FHBM1014 PRINCIPLES OF ECONOMICS

(Topic 2 – The Two Simple Economics Models)

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 Learning Objectives
2.1) The two sector circular flow model.

2.2) The Production Possibilities Frontier

(PPF) and opportunity costs.

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 Models & Assumptions
• Economists use models to study economic
issues.
• Economists make assumptions( 假设 ) in order to
make the world easier to understand.
• Nearly all theories( 理论 ) in economics are
expressed( 表达 ) using a ceteris paribus (holding
everything else constant). ( 保持其他一切不变 )
• Example: The theory that if I study harder, I
will perform better on a test, ceteris paribus.
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 Economic Models

First Model: The Two Sector Circular Flow

Model
Second Model: The Production Possibilities
Frontier (PPF)

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Learning Objectives
(2.1)
The Two Sector
Circular Flow Model

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 The Two Sector Circular Flow Model

• Def: visually( 视觉上 ) show the economic

transactions( 经济交易 ) that occur between
households and firms in the economy.
• In the shape of a circle because all of the
components work together and without one, it
would NOT function.
• Contain of two types of decision makers: firms
and households.

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 The Six (6) Assumptions of
Circular Flow Model

1. The economy consists of ONLY two

sectors: households and firms.
2. Households spend ALL of their income on goods
and services. There are no savings.
3. All output produced by firms are purchased by
households.
4. There is NO financial sector.
5. There is NO government sector.
6. There is NO overseas sector.
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FIRMS
– Produce and sell
goods and services
– Hire and use factors of production

HOUSEHOLDS
- Buy and consume
goods and services
- Own and sell factors
of production
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 The Two Sector Circular Flow Model

• Households and firms interact in two types of

markets:
1)Markets for goods and services
- Households are buyers
- Firms are sellers
2) Markets for the factors of production
- Households are sellers
- Firms are buyers
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The Two Sector Circular Flow Diagram

Markets
Revenue( 收 Spending( 花
入)
for 费)
Goods &
Goods & Services Goods &
Services Services
sold bought

FIRMS HOUSEHOLDS

Land,
Labor,
Factors of Capital
and
Production Markets Entreprenurship
for
Factors of
Production Income
Rental, wages, = Flow of inputs
and outputs
interest and profits
= Flow of ringgits
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 The Two Sector Circular Flow Model

The TWO loops of the circular-flow diagram:

• Inner loop: shows the flow of inputs and
outputs.
• The households sell the use of their labor, land
and capital to the firms in the markets for
factors of production. The firms then use these
factors to produce goods and services, which
are sold to households in the markets for
goods and services.
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 The Two Sector Circular Flow Model

• Outer loop: shows the flow of ringgits

• Households spend money for buying goods

and services from the firms. The firms use
some of the revenue from these sales to pay
for the factors of production, such as the
wages of their workers. The remaining
amount becomes profit for the firm owners.

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 Problem Application

To which part of the circular flow diagram

would the following activities fall under?
– Martin earns RM15 per hour working in a
factory _______________________________
– Matilda spends RM6 for a pizza
______________________________
– Madeline’s Bakery pays RM500 for the rent on
its shop _______________________________
– Maria purchases a new pair of earrings for
RM20 ________________________________
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 Learning Objectives
(2.2)
The Production Possibilities Frontier
(PPF)

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 The Production Possibilities Frontier

• Def: a graph that shows the combinations of

output that the economy can possibly
produce( 可能产生 ) in a certain period of time.
• The THREE (3) Assumptions of PPF:
1) Fixed resources
2) Fully employed resources( 充分利用的资源 )
3) Technology unchanged

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 The Production Possibilities Frontier

Output
Combinations Computers Wheat

A 500 0
B 400 1000
C 250 2500
D 100 4000
E 0 5000
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 The Production Possibilities Frontier

Wheat
Production (tons)
Point
on Com- 6,000
graph puters Wheat E
5,000
D G
A 500 0 4,000

B 400 1,000 3,000 C

C 250 2,500 2,000
D 100 4,000 F B
1,000
E 0 5,000 A
0
0 100 200 300 400 500 600
Computers

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 The Production Possibilities Frontier
Points on the PPF (like A – E)
• Possible( 可能 ) (feasible)( 可行的 )
• Efficient( 有效率的 ): all resources are fully utilized
( 所有资源都会充分利用 )

Points under the PPF (like F)

• possible (feasible)
• not efficient: some resources underutilized( 利用不足 )
(e.g., workers unemployed 工人失业 , factories idle 工厂闲
置)

Points above the PPF (like G)

• not possible (infeasible)
• Unattainable( 高不可攀 ) - does not have the capacity( 没能18
 The PPF and Opportunity Cost

• Moving along a PPF involves shifting

resources( 资源转移 ) (e.g., labor) from the
production of one good to the other good.
• Opportunity cost can be thought of in terms of
( 可以认为 )how decisions to increase the
production of an extra( 而外的产量 ), unit of one
good leads to a decrease in the production of
another good.
• The slope( 斜波 ) of the PPF tells us the
opportunity cost of one good in terms of the
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other.
 The PPF and Opportunity Cost

Wheat
(tons) 1000 tons of wheat
–1000 were removed in
6,000 slope = = –10
+ 100 order to gain 100
5,000
units of computers.
4,000
3,000 When we divide
2,000 1000 tons by 100
units, we find that
1,000
the opportunity
0 cost to produce 1
0 100 200 300 400 500 600 unit of computer is
Computers 10 tons of wheat.
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 The Shape of the PPF

• The PPF could be a straight line, or bow-shaped

• Depends on what happens to opportunity cost
as economy shifts resources from one industry
to the other.
– The opportunity cost of producing one good is
constant as the production of this good rises,
PPF is a straight line - shaped (linear).
– The opportunity cost of producing one good
increases as the production of this good rises,
PPF is bowed outward - shaped (Concave
curve) .
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Straight Line PPF

The opportunity cost

of moving from
producing zero pizza
to 1 unit pizza is 3
units of soda.

Moving from 1 unit to

2 units and from 2 to 3
units pizza also has
an opportunity cost of
3 units of soda.
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Straight Line PPF

In this case the

opportunity cost from
0 to 1 is the same as
going from 2 to 3.

This is why we say

that the opportunity
cost is constant.

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Concave Shape PPF

The opportunity cost

of going from 0 units
of pizza to 1 unit of
pizza is one unit of
soda.

Moving from 1 unit of

pizza to 2 units has an
opportunity cost that
is 3 units of soda.
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Concave Shape PPF

Similarly, moving
from 2 to 3 units of pizza
has an opportunity cost of
6 units of soda.
The opportunity cost of
going from 0 to 1 is
smaller than going from 2
to 3.
This is why we say that
the opportunity cost is
increasing.
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 Law of Increasing Opportunity Costs

• Dictates the bowed-out shape of the PPF.

• When the economy uses all resources
efficiently, each additional increment of one
good requires the economy to sacrifice
successively larger and larger increments of
the other goods.

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 Factors that can Shift the PPF

• Changes in Resource Availability

• Increases / Improvements in Quality/Quantity 
rightward shift
• Decreases /Reductions in Quality/quantity 
leftward shift

• Changes in Capital Stock

• Increases  rightward shift
• Decreases  leftward shift

• Technological Change
• Advancement  rightward shift
• Obsolete / Stagnation( 停滞 )  leftward shift 27
 Shifts in the PPF

Increase in available resources to produce

Good A and Good B

Increase in the size or the

health of the labor force, an
increase in the skills of the
labor force, or an increase
in the availability of other
Good A

resources shifts the PPF

from AF to A'F'.

Effects: The parallel

outward shift implies that
the change that occurred
could produce both good.

Good B 28
 Shifts in the PPF

Decrease in available resources to produce

Good A and Good B
Decrease in the availability
or the quality of resources
shifts the PPF inward from
AF to A''F''.

Effects: Parallel inward

shift implies that the
change was equally
applicable to both goods.

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 Shifts in the PPF

Increase in resources or technological change that benefits

Good A

Since the change affects only

Good A, where will be no
changes on Good B.

Effects: Outward shift from FA

to FA’ applicable for Good A
only.

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 Shifts in the PPF

Increase in resources or technological advance

that benefits Good B

Since the change affects only

Good B, where will be no
changes on Good A.

Effects: Outward shift from

AF to AF’ applicable for Good
B only.

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 Reference
• Tucker, I.B (2017). Economics for today.
(9th ed.). Mason, OH: Thomson South
Western.
• Lecture notes

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