Topic 2 - Understand the Two Simple Economic Models

8/10/2019 Topic 2 - Understand the Two Simple Economic Models

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FHBM1014 PRINCIPLES OF ECONOMICS

(Topic 2 Understand The Two SimpleEconomic Models)

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Learning Objectives

1. Demonstrate an understanding of

economic models and how economists use

them.

2. Elements of the two sector circular flow

modeland the concepts illustrated in the

Diagram.

3. The Production Possibilities Frontier

(PPF) and Opportunity Costs.

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Learning Objectives

(1)

Demonstrate an understanding

of economic models and howeconomists use them

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Assumptions & Models

Assumptions:simplify the complex world,

make it easier to understand.

Models: a highly simplified representation

of a more complicated reality.

Economists use models to study economic

issues.

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The Role of Assumptions

Economists make assumptionsin order tomake the world easier to understand.

Example:Two countries andtwo goods.

What two countries trade ONLYtwo goods? None!!!

However, you need to understand the simpleexamplebefore you can apply it to a larger,more

complexproblem.

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Virtually all theories in economics are

expressed using a ceteris paribus

(holding everything else constant)

assumption.

An example of ceteris paribus:

- The theory that if I study harder,

I will perform better on a test,ceteris paribus

(other things held constant).

The Ceteris ParibusAssumption

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LO1. Economic Models

Economists use

modelsto simplify

reality in order to

improve our

understanding of the

world.

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Economic Models

Two of the most basic economic

models include:

- The Circular Flow Diagram

- The Production Possibilities

Frontier (PPF)

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Learning Objectives

(2)

Elements of the two sector circular

flow model and the conceptsillustrated in the Diagram

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The circular-flow modelis a

simple way to visually show theeconomic transactionsthat

occur between households andfirmsin the economy

LO2. First Model:

The Circular-Flow Diagram

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The Circular-Flow Diagram

The circular flow diagram is in the

shape of a circle because all of

the components work together

and without one, it would

notfunction.

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The Circular Flow Diagram

Spending

Revenue

Goods &

Services

sold

Income= Flow of inputs

and outputs

= Flow of dollars

Wages, rental,

profits

FIRMS HOUSEHOLDS

Marketsfor

Goods &

Services

Marketsfor

Factors of

Production

Goods &

Services

bought

Factors of

Production

Land,

Labor,

Capital

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FIRMS

Produce and sell

goods and services

Hire and usefactors of production

HOUSEHOLDS

- Buy and consumegoods and services

- Own and sell factorsof production

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Households and firms interact in two

types of markets:

1) Markets for goods and services

- Households are buyers

- Firms are sellers

2) Markets for the factors of production

- Households are sellers

- Firms are buyers

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The above circular flow diagram

consists of 6 assumptions:

1. The economy consists of ONLYtwo

sectors: households and firms.

2. Households spend all of their income on goods and

services. There are no savings.3. All output produced by firms are purchased by

households.

4. There is NOfinancial sector.5. There is NOgovernment sector.

6. There is NOoverseas sector.

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PROBLEM APPLICATION

To which part of the circular flow diagramwould the following activities fall under?

Martin earns RM15 per hour working in a factory

Matilda spends RM6 for a pizza Madelines Bakery pays RM500 for the rent on its

shop

Maria purchases a new pair of earrings for RM20

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Learning Objectives

(3)

The Production Possibilities Frontier(PPF) and Opportunity Costs

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LO3. Second Model:

The Production Possibilities Frontier

The production possibilities frontier

(PPF)is a graph that shows the

combinationsof output that the economy canpossibly produce in a certain period of time

given the available resourcesand the

available technology.

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What assumptionsunderlie

the production possibilitiesmodel?

1. Fixed resources

2. Fully employedresources

3. Technologyunchanged

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PPF Example

Production

Computers Wheat

A 500 0

B 400 1000

C 250 2500

D 100 4000

E 0 5000

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Pointon

graph

ProductionCom-

putersWheat

A 500 0

B 400 1,000

C 250 2,500

D 100 4,000

E 0 5,0000

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Wheat

(tons)

Computers

A

B

C

D

E

PPF Example

G

F

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Points onthe PPF (like AE)

possible (feasible)

efficient: all resources are fully utilized

Points underthe PPF (like F)

possible (feasible) not efficient: some resources underutilized

(e.g.,workers unemployed, factories idle)

Points abovethe PPF (like G)

not possible (infeasible)

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The PPF and Opportunity Cost

Recall: The opportunity costof an itemis what must be given up to obtain that item.

Moving along a PPF involves shifting resources

(e.g., labor) from the production of one good tothe other.

Society faces a tradeoff: Getting more of one

good requires sacrificing some of the other. The slope of the PPF tells you the opportunity

cost of one good in terms of the other.

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The PPF and Opportunity Cost

The slope of a line

equals theriseover the run,

the amount the line

rises when you

move to the rightby one unit.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat

(tons)1000

100slope = =10

Here, the

opportunity cost ofa computer is

10 tons of wheat.

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Figure below shows how to calculate the opportunity cost of a bottle of water.

Example 1

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Moving fromAtoB, the first 1 million bottles of water costs 1 CD

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Moving from Bto C, the next 1 million bottles of water cost 2 CDs

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Moving from Cto D, the next 1 million bottles of water cost 3 CDs

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Moving from Dto E, the next 1 million bottles of water cost 4 CDs

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Moving from Eto F, the next 1 million bottles of water cost 5 CDs

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Figure below shows how to calculate the opportunity cost of a CD

Example 2

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Moving from Fto E, the first CD costs 1/5 of a bottle of water.

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Moving from Eto D, the next CD costs of a bottle of water.

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Moving from Dto C, the next CD costs 1/3 of a bottle of water.

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Moving from Cto B, the next CD costs 1/2 of a bottle of water.

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Moving from BtoA, the next CD costs 1 bottle of water.

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Opportunity Cost Is a Ratio

The opportunity cost of a bottle of water is the

quantity of CDs forgone divided by the

increase in the quantity of water.

The opportunity cost of a CD is the quantity of

bottled water forgone divided by the increase

in the quantity of CDs.

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The Shape of the PPF

The PPF could be a straight line, or bow-shaped

Depends on what happens to opportunity cost

as economy shifts resources from one industry

to the other.

The opportunity cost of producing one good isconstantas the production of this good rises,

PPF is a straight line.

The opportunity cost of producing one good

increasesas the production of this good rises,

PPF is bowed outward - shaped (Concave

curve) .

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Consider a Straight Line PPF

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The opportunity costof moving from

producing no pizza to

1 unit pizza is 3 units

of soda.

Moving from 1 unit to

2 units and from 2 to 3

units pizza also hasan opportunity cost of

3 units of soda.

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Consider a Straight Line PPF

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In this case the

opportunity

cost of going from 0 to

1 is the same asgoing from 2 to 3.

This is why we say

that the opportunitycost is constant.


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Concave Shape PPF

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The opportunity costof going from 0 units

of pizza to 1 unit of

pizza is one unit of

soda.

Moving from 1 unit of

pizza to 2 units has an

opportunity cost thatis 3 units of soda.

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Concave Shape PPF

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Similarly, movingfrom 2 to 3 units of pizza

has an opportunity cost of

6 units of soda.

The opportunity cost ofgoing from 0 to 1 is

smaller than going from 2

to 3.

This is why we say that

the opportunity cost is

increasing.


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Dictates the bowed-out shape of thePPF.

When the economy uses all resourcesefficiently, each additional increment ofone good requires the economy tosacrifice successively larger and larger

increments of the other goods.

Law of Increasing Opportunity Costs

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Factors that can Shift the PPF Changes in Resource Availability

Increases / Improvements in Quality/Quantityrightward shift

Decreases /Reductions in Quality/quantityleftward shift

Changes in Capital Stock Increases rightward shift

Decreases leftward shift

Technological Change Advancement rightward shift

Obsolete / Stagnation leftward shift

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Increase in the size or

the health of the labor

force, an increase in theskills of the labor force,

or an increase in the

availability of other

resources shifts the PPF

from AF to A'F.

The parallel shift implies

that the change that

occurred could produce

either good.

Increase inavailable resources

Shifts in the Economys PPF

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Shift i th E PPF


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Decrease in theavailability or the quality

of resources shifts the

PPF inward.

Parallel shift again

implies that the change

was equally applicable

to both consumer and

capital goods.

Decrease in available

resources

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Shif i h E PPF


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Increase in resources

or technological

change that benefits

consumer goods

Since the change affects

only consumer goods,

where will be no

changes on capitalgoods.

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Increase in resourcesor technological

advance that benefits

capital goods

Since the change affects

only capital goods,

where will be no

changes on consumergoods.

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There is a technologicalbreakthrough in the

production of computersonly, what will happen to

the PPF?

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A Shift in the Production Possibilities Frontier


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A Shift in the Production Possibilities Frontier

Copyright 2004 South-Western

Quantity of

Cars Produced

Quantity of

Computers

Produced

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P t Mi f C d


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Present Mix of Consumer and

Capital Goods:

The present mixofconsumer and

capital goods canaffect the futureeconomic growth

of an economy.


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Consumer Goods

Capital Goods

Pt. A

Pt. B

How will the present position on this

production possibilities curve affect

the future position of the PPF? What

if the current position is A? Whatabout it is in B?

Qty needed tomaintain existingca ital


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Consumer Goods

Capital Goods

PPF08

PPF09

With the present point of A, if the investment in capital

is less than the depreciation of capital, the PPF could

shift inward.

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ReferenceChapter 2

Tucker, I.B (2011). Economics for todays

world. (7th ed.). Mason, OH: Thomson

South Western.

Mankiw, G. N. (2007) Essentials of

economics (4th ed.). Mason, OH: Thomson

South Western.

LECTURE NOTES

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Topic 2 - Understand the Two Simple Economic Models

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