2.3 SUMMARY

1. Almost all economics is based on models, “thought experiments” or simplified versions of reality, many of which use mathematical tools such as graphs. 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 (showing how much less of one good can be produced if more of the other good is produced); efficiency (an economy is efficient in production if it produces on the production possibility frontier and efficient in consumption if it produces the mix of goods and services that people want to consume); and economic growth (an outward shift of the production possibility frontier). There are two basic sources of growth: an increase in factors of production—resources such as land, labour, and capital, inputs that are not used up in production—and improved technology.

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—some good or service in which that person has a lower opportunity cost than everyone else. But it is often confused with absolute advantage, an ability to produce a particular good or service better than anyone else. This confusion leads some to erroneously conclude that there are no gains from trade between people or countries.

4. In the simplest economies people barter—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, markets for factors of production—land, labour, and capital. It is useful in understanding how spending, production, employment, income, and growth are related in the economy. Ultimately, factor markets determine the economy’s income distribution, how an economy’s total income is allocated to the owners of the factors of production.

5. Economists use economic models for both positive economics, which objectively 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. The exceptions are when policies designed to achieve a certain objective can be clearly ranked in terms of efficiency.

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.