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Lesson 2.1: Circular Flow Diagram
The circular flow diagram (also called the circular flow model) is perhaps the simplest diagram/model of
economics to understand. In essence, the circular flow diagram displays the relationship of resources and money
between firms and households. Every adult and even most children can understand its basic structure from personal
experience. Firms employ workers, who spend their income on goods produced by the firms. This money (income
spent by workers which turns into revenue by firms) is then used to compensate the workers and buy raw materials
to make the goods. This is the basic structure behind the circular flow diagram (seen below.)
The Graph
Explanation
In the model, firms and households interact with one another in both the product market (or goods market) and the
factors of production market (or factors market). The product market, as mentioned in the name, is where all
products made by businesses/firms are exchanged. Thefactors of production market is where inputs such as
land, labor, capital, and other resources are exchanged. Households earn money by selling their “resources” (most
often labor) to businesses in the factor market. In return, households receive income. The price of the resources the
businesses purchase (labor from households) are the “costs.” From the resources provided by households,
businesses produce goods, which are then sold in the product market. Households use their incomes to purchase
these goods in the product market. In return for the goods, businesses bring in revenue. While this may seem like a
lot of information, it is actually quite logical. Even though the graph itself is extremely simple to most people, it is
important to have it completely memorized. Know the names of each market and the actions that occur in each. For
high school and college students, the circular flow diagram is a common theme on many tests. It should result in
easy points for those of you that have it memorized.
Lesson 2.2: The Production-Possibilities Curve
A production-possibilities curve (or PP curve for short) is one of the simplest graphs in economics. A PP
curve shows the relationship between output levels of two goods in an economy. It assumes the specified economy
can only produce these two goods. In the real world of economics, this is highly unrealistic, but it allows us to better
understand opportunity costs, trade-offs, and maximization/utilization. On each axis of the graph is the quantity of
one specific good. The further from the origin, the higher quantity of the good produced. An example of a PP curve
is shown below.
Understanding the Graph
Observe that at any point in the quadrant above, we are producing a specific amount of one good and a specific
amount of the other good. The curved line in the graph represents the economy atmaximum capacity (the
economy is working at “full employment”) for the time. The curve stems from different production levels of each good
based on technologies and efficiency of the workers producing the specific good. When less of one good is
produced in order to produce more of the other good, the land, labor, and/or capital (factors of production) used to
create the new good may not be able to produce this new good as efficiently as it could the good it did previously.
We will use an example to clarify. Suppose an imaginary economy produces an equal amount of cars and
televisions. The economy decides to begin producing fewer cars and more televisions, thus some car factories are
now used as television factories. However, because these new television factories have car-manufacturing
technology instead of television-manufacturing technology, they do not produce televisions as efficiently as they
produced cars. Thus, the decrease in the amount of cars produced will be greater than the increase in the amount of
televisions produced (due to inefficiency of factors of production), creating a curve on the graph at maximum
capacity.The space inside the curve represents an economy that is not operating at maximum capacity (e.g. one in
a recession) and the space outside the curve is an unattainable point at the given time (economic growth is needed
to achieve the point).
Determinants of the PP Curve
The following factors affect the position of the PP curve in any given economy. Changes in these factors can shift
the PP curve inward or outward. It is imperative to understand these determinants and how they affect the curve.
Some examples of these shifts will be shown in the upcoming lessons.
·
Size of the labor force - The more workers, the more goods that can be produced. An increase in the labor
force leads to an outward shift of the PP curve. (A decrease consequently leads to an inward shift of the PP curve.)
·
Quantity/quality of capital – The more capital available to produce goods, the more goods that can be
produced. Also, when the quality of the capital improves, more goods can be produced. An increase in the
quantity/quality of capital shifts the curve outward as more goods are produced. (Again, a decrease consequently
leads to an inward shift of the PP curve.)
·
Quantity/quality of resources - Similar to capital, more and better resources create more goods. An increase
in the quantity/quality of resources shifts the curve outward. (Again, a decrease consequently leads to an inward
shift of the PP curve.)
·
Technology - Improved technology produces goods faster and more efficiently. Thus, more goods can be
produced. Increases/improvements in technology shift the curve outward.
·
Health – Healthier economies have more citizens in the work force as well as stronger workers. When the
health of an economy increases, more goods can be produced, thus shifting the curve outward.
·
Education – Smarter economies create faster, better ways of producing goods. This increases the amount of
goods produced, leading to economic growth. With an increase in education, the PP curve shifts outward.
Lesson 2.3: Guns, Butter, and Opportunity Cost
Opportunity Cost on the PP Curve
Recall from Chapter One that the opportunity cost is the best alternative to a decision. When dealing with a PP
curve, the opportunity cost is simply the amount of goods given up to produce the other good (as there are only two
goods produced in the economy’s PP curve). Due to the nonlinear shape of the PP curve (after all, it is a curve), the
opportunity cost at a point on the curve is different than the opportunity cost at most of the other points. (It is
possible that the opportunity cost is the same at two points along the curve.) For linear PP curves used in entry-level
economics, the opportunity cost will be constant. Notice the economy below.
The PP curve graphed above represents Econoville, an economy capable of producing solely cars and boats. At
point A, the economy can produce 4 cars and 26 boats at maximum capacity. In order to move to point B, where the
economy can produce 9 cars but only 22 boats, the economy must produce 5 more cars and sacrifice 4 boats. In
this situation, the opportunity cost of producing the 5 additional cars is thus 4 boats, .8 boats for every car. If we
observe a movement along the curve from point C to point D, we see the economy of Econoville must sacrifice 10
boats for the additional production of 4 cars. This would be an opportunity cost of 10 boats (or 2.5 boats per car).
Notice the opportunity cost from points A to B is different than from C to D. Simple economies like Econoville must
evaluate opportunity costs on their PP curves in order to maximize economic well-being.
Guns vs. Butter
You have probably heard the phrase “guns or butter” before. Radio, television, and political speeches/debates use
the term to describe every economy. While guns and butter do not specifically refer to both guns and butter, they
represent domestic spending (butter) and foreign war/involvement spending (guns). The guns and butter concept
deals directly with the PP curve (guns on one axis and butter on the other). An economy can not produce high
amounts of both, so it must evaluate its current situation and decide the quantity of each to produce. Typically,
Liberals (Democrats in America) favor higher amounts of “butter” spending with lower amounts of “guns” spending.
Conservatives (Republicans in America) favor the opposite, high amounts of “guns” spending with lower amounts of
“butter” spending.
Lesson 2.4: Examples of PP Curve Movements
Before examining these examples and trying shifts of your own, it is important to understand that every graph you
write must be completely labeled and marked. Each axis needs to be labeled correctly and the economy of which
the PP curve belongs to should be labeled below the graph. All movements, whether between points or new curves,
should be displayed with arrows. For you students reading, it is vital to do this in order to show exactly what
happened in the situation and to receive full credit for your answers.
Example 1
Suppose the economy of Alphaville is currently in a recession. The economy of Alphaville produces both hammers
and shoes. Display a possible point on the PP curve of the current economic conditions in Alphaville.
Because Alphaville is in a recession, it is not operating at maximum capacity. Thus the current point of economic
output must be somewhere inside the curve.
Example 2
Now assume Alphaville is operating at full employment (maximum capacity.) The technology in Alphaville advances
significantly. Display this effect on Alphaville’s PP Curve.
The increase in technology creates more goods and shifts the PP curve outward.
Example 3
Assume Alphaville is again operating at full employment. A large amount of the population has retired with not
enough entry-level workers to fill the positions of these retirees. Display the effects on the PP curve of Alphaville.
Because more people are retiring
than entering the work force, the number of workers in this economy is decreasing. A fewer amount of workers
produces less and the curve thus shifts inward.Example 4
Again, Alphaville is at full employment. A new technology enables more shoes to be produced in a smaller amount
of time. Display the effects on the PP curve for Alphaville.
As mentioned in the context of the problem, technology increases and produces more shoes. However, it only
produces more shoes. The quantity of shoes increases while the amount of hammers remains the same. Thus, the
shift moves outward so that the quantity of shoes increases.
Chapter 2 Critical Thinking
Questions:
1. Suppose an economy can produce a maximum of 100 boats or 100 toy guns. Can the economy produce 100
boats and 30 toy guns?
2. A new material is synthesized to be used in factories. It is stronger, more reliable, and longer lasting that steel.
What effect would this new material have on an economy’s PP curve?
3. An economy can produce 33 toy cars and 11 battleships at maximum capacity. Suppose the economy is
producing 22 toy cars and 3 battleships. What is wrong with this economy?
4. An economy can produce 15 boats and 4 cars at Point A and 10 boats and 8 cars at Point B. What is the
opportunity cost (in terms of boats) of moving from Point A to Point B?
5. What are three possible ways for an economy to grow and shift its PP curve?
6. Is it better to produce a maximum of a specific good and zero of the other, or to produce some combination of
the two?