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Our First Model: The Circular-Flow Diagram A way to organize the economic transactions/decisions of 2 decision-makers: • Households • Firms (businesses) Households: Have people who go to work & provide resources (factors of production) buy and consume goods & services Firms Households 0 Our First Model: The Circular-Flow Diagram A way to organize the economic transactions/decisions of 2 decision-makers: • Households • Firms (businesses) Firms: Buy resources (factors of production) from households & use them to produce goods and services sell goods & services to households Firms Households 1 Factors of Production The factors of production are the resources that the economy uses to produce goods & services. They include: • labor • land • capital (buildings & machines used in production) 2 The circular flow diagram What does it show? 2 Scenarios: - Scenario 1: Market for goods & services (people buying stuff) – Households = buyers – Firms (businesses) = sellers - Scenario 2: Market for factors of production (inputs: land, labor, capital) – Households = sellers – Firms(businesses) = buyers • Inner loop = flow of goods and services between households & firms • Outer loop = flow of money between households & 3 firms FIGURE 1: The Circular-Flow Diagram Revenue Spending Markets for G&S Goods & G&S sold Services bought Firms Households Factors of Labor, land, production Markets for capital Factors of Wages, rent, Production Income profit 4 Circular Flow Example: Follow the $ Starts in the pocket of a person (household) Spent on a cup of coffee at Starbucks (firm) Starbucks uses the dollar to pay employees (household) Employees use the dollar to buy other things (firm) 5 Model #2: The Production Possibilities Frontier Shows the things (outputs) that the economy can possibly produce given the available factors of production (resources) that firms can use & the level of technology they have to create outputs 6 PPF Example #1 Assume Japan produces cars and computers • If all resources are devoted to producing cars, the economy can produce 1,000 cars per year • If all resources are devoted to producing computers, the economy can produce 3,000 computers per year • If resources are divided between the 2, the outputs are shown on the curve - 600 cars & 2200 computers - 700 cars & 2000 computers 7 Understanding the PPF An economy can produce at any point on or inside the frontier, but NOT outside the frontier • ON THE CURVE= EFFICIENT - An economy is getting all it can from scarce resources it has available • INSIDE THE CURVE = INEFFICIENT - Economy is producing less than it could be from resources available • OUTSIDE THE CURVE = IMPOSSIBLE 8 Calculating the Opportunity Cost using the PPF Calculate the opportunity cost of increasing the production of cars from: • 600 to 700 cars = give up 200 computers • 700 to 1000 cars = give up 2000 computers 9 Your turn What is the PPF? What does it show? What does a point on the curve mean? 10 PPF Example #2 Wheat Point Production (tons) on Com- 6,000 graph puters Wheat E 5,000 A 500 0 D 4,000 B 400 1,000 3,000 C C 250 2,500 2,000 D 100 4,000 B 1,000 E 0 5,000 A 0 0 100 200 300 400 500 600 Computers 11 ACTIVE LEARNING 1: Points on the PPF A. On the graph, find the point that represents (100 computers, 3000 tons of wheat), label it F. Would it be possible for the economy to produce this combination of the two goods? Why or why not? B. Next, find the point that represents (300 computers, 3500 tons of wheat), label it G. Would it be possible for the economy to produce this combination of the two goods? 12 ACTIVE LEARNING 1: Answers Point F: Wheat 100 computers, (tons) 6,000 3000 tons wheat 5,000 Point F: 4,000 Possible but not efficient: 3,000 F could get more 2,000 of either good 1,000 w/o sacrificing 0 any of the other. 0 100 200 300 400 500 600 Computers 13 ACTIVE LEARNING 1: Answers Point G: Wheat 300 computers, (tons) 6,000 3500 tons wheat 5,000 Point G requires 4,000 G more resources than are available 3,000 Not possible. 2,000 1,000 0 0 100 200 300 400 500 600 Computers 14 Check for understanding: the PPF What do we know about Points on the PPF? • possible • efficient: all resources are fully utilized Points under the PPF? • possible • not efficient: some resources underutilized (e.g., workers unemployed, factories idle) Points above the PPF? • not possible 15 The PPF and Opportunity Cost Recall: The opportunity cost of an item is 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 to the 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. 16 The PPF and Opportunity Cost Wheat The slope of a line (tons) equals the “rise –1000 over the run” – 6,000 slope = = –10 100 the amount the line 5,000 rises when you 4,000 move to the right 3,000 by one unit. 2,000 Here, the 1,000 opportunity cost of 0 a computer is 0 100 200 300 400 500 600 10 tons of wheat. Computers 17 A C T I V E L E A R N I N G 2: PPF and Opportunity Cost In which country is the opportunity cost of cloth lower? FRANCE ENGLAND Wine Wine 600 600 500 500 400 400 300 300 200 200 100 100 0 0 0 100 200 300 400 0 100 200 300 400 Cloth Cloth 18 A C T I V E L E A R N I N G 2: Answers England, because its PPF is not as steep as France’s. FRANCE ENGLAND Wine Wine 600 600 500 500 400 400 300 300 200 200 100 100 0 0 0 100 200 300 400 0 100 200 300 400 Cloth Cloth 19 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. • If opp. cost remains constant, PPF is a straight line. (In the previous example, opp. cost of a computer was always 10 tons of wheat.) • If opp. cost of a good rises as the economy produces more of the good, PPF is bow-shaped. 20 Why the PPF Might Be Bow-Shaped As the economy Soda shifts resources from soda to mountain bikes: • PPF becomes steeper • opp. cost of mountain bikes increases Mountain Bikes 21 Why the PPF Might Be Bow-Shaped At point A, At A, opp. cost of Soda A mtn bikes is low. most workers are producing soda, even those that are better suited to building mountain bikes. So, do not have to give up much soda to get more bikes. Mountain Bikes 22 Why the PPF Might Be Bow-Shaped At B, most workers Soda At B, opp. cost are producing bikes. of mtn bikes The few left in soda is high. are the best soda makers. B Producing more bikes would require shifting some of the best chemists away from soda Mountain production, Bikes would cause a big 23 drop in soda output. Economic Growth and the PPF With additional Wheat resources or an (tons) Economic improvement in 6,000 growth shifts the PPF technology, 5,000 outward. the economy can 4,000 produce more computers, 3,000 more wheat, 2,000 or any combination 1,000 in between. 0 0 100 200 300 400 500 600 Computers 24 The PPF: A Summary The PPF shows all combinations of two goods that an economy can possibly produce, given its resources and technology. The PPF illustrates the concepts of tradeoff and opportunity cost, efficiency and inefficiency, unemployment, and economic growth. A bow-shaped PPF illustrates the concept of increasing opportunity cost. 25
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