Chapter 2

Models What is a model? Models: Simplified representation of reality to help us study and understand reality. Reality is too complicated mesh of cause and effect interactions!

Other Things Equal A simplified model of reality lets us focus on one cause and effect at a time. Other Things Equal Assumption: Assume that all other relevant factors remain unchanged. Mentioning “Ceteris Paribus”, the Latin word for “other things equal” might be interesting for some students.

Some Components of a Model Assumptions (how we simplify) Mathematical Equations Price = 100 – 5*Quantity Variables (can take on multiple values) Graphs Ask students what life would be like if we had infinite resources, including infinite time.

Three Models to Start With Production Possibilities Frontier Comparative Advantage The Circular-Flow Model

1. PPF- Production Possibility Frontier Production Possibility Frontier- the model we use for analyzing the economic consequences of scarcity and the working market system. Definition- Curve showing the maximum attainable combinations of 2 products that may be produced with available resources and current technologies. Analyzes trade-offs and opportunity costs that individuals, firms, or countries face. Setup: Scarcity, Two Goods, Graph/Table

Main Ideas of PPF Increasing marginal costs A convex or “bowed out” PPF illustrates increasing marginal costs. Increasing marginal costs occur because some workers, machines, and other resources are better suited to one use than the other. The more resources already devoted to any activity, the smaller the payoff to devoting additional resources to that activity. How do we know if it’s linear or non-linear: The opportunity cost, slope or rate of change between two points is not constant. This is how you can tell whether the PPF is curved or not. You must be careful of this. If you assume that a curve is linear, and it is not, then you could get a question wrong.

Increasing Marginal Opportunity Cost The opportunity cost is increasing as you produce more and more of a particular good, the opportunity cost in terms of the other good increases at an increasing rate. i.e. If Tom starts by producing 40 Fish and 0 Coconuts, but then decides to produce 15 Coconuts, he must give up only 5 Fish. However, if he wants to produce 15 MORE Coconuts, he must then give up a whopping 35 Fish.

Example 6 The # of hours you have already spent studying economics, the smaller the increase in your test grade for each additional hour (and the greater the opportunity cost of using the hour in that way) Choice Hours spend studying Midterm Score A 75 B 1 81 C 2 86 D 3 90 E 4 93 F 5 95

PPF Continued What We Can Learn and Demonstrate Opportunity Costs, Trade-Offs (most valuable forgone alternative) Efficiency, Growth, Technology Comparative Advantage and Absolute Advantage

1.1 Tradeoffs a. Any point on the graph represents that tradeoff. Which of the following best represents the tradeoff faced by BMW between producing SUVs and producing roadsters? a. Any point on the graph represents that tradeoff. b. Tradeoff B and C c. Tradeoff F and G d. Tradeoff C and G

Which of the following best represents the tradeoff faced by BMW between producing SUVs and producing roadsters? a. Any point on the graph represents that tradeoff. b. Tradeoff B and C c. Tradeoff F and G d. Tradeoff C and G

1.2 Economic Growth Economic growth is represented by shifts in the PPF. At any given point in time the resources in an economy are fixed. But over time the resources may increase (population, technology). Shifts show how economic growth can lead to more production in goods and services which raises the standard of living. Growth may lead to greater increases in production for one good than another.

Economic Growth: The ability of the economy to produce increasing quantities of goods and services. What factors might influence economic growth? What could cause production in all industries to rise simultaneously? Be sure to know that when we talk about Economic Growth we are usually talking about the ability of the economy to produce more of everything. Graphically with the PPF this means that the entire curve shifts to the right and that both the X & Y intercepts increase. The Solow growth model that students learn about later relies on technology for increases in productivity which is the leading causal factor in economic growth. PRODUCTIVITY IS THE STANDARD!!!!

Example 1- Seats R US (Production choice of car seats and sofas) Assumptions Hypothesis Use economic data to test hypothesis. Seats R US Production Choices Choice Quantity of Car Seats Quantity of Sofas A 80 B 60 10 C 40 20 D 30 E

Example 2: Brady’s Sports Emporium Assumptions: Brady can produce 3 footballs or 2 bats per hour. He only has 5 hours to work Hours spent producing goods Quantity of goods made Choice Footballs Bats A 5 15 B 4 1 12 2 C 3 9 D 6 E 8 F 10

Example 3: Small Spa Inc. Assumptions: There is one room for services. Each hour the room can be used to give 1 massage or 2 facials. The spa is only open for 3 hours a day. Hours of Service Quantity of Services Choice Massage Facials A 3 B 2 1 C 4 D 6 The opportunity cost, slope or rate of change between two points is not constant. This is how you can tell whether the PPF is curved or not. You must be careful of this. If you assume that a curve is linear, and it is not, then you could get a question wrong.

Example 4 Quantity of Guns Quantity of Grenades 200 175 100 250

1.3 Comparative Advantage (in International Trade) Comparative advantage The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. Absolute advantage The ability to produce more of a good or service than competitors when using the same amount of resources. Note: The basis for trade is comparative advantage not absolute advantage.

Example 5: Tiger Woods Should Tiger Woods mow his own lawn? Woods can mow his lawn for 2 hours. In the same time, he could be filming commercials for Nike and earn $1 million. OR Forrest Gump can mow the lawn in 4 hours or could McDonald’s and earn $20. Let’s compare opportunity costs.

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How Countries Gain from International Trade Why Don’t We See Complete Specialization? Not all goods and services are traded internationally. Production of most goods involves increasing opportunity costs. Tastes for products differ. Does Anyone Lose as a Result of International Trade? Don’t Let This Happen to YOU! Remember That Trade Creates Both Winners and Losers

3. The Circular Flow Model: The Market System The Circular Flow of Income The Circular-Flow Diagram

The Market System Factors of production are divided into four broad categories: Labor includes all types of work, from the part-time labor of teenagers working at McDonald’s to the work of top managers in large corporations. Capital refers to physical capital, such as computers and machine tools, that is used to produce other goods. Natural resources include land, water, oil, iron ore, and other raw materials (or “gifts of nature”) that are used in producing goods. An entrepreneur is someone who operates a business. Entrepreneurial ability is the ability to bring together the other factors of production to successfully produce and sell goods and services. WRITE EXAMPLE FROM NOTES ON BOARD!

The Market System The Market Mechanism Individuals usually act in a rational, self- interested way. Adam Smith understood that people’s motives can be complex. In a famous phrase, Smith said that firms would be led by the “invisible hand” of the market to provide consumers with what they wanted.

A Story of the Market System in Action: How Do You Make an iPod? Making the Connection A Story of the Market System in Action: How Do You Make an iPod? The market coordinates the activities of the many people spread around the world who contribute to the making of an iPod. Your book looks at RedBull

The Market System The Legal Basis of a Successful Market System Protection of Private Property Property rights The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it. Enforcement of Contracts and Property Rights If property rights are not well enforced, fewer goods and services will be produced. This reduces economic efficiency, leaving the economy inside its production possibilities frontier.