Chapter 2 Microeconomics: Economic Models, Trade-Offs, and Trade

Economic Models and the Other Things Equal Assumption

  • Definition of an Economic Model: A model is a simplified representation of a real situation used to gain a deeper understanding of real-life economic events and mechanisms.

  • Methods for Constructing Economic Models:

    • Creating a Real but Simplified Economy: Economists can construct or study tangible, scaled-down real-world systems. An example includes analyzing the use of cigarettes as currency and a medium of exchange within World War II prisoner-of-war (POW) camps.

    • Simulating an Economy on a Computer: Complex economic systems can be modeled digitally. Examples include computer-generated tax models and monetary/money models designed to run scenario simulations.

  • The "Other Things Equal" Assumption (Ceteris Paribus):

    • Models enable economists to hold all other relevant factors unchanged while studying a specific variable or policy of interest.

    • This assumption allows for the isolation of cause-and-effect relationships without interference from simultaneous background changes.

  • Analytical Questions Addressed by Models:

    • Evaluating labor market effects: Determining if unemployment increases when the government raises the minimum wage.

    • Evaluating trade dynamics: Assessing how immigration impacts international trade in goods and services within Canada.

The Production Possibility Frontier

  • Scarcity and Trade-Offs: Resources in any economy are inherently scarce, forcing individuals and societies to face trade-offs when making allocation choices.

  • Definition of the Production Possibility Frontier (PPF): A simplified model used by economists to illustrate the trade-offs, constraints, and choices inherent in producing goods.

  • Simplified Model Setup:

    • Assume Canada functions as a simplified, single-company economy represented by Bombardier.

    • The economy produces only two distinct outputs: subway trains and jets.

  • Key Economic Concepts Analyzed via the PPF:

    • Feasibility: Identifying production combinations that are physically attainable given current resource levels versus those that are unattainable.

    • Production Efficiency: Assessing whether an economy is producing goods without wasting resources.

    • Opportunity Cost: Calculating the exact quantity of one good that must be given up to obtain additional quantities of another good.

    • Economic Growth: Modeling how expanded resources or improved technologies alter production capabilities over time.

  • Quantitative Breakdown of PPF Production Points:

    • Vertical Intercept (Y-axis): Represents producing 7070 subway trains and 00 jets.

    • Horizontal Intercept (X-axis): Represents producing 00 subway trains and 2020 jets.

    • Point A: Coordinates of 3535 subway trains and 1010 jets. Located directly on the PPF curve; feasible and efficient in production.

    • Point B: Coordinates of 2121 subway trains and 1414 jets. Located directly on the PPF curve; feasible and efficient in production.

    • Point C: Coordinates of 2121 subway trains and 1010 jets. Located strictly inside the PPF frontier line; feasible but inefficient in production because more of either good could be produced with existing resources.

    • Point D: Coordinates of 7070 subway trains and 2020 jets. Located strictly outside the PPF curve; not feasible given current resource constraints.

Production Possibility Frontier graph depicting points A, B, C, and D

Opportunity Cost and the Shape of the PPF

  • Influence of PPF Geometry: The specific curvature and shape of the PPF dictate how opportunity costs change as production shifts.

  • Straight-Line PPF: Represents constant opportunity costs, where giving up one unit of a good yields the same amount of another good regardless of production levels.

  • Bowed-Out PPF (Increasing Opportunity Cost):

    • A concave shape relative to the origin indicates increasing opportunity costs as production expands toward a specific good.

    • Initial Production Shift: Moving from 00 jets to 1010 jets requires reducing subway train production from 7070 to 6060. The opportunity cost of producing the first 1010 jets is giving up 1010 subway trains (reaching Point A at 1010 jets and 6060 subway trains).

    • Subsequent Production Shift: Moving from 1010 jets to 2020 jets requires reducing subway train production from 6060 down to 00. The opportunity cost of producing 1010 additional jets increases to giving up 6060 additional subway trains.

    • Economic Principle: As more of a good is produced, its opportunity cost rises because well-suited inputs are exhausted first, requiring the use of inputs less suited for that good's production.

Bowed-out Production Possibility Frontier illustrating increasing opportunity cost

Economic Growth and Factor Accumulation

  • Mechanics of Economic Growth: Economic growth shifts the PPF outward because the overall production capabilities of the economy expand, allowing for higher total output of all goods.

  • Graphical Representation of Growth:

    • Initial state: Baseline production sits at Point A (6060 subway trains and 1010 jets) on the original PPF line.

    • Post-growth state: The curve shifts outward to a new PPF, allowing production to reach Point E (7070 subway trains and 1212 jets).

    • The maximum potential jet output (horizontal intercept) expands from 2020 jets to 2525 jets.

  • Two Core Sources of Economic Growth:

    1. Factor Accumulation: An expansion in the economy's overall factors of production. Factors of production are key inputs that are not used up or destroyed in the production process, classified into:

      • Land: Natural physical resources.

      • Labour: Human effort and workforce size.

      • Capital: Manufactured assets used to produce other goods (e.g., machinery, buildings, tools).

      • Human Capital: The accumulated education, skills, knowledge, and expertise of the workforce.

    2. Technological Progress: Advancements in the technical means and processes used to manufacture goods and services, enabling greater output from the same volume of inputs.

Outward shift of the Production Possibility Frontier showing economic growth

Positive vs. Normative Economics

  • Positive Economics:

    • Definition: The branch of economic analysis that objectively describes and explains how the economy actually operates in reality ("what is").

    • Characteristics: Focuses on factual descriptions, cause-and-effect relationships, and empirical testing. Questions in positive economics have objective, verifiable, right-or-wrong answers.

  • Normative Economics:

    • Definition: The branch of economics that makes policy prescriptions and subjective evaluations regarding how the economy ought to function ("what should be").

    • Characteristics: Involves personal values, political opinions, and ethical judgments. Economists cannot provide single, scientifically verifiable answers for normative questions due to differing values among individuals.

  • Role of Efficiency in Policy Ranking:

    • Exceptions where economists agree on policy advice occur when competing policies aimed at achieving a specific normative prescription can be objectively evaluated and ranked based on economic efficiency.

  • Purpose of Complex Economic Modeling:

    • Economists utilize complex formal models not to demonstrate individual intellect, but because human cognition is not powerful enough to analyze the raw, unsimplified complexity of the real world without structural assumptions.

Applied Economics: Economists Beyond the Ivory Tower

  • Financial Markets and Private Industry Applications:

    • Finance theory plays a substantial role on Wall Street in pricing financial assets, risk management, and valuation models.

    • Businesses rely on economic analysis to construct future product demand forecasts, predict input raw-material price trends, and project corporate capital financing needs.

    • Major Canadian financial institutions (such as Royal Bank and National Bank) run dedicated economics departments that publish regular analyses detailing economic forces and market-moving events.

    • Economic consulting agencies sell custom market analysis, competitive assessments, and strategic policy advice to private enterprise clients.

  • Public Sector and Government Roles:

    • In Canada, economists serve across virtually every federal, provincial, and local ministry, with heavy concentrations in the Department of Finance and at the central bank, the Bank of Canada.

  • International Financial and Development Organizations:

    • International Monetary Fund (IMF): Headquartered in Washington, D.C.; employs economists to provide policy guidance, economic assessment, and financial stabilization loans to countries experiencing severe currency or fiscal imbalances.

    • World Bank: Headquartered in Washington, D.C.; employs economists to deliver strategic guidance, expert advice, and developmental loans aimed at spurring long-term economic development and infrastructure growth in lower-income nations.

Economic Perspectives on Growth and Trade-Offs

  • Critique of Traditional Growth Paradigms:

    • Analyses such as Professor Tim Jackson's presentation on "Prosperity Without Growth" (Global Transition 2012 / January 2012) re-examine fundamental economic assumptions.

    • Explores alternative frameworks for structuring a functional economy, prioritizing resource sustainability, ecological limits, and structural trade-offs over indefinite material expansion.