0 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 Households:  Have people who go to work & provide resources (factors of production)  buy and consume goods & services Households Firms

1 Our First Model: The Circular-Flow Diagram  A way to organize the economic transactions/decisions of 2 decision-makers: Households Firms (businesses) Households Firms Firms:  Buy resources (factors of production) from households & use them to produce goods and services  sell goods & services to households Firms:  Buy resources (factors of production) from households & use them to produce goods and services  sell goods & services to households

2 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)

3 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 & firms

4 FIGURE 1: The Circular-Flow Diagram Markets for Factors of Production Households Firms Income Wages, rent, profit Factors of production Labor, land, capital Spending G & S bought G & S sold Revenue Markets for Goods & Services

5 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)

6 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

7 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 cars & 2200 computers cars & 2000 computers

8 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

9 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

10 Your turn  What is the PPF?  What does it show?  What does a point on the curve mean?

11 Point on graph Production Com- puters Wheat A5000 B4001,000 C2502,500 D1004,000 E05,000 A B C D E PPF Example #2

12 A C T I V E L E A R N I N G 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

13 A C T I V E L E A R N I N G 1 : Answers 13  Point F: 100 computers, 3000 tons wheat  Point F: Possible but not efficient: could get more of either good w/o sacrificing any of the other. F

14 A C T I V E L E A R N I N G 1 : Answers 14  Point G: 300 computers, 3500 tons wheat  Point G requires more resources than are available Not possible. G

15 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

16 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.

17 The PPF and Opportunity Cost The slope of a line equals the “rise over the run” – the amount the line rises when you move to the right by one unit. – slope = = –10 Here, the opportunity cost of a computer is 10 tons of wheat.

18 A C T I V E L E A R N I N G 2 : PPF and Opportunity Cost 18 In which country is the opportunity cost of cloth lower? FRANCE ENGLAND

19 A C T I V E L E A R N I N G 2 : Answers 19 England, because its PPF is not as steep as France’s. FRANCE ENGLAND

20 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.

21 Why the PPF Might Be Bow-Shaped Mountain Bikes Soda As the economy shifts resources from soda to mountain bikes: PPF becomes steeper opp. cost of mountain bikes increases

22 A Why the PPF Might Be Bow-Shaped At point A, 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 Soda At A, opp. cost of mtn bikes is low.

23 B Why the PPF Might Be Bow-Shaped At B, most workers are producing bikes. The few left in soda are the best soda makers. Producing more bikes would require shifting some of the best chemists away from soda production, would cause a big drop in soda output. Mountain Bikes Soda At B, opp. cost of mtn bikes is high.

24 Economic Growth and the PPF With additional resources or an improvement in technology, the economy can produce more computers, more wheat, or any combination in between. Economic growth shifts the PPF outward.

25 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.