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The Circular Flow Diagram TeacherWeb

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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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