chapter 2

Models in Economics

• Models must hold all other things equal

  • All other factors remain unchanged and only look at one

• Production Possibility Frontier

  • Shows the trade offs of an economy producing two goods

• Shows economic concept of efficiency

  • Efficient means there is no way to make someone better off without making someone else worse off

  • Efficient in production

    • When an economy cant produce more of one good without producing less of another

  • Efficient in allocation

    • Economy that allocates its resources so consumers are as well off as possible

  • Efficiency for economy as a whole requires both efficiency in production and allocation

• PPF can be used to calculate opportunity cost

  • Opportunity cost is what must be given up to produce more of a good

  • Slope of PPF is opp cost

  • Real PPF is usually increasing

• PPF can be used to see Economic growth

  • Economic growth is growing ability of the economy to produce goods and services

  • Economic growth happens when PPf shifts outward

    • Increase in economies factors of production

      • Resources used to produce goods:

      • Land - natural resources, oil, water, etc.

      • Labour - physical workforce

      • physical capital - items used to produce other goods  

      • human capital - educational achievements and skills of labour force

    • Progress in technology

• Comparative advantage and gains from trade

  • Comparative advantage is when you can produce for cheaper compared to another country

  • Compares two countries PPF

    • Whatever country has the lower opportunity cost for a good should only make that good and trade with the other country

      • The country has a comparative advantage in producing that good

  • Country has an absolute advantage if they’re better at producing both goods

  • With trade, two countries can produce and consume more (outside of their PPF) 

Transactions: the circular-flow diagram

• Barter happens when people directly exchange goods for other goods

• Shows the transactions in economy with two flows around circle

  • Flow of physical things in one direction and flow of money in other direction

• Simplest shows an economy that only holds households(individuals or groups of people) and firms(organization that produces goods and employs households)

  • Households buy goods or services from firms

  • Firms buy factors from households to produce goods and services

• Income distribution

  • How income in economy is distributed between different people

• Ignores real world complications:

  • Distinction between firms and households isn’t always clear-cut

  • Firms sell to other firms

  • Doesn’t show government

Using models

• Positive vs normative economics

  • Positive is about facts

    • Describes how economy actually works

  • Normative doesn’t always have a right answer

    • Uses word should

    • prescribes how economy should work

• Forecast is a prediction

When and why economists disagree

• Media exaggerates differences in views

• Economics tied up in politics