Economic models Production Possibility Frontier Comparative Advantages Production

Economic models Production Possibility Frontier Comparative Advantages

Production Possibility Frontier

Cast away (2000) – Limited resources on the island – Limited resources from the plane – Limited time – Limited effort

Production Possibility Frontier (PPF) – Resources are scarce people face trade-offs – PPF illustrates the trade-offs facing an economy that produces only TWO goods

Trade-off between production of fish and production of coconuts

Production Possibility Frontier (PPF) – If a production point lies inside the frontier, it is feasible but not efficient – If a production point lies on the frontier, it is feasible and efficient – If a production point lies outside the frontier, it is not feasible.

How PPF help us understand: – Efficiency – Opportunity cost – Economic growth

1) Efficiency – Recall from Unit 1 that an economy is efficient when there are no missed opportunities—there is no way to make some people better off without making other people worse off. – Here we are talking about no missed opportunities in production—there is no way to produce more of one good without producing less of other goods. – If an economy is producing at a point on the PPF, we say the economy is efficient in production

Efficiency in production is not enough Suppose Tom prefers point B to point A

Efficiency in production & allocation – Efficiency in production: produce as much of each good as it can given the production of other goods – Efficiency in allocation: produce the mix of goods that people want to consume

2) Opportunity cost – Recall that the true cost of any good is not just the amount of money it costs to buy, but everything else in addition to money that must be given up in order to get that good—the opportunity cost

Constant opportunity cost: 1 fish=3/4 coconut

Increasing opportunity cost

Increasing Opportunity Costs – Economists believe that in reality, opportunity costs are typically increasing. – As more of a good is produced, its opportunity cost typically arise because well-suited inputs are used up and less adaptable inputs must be used instead.

3)Economic Growth – Recall that economic growth is the growing ability of the economy to produce goods and services – Economic growth means an expansion of the economy's production possibilities: economy can produce more of everything

Growth is shown as an outward shift of the PPF

Two sources of economic growth – (1) increases in factors of production – (2) progress in technology

Factors of production --resources not used up in production – Land: resources supplied by nature – Labor: workers – Capital: “created: resources such as machines, factories, fishing net in Tom’s case – Human capital: educational and skillsets of the labor force

Technological growth – Crucial force behind economic growth – In Tom’s case, a technological invention such as a fishing hook or wagon for transporting coconuts would shift his PPF outward

Comparative Advantage

There are Gains from Trade – There are gains from trade even if one of the trading parties isn’t especially good at anything – Let’s suppose that on the island, another castaway, Hank, is washed ashore

Lessons from the model – (1): by agreeing to specialize and provide goods to each other, Tom and Hank can produce more and therefore both be better off than if they tried to be self-sufficient – (2) as long as people have different opportunity costs, everyone has a comparative advantage in something, and everyone has a comparative disadvantage in something

Absolute Advantage –

International trade – Politicians and the public often question the desirability of international trade, arguing that the government should protect US industries from foreign competition. – Viewing in terms of comparative advantage, economists, however, have a very positive view of international trade. – Look at the following hypothetical example:

True or false? Explain. a. An increase in the amount of resources available to Tom for use in producing coconuts and fish does not change his production possibility frontier.

True or false? Explain. b. A technological change that allows Tom to catch more fish for any amount of coconuts gathered results in a change in his production possibility frontier.

True or false? Explain. c. The production possibility frontier is useful because it illustrates how much of one good an economy must give up to get more of another good regardless of whether resources are being used efficiently.

In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the United States, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day. a. Which country has an absolute advantage in the production of automobiles? In washing machines? b. Which country has a comparative advantage in the production of washing machines? In automobiles? c. What pattern of specialization results in the greatest gains from trade between the two countries?

Positive vs Normative Economics Positive economics is the branch of economic analysis that describes the way the economy actually works (description). e. g. How much would that revenue increase if the toll were raised from $1 to $1. 50? Normative economics makes prescriptions about the way the economy should work (prescription). e. g. Should the toll be raised, bearing in mind that a toll increase will reduce traffic and air pollution near the road but will impose some financial hardship on frequent commuters?

– Economists do mostly positive economics, analysis of the way the world works, in which there are definite right and wrong answers and which involve making forecasts. But in normative economics, which makes prescriptions about how things ought to be, there are often no right answers and only value judgments.

Positive or Normative Statement? a. Society should take measures to prevent people from engaging in dangerous personal behavior.

Positive or Normative Statement? b. People who engage in dangerous personal behavior impose higher costs on society through higher medical costs.