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>> Economic Models: Trade-offs and Trade
Krugman/Wells Economics

©2009  Worth Publishers

WHAT YOU WILL LEARN IN THIS CHAPTER
 Why models? Simplified representations of reality— play a crucial role in economics T Two simple b t i i l but important models: t t d l  production possibility frontier  circular-flow diagram  The difference between positive economics and normative economics  When economists agree and why they sometimes disagree

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Models in Economics  A model is a simplified representation of a real situation that is used to better understand real-life situations.  2 . 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 p y g p y produces only two goods by showing this trade-off graphically. 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 p produces only two g y goods.

.The Production Possibility Frontier Quantity of coconuts 30 Feasible and efficient in production D Not feasible A 15 Feasible F ibl but not efficient B C Production possibility frontier PPF 0 20 28 40 Quantity of fish 9 Increasing Opportunity Cost Quantity of coconuts Producing the first 20 fish . . …requires giving up 5 coconuts But producing 20 more fish . . . A 25 20 15 10 5 PPF 0 10 20 30 40 50 Quantity of fish …requires giving up 25 more coconuts… 35 30 3 .

an outward shift everything. fish and 30 are expanded.Economic Growth Quantity of coconuts 35 E 30 A 25 20 15 10 5 Production is can now The economy initially at point Economic growth results in produce more 25 coconuts). A (20 fish and of of the PPF  it can move to point E (25 because production possibilities coconuts). Original PPF New PPF 50 Quantity of fish 0 10 20 25 30 40 Production Possibilities for Two Castaways (a) Tom’s Production Possibilities Quantity of coconuts 30 Tom’s consumption without trade 9 Tom’s PPF 0 28 40 Quantity of fish 4 .

Production Possibilities for Two Castaways (a) Hank’s Production Possibilities Quantity of coconuts 20 Hank’s consumption without trade 8 Hank’s PPF 0 6 10 Quantity of fish Tom and Hank’s Opportunity Costs Tom’s Opportunity Cost One fish 3/4 coconut Hank’s Opportunity Cost 2 coconuts One 4/3 fish coconut 1/2 fish 5 .

it’s a good idea for Hank to gather coconuts for the both of them. Correspondingly.Specialize and Trade  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.   Comparative Advantage and Gains from Trade (a) Tom’s Production and Consumption Quantity of coconuts (b) Hank’s Production and Consumption Quantity of coconuts 30 Tom’s consumption without trade Tom’s consumption with trade Hank’s production with trade 20 Hank’s consumption with trade Hank s Hank’s consumption without trade Hank's PPF 0 6 10 Quantity of fish 10 0 9 Tom’s production with t d ith trade T om's PPF 10 8 0 2830 40 Quantity of fish 6 .

An individual has an absolute advantage in an activity if he or she can do it better than other people. thing having ti d t  7 . Having an absolute advantage is not the same thi as h i a comparative advantage. Hank’s consumption of fish increases by four.How the Castaways Gain from Trade Both Tom and Hank experience gains from trade:  Tom’s T ’ consumption of fish increases b t ti f fi h i by two.  Comparative vs. and his consumption of coconuts increases by two. and d his consumption of coconuts increases by one. 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.

But we’ve just seen that Tom can indeed benefit from a deal with Hank because comparative. production with trade U. even in coconuts.S. So Hank. who can use his time better by catching fish.S. Production Possibilities Frontier Quantity of aircraft (b) Canadian Production Possibilities Frontier Quantity of aircraft 3. advantage is the basis for mutual gain. Meanwhile Tom.S. has a comparative advantage in coconut gathering.S. his time) than Hank. has a comparative disadvantage in coconut-gathering. Comparative     Tom has an absolute advantage in both activities: he can produce more output with a given amount of input (in this case. consumption without trade U. Comparative Advantage and International Trade (a) The U. consumption with trade 1.Tom vs.000 U. Hank – Absolute vs. despite his absolute disadvantage.500 Canadian production with trade Canadian consumption without trade Canadian consumption with trade Canadian PPF 0.5 1 1.5 Quantity of pork (millions of tons) Quantity of pork (millions of tons) 8 .000 3 000 U.500 1. PPF 0 1 2 3 0 2. not absolute.S.000 1.

while Canada concentrates on aircraft and ships some of its output to the U. concentrates on producing pork and ships some of its output to Canada. and Canada can both achieve mutual gains from trade.  9 .S.S.S. The circular-flow diagram is a model that represents the transactions in an economy by flows around a circle. trade If the U. the U..  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. both countries can consume more than US if they insisted on being self-sufficient.Comparative Advantage and International Trade  Just like the example of Tom and Hank.

A firm is an organization that produces goods and services for sale.    10 . g Firms buy the resources they need to produce— factors of production—in factor markets. Firms sell goods and services that they produce to households in markets for goods and services.The Circular-Flow Diagram Money Goods and services Households Money Factors Factor Markets Goods and services Firms Factors F t Money Money Circular-Flow of Economic Activities  A household is a person or a group of people that share their income.

Using Models  Positive economics is the branch of economic analysis that describes the way the economy actually works.Circular-Flow of Economic Activities  Ultimately. factor markets determine the economy’s income distribution. Normative economics makes prescriptions about the way the economy should work.   11 . how total income is divided among the owners of the various factors of g production. A forecast is a simple prediction of the future future.

It is important to understand that economists don’t use complex models to show “how clever they are.   When and Why Economists Disagree There are two main reasons economists disagree:  Which simplifications to make in a model Values  12 .” but rather because they are “not clever enough” to analyze the real world as it is. but typically not for normative questions.Using Models  Economists can determine correct answers for positive questions. which involve value judgments. The exceptions are when policies designed to achieve a certain prescription can be clearly ranked in terms of efficiency.

13 . An important assumption in economic models is the other things equal assumption. capital. There are two basic sources of growth: an increase in factors of production. resources such as land. and money between households and firms. and improved technology. Everyone has a comparative advantage in g something. It illustrates: opportunity cost. inputs that are not used up in production. and economic growth. This is often confused with absolute advantage. which allows analysis of the effect of a change in one factor by holding all other relevant factors unchanged. people barter or trade goods and services for one another—rather than trade them for money. Almost all economics is based on models. One important economic model is the production possibility frontier. services. SUMMARY 3. 2. labor.SUMMARY 1. Another important model is comparative advantage. as in a modern economy. In the simplest economies. 4. These transactions occur in markets for goods and services and factor markets. The circular-flow diagram represents transactions within the economy as g p y flows of goods. an ability to produce a particular good or service better than anyone else. which explains the source of gains from trade between individuals and countries. efficiency. and human capital.

Economists can determine correct answers for positive questions.SUMMARY 5. y g y model. they may disagree about which simplifications to make in a . which involve value judgments. 14 . but typically not for normative questions. 6. One. which prescribes how the economy should work. Economists use economic models both for positive economics. economists may disagree—like everyone else—about values. which describes how the economy works. There are two main reasons economists disagree. Two. Positive economics often involves y making forecasts. and for normative economics.

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