IUP ECON 122 - Chapter 2: Economic Models: Trade-offs and Trade

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Chapter 2: Economic Models: Trade-offs and TradeModels in Economics: Some Important Examples- model: is a simplified representation of a real situation that is used to better understand real-life situations- example: stimulating the workings of the economy on a computer. When changes in tax law are proposed, government officials use tax models-large mathematical computer programs-to assess how the proposed changes would affect different types of people- a simple model example: when there are lines at a supermarket and people rearrange themselves when another line opens (many details were ignored like what is a customer buying)- a model is important because their simplicity allows economists to focus on the effects of only one change at a time (they allow us to hold everything else constant and study how one change affects the overall economic outcome) so an important assumption when building economic models is the other things equal assumption- other things equal assumption: all other relevant factors remain unchanged- production possibility frontier: a model that helps economists thing about the trade-offs every economy faces- circular-flow diagram: a schematic representation that helps us understand how flows of money, goods, and services are channeled through the economy- We make use of theoretical models to better understand the world in which we live- These models are highly simplified versions of the real world- Although they often make use of unrealistic assumptions, the insights gained from the models can still be valuable- Our first model is Production Possibilities Frontier (PPF)Trade-offs: The Production Possibility Frontier- Production Possibilities Frontier: illustrates the trade-offs facing an economy that produces onlytwo goods. It shows the maximum quantity of one good that can be produced for any given quantity produced of the other- This shows all the possible combinations of output that are available to a simple two-good economy- Island economy: resources – 1. Labor 2. Natural resourceso Only two goods can be produced – 1. Housing (huts) 2. Clothing (grass skirts)PPF – this shows all the combinations of huts and skirts that are available to us given our resourcesHuts/WeekSkirts/WeekEfficiency:o An economy is efficient if there are no missed opportunities – there is no way to make some people better off without making other people worse offo There is no way to produce more of one good without producing less of another goodo If the economy as a whole could not produce more of any one good without producing less of something else – that is, if it’s on its production possibility frontier – then we say that the economy is efficient in productiono If the economy could produce more of some things without producing less of others – which typically means that it could produce more of everything – then it is inefficient in production Example: an economy in which large numbers of workers are involuntarily unemployed is clearly inefficient in production which is bad because the economy could be producing more useful goods and serviceso Efficiency also requires that the economy allocate its resources so that consumers are aswell off as possible o To be efficient an economy must produce as much of each good as it can given the production of other goods, and it must also produce the mix of goods that people want to consumer (and must deliver them to the right people) Example: command economies like the Soviet Union are known for inefficiency in allocation. It was common for consumers to find stores well stocked with items few people wanted but lacking such basics as soap and toilet paperEfficient vs. Inefficient vs. not feasibleList Which Points are Feasible: - A, B, C, D, and E; all points on or inside the frontier are feasibleWhich Points are Efficient:- A, B, C, and D; any points on the PPF, even the corners, are efficientSkirts/WeekHuts/WeekACEBDFfeasible but Inefficient Not Feasiblefeasible and efficientYou are being efficient if it is impossible to have more of one good without giving up some of the otherAt Point E, we could have more huts without sacrificing skirts, or vice versaPoints E RecessionThe Slope of the PPF carries important information20177 8Slope from C to D: Rise = -3 = -3Run +1The slope tells us the opportunity cost of 1 unit of the good on the horizontal axis. From C to D, one Hut costs 3 skirts We must sacrifice 3 skirts by shifting resources from skirts to hutsWhat is the cost of one unit of the good on the vertical axis?- The reciprocal of the slope: 1 D to C 3- We gain 3 skirts and sacrifice 1 hut. Each skirt costs 1/3 of a hut.CD-3+1Opportunity Cost:- Opportunity cost: what is given up in order to get that good- The slope of a straight-line production possibility frontier is equal to the opportunity cost- The bowed-out shape of the production possibility frontier reflects increasing opportunity costOur PPF has a bowed-out shape:What does that mean?We are faced with increasing marginal opportunity cost of producing each good +11 14 15 +1The first hut costs .17 skirts, the 15th hut costs 10 skirts.What is a possible reason for a PPF having a bowed-out shape?o Some resources are better suited/specialized at one task over the other Next suppose Dr. Potts goes out one morning with a metal detector and searches for treasure, instead he finds…….saws, hammers, nails, needles, and sewing machineso We now have physical capitalHow does this affect our PPF?o It shifts outwardSkirtsHutsBCAD-1001-.17More labor shifts PPF out Labor becomes more productive Other sources of growth (human capital, technology)Economic Growth- The growing ability of the economy to produce goods and services- Economic growth results in an outward shift of the production possibility frontier because production possibilities are expanded- economic growth is an expansion of the economy's production possibilities; that is the economy can produce more of everything- economic growth is done by increase in factors of production and progress in technology- factors of production: resources used to produce goods and serviceso main factors of production: land, labor; physical capital, and human capitalo physical capital: created resources such as machines and buildingso human capital: educational achievements and skills of the labor force, which enhance


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IUP ECON 122 - Chapter 2: Economic Models: Trade-offs and Trade

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