2

Model Building and

Gains from Trade

Big Questions
1. How do economists study the economy?
2. What is a production possibilities frontier?
3. What are the benefits of specialization
and trade?
4. What is the trade-off between having
more now and having more later?

Scientific Method in Economics

Resembles the hard sciences in some ways

Construct a theory (or hypothesis)

Design experiments to test the theory
Collect data
Revise or refute the theory based on evidence

Different from hard sciences

Economists lab is the world around us;
firm and consumer behavior studied
Not always able to design experiments
Historical data often used

Positive and Normative

Analysis
Positive statement
A claim that can be tested to be consistent or
inconsistent with observed outcomes

Normative statement
Statement of opinion; cannot be tested
What ought to be or should be

Which is generally preferred?

Positive; like to test claims with data

Practice What You Know

Positive or Normative?
1.
2.
3.
4.
5.

The moon is made of green cheese.

Rich people should be taxed more.
More taxes on the rich will increase tax revenues.
Everyone should donate to charity.
I think everyone needs to work at a bank to see the true
value of money.
6. Government intervention in markets is bad.
7. Economics majors earn more on average than
sociology majors.
8. Everyone should take Economics 101.

Economic Models
Economists use models to
understand the complex
real-world economy.
Models
Simplified versions of
reality
Built with assumptions
considered good if
generate accurate
predictions

Economic Models Components

Endogenous factors
Variables determined inside a model

Exogenous factors
Variables that are not determined in a model
Outside our control

Economic Models
Ceteris paribus
Latin: other things being equal
Assumption through which we examine
a change in one variable, but hold all
other variables constant.
Allows us to isolate the effect of a single
variable

Models and Ceteris Paribus

What determines a persons wage rate?
Education

Age

Experience

W f
Skills

Working Conditions

Gender

Models and Ceteris Paribus

Education

Age

Experience

W f
Skills

Working Conditions

Gender

Ceteris paribus analysis

Change just ONE of the dependent variables
and examine how wage is affected. Assume
other variables do not change.

Danger of Faulty Assumptions

Economists continually examine and re-evaluate
the assumptions in models.
Example:
Assumption: housing prices always rise
Pre-2008 models used by banks to make loans didnt
account for declining housing prices

Production Possibilities
Frontier
Production possibilities frontier
Combinations of outputs that a society can
produce if all of its resources are being used
efficiently

Assumptions of this model

Technology fixed
Resources fixed
Simplified two-good analysis

Production Possibilities Frontier

Production Possibilities
Frontier
Why is the PPF downward-sloping?
Must give up one good to increase production of another

Why are we unable to produce certain combinations?

Scarcity and limited resources

Efficient points
Points ON the PPF (A, B, C, and D)

Inefficient points
Points INSIDE the PPF (F)
Workers goofing off, unused buildings

Unattainable (for now) points

Points OUTSIDE the PPF (E)

PPF and Opportunity Cost

Recall opportunity cost
Highest-valued alternative
What we give up as a result of an action

Opportunity cost in this case is the slope

of the PPF

PPF and Opportunity Cost

Nonlinear PPFs
We can draw a more realistic PPF by making it
nonlinear and bowed outward.
The PPF will not have a constant slope in this case.
The slope will get steeper as we move from left to
right, and opportunity costs will not be constant.

Increasing relative cost

Refers to the increasing opportunity cost of
production that occurs as you move along the
production
As we produce more of good A, we have to give up
increasingly larger amounts of good B.

PPF and Opportunity Cost

Nonlinear PPFs
Intuition behind nonlinear PFFs
Inputs (resources) are not perfectly homogenous.
Some inputs are better at making pizza than other
inputs.
As we increase pizza production, use the inputs that
are the best at making pizza (Italian chef, doughtossing master).
Keep expanding production - have to start using
inputs that arent as good at making pizza. Wont
make as much pizza as other inputs.
Pizza production doesnt expand at a linear rate!

PPF and Opportunity Cost

Shifts in the PPF

If the PPF were to expand outward, some
previously unattainable combinations
would now be possible to produce.
The PPF could shift for two reasons: New
resources or technology could become available
that either
1. Affect the production of one good, or
2. Affect the production of both goods.

A Shift in the PPF Pizza Productivity Increase

A Shift in the PPF Both Affected

Production Possibilities Quiz

1. (True/False) Point A represents the amounts of
cars and bicycles that will be sold.
Bicycles

Cars

Production Possibilities Quiz

1. (True/False) Point A represents the amounts of
cars and bicycles that will be sold.

False.

It represents
how many cars
and bicycles are
produced!

Bicycles

Cars

Production Possibilities Quiz

2. (True/False) A move from point F to point
G means the price of bicycles increases.
Bicycles

G
F

Cars

Production Possibilities Quiz

2. (True/False) A move from point F to point
G means the price of bicycles increases.
False.

Bicycles

The number of
bicycles
produced
increases.

Cars

Production Possibilities Quiz

3. (True/False) Movement along the curve from
point C to point A shows us the opportunity cost
of producing more bicycles.
Bicycles

Cars

Production Possibilities Quiz

3. (True/False) Movement along the curve from
point C to point A shows us the opportunity cost
of producing more bicycles.
Bicycles

False.
C

It represents the
opportunity cost
of producing
more cars.

+
Cars

Production Possibilities Quiz

4. (True/False) If we have high
unemployment, then the curve shifts in.
Bicycles

Cars

Production Possibilities Quiz

4. (True/False) If we have high
unemployment, then the curve shifts in.
False.

Unemployment means that not

everyone is working so
production is inside the PPC.
The PPC stays put since it
represents the maximum
output if all resources are
being used to the fullest.

Bicycles

Cars

Production Possibilities Quiz

5. (True/False) If an improved process for
manufacturing cars is introduced, then the
entire curve will shift out.
Bicycles

Cars

Production Possibilities Quiz

5. (True/False) If an improved process for
manufacturing cars is introduced, then the
entire curve will shift out.

False.

The curve only moves out

along the car axis. It is not
possible to make more
bicycles than before.

Bicycles

Cars

Specialization and Trade

Improvements in technology and more
resources can make an economy more
productive.
Specialization and trade can also create gains
for society.
Assume
Two goods produced(pizza and wings)
Two people with different abilities in the production of
pizza and wings

Specialization and Trade

Person
Debra Winger
Mike Piazza

Daily Production
Pizzas
Wings
60
120
24
72

Absolute advantage
One person can perform each task more effectively
than the other person.
Who has the absolute advantage in pizza production?
In wing production?

Specialization and Trade

Specialization and Trade

Without Trade
Person

Good

Production

Consumption

Debra

Pizza

40

40

Wings

40

40

Pizza

18

18

Wings

18

18

Mike

Without specialization and trade

Mike and Debra each have to produce their own
wings and pizza;
Each person can only consume what they produce.

Specialization and Trade

With Trade

Gains from
Trade

Person

Good

Production

Consumption

Debra

Pizza

60

41 (keeps)

+1

Wings

47 (from Mike)

+7

Pizza

19 (from Debra)

+1

Wings

72

25 (keeps)

+7

Mike

With specialization and trade

Debra produces pizza and gives 19 pizzas to Mike;
Mike produces wings and gives 47 wings to Debra;
Each person consumes more with trade.

Gains from Trade

Opportunity Cost
Person
Debra Winger
Mike Piazza
Person
Debra Winger
Mike Piazza

Daily Production
Pizzas
Wings
60
120
24
72

Opportunity Cost
1 Pizza
1 Wing
2 wings
1/2 pizzas
(120 60)
(60 120)
3 wings
(72 24)

1/3 pizzas
(24 72)

Opportunity Cost
Person
Debra Winger
Mike Piazza

Opportunity Cost
1 Pizza
1 Wing
2 wings
1/2 pizzas
(120 60)
(60 120)
3 wings
1/3 pizzas
(72 24)
(24 72)

Comparative advantage
Debra: comparative advantage in pizza production
She gives up fewer wings than Mike.

Mike: comparative advantage in wing production

He gives up fewer pizzas than Debra.

Gains from Trade

Previously, we noted the gains from
trade and specialization.
Terms of trade
The relative prices, or exchange rate of
goods
How many wings per pizza?

Terms of Trade
Person

Opportunity Cost

Ratio

Debra Winger

1 pizza equals 2 wings

1:2 = 0.50

Terms of trade

19 pizzas for 47 wings

19:47 = 0.40

Mike Piazza

1 pizza equals 3 wings

1:3 = 0.33

Terms of Trade
As long as the terms of trade are between the
opportunity costs of the trading partners, the
trade benefits both sides.

Practice What You Know

We often think of specialization and trade
occurring between countries.
However, it can occur on much smaller
levels as well

Examples?
Within a home?
At a gathering of friends and/or family?

Trade-off Between Present

and Future
Consumer goods
Goods produced for current
consumption
Food, housing, clothing, entertainment

Capital goods
Goods that help produce other
valuable goods
Buildings, factories, roads, machinery,
computers

Investment
Using resources to make new capital

Capital Goods and Future

Growth

Capital Goods and Future

Growth

Visualizing Investment
Often, we are hesitant to invest in capital
goods today even if it results in larger
consumer good production tomorrow.
Current investment may
Take a long time
Have a large opportunity cost
Have uncertain results

Visualizing Investment
Suppose that instead of producing
pizza, we spent resources in order to
improve pizza-making technology.
What happens
Today?
Tomorrow?

Visualizing Investment
Investment in
Capital Goods

Time Period
1

No Investment

Visualizing Investment
Other examples of long-term investment

Conclusion
Economists use simplified models to understand
how the economy works.
The production possibilities frontier (PPF)
illustrates the benefits of trade and allows us to
describe ways to grow the economy.
When producers specialize, they focus their
efforts on those goods and services for which
they have the lowest opportunity cost and trade
with others who are good at making something
else.

Summary
Economists design and implement theories and
test those theories using data.
The economists lab is the world around us.
A good model should be simple to understand
and able to make accurate predictions.
Positive statements can be verified by examining
evidence.
Normative statements reflect values or what
people think should be.

Summary
Microeconomics is primarily concerned with the
decisions of households and businesses.
Macroeconomics looks at the broader economy.
The PPF illustrates trade-offs that exist in society.
Even when an absolute advantage exists, society
is still better off by specializing and trading based
on comparative advantage.
Societies face a trade-off between consumption in
the short run and greater productivity in the long
run.

Practice What You Know

What is a possible problem with using
faulty assumptions when building an
economic model?
A. The model could become too popular.
B. It could lead to wrong economic decisions.
C. It means we never have to rebuild the
model.
D. It could cause too much wealth.

Practice What You Know

In the PPF model, an efficient point is a
point that is
A. impossible to reach.
B. inside the PPF.
C. outside the PPF.
D. on the PPF.

Practice What You Know

If we move down and to the right along a
PPF, the opportunity cost of this
movement can be measured in terms of
A. how much of the x-axis good we gain.
B. how much of the y-axis good we gain.
C. how much of the x-axis good we give up.
D. How much of the y-axis good we give up.

Practice What You Know

Suppose there is high unemployment.
With respect to the PPF, what will
happen?
A. The PPF will shift inward.
B. The PPF will shift outward.
C. We will produce at a point inside the PPF.
D. We will produce at a point outside the
PPF.

Practice What You Know

What is the opportunity cost of producing
capital goods instead of consumer
goods?
A. We give up consumption today.
B. We give up consumption tomorrow.
C. We have less employment today.
D. We have a lower standard of living
tomorrow.