Chapter 2: Economic Models: Trade-offs and Trade

Model

• any simplified representation of reality that is used to better understand real-life situations

• their simplicity allows economists to focus on the effects of only one change at a time- allows us to hold everything else constant and study how one change affects the overall economic outcome.

other things equal assumption

in the development of a model, the assumption that all other relevant factors remain unchanged.

The most effective form of economic modelling is…

the construction of “thought experiments” - simplified, hypothetical versions of real-life situations.

Three simple but important economic models

1. Production possibility frontier

2. Comparative advantage

3. Circular-flow diagram

Production possibility frontier

• a model that helps economists think about the trade-offs every economy faces

• considers a simplified economy that produces only two goods

Comparative advantage

a model that clarifies the principle of gains from trade — trade between both individuals and between countries

Circular-flow diagram

a schematic representation that helps us understand how flows of money, goods, and services are channeled through the economy.

efficient in production

if the economy as a whole could not produce more of any one good without producing less of something else (production possibility frontier)

Innefficient in production

the economy could not produce more of some things without producing less of others — could produce more of everything

Efficient in allocation

requires the economy to allocate its resources so that consumers are as well off as possible

Graphically, economic growth means…

• an expansion of the economy’s production possibilities — the economy can produce more of everything

• results in an outward shift of the PPF because production possibilities are expanded

What can lead the PPF to shift outward i.e economic growth?

1. Increase in the economy’s factors of production— the resources used to produce goods and services.

2. progress in technology— the technical means for the production of goods and services

The main factors of production are:

the resources (land, labor, physical capital, and human capital)

gains from trade

the mutual gains that inidividuals can achieve by specializing in doing different things and trading with one another.

comparative advantage

the advantage an individual or country has in producing a good or service if its opportunity cosy of producing the good or service is lower than other countries’ or individual’s cost.

absolute advantage

the advantage a country has in producing a good or service if the country can produce more output per worker than other countries. Likewise, an individual has an absolute advantage in producing a good or service if they are better at producing it than other people..

barter

trade in the form of the direct exchange of goods or services that people for other goods or services that people want.

The simplest circular-flow diagram illustrates an economy that contains only two kinds of inhabitants:

households and firms

Household

an individual or a group of people (usually, but not neecessarily, a family) that share their income

Firm

an organization that produces goods and services for sale — and that employs members of households.

Two kinds of markets

• markets for goods and services

• factor markets

Markets for goods and services

households buy the goods and services they want from firms

factor markets

firms buy the resources they need to produce goods and services

capital market

market in which capital is bought and sold

factor markets determin an economy’s…

income distribution

income distribution

how the total income created in an economy is allocated between less skilled workers, highly skilled workers, and the owners of capital and land.

Two roles of economic analysis:

• positive economics

• normative economics

Positive economics

analysis that tries to answer questions about the way the world works, which have definite right and wrong answers (description) — models play a huge role - often makes forecats

Normative economics

analysis thaat involves saying how the world should work (prescription)

forecast

a simple prediction of the future

Why do economists disagree?

• they may disagree about which simplifications to make in a model

• economists may disagree about values