Economic Models

Economic models are used by economists to communicate current economic conditions - causes and
effects on the future of the economy.

An economic model is a hypothetical construct that embodies economic procedures using a set of
variables in logical and/or quantitative correlations. It is a simplistic method using mathematical and
other techniques created to show complicated processes. An economic model can have many
constraints, which may change to generate different property.

Uses of Economic Models

There are five main reasons that economic models are used. These are:
1. To predict economic activities in which conclusions are drawn based on assumptions
2. To prescribe new economic guidelines that will change future economic behaviors
3. To provide logical defense to justify economic policies at three levels: national/political,
organizational, and household
4. For planning and allocating resources and planning logistics and business leadership
5. To assist with trading and investment speculation

Or

An economic model is a theoretical construct that represents a process by a number of variables and a
set of quantitative or logical relationships between them – to determine what might happen in different
scenarios or at a future date.

It is essentially a simplified framework used for describing the workings of the economy.

An economic model is what an economist uses to make a number of simplified assumptions and then
sees how different scenarios might play out.
a. Circular Flow Model

Economists use the circular flow model to show the interdependent relationships between households,
producers (businesses), and government. This diagram depicts how goods and services flow in exchange for
money. The two major actors in the circular flow model are households and businesses. They trade with each
other in two markets—the factor market and the goods and services market. The factor market is where
businesses go to purchase the items needed to produce goods or services. These factors include
entrepreneurs, land, natural resources, labor, and capital. The goods and services market is anywhere
businesses sell goods and services to the final consumer. Figure 1 illustrates how households and businesses
interact in the goods and services and factor markets in exchange for money.
The circular flow model illustrates how in an economy income must equal production. In other words, one
person's expenditure is another entity's income. For example, Ben is a mechanic. He sells his services to
Sandra. Sandra's expenditure is Ben's income. Ben uses some of Sandra's payment to pay George. George's
wages are income to George, but an expenditure to Ben. Ben also purchases parts from a local auto parts
store. His purchase is an expense to Ben, but income to the auto parts store. Fortunately, some of Sandra's
payment is left over as income to Ben. 

A simple model excludes the government, but when government is added the flows are altered, but income
still equals expenditures. The government goes to the factor market to hire its workers, just like the private
sector. The government hires companies through the goods and services market, just like households. Like
businesses, the government provides (sells) goods and services to businesses and households in return for
money (taxes).
B. Production Possibility Frontier

The production possibility frontier (PPF) is a curve depicting all maximum output possibilities for two
goods, given a set of inputs consisting of resources and other factors. The PPF assumes that all inputs
are used efficiently.

Factors such as labor, capital and technology, among others, will affect the resources available, which
will dictate where the production possibility frontier lies. The PPF is also known as the production
possibility curve or the transformation curve.

A production possibility curve measures the maximum output of two goods using a fixed amount of
input. The input is any combination of the four factors of production. They are land and
other natural resources, labor, capital goods, and entrepreneurship. The manufacture of most goods
requires a mix of all four.
Each point on the curve shows how much of each good will be produced when resources shift from
making more of one good and less of the other. The curve measures the trade-off between producing
one good versus another.

For example, say an economy can produce 20,000 oranges and 120,000 apples. On the chart, that's
point B. If it wants to produce more oranges, it must produce fewer apples. On the chart, Point C shows
that if it produces 45,000 oranges, it can only produce 85,000 apples.

By describing this trade off, the curve demonstrates the concept of opportunity cost. Making more of
one good will cost society the opportunity of making more of the other good. The production possibility
curve delineates the cost of society's choice between two different goods.

Production Possibility Frontier

The curve delineates the production possibility frontier. It's the maximum amount that can possibly be
produced of both goods given the amount of resources. An economy that operates at the frontier has
the highest standard of living it can achieve. It is producing as much as it can using the same resources.

If the amount produced is inside the curve, then all of the resources are not being used. On the chart,
that is point E.

One reason is that there is a recession or depression. There is not enough demand for either good.
Layoffs occur, resulting in lower levels of labor being used.
Another reason is a bit more complicated. An economy falls within the curve when it is ignoring
its comparative advantage. For example, Florida has the ideal environment to grow oranges. Oregon's
climate is best for apples. Florida has a comparative advantage in orange productions, and Oregon has
one in apple production. If Florida ignored its advantage in oranges, and tried to grow apples, it would
force the United States to operate within its curve. The U.S. standard of living would fall.

Conversely, any point outside the PPF curve is impossible. More of both goods cannot be produced with
the available limited resources. On the chart, that is point F.

What the Shape of the Curve Tells You

The production possibility curve bows outward. The highest point on the curve is when you only
produce one good, on the y-axis, and zero of the other, on the x-axis. On the chart, that is Point A. The
economy produces 140,000 apples and zero oranges.

The widest point is when you produce none of the good on the y-axis, producing as much as possible of
the good on the x-axis. On the chart, that is point D. The society produces zero apples and 40,000
oranges.

All the points in between are a trade-off of some combination of the two goods. An economy operates
more efficiently by producing that mix. The reason is that every resource is better suited to producing
one good than another. Some land is better suited for apples, while other land is best for oranges.
Society does best when it directs production of each resource toward its specialty. The more specialized
the resources, the more bowed out the production possibility curve.

How It Affects the Economy

The curve does not tell decision-makers how much of each good the economy should produce. It only
tells them how much of each good they must give up if they are to produce more of the other good. It is
up to them to decide where the sweet spot is.

In a market economy, the law of demand determines how much of each good to produce. In a command
economy, planners decide the most efficient point on the curve. They are more likely to consider how
best to use labor so there is full employment.

An economy's leaders always want to move the production possibilities curve outward and to the right.
They can do so only with growth. They must create more demand for either or both products. Only after
that occurs can more resources can be used to produce greater output.

Supply-side economists believe the curve can be shifted to the right simply by adding more resources.
But without demand, they will only succeed in having underutilized resources. But there is a small
benefit of increasing the labor force. Once the unemployed are working, they will increase demand and
shift the curve to the right. For it to work, they must be paid enough to create the demand that shifts
the curve outward.

A decrease in resources can limit growth. If there is a shortage of one input, then more goods will not be
produced no matter how high the demand. In those situations, prices rise until demand falls to meet
supply. It creates cost-push inflation.