Chapter 2 - Economics

SLIDES BY SOLINA LINDAHL
2 Economic Models:
CHAPT
Tr a d e - o f f s a n d Tr a d e
ER
FOOD FOR THOUGHT….
SOME GOOD BLOGS AND OTHER SITES TO GET THE JUICES FLOWING:
C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S
What you will learn
in this chapter
 Why models play a crucial role in economics

 Two simple but important models: the production possibility
frontier and comparative advantage
 The circular-flow diagram, a schematic representation of the
economy
 The difference between positive economics and normative
economics
 When economists agree and why they sometimes disagree
To First To Video
Active Learning
MODELS IN ECONOMICS
Model: a simplified representation of a real situation
that is used to better understand real-life situations.
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“OTHER THINGS EQUAL”
Other things equal assumption: all other relevant
factors remain unchanged.
We try to treat economics as

close to a laboratory science as
possible—with only one variable
allowed to change at a time.
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THE PRODUCTION POSSIBILITIES FRONTIER
The PPF is
a diagram
that shows the
combinations of
two goods that are possible
for a society
to produce at full Back to
C O P Y R I G employment.
H T 2 0 1 5 W O R T H P U B L I S H E R S
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TRADE-OFFS: THE PPF
We can use the PPF model to answer questions like:
How much can we produce?

What will it cost us to change our mix of
production?
Does it make sense to import the good from
somewhere else?
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TRADE-OFFS: THE PPF
All points under the curve are feasible (but not efficient)…
Quantity of
Dreamliners
And all points above the curve are not feasible.
All points on the curve are feasible and efficient.
The PPF line D
30
Production Possibilities
Dreamliners Small Jets

30 0
15 20
A 9 28
15 0 40
B
9
C
20 28 40
Quantity of Small Jets
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OPPORTUNITY COST
Opportunity Cost: what must be given up in order
to get a good.
Dreamliners Small Jets
30 0
15 20
9 28
0 40
EACH SMALL JET HAS AN

OPPORTUNITY COST OF ¾ OF A
DREAMLINER. Back to
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LEARN BY DOING: PRACTICE QUESTION
Suppose you are stranded on an island. Luckily, this
island is rich in clams and mangos. If you devote all
of your time to harvesting clams, you can get 100
clams in a week. If you us all of your time to collect
mangos, you can find 200 mangos in a week.
Assume it is possible to collect fractional amounts of
both goods and draw a sketch of your production
possibility frontier for a week. (Place mangos on the
x-axis and clams on the y-axis.)
Calculate the opportunity cost of each good.
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What is the opportunity cost of each lamp?

a) ¼ of a sofa
b) 1 sofa
c) 4 sofas
d) 200 sofas
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contents
With a partner, create your production possibilities
curve for the following two activities: (a) drawing
happy faces and (b) drawing elephants:
1. Take turns timing each other for 30 seconds and
recording the following:
The maximum number of happy faces drawn
The maximum number of elephants drawn
2. Now construct your PPF with elephants on the
vertical axis and faces on the horizontal axis.
3. Calculate your opportunity cost for each good.
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INCREASING OPPORTUNITY COST
Quantity of
Dreamliners
Producing the first …requires giving up
35 20 small jets . . . 5 Dreamliners
30 But producing
20 more small jets . . .
A
25
20
…requires giving up
15 25 more Dreamliners…
10
5
PPF
0 10 20 30 40 50 Quantity of small jets
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ECONOMIC GROWTH
Quantity of
Dreamliners
THE ECONOMY CAN NOW
35 PRODUCE MORE OF
E EVERYTHING.
30
A
25
20
15
10
5 Original New
PPF PPF
0 10 20 25 30 40 50 Quantity of small jets

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If you invent a clam rake that doubles your clam
production, what happens to your opportunity
cost?
Graph the effect of your new invention on the
original PPF.
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contents
WHAT CAUSES ECONOMIC GROWTH?
Two possibilities:
1. An increase in factors of production: resources
used to produce goods and services.
2. Better technology: the technical means for
producing goods and services.
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FACTORS OF PRODUCTION
1. Land includes natural resources, such as
mineral deposits, oil, natural gas, water, and
actual land acreage.
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2. Labor is the mental and physical

abilities of the workforce.
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3. Physical capital is manufactured items used to
produce other goods and services.
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ECONOMIC RESOURCES
4. Human capital is the educational achievements

and skills of the labor force (which increase labor
productivity).
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LEARN BY DOING: APPLICATION VIDEO
Check out how containerization shaped the modern
world. Click here or on the picture below. Consider
how the world’s PPF changed. (5 minutes)
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COMPARATIVE ADVANTAGE AND GAINS
FROM TRADE
Theory of Comparative Advantage:

It makes sense to produce the things you’re
especially good at producing… and buy everything
else from others.
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ORIGIN OF THE IDEA
David Ricardo (1772–1823)
Argued against Corn Laws in British Parliament.
Corn Laws: high tariffs on
imported grain that protected
British landowners.
His theory of comparative
advantage is still the ideological
foundation for free trade.
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FROM TRADE
Suppose that there are just two goods, computers
and shirts, and one input, labor.
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COMPARATIVE ADVANTAGE AND
GAINS FROM TRADE
Assume that in Mexico, it takes 12 units of labor to make
one computer and 2 units of labor to produce one shirt
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GAINS FROM TRADE
Suppose that Mexico has 24 units of labor. It can
produce 2 computers and 0 shirts…
or 0 computers and 12 shirts
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GAINS FROM TRADE
The PPF is about trade-offs.
If Mexico wants to produce more shirts, it must produce
fewer computers.
Each computer “costs” 12 workers,
who could produce 6 shirts.
So a computer “costs” 6 shirts in Mexico.
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GAINS FROM TRADE
AND…
Each shirt “costs” 2 workers,
who could produce one-sixth of a computer.
So a shirt “costs” one-sixth of a computer in Mexico.
1/6
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GAINS FROM TRADE
Computers Mexico’s Production Possibilities Frontier
6
Computers Shirts
5 The PPF
2 0
1 6
4 0 12
3
The slope = the trade-off (“cost”) of
2
one good for the other. (One-sixth
of a computer = 1 shirt: 1 shirt
“costs” 6 computers.)
1
2 4 6 8 10 12 Shirts
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Erin has a choice between two activities: She can

repair one transmission per hour or she can repair
two fuel injectors per hour. What is the
opportunity cost of repairing one fuel injector?
a) 1 transmission
b) 0.5 transmission
c) 2 transmissions
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contents
Deirdre can write either one more book this

year or five more articles this year. What is
the opportunity cost of writing half of a
book this year, in terms of articles?
a) 0.2 article
b) 1 article
c) 2.5 articles
d) 10 articles
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contents
FROM TRADE
Enter the U.S. with its own production and cost
ratios.
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GAINS FROM TRADE
Assume that in the United States, there are 24 units of
labor, and it takes 1 unit of labor to produce either good.
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GAINS FROM TRADE
Each shirt “costs” 1 worker,
who could produce 1 computer.
So a shirt “costs” 1 computer in the United States.
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FROM TRADE
Summary of costs: each country has a different opportunity cost
for each good.
Take a look at the opportunity costs for computers:
Would there be a benefit to trade?

If so, who should produce what? Back to
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FROM TRADE
A country has a comparative advantage in producing
goods for which it has the lowest opportunity cost.
The U.S. has the comparative advantage in (is the lower-

cost producer of) computers: Each computer costs 1 shirt.
(Mexico = 6 shirts.)
Mexico has the comparative advantage in (is the lower-

cost producer of) shirts: Each shirt costs one-sixth of a
computer. (United States = 1 computer.)
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FROM TRADE (a) U.S. Production Possibilities (b) Brazilian Production Possibilities
Quantity of Quantity of
large jets large jets
30 U.S. consumption
without trade
Brazilian consumption
18 without trade
10
8
U.S. Brazilian
PPF PPF
0 16 40 0 6 30
Quantity of small jets Quantity of small jets
Since each country has a different opportunity cost, it makes sense to

specialize and trade… Back to
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FROM TRADE
(a) U.S. Production Possibilities (b) Brazilian Production Possibilities
large jets If the U.S. specializes in large jets
And Brazil specializes
large jets… in small jets…
30 U.S. consumption
without trade
Brazilian consumption
18 without trade
10
8
U.S. Brazilian
PPF PPF
0 16 40 0 6 30
More airplanes will be produced with the same resources (up from 26
(18 + 8) to 30 large jets and up from 22 (16+6) to 30 small jets).
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FROM TRADE Both countries gain.
Quantity of Then the U.S. will send Quantity of

And Brazil will send some
large jets some large jets to Brazil in large jets small jets to the U.S. in
return for small jets… return for large jets…
30 U.S. consumption
without trade
U.S. consumption
with trade
20 Both are happy with 1 Brazilian consumption
18 without trade
large jet trading for 2
small jets. 10 Brazilian consumption
8 with trade
U.S. Brazilian
PPF PPF
0 16 20 40 0 6 10 30
Both countries will be happy to export their goods for any price
ABOVE their cost of production and import for any price BELOW
their cost of production.
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COMPARATIVE ADVANTAGE VS.
ABSOLUTE ADVANTAGE
Absolute advantage: a country can produce more output per worker
than other countries.
large jets large jets
30 U.S. has the absolute

advantage in BOTH
large and small jets.
10
U.S. Brazilian
PPF PPF
0 40 0 30
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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 it is for the United States, the United States
will want to import small jets from Brazil.
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COPYRIGHT 2015 WORTH PUBLISHERS
If Texia specializes in food, it can produce 1,000 units of food
and 0 units of clothing this year. If it specializes in clothing,
it can produce 500 units of clothing and 0 units of food. This
year Urbania can produce either 500 units of food and 0
units of clothing or 200 units of clothing and 0 units of food.
(assume linear production possibility frontiers)
_______has the absolute advantage in the production of
clothing and ________has the absolute advantage in the
production of food.
a) Texia; Texia
b) Texia; Urbania
c) Urbania; Texia
d) Urbania; Urbania
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contents
If Texia specializes in food, it can produce 1,000 units of food
and 0 units of clothing this year. If it specializes in clothing, it
can produce 500 units of clothing and 0 units of food. This
year Urbania can produce either 500 units of food and 0 units
of clothing or 200 units of clothing and 0 units of food.
(assume linear production possibility frontiers)
_______has the comparative advantage in the production of
clothing and ________has the comparative advantage in the
production of food.
a) Texia; Texia
b) Texia; Urbania
c) Urbania; Texia
d) Urbania; Urbania
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contents
If a country specializes according to its own
comparative advantage and then trades with other
nations:
a) it will operate at a point inside its production
possibilities frontier.
b) it can consume at a higher level than the
domestic production possibilities frontier.
c) its production possibilities frontier will shift or
rotate inward.
d) it can consume at the same level as the
domestic production possibilities frontier.
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Write down, then discuss with a partner:
What do you think? Would the U.S.

economy be better off if we did not import
so much clothing from China?
List the groups who you think would gain

and the groups who would lose if Chinese
clothing imports were restricted.
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contents
Suppose that in Australia, it takes 2 hours to harvest 10
bushels of apples and 4 hours to harvest 10 bushels of
tomatoes. Suppose a worker in Brazil can harvest 10 bushels
of apples in 4 hours or 10 bushels of tomatoes in 5 hours.
Which of these statements is TRUE?
a) Brazil has a comparative advantage in producing
tomatoes.
b) Brazil has a comparative advantage in producing
apples.
c) Brazil has an absolute advantage in producing both
goods.
d) In trade between these two countries, Australia would
gain and Brazil would lose.
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contents
TRANSACTIONS: THE CIRCULAR-FLOW
DIAGRAM
Production and trade in an economy can be represented by the
circular-flow diagram:
Money Money
Goods
and Factors
services
Trade in physical …and the money

things such as that pays for
goods, services, these physical
labor, and raw things flows in
materials flows in the opposite
one direction… direction.
Goods and services

Factors
Money Money Back to

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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
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An increase in household spending

leads to an increase in jobs in the
economy.
a) True
b) False
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USING MODELS: POSITIVE VERSUS
NORMATIVE ECONOMICS
Positive economics is the branch of economic
analysis that describes the way the economy actually
works.
Normative economics makes prescriptions about

the way the economy should work.
Positive economics is about description; normative

economics is about prescription.
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Label each of the following statements as normative (a)
or positive (b):
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
the whole society.
5. Single mothers are more than twice as likely as
married mothers to be in poverty.
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contents
Label each of the following statements as normative (a)
or positive (b):
1. More than 60% of women are in the labor market.
POSITIVE
2. Rent control laws should be implemented because
they help to achieve equity or fairness in housing.
NORMATIVE
3. Society should take measures to end gun violence.
NORMATIVE
4. People who smoke pass on increased medical costs to
the whole society. POSITIVE
5. Single mothers are more than twice as likely as
married mothers to be in poverty. POSITIVE Back to
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contents
USING MODELS: WHEN AND WHY
ECONOMISTS DISAGREE
Media coverage tends to exaggerate the real differences
in views among economists.
Economics is often tied up in politics.
Powerful interest groups find and promote economists who
profess supportive opinions.
Economic modeling requires simplifying assumptions.
Two economists can legitimately disagree about which
simplifications are appropriate.
In most cases such disputes are eventually resolved.
But it can take a long time before research settles important
disputes.
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SLIDES BY SOLINA LINDAHL

 Why models play a crucial role in economics

We try to treat economics as

How much can we produce?

The PPF line D

Dreamliners Small Jets

EACH SMALL JET HAS AN

What is the opportunity cost of each lamp?

0 10 20 30 40 50 Quantity of small jets

0 10 20 25 30 40 50 Quantity of small jets

2. Labor is the mental and physical

4. Human capital is the educational achievements

Theory of Comparative Advantage:

Erin has a choice between two activities: She can

Deirdre can write either one more book this

Would there be a benefit to trade?

The U.S. has the comparative advantage in (is the lower-

Mexico has the comparative advantage in (is the lower-

Since each country has a different opportunity cost, it makes sense to

Quantity of Then the U.S. will send Quantity of

30 U.S. has the absolute

Write down, then discuss with a partner:

What do you think? Would the U.S.

List the groups who you think would gain

Trade in physical …and the money

Goods and services

Money Money Back to

With a partner, trace the following events

An increase in household spending

Normative economics makes prescriptions about

Positive economics is about description; normative

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