ECONOMIC SECOND EDITION in MODULES S Paul Krugman Robin Wells with Margaret Ray and David Anderson MODULE 2 Models and Circular Flow Krugman Wells Why models are an important tool in the study of economics How to interpret the circular flow diagram of the economy How individual decisions affect the larger economy 3 of 11 Models in Economics A model is a simplified representation of a real situation that is used to better understand real life situations Create a real but simplified economy Ex Cigarettes in World War II prison camps Simulate an economy on a computer Ex Tax models money models The other things equal assumption means that all other relevant factors remain unchanged 4 of 11 Models for Money There is a growing business in creating economic models to help corporations make decisions A lucrative branch of economics is finance theory which helps investors what assets are worth The most famous application of finance theory was Long Term Capital Management LTCM a fund that used financial models to invest the money of wealth clients In 1998 bad economic news inflicted huge losses on LTCM s investments and LTCM closed a few months later 5 of 11 The Circular Flow Diagram The circular flow diagram is a model that represents the transactions in an economy by flows around a circle 6 of 11 The Circular Flow Diagram Money Households Goods and services Money Factors Markets for goods and services Factor Markets Goods and services Money Factors Firms Money 7 of 11 The Circular Flow Diagram A household is a person or a group of people that share their income A firm is an organization that produces goods and services for sale Firms sell goods and services that they produce to households in product markets Firms buy the resources they need to produce factors of production in factor markets 8 of 11 The Circular Flow Diagram The circular flow is simplified for a number of reasons Exports and imports with the rest of the world are ignored A more complete picture would include the sale of goods by firms to other firms Government is excluded Also absent are financial markets 9 of 11 Circular Flow of Economic Activities Ultimately factor markets determine the economy s income distribution Income distribution is how total income is divided among the owners of the various factors of production The circular flow diagram shows what goes around comes around One person s spending is another person s income 10 of 11 1 Almost all economics is based on models 2 An important assumption in economic models is the other things equal assumption which allows analysis of the effect of a change in one factor by holding all other relevant factors unchanged 3 The circular flow diagram represents transactions within the economy as flows of goods services and money between households and firms These transactions occur in markets for goods and services and factor markets 11 of 11