Chapter 2 (Thinking Like an Economist)

Section A

1 d 2 b 3 d 4 a 5 a 6 a
7 d 8 b 9 d 10 c 11 c 12 d
Section B

Question 1
Like all scientists, they make appropriate assumptions and build simplified models in order to
understand the world around them. The circular flow model is used to describe how the
economic activities (buying and selling) are organized and coordinated in the market.
The circular flow model is constructed based on the following assumptions:
 The economy has only two types of markets – The Good Market(GM) and the Factor
Market(FM)
 The economy comprises of only two economic sectors – The Households Sector (H) and the
Business Sector (B)
 There is no leakage or injection from and to the circular flow .

Expenditure Revenue
Goods and
Goods and Goods and
Services Market
services services

Inputs
Households Business
sector sector

Factors

Factors Market

Income Cost

Monetary flow

Physical flow
In essence, the circular flow diagram displays the relationship of resources and money between
firms and households. Firms employ workers, who spend their income on goods produced by the
firms. This money (income spent by workers which turns into revenue by firms) is then used to
compensate the workers and buy raw materials to make the goods. This is the basic structure
behind the circular flow diagram as shown above.

In the model, firms and households interact with one another in both the goods and services (G&
S) market and the factors of production market (or factors market). The G&S market, is where
all products made by businesses/firms are exchanged. The factors of production market is
where inputs such as land, labor, capital, and other resources are exchanged. Households earn
money by selling their “resources” (most often labor) to businesses in the factor market. In
return, households receive income. The price of the resources the businesses purchase (labor
from households) are the “costs.” From the resources provided by households, businesses
produce goods, which are then sold in the product market. Households use their incomes to
purchase these goods and services in the G&S market. In return for the goods, businesses bring
in revenue.

Question 2

The PPF model has to be used to explain opportunity cost, choice and scarcity. A PPF illustrate
the various combinations of two goods an economy can produce using all the resources
efficiently, assuming no changes to the production technology. The area outside the PPF is
unattainable as the resources are inadequate which represents scarcity. As a result of scarcity of
resources, economic decisions have to be made in term of the utilization of resources which
affects the production bundles. Increasing the production of one the good requires releasing
resources from the production the other goods hence affecting the production of the other good.
Every point on the PPF represents production efficiency where we can only produce more of one
good by producing less of the other good. Therefore, opportunity cost exists when we move
along a PPF. Any production point inside the PPF represents production inefficiency. Moving
point inside the PPF to on the PPF does not involve any opportunity cost.

Question 3

Economic growth represents an expansion of the production capacity. The PPF moves outward
when there is economic growth. The determinants for economic growth are such as
technological change and accumulation of resources.
Question 4

Capital goods
i)

PPF1

Consumer goods

ii) Yes because the production of 200 capital goods and 60 consumer goods is inside PP1.

iii)If only 120 capital goods and 150 consumer goods are being produced then the economy is
operating inside PP1. When an economy produced inside the production possibilities curve then
that economy is inefficient. The economy is getting less output from its inputs which if devoted
to some other activity would produce more output.

iv)

Capital Capital goods

Consumer goods goods (new)
200 0 0
180 90 117
150 170 221
110 240 312
60 300 390
0 350 455

V) The opportunity cost of producing 91 more units of capital, or moving from point C to point
D on the production curve, are (150 – 110) = 40 units of consumer goods.