Meeting 04

Andrew Pua

2025-01-23

Circular flow diagram

  • Example of a model

  • Assumptions are behind the diagram.

    • One assumption we discussed in Meeting 3 is that mutually beneficial exchanges should be free to take place.
    • Seinfeld clip about Kramer finding ways to get golf club access

  • The law might be supportive or not supportive of mutually beneficial exchanges.

  • Can you imagine the circular flow diagram applying to only 1 person acting as both the household and the firm? Why or why not?

    • Think of an individual stranded on a deserted island, similar to Robinson Crusoe.
    • An economy can nevertheless arise in this kind of setting.

  • Real-life circular flow diagrams are probably more complicated than what is presented in the textbook and in the 1-person economy.

    • But that is what a model is all about.
    • Our budget lines are also a model of what we can choose from. Two goods are probably not realistic, but there are ways to compensate for that.

Shapes and positions of budget lines

  • We took a lot of time thinking about why budget lines matter and working through why scarcity is reflected in such lines.

  • But we never discussed its shape and position beyond the fact that it is a line.

  • We had an example before where \(3x+2y=5\).

  • Focus on Alphonso’s budget constraint in Section 2.1. What will happen to the budget constraint if bus tickets now cost $1? Compare with the budget constraint found in Figure 2.2.

Which bundles to choose on the budget line

  • What you are going to see is somewhat of a preview of Chapter 6: Consumer Choices.
  • We observe that consumers typically prefer more to less.
  • This observation should convince you that bundles of the budget line would be chosen by such a consumer.
  • We observe that consumers typically would find it hard to give up another unit of a good if they already have less of that good.
  • This observation should convince you that “extreme” bundles are less likely to be chosen by such a consumer.
  • But if you want to know which bundle will be chosen by a consumer, then you have to apply marginal analysis.

  • What marginal analysis means is that we make choices by asking what happens when we have a little bit more or a little bit less.

  • It is not very obvious yet from the textbook but if we additionally assume that consumers make the best out of what they have, then

    • They would be choosing bundles on the budget line.
    • And they have to ask if a bundle on a budget line cannot be “improved upon”.
    • This will become clearer once we reach Chapter 6.

Production possibilities

  • Recall our discussion on FRED vs PSA/BSP?

  • We applied the idea of a “budget lines” here to:

    • think about how much of each product an organization would make
    • think about the price of data products relative to all other products produced by the Federal Reserve

  • Actually, the “budget line” here is really a production possibilities frontier (PPF).

    • But it is relatively simpler, because the PPF found in the textbook is for a country rather than one organization.
    • You might ask why do they look different?

Understanding the shape of the PPF in the textbook

  • Suppose there are two people who can both produce sandwiches and birdhouses.
  • Draw pictures of the PPF for each person.
  • What do you notice? Compare the shapes.
  • Let us now put these two people together in the same building.
  • We want them to produce both sandwiches and birdhouses. But we allow trade.
  • Who would make sandwiches? Who would make birdhouses?
  • Draw a picture of the combined possible production of the two people.
  • What do you notice in the picture?
  • Now, imagine adding another person who also knows how to make birdhouses and sandwiches. What would the combined PPF look like?
  • Add more people and what happens?