and lend money.

 They make money from the difference between borrowing and lending interest rates. Interest they pay on
deposits is much lower than the interest they charge on loans.

9.3.2 CENTRAL BANK

Central Banks oversee Base money, the number of notes and coins in circulation. Legal tender is a currency that must
be accepted as payment by law.
 Only banks that can create legal tender.

 Usually a government body (independent or not)

 Banker for commercial banks

o Commercial banks have accounts at the CB. By crediting these the Central Bank prints new money.

 Prints money and introduces it in the system by providing liquidity to commercial banks.

9.3.3 COMMERCIAL BANKS & BANK MONEY

Commercial banks create money by making loans. This is called bank money. Loans provided by commercial banks
to consumers are a liability to the bank, which earns profit by charging an interest on bank money.

 Banks make money by lending much more than they hold in legal tender.
Suppose Bonus Bank gives Gino a loan of 100€. The balance sheet looks as follows:
Bonus Bank holds 20€ of base money but managed to create bank money
Assets Liabilities
by borrowing 100€ from another bank, lending 120€ to Gino.
20€ base money Gino´s loan can be used to purchase goods and services in the economy.
100€ bank loan 120€ payable on
demand to Gino.
Total: 120€ Overall, money in the economy includes both base and bank money =>
𝑩𝒓𝒐𝒂𝒅 𝒎𝒐𝒏𝒆𝒚 = 𝒃𝒂𝒔𝒆 𝒎𝒐𝒏𝒆𝒚 + 𝒃𝒂𝒏𝒌 𝒎𝒐𝒏𝒆𝒚.

9.3.4 DEFAULT, LIQUIDITY RISK & BANKING CRISES

During the borrowing and lending activity, banks engage two activities.
This exposes banks to two types of risks:
Maturity transformation Liquidity transformation

Deposits can be withdrawn Default risk Liquidity risk

Deposits are liquid
any time
Loans to Borrowers are Banks may not have
Loans only need to be repaid Clients may not repay their
illiquid (frozen) enough liquidity to allow
after a specified time loans.
clients recover deposits.

9.3.5 MONEY MARKET

Banks need enough base money to cover net transactions, obtained mostly from transactions in the money market.
Commercial banks borrow base money at a short-term interest rate.

 The demand for base money depends on how many transactions commercial banks must make:
o Positive relation with economic growth and price level
o Negative relation with interest rates (when you save you are not using money)
The supply of base money is decided by the central bank: it is part of the monetary policy options. Two interest rates:
 Policy interest rate Bank lending rate

Interest rate on base money, set by the central bank. Average interest rate charged to firms and households.

9.3.6 FINANCIAL SYSTEM

The financial system groups the interactions of commercial
banks with customers and firms and the central bank.

9.3.7 BANK´S BALANCE SHEET

BANK´S COSTS BANK´S REVENUE We can summarize the banking
business as: interaction between
- Paying interest on their liabilities - Interest and repayment of loans. its costs and revenue. There is
(deposits and other borrowing).
- Other sources of revenue such as bank uncertainty over bank´s revenues.
- Operational costs (salaries, rents, etc.) fees, or other products like insurance, etc. Expected return is return on loans
considering default risk. Mitigation:
• Lending restrictions.
• Higher interest rates for riskier loans
• Diversifying activity and revenue streams.

ASSETS (OWNED BY THE BANK OR OWED % of LIABILITIES (WHAT THE BANK OWES) % of
TO IT) balance balance
sheet sheet

1. Cash and reserve Owned by the bank, Owned by

balances at the central immediately 2% 1. Deposits households and 50%
bank accessible. firms.

2. Financial assets.
2. Secured borrowing
Some (gov.bonds) can Owned by the bank 30% Includes 30%
(collateral provided)
be used as collateral borrowing from
other banks via
3. Unsecured borrows (no money market
3. Loans to banks Via money market 11% 16%
collateral)

4. Loans to
- 55% - - -
households and firms

5. Fixed assets Owned by the bank 2% - - -

TOTAL ASSETS 100% TOTAL LIABILITIES 96%

4. Net worth = T.Assets –

- 4%
T.Liabilities = Equity

Deposits must always come back to ones who made it (households and firms) and that is why they are liabilities
(compared to loans, which are resources that must come back to the bank, and that is why they are assets)
A Bank´s net worth is determined by 𝑁. 𝑊. = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = 𝐸𝑞𝑢𝑖𝑡𝑦. The net worth is what is owed
to shareholders/owners. When the net worth is negative, the bank is said to be insolvent.
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
 Several financial indicators can be used to assess the performance of a bank. One is 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 = .
𝑁𝑒𝑡 𝑊𝑜𝑟𝑡ℎ
If this ratio is high, the firm relies a lot on debt (which is likely to affect risk perceptions).
9.3.8 POLICY RATES AND THE ECONOMY
By setting the policy rate, Central Banks affect the whole banking system and can induce changes in economic
outcomes.
1. Note that we are not saying Central Bank controls
directly the interest rates charged by commercial
banks.
2. They are in general free to decide their rates.
3. However, CB policy rate constrains access to
money market, and so increases costs of banks.
As a real example, the ECB is currently increasing his
policy rate, to fight inflation. The goal is too cool down
economic activity to stop further price increases (they
are inducing the economy into a recession).

9.4 CREDIT RATIONING

Inside banking system, there is an asymmetric information problem. This is also a principal-agent problem (conflict of
interest between principal and agent about hidden actions or attributes of the agent that cannot be enforced or
guaranteed in a binding contract).
Think about the financing of a project:
• Lenders face the risk that money borrowed will not be repaid

• There is a lack of information about project success or borrower´s effort.

Thus, lender cannot ensure contractually that project succeeds. This issue can be mitigated in three ways:

• Equity: lender requires borrower to put some of its wealth into the project
• Collateral: borrower must set aside property that will be transferred to the lender if loan is not repaid

• Personal guarantee: a third party accepts the responsibility to repay debt in case borrower cannot
9.4.1 INEQUALITY IN ACCESS TO BANKING SYSTEM
People with less wealth find it more difficult to provide equity, collateral and often,
personal guarantees. Credit rationing means that those with less wealth, borrow
on unfavorable terms compared to those with more wealth; or are refused loans
entirely.
Inequality may increase if some people are in a position to profit by lending money
to others. Credit-rationing increases inequality.
People with limited wealth cannot profit from investment opportunities that are
available to those with more wealth.

10. ECONOMIC FLUCTUATIONS & UNEMPLOYMENT

We are now focusing on three questions:
 • How economic conditions matter for consumption and investment decisions
• Which indicators can we use to measure economic conditions
• How does the economic cycle relate with inflation
If we observe data, we conclude that in the last 50 years, there has been an overall economic growth (hockey stick
GDP growth). As growth is not homogenous, different fluctuations happen, and these are known as business cycles.

 Expansion/Boom: periods in which output increases or reaches a maximum point (real GDP & other rent
indicators).

 Recession/Busts: periods in which output decreases or reaches a minimum.

Potential GDP = Ideal GDP
When analyzing business cycles, we must take into account three fundamental factors that take place:
1. Economic fluctuations are irregular and unpredictable. They do not follow a regular pattern and are not
easily predictable.
2. Majority of Macroeconomic variables fluctuate simultaneously. Even if GDP is the most used variable to
look out for short-term fluctuations, other variables such as average income or production could also be used.
3. When Real GDP decreases, unemployment increases (OKUN´s Law).

10.1 BUSINESS CYCLES

Recalling Hockey Stick Growth of the evolution of GDP, and concretely,
looking at the graph plotting the evolution of Real GDP per capita in the UK
since 1875, we can discuss:

• Clear upward trend

o 1875 – 1914: 0,9%
o 1921 – 2020: 2,0%
Apart from the trend, there is also clear that there are periods in which growth
rates are larger and smaller, and have even become negative.
This means, there are periods of positive and negative growth rates, and we
call those business cycles. These have two important periods:

• Booms/Expansion: output increases or above potential

• Recessions/Bust: output decreases or below potential
The state of the business cycle has impacts on other dimensions, including
the labor market.

10.1.1 OKUN´S LAW

Okun´s Law explains that there is a strong and stable
negative relationship between unemployment and GDP
growth.
In other words, the higher GDP growth rate, the lower
unemployment will be in an economy.
However, when GDP growth rate decreases or is negative:
Output falls  Firms need less workers 
Unemployment rises  Well-being falls.

• Change in unemployment rate is in vertical axis, and

growth rate of output is in horizontal.

10.2 MEASURING AGGREGATE ECONOMY (GDP)

As we know already, GDP is an estimate of the total economic activity of a country in a period. It is computed based on
a system of national accounts, and there are three equivalent ways to compute it:
10.2.1 GDP APPROACHED TO SPENDING
It answers three basic questions:
1. Classification of expenses in consumption expenses and in investment expenses, without depending on the
origin of each (Public and Private Sector expenditure).
2. Classification of sectors in which we do differentiate between private and public expenses.
3. Establishment of origin where goods have been produced, and separates expenses in internal production,
with expenses in external production.
The total expenses of Private Sector = sum of all consumption and investment expenses. Whereas, the total expenses
of Public Sector = sum of all consumption and investment expenses.
The formula 𝐺𝐷𝑃 = 𝐶 + 𝐺 + 𝐼 + 𝑋𝑛 expresses the spending of all economy in national production. Xn is the result of
the difference between Exports and Imports.

• Consumption (C) is an aggregate quantity which measures the total value of all goods bought by households.
Consumtpion goods are lasting (such as cars, furniture…) or not lasting (such as food, electricity or cinema).

• Public expenditure (G) is divided into different items such as public salaries, public supplies purchase and
public investments. It does not include rent transfers such as retirement pensions or subsidies.

• Investment (I) is also an aggregate quantity which reflects the private expenditure (households and firms) in
goods that will serve to future production of more goods. It includes expenditure in infrastructure (houses,
fabrics, offices), productive capital (machinery, tools) and variations in stocks.
• Trade Balance (Xn) is the difference between all Exports (goods that national producers sell to consumers
abroad) and Imports (goods that national consumers buy to producers abroad).
Summary: calculates TOTAL SPENDING on domestic products and focuses on FINAL PRODUCTS sold in the
economy.
10.2.2 GDP APPROACHED TO PRODUCTION (AGGREGATE VALUE)
When calculating GDP as a value of production, we must take into account what goods do we include.

• Produced goods (not sold) during the corresponding period, that are of recent production, and the housing
market and second hand products trade are not included.
o The production must be paid (remunerada) to be included in GDP calculus.
o The production must be legal
o The production must have taken place inside the country.

• Produced goods must be final goods. This is a way of avoiding multiple accounting in the GDP calculus.
o To solve the problem of distinguishing intermediate goods and final ones, GDP is calculated accounting
only the added value of each company.

• The added value of a company is the difference between its production total value and the value of
intermediate goods that it buys to other companies.

• By adding all aggregate values of all companies, we obtain GDP.

Summary: it calculates total domestic PRODUCTION in ADDED VALUE terms, and focuses on the increase in
PRODUCTS´ VALUE throughout the production chain.

10.2.3 GDP APPROACHED TO INCOME

This approach states that GDP is the sum of all remunerations received by the economy´s agents.
In other words, 𝐺𝐷𝑃 = 𝑆𝑎𝑙𝑎𝑟𝑖𝑒𝑠 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑟𝑒𝑛𝑡𝑠 + 𝐿𝑎𝑛𝑑 𝑟𝑒𝑛𝑡𝑠 + 𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠.
National Accounting Identities help us calculate GDP from three different approaches, and obtain the exact same result:
𝐺𝐷𝑃 = 𝐸𝑋𝑃𝐸𝑁𝐷𝐼𝑇𝑈𝑅𝐸 = 𝐼𝑁𝐶𝑂𝑀𝐸  𝐺𝐷𝑃 = 𝐶 + 𝐺 + 𝐼 + 𝑋𝑛
Summary: it calculates total domestic INCOME and focuses on the income generated along the way.
 On the left, we have the Circular Flow of Income, which describes an
economy without government intervention, nor international trade.
Regarding approach on spending, recall the formula 𝐺𝐷𝑃 = 𝐶 + 𝐺 + 𝐼 + 𝑋𝑛.
An important question to solve, is which components matter the most?
Looking the table to the right, we can see that
the most important component depends on
the region.
For example, in the US, even if consumption is
the highest, we know the effect of investment
is in aggregate terms, much larger. The graph below shows that the contraction of

investment is the highest during 2009 crisis.

The reason for this, is that consumers usually try to balance consumption (they do not consume so much today, and
maybe nothing tomorrow), so the effect in consumption will be much lower.

10.2.4 MEASUREMENT ISSUES

NIGERIA´S GDP MEASUREMENT
Take the example of Nigeria in 2013, its GDP estimation suffered a revision, which
boosted the GDP 89% larger than previously stated.
This change occurred because the base year from calculations, was varied from
1990 to 2010, when the economic structure of Nigeria, was very different and
services such as banking and telecommunications had barely taken off.
This shows that GDP´s assumptions can radically change an economic estimation.
CONTRIBUTION TO GLOBAL GROWTH BY COUNTRIES
Another issue raised with GDP´s measurement occurred when measuring the contribution to global growth by country.
When using market exchange rates, the United States contributed to around 27% of global growth.
However, when using Purchasing Power Parity rates (to eliminate differences in prices) China contributed to almost
30% of global growth.
In theory, prices should be the
same everywhere, except for
differences in exchange rates.
The Law of one price says that
transaction costs and other
frictions create asymmetries
between prices.
PPP is used to correct these
differences in prices.

10.3 ECONOMIC FLUCTUATIONS AND CONSUMPTION

All economic systems experience fluctuations. A shock is an unexpected event (positive or negative) which makes
GDP to fluctuate. There can be many reasons for a shock to occur and can affect to national or global economy.
To protect from local shocks, households usually apply one of two strategies:
 Self-insurance (autoseguro): individual decisions of saving when income is high, and borrowing when income
is low (if credit restrictions allow for it).

 Co-insurance: based on support from social environment or government.

Since the mid 20th century, in the richest countries, the co-insurance has adopted the form of tax that citizens pay,
which are used to help people in low-income situations (such as unemployment benefits).
These strategies reflect two main ideas:

• Households prefer to smooth consumption (this is, stable consumption patterns)

• Households are, to a degree, altruistic.
These strategies can also be applied to a general shock. However, when we all face a negative situation, co-insurance
might be less effective, even if more necessary.
We also know that a basic source of stability in any economy
comes from the need of households to make lifetime
consumption plans based on expectations about the
future. See the graph.
When a household suffers a shock:
If temporary, it will do small changes that to do not alter long-
run consumption.
If permanent, it will readjust long-run consumption upwards or
downwards (orange line).

In the end, this need of planning lifetime consumption, avoids shocks to be very pronounced (consuming a lot
yesterday and zero today). If households were not affected by consumption smoothing, both negative and positive
shocks would be larger.

 Consumption smoothing is limited in several ways

o Credit constrains, weakness of will, limited co-insurance…

 Therefore, in many cases, consumption smoothing is not enough to stabilize the economy.
 These limitations allow to understand the behavior in the economy along the business cycle and manage it

10.3.1 LIMITATIONS TO CONSUMPTION SMOOTHING: CREDIT CONSTRAINS

Credit constrains limit the amount borrowed, or the ability to borrow.
This reduces the ability to adjust to temporary income shocks leading
to a lower welfare.
From this graph, we know:
No borrowing: ↓ income today & ↓ consumption today  no
change tomorrow (A  A´)
Borrowing: ↓ income today & ↓ consumption today  change
tomorrow (A  A´´)

10.3.2 LIMITATIONS TO CONSUMPTION SMOOTHING: WEAKNESS OF WILL

The Weakness of Will is the inability to commit to beneficial future plans. For instance, households can smooth
consumption, but they do not, which likely leads to lower consumption in the future.

10.4 ECONOMIC FLUCTUATIONS AND INVESTMENT

10.4.1 VOLATILITY OF INVESTMENT
Firms do not have the same preferences for smoothing as households; they adjust investment plans to both temporary
and permanent shocks to maximize profits. For this reason, we say that investment is more volatile than GDP.
However, this does not mean investment decisions do not have a forward-looking perspective.

 Investment depends on firm´s expectations about future demand

o The firm expands productions facility if it forecasts a demand increase
o Otherwise, firm will not invest.

 When an innovation is introduced, companies that use the new technologies can generate results at a lower
cost and with a higher quality  increase its market participation.
o The rest of the companies will also have to invest in new technologies if they do not want to stay
behind and even disappear.

 When the economy is booming, and earnings are high, companies can use part of those earnings into
financing investment projects and access more financing opportunities.
 When the expectations of companies towards demand are positive, there is business confidence. And so, if
companies invert and use their productive capabilities, there will also be a need of contracting more workers.
o Continuously, workers will buy more things, generating a higher demand.

Summarizing: High demand  High-capacity utilization  High investment  Higher

demand.

10.4.2 INVESTMENT COORDINATION

An important determinant of investment levels is what other
firms are doing => Investment game. There are two players, A
and B; the actions are to invest, or not; the structure consists in
both deciding simultaneously. The payoffs are the profits from
investing.

• Two Nash equilibrium:

o (100,100) => both invest
o (10,10) => both don´t invest
• Coordination could ensure the best social (and individual) outcome.
• Firms are better off by investing when other firms do the same.
The best option is to let people take their own decisions after negotiating with other agents.
Firm coordination in terms of investment is not achieved by 1-on-1 communication between firms:

 Industrial confidence indicators are built by Statistical Institutes based on surveys.

 Firms observe these indicators to ascertain how other firms are likely to behave.
 Strong correlation between investment and Industrial confidence indicators.
10.4.3 INVESTMENT AND THE AGGREGATE ECONOMY
Investment cycles are strongly related with business cycle. As we discussed, benefits of coordinating investment are
high. As a result:

• When everybody is investing, you invest more  amplifies booms

• When no one is investing, you invest less  amplifies busts
• Coordination makes cycles self-reinforcing
Consumption smoothing induces some stability in private consumption.

10.5 ECONOMIC FLUCTUATIONS AND OTHER COMPONENTS

10.5.1 NET EXPORTS AND GOVERNMENT SPENDING
The behavior of net exports also affects GDP fluctuations:

• Exports depend on demand from other countries, so will fluctuate according to the business cycles of major
export markets:
o International crises may sync cycles in different countries
• Imports depend on domestic demand, they have a negative effect on GDP:
o A reduction from imports of final goods may be good for the domestic economy if there is
substitutability.
o A reduction from imports of intermediate goods may signal firms are producing less.

• Government spending is also typically less volatile than investment.

Government actions may be constrained for budgetary reasons: counter cyclical policy during bust.

BOOMS BUST

COUNTER-CYCLICAL POLICY Decrease spending to reduce boom. Increase spending to reduce bust.

PRO-CYCLICAL POLICY Increase spending to increase boom. Decrease spending to increase bust.

10.6 ECONOMIC FLUCTUATIONS AND INFLATION

Inflation is an increase in the general price level in the economy. Prices tend to accelerate in booms (higher aggregate
demand) and slow-down in busts (lower aggregate demand).
Inflation exhibits:

• Positive relation with GDP growth.

• Negative relation with unemployment.
Data for UK, since 1875.
10.6.1 MEAUSRING INFLATION
Measuring inflation is a complicated task:
• Think about translating the behaviour of the prices of all goods, sold in very different places, into a unique
number.

• Rate of Inflation: calculated as the percentage variation of a price index. This means that there are so many
measures of inflation as price indexes. The two most important price indexes are the CPI and GDP deflector.
CONSUMER PRICE INDEX (CPI)
Generally, inflation is measured by the changes in CPI. In other words, it measures the general level of prices that
consumers must pay for goods and services, including excise taxes.

 The basket of goods and services is chosen to reflect the spending of a typical household in the economy. For
this reason, changes in the CPI are a measure of the evolution in the cost of living.

 The goods and services in the basket are weighted according to the fraction of household spending they
represent.
 • CPI in Spain:
o Designs the basket of representative consumption
▪ 479 products
▪ Decide the weights of each good/class in the basket: income, age, gender…
o Ensure geographical representativeness:
▪ National, Autonomous community and Province level
o Cover different types of stores; 33.000 different stores.
o Average number of prices per month: 220.000
Inflation has been increasing since the pandemic in Euro area:

• The pandemic brought restrictions in supply chain and changes in consumption

• As pandemic restriction softened, consumption increased and production was not able to keep up
• Russian-Ukranian war made this worse (disruptions in economic activity).
GDP DEFLACTOR
 Measures prices for domestically produced output (ratio of nominal to real GDP)

 Tracks prices of components of GDP (C, I, G, Xn) – includes exports and excludes imports
 Allows comparison of GDP across countries and over time

10.6.2 INFLATION FORECASTS

Inflation has been increasing since the pandemic, in Euro area:

• The pandemic brought restrictions in supply chain and changes in consumption

• As pandemic restrictions softened, consumption increased and production was not able to keep up
• Russian-Ukranian made things worse – disruptions in economic activity, energy costs.
11. UNEMPLOYMENT & FISCAL POLICY
11.1 AGGREGATE DEMAND: MULTIPLIER MODEL
In the simplest model, we exclude Governments (G=0) and exports Xn=0). This means that Aggregate Demand is only
composed by Consumption (C) and Investment (I). In the general Aggregate demand model, the components are private
consumption, investment, government, and exports.

11.1.1 PRIVATE CONSUMPTION FUNCTION

 Private Consumption Function is represented as 𝐶 = 𝑐0 + 𝑐1 (𝑦 − 𝑡)and is composed of three elements:
o Autonomous consumption (independent of income) = 𝑐0
o Induced consumption (depends positively on present income) = 𝑐1 ∗ 𝑦
o Disposable income = 𝑦 − 𝑡

 = 𝑐1 is the slope of the consumption function, or the marginal propensity to consume = MPC. It reflects how
much does consumption change when income increases in one unit. (MPC = 0 < x < 1).
o The lower the MPC, the flatter will be the consumption
function, which means that households are stabilizing
their consumption.
o MPC differs across people:
▪ Poor households react to changes in current
income [large MPC]
▪ Wealthy households current consumption
reacts little to changes in current income [small
MPC].
▪ Expectations about future income are reflected
in autonomous consumption.
HOUSEHOLD WEALTH
Consumption is the main component of GDP in most economies. Then, it is convenient to know how consumption
changes and how will it affect production, earnings, and employment.
Consumption can affect Aggregate Demand in two ways.

 Multiplier depends on the MPC

o The higher MPC, less flatter is Aggregate Demand, and higher is the multiplier effect over production.
 A change in autonomous consumption displaces Aggregate Demand.
o If = 𝑐0 increases, Aggregate Demand displaces upwards
o If = 𝑐0 decreases, Aggregate Demand displaces downwards
Let us suppose that households desire to maintain a target wealth. When something that affects wealth in relation with
the target, the household reacts increasing or decreasing savings to restore wealth to its objective.
Consider a household with a mortgage on its home. Household wealth affects autonomous consumption, and has
several components:
 For homeowners, the value of the house is part of wealth
o If the house was purchased with a loan:
▪ Outstanding loan value is not part of wealth
▪ Home equity is the difference between the value of the house and the outstanding debt

 Savings and other investments constitute financial wealth

  Expected future earnings from employment are
also part of wealth in a broad perspective.
 Target wealth is the level of wealth a household
aims to hold, based on economic goals (preferences
and expectations)
Broad wealth = Broad assets – debt
Another example is when shocks to household wealth
induce changes in consumption.
Suppose now that house price declines:

Shocks to household wealth may induce changes in

consumption. Suppose before the 1929 crisis,
households in the US had a broad wealth as described
in column A.
With the 1929 crisis:
• Value of houses declines (home equity ↓)

• Savings and investment value reduced (financial

wealth ↓)

• Downward revision of future earnings.

As a result, broad wealth is in column B below target
wealth. Households are likely to increase savings to
restore wealth to target level – precautionary savings;

A fall in expected earnings leads to a cut in autonomous consumption to restore wealth.

The effect of a large shock to wealth, like the one induced by the 1929 crisis, is not limited to the changes in expected
future earnings. Changes in house prices also affect consumption, from two channels:

 Declines in home equity reduce broad wealth, which incentivizes precautionary savings and a reduction in
consumption.
 Lower home equity increases credit constrains, so if your main asset is worthless, you are likely going to find it
harder to borrow. Greater credit constraints limit current consumption.

11.1.2 PRIVATE INVESTMENT FUNCTION

Investment is autonomous (does not depend on income). The profits of a firm´s activity can be distributed by the
owners and used for private consumption or savings or invested in production activity, either own or another firm.
The decision on the level of investment in the economy depends on:
• Owner´s discount rate (𝜌)
• Interest rate on assets (𝑟)
• Net profit rate on investment (Π)
Depending on these three elements, the company decides:

𝝆>𝒓≥𝚷 Company gives dividends and owners obtain additional income to consume more.
Less investment
𝒓>𝝆≥𝚷 Interest rate is high, company saves extra income, redeems debts or buys fin.assets.

𝚷>𝝆≥𝐫 ROI is high, company invests in production, redeems debts or buys financial assets More investment

The lower the interest rate, the more probable is the company to invest. This implies that the aggregate investment
function depends negatively on the interest rate.
Investment increases with:

• Lower interest rate [demand-side factor]

• Higher expected rate of profit [supply-side]
• Improvements in business environment [supply-side]
The aggregate investment function shows how investment depends on interest rate and profit expectations. Investment
is negatively correlated with interest rates (r): investment curve is downward sloping; if r = 4%, level of investment is
lower than if r = 3%.
If profit expectations (𝜫) are high => function shifts rightward.
Then: for the same interest rate (r = 4%) investment is higher
Rightwards shifts can be caused by:
Higher expected Benefit rate
Decrease in energy or commodities prices.
Improvement in business environment.

11.1.3 GOODS MARKET EQUILIBRIUM

A simplified aggregate demand model comprises
consumption and investment:
𝐴𝐷 = 𝐶 + 𝐼 = 𝑐0 + 𝑐1 𝑌 + 𝐼 = 𝑐0 + 𝐼 + 𝑐1 𝑌 => where 𝑐0 + 𝐼
is the intercept (autonomous consumption and
investment)
When Y = AD, we say the market is in equilibrium,
where supply = demand. 45º line represents the points
where that equality complies.
The equilibrium of the model is obtained where AD
intersects 45º line (point A) --- Y = AD.
Notice that slope of 45º = 1 ; slope of AD < 1 because
MPC = 𝑐1 < 1.
MULTIPLIER EFFECT
• Goods market is initially in equilibrium A
Suppose investment falls (I => I´)
• Aggregate demand decline (AD↓)

• At old production level AD < Y, so point B is not

an equilibrium

• Output declines to 45º line (B=>C), but this level

is stil not an equilibrium, so C=>E

• The process continues until the new

equilibrium, Z, is reached.
Due to multiplier effect, the total change in output stemming from a change in aggregate demand can be higher than
the initial change in demand.
In other words, when a variation in Aggregate Production is described as the successive sums of all additional
production variables that accumulate, the multiplier effect is happening.
This happens because of the circular flow of income, expenditure, and output. GDP (Y) and AD move in the same
direction, the multiplier represents the relative magnitude of the movement:
MULTIPLIER > 1 Change in AD leads to a more than proportional change in GDP
MULTIPLIER = 1 Change in AD leads to a proportional change in GDP
MULTIPLIER < 1 Change in AD leads to a less than proportional change in GDP
What determines the size of the multiplier in the AD model, is the slope of the AD curve (the marginal propensity to
consume), and the credit constrains and consumption smoothing preferences, which affect the MPC itself.

11.1.4 EXAMPLE OF GOODS MARKET EQUILIBRIUM: 1929 CRASH

We are going to use the previously explained AD model to
illustrate the effects of the 1929 crisis. Before this crisis, GDP
was 324Bn.
With the 1929 stock market crash, low investment led to:
aggregate demand fall, new equilibrium with lower income and
a more than proportional drop in GDP [multiplier > 1].
Facing a lower income, AD fell even more due to: drop in
consumption and further drop in investment.
This was caused by high uncertainty due to the stock crash,
pessimism, banking crisis…In the end, there will be a new
equilibrium with output = 206Bn, again with a multiplier > 1.

11.2 AGGREGATE DEMAND MODEL: ROLE OF THE GOVERNMENT

Now, we consider introducing the government (G) and external trade (Xn): 𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + Xn.
Government enters AD in three ways:
• Government spending (G) – autonomous (exogenos)

• Consumption (C) – income taxation (t) reduces disposable income and induced consumption.

• Investment (I) depends on interest rate and after-tax profit.

o High interest or tax rate reduce autonomous investment
External trade enters AD in two ways:

• Exports (X) are taken as exogenous and shift AD upwards

• Imports (C) are assumed to be proportional to income (I=mY)

o Where m = marginal propensity to import which measures the fraction of each additional unit of income
spent on imports.
Given all components: AD model is now:
𝐴𝐷 = 𝐶 + 𝐺 + 𝐼 + 𝑋𝑛 = 𝑐0 + 𝑐1 (1 − 𝑡)𝑌 + 𝐺 + 𝐼 + 𝑋 − 𝑚𝑌
= 𝑐0 + 𝐺 + 𝐼 + 𝑋 + [𝑐1 (1 − 𝑡) − 𝑚]𝑌

Autonomous components Endogenous components

y-intercept: 𝑐0 , 𝐺, 𝐼, 𝑋 (slope/multiplier): 𝑐1 (1 − 𝑡)𝑌, 𝑚𝑌

Savings, taxation and imports are refered to as leakages from the circular flow of income. The reason for this is because
they reduce the size of the multiplier.
• 𝑐1 : how much income goes to consumption and savings
• 𝑡: how much income goes directly to government as taxes
• 𝑚: how much income is used to buy goods abroad

11.2.1 STABILIZING ROLE OF THE GOVERNMENT

Government can stabilize economic fluctuations in several ways:

• Government spending/size: compared to private investment, public expenses in consumption and investment
are normally stable and do not fluctuate as much with the level of business hope. (Roosevelt after 1929)?

• Higher tax rate lowers the multiplier effect – it reduces disposable income and so, induced consumption

• Unemployment insurance: paying this helps consumption smoothing

• Fiscal policy changes can execute deliberate intervention.
Regarding higher tax rate and unemployment insurance, these are known as automatic stabilizers. Automatic
stabilizers are elements from tax system and transfers from an economy which functioning reduces economic
fluctuations automatically. In other words, they automatically offset expansion or contraction in the economy.

• Higher tax rate penalizes high income levels, reducing induced consumption in booms
• Unemployment benefits reduce drop in income in case of recession.
Suppose a negative prospects situation driving most household to cut of expenses, and save money under the mattress.
This can be introduced as a reduction in autonomous consumption 𝑐0 , which implies a reduction in aggregate
consumption, and the aggregated demand curve would displace downwards. The multiplier effect reduces
production, income and employment.
The impulse accumulated from increasing savings, produces a drop in rent or aggregate income, if the reduction in
consumption is not compensated with an investment increase, or in public expenditure.
The result could be a lower savings level, instead of a higher savings level, which is known as paradox of thrift (the
aggregate attempt to increase savings lead to a fall in aggregate income).

11.2.2 FISCAL STIMULUS

In a recession, Government can counteract the fall in AD from the private sector vía a discretionary change in fiscal
policy (counter-cyclical policy). Two examples are: increase spending – direct effect; or cut taxes – indirect effect, which
would be Keynesian policies.
These expansive policies, would operate through a multiplier effect provoking an increase in production, even higher
than the original increase in public expenditure.
Suppose economy is initially at point A of the graph,
autonomous consumption falls, and equilibrium output
drops to point B
If government spending increases, AD shifts upwards,
and equilibrium output increases to point C.

• In this context, this would be a pro-cyclical policy.

Due to the multiplier effect, drop in government spending
induces a more than proportional drop in output.

11.2.3 MULTIPLIER IN PRACTICE

In the model of Aggregate Demand, we have discussed the multiplier depends only on:
- Marginal propensity to consume 𝑐1
- Marginal propensity to import 𝑚 Slope of AD curve.
- Income tax rate 𝑡
However, in reality, the multiplier is affected by other factors, such as:
rate of capacity utilization (phase of business cycle), with fully employed resources [boom] increases in government
spending can crowd out private spending.
expectations of private sector (multiplier could be negative if rising fiscal deficit erodes consumer/business
confidence), deficit may be funded with debt, but debt means higher future taxes/lower future spending.
WHAT IS THE IMPACT OF FISCAL POLICY ON OUTPUT?
The main problem of addressing this question is a common one in economics research, endogeneity. For example,
say we observe government spending and output are positively correlated; can we infer that changes in government
spending lead to changes in output?
Not necessarily, a change in government spending may be the result of changes in output (reverse causality)

11.2.4 GOVERNMENT´S FINANCES

When government´s costs expenses are higher than what it earns, there is a public deficit, and the government has
to take a loan (issue public debt), comprising itself into repaying the loan in the future with an interest.
When we exclude public debt interest payment, we know public deficit as primary budget deficit, and it varies with
economic cycles (deficit increases when there is a recession and reduces when recession is reverted).
Public Debt: accumulation of all loans made by the government to finance its deficit, minus the debt already payed.

Primary budget Difference between government spending and revenue (G-T), excluding interest rate expenditure on debt.
deficit

Total Public debt Difference between overall spending and revenue (Interest Expenditure + Government spending – Revenue)
(budget deficit)

When a government issues public debt, it sells State bonds that private and external sectors can buy. In general, bonds
are attractive to investors because they provide with a fixed interest rate and are considered as a “safe” investment
because the default risk is usually low.

 Total outstanding government debt is the sum of all bonds sold over time to finance budget deficits:
o Bonds can be issued with different maturities: short (<5 years) to long (>5 years)
o Matured bonds are debt that has already been paid.sp
o Price of bonds is the interest rate [measure of risk] investors are willing to pay to hold the bond.

 A large stock of debt may be problematic, because default risk perception increases
o There is, however, no point at which all the stock of debt has to be repaid (government can issue new
bonds)

 An ever increasing debt (measured, for example, with debt-to-GDP ratio) is unsustainable, but there is no rule
that determines a specific limit.
Sovereign debt crisis: situation in which the State bonds are considered so risky, that it is posible that the government
asking for them will not receive any more loans.
INDEBTNESS LEVEL OF A GOVERNMENT
The level of indebtness of a government is measured in relation to the size of the economy, using the debt-to-GDP
ratio, and it can decrease for various reasons:
1. If there is a Primary Public Surplus
2. If, even with a Primary deficit, GDP is growing faster in comparison to how Public Debt is growing.
3. If inflation increases, the nominal value of debt (what the government must return in x time) does not change,
but inflation decreases its real value.

11.3 AGGREGATE DEMAND MODEL: FEEDBACK MECHANISMS

11.3.1 PRIVATE SECTOR, GOVERNMENT ACTIONS AND OUTPUT (DE)STABILIZATION
Overall, both private sector and government decisions may induce output stabilization. This is crucial to avoid large
booms and deep recessions. In general, the government aims to have a stabilizing role.
However, policy mistakes (too strict unemployment benefits access restrictions; systematic budget deficits) can limit the
tools governments can use to stabilize output (austerity in recession), and they generate public deficit (negative public
savings because public expenditure is higher than fiscal income).
 Public budget is the difference between fiscal income and public expenditure = T – G. A deterioration in the
budget position of a government during a recession is also part of its stabilizing role.
o When recession comes to an end, public deficit must be reversed to not increase public debt.

 On the contrary, if the government decides to apply austerity measures (cut public expenditure, and/or
increase taxes) during a recession, this could amplify the recession effects reducing more aggregated demand.
11.4 AGGREGATE DEMAND MODEL & FOREIGN TRADE
In modern economies, the interaction with external and foreing markets, also affects Aggregated Demand, and can vary
the effects of fiscal policy:

 Fluctuations in the growth rate of relevant foreign markets influence national economy through the
demand of exports.
o For example, China is a very important market for Australian exports, and when Chinese economy
deaccelerated in 2010, it came with a high loss in Australian net exports, and a reduction in economic
growth.

 Demand of imports dampens internal fluctuations.

o Given that when consumption increases, part of what households consume, is made abroad. The
multiplier effect decreases when the importing marginal propense increases.
 Commerce with other countries limits the capacity to use fiscal stimulus against recessions.
o Fiscal stimulus can only occur in countries producing highly competitive products and increase imports
without stimulating internal Aggregated Demand. This indirect effect can be so big, that it provokes the
opposite effect, and the economy takes longer to recover.

11.5 AGGREGATE DEMAND MODEL & UNEMPLOYMENT

We have to models to analyze, production, employment and unemployment rate:

OFFER PERSPECTIVE DEMAND PERSPECTIVE

We use the labor market model (week 8) which focuses on We use the multiplier model which explains how expenses
how labor is used to produce goods and services through the decisions generate goods and services demand and, as a
wage-setting curve and the price-setting curve. result, generate production and employment.

Medium-run model: wages and prices can change, but share Short-run model: wages and price are fixed.
capital, technology or institutions not.

C B

Displacements in A.D. cause economic

fluctuations in unemployment.

When the two models are combined, economic fluctuations (fluctuations in Aggregated Demand) can be analyzed
around the equilibrium of the labor market during business cycles.
Through the production function we positively connect employment (N, in the horizontal axis of labor market graph)
and production/output (Y, in the horizontal axis of the Aggregated Demand model graph).
1. The economy is initially in Point A of Labor Market graph (equilibrium in labor market with an unemployment
rate associated with unvoluntary unemployment of the equilibrium of the model).
2. The production level in Point A of Aggregated Demand graph is the normal production/output level.
3. Fluctuations in the short run are caused by changes in Aggregated Demand: if there is not enough demand for
goods and services in Point C, and additional cyclical unemployment would be generated.
a. If there is excess demand, unemployment falls and we would be in Point B.
12. INFLATION, UNEMPLOYMENT & MONETARY POLICY
12.1 INFLATION
Inflation (𝜋) is an increase in the gernal price level. It is typically measured by the change in a price index (such as
Consumer Price Index).
𝐶𝑃𝐼𝑡 −𝐶𝑃𝐼𝑡−1
𝜋𝑡 = We typically measure YoY inflation (change in inflation compared to previous year).
𝐶𝑃𝐼𝑡−1

There are three important concepts:

• Zero inflation: constant price level from Year to Year.

• Positive inflation: increasing price level from YoY. It must no be confused with increasing inflation, and it is
manifested in three cases
o Growing: prices increase and in a higher rate continuously.
o Disinflation: a decrease in the rate of inflation from a previous period
o Constant: prices increase in the same rate YoY.

• Deflation: inflation is negative, price level decreases.

Inflation allows to distinguish between nominal and real variables:
- Real interest rate = Nominal Interest Rate – Inflation Rate [Fisher equation]
- Real wage growth = Nominal wage growth – Inflation Rate
12.1.1 HOW MUCH INFLATION IS GOOD?
For a constant nominal income (pension, wages, rents…) inflation reduces purchasing power (you can buy less goods
with the same wage). Inflation also affects the real value of debt (debt repayment is done at nominal level – good for
borrowers, bad for creditors)

• High rates of inflation make the economy work less well. Households and firms take less decisions based in
prices.
o High inflation is often volatile, and unpredictability increases uncertainty
o It is harder to distinguish between changes in relative prices (the ones with transmit source scarcity)
and inflation, distorting consumption, production, and investment decisions.
▪ Relative prices: important to decide cost-effective input combinations (amount of labor/capital)
o Menu costs increase as firms must update prices more frequently.

• Continuous deflation is also problematic, and could have even harsher consequences than a high inflation:
o When prices are falling, households postpone consumption (particularly of durable goods) as they
expect future price drops.
▪ This means a shock in Aggregate Demand, which could lead to even lower prices.
▪ Firms will reduce production and likely employment.
o Deflation increases the real debt burden, which may lead households to save and reduce
consumption to reach the target wealth again.
▪ Poorer households will face higher credit constrains
▪ Leading to a lower consumption, and inducing a drop in Aggregated Demand, depressing
prices even further.

12.1.2 CAUSES OF INFLATION

Wages and prices are determined by the interactions between firms, consumers, and workers. Inflation surges when
any of these parties has enough power to sustain conflicting and inconsistent claims to goods and services.
Firms fix wages and prices, and if the wages and price levels are consistent with the profit maximizing objectives, there
will be no reason for them to change them. In this unemployment rate, inflation equals zero

• Unemployment rate where wage and price setting curves cross each other = Labor market Nash equilibrium.
Changes in price levels can be motivated by several factors, and these can be summarized into two situations:

 Increases in bargaining power of firms over consumers because competition is lower, and this allow firms
to fix higher prices (increase in prices leads to decline in price-setting curve and reduction of real wages [long
run]

 Increases in the bargaining power of workers over firms which allows labor unions have higher power and
allows workers to obtain a higher salary.
o Vertical shift of wage-setting curve upwards, higher real wage required for the same employment.
o Along the wage-setting curve movement because of an increase in employment levels.

1. In the first graph, real wage falls for any employment level, given that firms charge higher prices and have higher
earnings. Against this situation, workers can reduce their motivation to work, so firms will have to raise nominal
wages. Both prices and wages increase, generating inflation.
2. In the second graph, labor unions achieve a raise in nominal wages for any employment level, which means an
increase in production costs of firms. Against this situation, firms will increase prices to keep their margins,
generating inlation.
a. These las two cases correspond to medium-long term, the labor market equilibrium will change and there
will be an increase in unemployment which will affect the bargaining power of workers.
3. In the third graph, the idea that a higher employment could generate inflation is portrayed, confirming what Phillips
reflected in his dispersion graph for inflation, and unemployment levels in the UK.

12.2 THE PHILLIPS CURVE

The Phillips Curve reflects that there is negative relation between inflation and unemployment: when unemployment
is low, inflation is high, and viceversa.
 When labor market is in equilibrium, we are in the normal phase of the economic cycle (there is no pressure
from any of the agents to change wages nor prices – inflation = 0).

 During a boom period, aggregated demand increases and unemployment is reduced below equilibrium. As
unemployment is low, reservation wage also decreases (the cost of losing the job is lower).
o Workers expect a raise in wages, an higher salaries imply higher costs for the firm, which will increase
prices to maintain margin.
o The economy experiences wages and prices inflation even though that real wage does not
change. If Aggregated Demand keeps high, the situation goes on, wages will increase again, and the
economy enters into an inflationary spiral.

 If, instead of a boom, there is a recession period, the phenomena that occurs is a deflationary spiral, where
wages and prices decrease.
 C B

In this graph:
When employment is lower than unemployment equilibrium:
𝑐𝑜𝑚𝑝𝑎𝑛𝑖𝑒𝑠 𝑐𝑙𝑎𝑖𝑚𝑠 𝑜𝑛 𝑟𝑒𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 + 𝑤𝑜𝑟𝑘𝑒𝑟𝑠 𝑐𝑙𝑎𝑖𝑚𝑠 𝑜𝑛 𝑟𝑒𝑎𝑙 𝑤𝑎𝑔𝑒𝑠 > 𝑙𝑎𝑏𝑜𝑟 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦
 Upwards pressure on wages and prices
When employment is higher than unemployment equilibrium:
𝑐𝑜𝑚𝑝𝑎𝑛𝑖𝑒𝑠 𝑐𝑙𝑎𝑖𝑚𝑠 𝑜𝑛 𝑟𝑒𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 + 𝑤𝑜𝑟𝑘𝑒𝑟𝑠 𝑐𝑙𝑎𝑖𝑚𝑠 𝑜𝑛 𝑟𝑒𝑎𝑙 𝑤𝑎𝑔𝑒𝑠 < 𝑙𝑎𝑏𝑜𝑟 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦
 Downwards pressure on wages and prices

12.2.1 BARGAINING GAP

When the wage of the wage-setting curve and the price of the price-setting curve do not coincide there exists a
bargaining gap (difference between the real wage that firms should pay to incentivize effort and the real wage that
gives firms enough earnings to keep the business active).

• If unemployment is below equilibrium → bargaining gap is positive, and there is inflation

• If unemployment is above equilibrium → bargaining gap is negative, and there is deflation
• If labor market is in equilibrium → bargaining gap is zero, and there is constant inflation (=0)

We can illustrate the relation between business cycles´ booms and busts, and inflation using three tools: aggregate
labour market model, aggregated demand multiplier model, Phillips Curve.
Suppose the economy is in equilibrium at Point A, with an
unemployment of 6%.
AD increases, leading to a boom and a decrease in
unemployment of 3% (Point B)
AD decreases, leading to a bust and an increase in
unemployment to 9% (Point C).

Changes in unemployment create a bargaining gap. A

positive bargaining gap in boom leads to inflation, and
negative bargaining gap in bust leads to deflation.
In this case, the Phillips curve could be reinterpreted as a feasible set of unemployment and inflation, and that the
economic policymaker could choose the desirable combination, with preferences of low inflation and high employment.

 These preferences can be represented with Indifference Curves.

In this example, the best possible outcome is Point F, with a target
inflation of 2% and full employment.
Above target inflation, I.Curves have positive slope, given that
approaching to full employment is worthy to accept a higher inflation.
Below target inflation, I.Curves have negative slope.
We assume diminishing marginal returns for both objectives.
This implies that when the result if far from inflation aim, but near to
employment aim, the I.Curve is flatter because it is more valued to
approach the target inflation.
On the contrary, when the result is far from employment aim, but near
to inflation aim, the I.Curve is steeper as it is more valued to approach
target employment.
Policymakers try to use monetary and fiscal
policies to choose the Aggregated Demand level,
so that the Indifference Curve is tangent to the
Feasible Set represented by the Phillips Curve.

 Optimal decision is in Point C, between

inflation and unemployment, where: MRS = MRT.

12.2.2 OVER TIME CHANGES. PHILLIPS CURVE.

Data shows that inflation and unemployment combinations are not stable, which means that Phillips Curve varies over
time. According to Milton Friedman, the only way to maintain a very low unemployment is allowing a highly increasing
inflation.
When wages and prices are set, agents have expectations about inflation. Although when analyzing equilibrium in the
labor market we had a zero-inflation rate for equilibrium unemployment, if expected inflation is introduced, equilibrium
unemployment will be consistent with a positive inflation rate equal to the expected inflation rate.
There is no permanent trade-off:
• Phillips curve is not a traditional feasible set, there is only one employment rate at which inflation is stable, but
it changes over time.

• If a government tries to keep unemployment too low, the result will be higher and rising inflation.

12.3 CHANGES IN INFLATION

Expectations of future prices can lead to changes in the Phillips curve. These expectations come from agents which
react to the fix of wages and prices. This is known as expected inflation.
If we introduce expected inflation the equilibrium unemployment will be consistent with a positive inflation rate, and
equal to the expected inflation rate.

 The inflation-stabilizing rate is the unemployment rate which keeps inflation constant.
In this situation, when an economic boom happens, and Aggregated Demand increases, unemployment is lower than
the equilibrium, and there will be a positive bargaining gap, which makes inflation rate higher than expected.
 𝑂𝑏𝑠𝑒𝑟𝑣𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 + 𝑏𝑎𝑟𝑔𝑎𝑖𝑛𝑖𝑛𝑔 𝑔𝑎𝑝.
12.3.1 SUPPLY SHOCKS
Apart from aggregated demand shocks because of an economic boom, and the adjustment for the expected inflation,
there are other causes for a high and increasing inflation.
The Phillips Curve can also displace upwards if there is a supply shock (unexpected change in the offer). Supply shock
can happen because of two reasons:
When the labor market equilibrium changes because:

• Price-setting curve displaces downwards when the firms bargaining power increases
• Wage-setting curve displaces upwards when the employees bargaining power increases.
When negative events that affect supply (technology, natural resources…) occur, such as petroleum crisis.
While a negative demand shock carries an increase in
unemployment (reducing inflation), a negative supply shock
can lead to an increase in unemployment and inflation
simultaneously.
e.g.: an increase in the price of petroleum creates a
bargaining gap and leads to an inflationary spiral. Companies
of all sectors increase prices to maintain their margins,
specially those affected directly, which try to maintain their
margins. This reduces the real wage of employees, and the
price-setting curve displaces downwards.

12.4 MONETARY POLICY

As we have seen, a moderate and foreseeable inflation, constant in time and in quantity, can be positive. Many
institutions have as an objective an inflation rate of 2%.
When predictions are made on inflation, Central banks apply measures to adjust the level of Aggregated Demand and
employment, so that the economy is focused on the objective inflation.

 In this task, Central Banks are normally responsible setting monetary policy, and they have broadly two
dimensions they can control:
o Policy interest rate
o Base – Money supply
Depending on the exchange rate regime in place, they can also directly manipulate the exchange rate. Two extreme
cases:

Flexible exchange rate Currency allowed to float. Price determined by market. Central bank sould not intervene directly to
influence the value of the currency.

Fixed exchange rate Value of the currency is somehow fixed to another.

Still, even if the exchange rate is not the target, changes in monetary policy can induce changes in the exchange rate.

12.4.1 POLICY INTEREST RATE AND MONETARY POLICY TRANSMISSION MECHANISMS

We are interested in how policy interest rate may affect the economy. There are 4 essential transmission channels:
market interest rates, asset prices, expectations and exchange rate.
Together they influence the domestic aggregate demand, the net exports, and the import prices.
 12.4.2 MARKET INTEREST RATES
The market interest rates are one of the most
important transmission channels, as they affect
savings and borrowings (hence, consumption
and investment).
Policy interest rate conditions market
interest rates:
Some loans interest rate is directly anchored
to money market rates
Policy rate influences the cost of money
market funds for commercial banks.
In reality, policy rate is sort of defined backwards,
as Central banks:

1. Determine desired level of aggregate demand based on labor market equilibrium and Philips curve.
2. Estimate real interest rate which will produce this level of aggregate demand.
3. Calculate nominal policy rate that will produce the appropriate market interest rate.
12.4.3 ASSET PRICES AND PROFIT EXPECTATIONS
When the central bank changes the official interest rate, there is also effect on all interest rates in the economy. This is
affecting aggregate demand.

 When interest rates fall, the price of assets increases (households feel richer, increase consumption expenses)
 When central bank reduces interest rate, tries to transmit confidence to private sector:
o Firms expect higher demand – increase investment
o Households hope keeping employment – increase consumption

 When interest rates fall, national assets are less attractive to foregin investors – fall in demand of national
currency.
o When national currency demand falls, it depreciates.
o Depreciation of national currency causes increased exports and reduced imports.

12.4.4 EXCHANGE RATES

Exchange rate is the number of units of home currency that can be exchanged for one unit of foreign currency. The
exchange rate between the Euro and the US dollar can be determined as:
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐸𝑈𝑅
𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 𝐸𝑈𝑅 =
𝑜𝑛𝑒 𝑈𝑆𝐷
Let´s have a look at an example:
If the exchange rate is 1,07, this means that you need 1,07€ to buy 1$. Thus, a t-shirt that costs 20€ can be bought with
18,69$ (20/1,07).
The exchange rate typically fluctuates overtime. If exchange rate was 1,07 yesterday, then, if today:
- It is 1,00 – there was an exchange rate appreciation (€ is worth more compared to $)
o 20€ t-shirt can now be bought with 20$
- It is 1,25 – there was an exchange rate depreciation (€ is worth less compared to $)
o 20€ t-shirt can now be bought with 16$
Interest rates affect demand for home currency in the foreign exchange market. This leads to changes in the
value of the currency, and this means that there will also be an effect net exports.
Take a look at the next example:
 1. Australia´s Central Bank cuts interest rate
2. Fall in demand for Australian Bonds (recall, State Debt)
3. Fall in demand for AUD (Australian dollar is less valued)
4. Depreciation of AUD
5. Exports become relatively cheaper and imports more expensive
6. Increase in Net Exports (X – N)
7. Increase in Aggregated Demand
Explaining the 6th step, the depreciation of Australian dollars makes exports relatively less expensive (which induces an
increase in X) and imports relatively more expensive (which induces a decrease in N)

12.4.5 MULTIPLIER MODEL

In the aggregate demand multiplier model, the transmission channels of the official interest rate are reflected in the
investment function I(r) and the effects of the expectations and of changes in prices are reflected in investment and
in autonomous consumption.

• If central banks try to impulse the economy during a recession there will be a reduction in the interest rate,
thus, an upwards displacement in aggregate demand (expansionary monetary policy)

• If central banks are worried about controlling inflation and there is possibilities of a growing inflation when
the expectations are made with past inflation, there is an increase in the interest rates during economic boom
phases, and thus, a downwards displacement in aggregated demand (contractionary monetary policy)
Let´s see and example:
Suppose economy is initially in equilibrium (point A) and
then: autonomous consumption declines [𝑐0 > 𝑐0´]:
This shifts AD downwards; and leads to a new
equilibrium with lower output (point B)
To stabilize the economy, the central bank can decrease the
real interest rate [𝑟 > 𝑟´]. The effect of this policy is an
increase in investment [𝐼(𝑟) > 𝐼(𝑟´)].
This shifts AD upwards; and leads to a new equilibrium
with higher output (point A)!
What is the conclusion? Monetary policy can be used to
stabilize economy, instead of (or as a complement to)
changing in fiscal policy.
In this case, Central Bank is conducting countercyclical policy (decrease interest rates during recession, instead of
increasing them).

12.4.6 LIMITATIONS
Monetary policy could be used to stabilize the economy. This seems particularly appealing because it does not come
with direct budgetary costs. However, it also has important limitations:

• Discretionary monetary policy changes can erode Central Bank credibility:

o Imagine that the Central Bank stipulates a high Interest Rate. This will affect investments, loans…If that
same Central Bank suddenly drops the Interest Rate rapidly, the credibility of the CB will decrease too.
o In practice, this could mean lower investors would probably buy bonds from that State.

• The short-term nominal interest rate (policy rate) cannot go below zero:
o When the economy is in a bust, nominal interest rate of zero may not be low enough to stabilize it
o An alternative is quantitative easing, where central bank purchases financial assets to reduce yields
and boost investment

• Some countries do not have monetary policy autonomy:

o For example, in the Eurozone, the Spanish CB cannot decide to lower interest rate to face a domestic
crisis.
12.5 DEMAND SHOCKS
In case of a crisis, governments with monetary and budgetary policy
autonomy can use them jointly to stabilize the economy. A demand
shock is an unexpected change in aggregated demand.
Responding to a drop in autonomous consumption, AD will drop,
and:
Point D has a lower output, employment, and inflation than Point C.
Governments could simultaneously:
Decrease nominal interest rate (monetary policy)
Cut taxes/increase gov. spending (fiscal policy)
The joint use of these policies can reduce stabilization cost:
Interest rate does not have to be cut so much
Budget deficit does not rise as much.

The effect of a monetary and fiscal policy mix to stabilize the economy can be summarized as follows:

Fall in Fall in Aggregated Lower equilibrium

consumption (C) Demand output (Y)

Real interest rate

declines (r) Central Bank cuts
Increase in AD • Higher investment interest rate
• Depreciation of money

12.6 DISCRETIONARY POLICIES vs INFLATION TARGETING

12.6.1 CENTRAL BANK CREDITIBILITY
A relevant limitation of discretionary monetary policy is that it may reduce the credibility of the CB. An alternative is
to define a rule and stick to it:
Inflation targeting is a monetary policy regime where the CB uses policy instruments to keep the economy close to an
inflation target.
Under inflation targeting, the Central Bank becomes independent from the Government, which makes inflation targets
more credible, and can prevent inflation spirals:

• This rule anchors expectations about inflation and prevents Phillips curve shifts.
When inflation target is set, the deviations are not in
different Philips curves, but on the same one there is
lesser variation.
Central Bank´s independence has been
progressively implemented in developed economies
since 1990s:
Main target of CB is 2% inflation
Earlier evidence suggests less independent
bank delivered higher inflation rates.
12.7 INLATION AND LOW UNEMPLOYMENT
Up until now, we should know that the trade-off between (un)employment and inflation is explained as: when
employment is high, costs of job loss is lower, employers must offer higher wages and increase prices to keep profits
constant.
In reality, there is another reason for low unemployment and
high inflation (high capacity utilization):

 High-capacity utilization: all resources are used for

production:
o Long-run: firms respond to rising capacity
utilization by increasing investment
o Short-run: firms are capacity constrained; they
cannot increase investments or production
rapidly, resulting in prices raise.
o Summary: when productivity is very high, there
might also be low unemployment and high
inflation.

 Wage-price spiral is crated when all the firms respond the

same way (higher prices = higher inflation)
13. TECHNOLOGICAL PROGRESS, INSTITUTIONS, UNEMPLOYMENT AND LIVING
STANDARDS IN THE LONG-RUN
During the 1960s, unemployment rates were low and very similar. However, in the 1970s, these rates were very
different.
Differences on long-term unemployment patterns cannot be explained with differences in innovation and
technological progress, but they reflect differences in institutions and policies in countries.
Technological progress can provoke short-term unemployment, but on the long run. In fact, technological progress and
introduction of improvements in new technologies are the key factor to increase living standards on the long run.

Comparing living standards and unemployment over a long period we can distinguish low and high performers.
While some countries experienced high real wage growth and unemployment remained low, high unemployment
suggests growth living standards was unequal.

 In this class, we are going to use a long-run labor market model to discuss; 1) differences in labor market
performance across countries, and 2) how technological progress affects quality.

13.1 TECHNOLOGICAL PROGRESS AND LIVING STANDARDS

Companies can obtain innovation rents (profits above the opportunity cost of capital when they introduce new
technologies). Companies which do not innovate nor adapt to new technologies cannot compete in the market.
This process is known as creative destruction. Creative because these companies free up labor and capital goods
(machinery, equipment…) for using them in new work combinations.
 Creative destruction allows a sustained increase in the average living standards, given that technological
progress and capital goods accumulation complement each other:
o New technologies require new machines
o Technological advances are required to make the introduction of more capital-intensive methods
profitable.
There are also two key concepts which we must know, and that are going to be present in the production function
that we are going to model.

 In the horizontal axis, we measure the quantity of capital goods per worker = capital intensity of production.

 In the vertical axis, we measure the quantity of output per worker = mean productivity of labor.
13.1.1 TECHNOLOGICAL PROGRESS AND CAPITAL
INTENSITY
The effects of technological progress in the
production function can be summarized in:
 Upwards shift in production function

 Average Productivity of Labor increase and

provokes an offset in diminishing marginal
returns to capital.
 Profitability of Investment increase, leading to
higher capital intensity.
𝚫𝒀
The slope of the production function shows the marginal product of capital which reflects how much production
𝚫𝑲
increases if capital goods increase in one unit.
As production function is increasing and strictly concave, it presents diminishing marginal returns of capital (as the
worker uses more capital goods, production increases but in less proportion each time).

 This means that the economy cannot maintain the labor productivity growth by investing more capital.
o Entrepreneurs are interested in investing if the return is higher than what they would obtain by just
dedicating earnings to savings or to consumption.
 Sustained economic growth requires technological change that increases marginal product of capital.
o With technological progress, the production function displaces upwards, and allows for it to be
profitable, which leads to a higher capital use intensity.
Economies which were able to successfully grow have experimented a technological progress and a capital
accumulation combination (going from B to C) – labor productivity increases as capital intensity increases.
Technological innovation compensates diminishing marginal returns of capital. Thanks to this, capital productivity has
maintained constant along time in leading countries.
EFFECT ON EMPLOYMENT
With technological progress, some jobs are destroyed, but as investment is incentivized and there is contribution
towards expansion of production there is also job creation.
There is a reassignment of resources from less productive companies towards companies with higher productivity. The
effect on employment can also be described in an equation:
𝑵𝒆𝒕 𝒆𝒎𝒑𝒍𝒐𝒚𝒎𝒆𝒏𝒕 𝒄𝒉𝒂𝒏𝒈𝒆 = 𝑗𝑜𝑏 𝑐𝑟𝑒𝑎𝑡𝑖𝑜𝑛 − 𝑗𝑜𝑏 𝑑𝑒𝑠𝑡𝑟𝑢𝑐𝑡𝑖𝑜𝑛

13.2 JOB CREATION AND UNEMPLOYMENT

The increasingly capital-intensive production could have had sharp negative impacts on employment. If you are
increasing the proportion of capital inputs, you need less labor.
However, labor-saving tech improvements can also create jobs elsewhere, e.g.: reallocation of work from low to high
productivity firms. In many countries sizeable job destruction was compensated by strong job creation, which has
a generally, net positive effect.
Companies create and destroy jobs as a response to competitive pressure in the markets.
Job creation is strongly pro-cyclical (rises during booms and falls during recessions) whereas job destruction is
contra-cyclical (increases during recessions and falls during booms)

13.2.1 BEVERIDGE CURVE

Beveridge observed two things:
 During recessions, unemployment is high and rate of job vacancy is low = there are less job vacancies being
offered, there are more workers being laid off, and there are more job posts being eliminated.

 During booms, unemployment is low and rate of job vacancy is high = companies publish more job offers and
hire more workers to affront increasing demand.
The relation between jobs available and unemployment as a share of the labor force is the Beveridge Curve.

The adequacy between supply and demand in the labor market is the way in which companies with job vacancies find
people willing to work. Factors obstructing the adequacy in the labor market are the labor market matching issues:

 Discrepancies between location and nature of job seekers and jobs available: unemployed workers may
not have the skills required; or job seekers and vacancies may be located in different parts of the country.
 Missing information: job seekers and companies with vacancies may not know about each other.
Industry-specific shocks or shocks that prevent workers from moving, increase the mismatch (lower efficiency). In
general, policy and technology can improve efficiency. Overtime, changes in those shift the Bev.Curve to the origin.
Returning to the graph before, Beveridge curves can also provide information about overtime and cross-country labor
market differences:
• Germany: Beveridge curve shifts closer to the origin due to:
o Reforms: guidance to unemployed workers and earlier reduction in unemployment benefits.
• United States: Beveridge curve shifts away from the origin due to:
o Skills-based mismatch: 2008-09 crisis affected housing industry, for example.
o Limited worker mobility: housing bubble prevented workers from selling their houses and relocating.
13.3 LONG-RUN LABOR MARKET MODEL
In the long run, we know that unemployment depends on how good policies and institutions approach the two main
incentives problems of a capitalist economy:

 Work incentives – getting salaried workers to work hard – depends on wage-setting curve.
 Investment incentives – getting business owners to invest in creating jobs instead of investing abroad or using
their profits to buy consumer goods and not invest at all – depends on price-setting curve.
Now, we are going to extend the long-run labor market model allowing that companies enter and exit the market, as
well as letting that companies increase or reduce capital stock.
To simplify, we assume:
1. Companies have a certain size and the quantity of capital increases or decreases, augmenting or reducing the
number of companies in the market.
2. There exists constant returns to scale (percentage increases in employment are equivalent to increases in stock
capital).
The long-run equilibrium in the labor market is the situation in which not only real wages and employment level are
constant, but also the number of firms as well.

 Profit margin determines the number of companies in the market, as it determines the expected net profit:
o If Profit margin is low, number of companies decrease. When there are many companies,
competition increases, elasticity of demand is high, and profit margin is lower
▪ Companies leave the market and profit margin tends to increase.
o If Profit margin is high, number of companies increase. When there are few companies, competition
is low, and profit margin is high
▪ Companies enter the market attracted by high profits, and economy is more competitive.
This means that there is a self-correcting process through profit margin, the number of companies varies until the
equilibrium profit margin is reached.
Summarizing:
↑ profits → ↑ competition → ↑ elasticity of demand → ↓
markup → ↓ firms
Equilibrium profits that determine the number of firms
in the market can change:
Suppose legislation to improve business environment
(e.g.: lower risk of expropriation or compromise to not
increase taxes)
This will make it profitable for more firms to enter the
market, which will lower equilibrium markup.

13.3.1 REAL WAGE

Real wage (𝑤) is defined as whatever is produced but not retained as profit. It depends on two variables: let productivity
(𝜆) and equilibrium profits/markup (𝜏):
𝑳𝒐𝒏𝒈 𝒓𝒖𝒏 𝒑𝒓𝒊𝒄𝒆 − 𝒔𝒆𝒕𝒕𝒊𝒏𝒈 𝒄𝒖𝒓𝒗𝒆: 𝑤 = 𝜆(1 − 𝜏)

• The price-setting curve is higher if:

o Output per worker is high
o Markup is low:
▪ ↑ competition; quality of human capital/infrastructure
▪ ↓ expected long-run tax rates, risk of expropriation, opportunity cost of capital
Given the equilibrium profit margin (𝜏) in which there is no entrance nor exit of companies, and that the mean labor
productivity (𝜆), the real wage as the part of average labor productivity that companies keep through the profit
margin.
The long-run price-setting curve is given by the real wage: 𝑤 = 𝜆 ∗ (1 − 𝜏) such that there is no entrance nor exit of
companies. This curve is higher (= the resulted real wage of the profit margin is higher) when:
• The higher the average productivity of labor or product per worker

• The lower the profit margin with which the inputs and outputs of companies are zero, which depends on:
o Higher competition
o Lower risk of expropriation
o Better human capital and better infrastructure
o Lower expected long-term tax rate
o Lower opportunity cost of capital

13.3.2 REAL WAGES AND LONG RUN UNEMPLOYMENT

The introduction of a new technology in the market on the
long term, has not provoked an increase in unemployment, but
an increase in real wage.
On the short term, there are job losses, but the application of
new technologies implies additional investments that, sooner or
later, will lead to the creation of new jobs.
New technologies, can, finally, increase as much as real wages,
and as much as long term employment.
HOW DO WE GO FROM EQUILIBRIUM A TO B
When we analyze going from one equilibrium to the other, we must take into account that the economies are going to
be different in terms of diffusion and fit gaps.

 Diffusion gap: time between the introduction of an innovation and its widespread use. The diffusion gap marks
the speed at with the price-setting curve displaces upwards. In other words, the lag between an outside change
in labor market conditions and the movement to new equilibrium.

 Fit gap: time between a external change in the labor market conditions and movement to new equilibrium. In
other words, time it takes for the economy to adopt an innovation.
In the case of the graph shown before, in the short term, new technologies generate unemployment (from A to D). As
in D there is higher profit margin for companies, new ones will enter the market, investment will increase (from D to E).
Finally, as in E unemployment is lower, companies must fix higher salaries to incentivize workers to work harder, until
we reach equilibrium in B.
The size of these gaps depends, in the labor market model, on how labor and trade unions act, but it also depends on
how institutions and public policies act, which may be:

• Positive effects through job searching services, training and professional recycling, and also from competition
and market regulations which facilitate implementing new businesses.

• Negative effects through the protection with subsidies, rescues… of low productive companies, and with the
employment protection laws which make layoffs be more expensive for the company.
However, as we saw before, data indicated that unemployment does not decrease in a world with continuous
technological progress. The reason for this is that there are forces which make an upwards displacement in the
wage-setting curve such as union negotiation or unemployment benefits.
TECHNOLOGICAL PROGRESS AND WAGE INEQUALITY
Short term: going from A to D, inequality increases because of:
1. The number of workers with low-income increases.
2. Only companies obtain profits from new technologies → participation
of employers in the product increases and the wage participation of
employees decreases.
Long term: when the new equilibrium is reached, B, inequality decreases,
given that both workers and companies are benefiting from the new
technology.
• Even if wage participation returns to the initial level, now the real
wages are higher and unemployment is lower.

13.3.3 SHORT vs LONG-RUN

Short run Long run

Change A→D A→B

Employment ↑ ↑

Unemployment ↑ ↓

Wage share ↓ no change

Inequality ↑ slightly ↓

Number of firms and capital Outcome adjusts fully to new equilibrium of the model (B)
stock are fixed where there is no change in the wage-setting curve

Net job destruction Net job creation

There is no exact timeline that defines the long run. We distinguish the short and long run by a set of circumstances:

• If we have some production factors that cannot be changed (e.g.: capital) we know we are in the short run

• The long run could be seen as a period where everything is variable, so the economy can fully adapt and
accommodate the effects of shocks attaining a stable equilibrium.
13.4 THE ROLE OF INSTITUTIONS AND POLICIES
A “positive” economic performance implies a low unemployment and a high real wage per hour. If we situate ourselves
in a dynamic environment, and evaluating the economy during many years, a positive performance must combine a
rapid growth of real wage per hour, with a low unemployment rate.
To reach a positive performance, the economy must:
1. Be sure that the price-setting curve raises more than the wage-setting curve, so that we guarantee both real
wage and employment increase
2. Adjust rapidly so that the entire economy can benefit from technological progress
However, when we compare outcomes between 1970 as
2011, it is clear that some countries managed to do
better than others – this is due to the country
characteristics, namely their institutions and policies.

The chart shows long-term performance for several

advanced economies. A 40-year period is considered to
avoid the analysis being affected by the phases of the
economic cycle.

Policies and institutions make a difference, but there is no magic formula to guarantee a positive performance.
LABOR AND TRADE UNIONS
• Inclusive labor unions, which represent workers in many sectors, choose not to exercise the highest
bargaining power, and consider that high wage raises affect job creation in the long term.
o Not inclusive labor unions can negotiate wages without considering the effect on the long term, nor the
effect of their negotiations on other workers on other sectors.

• Inclusive trade unions, which represent firms in many sectors, consider the interests of many companies,
including those that could compete with the already established ones.

13.4.1 INCLUSIVE AND EXCLUSIVE UNIONS: DIFFERENCES BETWEEN COUNTRIES

Norway´s case: success for inclusive unions
This inclusive behavior is exactly the one which labor and trade unions showed in Norway and other Nordic countries.
Its centralized salary negotiation insisted in fixing a common salary for a specific type of work, depriving the low
productivity companies accessing to cheap labor, and pushing many of them to closure.
As workers started relocating to jobs in more productive companies, the main impact was an increase in average labor
productivity, which made the price-setting curve to raise as well, and this made higher wages to appear.
It was only when labor unions took advantage of the bargaining power that a low unemployment rate, a high union
affiliation rate, and their capacity to put salary agreements into practice, that productivity increased in all economy.
In conclusion:
1. Countries that implement generous and well-designed unemployment insurance systems, coordinated with job
placement services and other active labor market policies, can achieve low unemployment rates.
2. Giving people opportunities to stabilize their consumption can make them more willing to adopt new
technologies, which will shift the price-setting curve upwards.
Spain´s case: failure for exclusive unions
In Spain, labor unions protect jobs, with the backing of government intervention. They are strong enough to exert power
against firms, but not inclusive. A combination of non-inclusive and government intervention which protects jobs
rather than workers may help account for “poor” labor market performance.
Inclusive trade unions in Norway mitigate
“unsustainable” increases in wages (preventing high
unemployment)

• Active labor market policies help mitigate labor

market mismatch and reduce unemployment
(and length of unemployment spells) seemed to
be insufficient in Spain.

• The different structure of both labor markets can

be illustrated with the corresponding Beveridge
curves.

13.4.2 CHANGES OVER TIME

Institutions and policies make a bid difference for
employment and wage growth, however they are not
static, particularly in the long-run:
Changes in policies can help attain long run equilibrium faster. However, such changes are often difficult because they
create winners and losers (social consensus is not always easy).
Netherlands and UK -neither high or low performers- experienced increases in unemployment during the 1970s, due to
higher oil prices and higher bargaining power of labor.
 Both countries managed to shift the wage-setting curve down:
o Netherlands made institutions more inclusive (as in Norway)
o UK reduced the power of non-inclusive unions (highlighting the key role of Margaret Thatcher).
CHANGES OVER TIME: ECONOMIC STRUCTURE
Adjustment to shocks and the interplay with institutions and policies also depends on the structure of economic
activity. Nowadays, fewer than 1 in 20 workers in rich economies work in agriculture.

 As countries get richer: the share of labor devoted

to agriculture declines, in favor of an increase in the
importance of manufacturing, and then in services.
o This has consequences in terms of
productivity growth.
The impact of labour force shifts within large sectors of
economic activity can be illustrated graphically:

Regarding this graph to the left:

In point A people consumed the same share of goods and
services (50% each)
Increased productivity expands the feasibility set:
You now produce more goods with same inputs
If consumption patterns do not change, economy moves to
point B.
Labor shifted from the production of goods to services. There are important factors not being included in the previous
model:

• Productivity increase in some services (productivity advances were high in some sectors)
• Substitution of consumption of services by goods (if relative price of a good falls, consumers typically increase
proportion consumed, which requires higher employment to produce)

• Increase in relative demand for services (as income rises, people may choose to spend more of their budget
on services)

• Import and export patterns (international trade and opportunities affect which sectors grow or decline)
DETERMINANTS, INSTITUTIONS, POLICIES AND SHOCKS THAT AFFECT LONG-RUN UNEMPLOYMENT:
14. ECONOMIC INEQUALITY
14.1 TRENDS IN INEQUALITY
When analyzing economic inequality we usually calculate the Lorenz curves and estimate the Gini coefficient (see
3.6 for explanations). Moreover, we usually we discuss it in three dimensions:

• Wealth: value of the assets – liabilities of a household

• Market income: income from wages, businesses, and investments
• Disposable income: market income – taxes + transfers
Typically, inequality in wealth is much larger than in market income, which is also larger than in disposable income.
According to the data from the early 2000s, we see that:
1 – Wealth is distributed more unequally than market
income
2 – Market income is distributed more unequally than
disposable income
3 – A higher equality in disposable income could be due
to the extent to which the tax and transfers system
benefits the less economically favored.

14.1.1 GLOBAL INEQUALITY ACROSS TIME

Another way of measuring inequality would be to focus in the richest extract of the population, and compare what part
of the total income is owned by the 1% richest. This indicator allows to analyze inequality across time, and so:

1. During centuries XVIII and XIX → rising inequality in wealth.

2. During 1910 and 1980 → reduction in inequality
3. Since 1980 → high differences depending on the country analyzed
a. In Europe/Japan, it stabilizes
b. In US/UK, it increased
Some common trends in the period are that inequality in
wealth generally declined since 1900. In some
countries, like the US, it has resurged since 1990.
But the truth is that globally, inequality has declined; the
Gini coefficient declined from 0,71 to 0,62 (recall that the
closer to 0, the more equality).
This result is the combined effect of a drop in between-
country inequality, but also an increase in within-
country inequality. Look at the two graphs:

Drop is associated to the red

line: inequality between
countries if everyone average
income of the country (no within
inequality)
Increase is associated to
changes in job distribution.
As stated before, if we consider global inequality we consider not just inequalities inside countries, but also inequalities
between countries. Divergencies between countries come from when the hockey-stick growth happened.
The temporal differences in the development of the capitalist revolution meant an increase in inequality between
countries during the 19th and 20th centuries.
If a Lorenz curve were drawn for all individuals in the world and over the last few years and the corresponding Gini
indices were calculated (blue line), it would appear that, although global inequality is high, there is a downward trend.
Measuring inequality is complicated:
We need detailed information about income (preferably
components) for the whole residents in a country.
A common methodology relies on tax administrative
records and surveys to produce comparable statistics,
across time and countries.
Most of economic growth since the 80s was captured to
bottom 50% and top 1% of world income distribution.
The lower and middle classes of rich countries
experienced a reduction in income.
In the next pages, we discuss the different categories of inequality: categorical, intergenerational, and cross-sectional.

14.1.2 CATEGORICAL INEQUALITY

Categorical or group inequality refers to economic differences among people who are treated as different categories.
Schooling and lifetime earnings for men and women in the US. Generally, the result of ‘accidents of birth’:
- Country of citizenship
- Gender
- Ethnic group.

14.1.3 INTERGENERATIONAL INEQUALITY

Intergenerational inequality is the measuring of to which extent differences in generations of parents are transmitted to
children, and this means similar economic levels for parents and children.
The process of intergenerational transmission has different forms:

 Children inherit wealth from parents and receive their economic support
 Children inherit the genetic composition from their parents
 Parents influence in the unconventional education of the children and in the quality of their formal education.
Economists and sociologists measure international inequality building classifications of income and wealth from the
parents to compare with income and wealth that their children have later on.Data confirms that there exists a
significant intergenerational inequality.

 Intergenerational elasticity in income or wealth is the difference between the status of the second generation
associated with a 1% difference in the status of the first generation.
o It measures how richer is the son compared to the wealthy father with respect to the son of the poor
father
o The more intergenerational elasticity, the higher is the intergenerational transmission of the economic
status and the lesser is the intergenerational mobility between the different status.
14.1.4 CROSS-SECTIONAL INEQUALITY
Inequality in earnings tends to be positively correlated with intergenerational inequality. Possible reasons:
1. Societies with strong culture of fairness tend to have policies that:
a. Reduce cross-sectional inequality (among individuals of the same country in the same period)
b. Promote intergenerational mobility
2. Effects of good/bad luck shocks are passed on to the next generation, increasing connection with cross-
sectional inequality.
Inequality in earnings in income is a given moment and is measured with the Gini coefficient for income. In general,
data show that inequality in income tends to be positively with intergenerational: in any given moment in time,
inequality in earnings tends to be greater when intergenerational inequality is also high.
This positive correlation can be explained because countries with a strong equity culture (such as Denmark):
- Adopt policies to reduce cross-sectional
inequality, such as high social benefits to retired
or unemployed people
- Offer equal opportunities to access a high-quality
education to reduce intergenerational inequality.
It could also be due to those countries in which
there is a significant intergenerational inequality
(like in the US), effects of good/bad ‘luck’ shocks
are passed on to the next generation, increasing
connection with cross-sectional inequality.

14.2 EVALUATING INEQUALITY

Most people believe some inequality is acceptable, but there is a problem if there is too much of it. A survey conducted
in the US assesses how different groups perceive inequality:

• Ideal wealth distribution is not egalitarian

• Wealthier people tend to accept higher levels of inequality.
One of the reasons that inequality is considered a problem is that many people believe that there is too much inequality.
According to surveys, the actual distribution of wealth is much more unequal than the distribution that people think exists
and, in turn, this estimated distribution contrasts with the lower inequality that people would consider adequate.
On the other hand, in all countries redistributive policies of income and wealth generate controversies. It is not just a
question of whether one is rich or poor, but also one's beliefs about why the poor are poor and how the rich got rich.
Although opinions about whether inequality is “unfair” depend in part on individual interest, they are
fundamentally based on individual beliefs about how income distributions arise.
A person who believes that hard work and risk-taking are essential to economic success is much less likely to support
pro-poor redistribution than someone who believes that inheritance, having good connections…
The vast majority of people believe that categorical
inequality is unfair and that efforts should be made to
mitigate it, but they do not think that inequalities based
on working hard and taking risks can be a problem.
We can confront this with the estimated and actual wealth
inequality:
People estimate inequality is above their ideal preferences.
In reality, wealth inequality is even higher.
 Opinions about whether inequality is unfair, depend on
individual beliefs abbot how current distributions were
generated.

 Many people think categorical inequality is “unfair” and

should be addressed [higher support for redistribution].

 Less people believe inequality based on hard work or

taking risks should be addressed [lower support for
redistribution].

14.2.1 MODELLING PREFERENCES OVER INEQUALITY

In the experiment, we consider two groups: poor and rich. The individual has to decide how much inequality must be
between the rich and the poor, and then we determine to which group are we going to belong by throwing a coin.
According to Rawls: 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 = 0,5 ∗ 𝑖𝑛𝑐𝑜𝑚𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑜𝑜𝑟 + 0,5 ∗ 𝑖𝑛𝑐𝑜𝑚𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑟𝑖𝑐ℎ

 Even if we leave aside the categorical inequality, and there were equal conditions in the starting point, one
fundamental question would still have to be considered: how much richer should the rich be than the poor?
For the analysis, we use the veil of ignorance of Rawls, with which we must choose a social contract without knowing
in which position of the society are we going to be.
We can model the target inequality in a society using two components:
1. Feasible set: trade-off between income for the rich and the poor (MRT)
2. Indifference map: social preferences toward inequality (MRS)
The feasible set includes all possible income distributions between the rich and the poor.

 In point E the poor and rich would receive the same income and would be the maximum possible. At this point,
equality would be complete, but there are no incentives to work, study and take risks by innovating and
investing.

 In point R (preferred for Rawls), the poor receive the maximum income they can get in this economy; R would
be Pareto higher than E, since both poor and rich would be better off.
Preferences over inequality reflect society
satisfaction with different combinations for the rich
and the poor: the slope of the IC depends on the
degree of inequality aversion in the society.
Inequality aversion: means that you only care about
own payoffs, but dislike inequality between groups.
The optimal choice is where MRS = MRT. Points on
the arcs DF and ER are Pareto inefficient.
If preferences are represented by the IC in the figure:
B is the equilibrium, where society expects the
government to put policies in place (redistribution and
others) to attain this distribution.

If individuals were concerned only with their own income, the I.C. would be straight with slope = −1 and the preferred
point would be A.
If individuals not only care about their own income but also dislike inequality between groups, they might have strictly
convex indifference curves (like the ones in the graph) and choose a point like B.
14.3 EXPLAINING INEQUALITY
An individual´s income depends on 2 main components:

 Endowments: facts about an individual that may affect income (e.g.: wealth, financial strength physical assets,
education…)
 Value of each component of the endowment, which is also affected by two aspects:
o Technology: mechanization of tasks, economies of scale…
o Institutions and policies: taxes on inheritance, access to education....

Economic Inequality is caused by changes in institutions, technology and by the differences in

endowments, which are also transmitted from generation to generation.

For any individual, endowments, and income that it can obtain change continuously as they acquire new abilities, or the
value of any endowment changes.

Importantly, current levels of economic inequality can affect institutions, policies, technology, and endowments in the
future (as showed in the graph above). Let´s see some examples:
1. Rich people commonly have better access to politicians, and can influence policies in their favor.
2. Wage regulations can mitigate inequality, but increase costs for firms, and thus, be an incentive for
improvements in technology that allow for increased automation in the future.

14.3.1 SOURCES OF ECONOMIC INEQUALITY

Another source of inequality has to do with the
balance of power in principal-agent interactions.
Differences in endowments determine the
capacity to convert oneself into principle or
agent.

• In principal-agent interactions, principals can exercise power over agents, but agents lack power over principals,
and this is translated into economic inequality.
Individuals can use their wealth to lend money to others or to buy capital goods. If one is rich, it can be a lender =
principal in the credit market, as an employer = principal in the labor market.
INCREASED WORKER´S PRODUCTIVITY
Inequality may decline if workforce productivity grows, for instance because of increased education level: this may
be achieved by increasing compulsory schooling age. Effect of higher education levels is illustrated with the labor market
At the initial wage, firms make higher profits with more educated workforce.
- New firms are attracted to the market, reducing unemployment.
- With higher employment, cost of losing job is smaller, so wages must increase.
 - Less unemployment and higher wages lead
to lower inequality.

Inequality can be reduced with reduced labor market segmentation. One

source of segmentation are permanent vs temporary workers.

• Primary labor market: “good” jobs, with high wages, job security
and trade unions.

• Secondary labor market: short term contracts, limited wages, and low job security.
Eliminating or reducing segmentation raises average wages and reduces inequality.
AUTOMATION
The automation of work implies the introduction of new technologies, which allow machines to do the work which was
made by people before.
In the short run, inequality increases, given that:
• Machines replace routine labor = increase in unemployment

• Workers with complementary skills with technology earn higher wages

In the long run, the model cannot predict if inequality increases or decreases, given that:

• Higher unemployment = cost of job loss = lower wages

• High productivity = higher profits = incentive to invest = new job creation = low unemployment = higher wages
Active labor market policies help in incentivizing employment.

14.4 ADDRESSING UNFAIR INEQUALITY

14.4.1 GOVERNMENT POLICIES
Governments influence the degree of economic inequality in two ways:
1. REDISTRIBUTION. This is done through taxes and transfers that allow to reduce the differences in disposable
income of households; and also through expenditure to provide for public services for everyone.

• In-kind/physical transfers: disposable income does not include indirect taxation (such as VAT – IVA)
nor a measure of all public services that are free or subsidized such as public healthcare.

• When we account for indirect taxation and physical transfers we reach the final income, the most
complete measure of the living standards.
The set of policies that convert market income into final income constitute the welfare state.
▪ When direct effect is a reduction in inequality, system is progressive.
▪ When direct effect is an increase in inequality, system is regressive.
In general, monetary, and in-kind transfers have a large impact on inequality. Expenditures and taxes can be
considered separately, but it is important to know that expenditures come from money collected through taxes.
 2. PREDISTRIBUTIUON. Measures that generate a higher equality on endowments and in the value of the
endowments to reduce inequality in wealth and in market income (before taxes and transfers).

• Predistributive policies include a better workforce training, and a reduction in market segmentation.
Another measure is defining the legal framework in which companies, employees and labor unions
interact, such as legalizing unions, establishing a duration of patents…

• There is also legislation about hiring, such as minimum wage. Fixing a minimum wage affects the value
of the labor endowment of a certain group of workers, but it can also negatively affect the probability of
them finding employment.

ENDOWMENT POLICY DIRECT EFFECT INDIRECT EFFECT

Labor Free high quality Increases opportunities for poorer children Raises average productivity of labor,
primary education for to attain higher levels of schooling, shifting price-setting curve up, which
all children boosting market value of endowment increases wages and employment
labor. (ceteris paribus).

Labor Eliminate ethnic, Increases the value of the labor Raises incomes of targeted groups.
racial or gender endowment of those targeted by
discrimination discrimination.

Labor Minimum wage Increases value of labor endowments for Raises incomes of the poor and reduces
low earners. income of employers (unless employment
effect dominates).

Labor Policies to increase Increases value of labor endowments of Raises income of trade union members
worker´s bargaining trade union members and improves (unless negative employment or
power working conditions. productive effects dominates) and
reduces incomes of employers.

Ownership of Policies to stimulate Reduces price markup. Raises real wages and reduces profits.
firms competition

Intellectual Restrict Reduces value of endowment of May discourage innovation but enables
property patents/copyrights intellectual property among holders. quicker diffusion of innovation.

Professional Allow easier access to Increases supply and reduces income of Greater equality (if license holders are
license licenses license holders. richer than average).

14.5 TRENDS IN INCOME INEQUALITY

Declining within- 1. Increased education and productivity decreased unemployment

country inequality
2. Reduced labor market segmentation and other sources of inequality amongst workers
(1920 – 1980)
3. Technological improvements complementary to low/middle skilled workers

Stable or rising 1. Increased inequality among workers due to technological improvements that were complementary to
within-country skills of high earners and substitutes for workers in routine tasks.
inequality (1980 –
2. Weaker trade unions and conservative parties led to increased power of employers, but higher profits
2017)
did not translate into overall social benefits

Stable or 1. Reduced global labor market segmentation due to rapid growth of labor productivity and demand in
decreasing China and other poorer countries.
between-country
inequality (1995 –
2017)

On the other hand, according to data, GDP per Capita growth, and the degree of economic performance does not seem
to be related to the level of inequality.
▪ This result contradicts the claim by many economists that high taxes and transfers reduce incentives for effort
and innovation.
Some Asian countries such as Japan, Korea, Taiwan, and the Nordic countries appear to have achieved high
performance and benefited from lower economic inequality:
  The cooperation and trust necessary for the production of knowledge and support services are more difficult to
maintain with high inequality.
 Policies that improve the endowments of the poor and increase the value of those endowments, such as access
to high-quality education or public health, improve productivity.

 Fewer resources need to be diverted that can be used in productive activities instead of protecting and policing
the assets of the rich

14.6 INEQUALITY AND ECONOMIC GROWTH

There is no strong evidence of correlation between country-level inequality and economic growth:

There is also no evidence that high taxes and transfers necessarily reduce incentives to work hard or innovate. Lower
inequality has several benefits such as inducing trust, cooperation, social peace, security and boosted productivity.

14.7 A GLIMPSE ON POVERTY

A separate but close discussion on asymmetries in living conditions regards poverty, which is defined as a situation
where a person, or a household, does not have enough resources to satisfy their basic needs. Two types of poverty:

Absolute poverty According to UN: “condition of severe deprivation of basic needs, including food, safe drinking water,
sanitation facilities, health, shelter, education and information”.
It is more relevant in poorer countries.

Relative poverty The condition depends on the socio-economic context. Generally it is measured relative to the income
distribution in a region or country.
It is more relevant in richer countries. Eurostat: at risk of poverty are people whose income is 60% below
the median disposable income.

In recent years, we also have other

dimension to measure poverty. For
example, people at risk of poverty or
social exclusion is the share of people
living in households in: monetary
poverty, severe material deprivation or
with low labor intensity.