Prinecomi lectureppt ch02

Model Building and Gains from Trade2

Previously . . .

• Economics is the study of how people allocate their limited resources to satisfy their nearly unlimited wants.

• “Scarcity” refers to the limited nature of society’s resources.

• Incentives are factors that motivate a person to act or exert effort.

Big Questions

1. How do economists study the economy?

2. What is a production possibilities frontier?

3. What are the benefits of specialization and trade?

4. What is the trade-off between having more now and having more later?

Scientific Method in Economics• Similar to “hard sciences”

– Construct a theory (or hypothesis)– Design experiments to test the theory– Collect data– Revise or refute the theory based on evidence

• Difference from “hard sciences”– Economist’s lab is the world around us;

firm and consumer behavior studied– Not always able to design experiments– Historical data often used

Positive and Normative Analysis

• Positive statement– A claim that can be tested to be true or false

• Normative statement– Statement of opinion; cannot be tested to be

true or false– What “ought to be” or “should be”

• Which is generally preferred?– Positive; like to test claims with data

Practice What You Know—Positive or Normative?1. The moon is made of green cheese.2. Rich people should be taxed more.3. More taxes on the rich will increase tax

revenues.4. Everyone should donate to charity.5. I think everyone needs to work at a bank to see

the true value of money.6. Government intervention in markets is bad.7. Economics majors earn more on average than

sociology majors.8. Everyone should take Economics 101.

Economic Models

• Economists use models to understand the complex real-world economy.

• Models– Simplified versions of

reality– Built with some

assumptions– Are considered good if they

predict accurately

Economic Models

• Ceteris paribus– Latin: “other things being equal”

– Assumption in which we examine a change in one variable, but hold all other variables constant.

– Allows us to isolate the effect of a single variable

Economic Analysis

• Endogenous factors– Variables controlled for inside a model– Independent variables we freely change in the

model equations to study their effect on the dependent variable

• Exogenous factors– Variables that are not accounted for in a

model– Outside our control

Models and Ceteris Paribus

• What determines a person’s wage rate?

Female

ConditionsPleasant

Skills

Experience

Age

Education

fW


• Wage depends on the endogenous variables.• How will a change in the variables affect wage?• What might some exogenous variables be?

Female

ConditionsPleasant

Skills

Experience

Age

Education

fW

Positive Effect

Positive or Negative Effect?

Positive Effect

Positive Effect

Negative Effect

A Negative Effect here may be indicative of discrimination.


• Ceteris paribus analysis– Change just ONE of the dependent variables

and examine how wage is affected. Assume other variables do not change.

Female

ConditionsPleasant

Skills

Experience

Age

Education

fW

Danger of Faulty Assumptions• It is necessary to often examine and re-evaluate

the assumptions in models.• Example:

– Assumption that housing prices always rise– Pre-2008 computer models used by banks didn’t have

a variable for declining housing prices

Production Possibilities Frontier

• Production possibilities frontier– Combinations of outputs that a society can

produce if all of its resources are being used efficiently

• Assumptions of this model– Technology fixed– Resources fixed– Simplified two-good analysis

Production Possibilities Frontier

Production Possibilities Frontier• Why is the PPF downward-sloping?

– Must give up one good to increase production of another

• Why are we unable to produce certain combinations?– Scarcity and limited resources

• Efficient points– Points ON the PPF (A, B, C, and D)

• Inefficient points– Points INSIDE the PPF (F)– Workers goofing off, unused buildings

• Unattainable (for now) points– Points OUTSIDE the PPF (E)

PPF and Opportunity Cost

• Recall opportunity cost– Highest-valued alternative– What we give up as a result of an action

• Opportunity cost in this case is the slope of the PPF

PPF and Opportunity CostNonlinear PPFs• We can draw a more realistic PPF by making it

nonlinear and “bowed outward.”– The PPF will not have a constant slope in this case.– The slope will get steeper as we move from left to

right, and opportunity costs will not be constant.

• Law of increasing relative cost– Refers to the increasing opportunity cost of production

that occurs as you move along the production – As we produce more of good A, we have to give up

increasingly larger amounts of good B.

PPF and Opportunity CostNonlinear PPFs• Intuition of nonlinear PFFs

– Inputs (resources) are not perfectly homogenous.– Some inputs are better at making pizza than other

inputs.– As we expand pizza production, we’ll use the inputs

that are the best (Italian chef, dough-tossing master).– If we keep expanding production, we’ll have to start

using inputs that aren’t as good at making pizza. They’ll still be doing their best, but they won’t make as much pizza as other inputs.

– Pizza production doesn’t expand at a linear rate!

PPF and Opportunity Cost

Shift in the PPF

• If the PPF were to expand outward, some previously unattainable good combinations would now be possible to produce.

• The PPF could shift graphically in two ways. – New resources or technology could be

introduced that either• Affect the production of one good, or• Affect the production of both goods.

Shift in the PPF

Shift in the PPF

Practice What You Know—PPF Quiz

• You will have 30 seconds each to answer a number of true/false questions.

• Please join up with a partner.

Production Possibilities Quiz

1. (True/False) Point A represents the amounts of cars and bicycles that will be sold.

Bicycles

Cars

A


2. (True/False) As you move from point F to point G, the price of bicycles increases.

Bicycles

Cars

F

G


3. (True/False) Movement along the curve from point C to point A shows us the opportunity cost of producing more bicycles.

Bicycles

Cars

A

C


4. (True/False) If we have high unemployment, then the curve shifts in.

Bicycles

Cars

?


5. (True/False) If an improved process for manufacturing cars is introduced, then the entire curve will shift out.

Bicycles

Cars

?

Practice What You Know— PPF Quiz Answers

• We will ask each question again, and then reveal the answer.


1. (True/False) Point A represents the amounts of cars and bicycles that will be sold.

Bicycles

Cars

A

False.

It represents how many cars and bicycles are produced!


2. (True/False) As you move from point F to point G, the price of bicycles increases.

Bicycles

Cars

F

G

False.

The number of bicycles produced increases.


3. (True/False) Movement along the curve from point C to point A shows us the opportunity cost of producing more bicycles.

False.

It represents the opportunity cost of producing more cars.

Bicycles

Cars

A

C

+

-


4. (True/False) If we have high unemployment, then the curve shifts in.

Bicycles

Cars

?

False.

Unemployment means that not everyone is working so production is inside the PPC. The PPC stays put since it represents the maximum output if all resources are being used to the fullest.


5. (True/False) If an improved process for manufacturing cars is introduced, then the entire curve will shift out.

Bicycles

Cars

?

False.

The curve only moves out along the car axis. It is not possible to make more bicycles than before.

Specialization and Trade

• Improvements in technology and more resources can make an economy more productive.

• Specialization and trade can also create gains for society.

• Assume now– Two goods (pizza and wings)– Two people with different abilities in the production of

pizza and wings


• Absolute advantage– One person can perform each task more

effectively than the other person.– Who has the absolute in pizza? In wings?

Daily ProductionPerson Pizzas Wings

Debra Winger 60 120Mike Piazza 24 72



• Without specialization and trade– Mike and Debra each have to produce their own

wings and pizza;– Each person can only consume what they produce.

Without Trade

Person Good Production Consumption

Debra Pizza 40 40

Wings 40 40

Mike Pizza 18 18

Wings 18 18


• With specialization and trade– Debra produces pizza and gives 19 pizzas to Mike;– Mike produces wings and gives 47 wings to Debra;– Each person consumes more with trade.

With Trade Gains from Trade

Person Good Production Consumption

Debra Pizza 60 41 (keeps) + 1

Wings 0 47 (from Mike) + 7

Mike Pizza 0 19 (from Debra) + 1

Wings 72 25 (keeps) + 7

Gains from Trade

Opportunity Cost

Daily ProductionPerson Pizzas Wings

Debra Winger 60 120Mike Piazza 24 72

Opportunity CostPerson 1 Pizza 1 Wing

Debra Winger 2 wings(120 ÷ 60)

1/2 pizzas(60 ÷ 120)

Mike Piazza 3 wings(72 ÷ 24)

1/3 pizzas (24 ÷ 72)

Opportunity Cost

• Comparative advantage– Debra: comparative advantage in pizza production

• She gives up fewer wings than Mike.

– Mike: comparative advantage in wing production• He gives up fewer pizzas than Debra.

Opportunity CostPerson 1 Pizza 1 Wing

Debra Winger 2 wings(120 ÷ 60)

1/2 pizzas(60 ÷ 120)

Mike Piazza 3 wings(72 ÷ 24)

1/3 pizzas (24 ÷ 72)

Gains from Trade

• Previously, we noted the gains from trade and specialization.

• Terms of trade– The relative prices, or exchange rate of

goods

– How many wings per pizza?

Terms of Trade

• Terms of Trade– As long as the terms of trade are between the

opportunity costs of the trading partners, the trade benefits both sides.

Person Opportunity Cost Ratio

Debra Winger 1 pizza equals 2 wings 1:2 = 0.50

Terms of trade 19 pizzas for 47 wings 19:47 = 0.40

Mike Piazza 1 pizza equals 3 wings 1:3 = 0.33

Practice What You Know

• We often think of specialization and trade occurring between countries.

• However, it can occur on much smaller levels as well

• Examples?– Within a home?– At a gathering of friends and/or family?

Economics in Cast Away

• Cast Away (2000)– Imagine a world in which there was no

specialization and trade.– You would have to do everything by yourself.

http://books.wwnorton.com/iig/detail.aspx?id=4294977638&rid=4294977663&detid=4294981273

Trade-off Between Present and Future

• Consumer goods– Goods produced for current

consumption– Food, housing, clothing, entertainment

• Capital goods– Goods that help produce other

valuable goods– Buildings, factories, roads, machinery,

computers

• Investment– Using resources to make new capital

Capital Goods and Future Growth



• Over the last 20 years, China and India have invested in more capital compared to the United States and Europe.

• The result?– China is sacrificing today’s consumption for a

better future.– China and India have higher growth rates.– Another trade-off: Chinese workers have less

leisure time than American workers.

Visualizing Investment

• Often, we are hesitant to invest in capital goods “today” even if it results in larger consumer good production “tomorrow.”

• Today’s investment may• Take a long time• Have a large opportunity cost• May have uncertain results


• Suppose that instead of producing pizza, we spent resources in order to improve pizza-making technology.

• What happens…– Today?

– Tomorrow?


Investment in Capital Goods

No InvestmentTime Period

1

2

3

4


• Other examples of long-term investment

Conclusion

• Economists use simplified models to understand how the economy works.

• The production possibilities frontier (PPF) illustrates the benefits of trade and allows us to describe ways to grow the economy.

• When producers specialize, they focus their efforts on those goods and services for which they have the lowest opportunity cost and trade with others who are good at making something else.

Summary

• Economists design and implement theories and test those theories by collecting real data.

• The economist’s laboratory is the world around us.

• A good model should be simple to understand and able to make powerful predictions.

• Positive statements can be verified by examining evidence.

• Normative statements reflect values or what people think “should” be.

Summary

• Microeconomics is primarily concerned with the decisions of households and businesses.

• Macroeconomics looks at the broader economy.• A PPF illustrates the trade-offs that exist in society. • Even when an absolute advantage exists, society

is still better off by specializing and trading based on comparative advantage.

• Societies face a trade-off between consumption in the short run and greater productivity in the long run.


What is a possible problem with using faulty assumptions when building an economic model?

A. The model could become too popular.B. It could lead to wrong economic

decisions.C. It means we never have to rebuild

the model.D. It could cause too much wealth.


With regard to the PPF, an efficient point is a point that is

A. impossible to reach.B. inside the PPF.C. outside the PPF.D. on the PPF.


If we move down and to the right along a PPF, the opportunity cost of this movement can be measured in terms of

A. how much of the x-axis good we gain.B. how much of the y-axis good we gain.C. how much of the x-axis good we give up.D. How much of the y-axis good we give up.


Suppose there is high unemployment. With respect to the PPF, what will happen?

A. The PPF will shift inward.B. The PPF will shift outward.C. We will produce at a point inside the

PPF.D. We will produce at a point outside

the PPF.


What is the opportunity cost of producing capital goods instead of consumer goods?

A. We give up consumption today.B. We give up consumption tomorrow.C. We have less employment today.D. We have a lower standard of living

tomorrow.

Prinecomi lectureppt ch02

Education

variables constant

pizza production doe

realistic ppf

endogenous variables

exogenous variables

action opportunity cost

computer models

economic models economists