Principles of Economics - 2. Technological Change

The mystery of economic growth and the role of models in economicsExplaining growth: Allen’s model

Explaining stagnation: Malthus’ modelSummary

Principles of Economics1

2. Technological Change, Population, and Growth

Giuseppe Vittucci Marzetti2

SCORDepartment of Sociology and Social Research

University of Milano-Bicocca

A.Y. 2018-19

1These slides are based on the material made available under Creative Commons BY-NC-ND4.0 by the CORE Project©, https://www.core-econ.org/.

2Department of Sociology and Social Research, University of Milano-Bicocca, Via Bicoccadegli Arcimboldi 8, 20126, Milan, E-mail: [email protected]

Giuseppe Vittucci Marzetti Principles of Economics 1/37

https://www.core-econ.org/



Layout

1 The mystery of economic growth and the role of models in economicsThe Industrial revolutionEconomists, historians, and the Industrial RevolutionEconomic modelsFour key ideas of economic modeling

2 Explaining growth: Allen’s modelModeling technologyFirm’s choice: isocost lines and cost minimizationRelative prices, innovation and profitInnovation incentives in the British Industrial Revolution

3 Explaining stagnation: Malthus’ modelProduction function and diminishing average product of laborMalthusian economicsThe Malthusian trapEscaping the Malthusian trap

4 Summary




The Industrial revolutionEconomists, historians, and the Industrial RevolutionEconomic modelsFour key ideas of economic modeling

Real wage and population in Britain over seven centuries

Rapid growth in real wages and population in the last 2 centuriesStagnation in the centuries before that.

Figure: Real wages over seven centuries: Wages of craftsmen (skilled workers)in London (1264-2001), and the population of Britain





The mystery of economic growth

New (general-purpose) technologies introduced in textiles, energyand transports (e.g. James Watt’s steam engine) in Britain in themiddle of the 18th century and its cumulative character led to theIndustrial revolution.

This marked the beginning of the permanent technologicalrevolution, that is behind the recent rapid, sustained increase inincome and living standards, in spite of the striking increase of thepopulation.

These major changes started very suddenly, 200 years ago.

How did the technological revolution start?Why did it happen first in the 18th century, on an island off thecoast of Europe?

The Industrial Revolution was a complex combination of inter-relatedintellectual, technological, social, economic and moral changes.





Explanations of the Industrial RevolutionMokyr (2004), a historian of technology, stresses the role played byEurope’s scientific revolution and its Enlightenment century,which brought the development of new ways to transfer andtransform elite scientific knowledge into practical advice and tools.Landes (2006), a historian, emphasizes the political and culturalcharacteristics of nations: Europe ahead of China because theChinese state was too powerful and stifled innovation, and Chineseculture at the time favored stability over change.Clark (2007), an economic historian, also attributes Britain’s take-offto culture: along the lines of Max Weber (1905), success due tocultural attributes such as hard work and savings.Pomeranz (2000), a historian, claims that superior European growthafter 1800 was mainly due to the abundance of coal in Britain andBritain’s access to agricultural production in its New Worldcolonies fed the expanding class of industrial workers.Allen (2011), an economic historian, gives a central role to therelatively high cost of labor, coupled with the low cost of localenergy, in Britain at the time.





Economists, historians, and the Industrial Revolution

Scholars will probably never completely agree about what caused theIndustrial Revolution.

Different explanations not necessarily mutually exclusive.

Historians and economists disagree about the relative importance ofthe different factors:

Historians (e.g., Pomeranz, 2000) tend to focus on peculiarities oftime and place: the Industrial Revolution happened because of aunique combination of favorable circumstances (although they maydisagree about which ones).Economists (e.g. Allen, 2011) are more likely to look for generalmechanisms that can explain success or failure across both time andspace.

Historians vs. Economists:Often historians’ arguments are not precise enough to be testableusing a model.Historians may regard economic models as simplistic, ignoringimportant historical facts.





Models in economics

Economic theory is essentially a collection of models.

(Krugman, 1997)

A model is a particular stylized representation of a phenomenon, i.e.a relatively stable and general feature of the world that is interestingfrom a scientific point of view.

Why do economists use models?

What happens in an economy depends on the actions andinteractions of millions of people.Economists use models to “see the big picture”.

Models necessarily omit many details. This is their feature, not abug.





Krugman on the the aim and scope of economic modelsThe objective of the most basic physics is a complete description of whathappens. ... But most things we want to analyze, even in physical science,cannot be dealt with at that level of completeness. The only exact modelof the global weather system is that system itself. Any smaller-scalemodel of that system is therefore to some degree a falsification: it leavesout many aspects of reality.

And how do you know that the model is good? It will never be rightin the way that quantum electrodynamics is right. At a certain pointyou may be good enough at predicting that your results can be put torepeated practical use ...; in that case predictive success can be measured..., and the improvement of models becomes a quantifiable matter.

In the early stages of a complex science, however, the criterion for a goodmodel is more subjective: it is a good model if it succeeds in explaining orrationalizing some of what you see in the world in a way that you mightnot have expected. [...]

The important point is that any kind of model of a complex system – aphysical model, a computer simulation, or a pencil-and-paper mathemat-ical representation – amounts to pretty much the same kind of procedure.You make a set of clearly untrue simplifications to get the system downto something you can handle; those simplifications are dictated partlyby guesses about what is important, partly by the modeling techniquesavailable. And the end result, if the model is a good one, is an improvedinsight into why the vastly more complex real system behaves the way itdoes.

(Krugman, 1997)

Paul R. Krugman

(1953)

Nobel Memorial

Prize in

Economics 2008





Building a model

To create an effective model we need to distinguish between:the essential features of the economy that are relevant to thequestion we want to answer, which should be included in the model;unimportant details that can be ignored

Process of model building1 Construct a simplified description of the conditions under which

people take actions.2 Describe in simple terms what determines these actions.3 Determine how each of their actions affects each other.4 Determine the outcome of these actions. This is often an equilibrium

(something is constant).5 Get more insight by studying what happens when conditions change.

Equilibrium

Situation that is self-perpetuating. Something of interest does notchange unless an external force is introduced that alters the model’sdescription of the situation.





The use of math in economic models

“Mathematical translation is itself a substantive contribution to the theory.[...] Mathematics has become the dominant language of the natural sciencesnot because it is quantitative – a common delusion – but primarily becauseit permits clear and rigorous reasoning about phenomena too complex to behandled in words.”

(Simon, 1957, p. 89)

Economic models often use mathematical equations and graphs aswell as words and pictures.

Mathematics is part of the language of economics, and can help usto communicate our statements about models precisely to others.

A (formal) mathematical model is a particular representation of aphenomenon that allows one to analyze the phenomenon itself bymeans of math.





What is a good model?

[Models] are to our minds what spear-throwers were to stone age arms: theygreatly extend the power and range of our insight. In particular, I haveno sympathy for those people who criticize the unrealistic simplificationsof model-builders, and imagine that they achieve greater sophistication byavoiding stating their assumptions clearly. The point is to realize that eco-nomic models are metaphors, not truth. By all means express your thoughtsin models, as pretty as possible ... But always remember that you may havegotten the metaphor wrong, and that someone else with a different metaphormay be seeing something that you are missing.

(Krugman, 1992, How I work)

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

2 It predicts accurately : its predictions are consistent with evidence.

3 It improves communication: it helps us to understand what we agree(and disagree) about.

4 It is useful : We can use it to find ways to improve how the economyworks.





Four key ideas of economic modeling

In building a model to help explain the circumstances under which newtechnologies are chosen, we use four key ideas of economic modeling:

Ceteris paribus: simplification that involves “holding other things(in/outside the model) constant”.

Incentives: economic rewards or punishments, which influence thebenefits and costs of alternative courses of action.

Relative prices help us compare alternatives.

Economic rent: the benefit received from a choice, taking intoaccount the next best alternative(reservation option or opportunitycost).

Cost-benefit principle: economic rent forms the basis of how agents makechoices.





Ceteris paribus and simplification

As is common in scientific inquiry, economists often simplify ananalysis by setting aside things that are thought to be of lessimportance to the question of interest (holding other things constantor ceteris paribus).

These ceteris paribus assumptions, when used well, can clarify thepicture without distorting the key facts.

E.g. When we study the way a capitalist economic system promotestechnological improvements we assumed:

Prices of all inputs are the same for all firms.All firms know the technologies used by other firms.Attitudes towards risk are similar among firm owners.





Incentives matter

Agents respond to economic incentives.

All economic models have something equivalent to gravity, and adescription of the kinds of movements that are possible.

The equivalent of gravity is the assumption that, by taking onecourse of action over another, people are attempting to do as well asthey can (according to some standard).





Relative prices

Many economic models are often interested in ratios of things,rather than their absolute level.

Economics focuses attention on alternatives and choices.

Relative prices are simply the price of one option relative to another.

We often express relative price as the ratio of two prices.

E.g. If you are deciding where to shop, it is not the corner shopprices alone that matter, but rather the prices relative to those in thesupermarket and relative to the costs of reaching the supermarket.





Reservation positions and rents

Economic rent

A payment or other benefit received above and beyond what theindividual would have received in his or her next best alternative.

When taking some action (call it action A) results in a greaterbenefit to yourself than the next best action (call it action B), wesay that you have received an economic rent:

Economic rent = Benefit from option A - Benefit from option B

The best alternative (action B) is often called reservation option orfallback option.Economic rent gives us a simple decision rule:

If an action A would give you an economic rent: do it.If you are already doing action A, and it earns you an economic rent:carry on doing it.

Innovation rents are a form of economic rent.This decision rule motivates our explanation of why a firm mayinnovate by switching from one technology to another.




Modeling technologyFirm’s choice: isocost lines and cost minimizationRelative prices, innovation and profitInnovation incentives in the British Industrial Revolution

Modeling technology

5 different ways to produce 100 meters of cloth, using labor (numberof workers) and energy (tonnes of coal) as inputs.E-technology is relatively labor-intensive; A-technology is relativelyenergy-intensive.





Inferior technologies

Firms choose between technologies (specific combinations of inputs)to produce outputs.Some technologies (e.g. C) are dominated by others (e.g. A).





Cost minimization

Firms aim to maximize their profit.

This entails producing cloth at the least possible cost.

Firms’ choice of technology depends on economic information aboutrelative prices of inputs.

C︸︷︷︸Total cost

= w × L︸︷︷︸Wage×Workers

+ p × R︸︷︷︸Price of a tonne of coal×Tonnes of coal





Isocost lines

Isocost lines

Combinations of inputs that give the same cost.

We can derive it from the cost equation by re-arranging it:

R =C

p− w

pL

The slope is equal to the relative price of inputs.





Isocost lines

The firm will choose the least-cost technology.





Relative prices and incentives to innovate

Technology was labor-intensive before the Industrial Revolution(technology B).Increase in wages relative to coal price in Britain create the incentiveto innovate more capital-intensive technologies (technology A).





Entrepreneur and innovation rent

Because relative prices of inputs changed, a firm that switches tothe new cost-minimizing technology has an advantage over itscompetitors.

Profit = Revenue - Cost

The change in profit is equal to the fall in costs associated withadopting the new technology. This is the innovation (orSchumpeterian) rent.

The first adopter is called an entrepreneur.Innovation rents will not last forever:

Other firms, noticing that entrepreneurs are making economic rents,will eventually adopt the new technology.As more firms introduce the new technology, the supply of clothincreases and the price starts to fall.The process continues until everyone is using the new technologyand no one is earning innovation rents.The firms stuck to the old B-technology are unable to cover theircosts at the new lower price and they go bankrupt.





Schumpeter’s creative destruction

The economist Joseph Schumpeter made theadoption of technological improvements byentrepreneurs a key part of his explanation for thedynamism of capitalism.

Schumpeter called creative destruction the process bywhich old technologies and the firms that do notadapt are swept away by the new, because theycannot compete in the market.

The branch of economic thought known asevolutionary economics trace its origins toSchumpeter’s work, as well as most modern economicmodeling that deals with entrepreneurship andinnovation.

Joseph AloisSchumpeter

(1883-1950)





Technological change in the British Industrial Revolution

One of the first sectors to undergo technological change was textiles.

Before the Industrial Revolution, making clothes for the householdwere time-consuming tasks.By the late 19th century, a single spinning mule operated by a verysmall number of people could replace more than 1,000 spinsters.These machines were powered by water wheels and latercoal-powered steam engines instead of using human labor.

Old technology New technologyLots of workers Few workersLittle machinery Lots of capital goodsRequire only human energy Require energy (coal)Labor-intensive Labor-savingCapital-saving Capital-intensiveEnergy-saving Energy-intensive





Relative wages before the Industrial revolution

(a) Wages relative to energy price (early1700s)

(b) Wages relative to the cost of capitalgoods (late 16th to the early 19th century)

English wages were higher than wages elsewhere, and coal was cheaper inBritain than in the other countries.





Relative wages and technology adoption in Britain

The combination of capacity to innovate and changing relative prices ofinputs led to a switch to energy-intensive technology.




Production function and diminishing average product of laborMalthusian economicsThe Malthusian trapEscaping the Malthusian trap

Explaining economy before the Industrial Revolution:Malthus’ model

We need a different model to explain thestagnation in population and living standardsbefore 18th century.

Malthus provided a model of the economy thatpredicts a pattern of economic developmentconsistent with the flat part of the GDP percapita hockey stick.

His model introduces concepts that are usedwidely in economics.

One of the most important concepts is the idea ofdiminishing average product of a productionfactor.

Thomas RobertMalthus

(1766–1834)





Production function and diminishing average product oflabor

Production function gives maximum output for a given set of inputs(production factors).

Average product (or productivity) of an input: total output dividedby the quantity used of the input.

E.g. average product of labor:

Output per worker: total output divided by the number of workers;Output per worker per hour: total output divided by the totalnumber of hours of labor put in.

Law of diminishing average product of labor : If we hold the otherinputs fixed, and expand labor, the average output per worker isgoing to fall.





Production function of an agricultural economy

Simplifying assumptions:Agricultural economy producing just one good: grain.Grain production involves only farm labor and land.The amount of land is fixed.

The production function shows how the number of farmers workingthe land translates into grain produced in a given period.





Malthusian economics: living standards and populationdynamics

The diminishing average product of labor entails that livingstandards depend on population size.

Malthus also argues that population expands if living standardsincrease: with living standards

above the subsistence level, population grows.below the subsistence level, population decreases (death ratesincrease and birth rates fall)

Population expands if living standards increase, but the law ofdiminishing average product of labor implies that, as more peoplework on the land, their income will inevitably fall.

In equilibrium:

Living standards are at the subsistence level;Population and income stay constant.





The effect of technological improvement in Malthus’ model

The model predicts a self-correcting response to new technology.

In the long run, an increase in productivity will result in increasedpopulation, but not increased wages.





The Malthusian trap

Source: The CORE Project, Allen (2001).

Figure: Wages and population in England (1280-1600)





The Malthusian trap

Source: The CORE Project.Giuseppe Vittucci Marzetti Principles of Economics 34/37




Escaping the Malthusian trap

Conditions required to stay in the Malthusian trap:1 Diminishing average product of labor.2 Rising population in response to increases in wages.3 Absence of improvements in technology to offset the diminishing

average product of labor.

The permanent technological revolution meant that third conditionno longer holds, and explains why Britain was able to escape theMalthusian trap.





Escaping the Malthusian trap

Source: The CORE Project.




Summary

Introduction to economic modelsLess is more: use simplifying assumptions e.g. ceteris paribus

Used models for insights on the technological revolution

Model of a firm: high wages (relative to capital, including energy)motivated technological innovation;Malthus’ model: permanent technological change enabled economiesto escape economic stagnation.


Documents

Principles of Economics - 2. Technological Change