Ch. 2 - Simple Models and Production Possibilities We look...

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Unformatted text preview: Simple Models and Production Possibilities We look for the answers to these questions: (Material in Mankiw Ch. 2) What are models? How do economists use models? What is the difference between positive and normative statements? New Syllabus on Aplia with TA Hours Email TA before meeting them What are the elements of the ‘Circular-Flow Diagram’ (found in Mankiw)? What concepts does this diagram illustrate? How is the Production Possibilities Frontier related to opportunity cost? What other concepts does it illustrate? The Economist as a Social Scientist Methodology: • Observe • Construct theories to explain the world • Test theories using data and statistical techniques Experimentation is difficult: • Markets are complicated • Controlled experiments can be infeasible and/or • unethical Search for “natural” experiments The Economist as Policy Advisor As observational scientists, economists make positive statements, as policy advisors economists sometimes also make normative statements. A positive statement is a claim that attempts to describe how the world is. A normative statement is a statement which attempt to prescribe how the world should be. Positive statements can be confirmed or refuted (tested), normative statements can not. normative statement is a PREscription can't refute or confirm them use the word "ought" positive statement is a DEscription Assumptions & Models The Circular-Flow Diagram Households: own the factors of production, sell/rent them to firms for income buy and consume goods & services Assumptions simplify the complex world, make it easier to understand. Example: When studying international trade, we might assume the world consists of two countries and two goods. Very unrealistic, but simplifies the problem and yields useful insights about the more complicated real world. Firms Depicts some key ingredients in some economic models. 1. Populate with people. 2. Firms - entities that produce things Economists use models to study economic issues. A model is a highly simplified representation of a more complicated reality. Models are essentially a collection of assumptions. Choose assumptions that simplify complicated things. All models are "inaccurate" because they are "incomplete", except for real world. When scrutinizing a model see which assumption is critical to the results of the model. Then you analyze how realistic the assumption is. The Circular-Flow Diagram Households when you see capital - think machinery red arrows - represent outflows green arrows - represent flows of payment The Circular-Flow Diagram Revenue G&S sold Firms Firms: buy/hire factors of production, use them to produce goods and services sell goods & services Households Markets for Goods & Services Firms Factors of production Wages, rent, profit Spending G&S bought Households Markets for Factors of Production Labor, land, capital Income No government, no inflation, no unemployment, no taxes, no money, no economic beliefs, etc. Second Model: The Production Possibilities Frontier The Production Possibilities Frontier (PPF): PPF Example Producing one computer requires 100 hours labor. Producing one ton of wheat requires 10 hours labor. A graph that shows the combinations of outputs the economy is capable of producing given the available factors of production and the available technology. Employment of labor hours Production • Two goods: computers and wheat • One resource: labor (measured in hours) • Economy has 50,000 labor hours per month available for production. Need endowment of the factor of production, in this case, labor (50K) Need description of the technology Table helps you plot the PPF plot, begin with intercepts (max output in 1 sector) Point on Comgraph puters Wheat A 500 0 B 400 1,000 C 250 2,500 D 100 4,000 E 0 5,000 E G D 4,000 3,000 F 2,000 C A 0 0 100 200 300 400 500 600 Computers Linear PPF, we can know because there is constant technology (rate of labor for product 50,000 0 500 0 B 40,000 10,000 400 1,000 C 25,000 25,000 250 2,500 D 10,000 40,000 100 4,000 E 0 50,000 0 5,000 (e.g., workers unemployed, factories idle) B 1,000 Wheat Points on the PPF (like A – E) • possible • efficient: all resources are fully utilized Points under the PPF (like F) • possible • not efficient: some resources underutilized Wheat (tons) 6,000 5,000 Computers The PPF: What We Know So Far PPF Example Production Wheat A Example: Computers Points above the PPF (like G) • not possible efficiency - getting the most out of your scarce resources The PPF and Opportunity Cost The PPF and Opportunity Cost Recall: The opportunity cost of an item Moving along a PPF involves shifting resources (e.g., Wheat (tons) 6,000 labor) from the production of one good to the other. 5,000 Society faces a tradeoff: Getting more of one good The slope of a line equals the “rise over the run” – the amount the line rises when you move to the right by one unit. 4,000 is what must be given up to obtain that item. requires sacrificing some of the other. slope = –1000 = –10 100 3,000 In particular, 2,000 computers Slope of PPF = wheat Here, the opportunity cost of a computer is 10 tons of wheat. 1,000 0 opportunity cost 0 100 200 300 400 500 600 Computers Example: PPF and Opportunity Cost Example: PPF and Opportunity Cost In which country is the opportunity cost of cloth lower? England, because its PPF is not as steep as France’s. FRANCE FRANCE ENGLAND ENGLAND Wine Wine Wine Wine 600 600 600 600 500 500 500 500 400 400 400 400 300 300 300 300 200 200 200 200 100 100 100 100 0 0 0 0 0 100 200 300 400 Cloth 0 100 200 300 400 0 Cloth 14 100 200 300 400 Cloth 0 100 200 300 400 Cloth 15 Economic Growth and the PPF more wheat, or any combination in between. Wheat (tons) 6,000 Economic growth shifts the PPF outward. 5,000 PPF is a straight line. (In the previous example, opp. cost of a computer was always 10 tons of wheat.) 3,000 2,000 1,000 • If opp. cost of a good rises as the economy 0 100 200 300 400 500 600 Computers skills, scarcity of resources, etc can change and shift the PPF. in this case, increase in population but no change in skill level, just more people around (parallel shift) OR change in pop and skill in proportionate way Why the PPF Might Be Bow-Shaped • produces more of the good, PPF is bow-shaped. Amount of good produced next depends on number of goods produced before - slope is changing, thusly can't have one constant slope. Why the PPF Might Be Bow-Shaped Beer At point A, most workers are producing beer, even those that are better suited to building mountain bikes. PPF becomes steeper • as economy shifts resources from one industry to the other. • If opp. cost remains constant, 4,000 0 As the economy shifts resources from beer to mountain bikes: The PPF could be a straight line, or bow-shaped Depends on what happens to opportunity cost opp. cost of mountain bikes increases Mountain Bikes Beer With additional resources or an improvement in technology, the economy can produce more computers, The Shape of the PPF A At A, opp. cost of bikes is low. So, do not have to give up much beer to get more bikes. Mountain now we have labor that is differentially skilled, brewers Bikes vs. mountain bike builders and those who aren't good at either. Why the PPF Might Be Bow-Shaped So, PPF is bow-shaped when different workers Beer At B, most workers are producing bikes. The few left in beer are the best brewers. Why the PPF Might Be Bow-Shaped Producing more bikes would require shifting some of the best brewers away from beer production, would cause a big drop in beer output. At B, opp. cost of bikes is high. B Mountain Bikes The PPF: A Summary The PPF shows all combinations of two goods that an economy can possibly produce, given its resources and technology. The PPF illustrates the concepts of tradeoff and opportunity cost, efficiency and inefficiency, unemployment, and economic growth. A bow-shaped PPF illustrates the concept of increasing opportunity cost. have different skills, different opportunity costs of producing one good in terms of the other. The PPF would also be bow-shaped when there is some other resource, or mix of resources with varying opportunity costs. • E.g., different types of land suited for different uses differentially productive either in labor or in resources in regards to the production of goods SUMMARY Economists try to explain the world using models with appropriate assumptions. As policy advisers, economists offer advice on how to improve the world. Two simple models are the Circular-Flow Diagram and the Production Possibilities Frontier. Microeconomics studies the behavior of consumers and firms, and their interactions in markets. Macroeconomics studies the economy as a whole. ...
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