Chapter 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!
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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.
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Some Components of a Model
• Assumptions (how we simplify)
• Mathematical Equations
Price = 100 – 5*Quantity
• Variables (can take on multiple values)
• Graphs
4
Three Models to Start With
1. Production Possibilities Frontier
2. Comparative Advantage
3. The Circular-Flow Model
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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
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Main Ideas of PPF
1. 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.
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Increasing Marginal Opportunity Cost
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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)
Choice
Hours spend
studying
Midterm Score
A
0
75
B
1
81
C
2
86
D
3
90
E
4
93
F
5
95
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PPF Continued
What We Can Learn and Demonstrate
1. Opportunity Costs, Trade-Offs (most
valuable forgone alternative)
2. Efficiency, Growth, Technology
3. Comparative Advantage and Absolute
Advantage
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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
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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
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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.
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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?
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Example 1- Seats R US (Production
choice of car seats and sofas)
i. Assumptions
ii. Hypothesis
Seatsdata
R US Production
iii. Use economic
to testChoices
hypothesis.
Choice
Quantity of Car Seats
Quantity of Sofas
A
80
0
B
60
10
C
40
20
D
20
30
E
0
40
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Example 2: Brady’s Sports
Emporium
i. Assumptions: Brady can produce 3
footballs or 2 bats per hour. He only has 5
Hours spent producing goods Quantity of goods made
hours to
work
Choice
Footballs
Bats
Footballs
Bats
A
5
0
15
0
B
4
1
12
2
C
3
2
9
4
D
2
3
6
6
E
1
4
3
8
F
0
5
0
10
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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.
Hours of Service
Quantity of Services
Choice
Massage
Facials
Massage
Facials
A
3
0
3
0
B
2
1
2
2
C
1
2
1
4
D
0
3
0
6
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Example 4
Quantity of Guns
Quantity of Grenades
200
0
175
100
100
200
0
250
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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.
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.
20
12
9
6
3
9
10
9
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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
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3. The Circular Flow Model: The
Market System
The Circular Flow of Income
The Circular-Flow Diagram
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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.
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The Market System
The Market Mechanism
Individuals usually act in a rational, selfinterested 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.
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Making
the
Connection
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.
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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.
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