Models and the circular flow
How economists simplify the world with models, from the circular-flow diagram to the production possibilities frontier.
FinanceEveryday economicsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Explain why economists use assumptions and models
- Describe the two loops of the circular-flow diagram
- Read opportunity cost and efficiency from a production possibilities frontier
Builds toward: Run your own money. Budget so there's room to save, spot and clear costly debt, compare savings and loan offers, and see what interest and inflation do to your money.
Everyday economics: news, prices and choices: lesson 3 of 11
- Everyday economics
- Trade-offs and opportunity cost 5 min
- Thinking at the margin and incentives 5 min
- Models and the circular flow 5 min
- Positive and normative statements 6 min
- Demand and what shifts it 5 min
- Supply, equilibrium and shifts 6 min
- What money is 5 min
- What GDP counts 6 min
- Real and nominal GDP 5 min
- Measuring unemployment 5 min
- The costs of inflation 6 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 2
What it is
Economists try to work like scientists: they form theories, collect data and test them. Experiments on a whole economy are often difficult or impossible, so they also study history and data, and rely on models: simplified pictures built on assumptions that leave out detail to show what matters.
Mankiw's comparison: a physicist working out how fast a marble falls assumes there is no air resistance. That is close enough for a marble, but not for a beach ball. The skill lies in choosing which assumptions are harmless for the question at hand.
The circular-flow diagram is a model of how the economy is organised. It has only two kinds of decision maker:
- Households own the factors of production (labour, land and capital such as buildings and machines) and buy goods and services.
- Firms use the factors of production to make goods and services.
They meet in two kinds of market:
- In markets for goods and services, households buy and firms sell.
- In markets for the factors of production, firms buy and households sell.
The inner loop is the flow of real things: labour, land and capital go to firms; goods and services go to households. The outer loop is the matching flow of money: households spend on goods and services, and firms pay wages, rent and profit back to households.
Text description
Circular-flow diagram. Firms (left) and households (right) meet in two markets: the market for goods and services (top) and the market for factors of production (bottom). Inner arrows show real things: firms sell goods and services to households, and households sell labour, land and capital to firms. Outer arrows show money flowing the other way: households spend on goods and services, and firms pay wages, rent and profit to households.
Quick check
Tap an answer to check it.
In the circular-flow diagram, who sells in the market for the factors of production?
- Firms buy labour, land and capital there
Show answer
Households. Households own the factors of production and sell their use to firms.
Why it matters
The production possibilities frontier (PPF) is a second model. It shows the combinations of two goods an economy can produce with its resources and technology. In Mankiw's example, an economy makes only cars and computers:
- All resources on cars: 1,000 cars and no computers.
- All resources on computers: 3,000 computers and no cars.
- In between, for example point A: 600 cars and 2,200 computers; point B: 700 cars and 2,000 computers.
The PPF shows several ideas at once:
- Efficiency: points on the frontier use all resources fully; points inside waste some (for example, through unemployment).
- Trade-offs: on the frontier, more of one good means less of the other.
- Opportunity cost: the slope of the frontier shows what one good costs in terms of the other.
- Growth: better technology shifts the frontier outwards (in Mankiw's example only the computer end moves, after an advance in computer-making), so the economy can have more of both.
The frontier is usually bowed outwards: the more an economy already makes of one good, the more of the other it must give up for still more, because the resources best suited to it are already in use.
Micro and macro. Microeconomics studies how households and firms make decisions and interact in particular markets. Macroeconomics studies the economy as a whole: inflation, unemployment and growth. The two are linked, since economy-wide changes come from many individual decisions.
Worked example
Moving from point A (600 cars, 2,200 computers) to point B (700 cars, 2,000 computers):
- Cars gained: 700 − 600 = 100.
- Computers given up: 2,200 − 2,000 = 200.
- Opportunity cost of those 100 cars: 200 computers, or 2 computers per car at this part of the frontier.
If the economy were at a point inside the frontier, it could have more cars without giving up computers, by putting idle resources to work.
Text description
A production possibilities frontier for cars (across) and computers (up). The frontier is bowed outwards, running from 3,000 computers and no cars to 1,000 cars and no computers. Point A (600 cars, 2,200 computers) and point B (700 cars, 2,000 computers) lie on the frontier, so they are efficient; moving from A to B gains 100 cars for 200 computers. Point C lies outside the frontier and cannot be reached with the economy's resources. Point D lies inside: some resources are idle.
Common mistake
Treating a model's simplicity as a flaw. A model leaves things out on purpose, like a map. The question is whether what it leaves out matters for the question being asked.
Key terms
- model
- a simplified representation of how the economy, or part of it, works
- factors of production
- the inputs used to make goods and services: labour, land and capital
- circular-flow diagram
- a model of how money, goods and factors flow between households and firms through markets
- production possibilities frontier
- a graph of the output combinations an economy can produce with its resources and technology
- efficiency
- getting the most from scarce resources; on the PPF, being on the frontier
- microeconomics
- the study of how households and firms decide and interact in markets
- macroeconomics
- the study of economy-wide events, such as inflation, unemployment and growth
Practise the key terms
Tap a card to turn it over. 7 cards.
| Front | Back |
|---|---|
| model | a simplified representation of how the economy, or part of it, works |
| factors of production | the inputs used to make goods and services: labour, land and capital |
| circular-flow diagram | a model of how money, goods and factors flow between households and firms through markets |
| production possibilities frontier | a graph of the output combinations an economy can produce with its resources and technology |
| efficiency | getting the most from scarce resources; on the PPF, being on the frontier |
| microeconomics | the study of how households and firms decide and interact in markets |
| macroeconomics | the study of economy-wide events, such as inflation, unemployment and growth |
Practice
Work it through
An economy on its frontier moves from 300 tonnes of wheat and 80 tractors to 360 tonnes of wheat and 70 tractors.
- 360 − 300
- 80 − 70
- 60 ÷ 10
Quick quiz
Tap an answer to check it.
What does a point inside the production possibilities frontier show?
- That is a point outside the frontier
- Efficient points lie on the frontier
Show answer
Some resources are idle or wasted: the economy could have more of both goods. Inside the frontier, resources are not fully used.
What happens to the frontier when technology improves?
- That would mean the economy could produce less
Show answer
It shifts outwards, so more of both goods is possible (at least for the good whose technology improved). Better technology means more output from the same resources.
In the circular flow, what is the outer loop?
- That is the inner loop
Show answer
The flow of money: spending on goods and services, and wages, rent and profit paid to households. The two loops run in opposite directions and match each other.
In short
- Models simplify on purpose; the art is choosing assumptions that don't matter for the question.
- Circular flow: households and firms meet in markets for goods and for factors of production.
- The PPF shows efficiency, trade-offs, opportunity cost and growth.
- Microeconomics studies markets; macroeconomics the whole economy.
Mastery check
Answer without looking back. Score 80% or more and the lesson is marked done. Your result is kept only in this browser.
Check yourself
Answer in your head first, then open the answer. Nothing is saved.
Name the factors of production.
Show answer
Labour, land and capital.
In Mankiw's example, what is the opportunity cost of moving from 600 to 700 cars?
Show answer
200 computers (2,200 − 2,000).
What is the difference between microeconomics and macroeconomics?
Show answer
Micro studies households, firms and particular markets; macro studies the economy as a whole.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 2.
- On this site: Trade-offs and opportunity cost.
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