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Unformatted text preview: CHAPTER 2 ECONOMIC MODELS: TRADE-OFFS AND TRADE 25 supermarket. in which many details were ignored (what are the customers buying? never mind). that could be used to answer a I‘what if" question: what if another cash register were opened? As the cash register story showed. it is often possible to describe and analyze a use- ful economic model in plain English. However. because much of economics involves changes in quantities—in the price of a product. the number of units produced, or the number of workers employed in its production—economists often find that using some mathematics helps clarify an issue. In particular. a numerical example. a simple equa- tion, or—especially—a graph can be key to understanding an economic concept. Whatever form it takes. a good economic model can be a tremendous aid to under- standing. The best way to grasp this point is to consider some simple but important economic models and what they tell us. First, we will look at the production possibility fi'ontier. a model that helps economists think about the trade-offs every economy faces. Then we will turn to comparative advantage. a model that clarifies the principle of gains from trade—trade both between individuals and between countries. In addition, we'll examine the circular-flow diagram. a schematic representation that helps us under- stand how flows of money. goods. and services are channeled through the economy. In discussing these models, we make considerable use of graphs to represent math- ematical relationships. Such graphs will play an important role throughout this book. If you are already familiar with the use of graphs, the material that follows should not present any problem. If you are not. this would be a good time to turn to the appendix of this chapter. which provides a brief introduction to the use of graphs in economics. Trade-offs: The Production Possibility Frontier The hit movie Cast Away. starring Tom Hanks. was an update of the classic story of Robinson Crusoe. the hero of Daniel Defoe’s eighteenth-century novel. Hanks played the sole survivor of a plane crash. stranded on a remote island. As in the original story of Robinson Crusoe. the character played by Hanks had limited resources: the natu- ral resources of the island. a few items he managed to salvage from the plane. and, of course, his own time and effort. With only these resources, he had to make a life. In effect, he became a one-man economy. The first principle of economics we introduced in Chapter 1 was that resources are scarce and that. as a result. any economy—whether it contains one person or millions of people—faces trade-offs. For example, if a castaway devotes resources to catching fish. he cannot use those same resources to gather coconuts. To think about the trade-offs that face any economy. economists often use the model known as the production possibility frontier. The idea behind this model is to improve our understanding of trade-offs by considering a sim- plified economy that produces only two goods. This simplification enables us to show the trade-off graphically. Figure 2-1 on the next page shows a hypothetical production possibility frontier for Tom, a castaway alone on an island, who must make a trade-off between production of fish and production of coconuts. The frontier—the line in the diagram—shows the maximum quantity of fish Tom can catch during a week given the quantity of coconuts he gathers. and vice versa. That is. it answers questions of the form. I‘W’hat is the maximum quantity of fish Tom can catch if he also gathers 9 (or ‘15. or 30) coconuts?" There is a crucial distinction between points inside or on the production possibility frontier (the shaded area) and outside the frontier. [f a production point lies inside or on the frontier—like point C, at which Torn catches 20 fish and gathers 9 coconuts—it is feasible. After all. the frontier tells us that if Tom catches 20 fish. he could also gather a maximum of ‘15 coconuts. so he could The production possibility frontier illus- trates the trade-offs facing an economy that produces only two goods. It showrs the maximum quantity of one good that can be produced lor any given quantity produced of the other. What to do? Even a castaway faces traderffs. s: P e a z a; c E. k E. '1‘ s; E i ‘L. '5 S c d 9; n. q E a E x E: s F ...
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