Chapter 2

Economic Models: Trade-offs and Trades

 • Why models? Simplified representations
of reality—play a crucial role in
economics
• Two simple but important models:
WHAT YOU  production possibility frontier
WILL LEARN  circular-flow diagram
• The difference between positive
IN THIS
economics and normative economics
CHAPTER • When economists agree and why they
sometimes disagree
Models in Economics

• A model is a simplified representation of a real situation that

is used to better understand real-life situations. How? By
 Creating a real but simplified economy
Example: cigarettes in World War II prison camps
 Simulating an economy on a computer
Examples: tax models, money models…

• The “other things equal” assumption means that all other

relevant factors remain unchanged.
 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 good.

• The PPF improves our understanding of trade-offs by

considering a simplified economy that produces only two
goods by showing this trade-off graphically.
 The Production Possibility Frontier
Quantity of Dreamliners

30 D

Feasible and
efficient Not
in production feasible

A
15

Feasible B
9 but not
efficient C
Production possibility frontier
PPF

0 20 28 40
Quantity of small jets
 Increasing Opportunity Cost
Quantity of Dreamliners

Producing the …requires giving

35 first up
20 small jets . . . 5 Dreamliners.

30 But producing
20 more small jets . . .
A
25

20
…requires giving up
15 25 more
Dreamliners.
10

5
PPF

0 10 20 30 40 50
Quantity of small jets
Quantity of Dreamliners Economic
Production growth at
is initially
results
point Ain ansmall
(20 outward
jets
The economy can
andshift of the PPF it
25 Dreamliners),
now produce more of
because
35 can moveproduction
to point E
E (25 everything.
small jets and
possibilities are30
30
Dreamliners).
expanded.
A
25

20

15

10

5 Original New
PPF PPF

0 10 20 25 30 40 50
Quantity of small jets
Production Possibilities for Two Countries
U.S. Production Possibilities

Quantity
of large
jets

30

U.S. consumption
without trade

18

U.S.
PPF

0 16 40 Quantity of small jets

Production Possibilities for Two Countries
Brazilian Production Possibilities

Quantity
of large
jets

Brazil consumption
without trade

10
8

Brazil PPF

0 6 30 Quantity of small jets

United States and Brazilian Opportunity Costs

U.S. Brazilian
Opportunity Opportunity
Cost Cost

One small
3/4 large jet > 1/3 large jet
jet

One large 4/3 small

< 3 small jets
jet jets
Specialize and Trade
• Both countries are better off when they each specialize in
what they are good at and then trade.

• It’s a good idea for Brazil to make the small jets for both of
them, because its opportunity cost of a small jet in terms of
large jet not made is only 1/3 of a large jet, versus 3/4 large
jets for the United States.

• Correspondingly, it’s a good idea for the United States to

make large jets for both of them.
 Comparative Advantage and Gains from Trade

(a) U.S. Production and Consumption (b) Brazilian Production and Consumption

Quantity of large jets Quantity of large jets

U.S. production
with trade

30 U.S. consumption
without trade
Brazilian
consumption with
U.S. consumption
trade
with trade
Brazilian
consumption
without trade
20 10
18 Brazilian
8
U.S. Brazilian production with
PPF PPF trade

0 16 20 Quantity of small0
40 6 10 30
Quantity of sma
jets jets
How the Two Countries Gain from Trade

Both the United States and Brazil experience gains from trade:
 U.S. consumption of large jets increases by two, and its
consumption of small jets increases by four.
 Brazilian consumption of large jets increases by two, and
his consumption of small jets increases by four.
 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.
U.S. vs. Brazil – Absolute vs. Comparative

• The United States has an absolute advantage in both

activities: it can produce more output with a given amount of
input (in this case, its time) than Brazil.

• But we’ve just seen that the United States can indeed benefit
from a deal with Brazil because comparative, not absolute,
advantage is the basis for mutual gain.
U.S. vs. Brazil – Absolute vs. Comparative

• So Brazil, despite its absolute disadvantage, even in small

jets, has a comparative advantage in small jet making.

• Meanwhile the United States, which can use its time better
by making large jets, has a comparative disadvantage in small
jet making.
 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.
The Circular-Flow Diagram

Money Households Money

Goods
and Factors
services

Markets for
goods and Factor Markets
services

Goods
and Factors
services

Firms
Money 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.

• Firms sell goods and services that they produce to

households in markets for goods and services.

• Firms buy the resources they need to produce goods and

services—factors of production—in factor markets.
 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.
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.

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.
When and Why Economists Disagree

There are two main reasons economists disagree:

1. Which simplifications to make in a model

2. Values
VIDEO

• TED Video:
http://globaltransition2012.org/2012/01/tim-jackson-o
n-prosperity-without-growth/

• Prof. Tim Jackson on the principles for a new economy

and tradeoffs
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.
SUMMARY

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

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.
SUMMARY

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

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.
SUMMARY

5. 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.
 KEY TERMS

• Model • Firm
• Other things equal • Markets for goods and
assumption services
• Production possibility • Factor markets
frontier • Income distribution
• Factors of production • Positive economics
• Technology • Normative economics
• Comparative advantage • Forecast
• Absolute advantage • Specialization
• Barter • Equilibrium
• Circular-flow diagram • Efficient
• Household • Equity