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Chapter 2 Economic Models

Published on Nov 18, 2015

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1.

Chapter 2 Economic Models

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Example of a model: Map
Objectives?
Assumptions?
Is it a good model?

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Model 1: Circular Flow Diagram
Objective: Represent economic transactions taking place in any economy schematically.
Examples of economic activities?

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Assumptions:
1. Simple economy with only two sectors, firms and households
2. Two markets, market for goods and services and market for factors of production (land, labor and capital)

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5.

Firms
Produce and sell goods and services
Hire and use factors of production

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Households
Buy and consume goods and services
Own and sell factors of production

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Simplifications of the Model:
Excludes trade, exports, government, savings and investment, banking sector
Transactions among households and among businesses are not shown
The model implies constant flows of output and income, in reality these flows are variable
Is it a good model?

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Model 2 Production Possibilities Frontier

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The production possibilities frontier is a graph showing the various combinations of output (guns and butter) that the economy can possibly produce if all its resources were fully employed.

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Production Possibilities Frontier

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Suppose we are at point C, producing 2 guns, 12 butter.
1.Can we produce more guns? Where will we move?
2.Is there a tradeoff?
3.How can we measure the opportunity cost of producing one more gun?

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As we move from A to F, the opportunity cost of producing one more gun increases
This is the law of increasing opportunity cost

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The shape of the PPF is concave or bowed out reflecting the law of increasing opportunity cost

This happens because resources are not equally suited to the production of both guns and butter

What would be the shape of PPF for constant opportunity costs ? Think of an example.

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Productive efficiency is achieved when maximum possible output of one good is produced given the production of other goods.

Allocative efficiency is achieved when it is not possible to make one person better without making others worse off.

Which point on the PPF would be the best point or “optimal”?

PE-All points on PPF are efficient as production of one good can’t be increased without reducing the production of some other good
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We can show growth of the economy over time as an outward shift in the PPF.
What factors can accelerate the economic growth?
Growth can be balanced or biased.
Can PPF contract over time? Give an example.

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