Our First Model: The Circular-Flow Diagram
The economy consists of millions of people engaged in many activities buying, selling, working, hiring, manufacturing, and so on. To understand how the economy works, we must find some way to simplify our thinking about all these activities. In
other words, we need a model that explains, in general terms, how the economy is organized and how participants in the economy interact with one another Figure presents a visual model of the economy called a circular-flow diagram.
In this model, the economy is simplified to include only two types of decision makers-firms and households. Firms produce goods and services using inputs, such as labor, land, and capital (buildings and machines). These inputs are called
the factors of production. Households own the factors of production and consume all the goods and services that the firms produce.
(rims Households and firms interact in two types of markets. In the markets for goods and services, households are buyers, and firms are sellers. In particular, households buy' the output of goods and services that firms produce. In the markets for the factors of production, households are sellers, and firms are buyers. In these markets, households provide the inputs that firms use to produce goods and services. The circular-flow diagram offers a simple way of organizing the economic, rations that occur between households and firms in the economy The two loops of the circular-flow diagram are distinct but related. The inaner loop represented lows of inputs and outputs. The households sell the use of their labor, land, and capital to the firms in the markets for the factors of production. The firms then use these factors to produce goods and services, which in turn are sold to households in the markets for goods and services. The outer
loop of the diagram represents the corresponding flow of dollars. The households spend money to buy goods and services from the firms. The firms use some of the spend
revenue from these sales to pay for the factors of production, such as the wages of their workers. want s lent 1s. the profit of the firm owners, who are themselves of members of households.
Let's take a tour of the circular flow by following a dollar bill as it makes its way from person to person through the economy. Imagine that the dollar begins at a household-say, in your wallet. If you want to buy a cup of coffee, you take the dollar (along with a few of its brothers and sisters) to one of the economy's markets for goods, and services, such as your local Starbucks coffee shop. There, you spend it on your favorite drink. When the dollar moves into the Starbucks cash register, it becomes revenue for the firm. The dollar doesn't stay at Starbucks for long, however, because the firm uses it to buy inputs in the markets for the factors of production. Starbucks might use the dollar to pay rent to its landlord for the space it occupies or to pay the wages of its workers. In either case, the dollar enters the income of some household and, once again, is back in someone's
wallet. At that point, the story of the economy's circular flow starts once again.
The circular-flow diagram in Figure is a very Simple model of the economy.
A more complex and realistic. circular-flow model would include, for instance,
the roles of government and international trade. (A portion of that dollar you cave, to Starbucks might be used to pay taxes or to buy coffee beans from a termer in Brazil.) Yet these details are not crucial for a basic understanding Of how the economy is organized: Because of its simplicity, this circular-flow
diagram is useful to keep in mind when thinking about how the pieces of the
economy fit together.
Our Second Model: The Production Possibilities Frontier
Most economic models, unlike the circular-flow diagram, are built using the tools of mathematics. Here we use one of the simplest such models, called the production possibilities frontier, to illustrate some basic economic ideas.
Although real economies produce thousands of goods and services, let's
consider an economy that produces only two goods-cars and computers.
Together, the car industry and the computer industry use all of the economy's factors of production. The production possibilities frontier is a graph that shows the various combinations of outputting this case, cars 'and computers that the economy can possibly produce given the available factors of production and the available production technology that firms use to turn these factors into output.
Figure shows this economy's production possibilities frontier. 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. The two endpoints of the production possibilities frontier represent these extreme possibilities.
More likely, the economy divides its resources between the two industries, producing some cars and some computers. For example, it can produce 600 cars and 2,200 computers, shown in the figure by point A. Or, by moving some of the factors of production to the car industry from the computer industry, the economy can produce 700 cars and 2,000 computers, represented by point b Because resources are scarce, not every conceivable outcome is feasible. For example, no matter how resources are allocated between the two industries, the economy cannot produce the amount of cars and computers represented by point C.
Given the technology available for manufacturing cars and computers, the economy does not have enough of the factors of production to support that level of output. With the resources it has, the economy can produce at any point on or inside the production possibilities frontier, but it cannot produce at points outside the frontier.
An outcome is said to be efficient if the economy is getting all it can from the scarce resources it has available. Points on (rather than inside) the production possibilities frontier represent efficient levels of production. When the economy is producing at such a point, say point A, there is no way to produce more of one good without producing less of the other. Point D represents an inefficient outcome: For some reason, perhaps widespread unemployment, the economy is producing less than it could from the resources it has available: It is producing only 300 cars and 1,000 computers, If the source of the inefficiency is eliminated, the economy can increase its production of both goods. For example, if the economy moves from point D to point A, its production of cars increases from 300 to 600, and its production of computers increases from 1,000 to 2,200, One of the Ten Principles of Economics discussed in Chapter 1 is that people trade-offs. The production possibilities frontier shows one trade-off that society faces. Once we have reached an efficient point on the frontier, the only way of producing more of one good is to produce less of the other. When the economy moves from point A to point B, for instance, society produces 100 more cars at the
expense of producing 200 fewer computers.
This trade-off helps us understand another of the Ten Principles of Economics:
The cost of something is what you give up to get it. This is called the opportunity cost. The production possibilities frontier shows the opportunity cost of one good as measured in terms of the other good.. When society moves from point A to point B, it gives up 200 computers to get 100 additional cars. That is, at point A, the opportunity cost of 100 cars is 200 computers. Put another way, the opportunity cost of each car is two computers. Notice that the opportunity cost of a car equals the slope of the production possibilities frontier. (If you don't recall what slope is, you can refresh your memory with the graphing appendix to-this chapter.) The opportunity cost of a car in terms of the number of computers is not constant in this economy but depends on how many cars and computers the economy is producing. This is reflected in the shape of the production possibilities frontier. Because the production possibilities frontier in Figure 2 is bowed outward, the opportunity cost of a car is highest when the economy is producing many cars and few computers, such as at point E, where the frontier is steep. When the economy my is producing few cars and many computers, such as at point F, the frontier is flatter, and the opportunity cost of a car is lower.
Economists believe that production possibilities frontiers often have this bowed shape, When the economy is using most of its resources to make computers, the resources best suited to car production, such as skilled autoworkers, are being used in the computer industry. Because these workers probably aren't very good at making computers, increasing car production by one unit will cause
only a slight reduction in the number of computers produced.. Thus, at point F, the opportunity cost of a car in terms of computers is small, and the frontier is relatively flat. By contrast, when the economy is using most of its resources to make cars, such as at point E, the resources best suited to making cars are already at work in the car industry. Producing an additional car means moving some of the best computer technicians out of the computer industry and turning them into autoworkers. As a result, producing an additional car requires a substantial loss of computer output. The opportunity cost of a car is high, and the frontier is steep. The production possibilities frontier shows the trade-off between the outputs of different goods at a given time, but the trade-off can change over time.
For example, suppose a technological advance on the computer industry raises the number of computers that a worker can produce per week. This advance expands society's set of opportunities, For any given umber of cars, the economy can now make more computers, If the economy does not produce any computers, it can still produce 1000 cars, so one endpoint of the frontier stays the same. But if the economy devotes some of it's resources to the computer industry, it will produce more computers from those resources, As a result, the production possibilities frontier shifts outward, as in Figure .This figure illustrates what happens when an economy grows. Society can move production from a point on the old frontier to a point on the new frontier. Which point it chooses depends on its preferences for the two goods. In this example, society moves from point A to point G, enjoying more computers (2,300 instead of 2,200) and more cars (650 instead of 600).
The production possibilities frontier simplifies a complex economy to high-
light some basic but powerful idea scarcity, efficiency, trade-offs, opportunity cost, and economic growth. As you study economics, these ideas will recur in various form6, The production possibilities frontier offers one simple way of thinking about them firms in markets for specific goods and services. Or we can study the operation of the economy as a whole, which is the sum of the activities of all these decision makers in all these markets. The field of economics is traditionally divided into two broad subfields. Microeconomics is the study of how households and firms make decisions
and how they interact in specific markets. Macroeconomics is the study of economy-wide phenomena. A microeconomist might study the effects of rent control on housing in New York City, the impact of foreign competition on the U.S. auto industry, or the effects of compulsory school attendance on workers earnings. A macroeconomist might study the effects of borrowing by the federal
government, the changes over time in the economy's rate of unemployment, or alternative policies to promote growth in national living standards.
Microeconomics and macroeconomics are closely intertwined. Because changes in the overall economy arise from the decisions of millions of individuals, it is impossible to understand macroeconomic developments without considering the
associated microeconomic decisions.
For example, a macroeconomist might study the effect of a federal income tax cut on the overall production of goods and services. But to analyze this issue, he must consider how the tax cut affects households' decisions about how much to spend on goods and services.
Despite the inherent link between microeconomics and macroeconomics, the two fields are distinct. Because they address different questions, each field has its own set of models, which are often taught in separate courses.
In what sense is economics like a science? Draw a production possible.
Quick Quiz:
hillites frontier for a society that produces food and clothing. Show are feint point, an inefficient point, and an infeasible point. Show the effects of a drought.
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