Sessions 3 & 4
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Sessions 3 & 4 Basic Economic Models (With inputs from N. Gregory Mankiw: Principles of Economics, 4th Edition, Chapter 2)
[MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
2
The Role of Assumptions
Economists make assumptions in order to simplify the complex world and make it easier to understand Examples:
a)
to understand international trade, it may be helpful to start by assuming that there are only two countries in the world and each country is producing only two commodities. Once we understand how trade works in 2x2 framework, we can extend our analysis to a greater number of countries and goods.
a)
while specifying a particular form of a functional relationship, we normally start with the assumption that the relationship is linear.
One important role of an economist is to decide which assumptions to make. [MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
3
Economic Models
Economists use models to simplify reality in order to improve our understanding of the world.
Most economic models are composed of diagrams and equations.
While developing an economic model, the use of assumptions is helpful
Two basic economic models are:
The Circular-Flow Diagram
The Production Possibilities Frontier [MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
4
The Circular-Flow Diagram
It is a visual model of the economy that shows how money flow through markets among households and firms Assumptions:
The economy is a closed economy
There are two decision-makers in the economy: households and firms (ignore the role of government)
There are two markets: the market for goods and services (product market) and the market for factors of production (factor market)
Firms are sellers in the product market and buyers in the factor market
Households are buyers in the product market and sellers in the factor market [MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
5
The Circular-Flow Diagram Revenue
Goods & Services sold
MARKETS FOR GOODS AND SERVICES •Firms sell •Households buy
Wages, rent and profit
[MBA - 2008-10] 06.08.2008 & 11.08.2008
Goods & Services bought
HOUSEHOLDS •Buy and consume goods and services •Own and sell factors of production
FIRMS •Produce and sell goods and services •Hire and use factors of production Factors of production
Spending
Labour, land MARKETS & capital FOR FACTORS OF PRODUCTION •Households sell •Firms buy
Income
Flow of inputs and outputs Flow of income/payments
Dr. Jaydeep Mukherjee Ravenshaw University
6
The Production Possibilities Frontier
It 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. Example:
•
Two goods: computers and wheat
•
One resource: labour (measured in hours)
•
Economy has 50,000 labour hours available per month for production
•
Producing one computer requires 100 hours labour
•
Producing one ton of wheat requires 10 hours labour [MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
7
The Production Possibilities Frontier Employment of labour hours Computers A
50000
B
40000
C
30000
D
20000
E
10000
F [MBA - 2008-10] 0 06.08.2008 & 11.08.2008
Wheat
Production Computers
Wheat
Fill in the table and draw the PPF
Dr. Jaydeep Mukherjee Ravenshaw University
8
The Production Possibilities Frontier Quick Thinking!
Find the point in the graph that represents (100 computers, 3000 tons of wheat) and label it G.
Find the point in the graph that represents (300 computers, 3500 tons of wheat) and label it H.
Would it be possible for the economy to produce these two combinations of the two goods (at G & H)? If so, why? If not, why not?
What will be the impact on PPF if a)
there is an increase in economy’s resources?
c)
a technological advance in the computer industry enables the economy to produce more computers for any given tons of wheat [MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
9
The Production Possibilities Frontier What we learnt so far
Points on the PPF (like A-F)
Points below the PPF (like G)
possible efficient: all resources are fully utilized
possible inefficient: some resources underutilized (e.g., workers unemployed, factories idle)
Points above the PPF (like H)
not feasible
[MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
10
The Production Possibilities Frontier
Society faces tradeoff: once we have reached efficient points on the frontier, only way of getting more of one good is to get less of the other.
Points A-F are called Pareto efficient. 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.
Recall: The opportunity cost of an item is what must be given up to obtain that item
The slope of the PPF shows the opportunity cost of one good in terms of the other.
In the example, opportunity cost of a computer is 10 tons of wheat, i.e., producing an additional computer requires resources that would otherwise produce 10 tons of wheat. FOR INTRODUCTORY OVERVIEW ON GRAPHING AND SLOPE, MUST READ
[MBA - 2008-10]MANKIW: CHAPTER 2, APPENDIX, PAGES 38-44 06.08.2008 & Dr. Jaydeep Mukherjee 11.08.2008 Ravenshaw University
11
The Production Possibilities Frontier
In this example we have assumed that opportunity cost remains constant (i.e., always 10) as economy shifts resources from one industry to the other.
Hence PPF is a straight line
If the opportunity cost of computer rises as the economy produces more of it, PPF is bow-shaped
[MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
12
The Production Possibilities Frontier Tons of wheat produced A
FOR ANSWER, REFER TO
At A, Opp cost of Computer is low
WHY?
MANKIW: CHAPTER 2, PAGES 24-25
B
[MBA - 2008-10] 06.08.2008 & 11.08.2008
At B, Opp cost of Computer is high
Dr. Jaydeep Mukherjee Ravenshaw University
Quantity of computer 13 produced
Assignment – 2 (for practice) Prepare the following questions for the next class Chapter 2 (Problems and Applications): 2 and 4 [Page 37]
[MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
14
[MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
2
The Role of Assumptions
Economists make assumptions in order to simplify the complex world and make it easier to understand Examples:
a)
to understand international trade, it may be helpful to start by assuming that there are only two countries in the world and each country is producing only two commodities. Once we understand how trade works in 2x2 framework, we can extend our analysis to a greater number of countries and goods.
a)
while specifying a particular form of a functional relationship, we normally start with the assumption that the relationship is linear.
One important role of an economist is to decide which assumptions to make. [MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
3
Economic Models
Economists use models to simplify reality in order to improve our understanding of the world.
Most economic models are composed of diagrams and equations.
While developing an economic model, the use of assumptions is helpful
Two basic economic models are:
The Circular-Flow Diagram
The Production Possibilities Frontier [MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
4
The Circular-Flow Diagram
It is a visual model of the economy that shows how money flow through markets among households and firms Assumptions:
The economy is a closed economy
There are two decision-makers in the economy: households and firms (ignore the role of government)
There are two markets: the market for goods and services (product market) and the market for factors of production (factor market)
Firms are sellers in the product market and buyers in the factor market
Households are buyers in the product market and sellers in the factor market [MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
5
The Circular-Flow Diagram Revenue
Goods & Services sold
MARKETS FOR GOODS AND SERVICES •Firms sell •Households buy
Wages, rent and profit
[MBA - 2008-10] 06.08.2008 & 11.08.2008
Goods & Services bought
HOUSEHOLDS •Buy and consume goods and services •Own and sell factors of production
FIRMS •Produce and sell goods and services •Hire and use factors of production Factors of production
Spending
Labour, land MARKETS & capital FOR FACTORS OF PRODUCTION •Households sell •Firms buy
Income
Flow of inputs and outputs Flow of income/payments
Dr. Jaydeep Mukherjee Ravenshaw University
6
The Production Possibilities Frontier
It 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. Example:
•
Two goods: computers and wheat
•
One resource: labour (measured in hours)
•
Economy has 50,000 labour hours available per month for production
•
Producing one computer requires 100 hours labour
•
Producing one ton of wheat requires 10 hours labour [MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
7
The Production Possibilities Frontier Employment of labour hours Computers A
50000
B
40000
C
30000
D
20000
E
10000
F [MBA - 2008-10] 0 06.08.2008 & 11.08.2008
Wheat
Production Computers
Wheat
Fill in the table and draw the PPF
Dr. Jaydeep Mukherjee Ravenshaw University
8
The Production Possibilities Frontier Quick Thinking!
Find the point in the graph that represents (100 computers, 3000 tons of wheat) and label it G.
Find the point in the graph that represents (300 computers, 3500 tons of wheat) and label it H.
Would it be possible for the economy to produce these two combinations of the two goods (at G & H)? If so, why? If not, why not?
What will be the impact on PPF if a)
there is an increase in economy’s resources?
c)
a technological advance in the computer industry enables the economy to produce more computers for any given tons of wheat [MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
9
The Production Possibilities Frontier What we learnt so far
Points on the PPF (like A-F)
Points below the PPF (like G)
possible efficient: all resources are fully utilized
possible inefficient: some resources underutilized (e.g., workers unemployed, factories idle)
Points above the PPF (like H)
not feasible
[MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
10
The Production Possibilities Frontier
Society faces tradeoff: once we have reached efficient points on the frontier, only way of getting more of one good is to get less of the other.
Points A-F are called Pareto efficient. 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.
Recall: The opportunity cost of an item is what must be given up to obtain that item
The slope of the PPF shows the opportunity cost of one good in terms of the other.
In the example, opportunity cost of a computer is 10 tons of wheat, i.e., producing an additional computer requires resources that would otherwise produce 10 tons of wheat. FOR INTRODUCTORY OVERVIEW ON GRAPHING AND SLOPE, MUST READ
[MBA - 2008-10]MANKIW: CHAPTER 2, APPENDIX, PAGES 38-44 06.08.2008 & Dr. Jaydeep Mukherjee 11.08.2008 Ravenshaw University
11
The Production Possibilities Frontier
In this example we have assumed that opportunity cost remains constant (i.e., always 10) as economy shifts resources from one industry to the other.
Hence PPF is a straight line
If the opportunity cost of computer rises as the economy produces more of it, PPF is bow-shaped
[MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
12
The Production Possibilities Frontier Tons of wheat produced A
FOR ANSWER, REFER TO
At A, Opp cost of Computer is low
WHY?
MANKIW: CHAPTER 2, PAGES 24-25
B
[MBA - 2008-10] 06.08.2008 & 11.08.2008
At B, Opp cost of Computer is high
Dr. Jaydeep Mukherjee Ravenshaw University
Quantity of computer 13 produced
Assignment – 2 (for practice) Prepare the following questions for the next class Chapter 2 (Problems and Applications): 2 and 4 [Page 37]
[MBA - 2008-10] 06.08.2008 & 11.08.2008
Dr. Jaydeep Mukherjee Ravenshaw University
14
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