2 Model Building and

Gains from Trade

Previously . . .

• Economics is the study of how people

allocate their limited resources to satisfy
their nearly unlimited wants.
• “Scarcity” refers to the limited nature of
society’s resources.
• Incentives are factors that motivate a
person to act or exert effort.
Big Questions

1. How do economists study the economy?

2. What is a production possibilities frontier?
3. What are the benefits of specialization
and trade?
4. What is the trade-off between having
more now and having more later?
Scientific Method in Economics

• Similar to “hard sciences”

– Construct a theory (or hypothesis)
– Design experiments to test the theory
– Collect data
– Revise or refute the theory based on evidence
• Difference from “hard sciences”
– Economist’s lab is the world around us;
firm and consumer behavior studied
– Not always able to design experiments
– Historical data often used
Positive and Normative
Analysis
• Positive statement
– A claim that can be tested to be true or false
• Normative statement
– Statement of opinion; cannot be tested to be
true or false
– What “ought to be” or “should be”
• Which is generally preferred?
– Positive; like to test claims with data
Practice What You Know—
Positive or Normative?
1. The moon is made of green cheese.
2. Rich people should be taxed more.
3. More taxes on the rich will increase tax revenues.
4. Everyone should donate to charity.
5. I think everyone needs to work at a bank to see the true
value of money.
6. Economics majors earn more on average than
sociology majors.
7. Everyone should take Economics 101.
 Economic Models

• Economists use models to

understand the complex
real-world economy.
• Models
– Simplified versions of
reality
– Built with some
assumptions
– Are considered good if they
predict accurately
Economic Models

• Ceteris paribus
– Latin: “other things being equal”
– Assumption in which we examine a
change in one variable, but hold all
other variables constant.
– Allows us to isolate the effect of a single
variable
Economic Analysis

• Endogenous factors
– Variables controlled for inside a model
– Independent variables we freely change in the
model equations to study their effect on the
dependent variable
• Exogenous factors
– Variables that are not accounted for in a
model
– Outside our control
Models and Ceteris Paribus

• What determines a person’s wage rate?

 Education 
 
 Age 
 Experience 
W  f 
 Skills 
 Pleasant Conditions 
 
 
 Female 
 Models and Ceteris Paribus

 Education  Positive Effect

 
 Age  Positive or Negative Effect?
 Experience 
W  f  Positive Effect
 Skills  Positive Effect
 Pleasant Conditions 
  Negative Effect
 
 Female  A Negative Effect here may be
indicative of discrimination.

• Wage depends on the endogenous variables.

• How will a change in the variables affect wage?
• What might some exogenous variables be?
 Models and Ceteris Paribus
 Education 
 
 Age 
 Experience 
W  f 
 Skills 
 Pleasant Conditions 
 
 
 Female 

• Ceteris paribus analysis

– Change just ONE of the dependent variables
and examine how wage is affected. Assume
other variables do not change.
Danger of Faulty Assumptions

• It is necessary to often examine and re-evaluate

the assumptions in models.
• Example:
– Assumption that housing prices always rise
– Pre-2008 computer models used by banks didn’t
have a variable for declining housing prices
Production Possibilities
Frontier
• Production possibilities frontier
– Combinations of outputs that a society can
produce if all of its resources are being used
efficiently
• Assumptions of this model
– Technology fixed
– Resources fixed
– Simplified two-good analysis
Production Possibilities Frontier
Production Possibilities
Frontier
• Why is the PPF downward-sloping?
– Must give up one good to increase production of another
• Why are we unable to produce certain combinations?
– Scarcity and limited resources
• Efficient points
– Points ON the PPF (A, B, C, and D)
• Inefficient points
– Points INSIDE the PPF (F)
– Workers goofing off, unused buildings
• Unattainable (for now) points
– Points OUTSIDE the PPF (E)
 PPF and Opportunity Cost

• Recall opportunity cost

– Highest-valued alternative
– What we give up as a result of an action
• Opportunity cost in this case is the slope
of the PPF
PPF and Opportunity Cost
Nonlinear PPFs
• We can draw a more realistic PPF by making it
nonlinear and “bowed outward.”
– The PPF will not have a constant slope in this case.
– The slope will get steeper as we move from left to
right, and opportunity costs will not be constant.
• Law of increasing relative cost
– Refers to the increasing opportunity cost of
production that occurs as you move along the
production
– As we produce more of good A, we have to give up
increasingly larger amounts of good B.
PPF and Opportunity Cost
Nonlinear PPFs
• Intuition of nonlinear PFFs
– Inputs (resources) are not perfectly homogenous.
– Some inputs are better at making pizza than other
inputs.
– As we expand pizza production, we’ll use the inputs
that are the best (Italian chef, dough-tossing master).
– If we keep expanding production, we’ll have to start
using inputs that aren’t as good at making pizza.
They’ll still be doing their best, but they won’t make
as much pizza as other inputs.
– Pizza production doesn’t expand at a linear rate!
PPF and Opportunity Cost
Shift in the PPF

• If the PPF were to expand outward, some

previously unattainable good combinations
would now be possible to produce.
• The PPF could shift graphically in two
ways.
– New resources or technology could be
introduced that either
• Affect the production of one good, or
• Affect the production of both goods.
Shift in the PPF
Shift in the PPF
Practice What You Know—
PPF Quiz
• You will have a short time each to answer
a number of true/false questions.
• Please join up with a partner.
Production Possibilities Quiz

1. (True/False) Point A represents the amounts of

cars and bicycles that will be sold.
Bicycles

Cars
Production Possibilities Quiz

2. (True/False) As you move from point F to

point G, the price of bicycles increases.
Bicycles

Cars
Production Possibilities Quiz

3. (True/False) Movement along the curve from

point C to point A shows us the opportunity cost
of producing more bicycles.
Bicycles

Cars
Production Possibilities Quiz

4. (True/False) If we have high

unemployment, then the curve shifts in.
Bicycles

Cars
Production Possibilities Quiz

5. (True/False) If an improved process for

manufacturing cars is introduced, then the
entire curve will shift out.
Bicycles

Cars
Practice What You Know—
PPF Quiz Answers
• We will ask each question again, and then
reveal the answer.
Production Possibilities Quiz

1. (True/False) Point A represents the amounts of

cars and bicycles that will be sold.
Bicycles
False.

It represents A

how many cars

and bicycles are
produced! Cars
Production Possibilities Quiz

2. (True/False) As you move from point F to

point G, the price of bicycles increases.
Bicycles
False.
G
The number of F
bicycles
produced
increases. Cars
Production Possibilities Quiz

3. (True/False) Movement along the curve from

point C to point A shows us the opportunity cost
of producing more bicycles.
Bicycles
False.
C
-
It represents the A

opportunity cost
of producing +

more cars. Cars

Production Possibilities Quiz

4. (True/False) If we have high

unemployment, then the curve shifts in.
False. Bicycles

Unemployment means that not

everyone is working so
production is inside the PPC. ?
The PPC stays put since it
represents the maximum
output if all resources are Cars

being used to the fullest.

Production Possibilities Quiz

5. (True/False) If an improved process for

manufacturing cars is introduced, then the
entire curve will shift out.
Bicycles
False.
?
The curve only moves out
along the car axis. It is not
possible to make more
bicycles than before.
Cars
Specialization and Trade

• Improvements in technology and more

resources can make an economy more
productive.
• Specialization and trade can also create gains
for society.
• Assume now
– Two goods (pizza and wings)
– Two people with different abilities in the production of
pizza and wings
Specialization and Trade

Daily Production
Person Pizzas Wings
Debra Winger 60 120
Mike Piazza 24 72

• Absolute advantage
– One person can perform each task more
effectively than the other person.
– Who has the absolute in pizza? In wings?
Specialization and Trade
Specialization and Trade

Without Trade

Person Good Production Consumption

Debra Pizza 40 40
Wings 40 40
Mike Pizza 18 18
Wings 18 18

• Without specialization and trade

– Mike and Debra each have to produce their own
wings and pizza;
– Each person can only consume what they produce.
Specialization and Trade
Gains from
With Trade
Trade
Person Good Production Consumption
Debra Pizza 60 41 (keeps) +1
Wings 0 47 (from Mike) +7
Mike Pizza 0 19 (from Debra) +1
Wings 72 25 (keeps) +7

• With specialization and trade

– Debra produces pizza and gives 19 pizzas to Mike;
– Mike produces wings and gives 47 wings to Debra;
– Each person consumes more with trade.
Gains from Trade
Opportunity Cost
Daily Production
Person Pizzas Wings
Debra Winger 60 120
Mike Piazza 24 72
Opportunity Cost
Person 1 Pizza 1 Wing
2 wings 1/2 pizzas
Debra Winger
(120 ÷ 60) (60 ÷ 120)
3 wings 1/3 pizzas
Mike Piazza
(72 ÷ 24) (24 ÷ 72)
Opportunity Cost
Opportunity Cost
Person 1 Pizza 1 Wing
2 wings 1/2 pizzas
Debra Winger
(120 ÷ 60) (60 ÷ 120)
3 wings 1/3 pizzas
Mike Piazza
(72 ÷ 24) (24 ÷ 72)
• Comparative advantage
– Debra: comparative advantage in pizza production
• She gives up fewer wings than Mike.
– Mike: comparative advantage in wing production
• He gives up fewer pizzas than Debra.
Gains from Trade

• Previously, we noted the gains from

trade and specialization.
• Terms of trade
– The relative prices, or exchange rate of
goods
– How many wings per pizza?
Terms of Trade

Person Opportunity Cost Ratio

Debra Winger 1 pizza equals 2 wings 1:2 = 0.50

Terms of trade 19 pizzas for 47 wings 19:47 = 0.40

Mike Piazza 1 pizza equals 3 wings 1:3 = 0.33

• Terms of Trade
– As long as the terms of trade are between the
opportunity costs of the trading partners, the
trade benefits both sides.
Practice What You Know

• We often think of specialization and trade

occurring between countries.
• However, it can occur on much smaller
levels as well

• Examples?
– Within a home?
– At a gathering of friends and/or family?
 Trade-off Between Present
and Future
• Consumer goods
– Goods produced for current
consumption
– Food, housing, clothing, entertainment
• Capital goods
– Goods that help produce other
valuable goods
– Buildings, factories, roads, machinery,
computers
• Investment
– Using resources to make new capital
Capital Goods and Future
Growth
Capital Goods and Future
Growth
Capital Goods and Future
Growth
• Over the last 20 years, China and India
have invested in more capital compared to
the United States and Europe.
• The result?
– China is sacrificing today’s consumption for a
better future.
– China and India have higher growth rates.
– Another trade-off: Chinese workers have less
leisure time than American workers.
 Visualizing Investment

• Often, we are hesitant to invest in capital

goods “today” even if it results in larger
consumer good production “tomorrow.”
• Today’s investment may
• Take a long time
• Have a large opportunity cost
• May have uncertain results
Visualizing Investment

• Suppose that instead of producing

pizza, we spent resources in order to
improve pizza-making technology.
• What happens…
– Today?
– Tomorrow?
Visualizing Investment
Investment in Time Period No Investment
Capital Goods
1

4
Visualizing Investment

• Other examples of long-term investment

Conclusion

• Economists use simplified models to understand

how the economy works.
• The production possibilities frontier (PPF)
illustrates the benefits of trade and allows us to
describe ways to grow the economy.
• When producers specialize, they focus their
efforts on those goods and services for which
they have the lowest opportunity cost and trade
with others who are good at making something
else.
Summary

• Economists design and implement theories and

test those theories by collecting real data.
• The economist’s laboratory is the world around
us.
• A good model should be simple to understand
and able to make powerful predictions.
• Positive statements can be verified by examining
evidence.
• Normative statements reflect values or what
people think “should” be.
 Summary

• Microeconomics is primarily concerned with the

decisions of households and businesses.
• Macroeconomics looks at the broader economy.
• A PPF illustrates the trade-offs that exist in society.
• Even when an absolute advantage exists, society
is still better off by specializing and trading based
on comparative advantage.
• Societies face a trade-off between consumption in
the short run and greater productivity in the long
run.
Practice What You Know

What is a possible problem with using

faulty assumptions when building an
economic model?
A. The model could become too popular.
B. It could lead to wrong economic decisions.
C. It means we never have to rebuild the
model.
D. It could cause too much wealth.
Practice What You Know

With regard to the PPF, an efficient point

is a point that is
A. impossible to reach.
B. inside the PPF.
C. outside the PPF.
D. on the PPF.
Practice What You Know

If we move down and to the right along a

PPF, the opportunity cost of this
movement can be measured in terms of
A. how much of the x-axis good we gain.
B. how much of the y-axis good we gain.
C. how much of the x-axis good we give up.
D. How much of the y-axis good we give up.
Practice What You Know

Suppose there is high unemployment.

With respect to the PPF, what will
happen?
A. The PPF will shift inward.
B. The PPF will shift outward.
C. We will produce at a point inside the PPF.
D. We will produce at a point outside the
PPF.
Practice What You Know

What is the opportunity cost of producing

capital goods instead of consumer
goods?
A. We give up consumption today.
B. We give up consumption tomorrow.
C. We have less employment today.
D. We have a lower standard of living
tomorrow.