PPF Explorer & Circular FlowChapter 2: Thinking Like an Economist

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Max computers
500
Max wheat (tons)
5,000
Opp. cost of 1 computer
10 tons
Your point
none
Production possibilities frontier: click anywhere on the graph to test a point

Test a point

Chapter points:

Resources & technology (growth)

20,000100,000
25 (better tech)200
5 (better tech)25

What's happening?

Production schedule (current PPF)

Label the circular-flow diagram

Click a dashed box on the diagram, then click the label that belongs there. Green labels are flows of dollars; orange labels are flows of goods, services and inputs. Check your answers when all eight are placed.

MARKETS FOR GOODS & SERVICES MARKETS FOR FACTORS OF PRODUCTION FIRMS produce and sell goods hire and use factors HOUSEHOLDS buy and consume goods own and sell factors 1 2 3 4 5 6 7 8 green = flow of dollars orange = flow of goods, services and inputs

Practice quiz: questions from Chapter 2

Each round gives you 10 random questions. After you answer, use Show on graph to see the scenario on the PPF or the circular-flow diagram.

Chapter 2 in brief

Economists are scientists: they make appropriate assumptions and build simplified models. Two of the most important models are the circular-flow diagram and the production possibilities frontier.

The circular-flow diagram
A visual model of the economy showing how dollars flow through markets among households and firms.
  • Two decision makers: firms and households.
  • Two markets: the market for goods and services, and the market for factors of production (inputs: labor, land, capital).
  • Households buy goods and services (spending, which is firms' revenue) and sell factors of production (earning income: wages, rent, profit).
  • Firms sell goods and services and buy factors of production.
  • The simple diagram ignores government and international trade.
The production possibilities frontier (PPF)
A graph of the combinations of output the economy can possibly produce given its factors of production and technology. Chapter example: two goods (computers and wheat), one resource (labor), 50,000 hours per month, 100 hours per computer, 10 hours per ton of wheat.
PointHours on computersHours on wheatComputersWheat
A50,00005000
B40,00010,0004001,000
C25,00025,0002502,500
D10,00040,0001004,000
E050,00005,000
  • On the PPF (A to E): possible and efficient, all resources fully used.
  • Inside the PPF (like F: 100 computers, 3,000 wheat, only 40,000 hours): possible but inefficient, some resources are idle.
  • Outside the PPF (like G: 300 computers, 3,500 wheat, would need 65,000 hours): not possible.
Opportunity cost and the slope
Moving along the PPF shifts resources from one good to the other: society faces a tradeoff. The slope of the PPF (rise over run) is the opportunity cost of one good in terms of the other. In the example the slope is −1,000/100 = −10, so the opportunity cost of one computer is 10 tons of wheat (and of one ton of wheat, 1/10 of a computer). Comparing countries: the country whose PPF is flatter (with cloth on the horizontal axis) has the lower opportunity cost of cloth. England's PPF is not as steep as France's, so England's opportunity cost of cloth is lower.
Economic growth
With additional resources or an improvement in technology, the economy can produce more computers, more wheat, or any combination in between: the PPF shifts outward.
The shape of the PPF
  • Straight line: constant opportunity cost (the computers/wheat example).
  • Bowed outward: increasing opportunity cost. As more of a good is produced, increasing amounts of the other must be given up. This happens when workers have different skills or land has different uses: at point A (mostly cars) the opportunity cost of wheat is low because the workers who switch are the ones best suited to farming; at point B (mostly wheat) it is high because the only workers left are the best engineers.
Microeconomics vs macroeconomics
Microeconomics: how households and firms make decisions and how they interact in markets.
Macroeconomics: economy-wide phenomena, including inflation, unemployment and economic growth.
The two are closely intertwined: changes in the overall economy arise from the decisions of individual households and firms.