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Trade-offs in Economic Models

This document discusses economic models and their uses. It introduces the production possibility frontier (PPF) model, which illustrates the tradeoffs between producing two goods. Comparative advantage is also covered, using an example of two castaways who each specialize in producing the good they have a lower opportunity cost for. This leads to gains from trade for both parties. The circular flow diagram is presented as a model that represents transactions between households and firms in an economy. Finally, the document discusses why economists may disagree on models and forecasts.

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Sulayman Jallow
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25 views29 pages

Trade-offs in Economic Models

This document discusses economic models and their uses. It introduces the production possibility frontier (PPF) model, which illustrates the tradeoffs between producing two goods. Comparative advantage is also covered, using an example of two castaways who each specialize in producing the good they have a lower opportunity cost for. This leads to gains from trade for both parties. The circular flow diagram is presented as a model that represents transactions between households and firms in an economy. Finally, the document discusses why economists may disagree on models and forecasts.

Uploaded by

Sulayman Jallow
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

CHAPTER 2

Economic Models:
Trade-offs and Trade
What you will learn in this chapter:
Why models?
Æ simplified representations of reality
¾production possibility frontier
¾comparative advantage
¾circular-flow diagram
Positive economics vs. normative economics
When economists agree and why they sometimes
disagree.

2
Models in Economics:
A model is a simplified representation of a real
situation that is used to better understand real-life
situations.

The production possibility frontier (PPF)


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 production of the other.

3
Tom’s Trade-offs: The Production
Possibility Frontier

4
Increasing Opportunity Cost

5
Economic Growth Economic growth results in
an outward shift of the PPF
because production
possibilities are expanded.

6
Comparative Advantage and Gains from Trade
Ex.: Tom and Hank

7
Tom and Hank’s Opportunity Costs of
Fish and Coconuts
Tom’s Hank’s
Opportunity Opportunity
Cost Cost

One
3/4 coconut 2 coconuts
fish

One
4/3 fish 1/2 fish
coconut

Both castaways are better off when they each specialize


in what they are good at and trade.
8
Specialize and Trade

9
Comparative vs. absolute advantage
Comparative advantage: the opportunity cost of
producing the good is lower for that individual than
for other people.

Absolute advantage: if he or she can do it better


than other people.

Careful: Don’t confuse comparative advantage with


absolute advantage!

10
Comparative Advantage and
International Trade
Ex.: U.S. vs. Canadian Economy

The U.S. and Canada can both achieve mutual gains


from trade.
11
Transactions: The Circular-Flow Diagram

The circular-flow diagram is a model that represents


the transactions in an economy by flows around a circle.
12
Circular-Flow of Economic Activities
Economic Agents:
¾ Households
¾ Firms
Where they interact:
¾ Markets for goods and services
¾ Markets for factors of production

13
Growth in the U.S. Economy from 1962 to
1988

14
Using Models / Why economist (dis)agree?
¾Positive economics
¾Normative economics
A forecast is a simple prediction of the future.

There are two main reasons economists disagree:


¾ they may disagree about which
simplifications to make in a model
¾ they may disagree about values

15
The End of Chapter 2

Coming attraction:
Chapter 3:
Supply and Demand
Do Chapter 2 Appendix before
then!
16
Chapter 2 Appendix:
Graphs in Economics

17
Figure 2A-1 Plotting Points on a Two-Variable Graph
18
Figure 2A-2 Drawing Curves
19
Figure 2A-3 Calculating the Slope
20
Figure 2A-4 (a-b) Nonlinear Curves
21
Figure 2A-4 (c-d) Nonlinear Curves
22
Figure 2A-5 Calculating the Slope Using the Point Method
23
Figure 2A-6 Maximum and Minimum Points
24
Figure 2A-7 Time-Series Graph
25
Figure 2A-8 Scatter Diagram
26
Figure 2A-9 Pie Chart
27
Figure 2A-10 Bar Graph
28
Figure 2A-11 Interpreting Graphs: The Effect of Scale
29

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