Notes on Economic Models: Trade-offs and Trade

What are economic models, and why are they important to economists.
How three simple models—the production possibilities frontier (PPF), comparative advantage, and the circular-flow diagram—help us understand how modern economies work.
Why it matters to distinguish positive economics from normative economics for real-world application of economic principles.
Why economists sometimes disagree.

Model: a simplified representation of a real situation used to better understand real-life situations.
The "other things equal" assumption: all other relevant factors remain unchanged.
The aim is to treat economics as close to a laboratory science as possible—changing only one variable at a time.

The production possibilities frontier (PPF): a diagram showing the combinations of two goods that are possible for a society to produce at full employment.
The PPF helps us understand:
- Efficiency
- Opportunity cost
- Economic growth

Figure 1 (referenced): Krugman, Economics, 6e/7e visuals showing the PPF and its implications.

Efficiency means there are no missed opportunities.
In production: an economy is efficient if it could not produce more of any one good without producing less of something else—i.e., it lies on the PPF.
In production inefficiency: the economy could produce more of some goods without producing less of others.
In allocation: the economy is efficient in allocation if resources are distributed to make consumers as well off as possible.
Overall efficiency requires both efficiency in production and efficiency in allocation.

Opportunity Cost (OC): what must be given up to obtain a good.
Example: If Boeing shifts production from point A to point B, it produces 8 more small jets but 6 fewer Dream liners.
Therefore, the OC of a small jet is
$OC_{ ext{small jet}} = rac{6}{8} = rac{3}{4} ext{ of a Dreamliner}.$

Increasing opportunity cost: the more small jets the economy produces, the more costly it becomes to produce yet another small jet in terms of forgone Dream liners.
This concept is often illustrated by a concave (bowed-out) PPF shape, where OC rises as you move along the frontier.
Figure 2 (referenced): shows increasing OC.

What causes economic growth?
1. An increase in factors of production: resources used to produce goods and services, including land, labor, physical capital, and human capital.
2. Better technology: the technical means for producing goods and services.

Theory of Comparative Advantage: It makes sense to produce the things you’re especially good (relatively better) at producing and buy everything else from others.
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 their opportunity cost of producing the good or service is lower than for other people.

Figure 4 (referenced): demonstrates the concept of comparative advantage and mutual gains from trade.

Since each country has a different opportunity cost, it makes sense to specialize and trade.
Table 1: U.S. and Brazilian Opportunity Costs of Small Jets and Large Jets
- 1 small jet : U.S. opportunity cost = $rac{3}{4} ext{ large jet}$ ; Brazilian opportunity cost = $rac{1}{3} ext{ large jet}$
- 1 large jet : U.S. opportunity cost = $rac{4}{3} ext{ small jets}$ ; Brazilian opportunity cost = $3 ext{ small jets}$

Table 2: How the United States and Brazil Gain from Trade
- Without Trade: Production vs Consumption
- With Trade: Production vs Consumption
- Gains from Trade
- United States: Large jets — Without Trade Production 18, Consumption 18; With Trade Production 30, Consumption 20; Gains from Trade = 2
- United States: Small jets — Without Trade Production 16, Consumption 16; With Trade Production 0, Consumption 20; Gains from Trade = 4
- Brazil: Large jets — Without Trade Production 8, Consumption 8; With Trade Production 0, Consumption 10; Gains from Trade = 2
- Brazil: Small jets — Without Trade Production 6, Consumption 6; With Trade Production 30, Consumption 10; Gains from Trade = 4
Conclusion: Through specialization and trade, both countries produce more and consume more than if they were self-sufficient.

Don’t confuse absolute with comparative advantage.
Just because the United States can produce more of both goods doesn’t mean we’re better off without trade.
Pay attention to opportunity costs: if it’s cheaper for Brazil to produce small jets than for the United States, the United States will want to import small jets from Brazil.

Trade originally took the form of barter when people directly exchanged goods or services they have for goods or services they want.
The circular-flow diagram represents the transactions in an economy by flows around a circle.
A household is a person or a group of people that share their income.
A firm is an organization that produces goods and services for sale.

Positive economics: describes how the economy actually works.
Normative economics: makes prescriptions about how the economy should work.
Positive economics is about description; normative economics is about prescription.
A forecast is a simple prediction of the future.

Media coverage tends to exaggerate the real differences in views among economists.
Economics is often tied up in politics: powerful interest groups promote economists with opinions that support their positions.
Diverse people have diverse values: reasonable people can reach different conclusions because of their values.
Economic modeling requires simplifying assumptions: two economists can legitimately disagree about which simplifications are appropriate.