Basic Models
Referece: Chapter 2, Principles of Economics, G. Mankiw, 10th edition
Md. Nazmul Hossain
Assistant Professor of Economics, University of Dhaka
Topics to be Covered
• Circular flow if economic activities
• Production Possibility Frontier (PPF)
Circular Flow: Basics
• This is a visual model that shows how money, goods, services and resources
flow through markets in an economy.
• Millions of people engaged in many activities - buying, selling, working, hiring,
manufacturing, importing, exporting, takings loans and so on.
• Circular flow organizes the activities and shows how the agents interact with
each other.
• In the economy, there are many economic agents:
• Households, Firms, Government, Financial Sector, Foreign Sector
• In its simplest form, we can only consider two agents: Household and Firms.
Circular Flow: Setup
• Closed economy.
• No government.
• No financial sector.
• Two agents
• Firms: Produces good and services and sells them to households.
• Household: Owns factors of production (land, labor, capital) and lends them to firms for
production.
• Two types of market arises.
• Markets for goods and services
• Markets for factors of production (land, labor, capital, entrepreneurship)
Circular Flow: The Diagram
Households:
▪ Own the factors of production,
sell/rent them to firms for income
▪ Buy and consume goods & services
Firms Households
Firms:
▪ Buy/hire factors of production,
use them to produce goods and services
▪ Sell goods & services
Circular Flow: The Diagram
Revenue Spending
Markets for
Goods &
G & S sold Services G & S bought
Firms Households
Factors of Labor, land,
production Markets for capital
Factors of
Production
Wages, rent, profit Income
Circular Flow: More Agents
• The two-agent circular flow is the most basic.
• More realistic –
• Add government: this will include the tax payments, government
expenditures
• Add financial sector (banks): this will include savings, loan
• Add foreign market: this will include export, import
Production Possibility Frontier (PPF)
• PPF is a graph that shows the combinations of goods the economy can
possibly produce given the available resources and the available technology.
• For simplicity, take one two goods.
• Computer
• Car
Production Possibility Frontier (PPF)
Production Possibility Frontier (PPF)
• If the economy uses all its resources in the car industry, it
produces 1,000 cars and no computers.
• If it uses all its resources in the computer industry, it produces
3,000 computers and no cars.
• Any combination on the PPF is efficient (like A, B,E, F).
• The above two are the extreme combinations. Other
combinations can be:
• Point A: 600 cars and 2,200 computers
• Point B: 700 cars and 2,000 computers
• Point C: Not feasible with available resources
• Point D: Feasible but inefficient since resources are
underutilized.
PPF, Trade-off and Opportunity Cost
• Recall, the opportunity cost of an item is the next best
alternative that is forgone to get the item.
• Moving along the PPF, indicates what must be given up (say,
computer) to get an item (say, car).
• Moving from A to B:
250
• gives up 200 computers to get 100 additional cars.
• the opportunity cost of each car is two computers.
• Moving from B to E (950,250):
• gives up 1750 computers to get 250 additional cars.
• the opportunity cost of each car is seven computers.
• The opportunity cost is not same along the PPF.
Slope of PPF and Opportunity Cost
• Slope of PPF shows the opportunity cost of a good in terms of
other good.
• When the slope of PPF is flatter (like point A)
• opportunity cost of car (in terms of computers) is lower.
• When the slope of PPF is steeper (like point E)
• opportunity cost of car (in terms of computers) is higher.
250
• Opportunity cost is increasing.
• PPF is concave to origin/bow-shaped.
• At point E, many cars but few computers.
• There are very few resources well-suited for car production.
• Shift resources to car production that are better suited for
producing computers.
• So, we have to sacrifice more of computers for a car.
• PPF is bow-shaped when resources has different skills.
Slope of PPF and Opportunity Cost
• Straight line PPF.
• At every point, slope of PPF is same.
• At every point, opportunity cost of a
good (in terms of other good) is same.
• Straight line PPF is used for simplicity.
• Concave to origin/bow-shaped PPF is
more realistic.
Shift in PPF
Summary
Circular Flow Production Possibility Frontier (PPF)
• This is a visual model that shows how • PPF shows the maximum output
money, goods, services and resources combinations of two goods using all
flow through markets in an economy. resources efficiently.
• Circular flow organizes the economic • Highlights scarcity, choices,
activities and shows how the agents and opportunity cost in resource
interact with each other. allocation.
• Bowed-out shape reflects increasing
opportunity cost — resources are not
equally adaptable.
• Points on the curve = efficient, inside
= inefficient, outside = unattainable.