Economic Models and Production Possibilities Frontier

The expression of a model can be in the form of words, diagrams, or mathematical equations, depending on the audience and the point of the model. These are the classic examples to describe economic models.


A visual model of the economy that shows how dollars flow through markets among households and firms. In this model, the economy has two types of decision makers households and firms. Firms produce goods and services using inputs, such as labor, land, and capital (buildings and machines). These inputs are called the factors of production. Households own the factors of production and consume all the goods and services that the firms produce. Households and firms interact in two types of markets. In the markets for goods and services, households are buyers and firms are sellers. In particular, households buy the output of goods and services that firms produce. In the markets for the factors of production, households are sellers and firms are buyers. In these markets, households provide firms the inputs that the firms use to produce goods and services.

Let’s take a tour of the circular flow by following a dollar bill as it makes its way from person to person through the economy. Imagine that the dollar begins at a household, sitting in, say, your wallet. If you want to buy a cup of coffee, you take the dollar to one of the economy’s markets for goods and services, such as your local Barista coffee shop. There you spend it on your favorite drink. When the dollar moves into the Barista cash register, it becomes revenue for the firm. The dollar doesn’t stay at Barista for long, however, because the firm uses it to buy inputs in the markets for the factors of production. For instance, Barista might use the dollar to pay rent to its landlord for the space it occupies or to pay the wages of its workers. In either case, the dollar enters the income of some household and, once again, is back in someone’s wallet. At that point, the story of the economy’s circular flow starts once again.


A graph that shows the combination of output that the economy can possibly produce given the available factors of production and the available production technology. Another of the Ten Principles of Economics is that the cost of something is what you give up to get it. This is called the opportunity cost. The production possibilities frontier shows the opportunity cost of one good as measured in terms of the other good.

For example, if a technological advance in the computer industry raises the number of computers that a worker can produce per week, the economy can make more computers for any given number of cars.An economic advance in one industry shifts the production possibilities frontier outward, increasing the number of first item and the second item, the economy can produce. As a result, the production possibilities frontier shifts outward. Because of this economic growth, society might move production from one point to another, enjoying more computers and more cars.

The production possibilities frontier simplifies a complex economy to highlight and clarify some basic ideas. Some of the concepts mentioned briefly are; scarcity, efficiency, trade-offs, opportunity cost, and economic growth.

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