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chapter:. 2. >>. Economic Models: Trade-offs and Trade. Krugman/Wells Economics. ©2009  Worth Publishers. Why models? Simplified representations of reality—play a crucial role in economics Two simple but important models: production possibility frontier circular-flow diagram

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chapter:

2

>>

Economic Models:

Trade-offs and Trade

Krugman/Wells

Economics

©2009  Worth Publishers


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

  • Two simple but important models:

    • production possibility frontier

    • circular-flow diagram

  • The difference between positive economics and normative economics

  • When economists agree and why they sometimes disagree


Models in economics l.jpg
Models in Economics crucial role in economics

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

  • The “other things equal” assumption means that all other relevant factors remain unchanged.


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Trade-offs: The Production Possibility Frontier crucial role in economics

  • 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.

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


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The Production Possibility Frontier crucial role in economics

Quantity of coconuts

D

30

Feasible and

efficient

in production

Not feasible

A

15

B

Feasible but

not efficient

9

C

Production possibility frontier

PPF

0

20

28

40

Quantity of fish


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Increasing Opportunity Cost crucial role in economics

Quantity of coconuts

Producing the first

20 fish . . .

…requires giving up

5 coconuts

35

But producing

20 more fish . . .

30

A

25

20

…requires giving up

25 more coconuts…

15

10

5

PPF

0

10

20

30

40

50

Quantity of fish


Economic growth l.jpg
Economic Growth crucial role in economics

Quantity of coconuts

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).

35

E

30

A

25

20

15

10

5

Original

New

PPF

PPF

0

10

20

25

30

40

50

Quantity of fish


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Production Possibilities for Two Castaways crucial role in economics

(a) Tom’s Production Possibilities

Quantity of coconuts

30

Tom’s consumption

without trade

9

Tom’s

PPF

0

28

40

Quantity of fish


Production possibilities for two castaways9 l.jpg
Production Possibilities for Two Castaways crucial role in economics

(a) Hank’s Production Possibilities

Quantity of coconuts

20

Hank’s consumption

without trade

8

Hank’s

PPF

0

6

10

Quantity of fish


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Tom and Hank’s Opportunity Costs crucial role in economics


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Specialize and Trade crucial role in economics

  • Both 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.


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Comparative Advantage and Gains from Trade crucial role in economics

(a) Tom’s Production and Consumption

(b) Hank’s Production and Consumption

Quantity of coconuts

Quantity of coconuts

30

Tom’s consumption without trade

Hank’s production with trade

Tom’s consumption with trade

20

Hank’s consumption with trade

Tom’s production with trade

10

Hank’s consumption without trade

10

9

8

Hank's

T

o

m

's

PPF

PPF

0

28

30

40

0

6

10

Quantity of fish

Quantity of fish


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How the Castaways Gain from Trade crucial role in economics

  • 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.


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Comparative vs. Absolute Advantage crucial role in economics

  • 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.


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Tom vs. Hank – Absolute vs. Comparative crucial role in economics

  • 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 we’ve just seen that 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.


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Comparative Advantage and International Trade crucial role in economics

(a) The U.S. Production Possibilities Frontier

(b) Canadian Production Possibilities Frontier

Quantity of aircraft

Quantity of aircraft

Canadian production with trade

3,000

U.S. consumption without trade

Canadian consumption without trade

U.S. consumption with trade

2,000

1,500

1,500

U.S. production with trade

Canadian consumption with trade

1,000

U

.S.

Canadian

PPF

PPF

0

1

2

3

0

0.5

1

1.5

Quantity of pork (millions of tons)

Quantity of pork (millions of tons)


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Comparative Advantage and International Trade crucial role in economics

  • 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.


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Transactions: The Circular-Flow Diagram crucial role in economics

  • 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.


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The Circular-Flow Diagram crucial role in economics

Money

Households

Money

Goods

Factors

and

services

Markets for goods and services

Factor Markets

Goods

and

Factors

services

Firms

Money

Money


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Circular-Flow of Economic Activities crucial role in economics

  • 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—factors of production—in factor markets.


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Circular-Flow of Economic Activities crucial role in economics

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


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Using Models crucial role in economics

  • 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.


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Using Models crucial role in economics

  • 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.

  • 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.


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When and Why Economists Disagree crucial role in economics

There are two main reasons economists disagree:

  • Which simplifications to make in a model

  • Values


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  • Almost all economics is based on crucial role in economicsmodels. An important assumption in economic models is the other things equal assumption, which allows analysis of the effect of a change in one factor by holding all other relevant factors unchanged.

  • One important economic model is the production possibilityfrontier. It illustrates: opportunity cost, efficiency, andeconomic growth. There are two basic sources of growth: anincrease in factors of production, resources such as land,labor, capital, and human capital, inputs that are not usedup in production, and improved technology.


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  • Another important model is crucial role in economicscomparative advantage,which explains the source of gains from trade betweenindividuals and countries.Everyone has a comparativeadvantage in something. This is often confused with absolute advantage,an ability to produce a particular good or service betterthan anyone else.

  • In the simplest economies, people barter or trade goods andservices for one another—rather than trade them formoney, as in a modern economy. The circular-flowdiagram represents transactions within the economy asflows of goods, services, and money between householdsand firms. These transactions occur in markets for goodsand services and factor markets.


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  • Economists use economic models both for crucial role in economicspositiveeconomics,which describes how the economy works,and for normative economics,which prescribes howthe economy should work. Positive economics ofteninvolves making forecasts.Economists can determinecorrect answers for positive questions, but typically not for normative questions, which involve value judgments.

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


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