Chapter 2

1. Chapter 2

2. Models What is a model? • Models: Simplified representation of reality to help us study and understand reality. • Reality is too complicated mesh of cause and effect interactions!

3. Other Things Equal • A simplified model of reality lets us focus on one cause and effect at a time. • Other Things Equal Assumption: Assume that all other relevant factors remain unchanged.

4. Some Components of a Model • Assumptions (how we simplify) • Mathematical Equations Price = 100 – 5*Quantity • Variables (can take on multiple values) • Graphs

5. Three Models to Start With • Production Possibilities Frontier • Comparative Advantage • The Circular-Flow Model

6. 1. PPF- Production Possibility Frontier • Production Possibility Frontier- the model we use for analyzing the economic consequences of scarcity and the working market system. • Definition- Curve showing the maximum attainable combinations of 2 products that may be produced with available resources and current technologies. • Analyzes trade-offs and opportunity costs that individuals, firms, or countries face. Setup: Scarcity, Two Goods, Graph/Table

7. Main Ideas of PPF • Increasing marginal costs • A convex or “bowed out” PPF illustrates increasing marginal costs. Increasing marginal costs occur because some workers, machines, and other resources are better suited to one use than the other. • The more resources already devoted to any activity, the smaller the payoff to devoting additional resources to that activity.

8. Increasing Marginal Opportunity Cost

9. Example 6 • The # of hours you have already spent studying economics, the smaller the increase in your test grade for each additional hour (and the greater the opportunity cost of using the hour in that way)

10. PPF Continued What We Can Learn and Demonstrate • Opportunity Costs, Trade-Offs (most valuable forgone alternative) • Efficiency, Growth, Technology • Comparative Advantage and Absolute Advantage

11. 1.1 Tradeoffs Which of the following best represents the tradeoff faced by BMW between producing SUVs and producing roadsters? a. Any point on the graph represents that tradeoff. b. Tradeoff B and C c. Tradeoff F and G d. Tradeoff C and G

12. Which of the following best represents the tradeoff faced by BMW between producing SUVs and producing roadsters? a. Any point on the graph represents that tradeoff. b. Tradeoff B and C c. Tradeoff F and G d. Tradeoff C and G

13. 1.2 Economic Growth • Economic growth is represented by shifts in the PPF. At any given point in time the resources in an economy are fixed. But over time the resources may increase (population, technology). • Shifts show how economic growth can lead to more production in goods and services which raises the standard of living. Growth may lead to greater increases in production for one good than another.

14. Economic Growth: The ability of the economy to produce increasing quantities of goods and services. What factors might influence economic growth? What could cause production in all industries to rise simultaneously?

15. Example 1- Seats R US (Production choice of car seats and sofas) • Assumptions • Hypothesis • Use economic data to test hypothesis.

16. Example 2: Brady’s Sports Emporium • Assumptions: Brady can produce 3 footballs or 2 bats per hour. He only has 5 hours to work

17. Example 3: Small Spa Inc. • Assumptions: There is one room for services. Each hour the room can be used to give 1 massage or 2 facials. The spa is only open for 3 hours a day.

18. Example 4

19. 1.3 Comparative Advantage (in International Trade) Comparative advantage The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. Absolute advantage The ability to produce more of a good or service than competitors when using the same amount of resources. Note: The basis for trade is comparative advantage not absolute advantage.

20. Example 5: Tiger Woods • Should Tiger Woods mow his own lawn? • Woods can mow his lawn for 2 hours. In the same time, he could be filming commercials for Nike and earn $1 million. • OR • Forrest Gump can mow the lawn in 4 hours or could McDonald’s and earn $20. • Let’s compare opportunity costs.

21. 12 9 6 3 9 10 9

22. How Countries Gain from International Trade Why Don’t We See Complete Specialization? • Not all goods and services are traded internationally. • Production of most goods involves increasing opportunity costs. • Tastes for products differ. Does Anyone Lose as a Result of International Trade? Don’t Let This Happen to YOU!Remember That Trade Creates Both Winners and Losers

23. 3. The Circular Flow Model: The Market System The Circular Flow of Income The Circular-Flow Diagram

24. The Market System Factors of production are divided into four broad categories: • Labor includes all types of work, from the part-time labor of teenagers working at McDonald’s to the work of top managers in large corporations. • Capital refers to physical capital, such as computers and machine tools, that is used to produce other goods. • Natural resources include land, water, oil, iron ore, and other raw materials (or “gifts of nature”) that are used in producing goods. • An entrepreneur is someone who operates a business. Entrepreneurial ability is the ability to bring together the other factors of production to successfully produce and sell goods and services.

25. The Market System The Market Mechanism Individuals usually act in a rational, self-interested way. Adam Smith understood that people’s motives can be complex. In a famous phrase, Smith said that firms would be led by the “invisible hand” of the market to provide consumers with what they wanted.

26. MakingtheConnection A Story of the Market System in Action: How Do You Make an iPod? The market coordinates the activities of the many people spread around the world who contribute to the making of an iPod.

27. The Market System The Legal Basis of a Successful Market System Protection of Private Property Property rights The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it. Enforcement of Contracts and Property Rights If property rights are not well enforced, fewer goods and services will be produced. This reduces economic efficiency, leaving the economy inside its production possibilities frontier.