2. Describe two simple models — the circular flow and the production possibilities frontier. Draw the graphs Economic Models

• Economists use models to simplify reality in order to improve our understanding of the world

• Two of the most basic economic models include:

  • The Circular Flow Diagram

  • The Production Possibilities Frontier

First Model: The Circular-Flow Diagram

The circular-flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms.

Firms

Produce and sell goods and services

Hire and use factors of production

Households

Buy and consume goods and services

Own and sell factors of production

Markets for Goods and Services

Firms sell

Households buy

Markets for Factors of Production

Households sell

Firms buy

Factors of Production

Inputs used to produce goods and services

Land, labor, and capital

Second Model: The Production Possibilities Frontier

The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.

Concepts Illustrated by the Production Possibilities Frontier

Efficiency

Tradeoffs

Opportunity Cost

Economic Growth

3. Difference between micro and macro economics.Role of economists in making policy

• Microeconomics focuses on the individual parts of the economy.

How households and firms make decisions and how they interact in specific markets

Microeconomics. The study of decision making undertaken by individuals (or households) and by firms. Like looking though a microscope to focus on the smaller parts of the economy

Decision of a worker to work overtime or not

A family’s choice of having a baby

An individual firm advertising

• Macroeconomics looks at the economy as a whole.

Economy-wide phenomena, including inflation, unemployment, and economic growth

Macroeconomics .The study of the behavior of the economy as a whole. Deals with economy wide phenomena

The national unemployment rate

The rate of growth in the money supply

The national government’s budget deficit

THE ECONOMIST AS POLICY ADVISOR

When economists are trying to explain the world, they are scientists.

When economists are trying to change the world, they are policy advisor.

4 . Absolute advantage and comparative advantage.

Absolute Advantage

The comparison among producers of a good according to their productivity—absolute advantage

Describes the productivity of one person, firm, or nation compared to that of another.

The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.

The Rancher needs only 10 minutes to produce an ounce of potatoes, whereas the Farmer needs 15 minutes.

The Rancher needs only 20 minutes to produce an ounce of meat, whereas the Farmer needs 60 minutes.

The Rancher has an absolute advantage in the production of both meat and potatoes.

Opportunity Cost and Comparative Advantage

Compares producers of a good according to their opportunity cost.

Whatever must be given up to obtain some item

The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.

Compares producers of a good according to their opportunity cost.

Whatever must be given up to obtain some item

The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.

Comparative Advantage and Trade

• Who has the absolute advantage?

• The farmer or the rancher?

• Who has the comparative advantage?

• The farmer or the rancher?