Economic Models.

#1 - THE CIRCULAR-FLOW DIAGRAM

A visual model of the economy that shows how dollars flow through markets among households and firms. In this model, the economy has two types of decisionmakers—households and firms. Firms produce goods and services using inputs, such as labor, land, and capital (buildings and machines). These inputs are called the factors of production. Households own the factors of production and consume all the goods and services that the firms produce. Households and firms interact in two types of markets. In the markets for goods and services, households are buyers and firms are sellers. In particular, households buy the output of goods and services that firms produce. In the markets for the factors of production, households are sellers and firms are buyers. In these markets, households provide firms the inputs that the firms use to produce goods and services.

Let’s take a tour of the circular flow by following a dollar bill as it makes its way from person to person through the economy. Imagine that the dollar begins at a household, sitting in, say, your wallet. If you want to buy a cup of coffee, you take the dollar to one of the economy’s markets for goods and services, such as your local Starbucks coffee shop. There you spend it on your favorite drink. When the dollar moves into the Starbucks cash register, it becomes revenue for the firm. The dollar doesn’t stay at Starbucks for long, however, because the firm uses it to buy inputs in the markets for the factors of production. For instance, Starbucks might use the dollar to pay rent to its landlord for the space it occupies or to pay the wages of its workers. In either case, the dollar enters the income of some household and, once again, is back in someone’s wallet. At that point, the story of the economy’s circular flow starts once again.

#2 - THE PRODUCTION POSSIBILITIES FRONTIER

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. Another of the Ten Principles of Economics is that the cost of something is what you give up to get it. This is called the opportunity cost. The production possibilities frontier shows the opportunity cost of one good as measured in terms of the other good.

A SHIFT IN THE PRODUCTION POSSIBILITIES FRONTIER.
For example, if a technological advance in the computer industry raises the number of computers that a worker can produce per week, the economy can make more computers for any given number of cars.An economic advance in one industry shifts the production possibilities frontier outward, increasing the number of first item and the second item, the economy can produce. As a result, the production possibilities frontier shifts outward. Because of this economic growth, society might move production from one point to another, enjoying more computers and more cars.

The production possibilities frontier simplifies a complex economy to highlight and clarify some basic ideas. Some of the concepts mentioned briefly are; scarcity, efficiency, tradeoffs, opportunity cost, and economic growth.

How The Economy As A Whole Works?

PRINCIPLE #8: A COUNTRY’S STANDARD OF LIVING DEPENDS ON ITS ABILITY TO PRODUCE GOODS AND SERVICES

Almost all variation in living standards is attributable to differences in countries’ productivity—that is, the amount of goods and services produced from each hour of a worker’s time.

PRINCIPLE #9: PRICES RISE WHEN THE GOVERNMENT PRINTS TOO MUCH MONEY

Simply define as inflation, an increase in the overall level of prices in the economy. What causes inflation? In almost all cases of large or persistent inflation, the culprit turns out to be the same—growth in the quantity of money. When a government creates large quantities of the nation’s money, the value of the money falls.

PRINCIPLE #10: SOCIETY FACES A SHORT-RUN TRADEOFF BETWEEN INFLATION AND UNEMPLOYMENT

Reducing inflation is often thought to cause a temporary rise in unemployment. The curve that illustrates this tradeoff between inflation and unemployment is called the Phillips curve, after the economist who first examined this relationship. The tradeoff between inflation and unemployment is only temporary, but it can last for several years. The Phillips curve is, therefore, crucial for understanding many developments in the economy. In particular, policymakers can exploit this tradeoff using various policy instruments. By changing the amount that the government spends, the amount it taxes, and the amount of money it prints, policymakers can, in the short run, influence the combination of inflation and unemployment that the economy experiences. Because these instruments of monetary and fiscal policy are potentially so powerful.

TEN PRINCIPLES OF ECONOMICS

#1: People Face Tradeoffs
#2: The Cost of Something Is What You Give Up to Get It
#3: Rational People Think at the Margin
#4: People Respond to Incentives
#5: Trade Can Make Everyone Better Off
#6: Markets Are Usually a Good Way to Organize Economic Activity
#7: Governments Can Sometimes Improve Market Outcomes
#8: A Country’s Standard of Living Depends on Its
#9: Prices Rise When the Government Prints Too Much Money
#10: Society Faces a Short-Run Tradeoff between Inflation and Unemploymemt

How People Interact..

Previous four principles showed how individuals make decisions. The next three principles concern how people interact with one another.

PRINCIPLE #5: TRADE CAN MAKE EVERYONE BETTER OFF

Trade allows each person to specialize in the activities he or she does best, whether it is farming, sewing, or home building. By trading with others, people can buy a greater variety of goods and services at lower cost. Countries as well as families benefit from the ability to trade with one another. Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services.

PRINCIPLE #6: MARKETS ARE USUALLY A GOOD WAY TO ORGANIZE ECONOMIC ACTIVITY
Today, most countries that once had centrally planned economies have abandoned this system and are trying to develop market economies. In a market economy, the decisions of a central planner are replaced by the decisions of millions of firms and households. Firms decide whom to hire and what to make. Households decide which firms to work for and what to buy with their incomes. These firms and households interact in the marketplace, where prices and self-interest guide their decisions. Economist Adam Smith made the most famous observation in all of economics: Households and firms interacting in markets act as if they are guided by an “invisible hand” that leads them to desirable market outcomes. prices are the instrument with which the invisible hand directs economic activity. Prices reflect both the value of a good to society and the cost to society of making the good.

PRINCIPLE #7: GOVERNMENTS CAN SOMETIMES IMPROVE MARKET OUTCOMES

Although markets are usually a good way to organize economic activity, this rule has some important exceptions. There are two broad reasons for a government to intervene in the economy: to promote efficiency and to promote equity. That is, most policies aim either to enlarge the economic pie or to change how the pie is divided. Economists use the term market failure to refer to a situation in which the market on its own fails to allocate resources efficiently. One possible cause of market failure is an externality. An externality is the the impact of one person’s actions on the well-being of a bystander. Another possible cause of market failure is market power. Market power refers to the ability of a single person (or small group of people) to unduly influence market prices.