August 27, 2014EC 110Assumptions and Models-Assumptions simplify the complex world, make it easier to understand- Example: To study international trade, assume two countries and two goods. Unrealistic, but simple to learn and gives useful insights about the real world.-Model: a highly simplified representation of a more complicated reality. Economistsuse models to study economic issues. Our First Model:The Circular-Flow Diagram (look in notes for pic)-The Circular-Flow Diagram: a visual model of the economy, shows how dollars flow through markets among households and firms-Two types of “actors:”-Households-Firms:-buy/hire factors of production, use them to produce goods and services-Sell good and services-Two markets:-The markets for goods and services-The market for “factors of production”Factors of Production-Factors of Production: the resources the economy uses to produce goods and services, including:-labor-land-capitol (building and machines used in production) -entrepreneurship Our Second Model:The Production Possibilities Frontier-The Production Possibilities Frontier (PPF): a graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology. -Recall: The opportunity cost of an item is what must be given up to obtain that item.-Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to the other.-Society faces a tradeoff: Getting more of one good requires sacrificing some of the other.-The slope of the PPF tells you the opportunity cost of one good in terms of the other.The Shape of the PPF-The PPF could be a straight line, or bow-shaped-Depends on what happens to opportunity cost as economy shifts resources from one industry to the other.-If opp. Cost remains constant, PPF is a straight line. Essentially, the same resources are equally useful for producing in either industry. -If opp. Cost of a good rises as the economy produces more of the good, PPF isbow-shaped. Essentially, the resources are specialized and not easily adaptable for producing in either industry. -The slope of a line equals the “rise over the run,” the amount the line rises when you move to the right by one unit.-With additional resources or an improvement in technology, the economy can produce more barley, more wheat, or any combination in between. (EX in notebook)-PPF is bow-shaped when different workers have different skills, different opportunity costs of producing one good in terms of the other.-The PPF would also be bow-shaped when there is some other resource, or mix of resources with varying opportunity costs (e.g., different types of land suited for different uses). The PPF: Important Notes**-The PPF shows all combinations of two goods that an economy can possibly produce, given its resources and technology.-The PPF illustrates the concepts of tradeoff and opportunity cost, efficiency and inefficiency, unemployment, and economic growth.-A bow-shaped PPF illustrates the concept of increasing opportunity cost. A straight line PPF illustrates constant opportunity costs. Microeconomics and Macroeconomics-Microeconomics: The study of how households and firms make decisions and how they interact in markets.-Macroeconomics: The study of economy-wide phenomena, including inflation, unemployment, and economic growth. The Economist as Policy Advisor-As scientist, economists make positive statements, which attempt to describe the world as it is.-As policy advisors, economists make normative statements, which attempt to prescribe how the world should be. ***There will be a PPF on the first examThe PPF: What We Know So Far -Points on the PPF: -possible-efficient: all resources are fully utilized-Points under the PPF: -possible-not efficient: some resources underutilized(e.g., workers unemployed, factories idle)-Points above the PPF:-currently