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Section 1.2

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Erik Dean

on 26 September 2017

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Transcript of Section 1.2

Section 1.2

The Organization of Economic Activity

The Neoclassical Model of the Economy
The Circular Flow Model
Firms and Households
Marginal Thinking

Production Possibilities

Chapters 1 - 3

Mark Granovetter (economic sociologist) on the concept of embeddedness

The Neoclassical Framework
The Production Possibilities Model
A Simple Example
Endogenous and
Exogenous Variables

What are Models?
Ways of simplifying reality to help in understanding it
A model shows a certain relationship between 2 or more variables
For instance Y = 2X
Quantitative models (using numbers and math) can be expressed...
With equations
With a table
With a graph
Production Possibilities
Shows possible combinations of
that can be produced...
given an economy's
(resources, technology, institutions, &c.)

Typical outputs: guns and butter
But can be extended to any products

Guns and Butter
Opportunity Costs
Models can also illustrate important theoretical concepts

The Production Possibilities Model shows us the concept of
opportunity costs
that is, the benefit of something we give up when we choose something else instead

What is the
What are the
What is the relationship between inputs and outputs?
What is the
opportunity cost
of increasing gun production from 10 crates to 20?
The combinations of outputs (guns and butter) that can be produced if society uses all of its resources can be graphed given the data above

We'll call the resulting graph a
production possibilities frontier
(or a production possibilities curve)
The Basics
Private Economic Activity
Neoclassical economics sees all private economic activity as individuals engaged in...
And exchange through markets
Private Economic Activity
Consumers (households)
maximize their own utility (net benefit to themselves) by buying & consuming
Producers (firms)
maximize profits (net revenue) by making and selling
Bring firms and households together to maximize the net benefit to society

Product and Factor Markets
Households and firms are connected through two types of markets
Product markets
, in which firms sell what they've produced to households for consumption
Factor (input) markets
, in which households sell land, labor, and capital to firms (the inputs firms need to produce)

Neoclassical Reasoning
Scarcity and Optimality
Neoclassical economics starts with the premise that resources are
Your income & time, the land available for production, and so on are all limited
Then the question becomes how to allocate our resources
i.e. getting the most we can with what we have
Optimizing: Thinking at the Margin
Optimal use of our resources requires looking at the costs and benefits of the next additional resource spent
Economists call these...
marginal cost
(MC): the additional cost of doing something, over and above costs already incurred
marginal benefits
(MB): the additional benefits of doing something
Optimizing: Thinking at the Margin
In general...
If MB > MC then do it
If MC > MB then don't do it
Why not?

Can you identify the costs and benefits to households and firms in the circular flow model?
Notice the
of the curve, 4 (in absolute terms), is
the same as
opportunity cost
of producing 1 more crate of guns.

Why do you think this is?
Slope is rise over run, or ΔButter / ΔGuns

We can translate this as the decrease in butter that happens when we increase guns
Increasing Marginal Opp. Costs
PPF’s are usually concave to (bowed out from) the origin

Meaning the slope of the curve increases (in absolute terms) as we produce more guns (and less butter) or more butter (and fewer guns)

This is because marginal opportunity costs usually increase

And that loss of butter
the opp. cost of the extra guns (specifically the
marginal opportunity cost
- that is the opp. cost of making one more gun)
Slope is negative and increasing (increasing because marginal opportunity costs are increasing)
(given existing resources)
Comparative Advantage
Economists believe that marginal opportunity costs will usually increase because...
Resources will usually be better suited to produce one thing than another
For example, a cow is much better at producing butter than guns
In this case, economists would say the cow has a comparative advantage in producing butter

Comparative Advantage
Nevertheless, if society decides it needs more guns, we could start using cows to help produce the guns
But the lost butter would far exceed the gained guns - suggesting high marginal opportunity costs

Skeptical that cows could be used for weapons?

Endogenous Variables
The PPF is a model showing a relationship between two endogenous variables – taking several exogenous variables as given

Endogenous variables
those variables which are determined or explained within the model

Exogenous Variables
Exogenous variables
those variables which are defined outside of the model,
parameters that define the relationship between the endogenous variables (i.e. where the curve is and how it’s shaped)
What are the two endogenous variables in the PPF model we just looked at?

Endogenous & Exogenous Variables
Endogenous Variables: Guns and Butter

Then the exogenous variables are whatever is important to how much of these outputs we can produce
Technology – e.g. machinery used to produce guns
Institutions – e.g. norms allowing trade
Environment – e.g. availability of raw materials

: What happens to our model if one of these exogenous variables changes?

Suppose a natural disaster destroyed several dairy farms and factories. How would this be reflected in the model?
Suppose technological improvements made society generally more productive. How would this change the model?
Final Word...
The basic neoclassical framework
assumes full employment of resources
(Why would we leave idle resources that could be used to produce more stuff?)

Hence, every choice involves an opportunity cost

The goal then is to figure out how best to use (‘allocate’) these resources, based on what society wants

But, unlike the Feudal Era, capitalism is marked by perpetual under-use of productive resources

see Fed’s TCU figure: http://research.stlouisfed.org/fred2/series/TCU/
Question to consider: If the norm is for some resources to be unemployed, is it wise for economists to begin with the assumption that resources are scarce?
Bonus: what do you think the opportunity cost of producing one more crate of guns is?
Full transcript