2 Model Building and Gains from Trade Previously . . . • Economics - study of how people (and firms) allocate limited resources to satisfy nearly unlimited wants. • “Scarcity” refers to the limited nature of society’s resources. – Scarcity -> choices -> tradeoffs -> opportunity costs • Incentives - factors that motivate a person to act or make choices/decisions 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 Economic Models • The Scientific Method (Hubbard and O’Brien) 1. Decide on assumptions to be used in developing the model 2. Formulate a testable hypothesis 3. Use economic data to test the hypothesis 4. Revise the model if it fails to explain well the economic data 5. Retain the revised model to help answer similar economic questions in the future Scientific Method Role of Assumptions • Assumptions – Role of assumptions is to • reduce the complexity of the problem to its key elements and, • focus on the items that have the most significant impact (“80/20” rule) – 80% of the impact is due to 20% of the factors • Robust – If relaxing the assumptions has minimal impact on your conclusions then the model is deemed “robust” and is largely unaffected by these testable or nontestable assumptions – “robustness” is a desirable property 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 Today’s Big Questions 1. How do economists study the economy? – An example of a choice model - PPF 2. What is a production possibilities frontier? – Models trade between people/countries – Let’s us examine (and model) 1. What are the benefits of specialization and trade? 2. What is the trade-off between having more now and having more later? 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 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 – Opportunity Costs • 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 – Slope = rise over run – ∆y/∆x = (y2-y1)/(x2-x1) Calculating the Slope of a Line Price of Novels $11 10 9 8 7 6 5 4 3 2 1 0 (13, $8) 6-8=-2 (21, $6) 21-13=8 Demand, D1 5 10 13 15 20 21 25 30 Quantity of novels purchased To calculate the slope of the demand curve, we can look at the changes in the x- and y-coordinates as we move from the point (21 novels, $6) to the point (13 novels, $8). The slope of the line is the ratio of the change in the y-coordinate (–2) to the change in the x-coordinate (+8), which equals –1⁄4. 1 Production Possibilities Frontier Linear PPF – Opp Costs are constant No Specialization of Labor (or any input) 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 Opportunity Costs and the PPF - OC = slope of the PPF If the economy is producing 0 widgets and wants to produce 45 widgets, what is the opportunity cost (in gizmos) of producing the first 45 widgets? What is the incremental (additional or marginal) cost (in gizmos) of going from 45 widgets to 75 widgets? -10 G’s for + 30 W’s (-1/3) 75 widgets to 92 widgets? -10 G’s for +17 W’s (-10/17) 92 widgets to 100 widgets? -10 G’s for + 8W’s (-10/8) Are the opportunity costs (of foregone gizmos) increasing, constant or decreasing as we produce 1 more widget in (a) – (c)? Why? (d above) 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 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.