Model Building and Gains from Trade

Model Building and Gains from Trade

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.

Main Goals 1. How do economists study the economy? 2. Illustrating scarcity Production Possibilities Frontier (PPF). 3. Illustrate economics growth. 4. Gains from trade - If people (or countries) have different relative productivity (different opportunity cost) in producing goods, then they can all gain from trading with each other (more goods can be produced). This is without working more!

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. 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 Exogenous variables are variables that are determined outside the model. Endogenous variables are variables that are determined inside the model. Also regarded as the model's prediction.

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

Models and Ceteris Paribus What determines a person s wage rate? W f Education Age Experience Skills Pleasant Conditions Female

Models and Ceteris Paribus W Education Age Experience f Skills Pleasant Conditions Female Positive Effect Positive or Negative Effect? Positive Effect Positive Effect Negative Effect A Negative Effect here may be indicative of discrimination. Wage is endogenous variable in this model, and all the other factors affecting wage are assumed to be exogenous. Ceteris Paribus analysis means that we investigate the effect on wages of one exogenous variable at a time, holding all other exogenous variables constant.

Last time: Method of Economic Analysis Focus on positive analysis, instead of normative. Models (economic theory). Exogenous variables Endogenous variables Ceteris Paribus Statistical analysis use data (evidence) to test theories

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 consider the possibility of declining housing prices

Correlation is not CausalityG Causality Correlation

Production Possibilities Frontier Production possibilities frontier Combinations of outputs that a society can produce if all of its resources are being used efficiently Graphical illustration of scarcity 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 (scarcity) Why are we unable to produce certain combinations? Scarcity and limited resources Feasible and efficient points Points ON the PPF (A, B, C, and D) Feasible and inefficient points Points INSIDE the PPF (F) Workers goofing off, unused buildings Unattainable or not feasible (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 of X in this case is the slope (in absolute value) of the PPF Opp.cost of X Y X units of Y Opp.cost of Y X Y units of X

PPF and Opportunity Cost Nonlinear 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 PPF As we produce more of good X, we have to give up increasingly larger amounts of good Y.

PPF and Opportunity Cost Nonlinear 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

Point X Y A 0 72 B 8 70 C 15 66 D 21 60 E 26 52 F 30 42 G 33 30 H 35 16 I 36 0

Point X Y Opportunity Cost A 0 72 Section Opp. Cost of XOpp. Cost of Y B 8 70 A B 0.25 4 C 15 66 B C 0.571428571 1.75 D 21 60 C D 1 1 E 26 52 D E 1.6 0.625 F 30 42 E F 2.5 0.4 G 33 30 F G 4 0.25 H 35 16 G H 7 0.142857143 I 36 0 H I 16 0.0625 Opportunity cost of X is measured in units of Y Opportunity cost of Y is measured in units of X Note, as the economy produces more of X, its opportunity cost rises. As we produce more Y, its opportunity cost rises.

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

Production Possibilities Quiz 1. (True/False) Point A represents the amounts of cars and bicycles that will be sold. False. Bicycles It represents how many cars and bicycles are produced! A Cars

Production Possibilities Quiz 2. (True/False) As you move from point F to point G, the opportunity cost of bicycles increases. Bicycles True. Opp.cost of Opp.cost of X Y Y X X Y units units of of Y X G F Cars

Production Possibilities Quiz 2. (True/False) As you move from point G to point F, the opportunity cost of cars increases. Bicycles True. Opp.cost of Opp.cost of X Y Y X X Y units units of of Y X G F Cars

Production Possibilities Quiz 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 - C + A Cars

Production Possibilities Quiz 4. (True/False) If we have high unemployment, then the curve shifts in. False. Bicycles Unemployment means that not everyone is working so production is under the PPF. The PPF stays put since it represents the maximum output if all resources are being used to the fullest.? Cars

Production Possibilities Quiz 5. (True/False) If an improved process for manufacturing cars is introduced, then the entire curve will shift out. False. Bicycles The curve only moves out along the car axis. The maximal amount of bicycles does not change.? Cars

Production Possibilities Quiz 2. (True/False) At point A, the opportunity cost of cars and bicycles is zero. True. Bicycles A Cars

Specialization and Trade Improvements in technology and more resources can make an economy more productive (expand the PPF) Specialization and trade can also create gains for society.

Specialization and Trade Main result: If people (or countries) have different relative productivity (different opportunity cost) in producing goods, then they can all gain from trading with each other (more goods can be produced). This is without working more!

Specialization and Trade Absolute advantage - A person (or a country) has absolute advantage in producing a good if he can produce that good with less resources (say less time, less inputs). Comparative advantage - A person (or a country) has a comparative advantage in producing a good if he can produce it at lower opportunity cost.

Specialization and Trade Example Nicki and Drake operate an Italian pizza bar Anaconda, and produce pizza and salads. Time required (in min.) to: Opportunity Cost of one unit Make a pizza (X) Make a salad (Y) X Y Nicki 1.5 1.5 Drake 10 2 1 1 5 1/5 Nicki has absolute advantage in both goods. Nicki has comparative advantage in pizza (X) and Drake has comparative advantage in salad (Y).

Specialization and Trade Example Same information can be given in terms of output per unit of time. Output per hour: Opportunity Cost of one unit Pizzas (X) Salads (Y) X Y Nicki 40 40 Drake 6 30 1 1 5 1/5 Nicki has absolute advantage in both goods. Nicki has comparative advantage in pizza (X) and Drake has comparative advantage in salad (Y).

Specialization and Trade Time reallocation and gains from trade Nicki Pizza (X) Salads (Y) Drake Pizza (X) Salads (Y) Total change in output 1 hour +40-40 2 hours -12 +60 +28 +20

Specialization and Trade Conclusions Nicki and Drake reallocated their time towards the production of the good in which they have comparative advantage in. As a result, their total production of both goods went up, without working more time. In order to consume more of each good they need to trade with each other.

Specialization and Trade Specialization occurs when each person (or country) produces one good only. This is an extreme case of the above example, where each person reallocates all their resources towards the good in which they have comparative advantage.

Gains from Trade Example Daily Production Person Pizzas Wings Lebron 60 120 Dwyane 24 72 Absolute advantage Lebron has absolute advantage in both goods.

Gains from Trade Example Daily Production Person Pizzas Wings Lebron 60 120 Dwyane 24 72 Opportunity Cost Person 1 Pizza 1 Wing Lebron 2 wings (120 60) 1/2 pizzas (60 120) Dwyane 3 wings (72 24) 1/3 pizzas (24 72)

Gains from Trade Example Opportunity Cost Person 1 Pizza 1 Wing Lebron 2 wings 1/2 pizzas (120 60) (60 120) Dwyane 3 wings 1/3 pizzas (72 24) (24 72) Comparative advantage Lebron has comparative advantage in Pizza. Dwyane has comparative advantage in Wings.

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.

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, technology Investment Using resources to make new capital

Capital Goods and Future Growth

Capital Goods and Future Growth

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

Visualizing Investment Suppose that instead of producing pizza, we spent resources in order to improve pizza-making technology. What happens Today? Tomorrow?

Visualizing Investment Investment in Capital Goods Time Period 1 No Investment 2 3 4

Visualizing Investment 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 (i.e., goods in which they have comparative advantage) 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, as well as computer lab. 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.

Practice What You Know 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.

Practice What You Know 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.

Practice What You Know 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.

Practice What You Know 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.

Practice What You Know Circle all the correct answers A. Country 1 has absolute advantage in X. B. Country 2 has absolute advantage in Y. C. Country 1 has comparative advantage in Y. D. Country 2 has absolute and comparative advantage in X. PPFs of countries 1, 2 (per worker). Y 1 2 X

Practice What You Know A. Country 1 has absolute advantage in both goods, and therefore cannot gain from trade with country 2. B. Country 1 has absolute advantage in both goods, but comparative advantage only in X. C. Country 1 has absolute advantage in both goods, but comparative advantage only in Y. D. Both countries have comparative advantage in X. PPFs of countries 1, 2 (per worker). Y 1 2 X

Practice What You Know Which statement is incorrect? A. Neither country has comparative advantage in either good X or Y. B. County 1 has absolute advantage in both goods. C. Neither country can gain from trading with the other country. D. Neither country has absolute advantage in either good X or Y. PPFs of countries 1, 2 (per worker). Y 1 2 X