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.