Economic Models: PPF, Comparative Advantage, and Circular Flow

WHAT YOU WILL LEARN IN THIS CHAPTER

  • What are economic models, and why they are important to economists
  • How three simple models help us understand how modern economies work:
    • Production Possibility Frontier (PPF)
    • Comparative Advantage
    • Circular-Flow Diagram
  • Difference between positive economics and normative economics and why it matters in real-world application
  • Why economists sometimes disagree, including the role of simplifying assumptions and politics

MODELS IN ECONOMICS

  • A model: a simplified representation of a real situation used to better understand real-life situations
  • The other things equal (ceteris paribus) assumption: all other relevant factors remain unchanged/constant
  • Example: Grocery cashier opens (demonstrates a simple, controlled scenario to study trade-offs)

PRODUCTION POSSIBILITIES FRONTIER (PPF)

  • The PPF is 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 (OC)
    • Economic growth

TRADE-OFFS: THE PPF

  • Key ideas demonstrated by the PPF:
    • Efficiency: an economy is efficient if there are no missed opportunities; i.e., it cannot produce more of one good without producing less of another
    • Opportunity cost: what must be given up to obtain an additional unit of a good
    • Economic growth: an outward shift of the PPF over time

GRAPHICAL PPF (illustrative numbers)

  • Example: US can only produce aircrafts. Using all resources, it can produce either:
    • 30 Dreamliners or 40 commuter jets
  • Represented on a two-good PPF with mangos (x-axis) and clams (y-axis) in the island example below, where the axis choice is specified in later slides
  • Endpoints for a simplified two-good PPF (example context):
    • Point A: 0 mangos, 100 clams
    • Point B: 200 mangos, 0 clams
  • The PPF line connects these endpoints and shows feasible production combinations given full employment of resources

EFFICIENCY ON THE PPF

  • Efficiency condition: no missed opportunities; cannot increase output of any one good without decreasing output of another
  • Efficient in production means you are on the PPF; inefficient means you are inside the PPF (inside the frontier)

OPPORTUNITY COST ON THE PPF

  • OC: what must be given up to gain an additional unit of a good
  • Island example (mangos on x-axis, clams on y-axis):
    • If you move from point A to point B, you trade off some clams for mangos (or vice versa)
  • Key questions:
    • What is the opportunity cost of each small unit of the other good?
    • Does it matter which points on the frontier you use to calculate OC? (In linear/frontier-constant OC cases, not for the slope, but it can in bowed-out cases)

OPPORTUNITY COST (OC) AND ITS SHAPE

  • Increasing opportunity cost: the more of one good you produce, the more costly it becomes to produce yet another unit of that good in terms of forgone output of the other good
  • In many real-world PPFs, OC increases as you move along the frontier (bowed-out shape), reflecting resource suitability and specialization

ECONOMIC GROWTH

  • Definition: Economic growth is an expansion of the economy’s production possibilities
  • Causes of growth (two main possibilities):
    1. An increase in factors of production (land, labor, physical capital, and human capital)
    2. Better technology: the technical means for producing goods and services
  • Growth implies an outward shift of the entire PPF

CONCEPT CHECK (PPF)

  • Suppose you are stranded on an island rich in clams and mangos. If you devote all time to harvesting clams, you get 100 clams in a week. If you devote all time to mangos, you get 200 mangos in a week. Assume linear OC for this example.
    1. Draw a sketch of the production possibility frontier for a week (mangos on x-axis, clams on y-axis; assume OC is constant).
    2. Identify the following points: (A) feasible and efficient; (B) feasible but not efficient; (C) feasible, efficient, and ONLY produces one good; (D) not feasible
    3. Calculate the opportunity cost of each good: (A) OC of 1 mango; (B) OC of 1 clam
    4. Give a specific example of how point (D) could become feasible

COMPARATIVE ADVANTAGE AND GAINS FROM TRADE

  • Theory: It makes sense to produce the things you’re relatively better at producing (lower OC) and buy everything else from others
  • A person (or country) has a comparative advantage in producing a good if their OC of producing that good is lower than that of others

COMPARATIVE ADVANTAGE EXAMPLE (US vs Brazil)

  • Both countries can produce Large (L) and Small (S) jets with constant OC
  • The US can produce either: 30 L or 40 S, and is currently producing 18 L and 16 S
  • Brazil can produce either: 10 L or 30 S, and is currently producing 8 L and 6 S
  • Implication: Different OC across countries leads to potential gains from trade through specialization

COMPARATIVE ADVANTAGE AND O/C

  • Since each country has different opportunity costs, it makes sense to specialize according to comparative advantage and to trade
  • The next step is to determine who specializes in which product and why

COMPARATIVE ADVANTAGE AND GAINS FROM TRADE (illustration)

  • Compare a no-trade scenario to a trade scenario with a given exchange ratio (e.g., 10 L for 20 S)
  • Without trade: production and consumption are the same and reflect domestic constraints
  • With trade: specialization in each country according to comparative advantage and consumption can increase beyond domestic production
  • Gains from trade are realized as total output and consumption increase due to specialization and exchange

ABSOLUTE VERSUS COMPARATIVE ADVANTAGE

  • Don’t confuse absolute with comparative advantage: A country may produce more of both goods (absolute advantage) but still have a lower OC for one good, which creates a comparative advantage for that good
  • Pay attention to opportunity costs: if it’s cheaper for one country to produce a good, that country will export that good and import the other good

CONCEPT CHECK (ABSOLUTE vs COMPARATIVE)

  • Texia and Urbania example: Abbreviated version of a typical exercise
    1. Blank 1: who has absolute advantage in clothing? who has absolute advantage in food?
    2. Blank 2: who has comparative advantage in clothing? who has comparative advantage in food?

THE CIRCULAR FLOW MODEL

  • The circular-flow diagram represents the transactions in an economy as flows around a circle
  • Two kinds of economic agents: households and firms

TRANSACTIONS: THE CIRCULAR-FLOW DIAGRAM

  • In the simple two-actor model, households provide factors of production (labor, capital) to firms and receive wages, rents, and profits; firms produce goods and services which households consume

CONCEPT CHECK (CIRCULAR FLOW)

  • With a partner, trace the following events through the circular flow:
    a) The introduction of a new technology that boosts productivity
    b) The decision of consumers to save more money
    c) An increase in government spending

USING MODELS: POSITIVE VERSUS NORMATIVE ECONOMICS

  • Positive economics: describes how the economy actually works (descriptive)
  • Normative economics: makes prescriptions about how the economy should work (prescriptive)
  • Forecast: a simple prediction of the future

CONCEPT CHECK (POSITIVE VS NORMATIVE)

  • Label each statement as normative or positive:
    1. More than 60% of women are in the labor market.
    2. Rent control laws should be implemented because they help to achieve equity or fairness in housing.
    3. Society should take measures to end gun violence.
    4. People who smoke pass on increased medical costs to society.
    5. Single mothers are more than twice as likely as married mothers to be in poverty.

WHY ECONOMISTS DISAGREE (USING MODELS)

  • Media coverage tends to exaggerate the real differences in views among economists
  • Economics is often tied to politics: powerful interest groups promote economists with supportive opinions
  • Diverse values: reasonable people can differ due to values
  • Economic modeling requires simplifying assumptions: two economists can legitimately disagree about which simplifications are appropriate

SUMMARY

  • Models are simplified representations of reality
  • The PPF shows production under full use of resources and helps illustrate scarcity, efficiency, OC, and growth
  • Comparative advantage helps determine specialization; it depends on OC differences
  • The circular-flow diagram illustrates how someone’s spending becomes another’s income

ext{PPF equation example (linear case): } C = 100 - frac{1}{2}M,
ext{ where } M ext{ = mangos (x-axis), } C ext{ = clams (y-axis)}.

extEndpoints:(M,C)=(0,100)extand(200,0).ext{Endpoints: } (M,C) = (0,100) ext{ and } (200,0).

extOCofmango(inclams):extOCM=∣riangleC∣∣riangleM∣=100200=frac12extclampermango.ext{OC of mango (in clams): } ext{OC}_M = \frac{| riangle C|}{| riangle M|} = \frac{100}{200} = frac{1}{2} ext{ clam per mango}.

extOCofclam(inmangos):extOCC=∣riangleM∣∣riangleC∣=200100=2extmangosperclam.ext{OC of clam (in mangos): } ext{OC}_C = \frac{| riangle M|}{| riangle C|} = \frac{200}{100} = 2 ext{ mangos per clam}.

  • Economic growth causes outward shifts of the PPF, reflecting larger possible production frontiers.
  • The two drivers of growth are an increase in factors of production and technological progress.