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 & Dr. Jaydeep Mukherjee
11.08.2008 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 & Dr. Jaydeep Mukherjee
11.08.2008 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 & Dr. Jaydeep Mukherjee
11.08.2008 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 & Dr. Jaydeep Mukherjee
11.08.2008 Ravenshaw University 5
The Circular-Flow Diagram
MARKETS Spending
Revenue
FOR
GOODS AND SERVICES
•Firms sell Goods &
Goods &
Services •Households buy Services
sold bought

FIRMS HOUSEHOLDS
•Produce and sell •Buy and consume
goods and services
goods and services
•Own and sell factors
•Hire and use factors
of production
of production

Factors of MARKETS Labour, land

production FOR & capital
FACTORS OF PRODUCTION
•Households sell Income
Wages, rent Flow of inputs
and profit •Firms buy
and outputs
Flow of
income/payments
[MBA - 2008-10]
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 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 & Dr. Jaydeep Mukherjee
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 The Production Possibilities Frontier
Employment of labour Production
hours
Computers Wheat Computers Wheat

A 50000

B 40000
Fill in the
C 30000 table and
draw the PPF
D 20000

E 10000

F [MBA - 2008-10]
0
06.08.2008 & Dr. Jaydeep Mukherjee
11.08.2008 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 & Dr. Jaydeep Mukherjee
11.08.2008 Ravenshaw University 9
 The Production Possibilities Frontier
What we learnt so far
 Points on the PPF (like A-F)
 possible
 efficient: all resources are fully utilized

 Points below the PPF (like G)

 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 & Dr. Jaydeep Mukherjee
11.08.2008 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
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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 & Dr. Jaydeep Mukherjee
11.08.2008 Ravenshaw University 12
 The Production Possibilities Frontier
Tons of
wheat FOR ANSWER, REFER TO
produced At A, Opp cost of
WHY?
A Computer is low MANKIW: CHAPTER 2,
PAGES 24-25

At B, Opp cost of
Computer is high
B

[MBA - 2008-10]
06.08.2008 & Dr. Jaydeep Mukherjee Quantity of computer
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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 & Dr. Jaydeep Mukherjee
11.08.2008 Ravenshaw University 14