chapter:
2
>> Economic Models:
Trade-offs and Trade
Krugman/Wells
©2009  Worth Publishers
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WHAT YOU WILL LEARN IN THIS CHAPTER
 Why models? Simplified representations of reality—
play a crucial role in economics
 Two simple but important models:
 production possibility frontier
 circular-flow diagram
 The difference between positive economics and
normative economics
 When economists agree and why they sometimes
disagree
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Models in Economics

A model is a simplified representation of a real
situation that is used to better understand real-life
situations.





Create a real but simplified economy
Ex.: Cigarettes in World War II prison camps
Simulate an economy on a computer
Ex.: Tax models, money models…
The “other things equal” assumption means
that all other relevant factors remain unchanged.
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Trade-offs: The Production Possibility Frontier

The production possibility frontier (PPF)
illustrates the 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
by considering a simplified economy that produces
only two goods by showing this trade-off graphically.
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The Production Possibility Frontier
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
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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
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Economic Growth
Quantity of coconuts
Production
Economic
The
economy
growth
is initially
can results
now
at point
in
an(20
produce
A
outward
fishmore
and
shift
of
25of
everything.
coconuts),
the PPF

it can production
move to point E (25
because
possibilities
fish
and 30 coconuts).
are expanded.
35
E
30
A
25
20
15
10
5
Original
New
PPF
PPF
0
10
20
25
30
40
50
Quantity of fish
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Production Possibilities for Two Castaways
(a) Tom’s Production Possibilities
Quantity of coconuts
30
Tom’s consumption
without trade
9
Tom’s
PPF
0
28
40
Quantity of fish
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Production Possibilities for Two Castaways
(a) Hank’s Production Possibilities
Quantity of coconuts
20
Hank’s consumption
without trade
8
Hank’s
PPF
0
6
10
Quantity of fish
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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
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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.

Correspondingly, it’s a good idea for Hank to gather
coconuts for the both of them.
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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
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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.
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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.
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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 we’ve just seen that 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
coconut-gathering.
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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)
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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.

If 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.
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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”
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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.
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The Circular-Flow Diagram
Money
Households
Goods
and
services
Money
Factors
Factor Markets
Goods
and
services
Money
Factors
Firms
Money
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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.

Firms sell goods and services that they produce to
households in markets for goods and services.

Firms buy the resources they need to produce—
factors of production—in factor markets.
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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.
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Using Models

Positive economics is the branch of economic
analysis that describes the way the economy
actually works.

Normative economics makes prescriptions about
the way the economy should work.

A forecast is a simple prediction of the future.
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Using Models

Economists can determine correct answers for
positive questions, but typically not for normative
questions, which involve value judgments.

The 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.
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When and Why Economists Disagree
There are two main reasons economists disagree:

Which simplifications to make in a model

Values
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SUMMARY
1. Almost all economics is based on models. An important
assumption in economic models is the other things equal
assumption, 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.
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SUMMARY
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.
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SUMMARY
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.
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The End of Chapter 2
Coming attraction
Chapter 3:
Supply and Demand
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