1. Principals of Economics Law class 1
By Edward Gatwaza
12/03/2018
Lesson two

2. Economic Models Two of the most basic economic models include:
Economists use models to simplify reality in order to improve our understanding of the world
Two of the most basic economic models include:
The Circular Flow Diagram
The Production Possibilities Frontier.
First Model: The Circular-Flow Diagram: The circular-flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms.

3. A SIMPLIFIED ECONOMIC SYSTEM AND ITS CENTRAL PROBLEMS
This diagram is a schematic representation of the organization of the economy.
Decisions are made by households and firms.
Households and firms interact in the markets for goods and services (where households are buyers and firms are sellers) and in the markets for the factors of production (where firms are buyers and households are sellers). The outer set of arrows shows the flow of Francs, and the inner set of arrows shows the corresponding flow of inputs and outputs.

4. First Model: The Circular-Flow Diagram explained.
Markets for Goods and Services
Firms sell
Households buy
Markets for Factors of Production
Households sell
Firms buy
Factors of Production
Inputs used to produce goods and services
Land, labor, and capital 7

5. ECONOMICS CENTRAL PROBLEMS

6. The main problem arises mainly for two reasons:
2.2. Central problem of an economic system
What to produce?
The problem of “What to produce?” is the problem of choice between commodities. This is the determination of the product mixes in the economic system. The product mix is the combination of the different types of goods and services in the economy.
The main problem arises mainly for two reasons:
Scarcity of resources…..!
All goods and services are not equally valued in terms of their utility by the consumers.

7. Central problem of an economic system cont’d
Goods are of different types.
They are Capital goods are produced so that they can be used to produce other goods.
Consumer goods
Durable goods are hard and tensile
Non-durable goods, they can be consumed and perish in production or consumption.
Services are either economic or social. Roads and provision of electricity are economic services. Health and education are social services. Collective services are services that are used by the public without discrimination. These are like market places. There are different from services such as medical attention that are received at individual level.

8. Central problem of an economic system cont’d
How to produce?
How to produce is about techniques of production or the choice of Technology. This arises mainly due to scarcity of resources. In production we use more of capital relative to less of labour or use more labour relative to capital. Using more capital relative to labour is called a capital-intensive technique of production using more labour relative to capital is labour-intensive technique of production

9. Central problem of an economic system cont’d
For whom to produce?
This problem of the economic system is about distribution. Who gets what in the economy? If production is biased towards production of goods that meet the needs of rich then the economic system favours the upper stratum of society.
If a larger proportion of resources are directed to producing wine instead of food then distribution in the economy will be skewed in favour of the rich.
Distribution may also be between men and women
In the economy income disparities may also be by regions.
Income and distribution policy as well as taxation can be used to reduce disparities between incomes of different categories of people

10. Production possibility curve
The production Possibility Curve is an economic method that shows how the economic system can be simplified and how the different questions can be answered using diagrams and simple arithmetic.
It is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology.
It is base on the following assumptions
Factors of production are fixed in total supply. The resources can be allocated among different types of production
Technology is constant
Economy operates efficiently and resources are fully employed
Only two products are produced.

11. The production possibilities frontier (PPF)
Quantity of
Computers
Produced
The production possibilities frontier shows the combinations of output - in this case, cars and computers - that the economy can possibly produce.
The economy can produce any combination on or inside the frontier.
Points outside the frontier are not feasible given the economy’s resources. C
1,000
3,000 F
Production
Possibilities
Frontier A
2,200 B
2,000
600
700 D
1,000
300 E
Quantity of
Cars
Produced 11

12. Production possibility curve cont’d…!
Let us start explaining the concept by using the Production Possibility Frontier as represented by a hypothetical schedule of producing foods and clothing.
Below is table showing a hypothetical Production Possibility Schedule

13. Production possibility curve cont’d…!
Food (000s kg)
Clothing (000s m) A
100 B
750
125 C
500
250 D
375 E

14. Production possibility curve cont’d…!
A-E are possible choices of production. Resources may be used to produce a million kg of food and no clothing (A) or 500,000 tons of clothing and no food. Neither of these two extreme cases are likely choices in a closed economy. Society will choose to produce some food and some clothing. Choices will differ from one society to another. Line AE represent a set of such choices and is what is called the Product Possibility Frontier

15. Production possibility curve cont’d…!

16. Production possibility curve cont’d…!
But most likely then shape of the possibility frontier will not be linear. This is because of the Law of Diminishing Returns. This is an economic law that is common in land utilization specifically and other factors generally. Additional increase of a variable factor of production on a fixed factor will reach a point where additional increase of the variable factor will lead to less than proportionate returns. Outputs may continue to increase at a decreasing rate. It may reach a point where the total output will start to decline if an additional unit of the variable factor leads to negative marginal output. This law means the opportunity cost of food for cloth will be increasing with additional inputs for production of food or vice versa. In brief the production possibility curve is usually a curve as in Diagram below.

17. Production possibility curve cont’d…!

18. Production possibility curve cont’d…! What to produce!!!

19. Production possibility curve cont’d…!
What to produce can be illustrated by any PPC and is represented by all points on the curve. Any choice of the curve represents a mix of different commodities.
Thus in the diagram above, that represent investment and consumer goods, any choice represents different combination of capital and consumer goods. Choice A is a preference for more capital goods relative to consumer goods. Choice B is more consumer goods relative to investment goods. It can be said from economic theory that the society that has chosen A may experiment more growth in future than that which chose B.

20. Production possibility curve cont’d…! For whom to produce?

21. Production possibility curve cont’d…!
How to produce cannot be answered from the diagrams. It was assumed that technology is a constant.
For whom to produce, changing the type of commodities on both axes can show the direction of distribution. Thus if one axis shows wine as a commodity consumed by the rich, and rice on the other axis to represent a good for the poor, then the choice will reflect the bias in production.
Likewise society uses resources to produce goods for boys relative to girls at B and a society that uses resources to produce G is favouring the female.

22. Production possibility curve cont’d…! Growth

23. Production possibility curve cont’d…!
We show that it is possible to depict growth by using a PPC. A growth in the economy is reflected by a forward shift of the curve. From the diagram above, the society that will have chosen A will experience more growth than the one that chose B. therefore after some 10 years the curves for the two societies will no longer be the same. That for A will be further to the right reflecting more growth.
Therefore the PPC is a simplified way of showing how the economic system works. In reality it is more complex. Society do not produce two goods only. They produce thousands. Technology cannot be held as constant. It also changes. But in a simplified it shows us the central problems of any economic system

24. 2.4. Aims of economic policy
Full employment
Full employment is an economic terminology that means a situation where all factors of production are fully employed in the economy. It is a hypothetical situation used mainly in microeconomic modeling in this section we are referring to a simple economic phenomenon.
The aim may be to keep levels of unemployment below 5% or some other figure that cannot destabilize the economy. It may be difficult, very often it may require some manpower planning to balance the supply of skills and demand over a period of time.

25. Aims of economic policy cont’d..!
Price Stability
Price movements are measured using indices. The most common is the Consumer Price Index. When prices persistently rise and when the value of money deteriorates then a common economic problem is that known as inflation. Some people prefer to call it “too much money chasing too few goods.” The economic system aims at keeping the inflation rate low. Single digit inflation is usually tolerable

26. Aims of economic policy cont’d..!
Balance of payment
When receipts are more than payments in international trade we call it a surplus on balance of payments. It is goods although it is not necessarily the wisest event to target. When it happens in the economy there may be a tendency to overspend. In poor countries the most common event is the deficit on balance of payments.
Deficit may be because of investment that will stimulate growth in future. It is bad if the deficit is related to consumption of goods such as luxuries. It is bad if the deficit persists over a long period such that the economy lacks the capacity to import goods.

27. Aims of economic policy cont’d..!
Economic Growth
Growth is important to the economic system. Growth is directly related to living standards of the people. It is also the source of citizens’ welfare. Higher growth allows for government to reduce poverty and offer welfare services. Growth means more goods and services are produced in the economy over the years

28. Aims of economic policy cont’d..!
Income Distribution
Income distribution is important in the economy. If a few people have more income than may there can develop social tension. Unequal income distribution is not poverty but it reflects condition of poverty. A country with a lower income gap between the rich and poor or a better distribution in more likely to grow faster than the one with a wider gap of inequality. Reducing the gap between the rich and poor is also a distributive justice.
Levels of income distribution are measured by three methods: Lorenz curves, gini-coefficients and ratios.

29. Aims of economic policy cont’d..!
Allocation of resources
Under conditions of scarcity efficient allocation in one of the ways of raising outputs in the economy. Resources to be used efficiently are natural, human or financial.
One simple way of encouraging efficient utilization is encouraging competition in the use of resources. It may involve using technology and encouraging innovation. Public sector reform and privatization have been directed to encouraging competition and efficiency

30. Aims of economic policy cont’d..!
Collective services.
The aim of economic system is to provide public utilities and services required by society. Public goods are those goods that are required by society and are pure if using them does not leave any other person worse off. These are like national security. Most other services are semi-public or are just social. Education and health are social but consumers can also buy them.