Krugman and Wells Chapter 2ModelsModelsProduction Possibility Frontier (PPF)Production Possibility Frontier (PPF)Opportunity costOpportunity costOpportunity costSlide Number 9Economic growthThe PPFGains from specialization/tradeGains: exampleGains: exampleGains: exampleGains: example Gains: exampleGains: exampleGains: example Gains: lessons for int’l tradeCircular Flow DiagramCircular Flow: 2 types of marketsPositive vs. normative economicsWhy do economists disagree?Krugman and Wells Chapter 2 Steven J. Haider EC201 Spring 2015p2 Models  Models are simplified representations of reality  They can help us focus on important parts of a problem  A model useful for one purpose may not be useful for another  Example: a map  The map would be useless if it were not simplified This map is good for getting to Kalamazoo, but bad for getting to Stockbridgep3 Models  Economic models tend to be mathematical  We can make precise statements about the model  We can use models to help us think about real life situations  Key word is can—it depends on whether the model includes the important pieces  Models can help us focus on one piece of a problem at a time--“all else equal” or “ceteris paribus”  Two common pitfalls to using economic models  Mistaking the model for reality—the model may not apply  Dismissing all models as being “wrong”—of course the assumptions are “wrong”, but that doesn’t mean the model is uselessProduction Possibility Frontier (PPF)  Our first model!  Set-up: Boeing can produce Dreamliners and smaller jets each year  Some example production levels PPF provides the trade-off p4Production Possibility Frontier (PPF)  Concepts  Feasible vs. infeasible quantities  Efficiency  Technology  Opportunity cost… See next slide p5Opportunity cost  Opportunity cost: what must be given up for something else  Consider moving from A to B  A: 15 DL & 20 SJ  B: 9 DL & 28 SJ Thus, to move from A to B, one gives up 6 DL for 8 SJ  “From A to B, the opportunity cost for 8 SJ is 6 DL” p6Opportunity cost  We often talk about OC in terms of 1 unit  A: 15 DL & 20 SJ  B: 9 DL & 28 SJ Or, 6 DL = 8 SJ  1 SJ = 6/8 or 3/4 DL 1 DL = 8/6 or 4/3 SJ  Between A & B  The OC of 1 SJ is 3/4 DL (from A to B)  The OC of 1 DL is 4/3 SJ (from B to A) p7Opportunity cost  From B to A  6 DL = 8 SJ 1 DL = 8/6 or 4/3 SJ  From A to (0,30)  15 DL = 20 SJ 1 DL = 20/15 or 4/3 SJ  From (40,0) to B  9 DL = 12 SJ 1 DL = 12/9 or 4/3 SJ  OC for 1 DL is always the same! p8 Why is OC constant?  PPF is a straight line  OC is just the slope = ΔY / ΔX (negative)  The slope is constant  Generally, we think OC increases  Bowed out (Fig. 2.2)  First 20 SJ costs 5 DL, second 20 SJ costs 25 DL  Why? Some resources may be better suited to SJ than others: size of factory p9Economic growth  Economic growth: shift out of the PPF  Potential causes of economic growth  Increases in factors of production (e.g., pop growth)  Technological growth (e.g., more automation) p10The PPF p11 The PPF is a very simplified model (just two goods), but it has allowed us to precisely define and consider efficiency, opportunity cost, and economic growthp12 Gains from specialization/trade  Suppose there were two countries, US and Brazil, each of which produce two goods, large jets (LJ) and small jets (SJ)  Can they gain from specializing, and then trading?  If one was particularly skilled in LJ and the other in SJ, it would seem the answer is clearly yes Powerful insight: there are gains even if one of the two countries is more highly skilled in both  In economic jargon, absolute advantage doesn’t determine whether trade is beneficial  What matters? comparative advantage  We will work through an example firstp13 Gains: example  The technology (Fig 2.4)  The US is better at producing LJ and SJ than Brazil  In other words, the US has an absolute advantage in producing both  Note assumed consumption levels without trade (both are efficient): US at (16,18) and Brazil at (6,8)p14 Gains: example  Suppose they specialize and then trade—the result  Without trade, both consume what they produce  With trade, I propose levels of production that are consistent with PPF (see previous slide)  Total consumption always equals total production (i.e., the total consumption is feasible given production) Both are consuming bundles outside their PPF (more SJ and LJ)p15 Gains: example  Both are consuming bundles outside their PPF (more fish and more coconuts)  US gains 2 LJ and 4 SJ Brazil gains 2 LJ and 4 SJ With specialization, both US and Brazil achieved a level of consumption that was infeasible (outside the PPF) without tradep16 Gains: example  How does this work?  First, verify that opportunity costs below match Fig 2.4  The US has a comparative advantage in producing LJ because there is a lower opportunity cost: 4/3 < 3  The US gives up 4/3 small jets for each large jet, but Brazil gives up 3  Brazil has a comparative advantage in producing SJ because there is a lower opportunity cost: 1/3 < 3/4  Brazil gives up 1/3 large jet for each small jet, but the US gives up 3/4Gains: example  NOTE: don’t make this harder than it needs to be.  Does the US look relatively better than Brazil in SJ or LJ? That’s the product we have the comparative advantage in….  And Brazil must have the comparative advantage in the other product p17p18 Gains: example  How does this work? (continued)  In the trade laid out below, the US gave up 10 large jets for 20 small jets  The US is willing to do this: we get 2 SJ for each LJ we give up, but if we produced on our own, we would only get 4/3 SJ for each LJ we give up  Brazil is willing to do this: they get 1 LJ for every 2 SJ they give up, but if they produced on their own, they would need to give up 3 SJ for each LJGains: example  Some things to note:  The US has an absolute advantage in both goods  We can produce more SJ and more LJ than Brazil  US and Brazil both gain from trading with each other  We both consume something that was previously infeasible  Both specialized in the production of the good for which they have a comparative advantage  US had lower OC in LJ production, so we