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PPLE Economics for a Changing World 2 Lecture Notes
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In-depth lecture notes of lectures 1-7, 11-12 of ECW 2, with diagrams, examples and explanations.
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Lecture 1● The model of circular flow
○ The basic model of macroeconomy that introduces the main variables, entities and
markets of the economy
● Some basic concepts
○ Factors of production: inputs used to produce goods and services for more than one time
1. Factors of production - input has to replenish (itself, or manually) - has to be used
more than once
2. If an input is used up completely in one round of production, then it is either a
raw material or an intermediate good, but not a factor of production
3. Most important factors of production - labor (L), capital (K), land, knowledge
and skills - we can add natural resources as well
○ Goods and services: goods are tangible items and services are tasks (e.g. legal advice)
that are produced or performed for the benefit of the recipient (consumer). In our model,
only firms can produce goods and services, that are traded on the market of goods and
services.
1. Everyone has a subjective value attached to a good and service - satisfies needs
○ Production: the process of transforming factors of production and other inputs into goods
and services. In our simple model, this is done by firms
1. Intermediate good, raw matter: goods not consumed by a consumer, but use to
produce a good
○ Income: compensation or revenue received by the owners of the factors of production.
Production factors are owned by households. Income is used to buy goods and services
on the market for goods and services.
1. Income isn’t money, it is a purchasing power, or demand (way to buy) for goods
and services - income is measured in money, but not money, because you use it to
buy something else
○ Savings: what remains of income after consumption - not money. Households and
governments can save, these will appear as supply on the financial markets.
○ Investments: goods and services used to acquire or maintain capital stock. These can be
acquired on the financial markets. In our model only firms can invest. Investment also
includes changes in inventories.
● The circular flow model of the economy
○ The economy can be thought as a sume
of markets and entities
○ Looks like a closed system
○ Arrows show payment
○ Firms: entities producing goods and
services. They are owned by the
entrepreneurs. Firms buy labor and
capital from the factor markets and sell
their goods in the market
○ Households: includes everyone in the
society - workers and entrepreneurs as
, well. Households sell labor and lend their savings at the factor markets (labor and capital
markets). They spend part of their income on purchasing goods and services, the rest is
saved.
○ The government: doesn’t produce or invest. It purchases goods and services and pays for
it from the tax revenues.
○ This model suggests an important rule: expenditure = income
● The problem of aggregation
○ Aggregation means adding up data on different individuals, products or time periods.
Microeconomics is concerned about single goods or markets and aggregation only
happens in a very limited scale.
○ Examples of aggregation:
1. Aggregation over time - a dairy farm produces 1,000 liters milk in January, 1,200
liters in February and 1,300 liters in March. So in the 1st quarter it produces
3,500 liters of milk - we lost information: by knowing the quarterly production, I
can’t find the monthly output
2. Aggregation over individuals - mom earns $2,500 per month, Dad earns $2,400,
no other sources of income. Then the household’s total income is $4,900 per
month. Loss of information also applies -by knowing the total, we can’t go back
to the individual income
3. Aggregation over goods - a farm produces 300 tons of apples and 150 tons of
peaches - we can’t add this up
○ Adding up things which can’t be added up: only one way to do it, through value
(monetary units - but it isn’t money, it’s peaches and apples - money is a measure of the
goods and services)
1. E.g. you can’t add up 1000 peaches and 200 oranges
● Aggregation by value
○ You can’t add up different goods, since they aren’t homogeneous. 1 ton of apples isn’t
comparable to 1 ton of peaches, and 1 ton of apples can’t be added to 1 hour of legal
advice (service) - the only way to add them up is by market value, when available
○ Market prices reflect value judgement - if 1 ton of peaches is 1 euro, and 1 ton of apples
is 2 euros, we can add them up
○ But what about goods not traded in the market - e.g. produced by the state - national
defense (it is a public good) - we can add it to the GDP by cost
1. Is the cost the value of national defense? - we don’t know - if people were
allowed to buy it, they would pay more or less, but it’s not on the market, we
don’t have a choice to buy it
2. When there are no market prices, use cost
3. When a good isn’t traded in a free market, then we often use the cost-based
approach, so the value of goods equals all the costs that incurred while producing
it.
○ The market value of goods and services is determined on the market. The equilibrium
unit price is when the seller and the buyer agree on the value of the good.
● National accounting
○ Systematic measurement of economic activities happening in the whole economy
, ○ Different national accounting systems - but from the 1960s, a new system, the national
accounts system became an international standard where the main indicator is GDP
○ GDP doesn’t reflect the quality of living, but it isn’t meant to be a welfare measure
● Gross Domestic Product
○ GDP is officially defined as the market value of all final goods and services produced
within a country during a particular time period (output approach).
○ Market value: the biggest problem of measuring GDP is aggregation. How can you
aggregate (add up) different goods and services? - by adding them up by their value
1. Using market price, or costs (cost based valuation, as written above, is a weak
measure as you may have been willing to pay more for something than its cost,
so it may underestimate the actual value added)
○ Of all: GDP is a comprehensive measure, taking all activities into account. This may be
done when a transaction is recorded.
1. Doesn’t distinguish between goods and services - ideally, everything should be
included, but we can’t include what we don’t know about them - there are 2
important types of value creating activities that we can’t include in the GDP
1. Housing services: when you are an owner, you won’t pay rent - this
would be missing from the GDP. This is done by assuming that as owner,
you pay a rent to yourself. This requires some assumptions - statistical
agencies estimate the value of housing services for those living in
self-owned homes by assuming some rental price (average) based on the
market rents.
2. Activities outside the legal markets: this includes domestic services (e.g.
children working in the garden, people cooking at home - they are
services, but you don’t pay for them), hidden activities to avoid taxation
(e.g. black economy, shadow economy), illegal activities (e.g. smuggling,
selling illegal goods and services)
○ Final: we only add up final goods to the GDP - final goods and services are those which
are sold for consumption. All others, which are going to be used to produce other goods
are called intermediate goods.
1. Double counting: the value of a final good already contains the value of all
intermediate goods used in its production. So adding the value of intermediate
goods to the GDP as well as their final price would include their value twice -
once as intermediate goods, and once as part of the value of the final good
2. E.g. if a farmer sells 10kg of potatoes to another farmer, and the other farmer
feeds the potatoes to his pigs, then the potatoes become an intermediate good for
another good (pork) - the value of potatoes isn’t added to GDP
○ Goods and services: both tangible and intangible goods (e.g. legal advice) are included in
GDP
○ Produced: we are only interested in the new value added in a given period. Goods and
services that were created earlier (in a previous year) are not included in the GDP
1. E.g. if you sell your car to someone, it doesn’t enter the GDP because there is no
new value created, but if a trader buys your car for $2000 and sells it for $3000,
, then the trader created $1000 in value, and $1000 gets added to the GDP (not the
$2000 - value of the car)
○ Within a country: GDP only includes activities within a country
1. E.g. if a foreign citizen works in NL, their income will appear in Dutch GDP
○ In a given period of time: GDP is calculated over a year, or quarter - only transactions
taking place in the given interval are counted
● Calculating GDP - output approach example
○ Farmer grows 100 tons of wheat and sells it to the baker for $100 per ton. The baker uses
the wheat and makes 150 tons of bread, which he sells to the shopkeeper for $200 per ton.
The shopkeeper sells the bread to the 3 of them for $250 per ton. What is the GDP.
● Calculating GDP - expenditure approach
○ GDP can also be defined as the sum of all expenditures in an economy during a time
period
○ What do economic agents spend their revenue on?
Y = C + I + G + NX
○ The households consume some goods and services (C)
○ The government also purchases goods and services which is called government spending
or public spendings/consumption (G)
○ A part of the income is spent on buying equipment and buildings (including housing) or
piling up inventories (I - investment)
○ Finally, we have net exports (NX) which is the difference between exports and imports
● Calculating GDP - income approach
○ The 3rd definition is that GDP is the sum of all incomes created in the economy during a
certain period. These are:
1. Compensation of employees: contains all wages, and social contributions by the
employer and employees
2. Gross operating surplus: the difference between firms’ revenues and costs (inputs
and labor), but rental price of capital, land, etc. is not deducted. This is the sum of
profits and the income of the owners of capital
3. Mixed incomes: certain entrepreneurs are both investors and managers (working
for their company). Hence it is not obvious how to tell apart the income that
comes from capital-ownership and their earnings from their actual labor input
4. The government may affect the operating surplus by sales taxes and production
subsidies. You need to correct for this - add sales taxes and subtract production
subsidies
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