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The Economy — CORE Textbook
Complete study summary: Units 1 & 2
UNIT 1 — The Capitalist Revolution
How capitalism revolutionized the way we live, and how economics attempts to understand this and other economic systems.
Overview: the hockey-stick graph
- For most of human history, living standards barely changed — shown by the flat ‘handle’ of the hockey-stick graph of GDP per capita over time.
- Around 1700–1800, Britain experienced a sudden, permanent rise in living standards — the ‘blade’ of the stick — followed by other countries at different times.
- The same hockey-stick pattern appears in labour productivity, the speed of information travel, and atmospheric COn — all surging after the Industrial Revolution.
- Linear scale : best for comparing income levels across countries. Ratio (log) scale : best for comparing growth rates — a constant growth rate appears as a straight line; a steeper line means a faster rate.
- Growth rate = (change in income) ÷ (original income). Example: Britain’s GDP per capita rose from $31,946 to $32,660 in one year = a 2.2% growth rate.
Income inequality and measuring living standards
- 1,000 years ago, income differences between countries were small; differences within countries (rich vs. poor) were far more striking — what any traveller at the time would notice.
- Today, enormous gaps exist across countries (Norway earns ~19× Nigeria’s average) and within them (rich/poor ratio: Norway 5.4; USA 16; Botswana 145).
- GDP per capita = total market value of final goods and services ÷ population. Useful for comparisons but ignores inequality, unpaid work, public services, and environmental quality.
- Disposable income = wages + transfers − taxes. Better for individual welfare, but misses government-provided goods like healthcare and education.
- To compare across time: use real GDP (adjust for inflation using base-year prices, so changes reflect actual output). To compare across countries: use PPP prices — a common international price set that corrects for price-level differences (e.g., a cappuccino costs $3.90 in Stockholm but $2.63 in Jakarta; PPP narrows that gap).
- Absolute income matters for wellbeing, but so does relative income — people report lower wellbeing when they earn less than others in their reference group, even at the same absolute level.
Capitalism: the three core institutions
- Private property : the right to own, use, exclude others from, and sell an asset. Capital goods (machines, buildings) are a key form of private property in capitalism.
- Markets : voluntary, reciprocated, competitive exchange of goods or services. They differ from theft (involuntary), gifts (non-reciprocated), and central planning (non-voluntary assignments).
- Firms : private owners hire wage labour, direct production, and sell output for profit. Distinct from family businesses (unpaid labour), cooperatives (worker-owned), non-profits, and government entities. Firms can grow or collapse rapidly — creating a performance discipline absent in families and governments.
- Other economic systems: centrally planned economy (government controls production and distribution — e.g., Soviet Union); slave economy (workers are property, not wage earners); feudalism (lords and serfs). Most economies today are capitalist, but vary greatly.
- Capitalism combines centralisation (power concentrated within firms, owners direct workers) with decentralisation (firms compete in markets, limiting any single firm’s power). This drives both internal cooperation and external innovation.
- Capitalism encourages growth through: (1) competition-driven technology adoption — firms that adopt better technology earn higher profits; and (2) specialisation via the division of labour — focusing on narrow tasks raises total output per worker.
Adam Smith and the foundations of economics
- Adam Smith (1723–1790) is considered the founder of modern economics. Key work: An Inquiry into the Nature and Causes of the Wealth of Nations (1776).
- Invisible hand : individuals pursuing their own self-interest are, as if guided by an invisible hand, led to promote society’s broader interest — economic coordination arises spontaneously without central direction.
- Division of labour : Smith’s pin factory — 10 men each specialising in 1–2 of 18 operations could produce ~50,000 pins per day; working separately, perhaps not even 1 each. Specialisation is limited by the ‘extent of the market’ — you can only specialise if markets are large enough to absorb your output.
- Smith warned against monopolies (e.g., the East India Company) and collusion: people in the same trade ‘seldom meet together... but the conversation ends in a conspiracy against the public.’ He supported government investment in education and infrastructure — not a simple free-market ideologue.
Gains from specialisation and comparative advantage
- Reasons to specialise: learning by doing (skills improve with practice), differences in ability (natural talent or geographic endowments), and economies of scale (larger output reduces average cost).
- Absolute advantage : producing more of a good than another party with the same inputs. Comparative advantage : having a lower opportunity cost of producing a good. Even if one party has an absolute advantage in everything, both gain by specialising in their comparative advantage and trading.
- Example — Greta and Carlos: Greta is more productive in both wheat (2.5× better) and apples (1.25× better). Greta’s comparative advantage is wheat; Carlos’s is apples. By specialising and trading, both end up consuming more of both goods than under self-sufficiency.
Income remaining after taxes are paid and government transfers received. The maximum a person can spend or save without borrowing.
Real GDP GDP adjusted for inflation by valuing output at base-year prices, so changes reflect actual quantities produced rather than price increases.
PPP (purchasing power parity) A common set of international prices used to compare living standards across countries, correcting for the fact that money buys different amounts in different countries.
Growth rate The proportional change in a variable: (new value − old value) ÷ old value. Allows comparison of how quickly different economies are improving over time.
Ratio (log) scale A vertical axis where equal distances represent equal percentage changes. A series growing at a constant rate appears as a straight line; a steeper line means a faster growth rate.
Private property The right to own, use, exclude others from, and sell an asset — including capital goods such as machines and buildings. Essential for investment incentives.
Markets Voluntary, reciprocated, and competitive exchange of goods or services. Both buyer and seller must consent; competition limits the power of either side.
Firms Organisations where private owners hire wage labour, direct production, and sell output for profit. Can grow or fail rapidly, creating strong performance discipline.
Centrally planned economy An economic system where the government decides what is produced, how, and for whom. Private property and markets play little role — e.g., the Soviet Union.
Institutions The laws and informal rules that regulate social and economic interactions — the ‘rules of the game’ that shape incentives and behaviour.
Absolute advantage A producer has absolute advantage if it can produce more of a good than another using the same inputs.
Comparative advantage A producer has comparative advantage in a good if its opportunity cost of producing that good is lower than another’s. The basis for mutually beneficial specialisation and trade.
Economies of scale When doubling all inputs more than doubles output, so average cost falls as the scale of production increases.
Industrial Revolution The wave of technological and organisational change beginning in 18th-century Britain that transformed production from agrarian and craft-based to commercial and industrial.
Capitalist revolution The emergence of capitalism combined with the permanent technological revolution, together producing sustained increases in living standards for the first time in history.
Developmental state A government that takes a leading role in directing economic development — setting industrial strategy, subsidising key sectors, and investing in education — e.g., South Korea.
Democracy A political system giving equal political power to citizens through individual rights, free elections, and accountable government that leaves office if it loses.
UNIT 2 — Technology, Population, and Growth
How improvements in technology happen, and how they sustain growth in living standards.
Economic models
- A model is a simplified representation that highlights essential features of a situation while ignoring irrelevant details — like a map. The goal: see more by looking at less.
- Good models: (1) are clear — improve understanding; (2) predict accurately — consistent with evidence; (3) improve communication — clarify what people agree or disagree about; (4) are useful — suggest ways to improve outcomes.
- Model-building steps: (1) describe simplified conditions; (2) describe decision rules; (3) determine how actions interact; (4) find the equilibrium (a self-perpetuating outcome); (5) study what changes when conditions change.
- Ceteris paribus (‘other things equal’): hold all variables constant except the one being studied, to isolate its effect. Example: to study how wages affect technology choice, assume all firms face the same input prices and know each other’s technologies.
- Equilibrium : a model outcome that does not change unless an external force disturbs it. Deviations are self-correcting. Example: subsistence income is a Malthusian equilibrium — incomes above it cause population growth that pushes them back down.
Technology choices: isocost lines and relative prices
- A technology is a recipe specifying the combination of inputs (e.g., labour and energy) needed to produce a given output. Technologies differ in how labour-intensive or energy-intensive they are.
- A technology is dominated if another technology produces the same output using less of every input. Dominated technologies would never rationally be chosen and can be ruled out immediately.
- Isocost lines connect all input combinations that cost the same total amount. Their slope = −(wage ÷ price of energy). A firm minimises cost by choosing the technology on the lowest isocost line it can reach.
- Only relative prices matter for the technology choice, not absolute prices. If both wages and energy prices double, the isocost slope is unchanged and the same technology is chosen.
- When wages rise relative to energy prices, isocost lines become steeper → energy-intensive (labour-saving) technologies become relatively cheaper → rational firms switch to them. This is the
- Pillar 1 — Diminishing average product of labour : as more workers farm a fixed amount of land, each worker adds less output, so average output per worker falls. Bringing in new (worse) land reinforces the decline. This is represented by the production function — a curve that rises at a decreasing rate as labour increases.
- Pillar 2 — Population responds to living standards : when income rises above subsistence, birth rates rise and death rates fall, so population grows. When income falls below subsistence, population shrinks. The income level at which population is stable is the subsistence level.
- Together: technology improvement raises incomes temporarily → population grows → more workers on same land → diminishing returns → incomes fall back to subsistence. Long-run result: larger population, same low wages. The Malthusian trap.
- The production function shows output as a function of labour input (holding land fixed). The slope of a ray from the origin to a point on the curve equals the average product of labour at that point — which decreases as more labour is added.
Historical evidence: the Black Death and Malthusian cycles
- The bubonic plague (1348–51) killed roughly one-quarter to one-third of Europe’s population. Economic result: fewer workers on the same land → higher average product per farmer → wages rose sharply.
- King Edward III tried to cap wages by law (Statute of Labourers, 1351), but wages kept rising. Workers used their new bargaining power in the Peasants’ Revolt (1381) — economic forces outweighed political ones.
- By the mid-15th century, real wages of English building workers had doubled. As population recovered through the 16th century, wages fell back. By 1600, real wages had returned to pre-plague levels — exactly as the Malthusian model predicts.
- In the Malthusian world, landowners benefit from population growth (higher food demand → higher rents). In 17th–18th century England, unskilled wages relative to landowner incomes were only one-fifth of 16th-century levels.
- But crucially: while wages were low relative to landowner rents, they remained high relative to coal and were rising relative to the cost of capital goods — the exact conditions that made labour-saving machinery profitable and sparked the Industrial Revolution.
Escaping the Malthusian trap
- Malthus was wrong about one thing: he did not consider that technology could improve faster than population grows, permanently offsetting diminishing returns. That is exactly what happened.
- Around 1800, British data show a new pattern: both population and real wages rising simultaneously — an ‘escape’ from the Malthusian trap. The permanent technological revolution had broken the vicious circle.
- Mechanism: the spinning jenny, steam engine, and subsequent innovations raised output per worker → profits surged → firms expanded. But initially, displaced workers flooded labour markets, keeping wages flat from ~1750 to 1830 even as productivity grew rapidly.
- From the 1830s, wages began rising. Key factors: (1) Factory Acts (1833, 1844) and the Ten Hours Act (1847) restricted child and female labour, reducing labour supply; (2) factory demand for workers increased; (3) workers gained political voice through expanding voting rights (all men by 1918,
universal suffrage by 1928) and trade unions, raising their bargaining power and share of productivity gains.
- Countries escaped the trap at different times and via different routes. Later industrialisers (Germany, Japan, South Korea) were shaped by their own institutions, geography, and by Britain’s existing global dominance — they could not simply copy the British path.
Key concepts — Unit 2
Economic model A simplified representation of economic reality focusing on essential features and ignoring irrelevant details, used to analyse and predict outcomes.
Equilibrium A self-perpetuating model outcome: key variables do not change unless an external force disturbs the system, and deviations are self-correcting.
Ceteris paribus ‘Other things equal.’ Holding all variables constant except the one being analysed, to isolate its specific effect on the outcome of interest.
Incentives Economic rewards (profits, higher wages) or penalties (losses, bankruptcy) that influence which actions people and firms choose to take.
Relative prices The price of one input or good expressed as a ratio to another. Firms’ technology choices depend on relative, not absolute, prices.
Technology A process (recipe) specifying the combination of inputs required to produce a given output. Technologies vary in how labour-intensive or capital/energy-intensive they are.
Dominated technology A technology that uses more of every input than another technology to produce the same output. It would never be rationally chosen.
Isocost line A line connecting all combinations of inputs (e.g., workers and coal) that cost the same total. Its slope equals minus the relative price of labour (wage ÷ energy price).
Economic rent Any benefit received above what one would get in their next-best alternative (reservation option). A positive rent means the action is worth taking.
Reservation option A person’s or firm’s next-best alternative if they do not take a particular action. Also called the fallback option. Sets the baseline for measuring economic rents.
Innovation rent The extra profit earned by a firm adopting a cost-reducing technology before competitors copy it. The key incentive for technological progress under capitalism. Also called Schumpeterian rent.
Creative destruction
