Economic Models
Economic Models
January 18, 2007
Reading: Chapter 2, with appendix
a.
Models
b.
Production possibility frontier
c.
Comparative advantage
d.
Circular-flow diagram
e.
Using models
f.
Graphs and models
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Production Possibility Frontiers
Models
„
„
„
„
The production possibility frontier (PPF)
The model simplifies by assuming that there are
only two goods
„ Used to show the concepts of scarce resources,
choices, opportunity costs, tradeoffs and efficiency
„ Shows the maximum quantity of one goods that
can be produced for any given quantity produced of
another
„ Takes as given the amount of resources and
technology
Model: a simplified representation of reality that is
used to better understand real-world situations
Some types of models: physical models; simplified
economy; algebraic or geometric models with
equations; computer simulations
Why use models?
„ Understand complex phenomena using simple
analysis, focusing on what are considered
essential features
„ Focus on the effects of one change at a time –
other things constant or ceteris paribus
Examples of simple models
„
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Production Possibility Frontier, cont.
4
Production Possibility Frontier, cont.
Efficiency
Opportunity Cost
Increasing opportunity cost
Some resources especially
suited for one good
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6
1
Production Possibility Frontier, cont.
Growth
Comparative advantage and gains from trade
Economic growth results in
an outward shift of the PPF
because production
possibilities are expanded.
„ Shows how people or countries
that trade with each other can gain
from trade
„ Uses production possibility frontier,
but with constant opportunity cost –
simplicity
„ Ideas developed by David
Ricardo with example of trade
between England and Portugal
involving clothing and wine
„ Example of two people, then two
countries - simplicity
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Comparative Advantage and Gains from Trade, cont.
8
Comparative advantage and gains from trade, cont.
Opportunity costs
One
fish
Tom’s
Opportunity
Cost
Hank’s
Opportunity
Cost
3/4 coconut
2 coconuts
One
4/3 fish
coconut
1/2 fish
Both castaways are better off when they each specialize
in what they are good at and trade.
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Comparative advantage and gains from trade,
cont.
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Comparative advantage and gains from trade, cont.
„ A person (or country) has a comparative advantage in a
good if the opportunity cost of producing it is lower for that
individual (or country) than for other people (countries).
„A person (or country) has an absolute advantage in a
good if the person (or country) can do it better than other
people (or countries).
„ People and countries can trade and gain from trade even if
they do not have an absolute advantage in anything.
„Countries may not always gain from trade – example,
improvements in technology from experience in some goods
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Circular-Flow Diagram, cont.
Circular-Flow Diagram
Economic Agents:
¾ Households
¾ Firms
„ Where they interact:
¾ Markets for goods and services
¾ Markets for factors of production
ƒ Factors: Resources (like labor) used to produce goods and
services
ƒ Examines flows of money, and goods and services
ƒ Simplifications: households and firms distinguished; sales
within firms and households ignored; no government
„
The circular-flow diagram is a model that represents the
transactions in an economy by flows around a circle. Examines
changes in factor markets and markets for goods and services
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Growth in the U.S. Economy from 1962 to
1988
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Using Models
ƒ Models are used by researchers in economics and by policy-makers and
advisors in government and other institutions
ƒ Many types of issues: examples explaining, forecasting, effects of
changes; what should be done
ƒ Economists often distinguish between two kinds of economic statements
and analysis:
ƒ Positive economics: about what is – relating to facts
ƒ Normative economics: about what should be; involves value
judgments
ƒ Sometimes the distinction is not very tight
ƒ Reasons why economists disagree:
ƒ they may disagree about which simplifications to make in a model
ƒ they may disagree about values
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