ECONOMIC MODELS:
TRADEOFFS AND TRADE
Tunnel vision
A miniature airplane sitting motionless in a wind tunnel isn’t the same thing as an actual
aircraft in flight.
But it is a very useful model of a flying plane.
Economic theory consists mainly of a collection of models.
In this chapter, we will look at two economic models that illustrate why such models are so
useful.
Chapter Objectives
1. Why models in economics?
2. Three simple but important models:
A. Production possibility frontier
B. Comparative advantage
C. Circular-flow diagram
3. Positive economics and normative economics.
4. When economists agree and why they sometimes disagree.
Models in Economics
- A model is a simplified representation of a real situation - used to better understand real-
life situations.
- Models play a crucial role in economics
Used to study a real but simplified economy
Ex.: Cigarettes as currency in World War II prison camps
Used to simulate an economy on a computer
Ex.: Use Tax models to study impact of proposed study
The “other things equal” (ceteris paribus) assumption means that all other relevant
factors remain unchanged.
, Models for Money
An economic model can be worth quite a bit of money. Global Insight, the world’s
biggest consulting firm, uses economic models to predict future trends and give advice
to firms and governments.
A particularly lucrative branch is finance theory which calculates what assets, such as
shares in a company, are worth.
The most famous business application of finance theory was Long Term Capital
Management, a fund that used sophisticated models to invest money for its wealthy
clients.
The fund did well for a while, then it collapsed. People feared companies would be
brought down with it but the government organized a rescue operation. A similar
situation almost happened in the fall of 2008.
Three Models
The Production Possibility Frontier
- Illustrates trade-offs facing an economy that produces only two goods.
- It shows the maximum quantity of one good that can be produced for any given
production of the other.
- The PPF improves our understanding of trade-offs by considering a simplified economy
that produces only two goods by showing this trade-off graphically.
if a castaway devotes resources to catching fish, he cannot use those same resources to
gather coconuts.
Opportunity Cost and Slope of PPF
- If the tradeoff remains constant along the PPF then we say they face a Constant
Opportunity Cost and the PPF has a linear slope.
- If the tradeoff increases along the PPF than we say they face an Increasing Opportunity
Cost and the PPF has a nonlinear slope.
TRADEOFFS AND TRADE
Tunnel vision
A miniature airplane sitting motionless in a wind tunnel isn’t the same thing as an actual
aircraft in flight.
But it is a very useful model of a flying plane.
Economic theory consists mainly of a collection of models.
In this chapter, we will look at two economic models that illustrate why such models are so
useful.
Chapter Objectives
1. Why models in economics?
2. Three simple but important models:
A. Production possibility frontier
B. Comparative advantage
C. Circular-flow diagram
3. Positive economics and normative economics.
4. When economists agree and why they sometimes disagree.
Models in Economics
- A model is a simplified representation of a real situation - used to better understand real-
life situations.
- Models play a crucial role in economics
Used to study a real but simplified economy
Ex.: Cigarettes as currency in World War II prison camps
Used to simulate an economy on a computer
Ex.: Use Tax models to study impact of proposed study
The “other things equal” (ceteris paribus) assumption means that all other relevant
factors remain unchanged.
, Models for Money
An economic model can be worth quite a bit of money. Global Insight, the world’s
biggest consulting firm, uses economic models to predict future trends and give advice
to firms and governments.
A particularly lucrative branch is finance theory which calculates what assets, such as
shares in a company, are worth.
The most famous business application of finance theory was Long Term Capital
Management, a fund that used sophisticated models to invest money for its wealthy
clients.
The fund did well for a while, then it collapsed. People feared companies would be
brought down with it but the government organized a rescue operation. A similar
situation almost happened in the fall of 2008.
Three Models
The Production Possibility Frontier
- Illustrates trade-offs facing an economy that produces only two goods.
- It shows the maximum quantity of one good that can be produced for any given
production of the other.
- The PPF improves our understanding of trade-offs by considering a simplified economy
that produces only two goods by showing this trade-off graphically.
if a castaway devotes resources to catching fish, he cannot use those same resources to
gather coconuts.
Opportunity Cost and Slope of PPF
- If the tradeoff remains constant along the PPF then we say they face a Constant
Opportunity Cost and the PPF has a linear slope.
- If the tradeoff increases along the PPF than we say they face an Increasing Opportunity
Cost and the PPF has a nonlinear slope.
