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Model Building and Gains from Trade2
Previously . . .
• Economics is the study of how people allocate their limited resources to satisfy their nearly unlimited wants.
• “Scarcity” refers to the limited nature of society’s resources.
• Incentives are factors that motivate a person to act or exert effort.
Big Questions
1. How do economists study the economy?
2. What is a production possibilities frontier?
3. What are the benefits of specialization and trade?
4. What is the trade-off between having more now and having more later?
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
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
Practice What You Know—Positive or Normative?1. The moon is made of green cheese.2. Rich people should be taxed more.3. More taxes on the rich will increase tax
revenues.4. Everyone should donate to charity.5. I think everyone needs to work at a bank to see
the true value of money.6. Government intervention in markets is bad.7. Economics majors earn more on average than
sociology majors.8. Everyone should take Economics 101.
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
Economic Models
• Ceteris paribus– Latin: “other things being equal”
– Assumption in which we examine a change in one variable, but hold all other variables constant.
– Allows us to isolate the effect of a single variable
Economic Analysis
• Endogenous factors– Variables controlled for inside a model– Independent variables we freely change in the
model equations to study their effect on the dependent variable
• Exogenous factors– Variables that are not accounted for in a
model– Outside our control
Models and Ceteris Paribus
• What determines a person’s wage rate?
Female
ConditionsPleasant
Skills
Experience
Age
Education
fW
Models and Ceteris Paribus
• Wage depends on the endogenous variables.• How will a change in the variables affect wage?• What might some exogenous variables be?
Female
ConditionsPleasant
Skills
Experience
Age
Education
fW
Positive Effect
Positive or Negative Effect?
Positive Effect
Positive Effect
Negative Effect
A Negative Effect here may be indicative of discrimination.
Models and Ceteris Paribus
• Ceteris paribus analysis– Change just ONE of the dependent variables
and examine how wage is affected. Assume other variables do not change.
Female
ConditionsPleasant
Skills
Experience
Age
Education
fW
Danger of Faulty Assumptions• It is necessary to often examine and re-evaluate
the assumptions in models.• Example:
– Assumption that housing prices always rise– Pre-2008 computer models used by banks didn’t have
a variable for declining housing prices
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
• 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
PPF and Opportunity CostNonlinear 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 CostNonlinear 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
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
Practice What You Know—PPF Quiz
• You will have 30 seconds each to answer a number of true/false questions.
• Please join up with a partner.
Production Possibilities Quiz
1. (True/False) Point A represents the amounts of cars and bicycles that will be sold.
Bicycles
Cars
A
Production Possibilities Quiz
2. (True/False) As you move from point F to point G, the price of bicycles increases.
Bicycles
Cars
F
G
Production Possibilities Quiz
3. (True/False) Movement along the curve from point C to point A shows us the opportunity cost of producing more bicycles.
Bicycles
Cars
A
C
Production Possibilities Quiz
4. (True/False) If we have high unemployment, then the curve shifts in.
Bicycles
Cars
?
Production Possibilities Quiz
5. (True/False) If an improved process for manufacturing cars is introduced, then the entire curve will shift out.
Bicycles
Cars
?
Practice What You Know— PPF Quiz Answers
• We will ask each question again, and then reveal the answer.
Production Possibilities Quiz
1. (True/False) Point A represents the amounts of cars and bicycles that will be sold.
Bicycles
Cars
A
False.
It represents how many cars and bicycles are produced!
Production Possibilities Quiz
2. (True/False) As you move from point F to point G, the price of bicycles increases.
Bicycles
Cars
F
G
False.
The number of bicycles produced increases.
Production Possibilities Quiz
3. (True/False) Movement along the curve from point C to point A shows us the opportunity cost of producing more bicycles.
False.
It represents the opportunity cost of producing more cars.
Bicycles
Cars
A
C
+
-
Production Possibilities Quiz
4. (True/False) If we have high unemployment, then the curve shifts in.
Bicycles
Cars
?
False.
Unemployment means that not everyone is working so production is inside the PPC. The PPC stays put since it represents the maximum output if all resources are being used to the fullest.
Production Possibilities Quiz
5. (True/False) If an improved process for manufacturing cars is introduced, then the entire curve will shift out.
Bicycles
Cars
?
False.
The curve only moves out along the car axis. It is not possible to make more bicycles than before.
Specialization and Trade
• Improvements in technology and more resources can make an economy more productive.
• Specialization and trade can also create gains for society.
• Assume now– Two goods (pizza and wings)– Two people with different abilities in the production of
pizza and wings
Specialization and Trade
• Absolute advantage– One person can perform each task more
effectively than the other person.– Who has the absolute in pizza? In wings?
Daily ProductionPerson Pizzas Wings
Debra Winger 60 120Mike Piazza 24 72
Specialization and Trade
Specialization and Trade
• Without specialization and trade– Mike and Debra each have to produce their own
wings and pizza;– Each person can only consume what they produce.
Without Trade
Person Good Production Consumption
Debra Pizza 40 40
Wings 40 40
Mike Pizza 18 18
Wings 18 18
Specialization and Trade
• With specialization and trade– Debra produces pizza and gives 19 pizzas to Mike;– Mike produces wings and gives 47 wings to Debra;– Each person consumes more with trade.
With Trade Gains from Trade
Person Good Production Consumption
Debra Pizza 60 41 (keeps) + 1
Wings 0 47 (from Mike) + 7
Mike Pizza 0 19 (from Debra) + 1
Wings 72 25 (keeps) + 7
Gains from Trade
Opportunity Cost
Daily ProductionPerson Pizzas Wings
Debra Winger 60 120Mike Piazza 24 72
Opportunity CostPerson 1 Pizza 1 Wing
Debra Winger 2 wings(120 ÷ 60)
1/2 pizzas(60 ÷ 120)
Mike Piazza 3 wings(72 ÷ 24)
1/3 pizzas (24 ÷ 72)
Opportunity Cost
• Comparative advantage– Debra: comparative advantage in pizza production
• She gives up fewer wings than Mike.
– Mike: comparative advantage in wing production• He gives up fewer pizzas than Debra.
Opportunity CostPerson 1 Pizza 1 Wing
Debra Winger 2 wings(120 ÷ 60)
1/2 pizzas(60 ÷ 120)
Mike Piazza 3 wings(72 ÷ 24)
1/3 pizzas (24 ÷ 72)
Gains from Trade
• Previously, we noted the gains from trade and specialization.
• Terms of trade– The relative prices, or exchange rate of
goods
– How many wings per pizza?
Terms of Trade
• Terms of Trade– As long as the terms of trade are between the
opportunity costs of the trading partners, the trade benefits both sides.
Person Opportunity Cost Ratio
Debra Winger 1 pizza equals 2 wings 1:2 = 0.50
Terms of trade 19 pizzas for 47 wings 19:47 = 0.40
Mike Piazza 1 pizza equals 3 wings 1:3 = 0.33
Practice What You Know
• We often think of specialization and trade occurring between countries.
• However, it can occur on much smaller levels as well
• Examples?– Within a home?– At a gathering of friends and/or family?
Economics in Cast Away
• Cast Away (2000)– Imagine a world in which there was no
specialization and trade.– You would have to do everything by yourself.
Trade-off Between Present and Future
• Consumer goods– Goods produced for current
consumption– Food, housing, clothing, entertainment
• Capital goods– Goods that help produce other
valuable goods– Buildings, factories, roads, machinery,
computers
• Investment– Using resources to make new capital
Capital Goods and Future Growth
Capital Goods and Future Growth
Capital Goods and Future Growth
• Over the last 20 years, China and India have invested in more capital compared to the United States and Europe.
• The result?– China is sacrificing today’s consumption for a
better future.– China and India have higher growth rates.– Another trade-off: Chinese workers have less
leisure time than American workers.
Visualizing Investment
• Often, we are hesitant to invest in capital goods “today” even if it results in larger consumer good production “tomorrow.”
• Today’s investment may• Take a long time• Have a large opportunity cost• May have uncertain results
Visualizing Investment
• Suppose that instead of producing pizza, we spent resources in order to improve pizza-making technology.
• What happens…– Today?
– Tomorrow?
Visualizing Investment
Investment in Capital Goods
No InvestmentTime Period
1
2
3
4
Visualizing Investment
• Other examples of long-term investment
Conclusion
• Economists use simplified models to understand how the economy works.
• The production possibilities frontier (PPF) illustrates the benefits of trade and allows us to describe ways to grow the economy.
• When producers specialize, they focus their efforts on those goods and services for which they have the lowest opportunity cost and trade with others who are good at making something else.
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.
Summary
• Microeconomics is primarily concerned with the decisions of households and businesses.
• Macroeconomics looks at the broader economy.• A PPF illustrates the trade-offs that exist in society. • Even when an absolute advantage exists, society
is still better off by specializing and trading based on comparative advantage.
• Societies face a trade-off between consumption in the short run and greater productivity in the long run.
Practice What You Know
What is a possible problem with using faulty assumptions when building an economic model?
A. The model could become too popular.B. It could lead to wrong economic
decisions.C. It means we never have to rebuild
the model.D. It could cause too much wealth.
Practice What You Know
With regard to the PPF, an efficient point is a point that is
A. impossible to reach.B. inside the PPF.C. outside the PPF.D. on the PPF.
Practice What You Know
If we move down and to the right along a PPF, the opportunity cost of this movement can be measured in terms of
A. how much of the x-axis good we gain.B. how much of the y-axis good we gain.C. how much of the x-axis good we give up.D. How much of the y-axis good we give up.
Practice What You Know
Suppose there is high unemployment. With respect to the PPF, what will happen?
A. The PPF will shift inward.B. The PPF will shift outward.C. We will produce at a point inside the
PPF.D. We will produce at a point outside
the PPF.
Practice What You Know
What is the opportunity cost of producing capital goods instead of consumer goods?
A. We give up consumption today.B. We give up consumption tomorrow.C. We have less employment today.D. We have a lower standard of living
tomorrow.