Krugman Microeconomics: Economic Models: Trade-offs and Trade

Economic Models: Trade-offs and Trade

Welcome and Overview

In this chapter, we will explore the fundamental tools economists use to understand how economies work. We'll cover several key areas:

• What economic models are and their importance.

• Three crucial models: the production possibilities frontier (PPF), comparative advantage, and the circular-flow diagram.

• The distinction between positive and normative economics and its relevance to real-world applications.

• Reasons why economists might disagree.

Models in Economics

Economists use models as simplified representations of real situations to better understand complex real-life scenarios. These models are invaluable because their simplicity allows economists to isolate and focus on the effects of a single change at a time, holding all other factors constant.

Creating a Simplified Representation

There are several ways to create a simplified economic model:

• Real but Simplified Economy: Observing a smaller, real economy to understand effects.

• Computer Simulation: Simulating economic workings using computational models, though these are dependent on the quality of the data used.

The "Other Things Equal" Assumption

A crucial assumption in building economic models is the "other things equal" assumption (also known as ceteris paribus). This means that all other relevant factors are assumed to remain unchanged when studying the impact of a single variable. This approach aims to treat economics as closely to a laboratory science as possible, allowing for controlled observation of one variable's effect.

Limitations of Models

While models are helpful, they have limitations:

• It's challenging to find or create a small-scale version of an entire economy.

• Computer simulations are only as accurate as the data and assumptions they are built upon.

Key Economic Models

This chapter introduces three fundamental economic models:

1. Production Possibility Frontier (PPF): Illustrates the trade-offs an economy faces.

2. Comparative Advantage: Clarifies the principle of gains from trade between individuals and countries.

3. Circular-Flow Diagram: A schematic view of how money, goods, and services flow through an economy.

Trade-offs: The Production Possibility Frontier (PPF)

Introduction to the PPF

The first principle of economics is that resources are scarce, which leads to trade-offs. The production possibility frontier (PPF) is a graphical model used to understand these trade-offs by considering a simplified economy that produces only two goods. This simplification allows for a clear visual representation of resource allocation choices.

Definition

The production possibility frontier (PPF) is a diagram that shows the combinations of two goods that are possible for a society to produce if it is efficiently utilizing all its available resources, operating at full employment.

What the PPF Helps Us Understand

The PPF is a powerful tool for analyzing various aspects of an economy:

• Efficiency

• Opportunity Cost

• Economic Growth

Efficiency

An economy is considered efficient if there are no missed opportunities. This concept has two dimensions:

• Efficiency in Production: An economy is efficient in production if it cannot produce more of any one good without producing less of something else. This means the economy is operating on its PPF.

  • An economy is inefficient in production if it could produce more of some things without producing less of others (i.e., operating inside its PPF).

• Efficiency in Allocation: An economy is efficient in allocation if it distributes its resources among firms and sectors in such a way that consumers are as well off as possible, aligning with societal preferences.

• Overall Efficiency: Requires both efficiency in production and efficiency in allocation.

Opportunity Cost

The opportunity cost is what must be given up in order to get a good. It represents the true cost of any good, not just its monetary price, but the alternative foregone.

Calculating Opportunity Cost (Linear PPF)

If Bombardier (a simplified economy) shifts production from point A to point B, producing 4 more jets and 14 fewer subway trains:

• The opportunity cost of each jet is rac{14 ext{ subway trains}}{4 ext{ jets}} = rac{7}{2} ext{ subway trains}.

When the opportunity cost of one good in terms of another is constant, the PPF is a straight line. This implies that resources are equally adaptable to the production of both goods.

The Slope of a Curve

The slope measures the steepness of a curve, indicating how sensitive the y-variable (dependent) is to a change in the x-variable (independent).

• Slope of a Linear Curve: For a linear curve, the slope is constant and calculated as: Slope = rac{Change ext{ }in ext{ }y}{Change ext{ }in ext{ }x} = rac{ riangle y}{ riangle x}

• Slope of a Nonlinear Curve: For nonlinear curves, a straight line drawn between two points approximates the average slope between those points.

Increasing Opportunity Cost

In reality, economists believe opportunity costs are typically increasing. This means that the more of a good an economy produces, the more costly it becomes to produce an additional unit of that good in terms of other goods forgone.

• On a graph, this is represented by a PPF that bows outward from the origin. For example, producing more jets means increasingly more subway trains must be given up because resources are not perfectly adaptable between the two productions.

Economic Growth

Economic growth refers to an expansion of the economy's production possibilities, allowing it to produce more of all goods and services. This is shown as an outward shift of the PPF.

Causes of Economic Growth

Two primary factors contribute to economic growth:

1. Increase in Factors of Production: An increase in the resources used to produce goods and services, which include:

   • Land

   • Labor

   • Physical Capital (e.g., machinery, buildings)

   • Human Capital (e.g., education, skills of the workforce)

2. Better Technology: Advances in the technical means for producing goods and services, allowing for more output with the same amount of inputs.

Comparative Advantage and Gains from Trade

Specialization and Gains from Trade

Individuals and countries can realize gains from trade through specialization, meaning they focus on producing the goods and services they are relatively better at. The core principle behind this is the Theory of Comparative Advantage.

Comparative Advantage Definition

• A country has a comparative advantage in producing a good or service if its opportunity cost of producing that good or service is lower than for other countries.

• An individual has a comparative advantage in producing a good or service if his or her opportunity cost of producing that good or service is lower than for other people.

Example: Canada and Brazil

Consider Canada and Brazil producing jets and subway trains. If their opportunity costs differ, specialization and trade become mutually beneficial.

Opportunity Costs Comparison:

• Canadian opportunity cost of 1 subway train: rac{2}{7} jet

• Brazilian opportunity cost of 1 subway train: rac{1}{6} jet

  • Since rac{1}{6} < rac{2}{7}, Brazil has a comparative advantage in producing subway trains (its opportunity cost is lower).

• Canadian opportunity cost of 1 large jet: rac{7}{2} subway trains

• Brazilian opportunity cost of 1 large jet: 6 subway trains

  • Since rac{7}{2} < 6, Canada has a comparative advantage in producing jets (its opportunity cost is lower).

Gains from Specialization and Trade

By specializing according to their comparative advantage and then trading, both countries can consume more of both goods than they could produce on their own.

• Canada specializes in jets (produces 20) and sells 6 to Brazil. Brazil specializes in subway trains (produces 60) and sells 29 to Canada.

• Post-trade, Canada consumes 29 subway trains and 14 jets (up from 28 and 12).

• Brazil consumes 31 subway trains and 6 jets (up from 30 and 5).

• This demonstrates that through specialization and trade, both nations achieve a higher consumption level than if they were self-sufficient, effectively operating outside their individual PPFs from a consumption perspective.

Absolute Versus Comparative Advantage

• Absolute Advantage: The ability to produce more of a good or service with the same amount of resources (or the same amount of a good or service with fewer resources) than others.

• Important Distinction: Just because a country (like Canada in some scenarios) can produce more of both goods (absolute advantage) does not mean it is better off without trade. The key is to focus on opportunity costs to determine comparative advantage.

• Trade decisions are based on comparative advantage; if it's cheaper (in terms of opportunity cost) for one country to produce a good, another country will benefit from importing that good.

Transactions: The Circular-Flow Diagram

Introduction to the Circular-Flow Diagram

The circular-flow diagram is a simplified schematic representation of the transactions that occur in an economy. It illustrates the flows of goods, services, and money between households and firms.

Key Definitions

• Barter: Direct exchange of goods or services for other goods or services, without the use of money.

• Household: A person or group of people that shares income.

• Firm: An organization that produces goods and services for sale.

Flows in the Diagram

The circular-flow diagram depicts two main types of flows:

• Physical Flows (blue): Represent tangible items such as goods, services, labor, or raw materials moving in one direction.

• Money Flows (green): Represent the payments made for these physical things, moving in the opposite direction.

Markets

1. Markets for Goods and Services: Firms sell the goods and services they produce to households.

2. Factor Markets: Firms buy the resources they need to produce goods and services from households. The main factors of production are:

   • Land

   • Labor

   • Physical Capital

   • Human Capital

Income Distribution

An economy's income distribution refers to how total income is divided among the owners of the various factors of production. This distribution is determined in factor markets.

Real-World Complications (Ignored by the Basic Diagram)

The simplified circular-flow diagram intentionally omits several real-world complexities:

• Blurred Firm-Household Distinction: Many small, family-run businesses (e.g., farms, shops) blur the lines between household and firm.

• Firm-to-Firm Sales: A significant portion of sales are from one firm to another (e.g., steel companies selling to auto manufacturers), not directly to households.

• Government: The government's role (e.g., taxes, public services) is typically excluded in the most basic version of the diagram.

What do Economists Actually Do With Their Models?

Economists use their models for different purposes, primarily for describing how the economy works and prescribing how it should work.

Using Models: Positive Versus Normative Economics

Positive Economics

Positive economics is the branch of economic analysis that describes the way the economy actually works. It deals with objective statements that can be tested or verified by examining data and facts. There is, in principle, a single correct answer to a positive economic question.

• Examples:

  • "More than 60\% of women are in the labour market." (This is a factual claim that can be verified.)

  • "People who smoke pass on increased medical costs to the whole society." (This is a statement about economic effect that can be analyzed.)

  • "Single mothers are more than twice as likely as married mothers to be in poverty." (A verifiable statistical claim.)

• A forecast is a simple prediction about the future based on positive economic analysis.

Normative Economics

Normative economics makes prescriptions about the way the economy should work. It involves value judgments and opinions about what is desirable or optimal. There may not be a single "right" answer to a normative economic question, as different people hold different values.

• Examples:

  • "Rent control laws should be implemented because they help to achieve equity or fairness in housing." (This is a recommendation based on a value judgment about fairness.)

  • "Society should take measures to end gun violence." (This is a suggestion for action based on a societal goal.)

Key Distinction

• Positive economics is about description.

• Normative economics is about prescription.

Using Models: When and Why Economists Disagree

Despite employing structured models, economists sometimes disagree for several reasons:

1. Media Exaggeration: Media coverage often tends to magnify actual differences in views among economists.

2. Politics and Interest Groups: Economic issues are often intertwined with politics. Powerful interest groups may promote economists who support their specific viewpoints.

3. Diverse Values: Reasonable people, including economists, can come to different conclusions about policy recommendations because they hold different values.

4. Simplifying Assumptions: Economic modeling necessitates making simplifying assumptions. Two economists might legitimately disagree about which simplifications are most appropriate or relevant for a particular situation, leading to different conclusions.