Micro and Macro Models

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Micro and Macro Models

• Terms (almost all not involving money)– Opportunity Cost– Absolute Advantage– Comparative Advantage– Specialization– Production Possibility Frontier– Imports– Exports– Circular Flow Diagram

Opportunity Cost

• Opportunity Cost: The next best

alternative you give up in order to obtain or

produce an item

Opportunity Cost

• What would you be doing if you were not

in class today?

Opportunity Cost

Opportunity cost for each of three identical jobs with identical benefits, but with employers paying different salaries:

– Employer A: $70,000– Employer B: $50,000– Employer C: $30,000

Absolute and Comparative Advantage

• Two individuals, Kate and Charlie, are stranded on a desert island and subsist on a diet of bananas and coconuts.

Absolute and Comparative Advantage

• Production per HourBananas

• Kate: 40 per hour• Charlie: 20 per hour

Coconuts• Kate: 20 per hour• Charlie: 4 per hour

Absolute and Comparative Advantage

• Absolute Advantage: The person, firm, or

nation with a higher level of productivity

compared to that of another.

Absolute and Comparative Advantage

• Kate has the absolute advantage

producing both bananas and coconuts

Absolute and Comparative Advantage

• Who has the comparative advantage?

• Comparative Advantage: the person, firm,

or nation with the lower opportunity cost

vs. that of another.

Absolute and Comparative Advantage

Calculating opportunity cost (the next best

alternative)

– Opportunity cost of producing bananas = the

number of coconuts produced in a unit of time

divided by the number of bananas produced

in the same unit of time.

Absolute and Comparative Advantage

• Opportunity CostBananas

• Kate: ½ coconut• Charlie: 1/5 coconut

Coconuts• Kate: 2 bananas• Charlie: 5 bananas

Absolute and Comparative Advantage

• Let’s assume that each is eating only their own production in the following manner:

– Kate: 20 bananas and 10 coconuts– Charlie: 10 bananas and 2 coconuts

• Are there any shifts in production or trades that could be taken advantage of?

Absolute and Comparative Advantage

• Specialization: focusing production more heavily on a good for which you have a comparative advantage, with the expectation of trading for other goods for which you do not have a comparative advantage

Absolute and Comparative Advantage

• Let’s assume that they produce:– Kate: 12 bananas and 14 coconuts– Charlie: 20 bananas and 0 coconuts

• Is this a valid direction?

• Are the numbers valid?

Absolute and Comparative Advantage

• If Charlie trades 9 bananas to Kate for 3 coconuts, they will have– Kate: 21 bananas and 11 coconuts– Charlie: 11 bananas and 3 coconuts

• Compared to before:– Kate: 20 bananas and 10 coconuts– Charlie: 10 bananas and 2 coconuts

Absolute and Comparative Advantage

• The comparative advantage allows

people, firms, or nations to specialize and

trade

Production Possibility Frontier• A graph of all potential production

combinations in an economy (compare to the flat PPF for an individual)

Production Possibility Frontier

Efficient Points: points on the curve

Inefficient Points: points below the curve

Impossible Points: points above the curve

- Often Called the Production Possibility Curve (PPC)

Imports and Exports

• Imports: goods or services produced

abroad and sold in ones own country

• Exports: goods or services produced in

ones own country and sold abroad

Circular Flow Diagram (Mankiw)

Copyright © 2004 South-Western

Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of dollars

Factors ofproduction

Wages, rent,and profit

FIRMS•Produce and sellgoods and services

•Hire and use factorsof production

•Buy and consumegoods and services

•Own and sell factorsof production

HOUSEHOLDS

•Households sell•Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

•Firms sell•Households buy

MARKETSFOR

GOODS AND SERVICES

Circular Flow Diagram

• Enhanced diagram: Wikipedia

– http://upload.wikimedia.org/wikipedia/en/e/ee/Circular_flow_of_income.JPG

Circular Flow Diagram: Enhanced

Experiment Tomorrow

• EconPort

– www.econport.org