Chapter 2 Economic Models: Trade-offs and Trade

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1 Goldwasser AP Microeconomics Chapter 2 Economic Models: Trade-offs and Trade BEFORE YOU READ THE CHAPTER Summary This chapter introduces the concept of model building and the discusses two different economic models, the model of production possibilities frontiers and the model of comparative advantage. Models are a simplified representation of reality, and the study of economic models is a crucial aspect of the study of economics. The two models presented in this chapter provide a simplified framework for discussing the concept of opportunity cost, trade-offs, scarcity, efficiency, and gains from trade. The chapter also discusses the distinction between positive and normative economics. Chapter Objectives Objective #1. A model is a simplified representation of reality that is used to better understand real life situations. Underlying every model is a set of assumptions Objective #2. The production possibility frontier is a model that represents the production possibilities available to an individual or to an economy. The production possibility frontier model assumes that the individual (or country) has a set amount of resources, a set level of technology, and a set amount of time, and then the production possibility frontier delineates a set of points that indicate the maximum amount of two goods that can be produced by this individual (or country) given their resources, technology or available time. For simplicity, we will refer to the production possibility frontiers in terms of production by countries rather than individuals, but the made from the perspective of countries also hold for individuals. Figure 2.1 illustrates a linear production possibility frontier for a country where the frontier indicates the maximum amount of goods X and Y that con be produced from the available resources and technology. Points A and B are points that lie on the production possibility frontier and are feasible production points for this country. Points C and D are points that lie inside the production possibility frontier: this country can produce these points they are feasible but the country is not using its available resources fully. Points C and D are therefore feasible points, but not efficient points. Points E and F lie outside the production possibility frontier and are therefore not feasible points of production for this country.

2 Objective #3. The simplest version of this production possibility frontier model assumes that the frontier is a linear and thus has a constant slope. This implies that the opportunity cost of production another unit of the good measured on the x-axis stays the same as you move along the production possibility frontier. In Figure 2.2 the opportunity cost of moving from point A to point B and the opportunity cost of moving from point C to point D are illustrated. Remember that opportunity cost measures what you give up to get something: thus when moving from point A to point B, opportunity cost is measured in terms of good Y, the good you give up to get more of good X; whereas when moving from point C to point D, opportunity cost is measured in terms of good X, the good you give up to get more of good Y. The lines that are bold in figure 2.2 indicate the opportunity cost of moving from point A to point B or from C to point D.

3 Objective #4. A more realistic production possibility frontier is one that is bowed out from the origin: this implies that as the country produces more and more of one of the goods, the opportunity costs of producing this good increases. The production possibility frontier, has this shape due to specialization of resources: some of the resources available to the country are more suited to produce good X than they are good X than they are good Y. When the country decides to increase the production of one type of good, the first few units can be produced at relatively low opportunity cost since resources can be shifted from the production of one good to the production of the other good that are not particularly well suited to the production of the first good. However, the opportunity cost eventually will rise since the increased production of this good eventually will require the use of resources that are ill-suited to produce this good. Figure2.3 illustrates a bowed-out production possibility frontier and the opportunity cost of getting one more unit of the good measured on the x-axis. Notice that as we get more and more units of good X, the opportunity cost of each additional unit of X is larger thank the opportunity cost of the preceding unit. Objective #5. There are two types of efficiency to discuss with respect to production possibility frontiers; productive efficiency and allocative efficiency. Productive efficiency refers to producing at a point that lies on the production possibility frontier. Points that lie inside the frontier are inefficient, since it is possible to increase the level of production from the given set of resources. Allocative efficiency refers to producing the right mix of goods from the available resources. For an economy to be allocatively efficient, it must allocate its resources in such a way as to make consumers as well off as possible. Another way of saying this is that an allocatively efficient economy produces the mix of goods that people want. Objective #6. For an economy to be efficient it must achieve productive and allocative efficiency: it must not waste resources and it must produce the right mix of goods.

4 Objective #7. The production possibility frontier illustrates with scarcity in that there are points of production that cannot be produced because of the level of resources and/or technology restrain production. The production possibility frontier illustrates trade-offs: getting more of good X requires giving up some of good Y. Objective #8. Economic growth can be illustrated with the production possibility frontier model. When the frontier shifts away from the origin, this means that the represented economy can now produce more of good X and good Y. The production possibility frontier shifts out when there are increases in resources or increases in the available level of technology. Objective #9. The model of production possibility frontiers can also be used to illustrate the gains from trade, which is referred to as the model of comparative advantage. The model assumes that there are two countries, there are two good s that the countries produce, and that each country has a set amount of resources, technology and time available to them. Furthermore, this model assumes that the two countries have different opportunity costs of production. In this model, countries benefit from specializing in the production of that good for which they have the comparative advantage, or lower opportunity costs of production, and then trade with each other. Countries do not have to have absolute advantage in production to benefit from trade: the benefits from trade only require that countries have different opportunity costs of production for the two goods and that each country specialize in producing the good that it can produce at lower opportunity cost relative to another country. Objective #10. Positive economics is factual and descriptive, whereas normative economics is about what ought to be or what should be. Positive economics is objective and can be tested for accuracy, and it often involves forecasting. Normative economics is a subjective and prescriptive, and it is value based. However, it is possible to rank normative policies designed to achieve a certain prescription on the basis of the efficiency of each policy. Objective #11. Economists may come to different conclusions because they have different values or because they use different economic models

5 Key Terms Notes model a simplified representation of a real situation that is used to better understand real-life situations. other things equal assumption in the development of a model, the assumption that all relevant factors except the one under study remain unchanged. production possibility frontier illustrates the trade-off 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. factors of production the resources used to produce goods and services. Labor and capital are examples of factors. technology the technical means for producing goods and services. comparative advantage the advantage conferred on an individual or nation in producing a good or service if the opportunity cost of producing the good or service is lower for that individual or nation than for other producers. absolute advantage the advantage conferred on an individual in an activity if he or she can do it better than other people. barter people directly exchange goods or services that they have for goods or services that they want

6 circular-flow diagram represents the transactions in an economy by two kinds of flows around a circle: flows of physical things such as goods or labor in one direction and flows of money to pay for these physical things in the opposite direction. household a person or group of people that share their income. firm an organization that produces goods and services for sale. market for goods and services markets in which firms sell goods and services that they produce to households. factor markets markets in which firms buy the resources they need to produce goods and services. income distribution the way in which total income is divided among the owners of the various factors of production. positive economics the branch of economic analysis that describes the way the economy actually works normative economics the branch of economic analysis that makes prescriptions about the way the economy should work. forecast a simple prediction of the future

7 AFTER YOU READ THE CHAPTER Tips Tip #1 This chapter introduces the concept of models. This is a crucial concept that forms the basis of the majority of material you will study in the rest of the course. In working with models it is important to understand the simplifying assumptions underlying whatever model you are using. Tip #2 Many of the models you will encounter in this course make the other-thingsequal assumption, which means that the model considers only one change at a time while holding everything else constant. Make sure you understand this basic information before working with the models introduced in the chapter. Tip #3 Economic models can be described verbally, but they can also be represented by graphs or equations. You want to be comfortable working with all three types of representations. Tip #4 Throughout the course you will find it helpful to be able to sketch graphs to be able to illustrate the ideas you are analyzing. You should practice making precise, numerically significant graphs, but you should also practice less formal graphs that sketch the nature of the relationship rather than the precise mathematical relationship. Tip #5 Opportunity cost can be measured using the production possibility frontier model. To do this calculation pick a point on the production possibility frontier and identify how much of each good is being produced. Then pick a second point on the production possibility frontier and identify the new levels of production. The opportunity cost is measured as the number of units of the good you must give up to get more of the other good. Note that both points must be on the production possibility frontier. Figure 2.4 illustrates the measurement of opportunity cost when moving from point A to point B. In this example, the opportunity cost is measured as the amount of good Y, Y 1 -Y 2, that must be given up to increase the production of X from its initial value of X 1 to the new level X 2. The bold line indicates the amount of good Y that is given up to increase the production of good X from X 1 to X 2. Tip #6. You should practice working with the models and with specific techniques introduced with each model. For instance, you should be comfortable comparing the opportunity cost of production for two countries and deciding which good each country should specialize in producing.

8 Tip #7. If you are using flash cards, make sure to include the following cards: (a) a linear production possibility frontier indicating feasible and infeasible points as well as efficient and inefficient points, (b) a production possibility frontier bowed out from the origin showing these same concepts, and (c) an example of comparative advantage that illustrates two countries and then calculates each country s comparative advantage. Also, do not forget to include a card for each new vocabulary work as well as the chapter heading on each card. Tip #8. Calculating opportunity cost is a problem is often challenging for students initially. Let s explore a fail-safe method for this calculation based on a linear production possibility frontier (this is the type of production possibility frontier that we will use in the comparative advantage model). First, construct the production possibility frontier and, since it is linear, calculate the slope of the frontier. Then use this slope measure to generate the opportunity cost of producing one more unit of the good measured on the x-axis is given by the slope, since the slope tells us the change in the y-variable divided by the change in the x-variable. Thus, if the slope of the production possibility frontier is -2 then the opportunity cost of producing an additional unit of good X is 2 units of good Y. To find the opportunity cost of the good produced on the y-axis, simply need to use the reciprocal of the slope. Thus, if the slope of the linear production possibility frontier is -2, then the opportunity cost of producing one more unit of good Y is ½ unit of good X, since this is amount of good X we must give up to get one more unit of good Y. Tip #9. Once you can calculate the opportunity cost of producing good X or good Y, then you can compare the opportunity costs faced by two countries. The model of comparative advantage illustrates that countries will benefit from trade when they specialize and produce the good that has the lowest opportunity cost of production relative to the other country.