Economic Models

An economic model is a simplified representation of an economic process or relationship, used to explain and predict economic behaviour.

Circular Flow Diagram

Shows how the economy is organized and how firms and households interact through two loops:

• Inner loop (real flows)
  Households supply factors of production (labor, land, capital) to firms; firms supply goods and services to households.
• Outer loop (monetary flows)
  Firms pay factor payments (wages, rent, interest, profit) to households; households pay consumption expenditure to firms for goods and services.

The diagram below illustrates these two loops and the four flows between households, firms, factor markets, and product markets.

Production Possibilities Frontier (PPF)

The PPF shows the maximum combinations of two goods (Good X on the horizontal axis, Good Y on the vertical axis) that an economy can produce with its available resources, factors of production, and technology.

The axes represent quantities of the two goods. Any point on or inside the curve is attainable; points outside are not.

Assumptions

• The economy produces only 2 products.
• Given resources remain constant.
• Technology and other factors remain constant during the period.
• Resources are fully utilized with maximum efficiency.
• Resources can transfer from one product to the other.

Position

• On the boundary
  Resources fully and efficiently employed.
• Inside the boundary
  Resources unemployed or inefficiently employed.
• Outside the boundary
  Not attainable with current resources.

Shape

The curve has a negative slope: more of one good requires producing less of the other.

Straight Line

Constant opportunity cost. Homogeneous resources, equally efficient in both industries.

Real-life example: a bakery with identical ovens and bakers making two loaf sizes. Every loaf of either size uses the same oven time and labour, so each extra large loaf always costs the same number of small loaves.

Concave

Increasing opportunity cost. Resources are non-homogeneous and not equally efficient across industries. The first units of Good X come from resources that are relatively better at making X. Later units need resources that are relatively better at making Y, so each extra unit of X costs more Y.

Moving from 0 to 10 units of X sacrifices 2 units of Y. Moving from 10 to 20 units of X sacrifices 6 units of Y.

Real-life example: a country with hill country and wet lowlands. The lowlands suit rice, while the hill slopes suit tea. Expanding tea first uses the best hill land. Expanding further pushes tea onto poorer land and takes rice land, so each extra kilogram of tea costs more rice.

Convex

Decreasing opportunity cost.

A convex PPF has decreasing opportunity cost. Each extra unit of X costs less Y than the one before. This requires resources to become more productive as they move toward X, for example through learning effects or economies of scale. Such conditions are rarely observed, so a convex PPF is mainly theoretical.

Moving from 0 to 10 units of X sacrifices 6 units of Y. Moving from 10 to 20 units of X sacrifices 2 units of Y.

Real-life example: a factory moving workers into solar panel production. Early workers are inexperienced and output is low, so each panel costs a lot of other output. Workers gain skill with practice and better processes lower costs (learning effects), so each further panel costs less of other output.

Shifts and Pivots

• More available resources or economic growth shift the curve outwards.
• Technological improvement in one product pivots the curve from the relevant axis; improvement in both shifts it outwards.
• Production can increase without opportunity cost by using unemployed resources or raising resource efficiency.

Worked Examples

PPF Opportunity Cost

Techville can produce at most 60,000 smartphones or 30,000 laptops. Assuming a straight-line PPF, find the opportunity cost of 10,000 extra smartphones.