Chapter 2 Summary

LO 2.1 The Importance of Economic Theories and Models

• An economic model is a simplification of economic reality, which allows us to observe, understand, and make predictions about cause and effect in the real world.
• Economists use the scientific method to develop and discover useful economic models. A workable model provides reasonable predictions when applied to real-world situations.
• We must use economic models with caution, interpreting their predictions within the context of their assumptions.

LO 2.2 The Theories of Absolute Advantage and Comparative Advantage

• According to Adam Smith, absolute advantage arises from the ability of a country to make a product at lower input cost (i.e., using a smaller quantity of labour) than another country.
• Ricardo, advancing the idea of comparative advantage, showed there was a basis for trade even if a country had no absolute advantage in the production of any good.
• Comparative advantage arises from the ability of a country to produce a good at lower opportunity cost than another country.
• Trade based on comparative advantage benefits participating countries by facilitating greater production and consumption and lower product prices.

LO 2.3 The Benefits from International Trade Using the PPF and Indifference Curves

• We demonstrate the benefits from trade by comparing the economic outcomes (specifically regarding production, consumption, and prices) before trade and after trade.
• The production possibilities frontier, along with community indifference curves, can be used to demonstrate the underlying reason for, and benefits from, trade.
• If opportunity costs are constant, the PPF is linear; if opportunity costs are increasing, the PPF is concave.

LO 2.4 The Effects of International Trade on Production, Consumption, and Prices

• Countries specialize in the production and export of the good in which they have a comparative advantage while importing the good in which they are at a comparative disadvantage.
• The price of the export good rises in both countries while the price of the import good falls.
• International trade increases economic well-being as participating countries attain higher levels of consumption.
• Within each country, there are changes in production and consumption and average prices fall.

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