chapter 2 economic models: trade-offs and trade

CHAPTER 2Economic Models:

Trade-offs and Trade

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What you will learn in this chapter:1. Why models play a crucial role in economics?2. Production possibility frontier (PPF)3. Comparative advantage4. Circular-flow diagram

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1. Models in EconomicsA 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.

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2. Trade-offs: The Production Possibility Frontier

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Increasing Opportunity Cost

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Economic GrowthEconomic 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).

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

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

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Tom and Hank’s Opportunity Costs of Fish and Coconuts

Tom’s Opportunity Cost

Hank’s Opportunity Cost

One fish 3/4 coconut 2 coconuts

One coconut

4/3 fish 1/2 fish

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

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Comparative Advantage and Gains from TradeEx.: Tom and Hank

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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.

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Comparative vs. Absolute AdvantageAn individual has a comparative advantage in producing a good or service if the opportunity cost of producing the good is lower for that individual thanfor 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.

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3. PITFALLS: Misunderstanding Comparative AdvantageA common mistake is to confuse comparative advantage with absolute advantage.

Ex.: U.S. vs. Japan in 1980sCommentators: “U.S. might soon have no comparative advantage in anything”

Wrong! They meant “absolute advantage”

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4. Transactions: The Circular-Flow DiagramTrade 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.

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The Circular-Flow Diagram

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Growth in the U.S. Economy from 1962…

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…to 1988

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Summary1. 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

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The End of Chapter 2

coming attraction:Chapter 3:

Supply and Demand