Chapter 2: Economic Models: Trade-offs and Trades

Introduction: What You Will Learn in This Chapter

• Why models? Simplified representations of reality—play a crucial role in economics

• Two simple but important models:

 production possibility frontier

 comparative advantage

• Circular-flow diagram—a schematic representation of the economy

• The difference between positive economics and normative economics

• When economists agree and why they sometimes disagree

A. Models in Economics
A model is a simplified representation of a real situation that is used to better understand real-life
situations. How? By

 Creating a real but simplified economy

Example: cigarettes in World War II prison camps

 Simulating an economy on a computer

Examples: tax models, money models…

Ceteris Paribus: The “other things equal” assumption means that all other relevant factors remain
unchanged.

Trade-offs: The Production Possibility Frontier

The production possibility frontier (PPF) illustrates the 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
good.

The PPF improves our understanding of trade-offs by considering a simplified economy that produces
only two goods by showing this trade-off graphically.
Figure 2.1 The Production Possibility Frontier

Here, the maximum quantity of jets that a country can produce depends on the quantity of subway
trains being manufactured, and vice versa.

Its feasible production is shown by the area inside or on the curve.

 Points A and B are feasible and efficient in production (Production Efficiency).

 Production Efficiency is when an economy is producing at a point where it is not possible to
produce more of a good without producing less of another good.
 Production at point C is feasible but not efficient
 Point D is not feasible.

Measuring Opportunity Cost

Opportunity Cost of Jets

A to B: Give Up _14_ / Get _4_ = _3.5_ Subway Trains / Jets

B to E: Give Up _21_ / Get _6_ = ___3.5____ Subway Trains / Jets

F to A: Give Up _____ / Get __ = _______ Subway Trains / Jets

F to E: Give Up _____ / Get ______ = _______ Subway Trains / Jets

Opportunity Cost of Subway Trains

B to A: Give Up __4___ / Get ___14___ = ___0.285____ Jets/ Subway Trains

E to B: Give Up _____ / Get ______ = _______ Jets/ Subway Trains

A to F: Give Up _____ / Get ______ = _______ Jets/ Subway Trains

E to F: Give Up _____ / Get ______ = _______ Jets/ Subway Trains

Figure 2.2 Increasing Opportunity Cost

 The bowed-out shape of the production possibility frontier reflects increasing opportunity cost.
 In this example, to produce the first 10 jets, the country must give up 10 subway trains.
 But to produce an additional 10 jets, it must give up 60 more subway trains.

The Principle of Increasing Opportunity Cost: The more that we produce of a good, the greater the
opportunity cost (the more costly it is to produce it).

Figure 2.3 Economic Growth

 Economic growth results in an outward shift of the production possibility frontier because
production possibilities are expanded.
 The economy can now produce more of everything.

o For example, if production is initially at point A (10 jets and 60 subway trains), it could
move to point E (12 jets and 70 subway trains).
Figure 2.4 Production Possibilities for Two Countries

 Here, each of the two countries has a constant opportunity cost of jets and a straight-line
production possibility frontier.
 For Canada: each jet always has an opportunity cost of 7/2 of a subway train, and
each subway train always has an opportunity cost of 2/7 of a jet

 For Brazil: each jet always has an opportunity cost of 6 subway trains, and
each subway train always has an opportunity cost of 1/6 of a jet

Figure 2.5 Comparative Advantage and Gains from Trade

  By specializing and trading, the two countries can produce and consume more of both goods.
Canada specializes in manufacturing jets, its comparative advantage, and Brazil specializes in
manufacturing subway trains.
 The result is that each country can consume more of both goods than either could without
trade.

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.

• Canada vs. Brazil – Absolute vs. Comparative

 Even when Canada has an absolute advantage in both activities: it can produce more
output with a given amount of input (in this case, its time) than Brazil.

 But we’ve just seen that Canada can indeed benefit from a deal with Brazil because
comparative, not absolute, advantage is the basis for mutual gain.

 So Brazil, despite its absolute disadvantage, even in subway trains, has a comparative
advantage in subway train making.

 Meanwhile Canada, which can use its time better by making subway trains, has a
comparative disadvantage in subway train making.

Transactions: The Circular-Flow Diagram

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.

Figure 2.6 The Circular-Flow Diagram

 • 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.

• Firms sell goods and services that they produce to households in markets for goods and
services.

• Firms buy the resources they need to produce goods and services—factors of production—in
factor markets.

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

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

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

A forecast is a simple prediction of the future.

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

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

When and Why Economists Disagree

There are two main reasons economists disagree:

1. Which simplifications to make in a model

2. Values