Krugman Microeconomics: Economic Models, Trade-offs and Trade

Economic Models: Trade-offs and Trade

This chapter introduces fundamental economic models used to understand how economies function, focusing on trade-offs and the benefits of trade. The core models explored include the Production Possibility Frontier (PPF), comparative advantage, and the circular-flow diagram. It also addresses the distinction between positive and normative economics and reasons for disagreements among economists.

Economic Models

• Model: A simplified representation of a real situation designed to better understand real-life complexities. Economists create models to analyze specific aspects of the economy in a controlled way.
• The other things equal assumption (ceteris paribus): A crucial assumption in economic modeling where all other relevant factors are held constant while one variable is allowed to change. This approach mimics a laboratory science environment, allowing for the isolation and study of individual relationships between variables.

Trade-offs: The Production Possibility Frontier (PPF)

The Production Possibility Frontier (PPF) is a graphical model that illustrates the various combinations of two goods a society can produce when all its resources are fully and efficiently employed. It's a fundamental tool for understanding several key economic concepts:

• Efficiency: An economy is efficient if there are no missed opportunities to make people better off. On the PPF, efficiency has two components:
  • Efficiency in production: Achieved if the economy cannot produce more of any one good without producing less of something else. This means the economy is operating directly on its PPF curve.
  • Efficiency in allocation: Occurs when the economy allocates its resources in such a way that consumers are as well off as possible, meaning the specific point on the PPF chosen reflects societal preferences. True efficiency requires both production and allocative efficiency.
  • An economy operating inside the PPF is inefficient in production, as it could produce more of both goods or more of one without sacrificing the other.
• Opportunity Cost: What must be given up in order to get a good. The PPF clearly demonstrates opportunity cost as moving along the curve from producing more of one good necessarily means producing less of the other.
  • Example (Bombardier): If Bombardier shifts production from point A to point B, producing 4 more jets means producing 14 fewer ATVs. The opportunity cost of one jet is 14/4 = 3.5 (or 7/2) ATVs.
• Increasing Opportunity Cost: The more of a particular good an economy produces, the greater the opportunity cost of producing an additional unit of that good. This is represented by a PPF that bows outward (concave to the origin). For example, as more jets are produced, the resources best suited for ATV production must be diverted, leading to a larger sacrifice of ATVs for each additional jet.
• Economic Growth: An expansion of the economy's production possibility, illustrated by an outward shift of the PPF. This means the economy can produce more of both goods than before.
  • Causes of Economic Growth:
    1. Increase in factors of production: These are the resources used to produce goods and services, including land, labour, physical capital (man-made resources like machines and buildings), and human capital (the education and skills of the labour force).
    2. Better technology: Improvements in the technical means for producing goods and services allow more output to be generated from the same amount of inputs.

Comparative Advantage and Gains from Trade

The theory of comparative advantage states that it makes economic sense to specialize in producing goods and services in which one has a comparative advantage and to trade for everything else. This principle is fundamental to understanding why economies engage in trade.

• Comparative Advantage: A country or individual has a comparative advantage in producing a good or service if their opportunity cost of producing that good or service is lower than for other countries or people. It's about relative efficiency.
• Absolute Advantage: A country or individual has an absolute advantage if they can produce more output with the same amount of input, or the same output with less input, compared to others. This does not necessarily mean they should produce everything.
  • Relationship to Trade: Even if a country has an absolute advantage in producing all goods, it still benefits from trade by specializing in goods where it has a comparative advantage (lower opportunity cost).
• Example: Canada and Brazil (Jets and ATVs):

  	Canadian opportunity cost	Brazilian opportunity cost
  1 ATV	2/7 jet	1/6 jet
  1 jet	7/2 ATVs	6 ATVs

  • Brazil's opportunity cost for 1 ATV (1/6 jet) is lower than Canada's (2/7 jet, approximately 0.286 jet). Thus, Brazil has a comparative advantage in ATVs.
  • Canada's opportunity cost for 1 jet (7/2 ATVs) is lower than Brazil's (6 ATVs). Thus, Canada has a comparative advantage in jets.
  • Gains from Trade: By specializing (Canada in jets, Brazil in ATVs) and trading, both countries can consume more of both goods than they could if they were self-sufficient. For example, through trade:
    • Canada gains +1 ATV and +2 jets.
    • Brazil gains +1 ATV and +1 jet.

Transactions: The Circular-Flow Diagram

The circular-flow diagram is a model that illustrates how money, goods, and services flow through an economy between households and firms.

• Barter: Direct exchange of goods or services without using money. While simple, modern economies primarily use money as a medium of exchange.
• Household: A person or group of people who share their income and make consumption decisions.
• Firm: An organization that produces goods and services for sale.
• Flows in the Diagram:
  • Markets for Goods and Services: Where firms sell goods and services to households. Money flows from households to firms, and goods/services flow from firms to households.
  • Factor Markets: Where firms buy the resources (factors of production) they need to produce goods and services from households. Money (income) flows from firms to households (e.g., wages, rent, interest, profit), and factors of production flow from households to firms (e.g., labour, land, capital).
• Main Factors of Production:
  • Land: Natural resources.
  • Labour: Human effort.
  • Physical Capital: Man-made resources used in production (e.g., machinery, buildings).
  • Human Capital: The skills and knowledge embodied in the labour force.
• Income Distribution: The way an economy's total income is divided among the owners of the various factors of production.

Using Models: Positive Versus Normative Economics

Economists use models for both descriptive analysis and policy prescriptions.

• Positive Economics: The branch of economic analysis that describes the way the economy actually works. It deals with factual statements and verifiable propositions.
  • It aims to explain and predict economic phenomena. For example: