Economics: Models, Market Conditions, and Comparative Advantage

For an economic model to be good...

It has to accurate predictions from data and mimic reality.

After a model has been drawn, the assumptions of the relationship between variables are expressed as mathematical equations - as they provide a level of generality and logical rigor for reasoning.

What are economic models?

Simplified representations of reality. Assuming the motives of the decision makers (consumers and producers), the physical relationship between variables and the conditions of the confines of the model and the variables involved. From the model, we get predictions and a likely outcome.

What is a normative statement?

A statement that is prescriptive and describe how things should be, cannot be tested

What is a positive statement?

A statement that is descriptive, factual and objective as well as being mostly testable.

What conditions allow markets to efficiently allocate resources?

There is competition amongst producers, no public goods, and no externalities.

What do market prices reflect?

The values of items to buyers.

What happens if prices are distorted?

Total output will be wrongly valued.

What is a price mechanism?

It determines/responds to what to produce, how, and for whom by coordinating decentralized decisions.

What is an economic system made up of?

Finite resources and a population with unlimited wants and demands.

What are the three functions of prices?

Provide information, provide incentives, and determine who gets what based on affordability.

Central Planner

A government or agency that decides what to produce, how to produce, and who to produce it.

Command Economy

An economic system where a central planner controls production decisions.

Free Markets

Economic systems where demand and supply forces determine production.

Invisible Hand

The concept that self-interest in free markets leads to societal benefits.

Opportunity Cost

The next best alternative foregone and the quantity of other goods sacrificed to obtain another unit.

Law of Comparative Advantage

Countries gain by specializing in and exporting goods where they have a comparative advantage.

Absolute Advantage

The ability of a country to produce more of a good than another country using the same resources.

What should be done is a country has an absolute or comparative advantage?

US should focus on production of wheat while UK should focus on production of cloth. If the US exports 20 units of wheat, it must sacrifice 6 units of cloth. For the UK to produce 20 units of wheat, it must sacrifice 8 units of cloth. So both countries are willing to exchange for the goods they have sacrificed and mutually benefit.

Increasing opportunity cost

As we want to increase production of smartphones, the amount of food sacrificed increases due to possible increases in training or technology and resources needed to increase production and efficiency.

Constant Opportunity cost

Linear PPF as an increase in one unit leads to a decrease in another unit. Increasing OC - curved PPF

PPF (Production Possibility Frontier)

A trade-off that illustrates the relationship between the production of two goods, indicating that to produce more of one good, less of another must be produced.

Sector-biased Technological Improvement

Technological advances in one sector that increase production for that sector but not for others, due to increased efficiency.

Uniform technological improvement

allows for levels of production to increase for both agriculture and smartphones - so points A, B and C can increase and move further out. Even with the same resources but with more efficiency.

Shape of PPF is determined by:

• Possession of factors of production

• Technology (can produce more etc.) But these have to be considered

• Technological improvements that could improve production in all sectors

• Technological innovation Increased capital

Increase in endowment of capital

assuming that smartphone production is more capital intensive relative to agriculture, production will increase due to increased efficiency but could possibly lead to reallocation of labour to agriculture - possibly leading to an increase in production for agriculture too.

Adam Smith on absolute advantage...

Saw that an absolute advantage was required to gain from trade.

David Ricardo on comparative advantage...

Saw that only a comparative advantage is needed for gains from trade. Believing that a country can focus on producing one thing, that can be exchanged with another country.

Production possibilities frontier (PPF)

All the possible production that can be done in an economy if it takes full advantage of all its factors of production e.g. resources like employment and efficiency - taking advantage of all aspects of production in an economy

Absolute advantage

When more goods can be produced, using the same amount of resources - higher efficiency.

Comparative advantage (Ricardo)

A relative concept comparing one factor against another, such as price relative to opportunity cost. A person has a comparative advantage in doing a task relative to another individual if the opportunity cost of doing the task is lower. - this can be applied to countries and their economies

Opportunity Cost

The next best alternative foregone as well as the quantity of other goods that must be sacrificed to obtain another unit of that good.