1.3 Understand the world by use of models

Understanding the world by use of models

What is an economic model?

An economic model is a simplified representation of economic reality used to help explain, analyse or understand economic relationships.

Why do economists use models?

Economic reality is highly complex, so models simplify reality by focusing on important relationships and abstracting from less important details.

What is an assumption in an economic model?

An assumption is a condition accepted as true within a model to simplify analysis.

What is ceteris paribus?

Ceteris paribus means "other things being equal" or assuming that other relevant factors remain unchanged.

What is the production possibilities curve (PPC)? (Also known as the production possibilities frontier)

The PPC represents all combinations of the maximum amounts of two goods that an economy can produce given its resources and technology when resources are fully employed and efficiently used.

What does a point on the PPC represent?

A point on the PPC represents a combination of two goods that can be produced when resources are fully employed and efficiently used.

What does a point inside the PPC represent?

A point inside the PPC indicates that resources are not being fully employed and/or are not being used efficiently.

What does a point outside the PPC represent?

A point outside the PPC is currently unattainable given the economy's existing resources and technology.

What does movement along a PPC represent?

Movement along a PPC represents a choice between different combinations of two goods and involves an opportunity cost.

Why can't an economy produce outside its PPC?

Because its existing resources and technology are insufficient to produce that combination of goods.

What causes actual economic growth in the PPC model?

Actual growth occurs when an economy moves from a point inside the PPC toward the PPC, caused by reductions in unemployment and increases in production efficiency.

What causes growth in production possibilities?

Increases in the quantity of resources, improvements in resource quality and technological improvements shift the PPC outward.

What causes the PPC to shift inward?

A decrease in the quantity of resources or deterioration in resource quality.

What does a circular flow of income model show?

It shows the basic economic relationships between households and firms and the flows of income, expenditure and output.

What is a closed economy?

A closed economy is an economy with no links to other countries through international trade.

What are the two markets in the simple circular flow model?

Product markets and resource markets.

What happens in a product market?

Firms sell goods and services to households, while households make consumer expenditures.

What happens in a resource market?

Households supply factors of production to firms, while firms make payments for those factors.

What are the factor incomes?

Rent from land, wages from labour, interest from capital and profit from entrepreneurship.

What is the circular flow of income identity?

The value of output produced equals the total income generated in producing that output, which equals total expenditure on that output.

What are leakages?

Leakages are flows of income out of the circular flow of income: saving, taxes and imports.

What are injections?

Injections are flows of spending into the circular flow: investment, government spending and exports.