Group 1: The Basics

By: Tolu Salako, Lauren Lason, Belle Mueller and Frank Smith

Circular Flow Model

  • Basic Definition: a visual model of the economy that shows how dollars flow through markets among households and firm

Four Main Components of Circular Flow Model (outer-loop)

  • Firms: Produce goods and services (inputs - labor, land, capital)
  • Households: Consume all goods and services that firms produces
  • Markets for goods and services: households are buyers and firms are sellers
  • Markets for the factors of production: households are sellers and firms are buyers

Four Main Components of Circular Flow Model (inner-loop)


  • Labor, Land, Capital --> Inputs for production --> Good/Services Sold --> Goods/Services Bought
  • Spending --> Revenue --> Wages, Rent, Profit --> Income



Circular Flow Model and Specialization

Production Possibilities

  • Basic definition: 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

Key Points


  • Efficient outcomes: if economy is getting all it can from the scarce resources it has available
  • Inefficient outcomes: when the economy, for instance, is producing less than it could from the resources it has available


Production Possibilites Frontier

Comparative and Absolute Advantage

Comparative: the comparison among producers of a good according to their opportunity cost

Absolute: the ability to produce a good/service at a lower opportunity cos than the cost at which any other entity produces that good or service

Opportunity Cost: whatever must be given up to obtain some item


Key Points


  • the produce who has the smaller opportunity cost of producing a good, who has to give less of other goods to prouce it is said to have the compariative advantage in producing that good
  • Both people cannot have the comparative advantage (unless both have same opportunity cost)
  • Comparative advantage reflects relative opportunity costs
  • Specialization requires workers to give up performing other tasks at which they are not as skilled, leaving those jobs to others who are better suited for them (depends on time efficiency and amount produced)

Comparative Advantage