Model Building and Gains from Trade 2 Model Building and Gains from Trade

Previously . . . Economics - study of how people (and firms) allocate limited resources to satisfy nearly unlimited wants. “Scarcity” refers to the limited nature of society’s resources. Scarcity -> choices -> tradeoffs -> opportunity costs Incentives - factors that motivate a person to act or make choices/decisions

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 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.”

Economic Models The Scientific Method (Hubbard and O’Brien) Decide on assumptions to be used in developing the model Formulate a testable hypothesis Use economic data to test the hypothesis Revise the model if it fails to explain well the economic data Retain the revised model to help answer similar economic questions in the future

Scientific Method

Role of Assumptions Assumptions Robust Role of assumptions is to reduce the complexity of the problem to its key elements and, focus on the items that have the most significant impact (“80/20” rule) 80% of the impact is due to 20% of the factors Robust If relaxing the assumptions has minimal impact on your conclusions then the model is deemed “robust” and is largely unaffected by these testable or non-testable assumptions “robustness” is a desirable property

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 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.

Today’s Big Questions How do economists study the economy? An example of a choice model - PPF What is a production possibilities frontier? Models trade between people/countries Let’s us examine (and model) What are the benefits of specialization and trade? What is the trade-off between having more now and having more later?

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 predict accurately 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.

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 Lecture notes: The assumptions of the model help preserve ceteris paribus. Our two goods are pizzas and wings.

Production Possibilities Frontier 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

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

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 Slope = rise over run ∆y/∆x = (y2-y1)/(x2-x1)

Production Possibilities Frontier Linear PPF – Opp Costs are constant No Specialization of Labor (or any input) 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

Calculating the Slope of a Line Price of Novels 1 2 3 4 5 6 7 8 9 10 $11 Demand, D1 (21, $6) (13, $8) 6-8=-2 13 21-13=8 21 Quantity of novels purchased 5 15 10 25 20 30 To calculate the slope of the demand curve, we can look at the changes in the x- and y-coordinates as we move from the point (21 novels, $6) to the point (13 novels, $8). The slope of the line is the ratio of the change in the y-coordinate (–2) to the change in the x-coordinate (+8), which equals –1⁄4.

Tradeoffs – Calculating the Opportunity Costs The PPF above shows the various combinations of Widgets and Gizmos that your country’s economy can produce, given its current labor force, natural resources and technology.   If the economy is producing 0 widgets and wants to produce 45 widgets, what is the opportunity cost (in gizmos) of producing the first 45 widgets? What is the incremental (additional or marginal) cost (in gizmos) of going from 45 widgets to 75 widgets? 75 widgets to 92 widgets? 92 widgets to 100 widgets? Are the opportunity costs (of foregone gizmos) increasing, constant or decreasing as we produce 1 more widget in (a) – (c)? Why? (d above)

Opportunity Costs and the PPF - OC = slope of the PPF If the economy is producing 0 widgets and wants to produce 45 widgets, what is the opportunity cost (in gizmos) of producing the first 45 widgets? What is the incremental (additional or marginal) cost (in gizmos) of going from 45 widgets to 75 widgets? -10 G’s for + 30 W’s (-1/3) 75 widgets to 92 widgets? -10 G’s for +17 W’s (-10/17) 92 widgets to 100 widgets? -10 G’s for + 8W’s (-10/8) Are the opportunity costs (of foregone gizmos) increasing, constant or decreasing as we produce 1 more widget in (a) – (c)? Why? (d above)

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. 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.

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! 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).

PPF and Opportunity Cost 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.

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.

Shift in the PPF 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.

Shift in the PPF 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.

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.