Complete teaching guides for units 1–10 of The Economy 2.0: Microeconomics, plus the list of building blocks. This page is structured for machine reading.
How this page is organised
The Economy 2.0 – Microeconomics contains a new feature called “building blocks”. These are self-contained sections or groups of sections that explain certain concepts and techniques. Where building blocks are used in later units, a hyperlink is always provided there which opens the required material in a separate tab, making it easy for students to read the prerequisite material, either to provide the necessary background knowledge when the unit it comes from has not previously been covered, or to refresh their memories. Building blocks are designed to provide instructors with greater flexibility in the way the course is structured, because prerequisite knowledge is easily identifiable.
The use of building blocks in The Economy 2.0 – Microeconomics makes it easier for instructors to customize the structure of their class to suit their specific audience and context. There are only two cases where a whole unit is required as a prerequisite for another unit. These units are as follows:
| Prerequisite Units | Where used as a prerequisite |
|---|---|
| Unit 1 | Unit 2 |
| Unit 7 | Unit 8 |
| Unit | Section(s) | Title of Building Block | Where required? | Where linked as optional reading? |
|---|---|---|---|---|
| 1 | 1.6 | Production functions and the diminishing average product of labour | None | 5.4 |
| 1 | 1.8 | Capitalist institutions | None | None |
| 2 | 2.2 | Economic decisions: Opportunity costs, economic rents, and incentives | Unit 3 | 3.4, 5.6, 6.7, 6.8, 7.4 |
| 2 | 2.3 | Comparative advantage, specialization, and markets | None | 6.1 |
| 2 | 2.4 | Firms, technology, and production | None | None |
| 2 | 2.8 | Economic models: How to see more by looking at less | Unit 3 | 4.3, 9.11 |
| 3 | 3.2, 3.3, 3.4, 3.5 | Constrained choice problems | Section 4.7, Unit 5, Unit 6, Unit 7 | None |
| 3 | 3.2, 3.3, 3.4, 3.5, 3.6 | Constrained choice problems, and how choices change | Unit 9 | None |
| 3 | 3.7 | Income and substitution effects | None | 9.4, 9.7 |
| 4 | 4.2, 4.3 | Game theory and Nash equilibrium | Section 6.9 | None |
| 4 | 4.2, 4.3, 4.4 | Game theory, Nash equilibrium, and the prisoners’ dilemma | Unit 5 | None |
| 4 | 4.2, 4.3, 4.13 | Game theory, Nash equilibrium, and coordination games | None | 7.10, 8.9 |
| 4 | 4.5 | Evaluating outcomes: The Pareto criterion | Unit 5, Unit 10 | 7.7, 8.5 |
| 4 | 4.11 | The ultimatum game | Unit 5 | 5.2 |
| 5 | 5.12 | Measuring economic inequality: The Gini coefficient | None | 9.10 |
| 6 | 6.6 | Contracts, principals, and agents | Sections 9.9, 10.8 | 8.5 |
| 6 | 6.10, 6.11 | The wage-setting model | None | None |
| 7 | 7.4 | The cost function: Marginal and average cost | Unit 10 | None |
| 7 | 7.5 | Demand, elasticity, and revenue | None | None |
| 7 | 7.7 | Gains from trade: The surplus and how it is divided | Unit 10 | None |
Conceptual prerequisites:
Building blocks in this unit:
Unit overview: For many students, this unit will be the first material they encounter in an economics course. It takes a big picture view, examining per capita GDP around the world and over a long period of time. The unifying concept is the “hockey stick” diagram (Figure 1.1).
Units 1 and 2 should be considered together, as unit 1 introduces several threads that are tied together in unit 2 (which introduces models that help explain why the Industrial Revolution took place when and where it did).
Section 1.2 – the hockey stick, changes in GDP. Section 1.3 – changes in CO2 and global temperatures. Section 1.4 – Global income inequality since 1980.
Key concept: GDP
A short introduction to GDP is provided here, while the macroeconomics volume of The Economy goes into more detail. The relationship between per capita GDP and living standards is discussed in the extension to this section, but it is optional and not required to understand the rest of this unit
https://www.core-econ.org/visualizations/ Students can construct their own “skyscraper” diagrams and compare countries according to some measures of inequality. The interface guides students through step by step while also providing flexibility so that students can explore different countries according to their interests.https://tinyco.re/3290463). Ask them to describe the trends they observe for these countries (such as levels of income, when the hockey-stick growth began, etc.) and compare them to the trends for the default countries shown in the chart.https://www.core-econ.org/doing-economics/book/text/04-01.html) gets students to look at GDP data and consider how well GDP measures wellbeing. The project has 2 parts: part 1 uses GDP data, part 2 discusses the Human Development Index as an alternative measurement of wellbeing. (Each part would be 1 week’s worth of work so instructors can pick/choose questions to set).(Section 1.5 – Technological change; Sections 1.6 and 1.7 – Flat part of the hockey stick; Section 1.8 – Capitalist institutions)
Key concept: Production function
this will be an important concept in later units so it is important to cover it here
https://www.pnas.org/doi/10.1073/pnas.1815663116) asked people how much they’d be willing to pay to give up modern technology for a year (see Figure 2 which has a lot of interesting examples). Instructors could run a similar poll. Alternatively, the two polls below could be used to help students think about how they value technological innovations, in particular Google. Display the aggregated results for the polls to discuss the importance of technology in our lives.Key concept: Average product of labour
students need to understand that the slope of a ray from the origin to a point on the production function shows the average product of labour for that quantity of labour input. They will also need to recognize that as these rays get flatter, moving further to the right along the production function (higher levels of labour input), this demonstrates diminishing average product of labour
https://www.core-econ.org/experiencing-economics/instructors/book/text/50-01-other-experiments.html#paper-aeroplane-productionhttps://www.economicsnetwork.ac.uk/themes/games/tennis%20ballsKey concept: Equilibrium
the Malthusian model demonstrates this important concept. Equilibrium is defined here as a situation or model outcome that is self-perpetuating. If the outcome is reached, it does not change unless an external force acts on it.
Key concept: Capitalist institutions
private property, firms, markets. Although many students are likely to be familiar with these terms, it is important for them to have a precise definition in mind in order to understand the connections described in this unit.
(Section 1.9 – Structural change, section 1.10 – causation and natural experiments, section 1.11 – British colonization of India, Section 1.12 – Varieties of capitalism, section 1.13 – The economy and the biosphere)
Inequality and environmental considerations are two themes that run throughout The Economy. Instructors who want to emphasize inequality could spend more time on sections 1.11 and 1.12, and those who want to emphasize environmental considerations could spend more time on section 1.13. Section 1.10 introduces empirical methods, another theme which runs throughout the text, especially in the “How economists learn from facts” features.
Key concept: Structural transformation
this section highlights the dramatic changes in the share of employment in agriculture, manufacturing and service industries, as well as the share of total output represented by these sectors.
https://ourworldindata.org/grapher/share-of-agriculture-in-total-employmentKey concept: Correlation versus causation
The distinction between correlation and causation is crucial in examining economic data. Because CORE has an empirical focus, it is important to discuss this distinction at an early stage.
https://www.tylervigen.com/spurious-correlations). Contrast this to cases where they believe that a clear causal relationship exists.https://www.ft.com/content/01f74164-40fc-11e1-b521-00144feab49a.] The article compares the ‘invisible hand’ mechanism in free market economies to central planning, and discusses divergent outcomes on the Korean peninsula. Discussion question: Why is it that market economies can often allocate resources in a more efficient and robust way than centrally planned economies?Key concept: Context and wider setting
CORE stresses that economic choices and decisions are always made in context. In Unit 1, the environment limits and frames much of what economic processes can achieve; and economic decisions are made within the framework of rules and policies. Make the students aware of the wider settings (environmental, historical, institutional) within which economic activity inevitably takes place.
https://www.economist.com/special-report/2018/11/15/western-governments-need-a-plan-for-reinstating-effective-competition.]. Based on the information in the article, explain which elements of Western economies are preventing capitalism from being dynamic in those countries.https://www.economist.com/leaders/2006/08/24/of-property-and-poverty]. Using the examples in the media article, explain how the combination of markets, firms, and property rights can help economic development, as well as their limitations.Key concept: The biosphere
This section discusses how the economy is embedded within the larger society and the biosphere and demonstrates some linkages.
https://www.core-econ.org/doing-economics/book/text/01-01.html) gets students to make charts with climate change data (how temperatures have changed over time, changes in temperature variability, correlation between temperature and CO2 emissions).https://www.economist.com/graphic-detail/2019/02/25/how-global-warming-is-disrupting-business]. Discussion question: Choose two sectors in the economy and explain how the effects of global warming might affect those sectors.Conceptual prerequisites:
Building blocks in this unit:
(Section 2.2)
This section introduces four concepts related to economic incentives and decision-making: opportunity cost, economic cost, economic rent, and relative prices. Familiarise yourself with the equations in this section that express the relationships between these concepts, and the decision rules that use these concepts.
Key concept: Opportunity cost
Students often forget that opportunity cost is the net benefit of the next best option, rather than all available options. Use Exercise 2.1 and 2.2 to solidify their understanding of this concept.
Key concept: Economic rent
The most important thing for students to understand is that an economic rent is something the actor gets, not something an actor pays (as in the common use of the term ‘rent’ for an apartment or a car). Students will see in future units that economic rents are part of profits. Clarify that innovation rent is a type of economic rent.
Key concept: Relative prices
Emphasise that relative prices (rather than the absolute prices) matter for decisions. This concept will appear in both models in this unit.
https://www.economist.com/briefing/2013/01/12/has-the-ideas-machine-broken-down]. In groups, students use the concepts of incentives, relative prices, and economic rents to explain the driving forces behind technological innovations, and why some people believe that technology-driven growth is slowing down.(Section 2.8)
This section covers important concepts underlying all the models that appear in The Economy. Highlight the use of abstraction and simplification, ceteris paribus assumptions, and the general applicability of models. This section can either be taught in the order listed in the unit (a summary of the modelling approach used for the trade model and the technology choice model), or along with Section 2.2 as an introduction to the economic approach.
Key concept: Ceteris paribus
Emphasise that economic analysis typically involves holding all other factors constant aside from the factor of interest (only changing one factor at a time).
Endogenous and exogenous variables: These concepts are used throughout The Economy to distinguish between movements along a curve (endogenous) and movements of an entire curve (exogenous). A rule of thumb to help students: endogenous variables are those on the horizontal/vertical axes of the model’s diagram, while exogenous variables are not.
Equilibrium: This concept features in all the models in The Economy. Link the definition of equilibrium to the economic incentives in Section 2.2 (if individuals are doing the best they can they have no incentive to change their behaviour).
https://www.ft.com/content/4d5ea7c4-bd0d-11df-954b-00144feab49a] on the insights we can learn from economic models.)https://www.economist.com/free-exchange/2014/06/19/why-they-crashed-too] and explain why economic models did not predict the global financial crisis (what assumptions were incorrect?).(Section 2.3)
This section uses the Ricardian trade model (2 people, 2 goods) to illustrate how specialization and trade can be mutually beneficial. The concept of specialization and division labour is then applied at the economy-level and the firm-level.
Key concept: Comparative advantage
Clearly establish the link between comparative advantage and opportunity cost. Emphasise that specialization and trade patterns depend on comparative advantage and not absolute advantage. Work through the numerical example in Figure 2.2 to explain why specialization and trade can be mutually beneficial even if one party has an absolute advantage in both goods. Students may find a diagrammatic representation of Figure 2.2c helpful (Instructors can refer to Figure 18.16a in The Economy 1.0).
https://doi.org/10.1016/j.jinteco.2016.04.006] explains the consequences of population aging on comparative advantage and can be used to link back to the themes of between-country inequality from Unit 1.https://oec.world) and ask students to guess (based on comparative advantage) what the country’s main imports and exports are. This activity can be done to motivate the model or as an application after introducing the model.https://oec.world/en/tradle/. Instructors can either use a few examples in a poll or have students play the game on their own and discuss their reasoning.https://cepr.org/system/files/publication-files/60162-cloth_for_wine_the_relevance_of_ricardo_s_comparative_advantage_in_the_21st_century.pdf] as a prompt (Chapters 3 and 4 discuss the assumptions of the Ricardian Trade model and empirical evidence).https://www.ft.com/content/5788fb32-efb9-11e7-ac08-07c3086a2625] and use the concept of specialisation to examine recent changes in the workplace and consequences for productivity.(Section 2.4-2.6)
These sections build a model of technology choice. Technologies are defined according to their energy-to-labour ratio and the firm chooses the lowest-cost technology. This model is used to explain how creative destruction occurs and, in later sections, explain the role of incentives (relative prices) in prompting the Industrial Revolution in the UK.
Key concept: Technology
This unit uses fixed-proportions technology, meaning that to increase output, both inputs need to increase in a specified ratio.
1) Labour-intensive and energy-intensive technologies are defined by the ratio of energy to labour required to produce a given output (the steps in Figure 2.5 explain these concepts in detail).
2) Emphasise that to compare technologies, we need to hold output fixed. The concept of dominance is used to rule out inferior technologies (work through the steps in Figure 2.6 to ensure students understand the definition of “dominates” and “dominated”).
Isocost lines: Emphasise that along an isocost line, the total cost of production of 100 meters of cloth remains the same for all technologies.
The slope of the isocost line depends on the relative prices of labour and energy. The steps in Figure 2.10 explain how relative prices affect the firm’s choice of technology.
https://www.economist.com/business/2017/03/09/new-technologies-could-slash-the-cost-of-steel-production]. Students can use a diagram like Figure 2.10 to illustrate their chosen example.https://www.economist.com/briefing/2016/03/26/too-much-of-a-good-thing] and discuss the extent to which Schumpeter’s ‘creative destruction’ is happening in the US. This activity could be an assignment where students analyse a country of their choice.(Section 2.1, 2.7, 2.9-2.12)
These sections use the model of technology choice to explain why the Industrial Revolution occurred in the UK (Section 2.7). It is important to emphasise that relative prices is one explanation, not the explanation, because science, culture, and other institutions (colonialism, enslavement) played a vital role (Section 2.9 and 2.12). The remaining sections explore the consequences of the Industrial Revolution: while it enabled countries to escape the Malthusian Trap (Section 2.10), the environmental consequences mean that energy-intensive growth is unsustainable (Section 2.11).
Key concept: Industrial Revolution (Section 2.7, 2.9, 2.10, 2.12)
https://www.economist.com/finance-and-economics/2018/08/02/the-industrial-revolution-could-shed-light-on-modern-productivity]. In groups, have students discuss the evidence that supports/does not support Bob Allen’s explanation for the Industrial Revolution. Why is it difficult to determine whether his explanation is correct?https://www.ft.com/content/b7ad1c68-59fb-11e2-b728-00144feab49a] as a starting point). Students could be split into two groups. One group presents the argument, the other group criticizes/evaluates it. Groups could alternate.Key concept: Environmental consequences of the Industrial Revolution (Section 2.11)
https://tinyco.re/7334115] and in groups, have students discuss the benefits and drawbacks of labour-saving technologies. Use the discussion to stimulate debate around the relationship between growth, inequality, and the environment. This TED talk by Andrew McAfee (15 minutes) about the future of work can complement the discussion or be used as an alternative.https://www.youtube.com/watch?v=PYHd7rpOTe8], Erik Brynjolfsson[https://www.youtube.com/watch?v=lsdgdgJb3IM], and the debate about economic growth[https://www.youtube.com/watch?v=ofWK5WglgiI]. Discuss the following: Which arguments do you find most convincing? Are you optimistic or pessimistic about the future of economic growth? Explain your reasoning.Required Building Blocks:
Building blocks in this unit:
(Section 3.1)
Unit 3 is a foundational unit that fully introduces the constrained decision-making framework and a number of critical concepts including feasible sets, opportunity cost, preferences, and indifference curves, used throughout CORE. CORE introduces the entire framework in a single unit by approaching the theory through a data-based example on average working hours (over time and across countries). Keep the motivating empirical example of changes in average wages in clear focus when the concepts are being discussed and developed.
This unit contains the building block on constrained choice problems, which is used extensively in other units. It may be a good idea to emphasize to students that this is a key framework which they will need a solid understanding of. Instructors who are pressed for time could teach only the building block and set some of the applications as (optional) reading.
Key concept: Constrained choice problem
This modelling framework is used in several later units, including:
https://ourworldindata.org/time-use) also a very interesting set of has cross-country graphs on time use spent on various activities and a brief discussion of relevant research to help students interpret these graphs(Section 3.2, 3.4)
Key concept: Feasible frontier, budget constraint and feasible set
Key concept: Marginal rate of transformation (MRT)
“marginal” is introduced in a discrete manner i.e. a 1-unit increase in the x-axis value. Emphasise that the slope of the feasible frontier is the MRT.
Key concept: Opportunity cost
This concept was introduced in Unit 2 (Section 2.2). For a concrete interpretation, demonstrate the link between opportunity cost and the slope of the feasible frontier.
(Section 3.3)
Key concept: Indifference curves
The analogy with contour maps can help students understand the concept of an indifference curve “map”. It is important for students to realize the relationship between the slope of the indifference curve and the marginal rate of substitution.
https://www.econgraphs.org/graphs/v1/micro/consumer_theory/indifference_curves?textbook=varian (with the caveat that the examples are for the 2-good case rather than wages-free time). In general, the EconGraphs webpage (https://www.econgraphs.org) has helpful interactive visualizations that can aid students in understanding some of the concepts in Unit 3 (such as budget constraints).(Section 3.5, 3.8)
Students put preferences and constraints together to understand how individuals make choices. Here, you may want to remind students of the overarching question (how individuals choose working hours).
Key concept: MRS=MRT
Make sure the students fully appreciate the MRS=MRT condition. While this unit does not require knowledge of calculus, students should be familiar with what “tangency” means (two lines/curves touching but not intersecting). Go through the steps in Figures 3.7a carefully so students know why the tangency point is optimal (rather than any other point in the diagram).
(Section 3.6, 3.7)
This topic is conceptually challenging as it introduces income and substitution effects to analyse wage changes. Note that CORE uses the Hicks-Kaldor decomposition method, where the original feasible boundary is moved to be tangential to the new indifference curve to give the income effect first. Some other texts use the Slutsky decomposition method. Note also that the diagrams in these sections do not start with an x-axis value of 0, which might confuse students. It is possible to skip section 3.7 without loss of continuity.
Key concept: Income effect, substitution effect
Many students find it difficult to translate the definition of income and substitution effects to the feasible set-indifference curve diagram. Emphasise that income effects refer to changes in the size of the feasible set (consumption possibilities) and substitution effects refer to changes in the slope (relative prices). Go through the steps in Figure 3.9 carefully.
https://www.youtube.com/watch?v=D5M4jiKPo4Ehttps://www.ft.com/content/0556d66a-394d-11ea-a6d3-9a26f8c3cba4. Can you describe the change in working hour patterns of low- and high-income workers by using a feasible set-indifference curve diagram? Discuss factors behind this change that cannot be captured by such diagram.(Section 3.9, 3.10, 3.11, 3.12)
The final sections of Unit 3 apply the model to different empirical scenarios. Section 3.9 explains wage changes within countries over long time periods. Section 3.10 explains how Veblen effects and inequality affect working hours and consumption decisions. Section 3.11 extends the model of individual choice to household decision-making, where gender discrimination in paid work affects how time is allocated within the household. Section 3.12 uses the framework to explain cross-country differences in working hours.
Key concept: Veblen effects
Students should understand that some goods give utility from signalling (conspicuous consumption). Refer to the diagram in Question 3.12 to explain how Veblen effects change the shape of an individual’s indifference curves.
https://www.economist.com/christmas-specials/2014/12/20/why-is-everyone-so-busy. Use the concepts of income effect and substitution effect to explain the changes in time use mentioned in the article, and why these changes differ across groups of the population (e.g. rich vs. poor).https://doi.org/10.1016/j.joep.2011.08.013 (Findings: in Switzerland, one additional Ferrari or Porsche per 1,000 people would have the same effect on income satisfaction as a 27% reduction in household income, for everyone else in the neighborhood.) Instructors could use this article as a general discussion about how we could measure the negative effects of conspicuous consumption.Key concept: Gender discrimination and the gender division of labour
We assume that adults in the same household have the same preferences and share goods equally, so the model of individual decision-making still applies. Compare Figures 3.21 and 3.22 to illustrate how gender discrimination in paid work affects the household’s choice of consumption and free time.
Key concept: Differences in preferences can explain cross-country differences in working hours
Students get confused over how we can tell whether representative individuals in different countries are likely to have the same preferences or not. Go through the steps in Figure 3.25, focusing on the US and the Netherlands. Emphasise that indifference curves of different individuals can cross but indifference curves of the same individual can’t cross.
https://www.bbc.com/news/business-34677949) and then write a short paragraph comparing the feasible sets and indifference curves in Sweden to those of another country, e.g. the UK (mentioned in the article).Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
(Section 4.1-4.4)
These sections introduce the fundamental elements of a game (players, strategies, information, and payoffs) and concepts that we can use to predict the outcome of a game (best response, dominant strategy, Nash equilibrium). Section 4.2 and 4.3 introduce a 2×2 game (the “invisible hand” game) where self-interested actions lead to the best outcome for both players. Section 4.4 introduces the prisoners’ dilemma game, an example of a social dilemma (self-interested actions lead to worse outcomes for all players).
Key concept: Social dilemmas
Social dilemmas occur when people do not take adequate account of the effects of their actions on others, whether these are positive or negative. This unit starts and ends with the pressing problem of climate change. You can link climate change back to how we are all connected to the natural environment and biosphere (Unit 1).
Key concept: Game
Students should know how to define the five elements of a game (players, feasible strategies, order of play, information, payoffs).
Key concept: Best response
When identifying the best responses, the students find it confusing that they need to go row-by-row to find the column player’s best response and vice versa for the row player. Encourage the students to use the ‘dot and circle’ approach taught in Figure 4.2b to identify the best responses. Practice at this stage will facilitate finding Nash equilibria later.
Nash equilibrium (NE): Encourage the students to locate the equilibrium using the dots and circles to find the Nash position in a normal-form game. To help students operationalize NE point out that (i) the equilibrium denotes a position of stability, and (ii) every normal-form game has at least one NE, which will be helpful for checking whether they have done the dot-and-circle approach correctly. The games in The Economy all have at least one pure-strategy Nash equilibrium. Note that CORE does not discuss mixed strategies or randomization (everything is in pure strategies). Figure 4.21 in Section 4.13 uses different payoffs in the crop-choice problem of Anil and Bala than is the case in the invisible hand game in Section 4.2, to produce an outcome where there are two Nash equilibria. Explicitly contrasting these two games makes for a good focus in a lecture.
https://www.gametheory.net/popular/film.html; 10 other examples including “newer” films here, with explanations of the game: http://www.tasteofcinema.com/2016/the-10-best-movies-about-game-theory/) Instructors can also refer to Burke et al. (2018) (http://downloads.journalofeconomicsteaching.org/3/1/1-3.pdf) for further examples.Key concept: Dominant strategy; dominant strategy equilibrium
A dominant strategy exists when there is an entire row or column of circles (using the ‘dot and circle’ approach). Emphasize that not every game has a dominant strategy. The students will need practice to recognize dominant strategies by doing exercises using the diagrammatic approach. It is worth focusing on Nash equilibrium, rather than dominant strategy equilibrium (Section 4.4), as students get confused as to when the concept of ‘dominant strategy equilibrium’ applies whereas the concept of Nash equilibrium is broader.
Prisoners’ dilemma game: The students easily confuse the general concept of ‘a prisoners’ dilemma’ with the specific prisoners’ dilemma game (with strategies Deny and Confess). Emphasize that “prisoners’ dilemma” is a type of game rather than a specific game. Students may also be confused between prisoners’ dilemma and social dilemma (they both have the word “dilemma” in them); social dilemma is the more general concept. Devote time to practice identifying and solving prisoners’ dilemmas, and to reflect on the distinction between them and the invisible hand game in the previous Topic.
https://www.nber.org/system/files/working_papers/w12097/w12097. pdf. Focus on comparing the behaviour of participants with the predictions of economic theory.https://www.ft.com/content/3c0d4538-99c4-11e3-91cd-00144feab7de] and draw a payoff matrix to analyse this situation.(Section 4.5)
This section introduces the Pareto criterion as one way to evaluate outcomes from a game (allocations). The limitations of Pareto efficiency and an additional criterion for evaluating outcomes (fairness) are briefly discussed. (Unit 5 elaborates on the concept of fairness).
Key concept: Pareto criterion
According to the Pareto criterion, allocation A is better than allocation B if at least one party would be strictly better off with A than B, and nobody would be worse off. Use the steps in Figure 4.6 to clarify the usage of “Pareto improvement” and “Pareto dominates/dominated”.
Pareto efficiency: Make sure the students understand how to identify Pareto efficient outcomes/allocations i.e. under the outcome shown, no-one can be made better off without someone else being made worse off. Once this concept is understood, separate it from other evaluation criteria: in particular, underscore the distinction between Pareto efficiency and fairness. Highlight the fact that Pareto efficiency is sometimes a very weak criterion on which to base policy decisions and points to resistance to a change in institutional arrangements.
https://www.economist.com/finance-and-economics/2007/10/18/intelligent-design]. Discuss the following questions: 1. With reference to the article, explain how Pareto efficiency can be used to design mechanisms. 2. How useful is the concept of Pareto efficiency in evaluating allocations?(Section 4.7, 4.9)
Section 4.7 uses the framework of Unit 3 (indifference curves, feasible frontier) to illustrate how optimal choices differ depending on an individual’s preferences (altruistic vs self-interested). Section 4.9 covers two different methods that economists use to learn about people’s motivations (lab and field experiments), with examples. Note that this unit does not assume that self-interested behavior is in any way expected or ‘correct’. Instead, we appeal to the evidence, reinforcing CORE’s approach of critically appraising theory with real-world evidence and identifying which underlying assumptions need to be relaxed or modified.
Key concept: Social preferences
Social preferences are an explanation for the non-self-interested behavior we observe. Students often infer that social preferences can ‘solve’ social dilemmas, but we usually take preferences as fixed (very difficult to change) so social preferences are not a policy solution (we cannot ‘make’ people more altruistic). Students should also be aware that social preferences are just one potential explanation (usually not the only explanation unless the behavior was observed under a controlled experiment); in some cases, the observed behavior may also be consistent with self-interest (e.g. repeated interaction with punishment).
Altruism: Make it clear that an altruistic preference motivates someone to help others, even at a cost to that person. Students should understand how altruism affects the shape of an individual’s indifference curves and thus an individual’s preference ranking over outcomes/allocations. Use the steps Figures 4.11 and 4.12 to clarify these points.
Experimental methods: Students should be able to explain the usefulness and limitations of experiments. This section is a good opportunity to review some other methods of economic inquiry from earlier units (natural experiment, secondary data).
(Section 4.6, 4.8)
Section 4.6 describes the public goods game and compares its predictions to behaviour observed in the real-world (management of common pool resources). Section 4.8 discusses some experimental evidence of how repeated interaction, social norms, and peer punishment affect behaviour in the public goods game.
Key concept: Public goods game
Make sure you play this game BEFORE the students read Sections 4.6 and 4.8. This way, they will not have prior knowledge of the public goods game. If you are running this game in a large class, watch this video of students playing the game in a class of nearly 800 students[http://tinyco.re/5239657].
Altruism, reciprocity, inequality aversion: These concepts have a specific interpretation in Unit 4 (compared to how they may be used in everyday conversation), so make sure that students are familiar with the definitions. To make the distinction between different types of social preferences clear, link them to the public goods experimental evidence (Section 4.8) and get students to identify how the behavior of participants is consistent with each type of social preference (altruism, reciprocity, inequality aversion).
https://www.core-econ.org/experiencing-economics/instructors/book/text/01.html]. The instructor’s version (accessible if you have created a free CORE account) contains homework activities to accompany the experiment.https://www.core-econ.org/doing-economics/book/text/02-01.html] contains a set of Excel/R exercises that can be done individually or as an extended project.https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.14.3.137] and discuss the conditions that are required for successful collective action. The article also discusses evolutionary game theory (in a non-technical way); students can learn theories about how social norms develop and evolve.https://doi.org/10.3200/ENVT.50.4.8-21]. This article contains some data tables on environmental variables (e.g. fish stocks, forest area) that students can make graphs on. Students can also use game theory concepts to explain why the suggested policy solutions/rules for governance would work.https://www.ft.com/content/83df61cc-caf2-11e1-8872-00144feabdc0] and discuss: would the system of communal management of resources used in Bali be as effective on a larger scale, say, in a city? Why/why not?https://www.economist.com/business/2019/10/13/the-usefulness-of-managers]. Discuss the results of the game and explain how the outcomes of the public goods experiments in the unit and in the article depend on players’ incentives and preferences.(Section 4.10-4.12)
Sections 4.10 and 4.11 describe the ultimatum game. Section 4.12 shows some experimental evidence (Kenyan farmers and US students) and discusses the potential motivations of the Proposer and Responder. Section 4.12 uses the effect of competition in the ultimatum game to show how institutions (the rules of the game) can affect outcomes.
Key concept: Ultimatum game
Ensure that students can identify the 5 elements of this game. Note that unlike the simultaneous games described in earlier sections, this game is sequential.
Minimum acceptable offer: This term refers to the offer at which the satisfaction of accepting the Proposer’s offer is equal to the satisfaction the Responder would get from refusing the offer and getting no money, but ensuring that the Proposer also gets nothing. The extension to Section 4.11 goes through a numerical example.
https://ftalphaville.ft.com/2015/02/18/2119447/greek-games-in-theory-and-practice/] and draw a sequential game to illustrate the situation described. Ask students to give another example of a situation where appearing to act irrationally can provide a higher payoff.https://www.economist.com/game-theory/2011/11/15/thanks-but-no-thanks] and draw a game tree to illustrate and analyse the potential outcomes of this situation. Discuss/explain how the legal system helps break the deadlock in negotiations.(Section 4.13-4.14)
These sections present 2×2 games with 2 Nash equilibria (in contrast to games from earlier sections, which had a unique pure-strategy Nash equilibrium). The multiple equilibria create conflicts of interest over which equilibrium to coordinate on. Section 4.14 models climate policy as a coordination game and discusses coordination mechanisms.
Key concept: Coordination games
The choice of climate policy is represented as a specific type of coordination game called the ‘Hawk-Dove’ game (Figure 4.23). In this game, the players want to coordinate on the opposite action from their opponent; in each of the Nash equilibria, (Hawk, Dove) and (Dove, Hawk), the Hawk obtains the higher payoff; but both players choosing Hawk is the worst outcome for both.
https://www.core-econ.org/the-economy/book/text/20.html#202-climate-change] gives five reasons that make climate change and other environmental problems difficult to tackle.https://www.pnas.org/doi/full/10.1073/pnas.1400826111] where researchers compared how people from India and the US play a 3×3 coordination game (with someone of their population and someone of the other population). (The researchers find that the players’ cultural background affects how they play the game.) You could play the game in class.https://www.pnas.org/doi/full/10.1073/pnas.1400826111. Discuss how cultural norms influence their strategies.”https://www.bbc.com/worklife/article/20180417-a-thrilling-mission-to-get-the-swedish-to-change-overnight). This 1.30-minute video explains how history influenced the side of the road that countries drive on[https://www.businessinsider.com/uk-china-countries-drive-left-side-road-traffic-ancient-rome-sword-fight-2016-12?r=US&IR=T]https://www.economist.com/international/2016/09/24/to-coldly-go]. Discussion questions: 1. Use the game theory framework in the unit to explain the environmental outcomes of Montreal protocol. 2. Evaluate the success of the Montreal protocol in mitigating climate change.https://www.economist.com/special-report/2019/03/14/nato-members-promise-of-spending-2-of-their-gdp-on-defence-is-proving-hard-to-keep]. In groups, use the concepts discussed in the unit to explain why the NATO agreement is not as successful as its members hoped it would be.Key concept: Conflicts of interest
A conflict of interest occurs in a coordination game if players in the game would prefer different Nash equilibria. Sections 4.13 and 4.14 discuss various ways to change the rules of the game to resolve these conflicts of interest (e.g. transfers between players, sequential moving).
Required Building blocks:
Building blocks in this unit:
(Sections 5.1 – 5.3)
How do institutions influence the allocation of a good between parties? How do we evaluate such an allocation in terms of efficiency and fairness?
Key concept: Institutions, rules of the game
Another common source of confusion is the term institutions. Institutions in the text do not refer to the layman’s definition of physical buildings or organizations. Rather, institutions are the “rules of the game”. You should explicitly mention these misconceptions.
Key concept: Structural power and bargaining power
structural power has to do with one’s own reservation option (next best alternative) and the ability to influence the other player’s reservation option. Once the reservation options of the two players have determined the most and least that each player can attain (such that the interaction will take place), bargaining power determines how the surplus is divided between the two players.
Key concept: Pareto efficiency
Pareto efficiency is defined in section 4.5 (unit 4). Students may have their own interpretations of what efficiency means. Stress clearly the way that economists use the term and its relevance. Draw attention to the glossary and the importance of precision in the use of this term.
https://www.economist.com/finance-and-economics/2007/10/18/intelligent-design. To discuss: 1) With reference to the article, explain how Pareto efficiency can be used to design mechanisms. 2) How useful is the concept of Pareto efficiency in evaluating allocations?Key concept: Fairness
The text puts emphasis on substantive and procedural fairness but there can be multiple conceptions of what is fair. Stress the latter to avoid confusion among students with the use of the term. Referring to the examples in Section 5.3 to clarify the distinction between substantive and procedural fairness helps.
https://www.economist.com/finance-and-economics/2013/03/09/tilting-the-playing-field. Discuss: Using the concepts of substantive and procedural fairness, discuss whether you think bankers’ bonuses are fair. Do you think bankers’ bonuses should be capped?A set of cases where the players preferences and the technological constrsaints are held constant, but the rules of the game differ, resulting in different outcomes.
Key concept: Production function and feasible frontier
it is important that students understand where the feasible frontier comes from: it is determined by the available technology (reflected in the production function). It may be helpful to draw out the production function and the feasible frontier point by point (using the numbers provided in the text), and side by side. Note that in order to avoid confusing, a change in technology which would push out the production function has not been included in this unit, so that everything except for the changing institutions is held constant.
https://www.ft.com/content/2d9d8c2a-958d-11e6-a80e-bcd69f323a8b. Use the concepts in the Angela-Bruno framework to discuss what the experiment conducted on Ethiopian manufacturing workers suggests about the workers’ reservation option and outcomes of the worker-employer interaction.Key concept: Allocation vs outcome
in this unit, the term allocation is used to describe any point which demonstrate Angela’s hours of free time, as well as Angela and Bruno’s bushels of grain, respectively. The term outcome is only used to describe an allocation that is the final result of an interaction.
https://www.pbs.org/tpt/slavery-by-another-name/themes/sharecropping/. Writing exercise – Write a few sentences, based on the information and videos on the above webpage, about why sharecropping could be “slavery by another name.”. Discuss which of the cases in unit 5 would describe the situation of sharecropping most accurately. (Note to instructors – case 2 – the take-it-or-leave-it contract – discusses a fixed rent, this is easier to portray than sharecropping because under sharecropping the tenant pays a share of the output rather than a fixed rent. However, the key question for students is the extent to which farmers could walk away from the “offer”).Key concept: Quasi-linearity
Students do not necessarily need to know this term or its technical definition, but they should understand that in order to make the diagrams less complicated, all we are doing is holding MRS constant at each level of free time, as utility changes. Due to the optical illusion that the vertical distance between indifference curves seems to get wider as you move from left to right, it would be good to encourage students to take a moment to check this, so they are really convinced that the vertical distance between the indifference curves is constant at each level of hours of leisure.
Key concept: Pareto Efficiency
Make sure the students understand why the outcome resulting from slavery in this context is Pareto efficient: under the outcome shown, no-one can be made better off without someone else being made worse off—the definition of Pareto efficiency. Once this concept is understood, separate it from other evaluation criteria: in particular, underscore the distinction between Pareto efficiency and fairness. This highlights the fact that Pareto efficiency is sometimes a very weak criterion on which to base policy decisions and points to resistance to a change in institutional arrangements.
Pareto efficiency curve (PEC): These terms do not sound technical, yet they have precise interpretations:
a) Every point that is not on the PEC is dominated by at least one point on the PEC
b) Points on the PEC are not Pareto-dominated by any other points.
The curve is vertical and linear because of the quasi-linearity assumptions on preferences. Remind students that this is a simplification, but the economics behind the PEC is general. The PEC is often referred to as the ‘contract curve’ in other texts.
https://www.economist.com/special-report/2016/09/29/needed-but-not-wanted. Activities: 1) Use the Angela-Bruno framework in the unit to analyse the possible effects of immigration on the reservation indifference curve and distribution of the surplus. 2) Evaluate the costs and benefits of stricter migration restrictions.https://www.economist.com/finance-and-economics/2018/10/04/worries-about-the-rise-of-the-gig-economy-are-mostly-overblown. To discuss: 1) Using the information in the article and the Angela-Bruno framework in the unit, compare the reservation indifference curve and division of the surplus of a worker in the gig economy to a worker in a traditional company. 2) To what extent are workers in traditional companies better off than workers in the gig economy?https://www.ft.com/content/b4ae605a-99ce-11e6-8f9b-70e3cabccfae. Discuss: 1) How could firms, industries or countries get stuck in a potentially inefficient habit of overwork? 2) What is meant by the term ‘productivity’? Why might increasing hours work damage productivity?Instructors who want to put an emphasis on environmental considerations may like to take time to work through the environmental bargaining application thoroughly. It demonstrates that the principles demonstrated by the story of Angela and Bruno are also relevant and useful in other contexts.
Key concept: Gini coefficients
Gini coefficients are a commonly used measure of inequality. This section introduces how they are calculated. The section on Operation Barga provides an example of a policy which increased inequality, thereby reducing the Gini coefficient.
https://www.ft.com/content/24e88c30-bc5f-11e6-8b45-b8b81dd5d080. To discuss: 1) Choose one of the graphs in the article and describe, in your opinion, the most interesting feature. 2) Explain what is meant by the Gini coefficient. Explain what the article suggests has happened to income inequality since the 1970s. (Instructors can also ask students to look up income inequality statistics for their country or a country of their choice and compare it with those in the article).https://www.economist.com/graphic-detail/2019/04/13/american-inequality-reflects-gross-incomes-as-much-as-taxes; https://www.economist.com/finance-and-economics/2017/10/19/higher-taxes-can-lower-inequality-without-denting-economic-growth. Activities: 1) Choose two countries mentioned in the article and/or in the unit and suggest reasons for the observed differences in pre-tax and post-tax inequality. You may find it helpful to research the tax and benefit systems of those countries.2) Based on the information in the article and in the unit, to what extent is low post-tax inequality a result of government redistribution? Explain the challenges involved with designing a tax system that effectively reduces inequality.https://www.core-econ.org/visualizations/ Students can construct their own “skyscraper” diagrams and compare countries according to some measures of inequality. The interface guides students through step by step while also providing flexibility so that students can explore different countries according to their interests. (Instructors who used this activity in Unit 1 can ask students to focus on using the measures of inequality to make comparisons across countries and time.)https://www.core-econ.org/the-economy/book/text/19.html)https://www.core-econ.org/insights/a-world-of-differences/text/01.html)https://www.labxchange.org/library/pathway/lx-pathway:947bd402-9d3a-40f0-bcac-31c660f34459)Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
(Section 6.1-6.3, 6.6)
Sections 6.1-6.3 explain how the firm’s decision-making and information structures can result in misaligned incentives between owners, managers, and workers. Section 6.6 explains why the lack of relevant information and incomplete contracts result in a principal-agent problem between employer and employee.
Key concept: Separation of ownership and control
Examine the structure of firms (Figure 6.1) and the division of power between owners and managers. Follow with a discussion of information asymmetry in the context of the separation of owners (the residual claimants of profit) and managers (who are usually responsible for the performance of the firm but are not residual claimants). The relationship between the employee and the firm can be seen as an extension of the same logic.
https://youtu.be/2Zm5ZLMKhgQ] about outsourcing responsibility and the boundaries of the firm. Use the following questions to reinforce the concept of incomplete information in incomplete contracts: 1) explain what is meant by the phrase ‘you can’t outsource responsibility’ in the video. Do you agree? 2) Find one real-world example of a problem that has occurred when responsibility has been outsourced (look, for example, at recent news articles).https://hbr.org/2017/12/the-real-reasons-companies-are-so-focused-on-the-short-term]; 2) McKinsey report on the negative effects of short-termism [https://www.mckinsey.com/mgi/overview/in-the-news/the-case-against-corporate-short-termism]; 3) ESMA article on causes of short-termism, with survey evidence [https://www.esma.europa.eu/sites/default/files/trv_2020_1-short_termism_pressures_from_financial_markets.pdf].https://www.ft.com/content/fc3d707c-3e60-11de-9a6c-00144feabdc0] and discuss the following question: Is a company’s stock price always a good indicator of the strength of its performance and strategy?https://www.economist.com/business/2019/05/30/why-managers-should-listen-to-shareholders] and discuss the following: 1) With reference to the article, explain the role of shareholders in addressing the problems arising from the separation of firm ownership and control. 2) Evaluate the costs and benefits of greater shareholder participation in company decision-making.https://www.core-econ.org/doing-economics/book/text/06-02.html#part-61-looking-for-patterns-in-the-survey-data]. Instructors can set a few questions for homework or an in-class exercise.https://www.nber.org/system/files/working_papers/w16658/ w16658.pdf], which discusses a randomised field experiment in an Indian textile factory. (Pages 9-10 describe the experiment details, and Figure 12 shows the main results).Key concept: Wage-labour contract
Students should understand how wage-labour contracts different from “contracts” in consumption goods markets.
https://www.economist.com/economics-brief/2017/07/27/coases-theory-of-the-firm]. Discuss the following questions: 1) Using the information in the article and in the unit, compare and contrast the nature of interactions in markets and in firms. 2) If markets are so good at directing resources, why do firms exist?Key concept: Incomplete contracts
To explain what makes a contract ‘incomplete’, refer to the nature of the employment relationship (usually long-term, so impossible to predict all future events that may arise and include them in the contract) and the nature of the tasks (effort cannot be perfectly quantified or measured). Use real-world examples by relating to the activity in the student-facing course in which the students choose a job title. Ask them to compare the incentives of the firm and the worker and think about how the contract is incomplete. Emphasize that in an incomplete contract not all relevant information is available: firms cannot perfectly monitor each worker’s effort, and the tasks required cannot be fully specified.
https://www.core-econ.org/experiencing-economics/instructors/book/text/50-01-other-experiments.html#incomplete-contracts] to play in class.Key concept: Principal-agent problem
Students should understand the conflict of interest that arises between the profit-maximising employer (principal) and the effort-minimising employee (agent). Principal-agent problems arise because the relevant information is either asymmetric or non-verifiable. In the employment relationship, the employer can use employment rents as an incentive for employees to work hard (discussed in subsequent sections).
https://www.ft.com/content/ab860f60-5f5b-11e8-ad91-e01af256df68] and discuss the costs and benefits of an unequal voting rights model that gives management disproportionate control of a company.https://www.economist.com/business/2013/03/02/companies-moral-compasses] and answer the following: 1) To what extent is the separation of ownership and control a problem when contracts are incomplete, and how can the principal-agent relationship between owners and managers be managed well? 2) Analyse the potential costs and benefits of dispersed shareholding.(Section 6.4)
This section describes the labour market, focusing on transitions between employment and unemployment (Figure 6.3). This section also explains why the labour market is different from markets for consumption goods.
(Section 6.1-6.3, 6.6)
Key concept: Firm-specific assets
These refer to skills, networks, and friendships that are specific to an employment relationship (so value is lost to both sides if the employee leaves). Students should understand why both employer and employee benefit from a long-term employment relationship.
https://www.ciphr.com/survey-infographic-the-benefits-incentives-employees-value-most] and Gallup for the US [https://www.gallup.com/workplace/389807/top-things-employees-next-job.aspx]). Instructors can also poll students on what they would value in their ideal job after graduation, and compare the results to actual employee surveys. This exercise can illustrate the importance of finding a good match between employer and employee (different people value different things in a job).https://www.economist.com/finance-and-economics/2018/05/17/lawmakers-are-trying-to-curb-contracts-that-make-it-harder-to-change-jobs] and discuss the following questions: 1) To what extent are relationship-specific and firm-specific assets a plausible explanation for the widespread use of non-compete agreements in America? 2) Analyse the costs and benefits of non-compete agreements on firms, workers, and the whole economy.Key concept: Labour force; unemployment rate
This section mentions some macroeconomic concepts, but detailed explanations are left to Volume II. Figure 6.4 uses empirical data to illustrate actual labour market flows and shows how to calculate some labour market statistics (e.g., working-age population, unemployment rate) without providing definitions.
https://ilostat.ilo.org] and the OECD websites[https://www.oecd-ilibrary.org/employment/data/oecd-employment-and-labour-market-statistics_lfs-data-en]). Students can then calculate and compare the labour market statistics and discuss possible reasons for the similarities/differences observed.(Section 6.5, 6.7-6.9)
These sections represent the social interaction between employer and employee as a game, called the labour discipline model. Sections 6.7-6.8 discuss the determinants of the employee’s payoffs and decision to work or shirk, particularly the reservation wage. These sections use concepts from Unit 2 (economic rent) and Unit 4 (social interactions), though emphasis is placed on “expected” or “average” values when making decisions because players do not know exactly what will happen (e.g. how long it will take to find a job and what the pay in the new job will be).
Key concept: Reservation wage
The reservation wage gives the worker the same value as his/her reservation option (e.g., remain unemployed and continue job searching). Students should be able to identify individual and economy-wide factors that affect a worker’s reservation option (e.g. unemployment benefits). It is important to note that reservation wages differ across workers (as shown by the reservation wage curve). Students should be familiar with the equation for a worker’s reservation wage (Section 6.8).
Reservation wage curve (Figure 6.6): This curve shows wage required to employ a given number of workers and indicates the range of reservation wages of workers hired – at any point, the reservation wage of all workers hired is less than or equal to wage shown on the curve. The reservation wage curve slopes upwards because if the firm raises the wage, workers with higher reservation wages will accept a job offer and the firm can hire more workers.
https://data.oecd.org/benwage/benefits-in-unemployment-share-of-previous-income.htm); International Labour Organization (https://www.ilo.org/global/about-the-ilo/newsroom/news/WCMS_007901/lang--en/index.htm). In groups, students could use this information to discuss how the reservation wages of workers may differ across countries and groups in society (e.g. gender, age, type of occupation).Key concept: Employment rent
The employment rent is the net benefit from the job minus the net benefit of being unemployment. Students should know that the employment rent is a type of economic rent (refer to Section 2.2). Figures 6.8a and 6.8b explain how to calculate the employment rent.
Key concept: Labour discipline model
The employee’s decision to put in the required effort or shirk depends on whether the no-shirking condition is satisfied (the net payoff from working hard minus the net payoff from shirking). In the Nash equilibrium of the game, the employer thus chooses the wage that exactly satisfies this condition (no-shirking wage), and the employee exerts the required effort. Instructors can refer to Sections 4.1-4.4 to remind students of the relevant concepts.
No-shirking wage: The no-shirking wage is the employee’s reservation wage plus the cost of effort plus the employment rent. Students should know that the no-shirking wage is always above the reservation wage (an important fact in subsequent sections), and be familiar with the equation (Section 6.9).
https://www.economist.com/finance-and-economics/2018/03/01/labour-monitoring-technologies-raise-efficiency-and-hard-questions].(Section 6.10-6.13)
These sections use the constrained optimization framework of Unit 3 to model the firm’s wage-setting decision. The no-shirking wage curve represents the firm’s feasible set, isoprofit curves represent the firm’s preferences, and the firm’s profit-maximising choice is at the tangency of the two. Section 6.13 uses this framework to show how a minimum wage affects the firm’s profit-maximising choice.
Key concept: No-shirking wage curve (Figure 6.12)
This curve is derived from the labour discipline model (Section 6.9) and represents the firm’s feasible set. Students should understand why the no-shirking wage is above the reservation wage and why the reservation wage curve cannot be the firm’s feasible set (all employees whose reservation wage is between the no-shirking wage curve and reservation wage curve will accept the job offer but shirk). Figure 6.19 illustrates how the minimum wage affects the no-shirking wage curve.
Search unemployment; Involuntary unemployment: Students should know the difference between these two sources of unemployment. Search unemployment (also known as frictional unemployment) arises from search and matching costs. Involuntary unemployment arises from the labour discipline problem because firms must set wages to provide incentives for effort. Figure 6.17 shows how to find the size of involuntary unemployment in the wage-setting diagram.
Labour market power: Section 6.12 discusses two forms of power that firms have – labour market (monopsony) power (the firm’s power to hold down wages by restricting employment), and “power over others” (using the threat of employment termination to induce the required effort). Students should understand this distinction and how these two forms of power are related.
https://www.ncbi.nlm.nih.gov/pmc/articles/PMC9183946/] and Verick et al. (2021) [https://doi.org/10.1111/ilr.12230]. These articles also discuss the effects of both crises on inequality.https://www.economist.com/britain/2016/06/25/when-a-job-is-not-enough] and analyse (using an appropriate diagram) the likely effects of the national living wage on employment rents, employment, and inequality.(Section 6.14)
This section introduces worker-owned cooperatives (cooperative firms) as another way of organizing labour and provides comparisons with traditional firms (Sections 6.1-6.3).
Key concept: Cooperative firm
Students should know how the organizational and incentive structures of cooperative firms differ from those of traditional firms (Sections 6.1-6.3).
https://www.ft.com/content/30ca497e-438a-11e1-9f28-00144feab49a]. Discussion question: Why have stock incentive schemes in the financial industry not historically resulted in the same successful alignment of interests as the John Lewis partnership model?https://www.economist.com/business/2013/11/09/trouble-in-workers-paradise]. Discussion questions: 1) With reference to the article and the unit, evaluate the extent to which the cooperative firm business model is sustainable and beneficial for workers. 2) Discuss the benefits and risks of being a worker in a cooperative firm, compared to being a worker in a traditional firm.https://www.core-econ.org/espp/book/text/06.html#exercise-68-using-excel-who-owns-the-firms] gets students to compare the characteristics of firms and firm owners in different countries, using data from the World Bank’s Enterprise Survey.https://www.core-econ.org/espp/book/text/06.html#614-another-kind-of-business-organization-the-gig-economy]. Students can also read this Financial Times article on worker monitoring in the gig economy [https://www.ft.com/content/88fdc58e-754f-11e6-b60a-de4532d5ea35] and compare it with worker monitoring in traditional firms.Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
(Section 7.1-7.4, 7.6)
These sections use the constrained choice framework to model a price-setting firm’s choice of price (and quantity). Isoprofit curves represent the firm’s preferences, the demand curve represents the firm’s constraints, and the profit-maximising choice is characterized by the MRS=MRT condition. (Section 7.6 demonstrates the equivalence between MRS=MRT and MR=MC). Section 7.3 explains how and why a firm’s cost function (a determinant of its profits and the shape of its isoprofits) may vary with the firm’s size.
Key concept: Cost function (total costs, average costs, marginal costs, fixed costs)
Students should understand the formula for the total cost (fixed costs + variable costs) and how to derive average costs and marginal costs from a firm’s total cost function. Note that both examples from this unit (Cheerios and Beautiful Cars) assume constant marginal cost because it is the firm’s long-run cost function, though instructors may note that marginal cost can be increasing in the short-run while some inputs such as the stock of equipment are fixed.
https://www.economist.com/finance-and-economics/2014/02/08/massive-open-online-forces. Compare the cost structures of MOOCs and traditional courses offered by a university. (Instructors can refer students to Exercise 7.2 for an example of cost structures for traditional university courses.)Key concept: Economies/diseconomies of scale; constant returns
Economies of scale is a term used to describe the technological advantages of large-scale production. There can also be cost or demand advantages (network economies of scale). Students should be familiar with the definition and the underlying intuition.
https://www.ft.com/content/863409bc-5fca-11e0-a718-00144feab49a. Discuss the empirical evidence for diseconomies of scale.https://www.economist.com/business/2011/11/12/economies-of-scale-made-steel. To discuss: 1) Give two or three examples of the economies of scale that large shipping companies can benefit from. 2) Do you think that large shipping companies will suffer from diseconomies of scale due to growing further or merging?Key concept: Isoprofit curves
Isoprofit curves are the firm’s “indifference curves” since we assume the firm only cares about profits. Conveying the logic of the isoprofit curve is easiest in the constant cost case: given the cost, if the firm lowers the price, how many more units must it sell to keep total profits unchanged? A simple intuitive explanation, such as (high price, low quantity) gives the same profit as (low price, high quantity) can also help. Work through the steps in Figure 7.2b to illustrate how to draw isoprofit curves. Students may find the 3D representation in Figure 7.2a helpful for understanding this concept.
Profit maximization: Section 7.2 approaches profit maximization using the MRS = MRT tangency condition (Unit 3), while Section 7.6 applies a different but equivalent way of thinking about profit maximization, using marginal revenue and marginal cost. Work through the steps in Figures 7.4a and 7.4b to explain the intuition behind the MRS = MRT condition. Figure 7.18 shows the equivalency between MRS = MRT and MR = MC.
https://www.economist.com/finance-and-economics/2019/08/08/prices-for-many-goods-do-not-move-the-way-economists-think-they-should. Discuss the similarities and differences between price setting by real-world firms and firms in textbooks (as described in the article).https://www.economist.com/business/2019/09/12/porsche-is-small-but-highly-lucrative. 1) Compare the isoprofit curves of a luxury car to those of a non-luxury car. 2) Evaluate the use of cost sharing across different vehicle brands in a company.https://www.economist.com/finance-and-economics/2009/10/22/e-pluribus-tunum. 1) Discuss the constraints in online music providers’ profit maximisation problem. 2) Discuss the trade-offs faced by online music providers when choosing a pricing scheme. 3) Which pricing scheme mentioned in the article do you think firms should choose?(Section 7.5)
This section defines price elasticity of demand and explains why this concept is important for firms.
Key concept: Price elasticity of demand (PED)
This concept can be confusing to some students because it is a measure of proportional change and has no units. Motivate them by demonstrating how useful the measure can be. Many students believe that the elasticity is the same at any point along a straight-line demand curve because the slope remains constant. Use Figure 7.12 in class or get the students to do the calculations to understand that the elasticity is different along different points of a linear demand curve. Students should be aware of the equivalent formulae used to calculate PED and their interpretation (Figure 7.11).
https://scholar.harvard.edu/files/alada/files/price_elasticity_of_demand_handout.pdfhttps://www.ft.com/content/4f7add7e-4126-11da-a208-00000e2511c8. Identify the various pricing strategies mentioned in the article and use concepts from this unit (e.g. price elasticity of demand) to explain the firm’s decision.https://www.economist.com/business/2013/07/27/thinking-twice-about-price. 1) Evaluate the costs and benefits of having a clearly defined pricing strategy. 2) How have companies ‘gotten away’ with charging more for their products?https://www.econgraphs.org/graphs/concepts/elasticity/demand_elasticity/constant_slope, which shows how elasticity varies along a demand curve, along with the equation to calculate PED.(Section 7.7)
This section explains how the interaction between firms and consumers results in gains from trade (surplus), and discusses how the firm’s market power (its ability to influence the price in its own favour) affects the division of market surplus.
Key concept: Gains from trade/Gains from exchange
This unit links economic rents to consumer surplus and producer surplus. Consumer and producer surplus add up to the total surplus, which results from the interaction between the firm and its customers and provides a measure of the gains from trade.
Consumer surplus; Producer surplus: Students should be aware of the caveats with interpreting consumer and producer surplus. For example, students often equate producer surplus with profit, but the two concepts are distinct as profit accounts for fixed costs (Figure 7.19).
Deadweight loss: This model also provides a very good opportunity to highlight that the outcome of the firm’s profit-maximization decision is an equilibrium, but not a Pareto-efficient one. The inefficiency here is related to power and the rules of the game. The DWL arises because the firm must charge a single price.
https://www.economist.com/free-exchange/2013/03/11/measuring-consumer-surplus-online. To discuss: 1) How useful is the concept of consumer surplus in practice, given the difficulties in measurement discussed in the article? 2) Discuss the challenges involved with measuring the consumer surplus of online platforms. Do you agree with the estimate given in the article?Key concept: Price discrimination
Instructors can refer to Exercise 7.3 (perfect price discrimination) as a scenario where the profit-maximizing outcome is also Pareto efficient. These aspects are rarely discussed in this way in other texts. Figure 7.20 is useful to dispel the common confusion among students that a situation is Pareto efficient because the firm is maximizing profits.
https://www.ofcom.org.uk/__data/assets/pdf_file/0033/199248/personalised-pricing-discussion.pdf); OECD “Personalised pricing in the digital era” (https://one.oecd.org/document/DAF/COMP(2018)13/en/pdf).(Section 7.8, 7.10-7.11)
Section 7.8 explains how producers of differentiated products can enjoy market power, enabling them to set price above marginal cost. Section 7.10 uses game theory concepts (Unit 4) to model the strategic price-setting behaviour of two firms and explains how the type of game (coordination game vs prisoners’ dilemma) depends on the degree of consumers’ price sensitivity. Section 7.11 explain how a firm’s cost structure can be a source of market power: decreasing long-run average costs can result in natural monopolies.
Key concept: Market power; Market share
Market power is defined as the ability to influence the price in one’s own favour. It is a special case of bargaining power, a concept discussed in Unit 5. Market share (the firm’s share of total market quantity or revenue) is a common measure of market power. Students should understand the relationship between price markups and market power (both the intuition and the equation in Section 7.8).
Monopoly: The unit presents monopoly as a special case of price-setting firms (a single firm supplies the entire market).
https://www.ft.com/content/b62b46cc-216d-11e4-b145-00144feabdc0. Discuss: To what extent does the empirical evidence in the article support the theoretical concerns about monopolies discussed in this unit?Key concept: Natural monopoly
When there are very large economies of scale in an industry (specifically, decreasing long-run average costs, a single firm can supply the whole market at lower average cost than two firms. Section 21.4 (The Economy 1.0) provides a discussion and diagram of the TC, MC, and AC for this case.
https://www.core-econ.org/the-economy/book/text/21.html#214-economies-of-scale-and-winner-take-all-competition) explains the cost structure that gives rise to natural monopolies, with applications to knowledge-intensive innovation.https://www.ft.com/content/1c017e60-9eae-11e7-8cd4-932067fbf946. 1) Discuss the extent to which the water industry is a natural monopoly. 2) Have students research the water industry in their country and compare it with that of the UK.https://www.economist.com/finance-and-economics/2018/06/07/the-market-for-driverless-cars-will-head-towards-monopoly. Discuss: 1) To what extent is the market for driverless cars a natural monopoly? 2) What kinds of economies of scale do driverless car companies benefit from? Explain whether or not a monopoly in driverless cars is necessarily a bad thing.(Section 7.9, 7.12)
These sections outline various ways that firms can influence their market power, some of which are considered anti-competitive. Section 7.9 discusses the role of advertising and innovation. Section 7.12 focuses on how competition authorities can use antitrust policy to regulate such behaviour.
Key concept: Advertising and innovation
Students should understand how firms use these methods to differentiate their products from those of their competitors. Section 7.9 contains some examples.
https://www.core-econ.org/the-economy/book/text/21.html#introduction) uses familiar frameworks (game theory, constrained choice problems) to explore firms’ incentives to innovate and policies that can encourage innovation.Key concept: Competition policy/Antitrust policy
Instructors can use the surplus analysis in Section 7.7 to motivate the role of competition authorities (protect consumer surplus and maintain the wider benefits from competition). Students should be aware of ways that firms can influence rivalry (limiting access to production inputs or access to consumers, merging with other firms, collusion, innovation) and price elasticity of demand (advertising).
https://form.typeform.com/to/MQJ1s0?typeform-source=maxcma.typeform.com (or find an alternative for their country).https://www.gov.uk/government/collections/business-cartels-case-studies; instructors could find similar webpages for their own country). Or, have the students first brainstorm ways that firms behave anti-competitively, then find a case study as an example.https://www.economist.com/technology-quarterly/2018/11/15/regulators-across-the-west-are-in-need-of-a-shake-up. Discuss: 1) To what extent are current legal frameworks related to anti-competitive behaviour fit for purpose? 2) Discuss the challenges faced by competition authorities in identifying and punishing anti-competitive behaviour.Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
(Section 8.1-8.3, 8.6)
These sections build a model of price-taking buyers and sellers, focusing on how the interactions between buyers and sellers can lead to market equilibrium. Besides characterizing the equilibrium (Section 8.3), the unit also discusses out-of-equilibrium dynamics following exogenous shocks to supply and demand (Section 8.6), explaining in detail how rent-seeking behaviour results in movement from the old equilibrium to the new one. Students should understand the importance of prices as messages.
Key concept: Market-clearing price; equilibrium price
In an equilibrium the price satisfies three properties: a) it is such that consumers maximize utility, given their own constraints; b) it is such that firms maximize profits, given demand constraints; and c) markets clear.
Competitive equilibrium: Students should understand why the competitive equilibrium is a Nash equilibrium – given what all other actors are doing (trading at the equilibrium price), no actor can do better than to continue what he or she is doing (also trading at the equilibrium price). Figure 8.4 explains in detail why other prices cannot result in market equilibrium.
https://www.youtube.com/watch?v=mkz9AQhQFNY). Use the information in the video and Great Economists box to explain why Hayek thought price mechanisms were important for markets to function well (compared to centralized planning).https://www.economist.com/finance-and-economics/2015/02/12/guaranteed-profits. Discussion questions: Compare and contrast the potential effects of price guarantees and price discrimination. To what extent can we consider firms that offer price guarantees as ‘price takers’?https://www.economist.com/the-economist-explains/2017/09/20/how-supply-can-create-its-own-demand. To discuss: To what extent do you think Say’s law (supply creates its own demand) holds in real-world economies?)https://www.core-econ.org/experiencing-economics/instructors/book/text/04.html. (Instructors need to create a free account to access the teaching resources). The game has three scenarios – students only need to play scenario 1 (a simple “trading-pit” experiment).Key concept: Firm’s supply curve
This unit uses a step function rather than a continuous function and assumes that firms have capacity constraints. Marginal costs are constant until the capacity constraint, after which they immediate increase to a higher value (Figure 8.8). Students should understand why the marginal cost curve is the firm’s supply curve.
Market supply curve: Students should understand that the continuous market supply curve typically shown in supply-demand diagrams approximates the step function that combines the individual firm supply curves (which are step functions). Figures 8.9 and 8.10 explain the aggregation process in detail; students should know how to derive the market supply curve from the individual firm supply curves.
https://www.economist.com/special-report/2011/09/22/crowded-out. Questions: 1) Use the firm-level and market-level supply model to explain the effect of Chinese demand for raw materials. 2) Use appropriate diagrams to analyse and compare the effects of a rise in commodity prices on developing and advanced economies.Key concept: Exogenous shocks to supply and demand
Disequilibrium is modelled initially as an exogenous change that shifts the supply or demand curves. The focus is then on endogenous changes within the model which restore or move the economy back toward equilibrium. This is a useful framework in which to familiarize students with the use of these important terms. Distinguish between endogenous changes (when the x-axis or y-axis variable changes, we move along the curve) and exogenous changes (when a variable that is not on either axis changes, we shift the entire curve). Emphasize that a shock is called exogenous because our model cannot explain it; we use the model to study its consequences, not its causes.
Market equilibration through rent-seeking: Equilibrium is not a state that markets are permanently in. Prices contain information that signal market participants to behave in certain ways. The behavior of the market participants determines whether, when, and how the market gets to a stable competitive equilibrium. Work through the steps in Figures 8.14 and 8.15 to help students understand adjustment process.
https://www.economist.com/finance-and-economics/2019/09/12/soaring-pork-prices-hog-headlines-and-sow-discontent-in-china. Question: Use the supply and demand model to explain the changes in the price of pork discussed in the article, as well as the possible outcome of measures taken to increase supply.https://www.economist.com/the-economist-explains/2016/05/24/why-the-price-of-quinoa-has-fallen. Question: Use the supply and demand model to illustrate the changes in the price of quinoa discussed in the article.https://econclassexperiments.com/experiments/fishmarket/] teaches students to distinguish between shifts of a supply/demand curve from movements along the curve, comparative statics (supply curve shift in a hypothetical fishing market), and the concept of sunk costs. Note: Instructors need to register for a free account to access the game, and request accounts for their students.(Section 8.7)
This section explains how changes at the individual firm level affect market supply in the short-run and the long-run. An understanding of the individual firm diagram (Figure 8.16) is crucial.
Key concept: Definition of short run and long run
An important distinction between long-run and short-run equilibrium is that in the short run some variables are fixed while in the long run, all variables are free to adjust (including firm exit and entry). Students should understand that these terms do not refer to specific periods of time. You may want to review the isoprofit diagram from Unit 7 and relate it to Figure 8.16 (students need to be able to use it to identify whether a firm is making negative, positive, or zero economic profits).
Short-run and long-run equilibria: In the long run, the market supply curve shifts because existing firms can change their capacity (expand production to reduce average costs) and firms can choose to enter or leave the market. Students should understand the distinction between economic profits and normal profits – in long-run equilibrium, firms make zero economic profits but still make normal profits.
https://www.economist.com/leaders/2018/07/26/like-america-britain-suffers-from-a-lack-of-competition. Questions: 1) Analyse the possible short-run and long-run equilibria for markets in the UK, assuming that there is a lack of robust competition policy after Brexit. How do the outcomes differ from those in the unit? 2) With reference to the article, discuss the challenges that regulators face when designing competition policy. Is a lack of competition necessarily bad for consumers?(Section 8.5, 8.12-8.13)
Section 8.5 analyses surplus in competitive equilibrium, while Section 8.12 analyses how a tax affects market surplus and Section 8.13 analyses how a price ceiling (rent control) affects market outcomes and surplus.
Key concept: Consumer surplus; producer surplus
Figure 8.12 explains the definitions in detail. Students should know that producer surplus is not economic rent (a payment above what is needed to sustain an activity). Thus, the term surplus as used in this unit is a measure of benefit or welfare, and there is not enough of it to generate any economic rents in equilibrium. It is best to avoid using the term ‘rents’ in this unit, unless talking about out-of-equilibrium situations, such as the positive profits outside of equilibrium which would incentivize new entry.
Key concept: Pareto efficiency
Students should know that the efficiency properties of a competitive market equilibrium depend on the conditions under which buyers and sellers interact (homogenous product, price-taking behaviour, no external effects, complete contracts). Aside from Pareto efficiency, fairness is an important criterion to evaluate market outcomes.
https://www.economist.com/britain/2016/08/20/a-muggles-game. Questions: 1) Use the supply and demand diagram in the unit to illustrate why secondary ticket markets exist. Why are secondary ticket markets difficult to monitor and regulate? 2) Discuss whether or not secondary ticket markets should be allowed, on the grounds of fairness and efficiency.Key concept: Taxation; tax incidence
Students should understand the effects of a tax in a competitive market (go through the steps in Figure 8.23). While such taxes result in “deadweight loss”, when evaluating the welfare effects of a tax, students should be aware of the different policy aims for a tax (raise revenue, change behaviour) and the whether the conditions for Pareto efficiency hold. It is important to understand how the price elasticity of demand and supply affect the tax incidence. Note that The Economy uses the word “incidence” to mean “effective incidence” (who bears the tax burden, in surplus terms) not “formal incidence” (who legally pays the tax). The Economy always shows the supply curve shifting but students should know that an equivalent tax on demand would have the same implications for surplus.
https://www.ft.com/content/e76b60cc-d72e-11e6-944b-e7eb37a6aa8e. Discussion question: Examine the potential effects of a sugar tax on health, households’ and firms’ decisions, and prices in other markets.https://www.economist.com/international/2018/07/28/sin-taxes-eg-on-tobacco-are-less-efficient-than-they-look. To discuss: 1) Evaluate the arguments for and against ‘sin taxes’. 2) Based on the information in the article, what advice would you give to policymakers deciding how to levy a ‘sin tax’?https://www.econstor.eu/handle/10419/204347https://www.core-econ.org/doing-economics/book/text/03-01.html) gets students to analyse data from a natural experiment (tax on sugary beverages in California). Part 1 compares prices of sugary beverages before/after the tax, and Part 2 compares prices of beverages (taxed and non-taxed) in affected vs non-affected areas. Instructors can set one part as a week-long assignment, and/or ask students to read the paper that the data comes from (https://tinyco.re/6616217) and discuss the tax’s effects on beverage consumption.Key concept: Rent ceiling
Governments may intervene in a market to change the equilibrium price, to achieve other objectives such as fairness. Figure 8.25 analyses the effects of one such policy (rent ceiling, defined as the maximum price that landlords can charge tenants).
https://www.ft.com/content/fe805c60-a6ac-3aab-8582-41b7fcacbfc0); The Economist article on rent control in the US (https://www.economist.com/leaders/2019/09/19/rent-control-will-make-housing-shortages-worse). Students can compare/contrast the real-world examples from those in Exercise 8.14, and discuss alternative policies that governments could adopt to address the housing issue.(Section 8.10-8.11)
These sections evaluate whether the model of perfect competition outlined in Sections 8.1-8.4 is a “good” model – how can we determine (empirically) the extent of competition in a market and why might this model be useful even if the theoretical conditions do not hold. Section 8.11 presents a case study of how we can use prices to examine the functioning of a market, and emphasizes the concept of “prices as messages”.
Key concept: Perfectly competitive market
The model of perfect competition allows us to benchmark a real industry against a theoretically constructed one, and to hypothesize the potential gains from transitioning an actual industry to a more competitive one. Many students have issues with the model of perfect competition exactly because the industry structure it represents does not exist in real life, so it is important for them to understand why (and when) such models are useful. Point to how the models of perfect competition and monopoly (Unit 7) give us two extremes to set the limits of what we can observe in the real world. Emphasize that market structure is a “spectrum” (different degrees of competition, not a binary characteristic).
Characteristics of competitive equilibrium: Students should know the three characteristics (the Law of One Price, market clearing, price-taking participants) and apply them to real markets.
https://tinyco.re/4300778) and evaluate it against each of the conditions for competitive equilibrium.https://www.economist.com/graphic-detail/2019/08/10/silicon-valleys-giants-look-more-entrenched-than-ever-before. Discuss: With reference to the conditions for competitive equilibrium, explain whether tech companies behave more like price-takers or price-setters).https://www.economist.com/open-future/2018/10/10/capitalism-is-becoming-less-competitive. Questions: 1) Discuss the regulatory problems that are common to all or most of the countries covered in the article. 2) To what extent can the markets in these countries be classified as ‘perfect competition’?https://www.economist.com/finance-and-economics/2003/10/16/the-flaw-of-one-price. To discuss: Which of the conditions of perfect competition are unlikely to hold, resulting in the price dispersion shown in the article?)(Section 8.8-8.9)
These sections use two different frameworks to explore the behaviour of cartels. Section 8.8 uses the supply-demand diagram to show how cartels (such as OPEC) can drive up prices by limiting supply. Section 8.9 models the price-setting decision within a cartel as a social interaction, examining conditions that give rise to stable cartels (coordination game) and conditions where cartels cannot be sustained (prisoners’ dilemma).
Key concept: Cartel
Work through the analysis in Figure 8.19, pointing out the similarities and differences between the oil market and the price-taking examples in previous sections. Notice that the market for oil has a slightly different supply curve due to the market structure (the OPEC cartel limits supply). The economic rents that arise from the short-run supply conditions particular to the oil market may give rise to incentives to find more oil. This may involve innovations to find new types of oil (for example, tar sands oil) or new methods of extraction.
Coordination game; Prisoners’ dilemma: To analyse cartel behaviour as a game, students should be familiar with best response and Nash equilibrium (Sections 4.2-4.4).
https://ourworldindata.org/grapher/oil-production-by-country) to make charts comparing OPEC’s share with that of other countries and identify any other major “players”.https://www.economist.com/finance-and-economics/2018/11/15/the-oil-price-swings-dramatically). Have students 1) Compare and contrast the world market for oil in 2018 (article) and 2020 (report). 2) Analyse the impact of American production of oil on the price of oil and on the market of oil. Explain whether you think the growth of alternative oil suppliers (besides OPEC) is a good thing for the global economy.https://www.economist.com/finance-and-economics/2017/08/31/market-concentration-can-benefit-consumers-but-needs-scrutiny. Question: Analyse the effect of increased market concentration in terms of efficiency and fairness.Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
(Section 9.2)
This section explains the definitions and usage of personal finance terms that are commonly used in everyday language: income, wealth, investment, earnings, savings, depreciation, bonds, shares. The section also introduces the distinction between stock and flow variables.
Key concept: Income, wealth, investment, earnings, savings, depreciation
Students should know the definitions of these terms and how they are used in economics (which may be different from everyday usage). The bathtub analogy (Figure 9.1) can help students distinguish between the various concepts.
(Section 9.3-9.7, 9.11)
Sections 9.3-9.7 set up an individual’s choice of consumption over two time periods (“now” vs “later”) as a constrained choice problem, using the framework of Unit 3. These sections analyse the decisions of two individuals: Julia, who has her entire endowment “later”, and Marco, who has his entire endowment “now”. The effect of different actions (borrowing, saving, investing, lending) and changes in the interest rate on the feasible frontier and the optimal choice (income and substitution effects) are also discussed. Note that this unit uses the real interest rate and assumes zero inflation (so the real and nominal interest rates are the same). Section 9.5 applies the concept of discounting to environmental problems, and Section 9.11 discusses why observed behaviour may not be consistent with the intertemporal choice model is (hyperbolic discounting, imperfect information, risk aversion).
Key concept: Intertemporal choice model
Make clear links back to the model in Unit 3 (MRS and MRT). In Unit 9, the feasible set represents a person’s opportunities to benefit from the credit market and depends on his/her endowment and on whether they receive it ‘now’ or ‘later’. Link interest rates back to the concept of opportunity cost (Section 9.3).
Endowment: The unit discusses different interest rates in cases where the individuals’ endowments are on one of the two axes (either all the income in the future, or all the income now). Often, some students miss that the way to represent a change in the interest rate is to pivot the feasible set from the endowment point. To ensure students understand the relationship between the feasible set and the endowment point, set an exercise in which the individual’s endowment is not at a corner, namely where there is income in both periods. Ask students to draw an increase in the interest rate in this case to help them understand that one lends or borrows from one’s current position. (The feasible frontier must always include the endowment.)
Consumption smoothing, situational and intrinsic impatience: Ensure that students understand that smoothing behavior is related to diminishing marginal returns to consumption. Students should know the distinction between situational impatience and intrinsic impatience and how they affect the shape of the indifference curves: situational impatience (having unequal endowments across time periods) makes indifference curves convex while intrinsic impatience (preferences to consume more now rather than later determines the slope of the indifference curves (whether MRS = 1 + discount rate is greater than/less than one at a given point). Exercise 9.2 helps students understand the conceptual difference between intrinsic impatience and diminishing marginal returns to consumption.
Key concept: Evaluating the model
Students should understand three reasons why real-world decision making may differ from that predicted by the model – 1) people are not consistent (hyperbolic discounting); 2) people are not fully informed (lack important information needed for the decision); 3) people prefer outcomes that are certain over taking risk (risk aversion).
https://docs.iza.org/dp9674.pdf); for country-specific questionnaires, instructors can download them from the Global Preferences Survey website: https://www.briq-institute.org/global-preferences/downloads). Students can answer the questions and compare their responses to their country’s average and other countries: https://www.briq-institute.org/global-preferences/maps. Students could complete this activity asynchronously and share results with the class.https://www.economist.com/special-report/2005/09/24/anatomy-of-thrift. Discuss: Which of the article’s explanations for the low saving and investment rates do you find the most/least convincing, and why? 2) Why do people not save and invest as much as economic theories suggest? (Instructors may want to supplement this discussion with more recent articles from after the pandemic).(Section 9.1, 9.8-9.10, 9.12-9.13)
These sections explain the causes and consequences of inequality in credit markets. Differences in endowments mean that interest rate changes create conflicts of interest over the gains made possible by borrowing and lending; those with endowments “now” benefit from interest rate increases while those with endowments “later” do not (Section 9.8). Differences in endowments also affect the likelihood of obtaining a loan and the terms of loan repayment (Sections 9.9-9.10). Individuals who are unable to provide equity or collateral are either unable to obtain a loan (credit market excluded) or must borrow on unfavourable terms (credit constrained). Sections 9.12 discusses the vicious cycle of poverty these mechanisms create, and Section 9.13 discusses policies that could break the cycle.
Key concept: Conflict of interest
Students should understand that interest rates have different effects depending on whether an individual has all/most of their endowment “now” rather than “later”. The steps in Figure 9.14 use Julia and Marco to illustrate this point. Because the cost of moving consumption forward in time by borrowing (the rate of interest) is the same as the gain to Marco by postponing his consumption (by lending), Marco and Julia have a conflict of interest over how the mutual gains from exchange are shared.
https://www.ft.com/content/516d05e0-3de5-11e6-8716-a4a71e8140b0. Discuss the trends in credit card borrowing mentioned in the article and why they might be problematic. (As an extension, instructors could ask students to find equivalent data for a country of their choice and compare it with the data in the article).https://www.economist.com/finance-and-economics/2012/12/01/savers-lament; https://www.economist.com/finance-and-economics/2019/07/11/should-egalitarians-fear-low-interest-rates. Questions: 1) Who wins and who loses from low interest rates, and why? 2) To what extent does the model in the unit explain actual households’ response to a change in interest rate? What other factors need to be taken into account? (Instructors could contrast the situations described in the article with the more recent experiences of high interest rates to control inflation shortly after the pandemic.)https://www.economist.com/finance-and-economics/2019/10/10/a-group-of-fintech-firms-are-changing-the-way-consumers-borrow. To discuss: 1) Compare and contrast fintech firm loans and credit card loans. 2) To what extent is there a conflict of interest between lenders and borrowers in the fintech firm loans mentioned in the article?https://www.economist.com/business/2019/04/06/helping-workers-get-by. Questions: 1) With reference to the frameworks in the unit (intertemporal choice model; Lorenz curve), analyse the effect of companies such as Wagestream on individual workers’ consumption and economy-wide inequality. 2) Analyse the advantages and disadvantages of financial-services companies that offer salary advances.Key concept: Credit market constrained; Credit market excluded
Students should understand the distinction between these two groups of people, and how credit market exclusion affects inequality. Figure 9.18 provides a useful outline of how credit and labour markets shape the relationship between groups with different endowments (such as Julia and Marco). Figure 9.19 uses the Gini coefficient to illustrate how credit market exclusion affects inequality.
Principal-agent problem; Moral hazard: Borrowing and lending is a principal–agent relationship because the lender (the principal) takes a risk of not being repaid, and the extent of that risk is determined by the borrower (the agent) not the lender. Figure 9.17 illustrates the similarity between the borrower-lender relationship and the employer-employee relationship from Unit 6.
https://documents1.worldbank.org/curated/en/588931467993754857/pdf/Microfinance-a-critical-literature-survey.pdf (Section 4); 2) Yang and Stanley’s meta-analysis: https://www.hendrix.edu/uploadedFiles/Departments_and_Programs/Business_and_Economics/AMAES/Micro-Credit%20Meta-Analysis12-18(2).pdf; 3) Milan and Ashta (2020)’s article on challenges and opportunities created by microfinance: https://doi.org/10.1002/jsc.2339.https://www.myfico.com/fico-credit-score-estimator/estimator). Students should consider how the criteria used to assess creditworthiness may advantage/disadvantage certain groups in society. This website on factors used to calculate a credit score may also be helpful: https://myhome.freddiemac.com/blog/notable/20210831-factors-credit-score). Students could complete the questionnaire asynchronously and bring their answers to class.https://www.economist.com/finance-and-economics/2017/07/06/wanna-buy-some-cash-it-will-cost-you. Questions: 1) Use the concepts of impatience and consumption smoothing to explain the motivations of the e-commerce buyers mentioned in the article. 2) Discuss the factors that policymakers need to consider when designing regulations for lending money.https://www.economist.com/special-report/2015/05/07/from-the-people-for-the-people. Questions: 1) Discuss the role of information in loan provision, and the potential issues with collecting data for credit-scoring. 2) Compare and contrast peer-to-peer lending and traditional bank lending. What kind of regulation do you think should apply to peer-to-peer lending?https://www.ft.com/content/3d260e6c-956b-11e3-8371-00144feab7de. Discuss the effects of the global financial crisis on small business and inequality. (Instructors could ask students to make comparisons with the COVID pandemic).https://www.economist.com/free-exchange/2014/07/16/a-three-headed-hydra. Discus: 1) Define income, consumption, and wealth. For each of these concepts, explain what it can and cannot tell us about inequality. 2) With reference to the article, discuss the challenges with measuring inequality for the purposes of public policy.https://gflec.org/initiatives/national-financial-capability-study/) contains summary statistics on financial inclusion in the US; students can also download the data and construct summary statistics of credit market exclusion/constraints (alternatively; instructors can find equivalent surveys for non-US countries).https://www.core-econ.org/doing-economics/book/text/09-01.html) gets students to use Ethiopian household survey data to identify credit-constrained and credit-excluded households, and factors that affect a household’s credit status. Part 9.1 examines households who did not get a loan; Part 9.2 examines characteristics of households who did get a loan. Each part will take one week if done in full, but instructors can select specific questions as a shorter exercise (e.g. have students work with the cleaned data).https://www.jstor.org/stable/26363477)Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
(Section 10.1-10.5)
These sections lay out the framework for thinking about market failure: diagnosis (sources of the problem) and treatment (private solutions and/or policy instruments). The role of information and incomplete contracts are key to understanding how market failures arise (for example, information being unavailable or unverifiable) and understanding the limitations of the theoretical solutions.
Key concept: Market failure
Market failure happens when markets allocate resources in a Pareto-inefficient way. Students should already be familiar with market failure from Unit 7. In Unit 8, the (competitive) market reaches a Pareto-efficient outcome under some assumptions. The pesticide example in Section 10.1 demonstrates that the market equilibrium allocation is no longer Pareto efficient if the assumption of no effect on others does not hold.
Key concept: External effect (externality)
When a firm’s production imposes uncompensated costs on other parties there is a divergence between the private cost of production to the firm and the social cost imposed on others by the firm’s production (a marginal external cost). Bring attention to this divergence between marginal private cost and marginal social cost. Go over the surplus analysis in Figure 10.2 to compare the privately optimal and socially optimal situation (MSC – MPC represents a social cost so there will be DWL). Sections 10.2-10.4 present a diagrammatic illustration of a negative external effect. Note that the figures in these sections assume a constant output price to keep the analytics simple. Be explicit about this as some students will wonder what happens in the case where the demand curve is downward-sloping—this case could be used as an exercise. The constant-price assumption allows a quick revision about the underlying assumptions of competitive behavior that would guarantee a horizontal market price.
https://www.economist.com/banyan/2013/06/21/hazed-and-confused. Discussion questions: 1) Draw a cost-quantity diagram to illustrate the external effect described in the article. 2) Explain why the polluter being in a different country poses additional challenges to resolving the pollution issue.https://link.springer.com/article/10.1007/s11299-022-00288-6. Have students identify the various types of negative and positive externalities related to the COVID-19 pandemic, and the challenges with designing appropriate policy responses. (The policy responses themselves might have external effects e.g. developed countries do not sufficiently account for the effects of their policy actions on developing countries.)https://www.core-econ.org/doing-economics/book/text/11-01.htmlhttps://www.core-econ.org/the-economy/book/text/20.html#206-the-measurement-challenges-of-environmental-policy). Instructors can link this reading to the reading in Exercise 10.3 on Pigou’s ideas (https://www.ncbi.nlm.nih.gov/pmc/articles/PMC7814863/).https://doi.org/10.1016/j.joep.2011.08.013 (Findings: in Switzerland, one additional Ferrari or Porsche per 1,000 people would have the same effect on income satisfaction as a 27% reduction in household income, for everyone else in the neighborhood.)Key concept: Coasean bargaining
Some students find understanding the relative bargaining areas in the Coase bargaining model of Section 10.3 confusing. Spend some time explaining the areas in Figure 10.3. To help students understand when bargaining is possible, note that MSC – MPC is the fishermen’s willingness to pay/accept and P – MPC is the producer’s willingness to accept/pay (depending on who has the property rights). The relative size of these two values determines whether a Pareto-improving bargain is possible, and the maximum size of the compensation (per tonne). The analysis first assumes that plantation owners have the property rights over the resources so that they can use the pesticide. Later, an alternative legal framework is proposed, where the fishermen have a legal right to clean water. Redraw for the students the areas in Figure 10.3 for this second case. It helps considerably in students’ understanding of the Coase bargaining model. It also helps understand that while the same outcome is achieved in terms of production and use of pesticide (assuming no transaction costs), the distribution of gains will be different between the two legal frameworks. Point to the limitations of Coase’s Theorem at the end of Section 10.3.
Pigouvian tax: CORE introduces taxes to internalize the external effects on the benefit side. The tax sets P = MPC at the socially optimal quantity, and thus reduces the price received by the firm (Figure 10.4). Students with prior knowledge of economics may have seen models where taxes increase marginal private cost. In our set-up, both formulations are equivalent.
https://www.economist.com/free-exchange/2012/02/14/who-do-i-have-to-bribe. Questions: 1) Discuss the costs and benefits of using tax-increment financing for local infrastructure. What other practical issues might arise from this policy? 2) Why is Coasean bargaining difficult to implement in practice? 3) Do you think the tax-increment financing solution proposed in the article would help resolve the externality issue associated with property development?https://www.ft.com/content/2d9490f2-1291-11e8-a765-993b2440bd73 and explain the challenges of adopting carbon pricing at a national and global level. Instructors can link this reading to the reading in Exercise 10.3 on Pigou’s ideas (https://www.ncbi.nlm.nih.gov/pmc/articles/PMC7814863/).https://www.core-econ.org/the-economy/book/text/20.html#205-cap-and-trade-environmental-policies) . This section contains 3 exercises (Exercise 20.5 – 20.7) that can be used as class discussion or as a homework assignment. Exercise 20.5 asks students to write an op-ed on cap-and-trade, Exercise 20.6 asks students to analyse the US SO2 cap and trade program, and Exercise 20.7 discusses ideal climate policy.https://www.core-econ.org/experiencing-economics/instructors/book/text/03.html. The instructor’s version (accessible if you have created a free CORE account) contains homework activities to accompany the experiment.https://www.youtube.com/watch?v=2EFG6dvtQ6M). Ask students to research two examples of how governments have helped to incentivize the development of the current COVID-19 vaccine. Discuss the public-good/externality nature of vaccines and the interventions used to incentivize their development. You can enrich the discussion with Richard E. Easterlin’s article on the history of mortality, and the role of markets and public health policy on economic development: https://www.jstor.org/stable/41377854.(Section 10.6-10.7)
This section explains why public good are underprovided in a free market and discusses some methods of provision (with radio broadcasting as an example). The goods taxonomy in Figure 10.9 can help students understand how the nature of goods affects the performance of markets.
Key concept: Public good
CORE follows Paul Samuelson’s definition of public goods in ‘The Pure Theory of Public Expenditure’ (1954), a major contribution to the theory of public goods. Many economists since have refined the concept to include non-excludability as a defining characteristic of public goods. CORE, rather, distinguishes between non-excludable and excludable public goods, the latter called ‘artificially scarce.’ Use Figures 10.7 and 10.8 to compare the market surplus under socially efficient provision and private provision.
https://www.core-econ.org/experiencing-economics/instructors/book/text/01.html]. The instructor’s version (accessible if you have created a free CORE account) contains homework activities to accompany the experiment.http://www.jstor.com/stable/1821307. Ask students to identify the different solutions proposed and find examples of countries where each solution has been adopted. Which arguments need revising in light of legal/technological developments that have happened since he wrote the article (1966), and which arguments still stand?https://www.ft.com/content/517e31c8-45bd-11e1-93f1-00144feabdc0. Discussion questions: 1) Explain the historical origins of institutions that provide public goods and the challenges of public goods provision in today’s globalised world. 2) Why is economic stability a public good, and what are the challenges with “providing” it?https://www.economist.com/free-exchange/2007/07/27/are-children-a-public-good. Questions: 1) To what extent do children fit the economic definition of ‘public good’? What kind of externality (positive/negative) could be associated with having children? 2) Do you agree with the “kids as public goods” argument? Explain why/why not.(Section 10.8-10.9)
Section 10.8 provides an overview of problems resulting from information asymmetries (hidden action and hidden attributes). Section 10.9 discusses moral hazard and its implications for insurance and credit markets.
Key concept: Moral hazard
Problems of moral hazard can be characterized as principal-agent problems. Students should understand how measures to mitigate hidden action problems in can exacerbate inequality (for example, requiring equity or collateral in credit markets can exclude low-income borrowers).
https://www.economist.com/leaders/2018/09/06/the-world-has-not-learned-the-lessons-of-the-financial-crisis); The Financial Times (https://www.ft.com/content/4b84d45e-8bec-11e7-9084-d0c17942ba93). Discussion questions: 1)To what extent did the policy reforms after 2008 address the root cause(s) of the financial crisis? 2) According to the articles, what lessons did policymakers fail to learn from the 2008 financial crisis?https://www.economist.com/international/2019/08/22/the-poor-who-most-need-insurance-are-least-likely-to-have-it. Discussion questions: 1) Discuss the challenges that insurers face when providing insurance to the poor. How could they encourage the poor to purchase insurance? 2) According to the article, what factors affect the demand and supply of insurance for the poor?(Section 10.10)
This section uses Akerlof’s classic “lemons” example to explain how hidden attributes (such as product quality) can result in missing markets or Pareto inefficient outcomes (relative to the full-information case).
Key concept: Adverse selection
Work through the bullet points in the used car and health insurance examples to help students understand the logical steps behind market “unravelling”. Figure 10.13 shows how the asymmetric information problems of moral hazard and adverse selection fit into the unit’s framework for understanding external effects.
https://www.ft.com/content/4c4913a2-bbce-30ba-9c39-0ae23062adbf. To discuss: Explain why too little information and too much information pose problems for insurance markets.https://www.mercatus.org/students/research/working-papers/how-internet-sharing-economy-and-reputational-feedback-mechanisms. It discusses historical and modern methods of mitigating informational asymmetries and contains plenty of case studies for discussion.https://www.economist.com/finance-and-economics/2019/09/26/can-you-buy-a-good-second-hand-car. Questions to discuss: 1) Explain why Akerlof’s theory about the “market for lemons” differs from what actually happens in used car markets. 2) Compare and contrast the research findings discussed in the article with the predictions of Akerlof’s “market for lemons” paper.(Section 10.11)
This section discusses the limitations of markets on moral grounds, where the buying and selling of certain goods may violate ethical norms or undermine the dignity of those involved. Resources might instead be allocated by governments, firms, or families.
Key concept: Repugnant markets
Some market transactions conflict with the way we value humanity or democracy. You can refer to the United Nation’s declaration of human rights for a set of values that governments aim to protect. The section outlines examples of laws, like commercial surrogacy laws, that attempt to regulate repugnant markets.
Merit goods: Point to how there are moral/ethical reasons to provide some goods irrespective of ability to pay, just as there are moral or ethical reasons to ban transactions for certain goods. Merit goods are typically provided by governments.
https://www.un.org/en/about-us/universal-declaration-of-human-rightshttps://tinyco.re/7650014. Ask students to summarise Michael Sandel’s argument and explain why they agree/disagree with Michael Sandel’s points about markets, inequality, and democracy. Instructors can supplement the TED talk with this Financial Times article (also by Michael Sandel) on the limits of markets: https://www.ft.com/content/58c2a83a-63e2-11e2-b92c-00144feab49a.https://www.youtube.com/watch?v=r7vzgexzXOk. Alvin Roth’s Journal of Perspectives article is also helpful to explain why a transaction may be considered repugnant, with both current and historical examples: https://dash.harvard.edu/bitstream/handle/1/2624677/Roth_Repugnance.pdf?sequence=6https://www.economist.com/international/2008/10/09/the-gap-between-supply-and-demand. Questions: 1) Discuss the pros and cons of creating a legal market for organ transplants. 2) What important factors do policymakers need to consider in order to maintain the public’s trust in the market? 3) Explain whether or not you agree that buying and selling organs should be a legal transaction. If you agree, discuss some rules you think are necessary to regulate the market, If you disagree, suggest an alternative solution.Complete teaching guides for units 1–10 of The Economy 2.0: Macroeconomics, plus the list of building blocks. This page is structured for machine reading.
How this page is organised
The Economy 2.0 – Macroeconomics contains a new feature called “building blocks”. These are self-contained sections or groups of sections that explain certain concepts and techniques. Where building blocks are used in later units, a hyperlink is always provided there which opens the required material in a separate tab, making it easy for students to read the prerequisite material, either to provide the necessary background knowledge when the unit it comes from has not previously been covered, or to refresh their memories. Building blocks are designed to provide instructors with greater flexibility in the way the course is structured, because prerequisite knowledge is easily identifiable.
The use of building blocks in The Economy 2.0 – Macroeconomics makes it easier for instructors to customize the structure of their class to suit their specific audience and context. There are only two cases where a whole unit is required as a prerequisite for another unit. These units are as follows: (TO UPDATE)
| Prerequisite Units | Where used as a prerequisite |
|---|---|
| Unit 1 | Unit 2 |
| Unit 1, 2 & 3 | Unit 4 |
| Unit | Section(s) | Title of Building Block | Where required? | Where linked as optional reading? |
|---|---|---|---|---|
| 1 | 1.5, 1.6, 1.7 | The WS-PS model of the supply side of the macroeconomy | Unit 3, Unit 5 | None |
| 3 | 3.6, 3.7, 3.8 | The multiplier model | Unit 5, Unit 9 | None |
| 4 | 4.5, 4.6 | The Phillips curve | Unit 5 | None |
| 4 | 4.7, 4.8 | The business cycle model | Unit 5 | None |
| 5 | 5.2, 5.3, 5.4 | Role of fiscal and monetary policy | Unit 7 | None |
| 5 | 5.9, 5.10 | Monetary policy and inflation | Unit 7 | None |
| 5 | 5.13, 5.14 | The domestic and exchange rate channels for the transmission of monetary policy | Unit 7 | None |
| 5 | 5.14 | Monetary policy and the exchange rate | Unit 7 | None |
| 6 | 6.2-6.4 | Debt, financial sector, and banks | Unit 8 | None |
| 6 | 6.6 | Introducing the central bank | Unit 8 | None |
| 8 (Micro) | 8.2 and 8.3 | Demand and supply curves | Unit 8 | None |
| 1 (Micro) | 1.2 | History’s hockey stick | Unit 9 | None |
| 10 (Micro) | 10.3 and 10.5 | Addressing external effects | Unit 9 | None |
| 10 (Micro) | 10.6 and 10.7 | Public Goods | Unit 10 | None |
| 4 & 5 (Micro) | 4.5 and 5.3 | Pareto efficiency and fairness | Unit 10 | None |
| 4 (Micro) | 4.3 and 4.3 | Game Theory and Nash equilibrium | Unit 10 | None |
| 5 (Micro) | 5.12 | Measuring economic inequality: The Gini coefficient | Unit 10 | None |
| 3 (Micro) | 3.2-3.4 | Solving constrained choice problems | Unit 10 | None |
| 3 (Micro) | 3.7 | Income and substitution fees | Unit 10 | None |
| 7 (Micro) | 7.5 | Demand, elasticity, and revenue | Unit 10 | None |
| 6 (Micro) | 6.6 | Getting the work done: Contracts, principals, and agents | Unit 10 | None |
Conceptual prerequisites:
Building blocks in this unit:
Unit overview: This unit provides an introduction to macroeconomics and introduces (un)employment and real wages as key macroeconomic outcomes. It also introduces the WS-PS (supply-side) model. The main decision instructors will need to make is how much detail to provide about the background of this model. This would depend on how much time you have to teach the unit as well as your students’ strengths and weaknesses. Units 1 and 2 go together in the sense that unit 1 teaches the model and unit 2 provides various extensions and applications. Even if you do not teach all of unit 2, it would be good to use at least one section to let students work with the model after you have finished teaching unit 1. This will help your students so that the model does not seem abstract to them. Unit 2 also discusses the measurement of inequality via Lorenz curves and the Gini coefficient.
Key concept: Labour market statistics
the level of employment, unemployment and labour force participation are defined and students learn how they are calculated.
https://www.iz.sk/en/projects/eu-regions/SKhttps://www.bls.gov/opub/mlr/2023/article/labour-force-and-macroeconomic-projections.htm and this article provides detailed reasons for being out of the labour force, broken up by demographic characteristics: https://www.bls.gov/opub/btn/volume-4/people-who-are-not-in-the-labour-force-why-arent-they-working.htm You could ask your students to pull out two statistics that they find particularly interesting and share them with the class (e.g. post them on a discussion forum).Key concept: Real wages
students learn about nominal wages, the CPI price index and how real wages are nominal wages divided by the price level.
Key concept: Overview
The WS-PS model is introduced in unit 1 and applied in unit 2. It is used in the modelling of inflation in unit 4 and to describe the impacts of fiscal and monetary policy in unit 5. It is therefore important that students become comfortable with this model.
Key concept: The WS curve
The WS curve shows the real wage that firms must pay at different levels of employment in order to recruit a sufficient number of workers and motivate them to work hard. At the most basic level, students should understand that real wages tend to be high in “tight” labour markets when unemployment is low, and lower when unemployment is high. In a more detailed way, it will be helpful if students understand the meaning of the firm-level no-shirking wage curve which lies behind this model.
Key concept: The PS curve
The two things students really need to know are 1) the real wage w is determined by the nominal wage W (set by the HR department) and the price level P (set by the marketing department). Firms set prices to maximize profits based on the cost of production (wages, which depend on the extent of the firms’ power in labour markets) and a markup, which is higher when the firm has more power in product markets. Higher prices mean a lower real wage for workers. And 2) The real wage given by the PS curve shows how real output is split between workers (as real wages) and the owners of the firm (as real profits).
Key concept: Equilibrium and Disequilibrium
Section 1.8 describes why there must always be some unemployment, and explains how the economy would move back toward equilibrium from a state of disequilibrium (where the real wage on the WS curve is either higher or lower than the real wage on the PS curve).
https://www.economist.com/finance-and-economics/2018/05/17/lawmakers-are-trying-to-curb-contracts-that-make-it-harder-to-change-jobs] and discuss the following questions: 1) To what extent are relationship-specific and firm-specific assets a plausible explanation for the widespread use of non-compete agreements in America? 2) Analyse the costs and benefits of non-compete agreements on firms, workers, and the whole economy.Key concept: Section 2.11: Germany and Spain
Unit 1 starts with a puzzle and the last section of unit 2 directly answers that puzzle. Even if you do not have time to teach all of unit 2, it would be helpful for your students if you include a discussion of section 2.11 which compares macroeconomic outcomes (unemployment and real wages) in Germany and Spain. This helps them tie the threads together and provides at least one compelling application.
Key concept: Studying the economy as a whole
Section 1.9 explains the difference between microeconomics and macroeconomics and discusses aggregation, general equilibrium and some interesting paradoxes
https://www.nobelprize.org/prizes/economic-sciences/2015/popular-information/ The discussion of the representative consumer is interesting and highly relevant to this section.Conceptual prerequisites:
Building blocks in this unit:
Key concept: Lorenz Curves and the Gini Coefficient
Inequality is a key theme of this unit. Section 2.2 introduces the Lorenz curve as a way to depict the distribution (e.g. of income) within a society and shows how the Lorenz curve can be used to calculate an estimate of the Gini coefficient. The Gini coefficient was also introduced in unit 5 of the microeconomics text.
https://goodcalculators.com/gini-coefficient-calculator/). The exercise suggests calculating the Gini coefficient for heights of the students in the class. You could also calculate the Gini coefficient for distance from the university to their hometown.https://www.ncbi.nlm.nih.gov/pmc/articles/PMC9183946/] and Verick et al. (2021) [https://doi.org/10.1111/ilr.12230]. Students could draw on these articles to discuss in what ways the two crises had similar impacts on inequality and in what ways the impacts were different.https://www.ft.com/content/24e88c30-bc5f-11e6-8b45-b8b81dd5d080. To discuss: 1) Choose one of the graphs in the article and describe, in your opinion, the most interesting feature. 2) Explain what is meant by the Gini coefficient. Explain what the article suggests has happened to income inequality since the 1970s. (Instructors can also ask students to look up income inequality statistics for their country or a country of their choice and compare it with those in the article).https://www.core-econ.org/the-economy/book/text/19.html)https://www.core-econ.org/insights/a-world-of-differences/text/01.html)https://www.labxchange.org/library/pathway/lx-pathway:947bd402-9d3a-40f0-bcac-31c660f34459)Key concept: Lorenz curves and the WS-PS model
section 2.3 demonstrates how the WS-PS model and the Lorenz curve model are related. This is an important section because throughout unit 2, the effects of various policies will be demonstrated using these two models in connection with each other. This unit uses both diagrams to demonstrate the effects of a change in product market competition – which is discussed further in relating to the US in section 2.9. It is important that students understand why the PS curve moves UP when product market competition INCREASES (i.e. because the price markup falls and P is in the denominator of the w = W/P equation).
Key concept: Labour market policies
education and training; wage subsidies and unemployment benefits
https://www.econstor.eu/bitstream/10419/145286/1/dp9995.pdf) and South Africa (https://www.researchgate.net/profile/Tim-Koehler/publication/359745477_Wage_subsidies_and_COVID-19_The_distribution_and_dynamics_of_South_Africa%27s_TERS_policy/links/624dea6f4f88c3119ce45680/Wage-subsidies-and-COVID-19-The-distribution-and-dynamics-of-South-Africas-TERS-policy.pdf). Possible discussion – how were the two programs similar and different? Did they achieve their purpose of supporting employment during the economic crisis?https://data.oecd.org/benwage/benefits-in-unemployment-share-of-previous-income.htm); International Labour Organization (https://www.ilo.org/global/about-the-ilo/newsroom/news/WCMS_007901/lang--en/index.htm). In groups, students could use this information to discuss how the reservation wages of workers may differ across countries and groups in society (e.g. gender, age, type of occupation).https://www.core-econ.org/doing-economics/book/text/06-02.html#part-61-looking-for-patterns-in-the-survey-data]. Instructors can set a few questions for homework or an in-class exercise.Key concept: Labour unions
Section 2.5 describes how unionization could be represented by an upward shift the the WS curve. The “union voice effect” would shift the WS curve in the opposite direction. Unions can impact productivity negatively or positively (this would shift the PS curve, though that is not shown in the diagrams). The section discusses the different impacts of unions that act inclusively (showing restraint due to the impact on the whole economy) in contrast to unions that do not act inclusively (pushing for higher wages in their own corner of the economy).
https://www.bls.gov/news.release/pdf/union2.pdfhttps://home.treasury.gov/news/featured-stories/labour-unions-and-the-us-economyKey concept: Segmented labour markets
Section 2.6 uses the Lorenz curve to show how inequality amongst workers (in primary and secondary labour markets) introduces an additional source of inequality and leads to an increase in the Gini coefficient
https://www.bls.gov/charts/employee-benefits/percent-access-paid-leave-by-wage.htm. Paid vacation: https://www.bls.gov/ebs/factsheets/paid-vacations.htm. Employer provided health insurance: https://www.bls.gov/opub/ted/2023/coverage-in-employer-medical-care-plans-among-workers-in-different-wage-groups-in-2022.htmhttps://www.core-econ.org/espp/book/text/06.html#614-another-kind-of-business-organization-the-gig-economy]. Students can also read this Financial Times article on worker monitoring in the gig economy [https://www.ft.com/content/88fdc58e-754f-11e6-b60a-de4532d5ea35] and compare it with worker monitoring in traditional firms.Key concept: Taxes and Imported Materials
Sections 2.7 and 2.8 show how the equation of the PS curve can be modified to demonstrate how taxes (consumption and labour taxes) and the cost of imported materials will effect the outcomes of the model
Key concept: Competition and Inequality in the US
http://abcnews.go.com/Politics/ftc-started-takes-amazon-meta-chair-lina-khan/story?id=109928219Key concept: Danish “flexicurity”
Section 2.10 discusses the Danish response to the COVID-19 pandemic as well as Denmark’s long-running tradition of “flexicurity”
Key concept: Germany and Spain
Section 2.11 answers the puzzle that was introduced at the start of unit 1. If you already discussed this section when you taught unit 1, you could revisit it here briefly now that your students have seen a more detailed explanation of the potential impacts of unemployment benefits, union coverage and taxes.
Key concept: Sections 2.12 and 2.13 discuss what the model does well as well as some limitations including 1) it may take a long time (decades) to reach the long-run equilibrium so what is observed in the data at any given point in time may not match that and 2) it does not include aggregate demand, which is the topic of the following unit
Required Building Blocks:
Building blocks in this unit:
(Section 3.2-3.4)
These sections provide an in-depth discussion of how GDP is measured, how it is made comparable across time and across countries, and its limitations as a measure of wellbeing.
Key concept: GDP
Students should know the three ways to measure GDP (expenditure, output, income) and why they are equivalent (refer to the circular flow representation in Figure 3.3). For more detail on the “value added” (income) approach, instructors can refer to Extension 3.3. Students should also know how GDP measures are adjusted for comparisons: nominal GDP measures are made comparable over time by using prices in a specified base year (the result is known as real GDP or GDP at constant prices). GDP per capita is also made comparable across countries by using purchasing power parity (PPP) prices.
https://www.cdhowe.org/sites/default/files/attachments/research_papers/mixed/What to the Different Measures of GDP Tell Us.pdfKey concept: Components of GDP
From a national accounting perspective, students should be aware of what is included in each component of GDP (consumption, fixed investment, changes in inventories, government spending, and the trade balance (exports minus imports)) and what isn’t included (to avoid double-counting). For example, government transfers are not included as a component of GDP because these transfers are already counted as consumption and/or investment.
https://www.core-econ.org/doing-economics/book/text/04-02.html#part-41-gdp-and-its-components-as-a-measure-of-material-wellbeing. Questions 3-5 are suitable (individually or together) for a short homework exercise or the whole Part 4.1 could be a longer assignment. This activity is available in Excel, R, Google Sheets, and Python.https://www.ft.com/content/b54cda40-3659-11e8-8b98-2f31af407cc8. Discussion question: How have the components of GDP (specifically, consumption and investment) for China changed over time and why does the author of the article think these changes are a positive sign?https://www.economist.com/finance-and-economics/2008/01/03/an-old-chinese-myth. Discussion questions: 1) Compare the components of GDP mentioned in the article (net exports, investment, consumption) for China and the US. Which country is likely to be more affected by a fall in exports from that country? 2) Explain why value-added is a more accurate way to measure exports (compared to gross revenue), and how this measure changes the way we think about China’s economic growth in the 2000s. 3) How have the components of China’s GDP changed since the article was written (in 2008)?https://www.core-econ.org/insights/financing-american-government/text/01.html (Instructors may want to leave this activity until Unit 5, after covering fiscal and monetary policy in more depth).https://www.core-econ.org/insights/public-debt/text/01.html (Instructors may want to leave this activity until Unit 5, after covering fiscal and monetary policy in more depth).Key concept: Interpretation of GDP
Students should know the key measurement issues associated with GDP (does not account for changes in quality, excludes non-market activity, excludes the underground/illegal economy), and be aware of GDP’s limitations as a broader measure of national wellbeing.
https://www.ons.gov.uk/peoplepopulationandcommunity/wellbeing/bulletins/qualityoflifeintheuk/may2023https://www.core-econ.org/doing-economics/book/text/04-02.html#part-42-the-hdi-as-a-measure-of-wellbeing. The whole part will take a few weeks to complete (in class or in students’ own time) so is suitable for a semester-long assignment. This activity is available in Excel, R, Google Sheets, and Python.https://tinyco.re/6386280). Based on the data, instructors could then ask students to determine whether differences in GDP per capita would be smaller/larger when accounting for PPP compared to current exchange rates.https://www.economist.com/briefing/2016/04/30/the-trouble-with-gdp. Discussion questions: 1) Discuss some of the measurement issues associated with calculating GDP. 2) How useful is GDP as a measure of living standards?(Section 3.1 and 3.5)
Section 3.1 introduces the idea that falling economic output can cause affect individual prosperity and wellbeing. Section 3.5 uses data from the UK to demonstrate that economic growth (measured by percentage changes in GDP) is not smooth: it has peaks (booms) and troughs (recessions). Investment also tends to be more volatile than consumption. Sections 3.9-3.13 discuss some reasons why.
Key concept: The business cycle
The movement from boom to recession and back to boom is known as the business cycle. Students should know the two definitions of a recession (declining output vs economic output below its “normal level”). The concept of “normal output” will be discussed further in Unit 4.
https://www.economist.com/finance-and-economics/2018/04/19/economists-still-lack-a-proper-understanding-of-business-cycles. Discussion question: Compare and contrast the views of neoclassical and New Keynesian economics. How did the 2008 financial crisis challenge these views?https://www.economist.com/finance-and-economics/2019/04/26/americas-strong-growth-this-year-surprises-economists. Discussion question: Using the GDP decomposition in the unit, explain why US GDP grew by more than expected in the first quarter of 2019. Which components of GDP might be a concern for policymakers?https://www.core-econ.org/doing-economics/book/text/13-01.html. The full project will take at least a few weeks to complete, so instructors may assign parts or individual questions for week-long homework exercises. This project is available in Excel, R, and Google Sheets.(Section 3.6-3.8)
These sections introduce the multiplier model, which is a model of aggregate demand that includes the multiplier process. The concepts of equilibrium and exogenous shocks are essential for understanding this model; these are covered in Section 2.8 of the Microeconomics volume.
Key concept: Aggregate demand
Aggregate demand is the total of the components of planned spending in the economy. When the economy is not in goods market equilibrium (Y = AD), unplanned inventories (II) are nonzero. Students should know each variable in the aggregate demand equation (e.g. autonomous consumption/investment, marginal propensity to consume, interest rate, marginal propensity to import) and which variables change the intercept vs the slope of the aggregate demand line.
https://www.ncbi.nlm.nih.gov/pmc/articles/PMC7382353/) Instructors can compare the class’ average MPC and distribution of MPC to the EU data (17 countries) in Figure 1 and Table 2 of the Drescher paper.https://www.ft.com/content/b5b764cc-d657-11e6-944b-e7eb37a6aa8e. Discussion questions: 1) What did the Obama administration do to try and manage the economic recession in 2008-9, and what were the outcomes? 2) Do you think the US government went “far enough” to address the recession?Key concept: The multiplier
The multiplier process is the mechanism through which the direct effect of an increase (or decrease) in aggregate spending is amplified through indirect effects that further increase (or decrease) aggregate output. Figure 3.15 illustrates each step in the multiplier process from initial shock to new equilibrium. Students should know how to derive the equation of the multiplier and how each variable affects the size of the multiplier.
https://www.core-econ.org/experiencing-economics/book/text/05.html) is a game about the multiplier process. Some of the homework questions use the Excel multiplier simulation.https://www.economist.com/economics-brief/2016/08/11/where-does-the-buck-stop. Explain the arguments on both sides of the debate (Keynes’ view and those who disagree with him). Which view is more consistent with what happened in real-world economies?https://www.economist.com/finance-and-economics/2009/09/24/much-ado-about-multipliers. Why is it so difficult to estimate the size of the fiscal multiplier in practice? What are the potential consequences of deciding policy based on an incorrect value of the multiplier?(Section 3.9-3.10, 3.13)
These sections develop the life cycle model of consumption, which is a model of consumption spending in which individuals’ current consumption depends not only on their current income, but also on their expected future income, and their assets, allowing for savings and debts. This model is used to explain why consumption is relatively smooth (compared to investment), and how constraints on households’ ability to smooth consumption affect the economy-wide marginal propensity to consume. Section 3.13 uses China’s post-pandemic aggregate demand problem to illustrate how government social insurance policies affect consumption.
Key concept: Consumption smoothing
A key assumption of the life cycle model is that households prefer to smooth consumption (spread it relatively evenly across time periods rather than having large fluctuations in consumption from period to period). This principle of consumption smoothing explains why households may react differently to permanent vs transitory income shocks. Students may find consumption smoothing unintuitive because they are often credit-constrained and unable to smooth their own consumption. Relating this concept to students’ experiences (for example, student loans that they must repay in the future before saving for retirement) and that of their families can help here. Instructors can also refer to Section 9.3 of the Microeconomics volume for a more detailed explanation of why households may prefer to smooth consumption.
Limits to consumption smoothing: Section 3.10 discusses three limits – credit constraints (Figure 3.18), present bias (Figure 3.19), and limited co-insurance. It is important for students to understand that features of the economy, such as the level of inequality, may influence the number of credit-constrained households—and have consequences for the aggregate economy. It also shows students the importance of modelling economies with heterogeneous individuals because their differing responses to exogenous events may have material consequences for economic outcomes. Instructors can refer to Section 9.9 of the Microeconomics volume for a more detailed discussion of credit constraints and credit market exclusion.
https://www.economist.com/special-report/2005/09/24/anatomy-of-thrift. Discuss: Which of the article’s explanations for the low saving and investment rates do you find the most/least convincing, and why? 2) Why do people not save and invest as much as economic theories suggest? (Instructors may want to supplement this discussion with more recent articles from after the pandemic).https://www.economist.com/finance-and-economics/2009/05/14/smooth-operators). Discussion questions: 1) Compare and contrast the methods that the poor and the rich use to manage their finances. 2) How are the poor able to the smooth consumption despite limited access to conventional banks? Students can also read household stories on how the poor make ends meet around the word, taken from “Portfolios of the Poor” (http://www.portfoliosofthepoor.com).https://www.ilo.org/wcmsp5/groups/public/---ed_protect/---soc_sec/documents/publication/wcms_817572.pdf) and discuss why social protection is important and how countries responded differently to the COVID-19 crisis.https://docs.iza.org/dp9674.pdf); for country-specific questionnaires, instructors can download them from the Global Preferences Survey website: https://www.briq-institute.org/global-preferences/downloads). Students can answer the questions and compare their responses to their country’s average and other countries: https://www.briq-institute.org/global-preferences/maps. Students could complete this activity asynchronously and share results with the class.https://www.myfico.com/fico-credit-score-estimator/estimator). Students should consider how the criteria used to assess creditworthiness may advantage/disadvantage certain groups in society. This website on factors used to calculate a credit score may also be helpful: https://myhome.freddiemac.com/blog/notable/20210831-factors-credit-score). Students could complete the questionnaire asynchronously and bring their answers to class.https://gflec.org/initiatives/national-financial-capability-study/) contains summary statistics on financial inclusion in the US; students can also download the data and construct summary statistics of credit market exclusion/constraints (alternatively; instructors can find equivalent surveys for non-US countries).https://www.core-econ.org/doing-economics/book/text/09-01.html) gets students to use Ethiopian household survey data to identify credit-constrained and credit-excluded households, and factors that affect a household’s credit status. Part 9.1 examines households who did not get a loan; Part 9.2 examines characteristics of households who did get a loan. Each part will take one week if done in full, but instructors can select specific questions as a shorter exercise (e.g. have students with the cleaned data).https://www.social-protection.org/gimi/WSPDB.action?id=809) to compare the types of co-insurance/social insurance provided by different countries.(Section 3.11-3.12)
These sections explain the aggregate investment function in more detail, and use the concept of virtuous/vicious cycles (Figure 3.21) to explain why investment tends to be volatile. Extension 3.11 provides a more formal treatment of investment decisions as a coordination game. Instructors who want to cover this content should ensure students are familiar with the game theory concepts in Sections 4.2, 4.3, and 4.13 of the Microeconomics volume.
Key concept: Aggregate investment
Aggregate investment is modelled as function of the interest rate (slope) and profit expectations (vertical intercept). Figure 3.24 illustrates how investment changes in response to each of these variables.
https://www.core-econ.org/experiencing-economics/book/text/02.html) has students play an investment coordination game to understand why investment follows virtuous and vicious cycles.https://www.economist.com/books-and-arts/2017/12/14/businesses-investment-decisions-can-have-unexpected-consequences. Discussion questions: 1) Discuss the challenges involved with measuring intangible investment/assets. 2) What is “intangible investment” and why is it so important for explaining economic growth in developed countries?Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
(Section 4.1-4.3)
Section 4.1 introduces the topic with descriptive data on inflation across countries and time, including the most recent spike in inflation after the pandemic. Section 4.2 explains how inflation is measured using price indices and discusses some measurement issues with the “representative basket” method of calculating the consumer price index (substitution bias, quality changes). Section 4.3 covers key definitions (inflation, deflation, disinflation) and explains why inflation can be “bad” (it alters the distribution of real income and creates uncertainty about future prices), but that a low and predictable level of inflation can be desirable.
Key concept: Inflation, deflation, disinflation
Students need to know the distinction between these three terms. Students often find it hard to understand that the term “inflation” is used to refer to the growth rate of prices, so that when inflation is positive, prices are rising and when it is negative, prices are falling. A slower rate of inflation is often mistakenly referred to as deflation, and for this reason, this unit distinguishes between deflation (a cause for alarm!) and disinflation. Working with some numerical examples (e.g. the data in Question 4.1) might be helpful. Students should also understand the difference between inflation or constantly rising prices, and accelerating inflation, where the rate of inflation itself is rising.
https://tinyco.re/6386280) to discuss how the cost of living can be measured and compared across countries. For example, do students agree with the items being used?https://studentsforliberty.org/blog/five-myths-about-inflation/) and this YouTube video by Professor Antony Davies (https://www.youtube.com/watch?v=vsuSYJc3JuA).https://www.ft.com/content/4de1d464-0172-11dc-8b8c-000b5df10621. Discuss: What is the author’s argument about official measures of inflation? What measures do you think policymakers should use to assess price changes/price stability in the economy?https://www.economist.com/special-report/2019/10/10/technology-is-making-inflation-statistics-an-unreliable-guide-to-the-economy. Discussion questions: 1) How is technology challenging the way that we interpret and measure conventional indicators of living costs or living standards, such as GDP and inflation? 2) What are the consequences of mis-measuring inflation?https://www.economist.com/special-report/2019/10/10/inflation-is-losing-its-meaning-as-an-economic-indicator. Discuss: 1) To what extent is long-term low inflation consistent with economic models and theory, as discussed in the article? 2) Why do you think the author of the article is concerned about disinflation? 3) This article was written in 2019; how do events that happened afterwards change the way you view the arguments in the article?https://www.ft.com/content/d9f9955e-d932-11e4-a8f1-00144feab7de. Discuss: The author argues that high inflation is needed in some economies to help economic growth in the longer term. To what extent do you agree with this argument? (Note: this article was written in 2015.)https://www.imdb.com/list/ls026442468/)(Section 4.4-4.6)
These sections model inflation as arising from bargaining gaps (conflicting claims on output between workers and firms) and introduce the inverse relationship between inflation and unemployment (known as the Phillips curve). Section 4.6 shows how expected inflation can shift the Phillips curve (Figure 4.15 illustrates a wage-price spiral). These sections discuss the supply-side of the economy so require students to be familiar with the WS-PS model; instructors should ensure that Sections 1.5-1.7 are covered before teaching Unit 4. The unemployment rate in supply-side equilibrium is now interpreted as the inflation-stabilizing unemployment rate (or NAIRU).
Key concept: Bargaining gap
The bargaining gap is the distance between the wage on the WS curve (the wage workers expect to get) and the wage on the PS curve (the wage workers actually get). Students should understand that inflation arises from changes in bargaining power associated with movements along the wage-setting curve, rather than shifts of the entire wage-setting curve. Working through the steps in Figures 4.9 and 4.10 will help students understand the relationship between the bargaining gap and inflation.
https://www.epi.org/productivity-pay-gap/).Key concept: The Phillips curve
This curve represents the inverse relationship between the rate of inflation and the rate of unemployment. Students should understand the difference between movements along the Phillips curve (changes in the bargaining gap) and shifts of the curve (changes in expected inflation).
https://www.ft.com/content/91bb9cd4-292e-11e8-b27e-cc62a39d57a0. Discuss: What is the key debate discussed in the article, and why does it matter for policymakers?https://www.economist.com/finance-and-economics/2017/06/15/inflation-has-not-yet-followed-lower-unemployment-in-america. Discuss: 1) To what extent is the Phillips curve relationship a useful concept in practice? 2) What factors could explain why the Phillips curve relationship fails to hold in the real world? (Students can refer to the discussion and Figure 15.6 in Section 15.6 of The Economy 1.0: https://www.core-econ.org/the-economy/v1/book/text/15.html#155-what-happened-to-the-phillips-curve)https://www.economist.com/special-report/2019/10/10/economists-models-of-inflation-are-letting-them-down. Discuss: Assess the evidence for a non-linear Phillips curve presented in the article. How can technological progress explain the real-world relationship between inflation and unemployment?https://www.economist.com/economics-brief/2017/08/26/the-natural-rate-of-unemployment. Questions: Discuss issues with measuring the natural rate of unemployment. How useful is the natural rate of unemployment in practice?Key concept: Inflation expectations/Expected inflation
CORE takes expected inflation to be equal to last year’s inflation, which is a simple form of adaptive expectations. Another interpretation is that HR includes inflation over the past year in the wage settlement, to make up for the shortfall in the real wage that workers experienced because inflation turned out to be higher than expected. Students should understand how inflation expectations affect inflation: inflation this period is the sum of expected inflation (last period’s inflation) and the bargaining gap (this period). Figure 4.16 can help students understand how inflation evolves in this model. Inflation will only be stable at the unemployment rate of supply-side equilibrium. Unit 5 will discuss the concept of anchoring inflation expectations.
https://personal.lse.ac.uk/tenreyro/understandinginflation.pdf) explains how the Bank of England measures inflation expectations and discusses how (and why) inflation expectations vary across demographic groups in the UK. Instructors could ask students to read this article and discuss the findings in small groups.(Section 4.7-4.11)
These sections build a three-diagram model of the business cycle that brings together the demand-side and supply-side of the economy (Figure 4.18): the multiplier diagram (Unit 3), the WS-PS diagram (Unit 1), and the Phillips curve diagram. The business cycle model is used to analyse aggregate demand shocks (Figure 4.19) and supply-side shocks (Figures 4.20-4.21). Section 4.11 applies this model to explain post-pandemic inflation in the UK and makes some cross-country comparisons. Aside from familiarity with the WS-PS model (Sections 1.5-17), students should also be familiar with the price-setting curve equation allowing for imported input materials (Section 2.8).
Key concept: The business cycle model
This model brings together the supply-side WS-PS model (with the Phillips curve), and the demand-side multiplier model to explain how the economy fluctuates around the supply-side equilibrium over the business cycle. Figure 4.18 is crucial for demonstrating how the three diagrams relate to each other. CORE’s approach to modelling the macroeconomy is different from the “traditional” approach (IS-LM/AD-AS diagram) for three reasons: 1) CORE makes explicit that money supply is not exogenously supplied to the economy and that setting the interest rate is the lever that governments (or central banks) have to influence money supply. 2) CORE also explicitly models the product markets with imperfect competition (technically this is possible with the upward-sloping AS curve). 3) CORE also models the labour market with incomplete information so that unemployment is an equilibrium outcome.
https://www.economist.com/finance-and-economics/2017/01/14/inflation-is-on-the-way-back-in-the-rich-world-and-that-is-good-news?zid=295&ah=0bca374e65f2354d553956ea65f756e0. Ask students to choose two causes of inflation mentioned in the article and use the wage-setting/price-setting model and Phillips curve diagrams in the unit to illustrate their effect on rich economies.Key concept: The causes of inflation
Section 4.10 reviews four causes of inflation – cost-push inflation (Fig 4.20, 4.21, 4.24), demand-pull inflation (Fig 4.15, 4.19), expectations-driven inflation (Fig 4.9 vs 4.15), and profit-push/sellers’ inflation (Figure 4.26). Sellers’ inflation arises due to capacity constraints: firms can widen their markup when capacity utilisation rises. Students should know the differences between these four causes and the appropriate diagrams to illustrate each situation.
https://www.ft.com/content/a55933f2-3bc5-11e7-ac89-b01cc67cfeec. Instructors can ask students to relate the content of this article to post-pandemic inflation (what’s similar/different?).Required Building blocks:
Building blocks in this unit:
None
(Section 5.1-5.2, 5.4)
These sections introduce the two goals of macroeconomic policy (low and stable inflation, unemployment at/close to supply-side equilibrium), the two broad types of policies (fiscal and monetary), and the economic actors who implement these policies (governments and central banks).
Key concept: Fisher equation
Students should understand that the policy rate set by the central bank is a nominal interest rate, but it is the real interest rate that is relevant for spending and saving decisions in the economy. The Fisher equation defines the relationship between real and nominal interest rate: real interest rate = nominal interest rate – expected inflation. Sections 5.9-5.10 discuss the importance of the Fisher equation for monetary policy.
Key concept: Different monetary and fiscal policy regimes
While in many countries there is a division of labour between fiscal and monetary policymakers, with a central bank that is independent from the government, other countries follow different policy regimes. The unit discusses three alternative approaches: common currency areas, fixed/target exchange rate regimes, and direct control of fiscal and monetary policy by the government.
https://dash.harvard.edu/bitstream/handle/1/41426668/1093%20329576755.pdf?sequence=1). Their methodology to estimate preferences uses regression analysis, so instructors can provide an intuitive explanation and focus on the results.https://www.economist.com/leaders/2019/04/13/the-independence-of-central-banks-is-under-threat-from-politics). Questions: 1) Discuss the key threats to central bank independence. 2) Why is central bank independence important?https://www.economist.com/special-report/2019/10/10/how-to-make-economic-policy-fit-for-a-world-of-low-inflation). Discussion question: To what extent do you think monetary policy should be governed by economic theory, rather than depend on external forces such as the government’s fiscal policy or political pressure?Key concept: Statistical terminology
Some parts of the unit (e.g. Section 5.7) require an understanding of statistical terms typically taught in an introductory statistics module. Students should know the meaning of line of best fit, reverse causality, natural experiments, and the difference between correlation and causation.
https://tinyco.re/8861803) and ask students to identify the ‘unseen factors’ driving the observed relationship.(Section 5.6-5.8)
These sections outline the various ways that government spending decisions can dampen fluctuations (Section 5.6), and factors that affect the impact of fiscal policy. Section 5.7 builds on the concept of the multiplier from Unit 3, while Section 5.8 discusses austerity policy and why governments might not want to cut spending during a recession (the paradox of thrift).
Key concept: How governments can dampen fluctuations
Government spending has a stabilizing impact in 3 ways: 1) direct impacts on aggregate demand (due to its size and lower volatility compared with other components), 2) automatic stabilization of fluctuations that arises from the tax and transfer system, which indirectly affect consumption spending, and 3) the deliberate use of tax, transfer, and spending decisions (called discretionary fiscal policy) to offset shocks to aggregate demand. Students should understand why governments have an important role in providing social insurance – private markets cannot insure against economy-wide losses due to correlated risk, moral hazard, and asymmetric information. Instructors may find it helpful to review these market failures (Sections 10.8-10.10 of The Economy 2.0 Microeconomics volume). Students should also understand how the size of the multiplier affects the impact of fiscal policy.
https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19) summarises the economic policies that governments implemented during the COVID-19 pandemic (up until July 2021). Students could choose 2-3 countries and compare the fiscal policies implemented.Key concept: Government budget
Government expenditure and transfers must be paid for in the longer term, if not immediately. If the government spends more in total than it receives in tax revenue, the government budget is in deficit. However, during a recession, there is a tradeoff between budget balance and aggregate demand in the short run: cutting spending (austerity policy) can reinforce the recession by further lowering aggregate demand (the paradox of thrift).
https://www.ft.com/content/e7f1dfba-513a-11e5-b029-b9d50a74fd14). Questions: 1) Summarise Brazil’s fiscal problems and the policy options. 2) This article was written in September 2015 – do some research to find information and data on what the Brazilian government has done since then and how has it affected government debt.https://ifs.org.uk/election-2024/be-chancellor?mc_cid=fc4449feb6&mc_eid=e180beb77e) – Students can choose tax and government spending plans and see the effects on borrowing and debt under different assumptions about growth and interest rates.(Section 5.5, 5.9-5.10)
These sections explain how central banks use the policy interest rate to influence inflation and how central banks are limited by the zero lower bound. Section 5.5 illustrates the policy dilemma faced during a negative supply shock and emphasizes the importance of central banks reacting swiftly and proportionately. Sections 5.9-5.10 explain how central banks use inflation targets to help anchor inflation expectations.
Key concept: Policy interest rate; Zero lower bound
Central banks adjust the policy interest rate (nominal interest rate) by ‘enough’ so that the real interest rate changes. One limitation of the policy interest rate is the zero lower bound: the nominal interest rate cannot be negative, but in a severe recession, a zero nominal interest rate is not low enough to boost aggregate demand. (Instructors should refer to the Fisher equation (Section 5.2) to explain the reasoning.)
https://www.ft.com/content/f0c755e8-cc0c-37ec-852c-ac3b789e88a3. Discussion question: Explain what the Term Funding Scheme is and why the Bank of England implemented it alongside a cut in interest rates.https://www.economist.com/special-report/2018/10/11/central-bankers-will-fight-the-next-recession-with-their-backs-against-the-wall). Questions: 1) Evaluate the costs and benefits of using quantitative easing (QE) during a recession. 2) What other policies might be more effective?https://www.economist.com/finance-and-economics/2019/09/12/the-ecb-cuts-interest-rates-and-restarts-quantitative-easing). Questions: 1) Define quantitative easing (QE) and explain why the ECB chose to adopt this policy. 2) Use the 3-diagram model to illustrate the potential effects of the ECB’s monetary policy. Do you think that the ECB’s policies would be more effective when done in conjunction with appropriate fiscal policies? (Note: The ECB had a slightly negative interest rate in 2014-2019: https://www.ecb.europa.eu/stats/policy_and_exchange_rates/key_ecb_interest_rates/html/index.en.html).Key concept: Inflation targeting; anchored inflation expectations
Central banks try to influence inflation expectations as well as inflation, and committing to an inflation target is one way to do so. There is no consensus on which target rate to pick, though most central bank targets are in the 2-3% range. Due to the zero lower bound, some economists argue that the inflation target should be higher (such as 4%). Figure 5.14 illustrates how anchored expectations reduce the cost (in terms of employment/aggregate demand) of getting inflation back to target after a negative supply shock, even if the central bank delays its policy response.
https://core-econ.org/the-economy/v1/book/text/15.html#154-inflation-and-unemployment-constraints-and-preferences)https://www.ft.com/content/34f7848e-39a7-11de-b82d-00144feabdc0. Questions: 1) Explain how monetary policy contributed to the 2008 global financial crisis. 2) What other measures should central banks target besides inflation, and why?https://www.ft.com/content/4b6276f8-df95-11df-bed9-00144feabdc0. Questions: 1) Discuss the advantages and disadvantages with establishing an inflation objective. 2) Explain how central banks communicate their commitment to an inflation target. (Find some examples of central bank communications and use these to support your answer.)https://www.economist.com/the-economist-explains/2015/09/13/why-the-fed-targets-2-inflation). Questions: Explain why the Fed has adopted an official inflation target. What are the consequences of choosing too high or too low of an inflation target?(Section 5.12-5.14)
These sections discuss the various channels through which monetary policy affects inflation and aggregate demand. Sections 5.12-5.13 cover the domestic channels: market interest rates, asset prices, expectations/confidence (summarized in Figure 5.20), and Section 5.14 covers the exchange rate channel (summarized in Figures 5.21-5.22).
Key concept: Asset prices and investment
Asset prices depend on interest rates -> another channel through which monetary policy affects the economy. Students should know the formula and intuition for the present value criterion (firms will only undertake projects with a positive net present value). The present value criterion explains why aggregate investment depends on the interest rate and expected future profits (first discussed in Section 3.12).
Key concept: Exchange rate
Central banks must account for how changes in the interest rate could influence the exchange rate. Students should know how to identify an exchange rate depreciation and appreciation, and the difference between the nominal exchange rate (market rate at which one currency is exchanged for another) and real exchange rate (relative price of foreign goods and services compared to those produced domestically). Students should also know the causal chain between interest rates, real exchange rate, and inflation/aggregate demand.
https://www.ft.com/content/90c0fb30-a988-11e5-955c-1e1d6de94879. Questions: 1) Use a flowchart diagram to analyse the effects of higher US interest rates on the eurozone. 2) The article was written in 2015; find appropriate data to illustrate the Federal Reserve’s actual monetary policy decisions since the article was published and its effects on the eurozone.https://www.economist.com/finance-and-economics/2019/06/22/low-interest-rates-and-sluggish-growth-may-lead-to-currency-wars). Questions: 1) Draw appropriate diagram(s) (e.g. flowcharts) to explain why other countries might object to the ECB’s monetary policy. 2) Discuss the role of politics in the choice of monetary policy. Why are currency wars more likely when GDP growth is low?(Section 5.3, 5.11, 5.15)
These sections use the 3-diagram model and empirical data to illustrate the fiscal and monetary policy responses to demand shocks and supply shocks. Section 5.11 discusses the monetary response to the Russia-Ukraine war, and Section 5.15 discusses the UK’s fiscal and monetary responses to supply shocks between 1950-2023.
Key concept: Demand vs supply shocks
These two types of shock have different policy implications. Demand shocks are ‘easier’ for policymakers to handle than a supply shock. For a demand shock, both fiscal and monetary policy point in the ‘same direction’ (Figures 5.4-5.5): any efforts to increase employment will also reduce inflation. For a supply shock, there is a policy dilemma: any efforts to lower inflation will also reduce aggregate demand.
https://coreecon.github.io/voici/render/inflation.html) – students use interactive simulations to learn how the central bank could react to an oil shock, and consider different scenarios according to the central bank’s priorities (inflation vs unemployment).https://www.economist.com/free-exchange/2012/08/14/feeling-a-drought). Questions: 1) Use the model in the unit to illustrate the effect of the supply shock discussed in the article. 2) Why is the author of the article concerned about the Fed’s policy response to this shock?Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
(Section 6.1-6.2)
Section 6.1 introduces a question considered throughout this unit: how do you live if you don’t work? Through the lives of two people (Kwame in Ghana and Sophia in the US), this section explains how the financial sector, family, and the state can help people during times they are not working (childhood, unemployment, retirement). Section 6.2 introduces a simple economy without money or a financial sector, where individuals can enter bilateral debt contracts to consume and invest when they do not have an income. Balance sheets are used to illustrate the effects of borrowing and lending on an individual’s assets and liabilities.
Key concept: Balance sheet
A balance sheet summarizes the assets and liabilities of an entity at a particular point in time. The difference between a person’s assets and liabilities is their net worth, also known as their wealth. Students should be familiar with the balance sheet format presented in Figure 6.3.
https://www.economist.com/britain/2014/12/30/the-balance-sheet-boom). Questions: (1) Draw and explain household balance sheets to represent i) the years before the financial crisis, ii) the crisis years, iii) the years after the financial crisis. (2) How have household debt-to-income and the savings rate evolved from 2005-2015? (3) Find some more recent data on these variables and check if the article’s predictions about household debt were correct.https://www.ft.com/content/ba0da31c-0f61-11de-ba10-0000779fd2ac). Questions: (1) Based on the information in the article, draw a balance sheet to illustrate how household net worth changed. (2) Aside from house and asset prices, what could have affected households’ net worth after the 2007-09 financial crisis and recession?Key concept: Borrowing and lending
Students should know how to represent a bilateral loan contract in a balance sheet, for both the borrower and lender (Figure 6.3). Borrowing and lending does not change net worth (debt ‘cancels out’ when considering combined wealth) but can still benefit both parties.
https://www.oecd.org/en/topics/sub-issues/public-pensions.html) How might individuals in these countries plan differently for when they don’t work?https://www.ft.com/content/516d05e0-3de5-11e6-8716-a4a71e8140b0) and discuss the possible impact of higher interest rates.(Section 6.5)
This section explains the role money plays in modern economies (the three functions of money). It also explains the concepts of commodity money and bank money.
Key concept: Functions of money
Students should understand the three functions of money (means of exchange, store of value, unit of account).
Commodity money – In an economy without a well-developed banking system, people may use a particular commodity such as gold, as money. The commodity is typically a basic good that is widely valued, but can also act as a means of exchange, a store of value, and a unit of account.
Bank money – Deposits in commercial banks constitutes bank money. Exercise 6.5 uses bank balance sheets to show students how bank deposits functions as a means of exchange.
https://www.bbc.com/travel/article/20180502-the-tiny-island-with-human-sized-money). How did the Yap stones satisfy the three functions of money?https://www.ecb.europa.eu/stats/money_credit_banking/monetary_aggregates/html/index.en.html)(Section 6.3-6.4, 6.8, 6.12)
Commercial banks are the main financial intermediary covered in Unit 6. Section 6.3 introduces the role of financial intermediaries and the financial sector. Section 6.4 discusses bank balance sheets (Figure 6.8) and how banks make profits from charging interest on loans (Figure 6.9). Section 6.8 explains how commercial banks create money by lending, and the constraints banks face when lending (demand for loans, capital adequacy requirements, and reserve requirements).
Key concept: Commercial banks
Banks are capitalist firms that act as intermediaries between borrowers and lenders. Students should understand that banks face two types of risk: (1) When banks make loans, there is a risk of default, which they can mitigate by diversifying. Banks whose liabilities exceed their assets are insolvent. (2) Banks also face a liquidity risk, as their assets (loans to others) are illiquid while their liabilities (deposits) are liquid.
https://www.ft.com/content/7d15057c-d633-11e5-829b-8564e7528e54). Discuss: What is bank capital and why does it matter?https://www.ft.com/content/2719da9c-9560-11dd-aedd-000077b07658) Questions: Explain why, as mentioned in the article, banks were less willing to lend to each other during the financial crisis. Why did the interbank lending rate increase above the policy rate?https://www.economist.com/special-report/2019/05/02/the-banking-revolution-is-great-for-customers). Questions: (1) Discuss the benefits and potential problems of non-bank firms that offer financial services. (2) Discuss the similarities and differences between ‘traditional’ high-street banks and their newer competitors.https://www.economist.com/finance-and-economics/2018/09/20/the-fed-stalls-the-creation-of-a-bank-with-a-novel-business-model). Questions: (1) Explain how a narrow bank’s balance sheet differs from that of a traditional bank. (2) What are the potential advantages and disadvantages of the Narrow Bank’s business model? (3) Explain whether or not you agree with the Narrow Bank’s legal complaint. Do you think that narrow banks should be given the same rights to operate as traditional banks?https://www.law.uw.edu/news-events/news/2023/svb-collapse; Bank of England explainer: https://www.bankofengland.co.uk/explainers/what-happened-to-silicon-valley-bank-uk)https://getpenfold.com/pension-guides/what-is-a-pension-fund; https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/pension-fund.) (Note that the details of workplace pension schemes and pension funds may vary across countries.)Key concept: Money creation by lending
Students should understand how banks create bank deposits (and therefore money) when they make loans (Figures 6.12a and 6.12b). Students should also know the three constraints on the amount of loans banks will make (and therefore, on the amount of money they create): demand for loans (influenced by the interest rate), capital adequacy requirements, and reserve requirements.
https://www.ft.com/content/e336ea7e-0d33-11e5-a83a-00144feabdc0). Discuss: How does traditional economic theory underestimate the importance of banks’ money creation role?(Sections 6.6-6.7)
The model of banking in Sections 6.1-6.5 relied on commodity money and bank money. Section 6.6 introduces base money (reserves plus currency), which is managed by the central bank. Section 6.7 explains the central bank’s balance sheet and the relationship between the central bank, government debt, and monetary policy (managing inflation and quantitative easing).
Key concept: The central bank’s role
The central bank supplies two forms of base money: currency (notes and coins) and reserves, which are the deposits commercial banks have in their accounts at the central bank. The central bank is also responsible for monetary policy (discussed in Units 4-5); Section 6.7 explains quantitative easing in more detail. Students should be able to identify the central bank’s assets and liabilities (Figure 6.10) and explain why these liabilities are a form of government debt.
https://www.economist.com/finance-and-economics/2018/05/26/central-banks-should-consider-offering-accounts-to-everyone). Questions: (1) Explain why individual central-bank accounts could benefit consumers and policymakers. What factors need to be accounted for when implementing this proposal? (2) Analyse the costs and benefits of individual central bank accounts, and explain whether or not you think it is a good idea.https://www.rba.gov.au/education/resources/explainers/cryptocurrencies.html)) How do these two digital currencies differ? Can cryptocurrencies replace traditional forms of money? Why/why not?(Sections 6.9-6.11)
Financial markets are a key element of the financial sector. Section 6.9 explains the role that financial markets play in the wider economy: Figure 6.13 shows how both banks and financial markets enable households to channel their savings into different forms of productive capital. Section 6.10 discusses how businesses make investments, while Section 6.11 discusses household investment decisions.
Key concept: Leverage
Leverage (or gearing) refers to the process of increasing investments or asset purchases by borrowing. Students should be aware that leverage can be defined in various ways, but CORE uses the proportion of the investment financed by borrowing (the leverage ratio is the ratio of debt to assets). Figures 6.14a and 6.14b illustrate the benefits and downsides of leverage.
Key concept: Capital gain
If the market value of an asset increases, the owner of an asset receives a capital gain equal to the difference between the current and previous market prices. Students should know this formula: rate of return (%) = capital gain or loss (%) + income (%). Students should also understand the trade-off between risk and return (Figure 6.18 shows this relationship empirically).
https://www.core-econ.org/espp/book/text/10.html#108-the-value-of-an-asset-expected-return-and-risk (Students who have learned Unit 3 of the microeconomics volume will be familiar with the general framework.)Key concept: Collateral and inequalities in asset ownership
Students should understand the role collateral plays in loans and why asset ownership is so unequal across quartiles of household net worth (Figure 6.16). Section 9.9 of the microeconomics volume explains the role of collateral in alleviating credit constraints.
https://www.ft.com/content/3d260e6c-956b-11e3-8371-00144feab7de). Discuss: Many small businesses were excluded from credit markets after the financial crisis. What was the impact of the credit crunch on inequality?https://www.fca.org.uk/publication/research/financing-inequality.pdf. For each source of inequality, ask students to think of ways to address the underlying issue.https://www.economist.com/special-report/2015/05/07/from-the-people-for-the-people) Questions: (1) Discuss the role of information in loan provision, and the potential issues with collecting data for credit-scoring. (2) Compare and contrast peer-to-peer lending and traditional bank lending. (3) What kind of regulation do you think should apply to peer-to-peer lending?https://www.economist.com/finance-and-economics/2019/10/10/a-group-of-fintech-firms-are-changing-the-way-consumers-borrow) Questions: (1) Compare and contrast fintech firm loans and credit card loans. How might these new loans help/worsen inequality? 2) To what extent is there a conflict of interest between lenders and borrowers in the fintech firm loans mentioned in the article?Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
Unit overview: Unit 7 will be very useful for students / instructors who want to go beyond the model of monetary policy introduced in unit 5 where a country has an independent central bank that sets a credible inflation target, as well as a flexible exchange rate. It can be used in different ways depending on the context and goals of the class.
For instructors in countries with a fixed exchange rate, such as members of a common currency area:
Sections 1 and 2 provide an important introduction.
Section 4 focuses specifically on countries with a fixed exchange rate, and in particular those within a common currency area. It uses the multiplier and PC models to demonstrate how an aggregate demand shock effects competitiveness and the fact that the individual country cannot use monetary policy in response to the shock. It also discusses long-run competitiveness and inflation outcomes as well as reasons for joining a common currency area. Key points are illustrated by data on Spain and Germany.
Section 6 describes exchange rate regimes in practice and provides data on how common these regimes are. Instructors could highlight which regime the country they are teaching in belongs to.
Section 7 is quite important for FIX economies because it discusses how fixed exchange rate regimes are generally effective in pinning down inflation as well as caveats that indicate fixing exchange rates is not the only or possibly not the optimal way to do so, depending on the institutional context.
Sections 8 through 9 examine how different monetary / exchange rate regimes work within global financial markets focusing on the ‘uncovered interest parity’ condition. They are especially relevant for countries which have a fixed exchange rate and their own currency (and no capital controls) as they show that although governments have power to set the nominal policy interest rate, when exchange rates are truly fixed, markets rather than the policymaker determine interest rates, as the foreign and domestic policy rates must be equal.
Section 10 is more relevant for countries that experience high inflation. Section 11 concludes by illustrating the close negative relationship between institutional quality and inflation rates.
For instructors in countries with a flexible exchange rate, where there is no credible inflation target / where the central bank is not independent:
Sections 1 and 2 provide an important introduction.
Section 3 focuses specifically on countries with a FlexNIT system – a flexible exchange rate but no credible inflation target set by an independent central bank.
Section 6 describes exchange rate regimes in practice and section 7 highlights that FlexNIT countries often have high inflation.
Section 8 and 9 serve to explain how exchange rate regimes interact with global financial markets, and introduce the ‘uncovered interest parity’ condition. Though the implications for FlexNIT regimes are mentioned, section 9 focuses more on FlexIT and FIX regimes.
The issue of high inflation outcomes in FlexNIT countries is examined in sections 10 and 11, which discuss the roles of debt and monetary finance as well as governance quality. These sections are especially relevant for FlexNIT economies and can be understood even if sections 8 and 9 are not covered in detail. Section 11 provides data on the relationship between inflation and governance quality.
For instructors who want to teach the whole unit, as part of one of the following courses: introduction to macroeconomics, international finance, or economic development.
This unit includes material that is more challenging and would work well in upper-division elective classes, however, it would also work well in a first-year class as it builds on the framework established in unit 1 through 6. It provides students with an extension to unit 5 that explains how monetary policy is implemented in a variety of countries worldwide. There is extensive use of real-world data and case studies (e.g. Spain and Argentina) which help to make the material relatable and engaging for students at various levels.
Key concept: Section 1 describes what it is like to live with high inflation in Argentina and shows that various countries have seen extremely high rates of inflation
https://www.worldbank.org/en/research/brief/inflation-database Inflation data are available for download in excel and stata and the database is updated twice per year.Key concept: Section 2 introduces several important cornerstones of this unit and it is important to spend enough time on it to lay the foundation for the rest of the unit
– fixed and flexible exchange rates
– the three monetary / exchange rate regimes (FlexIT, FlexNIT and FIX)
– A section which models an aggregate demand shock in a FlexIT economy using the Phillips curve and multiplier models from unit 5. This is the benchmark against which the other two regimes are compared
Key concept: Section 3 discusses the FlexNIT regime
a country without a credible inflation target, and where the exchange rate is flexible.
This section describes a process by which the policymaker, in trying to hold unemployment below the supply-side equilibrium, allows a spiral of high inflation and rapid exchange rate depreciations to take hold. This section introduces the rate of exchange rate depreciation (discussed further in the extension to this section) and the implications for competitiveness. The PC and Multiplier models are used to illustrate how rapid increases in inflation can take hold under this regime.
https://manifold.bfi.uchicago.edu/projects/monetary-fiscal-history-latin-america-1960-2017 Instructors could apply the data on Argentina to further illustrate the model presented in this section, or this could be set for students as an exercise.Key concept: Section 4 discusses the FIX regime, and more specifically, countries within a common currency area.
The PC and Multiplier models are used to illustrate the effects of a positive AD shock that affects only one member country.
The determinants of long-run inflation are discussed as well as the reasons for joining a monetary union.
The data focuses on Spain, in comparison to Germany
https://www.iz.sk/en/projects/EU-indicators/hicp-inflation-rate and https://www.iz.sk/inflationhttps://www.iz.sk/inflationKey concept: Section 5 is a short section that summarizes the early parts of the unit. This will be especially useful for instructors who want to compare the different approaches.
Key concept: Section 6 provides a description of exchange rate regimes as they are practiced, including ‘Dollarization’ and ‘euro-ization’, as well as ‘Managed’, ‘target’, and ‘shadow’ exchange rate regimes
This section also provides data about the share of population living under different exchange rate regimes
Key concept: Section 7 provides data on the relationship between the exchange rate and inflation across a large number of countries, spanning all the monetary regimes described in the previous section.
Countries that have experienced very little exchange rate depreciation relative to the $US have also enjoyed low inflation rates. However, using case studies of Spain and Argentina, this section argues that fixing the exchange rate is not a silver bullet for dealing with inflation.
Key concept: Section 8 explains the constraints that policymakers in different regimes face in terms of setting policy interest rates. To do it, it moves away from the policymaker’s perspective and examines the world from the viewpoint of a global investor.
Key assumption: No capital controls
Key concept: This section provides a relatively straightforward introduction to the principle of uncovered interest parity. This is based on the relationship of ‘equal expected returns’ and the argument that trading in financial markets will always ensure that this relationship holds. The extension to this section provides further algebra as well as data on whether the UIP condition holds in practice.
Key concept: Section 9 demonstrates that in a flexible exchange rate regime, the policymaker sets the policy interest rate, and the exchange rate is set in the market. In the long-run, the real interest rate is set in the market. On the other hand, in a fixed exchange rate regime, the policymaker fixes the exchange rate, and the market determines the interest rate. This section focuses on FlexIT and FIX regimes and the following section focuses on FlexNIT regimes.
https://www.bbc.com/news/business-34178247Key concept: Section 10
this section describes how FlexNIT countries often have high deficits and use monetary finance combined with high inflation to finance them. Mechanisms leading to hyperinflation are described.
“Tying ones hands” – in a FlexIT country, the interest rate is used by an independent central bank to control inflation, thus it cannot be used by government to lower borrowing costs.
In a FIX regime, the government sets the exchange rate and interest rates are determined in the market, thus the government cannot manipulate interest rates in order to bring down borrowing costs.
In a FlexNIT regime, no such constraints exist. The government can set the nominal interest rate, and can achieve negative real interest rates by financing expenditure through monetary financing (expanding the money supply) and allowing high inflation. This allows the government to have persistent, large deficits, even when they find it difficult to borrow in international markets. Possible motivations for doing this are discussed. In general, this could benefit the government but make life extremely difficult for the citizens of that country.
Key concept: Section 11 demonstrates that countries with high inflation rates are often also those with poor scores on the World Bank’s measures of governance quality. We have seen that in both FlexIT and FIX regimes, the hands of the government are tied in some way. Countries with higher quality governance may have the institutional context which makes it possible to tie the hands of the government, in this sense.
Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
(Section 8.1-8.3)
Section 8.1 introduces the theme of out-of-equilibrium dynamics. Section 8.2 covers key concepts related to dynamics (stability of equilibria and feedback processes). Section 8.3 applies these concepts to poverty traps by discussing a field experiment by Balboni et al. (2022) where villagers in Bangladesh were randomly selected to receive a major asset.
Key concept: Stable/unstable equilibrium
Students should be able to distinguish between stable and unstable equilibria. For stable equilibria, there is a tendency for the equilibrium to be restored after it is disturbed by a small shock. For unstable equilibria, if a shock disturbs the equilibrium, there is a subsequent tendency to move even further away from the equilibrium. The ‘ball on a hill’ analogy (Figure 8.3) can be a helpful visual representation.
Tipping point: A tipping point is an unstable equilibrium at the boundary between two regions characterized by distinct movements in some variable.
Positive/negative feedback: A negative feedback process counteracts (pushes back against) movement away from equilibrium. Positive feedback processes amplify (reinforce) a movement away from equilibrium. Students commonly confuse the direction of movement (larger/smaller horizontal axis value) with positive/negative feedback, respectively. Instructors should emphasise that the word positive/negative relates to the original equilibrium (movement away/towards, respectively).
(Section 8.4-8.6)
Section 8.4 introduces the concept of asset price bubbles, using data from the US housing market before the 2007-09 financial crisis. Sections 8.5 and 8.6 use a two-dimensional diagram with a price dynamics curve to model out-of-equilibrium behaviour. This diagram is a simple representation of a discrete-time dynamic system. This model is applied to asset price bubbles (but is more general and will be applied to environmental processes and green technology adoption later in the unit). Disequilibrium is modelled initially as an exogenous change which shifts the supply or demand curves. The focus is then on endogenous changes within the model which restore or move the economy back towards equilibrium.
Key concept: Asset price bubble
An asset price bubble is a sustained and significant rise in the price of an asset, fuelled by expectations of future price increases. Students should know what features of assets make them subject to bubbles (such as resale value/speculation).
https://www.ft.com/content/cb405410-a40f-3421-858e-1ba3be193e3d. Which view discussed in the article seems best descriptive of financial markets over the past decades? (Note: The article was written in 2013; instructors can ask students to find more recent data to answer this question. What (if anything) has changed since the article was written?)https://www.economist.com/finance-and-economics/2019/03/23/why-book-value-has-lost-its-meaning. Questions: With reference to the article, explain the distinction between the price of an asset and its value. Discuss the limitations of using price to measure the value of an asset. Why is measuring the value of an asset so difficult?https://www.economist.com/christmas-specials/2018/12/18/the-great-texas-emu-bubble. Questions: Explain why there was a bubble in the market for emus in Texas, and why the bubble popped. What lessons for policymaking can we learn from this example?https://www.economist.com/finance-and-economics/2019/08/22/the-onset-of-a-downturn-is-as-much-a-matter-of-mood-as-of-money. Questions: To what extent are recessions caused by changes in public sentiment rather than other shocks? Discuss the role of ‘animal spirits’ in the business cycle.Key concept: Price dynamics curve (PDC); multiple equilibria
The price dynamics curve shows the relationship between the price in the current period and the price in the next period. Points where the PDC intersects the 45-degree line are equilibria, and the slope of the PDC at that point determines whether the equilibrium is stable (<45 degrees) or unstable (>45 degrees). Students should be familiar with the S-shaped price dynamics curve (which is used in other applications later in the unit), and how to distinguish between movements along the PDC (changes in price due to shifts in demand/supply) vs movement of the whole PDC (changes in beliefs for reasons other than a change in the price itself). Figures 8.14-8.16 illustrate these concepts and show how shifts in the PDC can affect the number of equilibria.
(Section 8.7-8.8)
Section 8.7 explains a mechanism that contributed to the US housing price boom in the early 2000s (the financial accelerator) and its effect on aggregate consumption and output. Section 8.8 discusses the unequal effects of the 2007-09 financial crisis on households depending on their wealth levels.
Key concept: Housing price bubble, financial accelerator
The financial accelerator refers to mechanism through which firms’ and households’ ability to borrow increases when the value of the collateral they have pledged to the lender (often a bank) goes up. Instructors can refer to the aggregate demand model in Unit 3 to explain household behaviour when housing prices rise and fall, referring to the concepts of consumption smoothing, target wealth, and precautionary saving.
https://www.ft.com/content/4c6731ae-5fca-11dc-b0fe-0000779fd2ac How did the securitisation of mortgage debt affect financial stability when house prices fell in 2007?https://www.economist.com/graphic-detail/2019/06/29/for-now-residential-property-prices-are-likely-to-keep-rising. Questions: Choose two countries mentioned in the article and explain where you think they are on the price-dynamics curve in Q1 2019. This article was written in 2019; discuss the effects of major economic events since then (such as the COVID-19 pandemic) on the price dynamics curve and housing prices. Why is it so important for policymakers to monitor trends in housing prices?https://wid.world) may be a useful data source.)(Section 8.9-8.10)
Section 8.9 discusses the role of banks in the 2007-09 financial crisis, and why the banking system is unstable. Section 8.10 outlines the incentive problem (moral hazard due to being ‘too big to fail’) and the regulations implemented after the financial crisis to address the financial system’s instability.
Key concept: External effects; Moral hazard
As discussed in Unit 6, leverage is critical to how banks make profits. Figure 8.21 shows how leveraged banks were before the financial crisis, due to misaligned incentives: banks took on excessive risks because they knew the government would bail them out (moral hazard). The banks’ decisions had external effects on the rest of the economy (Figure 8.24 provides a useful summary).
https://www.core-econ.org/espp/book/text/10.html#1014-banking-markets-and-morals).Key concept: Policies to address financial system instability
Students should be able to identify post-crisis policies that were implemented (restrictions on leverage, resolution regimes) and explain why these policies help prevent similar crises from happening in the future.
https://www.core-econ.org/insights/too-big-to-fail/text/01.html)https://www.ft.com/content/4b84d45e-8bec-11e7-9084-d0c17942ba93. What lessons did policymakers learn from the financial crisis and what policies could they implement as a result?https://www.economist.com/finance-and-economics/2010/07/22/agents-of-change. Questions: With reference to the article, explain the challenges with getting accurate predictions about the economy. Explain how economists’ approach to modelling the economy have changed since the financial crisis.https://www.economist.com/finance-and-economics/2017/12/16/a-decade-after-it-hit-what-was-learnt-from-the-great-recession. Questions: Compare and contrast the effectiveness of the policies adopted by the US during the 1930s Great Depression and the 2008 Great Recession. To what extent was the policy response to the Great Recession not ‘dramatic’ enough?https://www.core-econ.org/doing-economics/book/text/10-01.html) uses World Bank’s Global Financial Development Database to compare stability of financial institutions before and after the 2007-09 financial crisis.(Section 8.11-8.13)
The same S-shaped dynamics curve model from Sections 8.5-8.6 is now applied to two types of environmental tipping points. The first type is ‘negative’, referring to environmental collapse (Arctic sea ice; Section 8.11). The second type is ‘positive’, referring to green technology adoption (electric vehicles; Section 8.13). Section 8.12 discusses policies that are suitable for addressing environmental tipping points.
Key concept: Environmental dynamics curve; Adoption dynamics curve
The environmental dynamics curve shows how an environmental variable changes from period to period, whereas the adoption dynamics curve shows how the number of electric vehicle users changes from period to period. Unlike the housing prices model, the equilibria in both models can be labelled as ‘good’ or ‘bad’.
https://report-2023.global-tipping-points.org/resources/https://www.core-econ.org/experiencing-economics/instructors/book/text/07.htmlKey concept: Environmental tipping points; Prudential policies
The ‘middle equilibrium’ in the S-shaped dynamics curve diagram is the tipping point. For environmental processes, there is some uncertainty over where this tipping point is. Prudential policies place a very high value on reducing the likelihood of a disastrous outcome, even if this is costly in terms of other objectives foregone. Such an approach is often advocated where there is fundamental uncertainty about the conditions under which a disastrous outcome would occur. Students should understand the difference between risk and uncertainty, and why prudential policies are important in the latter case.
https://youtu.be/2dIaGkFo2G0; https://youtu.be/QFp_R9ZXPs0https://youtu.be/A8aOfrvc43khttps://www.economist.com/briefing/2019/08/01/the-amazon-is-approaching-an-irreversible-tipping-point. Questions: Use the tipping point model in the unit to explain the potential effects of Amazon rainforest deforestation. Where on the environmental dynamics curve do you think we currently are? Use the concept of external effects to explain the issues surrounding the deforestation of the Amazon rainforest.https://doi.org/10.1080/1350178X.2022.2040740. Discuss: What are the problems with the current models (Integrated Assessment Models), and alternative approaches do the authors recommend?Conceptual prerequisites:
Optional Building blocks:
Building blocks in this unit:
(Sections 9.1 – 9.2)
This unit starts by describing rapid economic growth in China, and then by discussing how we measure economic growth, introducing the concepts of ratio scales, CAGR and the rule of 70.
Key concept: Economic growth
This unit introduces various concepts related to economic growth and development. Instructors could start with a game that touches on some of these concepts.
https://journalofeconomicsteaching.org/devsim-a-powerpoint-based-choose-your-own-adventure-game-for-teaching-economic-development-fabianhttps://upgrader.gapminder.org.Key concept: Economic development
This unit focuses on economic growth and does not examine in detail the question of growth vs economic development. However, the text does examine the limitations of GDP as a measure of well-being in Micro Unit 1 Extension 1.2
https://books.core-econ.org/doing-economics/book/text/04-01.html As an extension to this project, students could focus on an interesting pair of countries (similar to Section 9 on Botswana and Tanzania and section 10 on Bangladesh and Pakistan).https://books.core-econ.org/doing-economics/book/text/0-3-contents.html) and Project 9 on Credit Excluded Households in a Developing Country (i.e. Ethiopia) (https://books.core-econ.org/doing-economics/book/text/09-01.html) are also both relevant to the contents of this unitKey concept: Economic development in China
China is provided here as an interesting and important case study of rapid transformation. The later parts of the unit do not discuss China’s development in detail, because it is a bit exceptional. However, the following section (on growth rates, CAGR and the rule of 70) uses data for China, and can be taught together with the hook section as a single introduction.
https://www.gapminder.org/tools/#$chart-type=bubbles&url=v2) and see how China has caught up with and overtaken many other countries. The dip in incomes and especially life expectancy that occurred during the Great Leap Forward (1958 – 1962) is also clearly visible in this animation.Key concept: Measuring Economic growth
this section introduces ratio scales, Compound annual growth rates (CAGR), and the rule of 70. It does not require students to know what logarithms are.
https://unstats.un.org/unsd/snaama/downloads(Sections 9.3 – 9.5)
These sections examine the role that capital accumulation and investment, as well as technological progress, play in economic growth, using theory and data.
Key concept: Production functions
Section 9.3 discusses production functions. This concept can be understood without any background knowledge, but if instructors want to extend the discussion, students may find the earlier material on production functions helpful, especially Micro section 1.6, as well as 2.4 (including the extension) and possibly extension 5.4.
https://books.core-econ.org/the-economy/microeconomics/02-technology-incentives-04-firms-technology-production.html#figure-e2-1a A full set of similar graphs can be found here: https://www2.hawaii.edu/~fuleky/anatomy/anatomy.html The most relevant graph that matches up with Figure 9.4 is the middle graph in the “constant returns” section. In this case, we are holding labour constant and changing capital (in Figure 9.4 this is expressed in per capita terms).Key concept: Labour productivity (Y/N), total factor productivity (z), capital intensity (K/N), average product of capital (APK)
Students should become comfortable with these concepts, linking them all back to the production function.
https://books.core-econ.org/insights/government-debt-and-wealth/00-highlights.htmlKey concept: Accounting for growth
Section 4 explains how growth can be decomposed into three components (capital, labour and everything else). Work through the tables and graphs so that students can see how they fit together.
Key concept: Investment and saving
This section again uses both theory and data to describe the role of investment in economic growth. Be sure that students are connecting the theory with the real-world evidence provided.
(Sections 9.6 – 9.7)
This section discusses education, infrastructure and co-ordination failures as barriers to growth, and describes the important role of institutions, both in terms of economic systems (planned vs capitalist economies) as well as the quality of economic institutions.
Key concept: Infrastructure and Education
ideally instructors could supplement this section to draw on examples that are relevant to your country (or which your students would be interested in)
https://energyforgrowth.org/article/how-does-energy-impact-economic-growth-an-overview-of-the-evidencehttps://www.gapminder.org/tools/#$model$markers$line$encoding$y$data$concept=primary_completion_rate_total_percent_of_relevant_age_group&source=sg&space@=geo&=time;;&scale$type:null&domain:null&zoomed:null;;;;;;&chart-type=linechart&url=v2https://www.dw.com/en/poverty-keeps-countless-nigerian-children-out-of-school/video-70275327Key concept: Co-ordination failures
Section 9.6 discusses a specific example of coordination failure where a vicious cycle perpetuates low demand for electricity and skilled workers and low investment in the modern sector.
https://books.core-econ.org/experiencing-economics/instructors-preview/book/text/02.htmlhttps://www.bbc.com/worklife/article/20180417-a-thrilling-mission-to-get-the-swedish-to-change-overnight). This 1.30-minute video explains how history influenced the side of the road that countries drive on[https://www.businessinsider.com/uk-china-countries-drive-left-side-road-traffic-ancient-rome-sword-fight-2016-12?r=US&IR=T]https://www.clevelandfed.org/publications/economic-commentary/2007/ec-20071101-coordination-failures-in-the-labour-marketKey concept: Institutions
Section 9.7 first describes how planned economies fared after transitioning to a new economic system, highlighting differences between economies that were more or less industrialized when they implemented a planned system. Secondly, the section discusses research on institutional quality, highlighting the legacies of colonialism in settler and extractive colonies.
(Section 9.8)
This section introduces a model of economic growth which helps explain both low growth traps as well as dynamic economic growth. It is related to the multiple equilibria models in unit 8 but does not use an S-curve. The growth accounting equation from section 4 is used again here with the same definitions for technological progress and growth rates of capital and labour.
Key concept: Exogenous vs endogenous growth
Students should understand what is meant by exogenous and endogenous growth. In this model, exogenous growth occurs through learning by doing and from others. Endogenous growth occurs through investment (according to a simple investment rule).
(Sections 9.9 – 9.12)
Section 9 is a case study of Botswana and Tanzania and applies the growth dynamics model from section 8. Section 10 is a case study of Bangladesh and Pakistan. Section 11 examines the global income distribution. Section 12 explored environmental sustainability and asks what would be required to transition to green energy sources such that economic growth can be de-coupled from carbon emissions.
Key concept: Country case studies
examining two pairs of countries which are similar in some ways but have seen very different growth trajectories.
Key concept: Global income distribution
rather than comparing average income between countries, this section looks at the global income distribution, with data from 1950 on the 10th to the 90th percentile. This data is very rich and contains a lot of insights within in. The text helps contextualize this data.
https://www.gapminder.org/tools/#$model$markers$mountain$data$filter$dimensions$geo$/$or@$geo$/$in@=africa&=americas&=asia&=europe&=gha&=rwa&=deu&=ind&=usa;;;;;;;;&encoding$color$data$constant=_default;&scale$type:null&domain:null&zoomed:null;;;;&billy$encoding$selected$data$;;;;;;&chart-type=mountain&url=v2Key concept: Sustainable economic growth
students should be able to differentiate between the idea of “degrowth” and the approach of “green growth”. This section discusses what would be involved in an energy transition whereby economic growth is decoupled from harmful emissions of carbon. The potential roles of relative prices, taxation, regulation, institutions and social movements are discussed.
Conceptual prerequisites:
Required Building blocks:
Building blocks in this unit:
(Section 10.2)
This section explains the characteristics of the government and its role in society. Students who have studied the microeconomics volume will be familiar with the government’s role in addressing market failures (Unit 10), and with the concepts of Pareto efficiency and fairness for evaluating outcomes (Units 4 and 5). Instructors can refer to Sections 4.5, 5.3, and 5.12 of The Economy: Microeconomics for an overview of these concepts.
Key concept: Government
Students should understand the difference between the government and private economic actors (the government has coercive power, authority to collect taxes, and obligations to advance and protect civil/human rights e.g. providing public goods and merit goods). Section 10.2 outlines four ways for governments to pursue their objectives: incentives, regulation, persuasion/information, public provision.
https://obr.uk/forecasts-in-depth/brief-guides-and-explainers/public-finances/). Identify the purpose of each spending category listed in the budget (e.g. national defense = public good provision). Instructors can ask students to compare across countries – for example, what are the 3 largest spending categories? (Instructors can refer to Figure 12.10 of Economy, Society, and Public Policy for examples of spending categories and cross-country comparisons: https://books.core-econ.org/espp/book/text/12.html#127-spending-by-democratic-governments-priorities-of-a-nation)https://www.ft.com/content/e6b9fd0e-593c-11df-adc3-00144feab49a) about how the financial crisis changed consensus in the US on the role of the government as an economic actor. Instructors can ask students to compare the article’s findings with those in other countries or events (such as after the COVID-19 pandemic).https://www.economist.com/open-future/2019/05/09/the-role-of-the-state-in-creating-economic-value). Questions: How do Mariana Mazzucato’s ideas challenge conventional views about the role of government and public policy? To what extent do you agree with Mariana Mazzucato’s ideas about the role of government?(Section 10.3-10.6)
Section 10.3 describes the key characteristics of democracy. Section 10.4 covers the median voter model, which outlines conditions under which the Nash equilibrium of both parties (in a two-party system) is to offer very similar, ‘middle-of-the-road’ political platforms. Section 10.5 presents data showing the advance of democracy and its recent stalling (Figure 10.7). Section 10.6 shows descriptive data on the correlation between democracy and policy outcomes (inequality, working hours, size of government).
Key concept: Political institution
These are the ‘rules of the game’ that determine who has power and how it is exercised in a society.
Democracy: A type of political institution with three characteristics – rule of law, civil liberties, and elections that are inclusive, decisive, and fair). Instructors should emphasise that democracy is a spectrum; for example, many countries have historically had elections that were only open to select groups in society. There are also many varieties of democracy, as each country has different electoral systems and voting rules.
https://freedomhouse.org/country/scores) – Ask students to explore: What criteria does the Freedom House use to construct these measures, and how does your country rank? Pick a country – which aspects of democracy does it do well/not so well in?https://www.economist.com/the-americas/1997/10/23/the-varieties-of-democracy) Questions: For each of the Latin American countries mentioned in the article, how closely does their electoral system correspond to the definition of democracy used in the unit (3 criteria)? Instructors can ask students to find recent information about the countries mentioned to determine the extent to which the political situation has changed since the article was written (1997).https://www.ft.com/content/354d2e78-f419-11db-88aa-000b5df10621). Instructors can ask students to find more recent examples to support/refute the arguments in the article.https://www.ft.com/content/43ea5f04-5d4c-11e6-bb77-a121aa8abd95) about how the advance of democracy has arguably stagnated in the 21st century. Instructors could ask students to find more recent examples (after 2016) to support or refute the article’s arguments.https://www.economist.com/international/2015/11/26/the-road-less-travelled). Questions: To what extent are the case studies in the article consistent with the model in the unit? Based on the case studies discussed in the article, what factors contribute to a successful transition from dictatorship to democracy?https://www.economist.com/finance-and-economics/2019/06/13/how-compatible-are-democracy-and-capitalism) about the historical relationship between capitalism and democracy, and whether this relationship is likely to continue. Questions: To what extent is the relationship between capitalism and democracy stable? What factors determine the stability of the relationship between capitalism and democracy?https://www.economist.com/finance-and-economics/2018/07/21/as-inequality-grows-so-does-the-political-influence-of-the-rich), which discusses research findings on the relationship between democracy and inequality. Questions: To what extent are economic outcomes in the US driven by special interests? (Students can make comparisons with other countries.) Explain how inequality can affect the democratic system and policies chosen by a country.https://www.economist.com/free-exchange/2013/03/27/autocracy-or-democracy) about the relationship between political regime and economic growth in East Asian countries. Questions: From the information in the article, what lessons can we learn about the types of political systems that help economic growth? Discuss the role of political systems in helping economic growth. Why is it difficult to make broad statements about the type of political system countries should adopt?Key concept: Median voter model
This model aims to explain the policies that political parties adopt when competing in democratic elections. Students should be able to explain what happens to the Nash equilibrium when the model’s assumptions are relaxed.
https://www.economist.com/special-report/2018/07/12/should-the-party-move-to-the-left-or-to-the-centre), which analyses the policy platforms chosen by the Democrat party in recent US elections (up to 2018). Questions: How well does the basic median voter model represent the situation that political parties in the US face? Discuss the challenges that political parties face with determining what voters actually want.https://www.ft.com/content/1188eefe-dd0a-11e4-975c-00144feab7de), which discusses Hotelling’s model on spatial competition, and how it maps (imperfectly) to democratic politics.https://www.economist.com/international/2017/02/04/millennials-across-the-rich-world-are-failing-to-vote) – Instructors could ask students to find more recent data to determine whether this trend still holds after the article’s publication year (2017). Questions: Use the median voter model to analyse the consequences of millennials choosing not to vote. What are the main reasons why young people choose not to vote, and how could they be encouraged to vote? (Instructors can also have a quick poll in lecture asking students whether they vote or not, and have a think-pair-share discussion on the reasons why/why not.)(Section 10.7-10.10)
These sections introduce a model of political rent-seeking that uses the same constrained choice framework as that of the price-setting firm in Unit 7 of the microeconomics volume.
Key concept: Political rent
The ‘reward for being in power’. Political rent is the difference between the net benefit (monetary or otherwise) that an individual receives as a result of their political position, and the net benefit from their next best alternative (what they would receive in the absence of a privileged political position).
Political rent-seeking model (isorents, duration curves): Figure 10.13 summarises the model. Students should understand how political competition changes the slope of the duration curve and the political elite’s preferred choice. If students have studied Unit 7 of the microeconomics volume, instructors can draw analogies to the price-setting firm’s decision (isorents and isoprofits, duration curves and demand curves). Figure 10.18 outlines the parallels between political competition and economic competition. If students have studied Unit 3 of the microeconomics volume, instructors can use the concepts of income and substitution effects to analyse the impact of changes in the duration curve.
https://www.ft.com/content/5fe10fea-cd13-11e7-b781-794ce08b24dc), which discusses how a monopoly government without accountability can inflict severe damage to the economy.https://www.economist.com/finance-and-economics/2018/10/04/bought-and-paid-for) about how the close relationships between business and politics can be harmful for market competition. Questions: Use the model in the unit to illustrate the potential consequences of lobbying on the political system. Discuss the consequences of strong links between firms and politicians.(Section 10.11-10.14)
These sections outline various reasons why governments may fail to address societal problems. Sections 10.11-10.12 describe three different concepts of feasibility (economic, political, administrative) that must be satisfied for policies to be implemented and have the intended effect. Section 10.13 explains the conflicts of interest arising from the principal-agent relationship between citizens and elected leaders. Section 10.14 concludes the unit with some examples of government successes (climate change, inequality, education).
Key concept: Economic feasibility; Political feasibility; Administrative feasibility
Students should know the difference between these concepts. Economically feasible (policy must work – be economically sound and a Nash equilibrium); politically feasible (people in power must want the policy to be implemented – no lobbying by special interests); administratively feasible (government must have the capacity to implement the policy).
https://books.core-econ.org/espp/book/text/12.html#how-economists-learn-from-data-administrative-infeasibility-an-application-from-nigeria) discusses the findings of this paper: Imran Rasul and Daniel Rogger. 2016. ‘Management of bureaucrats and public service delivery: Evidence from the Nigerian civil service’. The Economic Journal 128 (608): pp. 413–46.https://tinyco.re/15357399https://tinyco.re/3513621https://www.ft.com/content/dbb420c0-3069-11df-bc4a-00144feabdc0) about special interests in the US. Instructors may want to supplement this discussion with recent examples for the US or other countries.https://www.economist.com/europe/2012/08/25/the-boat-tax-war). Questions: Evaluate the effectiveness of Italy’s boat tax policy. What policy might be more effective in raising tax revenue? Discuss the unintended consequences of Italy’s boat tax policy. What constraints does the government face with implementing this tax policy?https://books.core-econ.org/doing-economics/book/text/12-01.htmlhttps://books.core-econ.org/espp/book/text/03.html#39-unintended-consequences-of-a-redistributive-taxhttps://books.core-econ.org/espp/book/text/12.html#1213-free-tuition-in-higher-education-can-it-be-fair-to-non-students) evaluates 5 different ways to finance higher education, ranging from fully private to fully government-funded. Instructors can present this content in lecture or run an in-class debate on which measures they think governments should use.https://www.ft.com/content/867b430e-8132-11e8-8e67-1e1a0846c475. Instructors can ask students to find examples from other countries.https://www.ft.com/content/a00a3312-5913-11e8-806a-808d194ffb75. For a longer assignment, instructors can ask students to write a similar article comparing two different countries.Key concept: Principal-agent relationship
In this context, the citizens are the principals and the government is the agent. Democracies can address the principal-agent problem by giving elected leaders political rents and holding them accountable (with the threat of replacement). Section 10.13 explains why not all citizens have equal say in a democracy (for example, wealthier citizens have more power to influence policy).
https://books.core-econ.org/insights/government-debt-and-wealth/07-conflicts-of-interest.html