Chapter 2

©2010 Worth Publishers

Economic Models:

Tradeoffs and Trade

Slides created by Dr. Amy Scott

TUNNEL VISION

A miniature airplane sitting motionless in a wind tunnel isn’t the same thing as an actual aircraft in flight.

But it is a very useful model of a flying plane.Economic theory consists mainly of a collection of models.

In this chapter, we will look at two economic models that illustrate why such models are so useful.

1. Why models in economics?

2. Three simple but important models:

A. Production possibility frontier

B. Comparative advantage

C. Circular-flow diagram

3. Positive economics and normative economics.

4. When economists agree and why they sometimes disagree.

Chapter Objectives

Models in Economics

A model is a simplified representation of a real situation - used to better understand real-life situations.

Models play a crucial role in economics Used to study a real but simplified

economyEx.: Cigarettes as currency in World War II prison

camps Used to simulate an economy on a

computerEx.: Use Tax models to study impact of proposed

study

The “other things equal” (ceteris paribus) assumption means that all other relevant factors remain unchanged.

Models for Money An economic model can be worth quite a bit of money.

Global Insight, the world’s biggest consulting firm, uses economic models to predict future trends and give advice to firms and governments.

A particularly lucrative branch is finance theory which calculates what assets, such as shares in a company, are worth.

The most famous business application of finance theory was Long Term Capital Management, a fund that used sophisticated models to invest money for its wealthy clients.

The fund did well for a while, then it collapsed. People feared companies would be brought down with it but the government organized a rescue operation. A similar situation almost happened in the fall of 2008.

Three ModelsThe Production Possibility Frontier

Illustrates trade-offs facing an economy that produces only two goods.

It shows the maximum quantity of one good that can be produced for any given production of the other.

The PPF improves our understanding of trade-offs by considering a simplified economythat produces only two goods by showing this trade-off graphically.

What to do? Even a castaway faces trade-offs.

Opportunity Cost and Slope of PPF

If the tradeoff remains constant along the PPF then we say they face a Constant Opportunity Cost and the PPF has a linear slope.

If the tradeoff increases along the PPF than we say they face an Increasing Opportunity Cost and the PPF has a nonlinear slope.

The Production Possibility Frontier with Constant Opportunity Cost

2820 400

30

9

15

Quantity of coconuts

Production possibility frontier

A

B

D

C

Feasible and efficientin production

Not feasible

PPF

Quantity of fish

Feasible butnot efficient

PPF with Increasing Opportunity Cost

A

PPF

10 20 30 40 500

35

30

25

20

15

10

5

Producing the first 20 fish . . .

…requires giving up 25 more coconuts…

…requires giving up 5 coconuts

But producing 20 more fish . . .

Quantity of coconuts

Quantity of fish

Economic Growth

Economic Growth is the growing ability of the economy to produce goods and services

Economic Growth can come from two sources:

Increase in Factors of Production – resources used to produce goods and services (Land, Labor and Capital)

Technological Improvement – improvement in the technical means of producing goods and services

Economic Growth Economic growth results in an outward shift of the PPF because production possibilities are expanded.

The economy can now produce more of everything.Production is initially at point A (20 fish and 25 coconuts), it can move to point E (25 fish and 30 coconuts).

A

10 20 25 30 40 500

35

30

25

20

15

10

5

E

NewPPF

Original

PPF

Quantity of coconuts

Quantity of fish

Production Possibilities for Two Castaways

28 400

30

9

(a) Tom’s Production Possibilities

Tom’s consumptionwithout trade

Tom’sPPF

Quantity of coconuts

Quantity of fish

Production Possibilities for Two Castaways

1060

20

8

Hank’s

PPF

Quantity of coconuts

Quantity of fish

(a) Hank’s Production Possibilities

Hank’s consumptionwithout trade

Tom and Hank’s Opportunity Costs

Tom’s Opportunity Cost

Hank’s Opportunity Cost

One fish 3/4 coconut 2 coconuts

One coconut 4/3 fish 1/2 fish

Specialize and TradeBoth castaways are better off when they each specialize in what they are good at and trade.

It’s a good idea for Tom to catch the fish for both of them, because his opportunity cost of a fish in terms of coconuts not gathered is only 3/4 of a coconut, versus 2 coconuts for Hank.

Correspondingly, it’s a good idea for Hank to gather coconuts for the both of them. His opportunity costs is less, only 1/2 of a fish to 4/3 fish for Tom.

Comparative Advantage and Gains from Trade

28 400

30

910

1060

20

810

(a) Tom’s Production and Consumption

Tom’s consumption without trade

30

Tom'sPPF

Hank'sPPF

Quantity of coconuts Quantity of coconuts

Quantity of fishQuantity of fish

Tom’s consumption with trade

Tom’s production with trade

(b) Hank’s Production and Consumption

Hank’s production with trade

Hank’s consumption with trade

Hank’s consumption without trade

How the Castaways Gain from Trade

Both Tom and Hank experience gains from trade:

Tom’s consumption of fish increases by two, and his consumption of coconuts increases by one.

Hank’s consumption of fish increases by four, and his consumption of coconuts increases by two.

Comparative vs. Absolute Advantage

An individual has a comparative advantage in producing a good or service if the opportunity cost of producing the good is lower for that individual than for other people.

An individual has an absolute advantage in an activity if he or she can do it better than other people.

Having an absolute advantage is not the same thing as having a comparative advantage. You can have an absolute advantage in both goods and still benefit from trade.

Tom vs. Hank – Absolute vs. Comparative

Tom has an absolute advantage in both activities: he can produce more output with a given amount of input (in this case, his time) than Hank.

But Tom can indeed benefit from a deal with Hank because comparative, not absolute, advantage is the basis for mutual gain.

So Hank, despite his absolute disadvantage, even in coconuts, has a comparative advantage in coconut gathering.

Meanwhile Tom, who can use his time better by catching fish, has a comparative disadvantage in coconut-gathering.

Comparative Advantage and International Trade

0

1,500

1,000

Quantity of pork (millions of tons)

Quantity of aircraft

(a) The U.S. Production Possibilities Frontier

321 0

3,000

2,000

1,500

10.5 1.5

U.S.PPF

CanadianPPF

Quantity of pork (millions of tons)

Quantity of aircraft

(b) Canadian Production Possibilities Frontier

U.S. consumption without trade U.S.

consumption with trade

U.S. production with trade

Canadian production with trade

Canadian consumption with trade

Canadian consumption without trade

Comparative Advantage and International Trade

Just like the example of Tom and Hank, the U.S. and Canada can both achieve mutual gains from trade.

If the U.S. concentrates on producing pork and ships some of its output to Canada, while Canada concentrates on aircraft and ships some of its output to the U.S., both countries can consume more than if they insisted on being self-sufficient.

Misunderstanding Comparative Advantage

A common mistake is to confuse comparative advantage with absolute advantage.

Ex.: U.S. vs. Japan in 1980s:

Commentators: “U.S. might soon have no comparative advantage in anything”

Wrong! They meant “absolute advantage”

PITFALLS

Pajama Republics

Poor countries tend to have low productivity in clothing manufacturing but even lower productivity in other industries.

Comparing per capita income with the share of the clothing industry in manufacturing employment shows a strong effect.

Trade takes the form of barter when people directly exchange goods or services they have for goods or services they want.

The circular-flow diagram is a model that represents the transactions in an economy by flows around a circle.

Households buy goods and services from firmsFirms buy factors of production from householdsInner Flow = goods and servicesOuter Flow = money

Transactions: The Circular-Flow Diagram

The Circular-Flow Diagram

Money

FactorsGoods

andservices

Factors

Households

Firms

Markets for goods and services

Factor Markets

Goodsand

services

Money Money

Money

Circular-Flow of Economic Activities

A household is a person or a group of people that share their income.

A firm is an organization that produces goods and services for sale.

The markets for goods and services is where firms sell goods and services that they produce to households.

The factor markets are where firms buy the resources they need to produce—factors of production.

Circular-Flow of Economic Activities

Ultimately, factor markets determine the economy’s income distribution: how total income is divided among the owners of the various factors of production.

Rich Nation, Poor Nation

Look at the labels inside your clothing. Most clothing is manufactured outside of the

United States. These countries are typically much poorer than

the United States usually because they are less productive-they cannot produce as much from a given quantity of resources as comparable firms in the United States.

This is ‘comparative advantage’ – they can make clothing at a lower opportunity cost than the US – while the US can make other goods at a lower opportunity cost.

True or False? An increase in the amount of resources available to Tom for use in producing coconuts and fish does not change his production possibility frontier.

1. True2. False

True or False? A technological change that allows Tom to catch more fish for any amount of coconuts gathered results in a change in his production possibility frontier.

1. True2. False

True or False? The production possibility frontier is useful because it illustrates how much of one good an economy must give up to get more of another good regardless of whether resources are being used efficiently.

1. True2. False

Which country has an absolute advantage in the production of automobiles?

1. Italy2. United States

In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the United States, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day.

Which country has an absolute advantage in the production of washing machines?

1. Italy2. United States

Which country has a comparative advantage in the production of washing machines?

1. Italy2. United States

In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the United States, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day.

Which country has a comparative advantage in the production of automobiles?

1. Italy2. United States

What pattern of specialization results in the greatest gains from trade between the two countries?

1. Italy specializes in automobiles and the U.S. specializes in washing machines.

2. Italy specializes in washing machines and the U.S. specializes in automobiles.

In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the United States, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day.

Use the Circular-Flow Diagram to determine if the statement is true or false:An increase in household spending leads to an increase in jobs in the economy.

1. True2. False

Positive vs. Normative Economics

Positive economics is the branch of economic analysis that describes the way the economy actually works.

Statement of fact‘what is’

Normative economics makes prescriptions about the way the economy should work.

Statement of opinion‘what ought to be’

A forecast is a simple prediction of the future.

Positive vs. Normative Economics

Economists can determine correct answers for positive questions, but typically not for normative questions, which involve value judgments.

There are exceptions are when policies designed to achieve a certain prescription can be clearly ranked in terms of efficiency.

It is important to understand that economists don’t use complex models to show “how clever they are,” but rather because they are “not clever enough” to analyze the real world as it is.

When and Why Economists Disagree

There are two main points on which economists disagree:

Which simplifications to make in a model

Values

When Economists Agree “If all the economists in the world were laid end

to end, they still couldn’t reach a conclusion” A survey by the American Economic Association

published in May of 1992 in the American Economic Review reported that in fact many economists do agree.

At the top, more than 90 percent of the economists agreed that tariffs and import quotas usually reduce general economic welfare.

There is a lot of common ground but also much disagreement.

Economists in Government Economists play an important role in the

business world and also in government. One of their most important functions is

to make economic policy. In the United States, a key role is played

by the Council of Economic Advisors. Economists are also active in the Bureau

of Labor Statistics and the Federal Reserve as well as the World Bank and the International Monetary Fund.

Which of the following statements is a positive statement?

1. Society should take measures to prevent people from engaging in dangerous personal behavior.

2. People who engage in dangerous personal behavior impose higher costs on society through higher medical costs.

3. both A and B4. none of the above

1. True2. False

Policy choice A and policy choice B attempt to achieve the same social goal. Policy choice A, however, results in a much less efficient use of resources than policy choice B. Therefore economists are more likely to agree on choosing policy choice B.

1. True2. False

When two economists disagree on the desirability of a policy, it’s typically because one of them has made a mistake.

1. True2. False

Policy makers can always use economics to figure out which goals a society should try to achieve.

1. Almost all economics is based on models. An important assumption in economic models is the other things equal assumption (ceteris paribus), which allows analysis of the effect of a change in one factor by holding all other relevant factors unchanged.

2. One important economic model is the production possibility frontier. It illustrates: opportunity cost, efficiency, and economic growth. There are two basic sources of growth: an increase in factors of production, resources such as land, labor, capital, and human capital, inputs that are not used up in production, and improved technology.

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3. Another important model is comparative advantage, which explains the source of gains from trade between individuals and countries. Everyone has a comparative advantage in something. This is often confused with absolute advantage, an ability to produce a particular good or service better than anyone else.

4. In the simplest economies, people barter or trade goods and services for one another—rather than trade them for money, as in a modern economy. The circular-flow diagram represents transactions within the economy as flows of goods, services, and money between households and firms. These transactions occur in markets for goods and services and factor markets.

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5. Economists use economic models both for positive economics, which describes how the economy works, and for normative economics, which prescribes how the economy should work. Positive economics often involves making forecasts. Economists can determine correct answers for positive questions, but typically not for normative questions, which involve value judgments.

6. There are two main reasons economists disagree. One, they may disagree about which simplifications to make in a model. Two, economists may disagree—like everyone else—about values.

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The End of Chapter 2

Coming attractionChapter 3:

Supply and Demand