Macroconomics Chapter 2
Assumptions & Models
• Assumptions simplify the complex world, make it easier to understand
• Example: To study international trade, assume two countries and two goods.
Unrealistic, but simple to learn and gives useful insights about the real world.
• Model: a highly simplified representation of a more complicated reality.
Economists use models to study economic issues.
The Circular-Flow Diagram
• The Circular Flow Diagram: a visual model of the economy, shows how
dollars flow through markets among households and firms.
• Two types of “actors”:
o Own the factors of production, sell/rent them to firms for income.
o Buy and consume goods and services
o Produce and sell goods and services
o Hire and use factors of production
• Two markets:
➢ The market for goods and services
➢ The market for “factors of production”
Factors of Production
• Factors of Production: the resources the economy uses to produce goods
and services, including
➢ Capital (buildings & machines used in production)
The Production Possibilities Frontier
• The Production Possibilities Frontier (PPF): a graph that shows the
combinations of two goods the economy can possibly produce given the
available resources and the available technology.
The PPF and Opportunity Cost
• Recall: the opportunity cost of an item is what must be given up to obtain
• Moving along the PPF involves shifting resources (e.g. labor) from the
production of one good to the other.
• Society faces a tradeoff: getting more of one good requires sacrificing some of
• The slope of the PPF tells you the opportunity cost of one good to the other. The Shape of the PPF
• The PPF could be a straight line, or bow-shaped
• Depends on what happens to the opportunity cost as economy shifts
resources from one industry to the other.
➢ If opportunity cost remains constant, PPF is a straight line. Essentially the
same resources are equally useful for producing in either industry.
➢ If opportunity cost of a good rises as the economy produces more of the
good, PPF is bow-shaped. Essentially, the resources are specialized and not
easily adaptable for producing in either industry.
Economic Growth and the PPF