Chapter 2

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Models

What is a model?• Models: Simplified representation of

reality to help us study and understand reality.• Reality is too complicated mesh of

cause and effect interactions!

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Other Things Equal

• A simplified model of reality lets us focus on one cause and effect at a time.• Other Things Equal Assumption:

Assume that all other relevant factors remain unchanged.

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Some Components of a Model

• Assumptions (how we simplify)• Mathematical Equations

Price = 100 – 5*Quantity • Variables (can take on multiple values)• Graphs

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Three Models to Start With

1. Production Possibilities Frontier

2. Comparative Advantage

3. The Circular-Flow Model

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1. PPF- Production Possibility Frontier

• Production Possibility Frontier- the model we use for analyzing the economic consequences of scarcity and the working market system.

• Definition- Curve showing the maximum attainable combinations of 2 products that may be produced with available resources and current technologies.

• Analyzes trade-offs and opportunity costs that individuals, firms, or countries face.

Setup: Scarcity, Two Goods, Graph/Table

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Main Ideas of PPF

1. Increasing marginal costs• A convex or “bowed out” PPF illustrates

increasing marginal costs. Increasing marginal costs occur because some workers, machines, and other resources are better suited to one use than the other.

• The more resources already devoted to any activity, the smaller the payoff to devoting additional resources to that activity.

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Increasing Marginal Opportunity Cost

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Example 6• The # of hours you have already spent studying economics,

the smaller the increase in your test grade for each additional hour (and the greater the opportunity cost of using the hour in that way)

Choice Hours spend studying

Midterm Score

A 0 75

B 1 81

C 2 86

D 3 90

E 4 93

F 5 95

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PPF Continued

What We Can Learn and Demonstrate1. Opportunity Costs, Trade-Offs (most valuable

forgone alternative)2. Efficiency, Growth, Technology3. Comparative Advantage and Absolute

Advantage

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Which of the following best represents the tradeoff faced by BMW between producing SUVs and producing roadsters?

a. Any point on the graph represents that tradeoff.

b. Tradeoff B and Cc. Tradeoff F and Gd. Tradeoff C and G

1.1 Tradeoffs

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Which of the following best represents the tradeoff faced by BMW between producing SUVs and producing roadsters?

a. Any point on the graph represents that tradeoff.

b. Tradeoff B and Cc. Tradeoff F and Gd. Tradeoff C and G

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1.2 Economic Growth

• Economic growth is represented by shifts in the PPF. At any given point in time the resources in an economy are fixed. But over time the resources may increase (population, technology). • Shifts show how economic growth can lead to

more production in goods and services which raises the standard of living. Growth may lead to greater increases in production for one good than another.

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Economic Growth: The ability of the economy to produce increasing quantities of goods and services.

What factors might influence economic growth?

What could cause production in all industries to rise simultaneously?

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Example 1- Seats R US (Production choice of car seats and sofas)

i. Assumptionsii. Hypothesisiii. Use economic data to test hypothesis. Seats R US Production Choices

Choice Quantity of Car Seats Quantity of Sofas

A 80 0

B 60 10

C 40 20

D 20 30

E 0 40

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Example 2: Brady’s Sports Emporiumi. Assumptions: Brady can produce 3

footballs or 2 bats per hour. He only has 5 hours to workHours spent producing goods Quantity of goods made

Choice Footballs Bats Footballs Bats

A 5 0 15 0

B 4 1 12 2

C 3 2 9 4

D 2 3 6 6

E 1 4 3 8

F 0 5 0 10

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Example 3: Small Spa Inc.

• Assumptions: There is one room for services. Each hour the room can be used to give 1 massage or 2 facials. The spa is only open for 3 hours a day.

Hours of Service Quantity of Services

Choice Massage Facials Massage Facials

A 3 0 3 0

B 2 1 2 2

C 1 2 1 4

D 0 3 0 6

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Example 4 Quantity of Guns Quantity of Grenades

200 0

175 100

100 200

0 250

1.3 Comparative Advantage (in International Trade)

Comparative advantage The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors.

Absolute advantage The ability to produce more of a good or service than competitors when using the same amount of resources.

Note: The basis for trade is comparative advantage not absolute advantage.

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Example 5: Tiger Woods

• Should Tiger Woods mow his own lawn?

• Woods can mow his lawn for 2 hours. In the same time, he could be filming commercials for Nike and earn $1 million.

• OR• Forrest Gump can mow the lawn in 4 hours or could

McDonald’s and earn $20.

• Let’s compare opportunity costs.

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129

6

3

9

910

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Don’t Let This Happen to YOU!Remember That Trade Creates Both Winners and Losers

• Not all goods and services are traded internationally.

• Production of most goods involves increasing opportunity costs.

• Tastes for products differ.

How Countries Gain from International Trade

Why Don’t We See Complete Specialization?

Does Anyone Lose as a Result of International Trade?

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The Circular-Flow Diagram

3. The Circular Flow Model: The Market System

The Circular Flow of Income

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The Market System

• Labor includes all types of work, from the part-time labor of teenagers working at McDonald’s to the work of top managers in large corporations.

• Capital refers to physical capital, such as computers and machine tools, that is used to produce other goods.

• Natural resources include land, water, oil, iron ore, and other raw materials (or “gifts of nature”) that are used in producing goods.

• An entrepreneur is someone who operates a business. Entrepreneurial ability is the ability to bring together the other factors of production to successfully produce and sell goods and services.

Factors of production are divided into four broad categories:

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The Market SystemThe Market Mechanism

Individuals usually act in a rational, self-interested way. Adam Smith understood that people’s motives can be complex.

In a famous phrase, Smith said that firms would be led by the “invisible hand” of the market to provide consumers with what they wanted.

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Makingthe

Connection

A Story of the Market Systemin Action: How Do You Make an iPod?

The market coordinates the activities of the many people spread around the world who contribute to the making of an iPod.

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Property rights The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it.

The Legal Basis of a Successful Market System

The Market System

Protection of Private Property

Enforcement of Contracts and Property Rights

If property rights are not well enforced, fewer goods and services will be produced. This reduces economic efficiency, leaving the economy inside its production possibilities frontier.