Chapter 2
Economic
Models:
Tradeoffs and
Trade
Slides created by Dr. Amy Scott
©2010  Worth Publishers
TUNNEL VISION
A miniature airplane sitting motionless
in a wind tunnel isn’t the same thing as
an actual aircraft in flight.
But it is a very useful model of a flying
plane.
Economic theory consists mainly of a collection of
models.
In this chapter, we will look at two economic models
that illustrate why such models are so useful.
Chapter Objectives
1. Why models in economics?
2. Three simple but important models:
A. Production possibility frontier
B. Comparative advantage
C. Circular-flow diagram
3. Positive economics and normative economics.
4. When economists agree and why they sometimes
disagree.
Models in Economics
A
model is a simplified representation of a real situation
- used to better understand real-life situations.
 Models play a crucial role in economics
 Used to study a real but simplified economy
Ex.: Cigarettes as currency in World War II prison camps

Used to simulate an economy on a computer
Ex.: Use Tax models to study impact of proposed study
 The
“other things equal” (ceteris paribus)
assumption means that all other relevant factors remain
unchanged.
Models for Money




An economic model can be worth quite a bit of money. Global
Insight, the world’s biggest consulting firm, uses economic models
to predict future trends and give advice to firms and governments.
A particularly lucrative branch is finance theory which calculates
what assets, such as shares in a company, are worth.
The most famous business application of finance theory was Long
Term Capital Management, a fund that used sophisticated models
to invest money for its wealthy clients.
The fund did well for a while, then it collapsed. People feared
companies would be brought down with it but the government
organized a rescue operation. A similar situation almost happened
in the fall of 2008.
Three Models
The Production Possibility Frontier
Illustrates
trade-offs facing an economy that
produces only two goods.
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
What to do?
by considering a simplified economy Even a castaway
faces trade-offs.
that produces only two goods
by showing this trade-off graphically.
Opportunity Cost and Slope of PPF


If the tradeoff remains constant along the PPF
then we say they face a Constant
Opportunity Cost and the PPF has a linear
slope.
If the tradeoff increases along the PPF than
we say they face an Increasing Opportunity
Cost and the PPF has a nonlinear slope.
The Production Possibility Frontier with
Constant Opportunity Cost
Quantity of
coconuts
D
30
Feasible and
efficient
in production
Not
feasible
A
15
9
Feasible
but
not efficient
B
C
Production possibility frontier
PPF
0
20
28
40
Quantity of fish
PPF with Increasing Opportunity Cost
Quantity of coconuts
35
…requires giving up
5 coconuts
Producing the first
20 fish . . .
But producing
20 more fish . . .
30
A
25
20
…requires giving up
25 more coconuts…
15
10
5
PPF
0
10
20
30
40
50
Quantity of fish
Economic Growth


Economic Growth is the growing ability of the
economy to produce goods and services
Economic Growth can come from two sources:
 Increase in Factors of Production – resources
used to produce goods and services (Land,
Labor and Capital)
 Technological Improvement – improvement
in the technical means of producing goods
and services
Economic Growth
Quantity of coconuts
35
Economic growth results in
an outward shift of the PPF
because production
possibilities are expanded.
E
30
A
25
20
15
10
5
Original
New
PPF
PPF
0
10
20
25
30
40
The economy
can now
produce more
of everything.
Production is
initially at point
A (20 fish and
25 coconuts),
 it can move
to point E (25
fish and 30
coconuts).
50
Quantity of fish
Production Possibilities for Two Castaways
Quantity of coconuts
(a) Tom’s Production Possibilities
30
Tom’s consumption
without trade
9
Tom’s
PPF
0
28
40
Quantity of fish
Production Possibilities for Two Castaways
Quantity of coconuts
(a) Hank’s Production Possibilities
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
Hank’s
Opportunity
Cost
One fish 3/4 coconut
2 coconuts
One
4/3 fish
coconut
1/2 fish
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
30
(b) Hank’s Production and Consumption
Quantity of coconuts
Tom’s consumption
without trade
Hank’s production
with trade
Tom’s consumption
with trade
Tom’s production
with trade
10
9
20
Hank’s consumption
with trade
Hank’s consumption
without trade
10
8
Hank's
PPF
Tom's
PPF
0
2830
40 Quantity of fish
0
6 10
Quantity of fish
How the Castaways Gain from Trade
Both Tom and Hank experience gains from trade:


Tom’s consumption of fish increases by two, and his
consumption of coconuts increases by one.
Hank’s consumption of fish increases by four, and his
consumption of coconuts increases by two.
Comparative vs. 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.
An individual has an absolute advantage in an activity if he or she
can do it better than other people.
Having an absolute advantage is not the same thing as having a
comparative advantage. You can have an absolute advantage in
both goods and still benefit from trade.
Tom vs. Hank – Absolute vs. Comparative
 Tom
has an absolute advantage in both activities: he
can produce more output with a given amount of input
(in this case, his time) than Hank.
 But Tom can indeed benefit from a deal with Hank
because comparative, not absolute, advantage is the
basis for mutual gain.
 So Hank, despite his absolute disadvantage, even in
coconuts, has a comparative advantage in coconut
gathering.
 Meanwhile Tom, who can use his time better by catching
fish, has a comparative disadvantage in coconutgathering.
Comparative Advantage and International Trade
(a) The U.S. Production Possibilities Frontier
Quantity of aircraft
(b) Canadian Production Possibilities Frontier
Quantity of aircraft
3,000
Canadian production
with trade
U.S. consumption
without trade
U.S. consumption
with trade
1,500
Canadian
consumption
without trade
2,000
1,500
U.S.
production
with trade
1,000
Canadian
consumption
with trade
U.S.
PPF
0
1
2
3
Quantity of pork (millions of
tons)
Canadian
PPF
0
0.5
1
1.5
Quantity of pork (millions of
tons)
Comparative Advantage and International Trade
 Just
like the example of Tom and Hank, the U.S. and Canada
can both achieve mutual gains from trade.
the U.S. concentrates on producing pork and ships some
of its output to Canada, while Canada concentrates on
aircraft and ships some of its output to the U.S., both
countries can consume more than if they insisted on being
self-sufficient.
 If
PITFALLS
Misunderstanding Comparative Advantage
A common mistake is to confuse comparative
advantage with absolute advantage.
Ex.: U.S. vs. Japan in 1980s:
 Commentators: “U.S. might soon have no
comparative advantage in anything”
 Wrong! They meant “absolute advantage”
Pajama Republics


Poor countries tend to
have low productivity in
clothing manufacturing
but even lower
productivity in other
industries.
Comparing per capita
income with the share of
the clothing industry in
manufacturing
employment shows a
strong effect.
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.
 The
circular-flow diagram is a model that represents
the transactions in an economy by flows around a circle.
 Households buy goods and services from firms
 Firms buy factors of production from households
 Inner Flow = goods and services
 Outer Flow = money
The Circular-Flow Diagram
Money
Households
Goods
and
services
Money
Factors
Factor Markets
Goods
and
services
Money
Factors
Firms
Money
Circular-Flow of Economic Activities
A
household is a person or a group of people that share
their income.
A
firm is an organization that produces goods and services
for sale.
 The
markets for goods and services is where firms sell
goods and services that they produce to households.
 The
factor markets are where firms buy the resources
they need to produce—factors of production.
Circular-Flow of Economic Activities
Ultimately,
factor markets determine the
economy’s income distribution: how total
income is divided among the owners of the
various factors of production.
Rich Nation, Poor Nation




Look at the labels inside your clothing.
Most clothing is manufactured outside of the United
States.
These countries are typically much poorer than the
United States usually because they are less productivethey cannot produce as much from a given quantity of
resources as comparable firms in the United States.
This is ‘comparative advantage’ – they can make
clothing at a lower opportunity cost than the US – while
the US can make other goods at a lower opportunity
cost.
True or False? An increase in the amount of resources available to
Tom for use in producing coconuts and fish does not change his
production possibility frontier.
1.
2.
True
False
True or False? A technological change that allows Tom to catch
more fish for any amount of coconuts gathered results in a change
in his production possibility frontier.
1.
2.
True
False
True or False? The production possibility frontier is useful because it
illustrates how much of one good an economy must give up to get more of
another good regardless of whether resources are being used efficiently.
1.
2.
True
False
In Italy, an automobile can be produced by 8 workers in one day and a
washing machine by 3 workers in one day. In the United States, an
automobile can be produced by 6 workers in one day, and a washing
machine by 2 workers in one day.
Which country has an absolute advantage in the production of
automobiles?
1.
2.
Italy
United States
Which country has an absolute advantage in the production of
washing machines?
1.
2.
Italy
United States
In Italy, an automobile can be produced by 8 workers in one day and a
washing machine by 3 workers in one day. In the United States, an
automobile can be produced by 6 workers in one day, and a washing
machine by 2 workers in one day.
Which country has a comparative advantage in the production of
washing machines?
Italy
United States
1.
2.
Which country has a comparative advantage in the production of
automobiles?
1.
2.
Italy
United States
In Italy, an automobile can be produced by 8 workers in one day and a
washing machine by 3 workers in one day. In the United States, an
automobile can be produced by 6 workers in one day, and a washing
machine by 2 workers in one day.
What pattern of specialization results in the greatest gains from
trade between the two countries?
1.
2.
Italy specializes in automobiles
and the U.S. specializes in
washing machines.
Italy specializes in washing
machines and the U.S.
specializes in automobiles.
Use the Circular-Flow Diagram to determine if the statement is true or false:
An increase in household spending leads to an increase in jobs in the
economy.
1.
2.
True
False
Positive vs. Normative Economics
 Positive
economics is the branch of economic analysis
that describes the way the economy actually works.
 Statement of fact
 ‘what is’
 Normative
economics makes prescriptions about the
way the economy should work.
 Statement of opinion
 ‘what ought to be’
A
forecast is a simple prediction of the future.
Positive vs. Normative Economics
 Economists
can determine correct answers for positive
questions, but typically not for normative questions, which
involve value judgments.
 There
are exceptions are when policies designed to achieve a
certain prescription can be clearly ranked in terms of
efficiency.
 It
is important to understand that economists don’t use
complex models to show “how clever they are,” but rather
because they are “not clever enough” to analyze the real
world as it is.
When and Why Economists Disagree
There are two main points on which
economists disagree:

Which simplifications to make in a model

Values
When Economists Agree




“If all the economists in the world were laid end to end,
they still couldn’t reach a conclusion”
A survey by the American Economic Association
published in May of 1992 in the American Economic
Review reported that in fact many economists do agree.
At the top, more than 90 percent of the economists
agreed that tariffs and import quotas usually reduce
general economic welfare.
There is a lot of common ground but also much
disagreement.
Economists in Government




Economists play an important role in the
business world and also in government.
One of their most important functions is to
make economic policy.
In the United States, a key role is played by the
Council of Economic Advisors.
Economists are also active in the Bureau of
Labor Statistics and the Federal Reserve as well
as the World Bank and the International
Monetary Fund.
Which of the following statements is a positive
statement?
1.
2.
3.
4.
Society should take measures to prevent people from
engaging in dangerous personal behavior.
People who engage in dangerous personal behavior
impose higher costs on society through higher medical
costs.
both A and B
none of the above
Policy choice A and policy choice B attempt to achieve the same social
goal. Policy choice A, however, results in a much less efficient use of
resources than policy choice B. Therefore economists are more likely to
agree on choosing policy choice B.
1.
2.
True
False
When two economists disagree on the desirability of a policy,
it’s typically because one of them has made a mistake.
1.
2.
True
False
Policy makers can always use economics to figure out
which goals a society should try to achieve.
1.
2.
True
False
Summary
1 of 3
1. Almost all economics is based on models. An important
assumption in economic models is the other things
equal assumption (ceteris paribus), which allows
analysis of the effect of a change in one factor by holding
all other relevant factors unchanged.
2. One important economic model is the production
possibility frontier. It illustrates: opportunity cost,
efficiency, and economic growth. There are two basic
sources of growth: an increase in factors of production,
resources such as land, labor, capital, and human capital,
inputs that are not used up in production, and improved
technology.
Summary
2 of 3
3. Another important model is comparative advantage,
which explains the source of gains from trade between
individuals and countries. Everyone has a comparative
advantage in something. This is often confused with
absolute advantage, an ability to produce a particular
good or service better than anyone else.
4. In the simplest economies, people barter or trade
goods and services for one another—rather than trade
them for money, as in a modern economy. The
circular-flow diagram represents transactions within
the economy as flows of goods, services, and money
between households and firms. These transactions
occur in markets for goods and services and factor
markets.
Summary
3 of 3
5. Economists use economic models both for positive
economics, which describes how the economy works,
and for normative economics, which prescribes how
the economy should work. Positive economics often
involves making forecasts. Economists can determine
correct answers for positive questions, but typically not
for normative questions, which involve value
judgments.
6. There are two main reasons economists disagree. One,
they may disagree about which simplifications to
make in a model. Two, economists may disagree—like
everyone else—about values.
The End of Chapter 2
Coming attraction
Chapter 3:
Supply and Demand