MODULE 1.

3 - UNDERSTANDING THE WORLD BY USE OF MODELS

ECONOMIC MODELS

An economic model is a simplified version of reality that helps gain insight into economic phenomena. A
model usually starts with simplifying assumptions about the characteristics of economic agents, the
features of the economic environment in which they operate, the relationship between economic
variables, etc. A good model is simple enough to be understood, while complex enough to capture key
information. In other words, a good model ignores unnecessary details and focuses on capturing the
essential relationships and factors that drive economic behaviour and outcomes. The expression of a
model can be in the form of words, diagrams, or mathematical equations. Economic models can be used
to make simulations (i.e. to investigate how different scenarios might play out) as well as predictions (i.e.
to forecast a range of economic indicators). Examples include models that predict the impact of a rise in
the interest rate on the rate of inflation; models which assess how a cut in income tax will affect tax
revenue, etc.

THE PRODUCTION POSSIBILITIES MODEL

A Production Possibilities Curve (PPC) (or Frontier) is a curve showing the maximum amounts of 2 goods
that can be produced by an economy given its resources and technology. Any output combination that
lies on or below the PPC is attainable. Due to the existence of scarcity, any output combination that lies
above the PPC is unattainable.

A PPC is always downward sloping. The vertical (resp. horizontal) intercept of the PPC represents a
situation where all of the economy’s resources are allocated to the production of the good labelled on
the vertical (resp. horizontal) axis. A Production Possibilities Curve (PPC) (or Frontier) is a curve showing
the maximum amounts of 2 goods that can be produced by an economy given its resources and
technology.

Instead of considering 2 specific goods, it is common to consider 2 categories of goods: consumer goods
and capital goods. Consumer goods are goods that are purchased by households for their own
consumption (e.g. noodles, shoes, healthcare, etc.) Spending on consumer goods is known as
consumption. Capital goods are man-made goods that are used in a manufacturing process (e.g.
machines, tools, office building, vehicles, etc.) Spending on capital goods is known as investment or fixed
capital formation.
PRODUCTIVE EFFICIENCY

Productive Efficiency (PE) is achieved when it is impossible to produce more of one good without
producing less of another. All points on the curve are known as production possibilities and are
productively efficient. All output combinations that lie below the PPC are productively inefficient. In order
for an economy to achieve productive efficiency, all resources must be fully employed (i.e. zero
unemployment) and all resources must be used efficiently (i.e. optimal input-mix).
ECONOMIC EXPANSION & CONTRACTION

In the real world, no economy is ever likely to produce on its PPC. This is because there is always some
unemployment and some inefficiencies in production. Therefore, an economy’s actual output is always
a point inside the PPC. The greater unemployment or inefficiencies in production, the further away is the
point of production from the PPC and vice versa.Note that changes in unemployment or productive
inefficiencies do not shift the PPC in the short-run.

A movement away from the PPC is known as an economic contraction (i.e. fewer goods and services are
effectively being produced). It can be caused by an increase in unemployment or productive
inefficiencies.

An movement towards the PPC is known as an economic expansion (i.e. more goods and services are
effectively being produced). It can be caused by a decrease in unemployment or productive inefficiencies.
PPC & OPPORTUNITY COST

Any output combination that lies on the PPC is such that it is impossible to produce more of one good
without producing less of another. In other words, the economy’s resources are used fully and efficiently.
In that case, producing more of one good has an OC because it requires a reduction in the production of
the other good (i.e. movement along the PPC). In particular, the opportunity cost associated with an
increase in the production of Good X is equal to the value of the units of Good Y which can no longer be
produced.

Any output combination that lies below the PPC is such that it is possible to produce more of one good
without producing less of another. In other words, the economy does not produce as much as it could.
This may be caused by the unemployment of some resources (e.g. workers, machines, fields, etc.), or
because of an inefficient input-mix (i.e. when resources are not combined in the best possible way). In
that case, producing more of one good (i.e. movement towards the PPC) does not have an OC because it
does not require a reduction in the production of the other good.
CONSTANT VS INCREASING OPPORTUNITY COST

A linear PPC (i.e. represented as a straight line) indicates that the OC of producing each additional unit
of either good is constant. That is, the quantity of Good X which must be given up in order to produce
each additional unit of Good Y is fixed. For example, for every additional melon that I produce, I must
give up 5 tomatoes.

In practice, however, constant OC is not quite realistic. Indeed, it often becomes more and more difficult
to produce each additional unit of output (e.g. mineral resources, cherries, grades at an exam, etc.).
Besides, resources are heterogeneous in the sense that they are not all equally suited to the production
of different products (i.e. soil, workers, factories, etc.). Therefore, more and more resources are usually
required to produce each additional unit of Good X. In that case, the OC of Good X is increasing (i.e. more
and more units of Good Y must be given up in exchange for each additional unit of Good X). Graphically
speaking, the PPC is represented by a concave (i.e. bowed out) curve.
ECONOMIC GROWTH

An economy experiences (potential or long-run) economic growth when it can produce more goods and
services over a given period of time. Economic growth can be represented by an outward shift of the PPC
(i.e. growth in production possibilities). Note that the outward shift of the PPC can be either bilateral (i.e.
parralel shift) or unilateral (i.e. pivot shift).

Economic growth can be caused by an increase in the quantity of the resources available in the economy.
In particular, the size of the labour force, and arguably the pool of entrepreneurs, is likely to increase
when the economy has a positive rate of natural increase, or a positive rate of net migration. Besides,
the stock of physical capital available in the economy increases as the result of investment spending (i.e.
spending by firms on capital goods). In particular, in order for the stock of physical capital to increase, it
is necessary that firms purchase new capital equipment at a rate that is greater than the rate at which
the current stock of capital equipment depreciates (i.e. loses value over time due to wear and tear). In
other words, net investment must be positive. Finally, the stock of natural resources available in the
economy increases when new deposits are discovered or exploited (e.g. new oil fields, new gold veins,
etc.), or through territorial gains (e.g. wars).

Economic growth can also be caused by an increase in the productivity (or quality) of the resources
available in the economy. Simply put, the productivity of a given resource is equal to the quantity of
goods and services that it can produce over a given period of time. Labour productivity, and arguably the
productivity of entrepreneurs, can rise due to human capital investments (i.e. investments in education
or training). Labour productivity can also rise due to the use of more or better physical capital by workers
(e.g. backhoe vs shovel). Finally, labour productivity can rise due to an improved nutrition and healthcare.
The productivity of physical capital can rise as the result of Research & Development (R&D) investments
aimed at introducing new and improved machinery and equipment. The productivity of natural
resources, and soil productivity in particular, can be impoved by mitigating climate change, by combating
desertification (e.g. Great Green Wall), by using fertilisers, by adopting crop rotation or fallowing, or by
building irrigation and drainage systems.
ECONOMIC DECLINE

Economic decline refers to a fall in the productive potential of an economy. Economic decline can be
represented by an inward shift of the PPC. Economic decline can be caused by natural disasters (e.g.
floods, droughts, earthquakes, hurricanes, etc.), wars, epidemics (i.e. Covid-19, 1918 flu pandemic, Black
Death, etc.), negative net investment (i.e. when firms do not sufficiently invest to replace the existing
capital equipment), population decline (e.g. negative net migration rate, fertility below the replacement
level, etc.), the exhaustion of non-renewable natural resources, etc.

THE SIMPLIFIED CIRCULAR FLOW DIAGRAM

The circular-flow diagram shows how resources, products, and money flow through the economy. In its
simplified form, there are only 2 types of economic agents: households & firms (i.e. free-market economy
with no government intervention). Resources (i.e. land, labour, capital & entrepreneurship) are owned
by households. Firms buy resources from households in factor markets in order to produce goods &
services. In return, households receive income from firms (i.e. rent, wage, interest & profit). Households
spend exactly their income to purchase goods & services from firms in product markets (i.e. no savings
and no borrowing). The economy is closed (i.e. no connection with the rest of the world).

This model shows that the household incomes coming from the sales of factors of production is equal to
the expenditure flow by households on goods and services. In addition, these two flows must be equal
to the value of total output produced by firms (i.e. the output flow). Overall, the circular flow of income
shows that in any given time period, the value of output produced in an economy is equal to the total
income generated in producing that output, which is equal to the expenditures made to purchase that
output.
THE EXTENDED CIRCULAR FLOW

A real-world economy is more complicated than the simplified model previously considered.
Governments collect tax revenue, provide transfer payments and purchase goods and services. The
economy is open, so it engages in international trade by exporting and importing goods and services.
Both domestic and foreign residents can lend or borrow money in financial markets.

Injections (J) refer to non-household spending on domestic goods and services. There are 3 main types
of injections: Investment, Government spending & Exports. Investment (I) refers to spending on capital
goods by firms. Government spending (G) refers to public expenditure on goods and services (e.g.
education, healthcare, infrastructure, national defence, etc.). Exports (X) refer to spending on domestic
goods and services by non-residents.

J=I+G+X
Leakages, or Withdrawals (W), refer to national income which is not spent on domestically produced final
goods and services. There are 3 main types of leakages: Savings, Taxes & Imports. Savings (S) refers to
the portion of household (disposable) income that is not spent. Taxes (T) refer to the portion of national
income that is collected by the government. Imports (M) refer to spending on foreign goods and services
by domestic residents.

W=S+T+M

In the real world, leakages and injections are unlikely to be equal. If injections are larger than leakages,
then the size of the circular flow becomes larger (i.e. national income rises). If injections are smaller than
leakages, then the size of the circular flow becomes smaller (i.e. national income falls).