Question

how do three simple models -the ppf , comparative advantage and circular flow diagram help us understand how modern economics work?

Answer 1

Answer

Production possibility frontier(PPF) : The model of production possibility frontier or PPF arises because of the scarcity of resources in an economy.The resources are scarce but wants are unlimited. So the basic problem of an economy is, what to produce, how to produce, and for whom to produce, by optimal utilization of the scarce resources. The PPF shows different possible combinations of the maximum amounts of two goods that can be produced by using all the available resources and technology of an economy. Now, as the resources are scarce, and fixed in an economy , so if there is a need to increase the production of one good, some amount of production of another good must be sacrificed.When some amount of production of one good is sacrificed, some resources are released from that sector, that can be used in another sector whose production needs to increase. In this context, the concept of opportunity cost arises.Let us assume that, there are two goods, X, and Y.The opportunity cost of production of X shows, the amount of Y which is sacrificed for one unit increase of the production of X.The opportunity cost of production is basically the slope of the PPF. Now as the resources are scarce, and specialized in the production of a particular good, so the opportunity cost gradually rises, i.e., more and more of one good needs to sacrifice for one unit increase of the production of another good. So the PPF is downward sloping, concave to origin curve. If opportunity cost is constant, the PPF is downward sloping straight line.

Let an economy is producing two goods, X, and Y. The above figure shows the PPF of the economy. With the given resources, and technology, the economy can produce X, and Y, at any point within and on the PPF, which is downward sloping concave to origin green color curve. One of these points is point 'B', which is within the PPF but is not efficient, because the economy can produce more if it moves towards point 'A', which is an efficient point of production, because it is on PPF. So production at any point within the PPF, shows inefficient point of production, because the economy has still unused resources by which it can produce more. Any point beyond PPF is not attainable, because with the given resources, production is not possible there. One of these points is point 'D'.

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Comparative advantage : David Ricardo's comparative cost is based on the opportunity cost of production. It says, that a country has a comparative advantage in the production of that good in which it has lower opportunity cost. So, a country will produce the good in which it has comparative advantage. Under free trade, a country will export the good in which it has comparative cost advantage, and thus specialization in production, and will import the good, in which it has comparative cost disadvantage.

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Circular flow diagram:The circular flow diagram shows how the factor movement, goods and services, factor income, and spending flow between the household sector and the firm sector. The firm hires factors of production to produce goods and services, and pays remuneration. The remuneration, like wage payment to the workers, is the income of the factor. The factor, such as worker represents the household sector, who purchase goods and services from the firm sector, and pays price for those goods and services in terms of money.Thus the income, the factor earns from the firm sector in terms of factor payment, that income flows back again to the firm sector as spending on goods and services. This is firm sector's income.

So we see in the circular flow, the firm hires workers as factors of production. These workers produce goods and services.When the household sector purchases these good and services, they flow back to the household sector from the business or the firm sector. When the firm hires workers, they are remunerated. When the workers pays for goods and services, the part of income that they received as remuneration, again flows back to the firm sector, as expenditure on goods and services.

This diagram is shown below. The H.H is the household sector.H.H sector provides factors to the firms and thus earns income. The firms provide goods and services and thus earn revenue, comes as expenditure or spending from the H.H sector.