CHAPTER 2 Economic Models: Trade-offs and Trade

1. CHAPTER 2 • Economic Models: • Trade-offs and Trade

2. What you will learn in this chapter: 1. Why models play a crucial role in economics? 2. Production possibility frontier (PPF) 3. Comparative advantage 4. Circular-flow diagram

3. 1. Models in Economics • A model is a simplified representation of a real situation that is used to better understand real-life situations. • Ex: concept of equilibrium – example of how customers at a supermarket would rearrange themselves when a new cash register opens • The “other things equal” assumption means that all other relevant factors remain unchanged.

4. 2. Trade-offs: The Production Possibility Frontier

5. Increasing Opportunity Cost

6. Economic Growth Economic growth results in an outward shift of the PPF because production possibilities are expanded. The economy can now produce more of everything. Production is initially at point A (20 fish and 25 coconuts),  it can move to point E (25 fish and 30 coconuts).

7. 3. Comparative Advantage and Gains from Trade. Ex.: Tom and Hank

8. 3. Comparative Advantage and Gains from Trade. Ex.: Tom and Hank

9. Tom and Hank’s Opportunity Costs of Fish and Coconuts

10. Comparative Advantage and Gains from Trade. Ex.: Tom and Hank

11. Comparative Advantage and Gains from TradeEx.: Tom and Hank

12. How the Castaways Gain from Trade • Both Tom and Hank experience gains from trade: • Tom’s consumption of fish increases by two, and his consumption of coconuts increases by one. • Hank’s consumption of fish increases by four, and his consumption of coconuts increases by two.

13. Comparative vs. Absolute Advantage • An individual has a comparative advantage in producing a good or service if the opportunity cost of producing the good is lower for that individual than • for other people. • An individual has an absolute advantage in an activity if he or she can do it better than other people. Having an absolute advantage is not the same thing as having a comparative advantage.

14. 3. PITFALLS: Misunderstanding Comparative Advantage • A common mistake is to confuse comparative advantage with absolute advantage. • Ex.: U.S. vs. Japan in 1980s • Commentators: “U.S. might soon have no comparative advantage in anything” • Wrong! They meant “absolute advantage”

15. 4. Transactions: The Circular-Flow Diagram • Trade takes the form of barter (Tom & Hank example above)when people directly exchange goods or services that they have for goods or services that they want. • The circular-flow diagram is a model that represents the transactions in an economy by flows around a circle.

16. The Circular-Flow Diagram

17. Growth in the U.S. Economy from 1962…

18. …to 1988

19. Summary 1. Almost all economics are based on models, “thought experiments” or simplified versions of reality. Important assumption: other things equal 2. Production possibility frontier: illustrates opportunity cost, efficiency, and economic growth 3. Comparative advantage: explains source of gains from trade. Often confused with absolute advantage 4. Circular-flow diagram: represents transactions occur in markets for goods and services & factor markets

20. The End of Chapter 2 coming attraction:Chapter 3: Supply and Demand