📘 Chapter 2 – Economic Models: Trade-offs and Trade

Model

A simplified representation of a real situation used to understand real-life behavior.

Other-Things-Equal Assumption

All other relevant factors remain unchanged (ceteris paribus).

Purpose of Models

To analyze one variable at a time, like an experiment in a lab.

PPF (Production Possibilities Frontier)

A diagram showing the combinations of two goods that can be produced at full employment.

PPF Shows

Trade-offs, efficiency, opportunity cost, and economic growth.

Efficiency

An economy is efficient if there are no missed opportunities—can't produce more of one good without less of another.

Efficient in Production

If it's on the PPF line.

Inefficient in Production

If it's inside the PPF (can produce more of some goods without producing less of others).

Efficient in Allocation

Resources are allocated so consumers are as well off as possible.

Efficiency Requires

Both production and allocation efficiency.

Opportunity Cost

What must be given up to obtain a good.

Numerical Example (Boeing)

Moving from point A to B: +8 small jets, -6 Dreamliners → each small jet costs 6/8 = ¾ of a Dreamliner.

Increasing Opportunity Cost

The more small jets produced, the higher the cost in terms of forgone Dreamliners.

Formula

Opportunity Cost of Good A = Loss in Good B / Gain in Good A.

Economic Growth

An expansion of an economy's production possibilities (outward shift of the PPF).

Causes of Growth (1) Increase in factors of production (land, labor, physical capital, human capital). (2) Better technology.

Factors of Production

Resources used to produce goods/services: land, labor, physical capital, human capital.

Technological Improvement

The technical means for producing goods and services more efficiently.

Theory of Comparative Advantage

Each person/country should specialize in what they produce at the lowest opportunity cost and trade for everything else.

Comparative Advantage

When the opportunity cost of producing a good is lower for that producer than others.

Absolute vs Comparative Advantage

Absolute = can produce more of a good overall; Comparative = lower opportunity cost.

Circular-Flow Diagram

Illustrates how goods, services, and money flow through the economy between households and firms.

Flows in the Model

Households supply factors of production and receive income; firms produce goods and services and receive revenue.

Question: Why can't the PPF be bent upward?

Because of increasing opportunity cost—resources aren't equally suited to producing both goods.

Question: What happens if technology improves in one industry?

The PPF shifts outward for that good only (specialized growth).

Positive Economics

Describes the way the economy actually works (facts).

Normative Economics

Makes prescriptions about how the economy should work (value judgments).

Reasons Economists Disagree

(1) Differences in values. (2) Differences in models or assumptions about how the economy works.

Example of Disagreement

One economist may favor tax cuts to stimulate growth; another may favor government spending.

Opportunity Cost Formula

Opportunity Cost = Loss in Good B / Gain in Good A.

Slope of PPF Formula

Slope = Opportunity Cost of x-axis good (Δy / Δx).

Economic Growth Definition

Outward shift of the PPF due to increased resources or improved technology.

Comparative Advantage Rule

Specialize in the good with the lowest opportunity cost.