Chapter 2 Economic Models Trade offs and Trade Models 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 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 buying different types of customer 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 only two 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 resources o Only two goods can be produced 1 Housing huts 2 Clothing grass skirts Skirts Week PPF this shows all the combinations of huts and skirts that are available to us given our resources Huts Week Efficiency 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 off o There is no way to produce more of one good without producing less of another good o 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 production o 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 services o Efficiency also requires that the economy allocate its resources so that consumers are as well 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 paper Efficient vs Inefficient vs not feasible Skirts Week C F Not Feasible A D feasible and efficient E feasible but Inefficient Huts Week B List Which Points are Feasible A B C D and E all points on or inside the frontier are feasible Which Points are Efficient A B C and D any points on the PPF even the corners are efficient You are being efficient if it is impossible to have more of one good without giving up some of the other At Point E we could have more huts without sacrificing skirts or vice versa Points E Recession The Slope of the PPF carries important information 3 20 17 C D 7 8 1 Slope from C to D Rise Run 3 3 1 The 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 huts What 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 Opportunity 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 cost What does that mean We are faced with increasing marginal opportunity cost of producing each good Our PPF has a bowed out shape Skirts A B 1 17 10 0 11 C D 14 15 1 Huts The 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 machines o We now have physical capital How does this affect our PPF o It shifts outward Skirts More labor shifts PPF out Labor becomes more productive Other sources of growth human capital technology Economic Growth Huts 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 services o main factors of production land labor physical capital and human capital o physical capital created resources such as machines and buildings o human capital educational achievements and skills of the labor force which enhance its productivity technology the technical means for producing goods and services Comparative Advantage and Gains From Trade the mutual gains that individuals can achieve by specializing in doing