02 Model Building and Gains from Trades

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Misconception - Trade always results in winners and losers
When most people think of trade, they think of it as a zero-sum game, that is, a game in which one side wins what the other side loses.

How Do Economists Study the Economy?

Economics is a social science that uses the scientific method to develop economic model. To create these models, economists make many assumptions to simplify reality.

The Scientific Method is Economics

The scientific method consists of four steps:

  1. First, researchers observe a phenomenon that interests them.
  2. Next, based on these observations, researchers develop a hypothesis, which is a proposed explanation for the phenomenon,
  3. Then they construct a model to test the hypothesis.
  4. Finally, they design experiments to test how well the model (which is based on the hypothesis) works. After collecting data from the experiments, they can verify, revise, or refute the hypothesis.

Often, they gather historical data or wait for real-world events to take place to test their hypotheses.

Positive and Normative Analysis

  1. A Positive statement can be tested and validated; it describe "what is". - The unemployment rate is 7%.
  2. A Normative statement is an opinion that cannot be tested or validated; it describe "what ought to be". - An unemployed worker should receive financial assistance to make ends meet.

Economics Models

Ceteris Paribus

The process of examining a change in one variable while holding everything else constant involves a concept known as ceteris paribus, from the Latin meaning "other things being equal" or "all else equal".

If the Wright brothers had changed many design elements simultaneously and found that a new version of the wing worked better, they would have had no way of knowing which change was responsible for the improved performance.

##Endogenous versus Exogenous factors

  1. Endogenous factors are the variables that can be controlled for in a model. - the design of the wing within the control of the Wright brothers
  2. Exogenous factors are the variables that cannot be controlled for in a model. - wind, air pressure, and other atmospheric conditions beyond the control of the Wright brothers
The Danger of Faulty Assumption

Using a model that contains a faulty assumption can lead to spectacular failures.

In the years leading up the crisis, banks sold and repackaged mortgage-backed investments under the faulty assumption that real estate prices will always rise. This assumption seemed perfectly reasonable in a world where real estate prices were rising annually. Unfortunately,the assumption turner out to be false. From 2006 to 2008, real estate prices fell. Because of one faulty assumption, the entire financial market teetered on the edge of collapse.

What is a Production Possibilities Frontier?

A production possibilities frontier (PPF) is a model that illustrates the combinations of outputs that a society can produce if all of its resources are being used efficiently. An outcome is considered efficient when resources are fully utilized and potential output is maximized. To preserve "ceteris paribus", we assume that the technology available for production and the quantity of resources remain fixed, or constant. These assumption allow us to model trade-offs more clearly.

The Production Possibility Frontier and Opportunity Cost

Figure 2.2
The Law of Increasing Opportunity Cost
To make more pizzas, the society will have to use workers who are increasingly less skilled at making them. As a result, as we move up along the PPF, the opportunity cost of producing an extra 20 pizzas rises from 30 wings between points D and C to 80 wings between points B and A.

A bowed-out production possibilities frontier reflects the increasing opportunity cost of production. Figure 2.2 illustrates the law of increasing opportunity cost, which states that the opportunity cost of producing a good rises as a society produces more of it. Changes in relative cost mean that a society faces a significant trade-off if it tries to produce an extremely large amount of a single good.

The Production Possibility Frontier and Economic Growth

Economic growth is the process that enables a society to produce more output in the furture.

Figure 2.3
A Shift in the Production Possibilities Frontier
A new pizza assembly line that improves the productive capacity of pizza makers shifts the PPF upward from PPF1 to PPF2. More pizzas can be produceds. Comparing points A ans B, you can see that the enhances pizza-making capacity also makes it possible to produce more wings at the same time.

Figure 2.4
More Resource and the Production Possibilities Frontier
When more resources (such as additional workers) are available for the production of either pizza or wings, the entire PPF shifts upward and outward. The shift makes point C, along PPF2, possible.

What Are the Benefits of Specialization and Trade?

  1. Specialization is the limiting of one's work to a particular area.
  2. Abosulte advantage
    - the ability of one producer to make more than another producer with the same quantity of resources.
  3. Comparative Advantage
    - the ability to makes a good at a lower opportunity cost than another producers.
  4. Finding the Right Price To Facilitate Trade
    - As long as the terms of trade fall between the trading partners' opportunity costs, the trade benefits both sides.
  1. Why LeBron James Has Someone Else Help Him Move
  2. Opportunity Cost - Saving Private Ryan

What Is the Trade-off between Having more now and Having More Later?

The short run is the period in which we make decisions that reflect our immediate or short-term wants, needs, or limitations. In the short run, consumers can partially adjust their behavior.
The long run is the period in which we make decisions that reflect our needs, wants, and limitations over a long time horizon. In the long run, consumers have time to fully adjust to market conditions.

Consumer Goods, Capital Goods, and Investment

  • Consumer Goods are produced for present consumption.
  • Capital Goods help produce other valuable goods and services in the furture.
  • Investment is the process of using resources to create or buy new capital.

Figure 2.7
Investing in Capital Goods and Promiting Growth
(a) When a society chooses point A in the short run, very few capital goods are created. Because capital goods are needed to enhance future growth, the long-run PPF2 expands, but only slightly.
(b) When a society chooses point B in the short run, many captial goods are created, and the long-run PPF2 expands significantly.

Over the last 20 years, the citizens of China and India have invested significantly more in capital goods than have the citizens of wealthier nations in North America and Europe. Not suprisingly, economic growth rates in China and India are much higher than they are in more developed countries.

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