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Modeling Trade Benefits with Production Possibilities
- 1. Model Building and Gains from Trade 2
- 2. Previously . . . • Economics is the study of how people allocate their limited resources to satisfy their nearly unlimited wants. • “Scarcity” refers to the limited nature of society’s resources. • Incentives are factors that motivate a person to act or exert effort.
- 3. 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?
- 4. Scientific Method in Economics • Similar to “hard sciences” – Construct a theory (or hypothesis) – Design experiments to test the theory – Collect data – Revise or refute the theory based on evidence • Difference from “hard sciences” – Economist’s lab is the world around us; firm and consumer behavior studied – Not always able to design experiments – Historical data often used
- 5. Positive and Normative Analysis • Positive statement – A claim that can be tested to be true or false • Normative statement – Statement of opinion; cannot be tested to be true or false – What “ought to be” or “should be” • Which is generally preferred? – Positive; like to test claims with data
- 6. Practice What You Know— Positive or Normative? 1. The moon is made of green cheese. 2. Rich people should be taxed more. 3. More taxes on the rich will increase tax revenues. 4. Everyone should donate to charity. 5. 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.
- 7. Economic Models • Economists use models to understand the complex real-world economy. • Models – Simplified versions of reality – Built with some assumptions – Are considered good if they
- 8. Economic Models • Ceteris paribus –Latin: “other things being equal” –Assumption in which we examine a change in one variable, but hold all other variables constant. –Allows us to isolate the effect of a single variable
- 9. Economic Analysis • Endogenous factors – Variables controlled for inside a model – Independent variables we freely change in the model equations to study their effect on the dependent variable • Exogenous factors – Variables that are not accounted for in a model – Outside our control
- 10. Models and Ceteris Paribus • What determines a person’s wage rate? = Female ConditionsPleasant Skills Experience Age Education fW
- 11. Models and Ceteris Paribus • Wage depends on the endogenous variables. • How will a change in the variables affect wage? • What might some exogenous variables be? = Female ConditionsPleasant Skills Experience Age Education fW Positive Effect Positive or Negative Effect? Positive Effect Positive Effect Negative Effect A Negative Effect here may be indicative of discrimination.
- 12. Models and Ceteris Paribus • Ceteris paribus analysis – Change just ONE of the dependent variables and examine how wage is affected. Assume other variables do not change. = Female ConditionsPleasant Skills Experience Age Education fW
- 13. Danger of Faulty Assumptions • It is necessary to often examine and re-evaluate the assumptions in models. • Example: – Assumption that housing prices always rise – Pre-2008 computer models used by banks didn’t have a variable for declining housing prices
- 14. 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
- 16. 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)
- 17. 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
- 18. 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. • Law of 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.
- 19. PPF and Opportunity Cost Nonlinear PPFs • Intuition of nonlinear PFFs – Inputs (resources) are not perfectly homogenous. – Some inputs are better at making pizza than other inputs. – As we expand pizza production, we’ll use the inputs that are the best (Italian chef, dough-tossing master). – If we keep expanding production, we’ll have to start using inputs that aren’t as good at making pizza. They’ll still be doing their best, but they won’t make as much pizza as other inputs. – Pizza production doesn’t expand at a linear rate!
- 20. PPF and Opportunity Cost
- 21. Shift in the PPF • If the PPF were to expand outward, some previously unattainable good combinations would now be possible to produce. • The PPF could shift graphically in two ways. – New resources or technology could be introduced that either • Affect the production of one good, or • Affect the production of both goods.
- 22. Shift in the PPF
- 23. Shift in the PPF
- 24. Practice What You Know— PPF Quiz • You will have 30 seconds each to answer a number of true/false questions. • Please join up with a partner.
- 25. Production Possibilities Quiz 1. (True/False) Point A represents the amounts of cars and bicycles that will be sold. Bicycles Cars A
- 26. Production Possibilities Quiz 2. (True/False) As you move from point F to point G, the price of bicycles increases. Bicycles Cars F G
- 27. 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 A C
- 28. Production Possibilities Quiz 4. (True/False) If we have high unemployment, then the curve shifts in. Bicycles Cars ?
- 29. Production Possibilities Quiz 5. (True/False) If an improved process for manufacturing cars is introduced, then the entire curve will shift out. Bicycles Cars ?
- 30. Practice What You Know— PPF Quiz Answers • We will ask each question again, and then reveal the answer.
- 31. Production Possibilities Quiz 1. (True/False) Point A represents the amounts of cars and bicycles that will be sold. Bicycles Cars A False. It represents how many cars and bicycles are produced!
- 32. Production Possibilities Quiz 2. (True/False) As you move from point F to point G, the price of bicycles increases. Bicycles Cars F G False. The number of bicycles produced increases.
- 33. 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. False. It represents the opportunity cost of producing more cars. Bicycles Cars A C + -
- 34. Production Possibilities Quiz 4. (True/False) If we have high unemployment, then the curve shifts in. Bicycles Cars ? 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.
- 35. Production Possibilities Quiz 5. (True/False) If an improved process for manufacturing cars is introduced, then the entire curve will shift out. Bicycles Cars ? False. The curve only moves out along the car axis. It is not possible to make more bicycles than before.
- 36. 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 now – Two goods (pizza and wings) – Two people with different abilities in the production of pizza and wings
- 37. Specialization and Trade • Absolute advantage – One person can perform each task more effectively than the other person. – Who has the absolute in pizza? In wings? Daily Production Person Pizzas Wings Debra Winger 60 120 Mike Piazza 24 72
- 39. Specialization and Trade • Without specialization and trade – Mike and Debra each have to produce their own wings and pizza; – Each person can only consume what they produce. Without Trade Person Good Production Consumption Debra Pizza 40 40 Wings 40 40 Mike Pizza 18 18 Wings 18 18
- 40. Specialization and Trade • 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. With Trade Gains from Trade Person Good Production Consumption Debra Pizza 60 41 (keeps) + 1 Wings 0 47 (from Mike) + 7 Mike Pizza 0 19 (from Debra) + 1 Wings 72 25 (keeps) + 7
- 41. Gains from Trade
- 42. Opportunity Cost Daily Production Person Pizzas Wings Debra Winger 60 120 Mike Piazza 24 72 Opportunity Cost Person 1 Pizza 1 Wing Debra Winger 2 wings (120 ÷ 60) 1/2 pizzas (60 ÷ 120) Mike Piazza 3 wings (72 ÷ 24) 1/3 pizzas (24 ÷ 72)
- 43. Opportunity Cost • 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. Opportunity Cost Person 1 Pizza 1 Wing Debra Winger 2 wings (120 ÷ 60) 1/2 pizzas (60 ÷ 120) Mike Piazza 3 wings (72 ÷ 24) 1/3 pizzas (24 ÷ 72)
- 44. 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?
- 45. Terms of Trade • Terms of Trade – As long as the terms of trade are between the opportunity costs of the trading partners, the trade benefits both sides. 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
- 46. 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?
- 47. Economics in Cast Away • Cast Away (2000) – Imagine a world in which there was no specialization and trade. – You would have to do everything by yourself.
- 48. 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
- 49. Capital Goods and Future Growth
- 50. Capital Goods and Future Growth
- 51. Capital Goods and Future Growth • Over the last 20 years, China and India have invested in more capital compared to the United States and Europe. • The result? – China is sacrificing today’s consumption for a better future. – China and India have higher growth rates. – Another trade-off: Chinese workers have less leisure time than American workers.
- 52. Visualizing Investment • Often, we are hesitant to invest in capital goods “today” even if it results in larger consumer good production “tomorrow.” • Today’s investment may • Take a long time • Have a large opportunity cost • May have uncertain results
- 53. Visualizing Investment • Suppose that instead of producing pizza, we spent resources in order to improve pizza-making technology. • What happens… –Today? –Tomorrow?
- 54. Visualizing Investment Investment in Capital Goods No InvestmentTime Period 1 2 3 4
- 55. Visualizing Investment • Other examples of long-term investment
- 56. 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.
- 57. Summary • Economists design and implement theories and test those theories by collecting real data. • The economist’s laboratory is the world around us. • A good model should be simple to understand and able to make powerful predictions. • Positive statements can be verified by examining evidence. • Normative statements reflect values or what people think “should” be.
- 58. Summary • Microeconomics is primarily concerned with the decisions of households and businesses. • Macroeconomics looks at the broader economy. • A PPF illustrates the 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.
- 59. 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.
- 60. Practice What You Know With regard to the PPF, an efficient point is a point that is A. impossible to reach. B. inside the PPF. C. outside the PPF. D. on the PPF.
- 61. 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.
- 62. 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.
- 63. 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.
Editor's Notes
- Lecture notes: Hard sciences: natural and physical sciences. Social sciences are sometimes called soft sciences. The point of the theory is to provide an explanation for reality. Picture: grocery store. Economists often collect data on real-world shopping habits to study consumer behavior. Which goods do we buy? Text provides a reference from the TV show MythBusters. From the text: On the television show, MythBusters, popular myths are put to the test by two well-known model-builders, Jamie Hyneman and Adam Savage. At the end of each episode, the myth is confirmed, labeled plausible, or busted. For instance, during a memorable episode Hyneman and Savage tried to determine whether you could swim as fast in syrup as you could in water. In order to test this myth, they built a special swimming tank and had Adam swim in water and then in syrup. After many trials, they determined that the myth was “busted.”
- Lecture notes: While positive economics is preferred since they can be tested with data, it is still many normative statements and opinions that are the basis for economic and political policy.
- Lecture notes: For this activity, you can have the students do something fun. For example, they can stomp their feet for positive and clap for normative. Or, they can bark like a dog for positive and meow like a cat for normative. I’m not sure why, but students seem to like making the animal noises, and some of them are pretty good at it. Positive (although clearly false!) Normative Positive; this statement can be tested. Normative Normative Normative. “Bad” is a broad and poorly defined term. This statement could be turned into a positive statement perhaps if we listed more specific markets, government interventions, and the change in other variables such as prices, quantities, or consumer surplus. Positive. We can look at salaries of graduates to see if this is true or false. It’s true. Normative. You can change Economics 101 to the course number that you teach.
- Lecture notes: Top Picture: Overhead view of road map A map is a good model. Looks nothing like real life, but it gets you from point A to B successfully. A toy train is a model too; we can look at it and know what it represents. Bottom Picture: A water molecule (H20) Once again, we see what the model represents, even though that is not what a real molecule looks like. Economic models are simplified like these models as well. Just because the models are simplified doesn’t mean the models are bad! Models are built with assumptions. Not all models will work in all conditions. We’ll see on the next slide that ceteris paribus means we assume some factors do not change. If a model predicts well, we can use it. If a model’s predictions are far off from real data, the model may be missing some important variables or information.
- From text: Using a controlled setting also allows us to experiment with different designs. By altering only a single element, we can test whether or not the change in design is advantageous. This process of examining a change in one variable while holding everything else constant is known as ceteris paribus, from the Latin meaning “other things being equal.” This idea is central to model building. If we change many variables simultaneously, and our model predicts better, we have no way of knowing which change is responsible for the improved performance. For this reason, engineers generally modify only one element at a time, test it, and then try different design approaches separately to see which is most successful.
- Lecture notes: To build an economic model we need to be mindful of two factors—what we include and the outside conditions that can affect our model’s performance. Factors that we know about and can control are endogenous factors. Factors beyond our control—outside the model—are known as exogenous factors. The model becomes more realistic as we add more variables. At the same time, the more variables we add, the harder the model will be to understand. For this reason, many models exclude variables, or exogenous factors, to be able to make clearer predictions. The catch is that the prediction might not be built on realistic assumptions.
- “Beyond the Book” Slide Lecture notes: Ask the students the following questions. Who gets paid more: Educated or uneducated? Skilled or unskilled labor? Worker right out of college or an older worker? New employee or “veteran” employee? A “safe” job or a “dangerous” job? –For this last question, mention the show Deadliest Catch. Even though some of the people on the show are young, relatively unskilled, and have no college degree, the Alaskan crab fishermen get paid a lot of money since the job is so dangerous. The equation above uses function notation. Read aloud, it says that “wage is a function of education, age, experience, skills, pleasant conditions, and gender.” Pleasant conditions means pleasant working conditions. Do you work in a nice air-conditioned office, or work in a dangerous coal mine?
- “Beyond the Book” Slide Lecture notes: This is an example of a model to predict the wage of a person. Age will probably have a direct effect on wages, but this may change if the person gets TOO old. Perhaps the worker will approach retirement age, start working part-time, or will not invest as much effort into his work anymore. In this case, ceteris paribus means we ask the following question. What happens if we change JUST ONE of the variables and hold the rest constant? How will wage be affected? Ceteris paribus analysis: pleasant job conditions have a negative effect on wage. Pleasant conditions could include summers off for academics, flexible job hours, part-time jobs rather than a demanding full-time job, etc. Full-time private-sector economists earn more wages than academic economists, partly due to the more pleasant job hours of academia. Exogenous variables may include labor demand and the state of the economy.
- “Beyond the Book” Slide Lecture notes: For example, suppose you increase your education: how much more would you expect to earn? How much more would you expect to earn if you learned a new skill? Everything else equal, does being a female mean smaller wages? If so, this may be a sign of discrimination in this particular labor market.
- Lecture notes: In every model, we make certain choices about which variables to include and how to model them. Ideally, we would like to include all the important variables inside the model and exclude all of the variables that should be ignored. This is like saying that a good cook includes the ingredients that make a dish taste better and excludes the ingredients that do not add any flavor. Unfortunately, modeling mistakes are often made and those errors can lead to spectacular policy failures. There is no better example than the Financial Crisis and Great Recession that began in 2008. Picture: Models just assumed that houses = money. Models assumed values of homes never dropped! In the years leading up to the crisis, banks sold and repackaged mortgage-backed securities under the faulty assumption that real estate prices would always rise. In fact, the computer models at most of the banks did not even have a variable for declining real estate prices. Investors around the globe bought these securities because they thought they were safe; after all, real estate prices were a sure thing. This sounds perfectly reasonable in a world where real estate prices rise on an annual basis. Unfortunately, that premise turned out to be false. From 2006–2008, real estate prices fell. Because of one faulty assumption, the entire financial market teetered on the edge of collapse. This is the danger of poor modeling.
- Lecture notes: The assumptions of the model help preserve ceteris paribus. Our two goods are pizzas and wings.
- Image: Animated Figure 2.1 Lecture notes: Let’s begin by imagining a society that produces only two goods—pizzas and wings. This may not seem very realistic, since the entire economy is comprised of millions of different goods and services, but the benefit of this approach is that it allows us to understand the trade-offs in the production process without making the analysis too complicated. The figure shows the production possibilities frontier for our two-product society. It is important to remember that the number of people and the total resources of this two-product society are fixed. If the economy uses all of its resources to produce pizzas, it can produce 100 pizzas and zero wings. If it uses all of its resources to produce wings, it can make 300 wings and zero pizzas. These outcomes can be found by locating points A and B on the production possibilities frontier. It is unlikely that the society will choose either of these extreme outcomes because it is human nature to enjoy variety. At any combination of wings and pizzas along the production possibilities frontier, the society is using all its resources to be productive. These points are considered efficient because society is producing the largest possible output from its resources. But what about point F, and all the other points located in the purple shaded region? These points represent an outcome inside the production possibilities frontier and are, therefore, inefficient. Whenever society is producing along the production possibilities frontier, the only way to get more of one good is to accept less of the other
- Lecture notes: Downward-sloping PPF illustrates opportunity costs of production. When we produce more wings, we have to give up some pizza. If we are on the PPF, we can’t JUST produce more wings since we are already using all our resources. If we want more wings, we must take away some resources currently devoted to pizza production. Inefficient points are attainable (we COULD produce at F), but undesirable in the sense that we would do better. F has us producing 40 pizzas and 70 wings. We could produce 40 pizzas and 270 wings. We’re not doing as well as we can. We say “unattainable (for now)” because point E may become attainable later on if we experience economic growth, which may increase resources or technology.
- Lecture notes: The production possibilities frontier reflects the increasing opportunity cost of production, known as the law of increasing relative cost. That is, as you move along the production possibilities frontier toward a greater quantity of one good, the costs of production increase relative to the costs of producing the other good. Changes in relative cost mean that society faces a significant trade-off if it tries to produce an extremely large amount of a single good.
- Lecture notes: Similarly, moving left to right, think about expanding wing production. We have to take some resources away from pizza, so we want to take away the resources with the lowest opportunity cost (so we give up the least amount of pizza). However, as we produce more and more wings, we have to take away better and better pizza-makers, so the opportunity cost is larger (slope of PPF gets steeper).
- Image: Animated Figure 2.2 Notes from text: Start at point C. This point means we are efficiently producing 50 pizzas and 250 wings. In order to produce 20 extra pizzas, society must move from point C (70 pizzas) to point B (90 pizzas). But moving from point C (250 wings) to point B (200 wings) means giving up 50 wings. Moving from C to B produces a “rise” of 20 pizzas over a ‘run” of -50 wings, this produces a slope of negative 0.4. The opportunity cost between points C and B (50 wings) is higher than it is between points D and C where society can produce 20 extra pizzas at a cost of only 30 wings.
- Image: Animated Figure 2.3 Lecture notes: Here, a new technology allows us to produce more pizzas, but our wing production capabilities are not changed. From the text: With the new technology, it becomes possible to produce 120 pizzas in the same amount of time that it previously took to produce 100 pizzas. However, the ability to produce wings has not changed—it remains the same as before. The result is that the production possibilities frontier expands outward from PPF1 to PPF2. If society had been operating at point C, the new pizza technology makes it possible for society to move to point G. Even though society is not any better at producing wings, the movement from C to G illustrates that society can now choose a new point along PPF2 where it is capable of producing more of both (80 pizzas and 210 wings). Improvements in technology make point G possible. Since the production of pizzas has become more efficient, society needs fewer resources to produce pizzas. This frees up resources to make more pizzas and also more wings.
- Image: Animated Figure 2.4 Lecture notes: Here, more resources allow to produce more of all goods. Additional resources could include more people, land, or natural resources. From the text: Because the additional resources make the production of more pizzas and wings possible at the same time, the curve moves from PPF1 to PPF2, expanding up along the y axis and out along the x axis. Like improvements in technology, additional resources expand the frontier and allow society to reach a point—in this case, H—that was not possible before.
- Lecture tips: Have students get into groups of two or three and discuss each question. Five slides of questions are presented, and the answers are all shown afterward.
- Lecture notes: We produced more cars. How many bicycles did we have to give up to do this?
- Lecture notes: The curve itself represents what we CAN produce. If we are at high levels of unemployment, then we are producing at a point inside the curve. However, the amount that we actually COULD produce doesn’t change!
- Lecture notes: Here, Debra and Mike can each make pizza and wings. It appears Debra is better than Mike at production of both goods. Can these two people still benefit from trade? Yes; gains from trade depend on comparative advantage, NOT absolute advantage.
- Image: Animated Figure 2.5 Lecture notes: Why a linear PPF for an individual? For society, the PPF was curved due to heterogeneity of inputs. This means that different inputs (capital and labor and resources) all have different abilities in production. Here, we are just looking at a single person and his/her ability to produce pizza or wings. Debra and Mike each face a constant trade-off between producing pizza and wings. For Debra, this means that her trade-off between producing pizza and wings is fixed at 1:2 (she produces 60 pizzas for every 120 wings). Mike’s trade-off between producing pizzas and wings is fixed at 1:3 (he produces 24 pizzas for every 72 wings). Since Debra and Mike can produce at any point along their production possibilities frontiers, it is helpful to assume that they initially enjoy both foods equally so they try to produce the same amount of each. When this is the case, Debra produces 40 pizzas and 40 wings, while Mike produces 18 pizzas and 18 wings. Since Debra is more productive in general, she produces more of each food. We say that Debra has an absolute advantage, meaning that she is as good, or better, than Mike at producing both items.
- Lecture notes: Since Debra and Mike can produce at any point along their production possibilities frontiers, it is helpful to assume that they initially enjoy both foods equally so they try to produce the same amount of each. When this is the case, Debra produces 40 pizzas and 40 wings while Mike produces 18 pizzas and 18 wings. Since Debra is more productive in general, she produces more of each food. We say that Debra has an absolute advantage, meaning that she is as good, or better, than Mike at producing both items. At first glance, it would appear that Debra should work alone. In economics, we generally assume that consumers enjoy variety. This is why Debra and Mike are each producing some of each good.
- Click through to show the table. Lecture notes: When Debra specializes and produces only pizza, her production is 60 units. In this case, her individual pizza output is greater than the combined production of 58 pizzas (Debra’s 40 + Mike’s 18). Similarly, if Mike specializes in wings, he is able to make 72 units. His individual wing output is greater than their combined output of 58 wings (Debra’s 40 + Mike’s 18). Specialization has resulted in the creation of two additional pizzas and 14 additional wings. But Debra and Mike would like to have both pizzas and wings. So if they specialize and then trade with each other, they will each benefit. If Debra gives Mike 19 pizzas in exchange for 47 wings, they are each better off by one pizza and 7 wings.
- Image: Animated Figure 2.6 Lecture notes: On each graph for each person, it is possible to produce (and consume) without trade at points A and B. By themselves with no trade, point B might be better than A since consumers generally prefer variety in consumption. However, with specialization and trade, any person can consume at point C on their graph. Point C is clearly better than point B, since point C has more of BOTH goods for each person. This graph shows the gains from trade. With trade, we are able to consume beyond what we would have been able to produce by ourselves. The numbers at point C come from the table in the previous slide.
- Lecture tip: Click through to show the bottom table. Lecture notes: Opportunity cost is what could have been produced instead. When Debra makes pizzas, she COULD HAVE made wings instead. We can use division to find the numerical quantities. In this bottom table, it is important to note that we are looking for a number AND a unit. When Debra makes a pizza, she gives up wings. Specifically, she gives up 2 wings for each pizza she makes. When she makes a wing, she gives up half a pizza. Note that these numbers (2 and ½) are reciprocals of each other. The same analysis can be done for Mike.
- Lecture notes: Note that with a simple two-person two-good model, one person will always have the comparative advantage in one good, and the other person will have the comparative advantage in the other good. This is true even if one person has the absolute advantage in both goods. Gains from trade can occur even if one person is absolutely better in production of both goods.
- Lecture notes: For terms of trade, we further need to ask the following: how are the terms of trade determined so trade can benefit both people?
- Lecture tip: Click to reveal the middle row of the table. Lecture notes: The terms of trade need to be made such that trade benefits both parties. Thus, with production from Mike and Debra, we need to find out how many wings each pizza is worth for both people. The terms of trade need to be set somewhere between these two boundaries. Detail from text: If Mike insists on a trading ratio of one wing for one pizza, which would be a good deal for him, Debra will refuse to trade because she will be better off producing both goods on her own. Likewise, if Debra insisted on receiving 4 wings for every pizza she gives to Mike, he would refuse to trade with her because he would be better off producing both goods on his own.
- Lecture tip: Ask the students the question. Lecture notes: Suppose there is a husband and wife in a house. What are some possible examples of specialization within a home? Husband mows lawn while wife goes grocery shopping. Husband cooks dinner for whole family, while wife runs errands. Children mow the lawn and clean the house. Husband cooks dinner and wife does dishes afterward. Examples of specialization at a family gathering: Everyone brings one type of food. Mike brings potatoes, Jon brings pie, Julie brings chicken. We all don’t bring a little bit of each food we want. Adults finish preparing the food while children set the table. Picture: Hey, you cook, and I’ll clean up afterward.
- Economics in the Media Lecture tip: The clip mentioned on the slide can be found in the Interactive Instructor’s Guide. Access the direct link by clicking the icon in the PowerPoint above.
- Image: Animated Figure 2.7.a Lecture notes: When a society chooses point A in the short-run, very little capital goods are created. Since capital goods are needed to enhance future growth, the long-run PPF expands, but only slightly.
- Image: Animated Figure 2.7.b Lecture notes: When a society chooses point B in the short-run, many capital goods are created. Since capital goods are needed to enhance future growth, the long-run PPF expands significantly. Thus, we see the trade-offs: we want to plan for our future to increase our standard of living, but we often do not want to give up today’s consumption. In addition, we still must produce at least some consumption goods during each time period. (We’ll always need food, housing, and clothing).
- Lecture tip: Beyond the scope of this course: Higher growth rates in India and China also are explained by the Solow growth model. The farther away from the steady state an economy is, the faster it moves toward that steady state. The model shows that less developed economies grow at a faster rate than developed economies.
- “Beyond the Book” Slide Lecture notes: Also, with time periods: Time periods are often vaguely defined; hence, the use of quotation marks. Some people with a very myopic (short-sighted) view of things may think investment isn’t worth it. Live for today, and let the future worry about problems later. Other people have an attitude about wanting to make the world a better place for their children. Investment can be frustrating since large projects often miss deadlines and go over budget.
- “Beyond the Book” Slide Lecture notes: Behavior economists and social psychologists have actually found that we generally are enormously impatient. We tend to place a much larger emphasis on today’s consumption and place a large discount on tomorrow’s consumption. “Tomorrow” is just defined as the next time period. It could be next year. Clearly, this is an intertemporal (across time) trade-off. If we spend effort making better pizza ovens today, we’ll have less pizza today. But tomorrow (and all times afterward), we’ll have more pizzas.
- “Beyond the Book” Slide Lecture notes: It’s a picture of a pizza oven. Investing in capital goods today has an opportunity cost of less consumption goods today. In time period 2, if we invest, we have less consumer goods. But if we invest, we have more consumer goods in time period 3, 4, 5, etc. Thus, it often is useful to look at things in the long term, rather than just the immediate time period.
- “Beyond the Book” Slide Lecture notes: Okay, so the pizza example may seem a bit trivial. What about big projects or really long-term time investments? Left picture: Wind farm. Expensive (big opportunity cost; could do something else with money) Take a long time to pay for themselves However, in the very long run, we get cheap, renewable, and clean energy. Right picture: Long term investment in human capital Human capital is your own set of skills and abilities. Going to college has a big monetary opportunity cost (direct expenses). There is also a big opportunity cost of time (takes 4 to 5 years of your time). However, in the long run, you may end up having more skills as a result of higher education, and you may become a more productive worker. This could land you a higher paying job.
- Clicker Question Correct answer: B If your model is based on bad assumptions, the results given may not have the desired real-world results you hoped for. Think about the block of text considering the financial crisis. The models didn’t even have a variable for falling home prices, assuming that the prices would NEVER fall. “Wrong” is a bit of a normative word here. You could also say that it could lead us to make different decisions than we otherwise would have made with the correct (or more accurate) information.
- Clicker Question Correct answer: D Efficient points are ON the PPF. Inefficient points are INSIDE the PPF. Points outside of the PPF are currently unattainable.
- Clicker Question Correct answer: D Why is C not correct? The PPF is downward-sloping. If we move down and to the right, we gain some x-axis goods, but at a cost of losing some y-axis goods. Why is A not correct? Because opportunity cost is what we give up, not what we gain.
- Clicker Question Correct answer: C Unemployment means we aren’t being fully efficient. It doesn’t decrease what we CAN produce.
- Clicker Question Correct answer: A We don’t “directly” consume capital goods. If we produce them, we don’t have as many consumable goods “today,” but we’ll have more tomorrow.