Economic Models

Economic ModelsMr. Barnett

University High SchoolAP Econ

Making Choices

Limited Resources

Unlimited Wants

Of Goods and Services

Types of ResourcesO Land

O Economic meaning of the word: Non-human natural resources

O Lakes, rivers, crude oil, oceans, iron ore, land beneath our feet

Types of Resources

O CaptialO Economic meaning of the word: Manufactured

resource – Something you produce that is used to produce something else

O Factories, tractors, toolsO Money is NOT a capital resource…unless you

are wallpapering your house with dollar bills

Types of ResourcesO LaborO Entrepreneurs

O Comes up with new and innovative ideasO Brings all the other resources togetherO Organizes and makes necessary decisions O Supplies their own RISK capital

O Without entrepreneurs the various resources (factors of production) are not combined to create new and exciting businesses, products and innovations

Types of ResourcesO Payment for resources

O Land – RentO Capital – Interest O Labor – WagesO Entrepreneurial Ability – profits or losses

O Economic Growth occurs when…O More resourcesO Better resourcesO Better technology

Economic ModelsO Used to simplify complex issuesO Hold some variables constant in

order to closely evaluate othersO These variables are omitted O Called “ceteris paribus” – all other

things being equal or constant

Model #1 – Production Possibilities Curve/Frontier

O Shows the potential output of an economic entity (firm, individual or entire economy) at a given time

O Based on following assumptions:O Fixed resources

O Quantity of resources does not changeO Fixed technology

O No new technological improvements while we use graphO Full Production

O Productive efficiencyO Full employment

O Only 2 goodsO Graph also measures the utilization of land, labor,

and capital that is available to the farmer (limited resources)

Model #1 – Production Possibilities Curve/Frontier

O So let’s create one with two goods: Wheat and Robots

Model #1 – Production Possibilities Curve/Frontier

O Not PossibleO Beyond the curve/frontier

O Productive Efficiency & Full EmploymentO On the curve/frontier

O Productive Inefficiency O Inside the curve/frontierO UnderutilizationO Unemployment

O Trade-Offs on the curve/frontierO Society must choose point based on

preferencesO Value of the slope of a society’s PPC is called

the marginal rate of transformation

Model #1 – Production Possibilities Curve/Frontier

O Opportunity CostsO Cost of something is what you give up to get itO Bowed shape

O Law of Increasing CostsO Not all resources are the same

O Some are better for producing wheat O Farmers, tractors, fertile soil

O Others are better for producing robotsO Engineers, factories

O The very best engineers or farmers might be able to make the transition but as we need more robots/wheat, the less capable will be needed and thus we get increased costs

O Same with the land and capital goods used

Model #1 – Production Possibilities Curve/Frontier

O Increasing potential outputO Better technology with same land,

labor and capitalO Better resources

O More landO More capitalO More labor

O Shift outward = CAN produce more

Model #1 – Production Possibilities Curve/Frontier

O Shrinking PPCO Fewer resources, Unemployment,

InefficiencyO War, famine, environmental

degradationO Floods in Queensland Australia

Model #1 – Production Possibilities Curve/Frontier

O Constant Cost ModelO Straight line curve/frontierO Constant opportunity cost

Model #1 – Production Possibilities Curve/Frontier

O Using Constant Cost ModelO Absolute Advantage – The ability of a country,

individual, company or region to produce a good or service at a lower cost per unit than the cost at which any other entity produces that good or service. Comparative Advantage – when one entity can produce a good at a lower marginal opportunity cost than another entity

O So what determines what gets produced?O David Ricardo said it is comparative advantage

that should determine what different entities produce

Model #1 – Production Possibilities Curve/Frontier

O Time to model!

Model #1 – Production Possibilities Curve/Frontier

O 5 steps in figuring out comparative advantageO Step 1: Know definition of comparative

advantage: “One entity can produce something at a lower marginal opportunity production cost than another entity”

O Step 2: Set up table to figure out marginal (additional) opportunity cost

O Step 3: Go to the extremes O Step 4: Set up ratios & fill out tableO Step 5: Ovals and Arrows

O To figure out comparative advantage, ask “which entity can produce product at a lower marginal opportunity cost than the other entity

Model #2 – Circular-Flow Diagram

O A visual model showing how dollars flow through markets among households and firms

O Firms produce goods and services using inputs - the factors of productionO Labor, land and capital

O Households own the factors of production and buy the goods and services produced by firms

O Thus, there are 2 markets: O Markets for goods and services – households buy, firms sellO Markets for factors of production – households sell, firms buy

Model #2 – Circular-Flow Diagram

Outward Shifts in Production Possibilities Curve/Frontier

Outward Shifts in Production Possibilities Curve/Frontier

Production Possibilities Revisited

O Productive versus Allocative Efficiency

Production Possibilities Revisited

The steeper is the PPF, the higher is the opportunity cost of Spam in terms of Beer

Specialization and Trade

O Let’s continue our guns and Butter examination…

“It is maxim of every prudent master of a family, never to attempt to make at home what will cost him more to make than to buy. The taylor does not attempt to make his own shoes, but buys them of the shoemaker.”

-- Adam Smith, 1776

The greater is the difference in opportunity costs, the greater could be the benefits to both countries.

The greater is relative demand for the good a country exports, the greater will be its gains from trade.

Smaller countries (i.e., having less L) tend to gain more than larger countries.

How are the gains shared by trading countries? i.e., How far is the world price from each country’s opportunity cost?