Transcript Illustrating Economic concepts

Theories or Models
• An Economic model is a simplified way to explain
how the economy (or parts of it) work and to make
predictions about what could happen when something
changes.
Begins with observing the economy
• All Scientific inquiry starts with observations about
what is happening in the world.
• Economists gather information and describe the
economy by organizing the data.
• This data can be shown with tables of numbers which
we can translate into a picture (graph).
• However, this is only the start: Descriptions are not
explanations…
…this is why economic models or theories are needed:
To explain the data that is collected
Two types of Scientific inquiry
• Positive Economics...making objective statements about
economic phenomena that can be tested and proved
right or wrong. What “is”.
a. Explaining why events occur
b. Predicting under what circumstances economic events
will occur in the future…
Example: An increase in income taxes will cause
consumer spending to go down
• Normative Economics...a way of determining the
desirability of outcomes based on some value judgments
(opinions). What “should be”.
a. Recommending appropriate courses of actions to take.
Example: Taxes should be lowered in order to increase
consumer spending.
b. Criteria: 1. Efficiency
2. Equity
Theories or models include four steps
1. Identify what you want to study (variables)
2. Make assumptions on variable behavior
3. Make hypothesis or Predictions
(In the form of IF... THEN…)
ceteris paribus: All other things held constant.
(This is an implicit assumption made with all
predictions)
It means that we only use two variables at a time when
making predictions (do this in order to isolate how one
variable affect one other variable)...
...everything else is assumed not to change.
4. Test your predictions
If wrong you may have to adjust theory
Studying Scarcity and opportunity cost
• Example: Suppose a person is stranded on an island.
1. Identify the variables
– can gather coconuts or catch fish
– has resources (time and labor) and technology (know
how)
2. Make assumptions
– limited resources (given amount of time and labor)
– given or fixed technology (his knowledge of tree
climbing and fishing)
3. Make Predictions
– How many coconuts can he gather and how many fish
can he catch with a limited amount of time and labor?
4. Test Predictions
Quantity of
Coconuts
A
40
B
30
20
D
10
0
Production Possibilities Frontier
Coconuts
Fish
per week per week
Unattainable with given
resources & technology
0
A 40
5
B 30
Z
C 20
10
15
D 10
C
E 0
20
Tom
5
E
10 15 20
Scarcity is shown by the
mere existence of the PPF
Quantity
of Fish
What if Tom wanted more fish? The only way he can get more
fish is to give up some coconuts.
Suppose he is at point C and wants 5 more fish. To get 5 more
fish he has to give up 10 coconuts. Moving up & down the PPF
illustrates the concept of opportunity cost. For Tom, he has to
give up 2 coconuts for every fish gained.
Opportunity cost is measured by the slope of the PPF, which is a
marginal value.
Quantity of
Coconuts
Production Possibilities Frontier
Coconuts
Fish
per week per week
unattainable with given
0
A 40
resources & technology
Allocative
Economy
30
5
B efficiency:
Z
needs toCproduce
20 those goods
10 that
consumers desire and in correct
10
15
C
quantity.DMarket-Capitalist
system
E 0 this.
20
should achieve
Tom
A
40
B
30
20
X
10
0
5
D
E
10 15 20
Point X is a level of production that
Tom can make, but would he want to?
Quantity
of Fish
From point X it is possible for Tom to either increase Fish or
Coconuts without having to give up any of the other good.
The only way that is possible is if he is not being as efficient as
possible (he is not maxing out production of one good given
production of the other).
He is not fully exploiting his opportunities. So any point below the
PPF is productively inefficient.
Quantity of
Coconuts
A
Tom
1 fish:
2 Coconut
1 Coconut: 1/2 Fish
Hank
Quantity of
Coconuts
1 fish:
1/2 Coconut
1 Coconut: 2 Fish
40
B
30
20 A’
C
20
15
D
10
B’
10
D’
5
0
5
E
10 15 20
Quantity
of Fish
0
E’
10
20
30
40
Quantity
of Fish
Produce the good at the lowest opportunity cost:
Tom – Coconuts; Hank – Fish
This is called a Comparative advantage, producing a good at a
lower opportunity cost than someone else.
Suppose that Tom initially is at point C and Hank is at point C’
Quantity of
Coconuts
A
Tom
1 fish:
2 Coconut
1 Coconut: 1/2 Fish
Hank
Quantity of
Coconuts
1 fish:
1/2 Coconut
1 Coconut: 2 Fish
40
B
30
20 A’
F
C
20
15
D
10
B’
F’
10
D’
5
0
5
E
10 15 20
Quantity
of Fish
0
E’
10
20
30
40
Quantity
of Fish
Suppose that Tom initially is at point C and Hank is at point C’
Tom now only produces Coconuts (point A) and Hank only produces
Fish (point E’).
Together they can now produce 40 of each instead of 30 separately.
Suppose Tom and Hank agree that Tom will exchange 15 coconuts
for 15 fish. They will now be able to consume more of both!
Comparative vs. Absolute advantage
• Comparative advantage refers to an ability to produce at a
lower opportunity cost than another
• Absolute advantage refers to the ability to do something
better (such as produce more) than another.
• It is possible to have a comparative advantage over
another without having an absolute advantage in anything.
– Comparative advantage is based on relative costs
between two goods for an individual and not being
physically better.
– An individual will always have a comparative advantage in
something.
• Since this model is based on scarcity and opportunity cost
we can say that not only can trade (based on comparative
advantage) between individuals make each better off but
two countries can also benefit from trade with one another.
Production Possibilities Frontier for a Country
•Looking at an individual’s production gives us important
insights on scarcity and opportunity cost.
•To gain more insight we can apply the model to an
entire country which also faces the problem of scarcity.
•A big difference is that for an individual they are the only
resource and it is the same resource producing both
goods.
•However, for an entire nation there people, land, and
machinery who have differing abilities in producing
goods & services.
−This is called specialization of resources
−Some resources are better able to produce one good
better than the other good
Types of Resources:
• Land is the bounty of the Earth: includes natural
resources such as oil, coal, minerals, etc.
• Labor includes both physical and mental human effort
• Capital are the tools, equipment, and factories to help
Labor produce goods & services
To produce capital one must use resources to create it
• Entreprenurship is the ability to organize resources &
take risks to develop new ways of production and new
products.
Technology:
• Is the knowledge of how to produce goods and services.
– An increase in technology means firms are able to
produce more goods and services with the same
amount of resources.
– The same amount of goods with the less resources.
Quantity of
Coconuts
Tom
A
160,000
150,000
40
120,000
B
30
C
20
70,000
A
Country A
B
C
A to B: 10,000 coconuts
B to C: 30,000 coconuts
C to D: 50,000 coconuts
D to E: 70,000 coconuts
D
D
10
0
Quantity of
Coconuts
5
E
10 15 20
E
60,000
Quantity 0 20,000
of Fish
40,000
80,000
Quantity
of Fish
When resources are specialized this leads to increasing
opportunity costs:
As the production of a good increases a country must give up
greater amounts of the other good to get the same increase of
production as before.
Quantity of
Coconuts
160,000
150,000
120,000
70,000
A
Country A
New PPF
B
C
D
This is called Economic Growth:
More goods & services can be
produced than before.
Also called an increase in the
standard of living.
Model says that only increases in
resources and improvements in
technology can increase standard
of living
E
0 20,000
60,000
40,000
80,000
Quantity
of Fish
The position of the PPF is dependent on the amount of
resources a country has and the level of technology.
If the quantity of resources increases or technology improves,
then the PPF will shift to the right.
Quantity of
Coconuts
160,000
150,000
120,000
A
Country A
B
We can conclude that any
technology improvement can make
a country better off.
C
New PPF
70,000
D
E
0 20,000
60,000
40,000
80,000
Quantity
of Fish
If technology only improves for one good (a new fishing
technique increases the catch with same amount of ships) then
the PPF will shift out from that axis only.
This does not mean that we can only produce more fish.
The increase in fish technology frees up resources that can
move to coconut production so that both can increase
production.
Other Ingredients to Economic Growth
• Private Property and Property rights
– Private citizens own resources and have the right to
employ them as they see fit in a market-capitalist
economy
– If you don’t benefit from your investment why bother to
invest in the first place?
• Competition in the marketplace
– This forces firms to improve and innovate to earn profit
• Limited government and stable institutions
• Adam Smith in a 1755 lecture: “Little else is requisite
to carry a state to the highest degree of opulence from
the lowest barbarism but peace, easy taxes, and a
tolerable administration of justice: all the rest being
brought about by the natural course of things”
>Economics in Action
• A Tale of Two Colonies
• One of the most informative contrasts in long-run
growth is between Canada and Argentina.
• Economic historians believe that the average level of
per capita income was about the same in the two
countries as late as the 1930s.
• After World War II, however, Argentina’s economy
performed poorly, largely due to political instability and
bad macroeconomic policies.
• Meanwhile, Canada made steady progress. Thanks to
the fact that Canada has achieved sustained long-run
growth since 1930, but Argentina has not, Canada
today has almost as high a standard of living as the
United States—and is about three times as rich as
Argentina.
Amount of
Environmental
Improvement
D
C
Same
increase
Let’s say we start at point A, which is very
polluted. To get cleaner we must give up some
amount of other goods. At point A to B it is not
very much.
But if we were to start at point C and then decide
to get the same increase in environmental
improvement...
B
…we must give up MORE of all other
goods then if we started at point A
A
0
Quantity
of All other goods
The PPF model is very flexible. The goods on each axis
represent goods in which a tradeoff exists.
Put any two goods where a tradeoff exists on each axis and use
model to illustrate the problem.
Example: Environmental improvement
To get a cleaner environment a country must sacrifice production
of all other goods. How much will they have to give up?
Amount of
Capital Goods
PPFA
A
B
0
Economic growth and Capital Goods
Example: Let’s say that our country decides on
more consumption today. Move from point A to
point B.
We still produce capital goods so the PPF
still shifts to the right. But we don’t
produce as much capital as point A.
Future possibilities are greater if
today’s economy is at point A instead
PPF
of point B due to the greater amounts
of capital goods
B
Amount of Consumption goods
• Capital goods are a resource
– the greater the production of capital goods the greater the shift
outward of the PPF (faster economic growth)
• Tradeoff: Today we must give up consumption goods.
– that is we must Save more today
• Saving is the sacrifice of current consumption
A Country that produces more Capital goods today will have
more production possibilities in the Future (Faster Economic
The Circular-Flow Diagram
• The circular-flow diagram is a model that represents the
transactions in an economy by flows around a circle.
Money
Households
Goods
and
services
Money
Factors
Factor Markets
Goods
and
services
Money
Factors
Firms
Money
Circular-Flow of Economic Activities
• A household is a person or a group of people that share
their income.
• A firm is an organization that produces goods and
services for sale.
– Firms sell goods and services that they produce to
households in markets for goods and services.
– Firms buy the resources they need to produce—factors
of production—in factor markets.
• Ultimately, factor markets determine the economy’s
income distribution, how total income is divided
among the owners of the various factors of production.
When and Why Economists Disagree
There are two main reasons economists
disagree:
• Which simplifications to make in a model
• Values
Problems in theory building
1. Fallacy of Composition
The often mistaken belief that what is true for a part is
necessarily true for the whole.
When I stand up at a ballgame, I can see better. Therefore, if
everyone stands up, everyone will be able to see better?
If Farmer Jones produces more corn, her revenues will rise. If
all farmers produce more corn, their revenues will all rise?
2. Post hoc, ergo Propter Hoc
If event A happens before event B, it is not necessarily true that
event A caused event B.
I went to the beach and it began to rain. It must have rained
because I went to the beach?
We increased our advertising budget and people stopped buying
our product. Our advertising must be discouraging consumers?
Correlation vs. Causation
Two variables are correlated if one variable changes with the other
variable. This does not mean that the first variable causes
changes in the second variable.
APPLICATION: Correlation vs.
Causation
Cities with high crime rates also have
many automobiles. Does this mean that
automobiles cause crime?
 President Bush took office in 2001 and
soon after the economy began to get
worse. Does this mean that the Bush
inauguration caused the worsening
economy?

Summary
1. Almost all economics is based on models. An
important assumption in economic models is the other
things equal assumption, which allows analysis of the
effect of a change in one factor by holding all other
relevant factors unchanged.
2. One important economic model is the production
possibility frontier. It illustrates: opportunity cost,
efficiency, and economic growth. There are two basic
sources of growth: an increase in factors of
production, resources such as land, labor, capital, and
human capital, inputs that are not used up in
production, and improved technology.
Summary
3. Another important model is comparative advantage, which
explains the source of gains from trade between individuals
and countries. Everyone has a comparative advantage in
something. This is often confused with absolute advantage,
an ability to produce a particular good or service better than
anyone else.
4. In the simplest economies, people barter or trade goods and
services for one another—rather than trade them for money,
as in a modern economy. The circular-flow diagram
represents transactions within the economy as flows of
goods, services, and money between households and firms.
These transactions occur in markets for goods and
services and factor markets.
Summary
5. Economists use economic models both for positive
economics, which describes how the economy works, and
for normative economics, which prescribes how the
economy should work. Positive economics often involves
making forecasts. Economists can determine correct
answers for positive questions, but typically not for
normative questions, which involve value judgments.
6. There are two main reasons economists disagree. One,
they may disagree about which simplifications to make in
a model. Two, economists may disagree—like everyone
else—about values.