Economic Models: Circular-Flow, PPF, and Market Forces

Circular-Flow Diagram

A visual model of the economy that shows how dollars flow through markets among households and firms.

Households

Own the factors of production and sell/rent them to firms for income. They also buy and consume goods & services.

Firms

Buy/hire factors of production and use them to produce goods and services. They also sell goods & services.

Market for Goods and Services

Where goods and services are bought and sold. Households spend money to buy goods and services, and firms receive revenue from selling them.

Market for Factors of Production

Where resources used to produce goods and services are exchanged. Households provide factors of production (labor, land, capital) to firms, receiving income (wages, rent, profit) in return.

Factors of Production

The resources an economy uses to produce goods & services, including labor, land, and capital

Production Possibilities Frontier (PPF)

A graph that shows the combinations of two goods an economy can possibly produce given its available resources and technology.

Opportunity Cost

The opportunity cost of an item is what must be given up to obtain that item.

Slope of the PPF

the opportunity cost of one good in terms of the other

Economic Growth

Represented by an outward shift of the PPF, meaning the economy can produce more of both goods with additional resources or improved technology.

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.

Positive Statements

Attempt to describe the world as it is. They can be confirmed or refuted with data.

Normative Statements

Attempt to prescribe how the world should be. They involve value judgments and cannot be confirmed or refuted by data.

Interdependence

The reliance of people on others worldwide for goods and services.

Trade

An economic principle stating that trade can make everyone better off.

Consumption Without Trade

A country's consumption is limited to what it produces within its own PPF.

Consumption With Trade

Countries can specialize and exchange goods, allowing them to consume combinations of goods outside their individual PPFs.

Exports

Goods produced domestically and sold abroad.

Imports

Goods produced abroad and sold domestically.

Absolute Advantage

The ability to produce a good using fewer inputs than another producer.

Comparative Advantage

The ability to produce a good at a lower opportunity cost than another producer.

Gains from Trade

Arise from comparative advantage and occur when countries specialize in goods where they have a comparative advantage.

Market

A group of buyers and sellers of a particular product.

Competitive Market

A market with many buyers and sellers, where each has a negligible effect on price.

Perfectly Competitive Market

Characterized by all goods being exactly the same and buyers & sellers being numerous enough that no one can affect the market price.

Quantity Demanded (Qd)

The amount of a good that buyers are willing and able to purchase.

Law of Demand

States that the quantity demanded of a good falls when the price of the good rises, other things equal.

Demand Schedule

A table showing the relationship between price and quantity demanded.

Market Demand

The sum of quantities demanded by all buyers at each price.

How number of buyers affect the demand curve

increases quantity demanded at each price, shifting the demand curve to the right.

Normal Good

Demand is positively related to income; an increase in income shifts the demand curve to the right.

Inferior Good

Demand is negatively related to income; an increase in income shifts the demand curve to the left.

Substitutes

An increase in the price of one good causes an increase in demand for the other.

Complements

An increase in the price of one good causes a fall in demand for the other.

Tastes

Anything that shifts tastes toward a good increases demand, shifting the demand curve to the right.

Expectations

Consumers' expectations about future prices or income affect current buying decisions.

Change in Demand

A shift in the entire demand curve, caused by a change in a non-price determinant.

Change in Quantity Demanded

A movement along a fixed demand curve, caused by a change in the good's price.

Quantity Supplied (Qs)

The amount that sellers are willing and able to sell.

Law of Supply

States that the quantity supplied of a good rises when the price of the good rises, other things equal.

Supply Schedule

A table showing the relationship between price and quantity supplied.

Market Supply

Market supply is the sum of quantities supplied by all sellers at each price.

Individual Supply

The quantity supplied by a single seller at each price.

Input Prices

A fall in input prices (e.g., wages, raw materials) makes production more profitable, causing firms to supply a larger quantity at each price, shifting the supply curve to the right.

Technology

Cost-saving technological improvements have the same effect as falling input prices, shifting the supply curve to the right.

Number of Sellers

An increase in the number of sellers increases the quantity supplied at each price, shifting the supply curve to the right.

Expectations (Supply)

Sellers may adjust supply based on expectations of future prices (if the good is not perishable).

Change in Supply

A shift in the entire supply curve, caused by a change in a non-price determinant.

Change in Quantity Supplied

A movement along a fixed supply curve, caused by a change in the good's price.

Equilibrium

The point where quantity supplied equals quantity demanded.

Equilibrium Price

The price that equates quantity supplied with quantity demanded.

Equilibrium Quantity

The quantity supplied and quantity demanded at the equilibrium price.

Surplus

Occurs when quantity supplied is greater than quantity demanded (price is above equilibrium).

Shortage

Occurs when quantity demanded is greater than quantity supplied (price is below equilibrium).

Elasticity

Measures how much one variable responds to changes in another variable.

Price Elasticity of Demand (PED)

Measures how much Qd responds to a change in Price (P).

Formula for PED

Percentage change in Qd / Percentage change in P.

Calculating Percentage Changes

Use the midpoint method: % change = (End value - Start value) / Midpoint * 100%.

Midpoint

Midpoint = (Start value + End value) / 2.

Determinants of Price Elasticity of Demand

Factors that affect the price elasticity of demand.

Availability of Close Substitutes

PED is higher when close substitutes are available.

Necessities vs. Luxuries

PED is higher for luxuries than for necessities.

Definition of the Good (Broad vs. Narrow)

PED is higher for narrowly defined goods than broadly defined ones.

Time Horizon

PED is higher in the long run than in the short run.

Perfectly Inelastic Demand

Vertical demand curve, Qd does not change with P. PED = 0.

Inelastic Demand

Relatively steep demand curve, Qd changes proportionally less than P. PED < 1.

Unit Elastic Demand

Intermediate slope, Qd changes proportionally the same as P. PED = 1.

Elastic Demand

Relatively flat demand curve, Qd changes proportionally more than P. PED > 1.

Perfectly Elastic Demand

Horizontal demand curve, Qd changes infinitely with a tiny change in P. PED = infinity.

Slope vs. Elasticity on a Linear Demand Curve

The slope is constant, but elasticity changes along a linear demand curve.

Total Revenue (TR)

Total Revenue = Price (P) x Quantity (Q).

Demand Elasticity and Total Revenue

If Demand is Elastic (PED > 1), a price increase causes total revenue to fall.

Demand Inelasticity and Total Revenue

If Demand is Inelastic (PED < 1), a price increase causes total revenue to rise.

Unit Elastic Demand and Total Revenue

If Demand is Unit Elastic (PED = 1), total revenue remains constant with a change in price.

Price Elasticity of Supply (PES)

Measures how much Qs responds to a change in P.

Formula for PES

Percentage change in Qs / Percentage change in P.

Perfectly Inelastic Supply

Vertical supply curve, Qs does not change with P. PES = 0.

Inelastic Supply

Relatively steep supply curve, Qs changes proportionally less than P. PES < 1.

Unit Elastic Supply

Intermediate slope, Qs changes proportionally the same as P. PES = 1.

Elastic Supply

Relatively flat supply curve, Qs changes proportionally more than P. PES > 1.

Perfectly Elastic Supply

Horizontal supply curve, Qs changes infinitely with a tiny change in P. PES = infinity.

Determinants of Supply Elasticity

The more easily sellers can change the quantity they produce, the greater the PES.

Income Elasticity of Demand

Measures the response of Qd to a change in consumer income.

normal goods income elasticity

Income elasticity > 0 (demand increases with income).

Inferior goods income elasticity

Income elasticity < 0 (demand decreases with income).

Cross-Price Elasticity of Demand

Measures the response of demand for one good to changes in the price of another good.

Price Controls

Legal limits on prices.

Price Ceiling

A legal maximum on the price of a good or service (e.g., rent control).

Price Floor

A legal minimum on the price of a good or service (e.g., minimum wage).

Taxes

Government levies taxes on goods & services to raise revenue. Can be imposed on buyers or sellers.

Binding Price Ceiling

A price ceiling below the equilibrium price is binding and is illegal.

Non-binding Price Ceiling

A price ceiling above the equilibrium price is not binding and has no effect.

Effect of a Binding Price Ceiling

Causes a shortage (quantity demanded > quantity supplied).

Shortages and Rationing

With a shortage, sellers must ration goods, often unfairly and inefficiently.

Evaluation of Price Ceilings

Price ceilings are often intended to help the poor but can hurt more than help by altering the allocation of resources and creating inefficiencies.

Binding Price Floor

A price floor above the equilibrium price is binding.

Non-binding Price Floor

A price floor below the equilibrium price is not binding and has no effect.

Effect of a Binding Price Floor

Causes a surplus (quantity supplied > quantity demanded).

Minimum Wage

A binding minimum wage causes a surplus of labor, which is unemployment.