Study Guide in BAC 102 Basic Microeconomics Module 2 –Economic Models

MODULE 2

ECONOMIC MODELS

MODULE OVERVIEW

Economists do a lot of things. Basically, they examine how scarce resources will be efficiently allocated.
They conduct research, forecast economic trends, and prepare data-driven decisions concerned with
practical applications of economic policies. They also build certain economic models to make economic
theories easier to understand and simplify the analysis of complicated economic issues.

This module will find out how economists build economic models using economic data and variables. It
explains how an economic model, specifically two-sector circular flow model of microeconomics, helps in
analyzing economic behavior and assessing how the economy operates. Since economics is mainly a
matter of creating models that draw on a set of basic concepts, this module will cover topics related to
economic modelling and present essential tools of economic analysis. The module covers the forms of
economic models, assumptions, economic statements, graphs, variables, economic relationships, and linear
equations. It also places emphasis on two useful models—the circular flow of income model and the
Production Possibility Frontier model.

LEARNING OBJECTIVES

After studying and completing this module, you should be able to

1. Define an economic model and explain the process of model building in economics.
2. List and describe the different forms of an economic model.
3. Explain the use of the ceteris paribus assumption.
4. Compare positive and normative economic statements.
5. Discuss and illustrate, using a diagram, the circular flow of income between households and firms.
6. Demonstrate how production possibility curves can be used to illustrate choice and resource
allocation
7. Describe a graph and outline its uses in economic analysis.
8. Interpret the rectangular coordinate system as a way of representing economic relationships.
9. Describe a variable and a constant.
10. Distinguish between a dependent variable and an independent variable.
11. Analyze the types of economic relationships—inverse relationship and direct relationship.
12. Calculate the slope of a line.
13. Define and solve a linear equation.

LEARNING CONTENTS

Definition and Forms of Economic Model

The economic activities and phenomena are so complex. Thus, a model is necessary in order to reduce the
complexity of economic problems. A model is described by Krugman (2014) as a simplified representation
of a real situation that is used to better understand real-life situations.

Most economists define the economic model as a simplified framework of reality and representation of
economic phenomena. Economists use and build models to explain and understand the economic situation
and any related problems. Economic models are designed to be simple, flexible, and useful to make an
easier understanding of how the economy functions partly and as a whole.

Economic models can be represented in various forms, in words or statements (descriptive model), in
diagrams (graphical model), and in equations (mathematical model).

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Study Guide in BAC 102 Basic Microeconomics Module 2 –Economic Models

Many economic principles such as aggregate output, Production Possibility Frontier, the functional
relationship between consumption and national income, and so on can be easily analyzed using an
economic model. One popular and essential economic model is demand and supply, which economists use
to describe how markets work. The model defines the relationship between the price of a good and the
quantity that consumers will buy or producers will sell, assuming that everything else is constant. This
particular model can be stated verbally using the statements of the Law of Demand or Law of Supply, be
expressed mathematically using demand or supply equation, or can be illustrated graphically using the
demand or supply curves/schedules, which makes it easier to understand.

Ceteris Paribus Assumption

In building a model, economists make use of assumptions to lessen the difficulty of economic analysis. In
economics, the ceteris paribus assumption is applied to determine the causal relationships among
variables. Ceteris paribus is a Latin phrase that means “other things being held constant.”

This assumption allows an analysis to examine the effect of change in one variable letting all other relevant
variables unchanged. In the real world, economic relationships among variables are difficult to isolate since
most of them are influenced by more than one factor. However, multiple independent variables can be
isolated because models will likely depend on certain assumptions.

In a price-quantity demanded relationship, for example, it is assumed that the price of a good varies.
Nevertheless, other variables that may also affect the amount of quantity demanded, such as the number of
buyers, consumer’s income, prices of related goods, and the rest, are held constant under the ceteris
paribus assumption. This separates the relationship between the specific dependent and independent
variables.

Positive versus Normative Economics

Economic statements can be in the form of positive or normative analysis.

Positive economics is concerned with statements that can be proved by appealing to relevant facts and
figures. It focuses on cause-and-effect relationships and involves theory development. Some examples of
positive statements are:

 Increasing the minimum wage results in a higher unemployment rate.

 Recession is a serious economic issue.
 The GDP of the Philippines is lower than that of Singapore in 2018.
 If the government cuts taxes, then the supply of cigarettes will rise.

Normative economics requires normative statements that are based on value judgments. It concentrates
on the formulation of economic policies about what the economy should be like or what certain policy
actions or recommendations should be undertaken. Some examples of normative statements are as follows:

 The Philippine government should not tax online businesses.

 It is right to spend on social works more than the public works.
 The police earn more than teachers in the Philippines.
 Every Filipino ought to have equal access to freedom of expression.

The Microeconomics Circular Flow of Income Model

To simplify the understanding of how the economy is organized and how the sectors in the economy interact
with one another, one economic model must be used. This can be explained by the circular flow of income
model. The circular flow of income is a visual model that depicts how money, goods, and services flow
through markets between households and firms in the economy. In this model, the economy is simplified as
there are only two sectors—firms and households. Further, the model assumes that there is no government
intervention, the economy is closed, households spend all their income on goods and services and the firms
spend all of their income on economic resources

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The components of the circular flow diagram include:

1. Households and Firms. Households are considered the consuming unit of the economy that sells
economic resources and buy goods and services and. The firms serve as the producing unit that
buys inputs of productions and sell goods and services.
2. Resource Market and Product Market. A resource market is a market in which an economic
resource is sold by households and bought by households. A product market is a place in which a
good or service is sold by firms and bought by households
3. Real Flow and Money Flow. Real (input-output) flow indicates the movement of the economic
resources flowing from households to firms through the resource market and of the goods and
services flowing from firms to households through the product market. Money flow illustrates the
movement of income or payment made in exchange for supply economic resources and of
expenditures on goods and services.
4. Income. This represents the resource payments (rent, wage, interest) made by the households
in return for the resources (land, labor, and capital) provided by the households and the profit
received by firms from the consumption spending of goods and services.

The two-sector circular flow diagram is presented in Figure 2.1.

The economy can be represented as two

cycles moving in opposite directions. In
one direction (inner loop), economic
resources flow from households to firms,
and goods and services flow from firms
to households. The households sell land,
labor, and capital to the firms in the
resource market. These resources will be
organized by firms to produce goods and
services. The output will then be sold to
households in the product market.

The other direction (outer loop),

spending on goods and services flows
from households to firms, and income
flows from firms to households. The
households receive income in the form of
rent, wage, and interest as payments for
providing these resources. The income
Figure 2.1
will–then
Circular
be Flow
usedoftoIncome Diagram
buy goods in the product market.
The firms use some profit received from the sales of the product to pay for economic resources.

The Production Possibilities Frontier Model

Every economy uses its scarce resources to produce goods and services. The choices a society faces or
the impact created by scarcity on an economy can be demonstrated with the use of the production
possibilities frontier (PPF) model.

The Production Possibilities Frontier (PPF) is a graphical model that illustrates the combinations of output
that the economy can efficiently produce using the available quantity of economic resources. To simplify
things, PPF follows some certain assumptions:

1. Fixed resources. The quantity of factors of production (land, labor, capital, and entrepreneurial
ability cannot be adjusted.
2. Full employment. The economy is at its full capacity using all available resources without
waste.
3. Two goods produced. Only two goods can be produced: consumer good or capital good.

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Study Guide in BAC 102 Basic Microeconomics Module 2 –Economic Models

4. Fixed technology. The state of technology remains unchanged.

The PPF is presented in Figure 2.2, which shows a hypothetical economy that devotes its economic
resources using two goods: delivery trucks and smartwatches with different possible combinations of output
that could be produced over a given period.
The units of delivery trucks are measured in the
horizontal axis and units of smartwatches on the
other. The curve shows all the possible
combinations of two goods that can be produced
given all nation’s resources are fully and efficiently
employed. For example, production could take
place at point B, with 30 thousand units of delivery
trucks and 50 thousand units of smartwatches
produced.

All points within the curve (A, B, C, D, E) are

considered efficient because the output is
produced from available resources. Points outside
the PPF (H and I), are unattainable. In other
words, production cannot take place beyond the
curve as the economy is constrained with
resources to do this. Points inside the PPF (F and
G) are inefficient because the economy is not fully
using its resources.

The PPF demonstrates the principles of choice and opportunity cost. If the economy chooses to produce
Figure
more delivery trucks, it would have to forego the production of some2.2 – Production Possibilities
smartwatches. Frontier Model
This sacrifice
made of smartwatches is the opportunity cost of the extra delivery trucks.

Graphs in Economics

Economists always use graphs to represent economic relationships visually.

Mankiw (2015) pointed out that graphs serve two purposes. First, when developing economic theories,
graphs offer a way to visually express ideas that might be less clear if described with equations or words.
Second, when analyzing economic data, graphs provide a powerful way of finding and interpreting patterns

Graphs of a single variable can be represented with the use of a pie chart, bar graph, or line graph. A pie
chart is conveniently used to represent the different parts of something of a whole. The bar graph makes it
particularly useful to compare sets of numbers using rectangular bars. The line graph makes it easy to
display information as a series of data or changes over time. The number of Economics books sold by a
publisher per month in 2019 can be displayed with the use of any of these graphs.

Economic data are typically concerned with the relationships between variables. Thus, two variables must
be illustrated on a single graph, and the rectangular coordinate system makes it possible. Most graphs in
economic analysis are based on this coordinate system which helps display and visualize the relationship
between variables easily.

The rectangular coordinate system, which is also known as the Cartesian coordinate is based on a two-
dimensional grid, every point on the plane can be identified by unique x and y coordinates. Ordered pairs
are plotted in a grid. The first number in each ordered pair is called the x -coordinate, which indicates the
horizontal location of the point. The second number is called the y -coordinate, indicating the vertical
location of the point. The point with both an x -coordinate and a y -coordinate of zero is known as the origin.
The two coordinates in the ordered pair specify where the point is located in relation to the origin: x units to
the right of the origin and y units above it. Axes naturally divide the plane up into four regions or quarters
called quadrants marked I, II, III, and IV

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Economic data normally require positive

numbers: the price of a product, the quantity
demanded or supplied, national income,
unemployment rate, and many more. Because
economic data are typically positive values, the
upper right region (quadrant I) is the only
appropriate region of the coordinate system that
can be applied for. When data are negative, the
other quadrants of the coordinate system may be
used.

When graphing economic data, the dependent

variable ( y ) is placed on the vertical axis, and the
independent variable ( x ) is labeled on the
horizontal axis.

An example of the coordinate system showing the

x and y coordinates, quadrants, ordered pairs,
and the point of origin is shown in Figure 2.3.

Figure 2.3 – The Rectangular Coordinate System

Economic Variables

In economic analysis, a variable is a quantity that can take a variety of values in a particular problem. Many
economic variables can take on more than one value: the profit earned by a firm, the price of a face mask,
consumer’s income, unemployment, or inflation rate.

Variable is different from a constant as the latter does not change its value over time. Constant as a
quantity has a value that remains unchanged throughout a specific problem. There are two variables in a
function or relationship: the independent variable and the dependent variable.

An independent variable represents the value that is changed, while the dependent variable is the
observed result of the independent variable being changed.

In a linear relationship, y is said to be a function of x if every value of x is associated with exactly one value
of y. In the function, y=f ( x ), 𝑦 represents the dependent variable, and 𝑥 is the independent variable.

For instance, an entrepreneur wants to predict how much sales would be made for every additional unit of a
good sold. The quantity sold would be the independent variable, whereas the sales or revenue would
represent the dependent variable. Mathematically, in R=25 x , where R is the revenue, x is quantity sold,
and 25 is the price of the good, R and x are both variables, while P=25 is a constant. Revenue depends on
the quantity sold because as x increases, y also increases.

Economic Relationships

Economists are quite interested in determining the type of relationship that exists between variables. There
are two types of economic relationships: the direct relationship and the inverse relationship.

A direct relationship is a positive relationship between variables in which a change in the value of one
variable is associated with a change in the value of the other variable in the same direction. If one
increases, the other also increases. If one decreases, the other decreases.

In the case of consumption-income relationship, a rise in consumption (dependent variable) spending is

associated with an increase in income (independent variable); a fall in consumption is associated with a

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Study Guide in BAC 102 Basic Microeconomics Module 2 –Economic Models

decrease in income. If the independent variable rises, the dependent variable also increases, and vice
versa.

Other examples that exhibit direct relationships are price and quantity supplied, demand for a product
and number of buyers, cost of production and output produced, consumption spending and GDP,
and the like.
The graph of two variables having a direct relationship is illustrated by a curve that slopes upward or an
upsloping line.

On the contrary, an inverse relationship is a negative relationship between variables in which a change in
the value of a variable is associated with a change in the value of the other variable in an opposite direction.
If one goes up, the other one goes down and if one goes down, the other one goes up.

The popular example of an inverse relationship is price and quantity demanded. For consumers, the price
of a product is inversely related to the quantity they will purchase. As the price (independent variable) of
good increases, its quantity demanded (dependent variable) decreases, and as the price decreases, the
amount of good demanded increases. Common examples also include tax rate incurred and the number
of goods supplied by a firm, demand for a good and the price of a complementary good, and the
Phillips curve illustrating the relationship between inflation and unemployment.

When two variables are negatively or inversely related, the graph is illustrated by a curve that slopes
downward from left to right or downward sloping line.

The Slope of a Curve

The concept of slope is useful in economic analysis. The slope of a curve determines how steep it is or how
sensitive the dependent variable to a change in the independent variable.

The slope of a curve at any point can be measured in numerical terms. To calculate slope, the rise or the
amount that y changes, and the run or the amount that x changes are measured. It is expressed as:

rise ∆ Y Y 2−Y 1
m= = =
run ∆ X X 2−X 1

The slope of a line varies. These variations result in four types of slope:

1. Positive slope. It indicates that x and y variables are positively related, and the line slopes upward
to the right.
2. Negative slope. This indicates that x and y are negatively related, and the line slopes downward to
the right.
3. Infinite slope. The value of the x -variable along the curve is constant; thus, the line is vertical.
4. Zero slope. This means that there is no relationship between x and y . The value of the y -variable
is constant; thus the line is horizontal.

The graphical representation of the four types of slope is presented in Figure 2.4.

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Figure 2.4 – The Four Types of Slope of a Curve

Linear Equation in Economics

The linear equation is a simple mathematical model that has numerous applications in economics. It is an
algebraic expression that measures the relationship between two variables represented by a straight-line
graph.
The equation of a linear relationship may be in the general form, y=mx+b , where y is the dependent
variable, x is the independent variable, m is the slope of the line, and b is the constant term or vertical
intercept.
For example, the linear equation is given by
Qd =300−4 P , where Qd represents quantity
demanded, and P denotes the price of the good. This
equation allows an analysis to estimate the amount of
quantity demanded at any specific level of price. When
the price is set to 50, it is predicted that the quantity
demanded is 100.
To graph a linear relationship, identify two points that
satisfy the equation, plot them, and connect the points
with a straight line. Alternatively, find the x -intercept
and horizontal y -intercept. The x-intercept is where a
line crosses the horizontal axis, and the y-intercept is
the point where the line crosses the vertical axis.

The graph of the demand-price relationship using x and y intercepts is presented in Figure 2.5.

Figure 2.5 – Graph of Q d =300−4 P

LEARNING POINTS

 Economic model is necessary to reduce the complexity of economic problems. Most economists
define the economic model as a simplified version of reality and representation of economic forces.
 Economic models can be represented in words (descriptive model), tables and diagrams (graphical
model), and equations (mathematical model).
 In building a model, economists make of the Ceteris paribus assumption that means “other things
being held constant.”
 Economic statements can be in the form of positive or normative economics. Positive economics is
about theory development, while normative economics is about policy development.
 The circular flow diagram can explain the interaction between households and firms in the
economy. It is a visual model that shows how money, goods, and services flow through markets
between and firms in the economy.
 One useful model that helps economists understand the trade-offs every economy faces is the
Production Possibilities Frontier (PPF). It is a graphical model that illustrates the combinations of
output that the economy can efficiently produce using the available quantity of economic resources.
 Economists use graphs to express economic relationships visually. Graphs of a single variable can
be represented with the use of a pie chart, bar graph, or line graph. Two variables can be illustrated
on a single graph using the rectangular coordinate system. Since economic data normally require
positive numbers, the upper right quadrant of the coordinate system is used primarily in economic
analysis.
 A variable is a quantity that can take a range of values, while constant is a value that remains
unchanged throughout a particular problem. The value of the dependent variable is determined by
the value of the independent variable.
 Economic relationships are expected to be direct or inverse. A direct relationship is a positive
relationship between two variables, while the inverse relationship is the negative relationship
between variables.

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Study Guide in BAC 102 Basic Microeconomics Module 2 –Economic Models

 The slope of a curve measures the amount that 𝑦 changes, and the amount that x changes. The
slope of a line varies; it can be positive, negative, zero, or infinite.
 The linear equation is a simple mathematical model that has numerous applications in economics. It
is an expression that measures the relationship between two variables represented by a straight-
line graph. The equation of a linear relationship may be in the general form, 𝑦 = 𝑚𝑥 + 𝑏.

LEARNING ACTIVITIES

ACTIVIT ITY A

Modified True or False. Write true if the statement is correct. If false, underline the word or phrase to make
the statement right and write the correct answer in the blank space provided.
1. Economists seldom use models to simplify complex economic problems. ______________
2. An economic model can be expressed using words but not equations. ______________
3. A positive economic statement is a form of descriptive model. ______________
4. A bar graph is used to represent the different parts of something of a whole. ______________
5. In consumption-income relationship, income variable assumes to be constant. ______________
6. Wage is the resource payment for a capital resource. ______________
7. In Production Possibilities Frontier model, the amount of resources can be adjusted. ____________
8. The upper left quadrant of the coordinate system is used mostly in economic analysis. __________
9. The value of the independent variable is determined by the value of the dependent variable.
10. Two variables are directly related if they move in an opposite direction. ______________
11. An independent relationship occurs when two variables. ______________
12. The slope of an upward-sloping line is positive. ______________
13. In the equation, Q d =100−P , the slope of the line is 0. _____________

ACTIVITY B

Categorization. Determine what form of economic model can be appropriately used in the following. Write
D for descriptive model, G for graphical model, or M for mathematical model in the blank space provided.

14. Concept of scarcity ______________

15. Circular flow of income diagram ______________
16. Derivation of consumption function ______________
17. Positive statement of an economic theory ______________
18. Total utility schedule ______________
19. Approaches to GDP measurement ______________
20. Phillips curve ______________
21. Calculation of unemployment rate ______________
22. Definition of inflation ______________
23. Upward sloping supply curve ______________

ACTIVITY C

Categorization. Determine what economic statement is associated with the following. Write P for positive
economics or N for normative economics in the blank space provided.

24. The Bangko Sentral ng Pilipinas should print more money. ______________
25. Higher supply of money in circulation results in inflation. ______________

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26. Canada is a richer country than India. ______________

27. The cost of living has increased fifty percent over the past ten years. ______________
28. An increase in consumption spending leads to an increase in GDP. ______________
29. What are the factors that induce the supply of hand sanitizers? ______________
30. In the Philippines, media is more powerful than the government. ______________
31. The Philippine government spent more than it earned in 2019. ______________
32. Economic development cannot be achieved without economic growth. ______________
33. This country must produce more capital goods than consumer goods. ______________

ACTIVITY D

Fill in the blanks. Refer to the circular flow of income model and use the terms there to fill in the blank in
each statement below. Write the answer in the blank space provided.
34. The circular flow model assumes that the economy is ______________.
35. In the circular flow diagram, ______________ flows from households to firms.
36. Households and firms interact in the ______________ and product market.
37. The ______________ loop illustrates the flows of inputs and outputs.
38. Firms ______________ land, labor and capital in the resource market.
39. In the product market, households are ______________.
40. Households provide the inputs that firms use to ______________ goods and service.
41. Firms receive income from through the ______________.
42. ______________ flows from firms to households.
43. When ______________ is sold, it is paid in rent.

ACTIVITY E

Graph Interpretation. Refer to the diagram below depicting the PPF between two goods–garlic and bread,
and answer the questions that follow. Write the answer in the blank space provided.
44. How many units of garlic and bread
are produced at Point V?
______________ 90
I A
45.How many units of bread are produced in 80
the economy if there are no garlic L X
70 O
Bread (in million units)

produced? _____________
60
46.What points or combinations demonstrate
efficiency? ______________ 50 S V Y
47.What are the inefficiency points? 40
______________ P
30 E
48.What are the unattainable points?
______________ 20

49.What are the full employment production 10

points? ______________ 0 U
0 10 20 30 40 50 60
50.What is the opportunity cost of producing
20 million kilos of garlic? _____________ Garlic (in million kilos)
51.What is the opportunity cost of moving
from point O to E? _____________

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REFERENCES

Arnold, R. A. (2016). Economics, 12th Edition. Melbourne, Australia: Cengage Learning

Boyes, W. and Michael, M. (2013) Economics 8th Edition. Mason, U.S.A: South-Western Cengage
Case, K.E. (2013) Principles of Economics. Singapore: Pearson Education South Asia Pte Ltd.
Calilung, F. C. (2013) Fundamentals of College Economics with Taxation and Agrarian Reform. Manila: Books Atbp.
Estrada, J.N. (2020) The Contemporary World Workbook. Lingayen, Pangasinan: Pangasinan State University
Estrada, J.N. (2017) Microeconomics Worktext. Lingayen, Pangasinan: Pangasinan State University
Krugman, et al. (2014) Essentials of Economics, 3rd Edition. New York, NY: Worth Publishers
Lieberman, Marc (2012) Principles and Applications of Economics. New York, USA: Cengage Learning
Mankiw, N. G. (2015) Principles of Economics. Melbourne, Australia: Cengage Learning
McConnell, C. R. (2015). Economics: Principles, Problems, and Policies. New York, USA: McGraw-Hill Education
Salazar, E. M. et al. (2013) General Economics, Taxation, and Land Reform. Bulacan, Philippines: IPM Publishing
Samuelson, P.A., and Nordhaus, William D. (2015). Economics. New York, NY: McGraw-Hill
Schiller, B. (2016). The Economy Today, 14 the Edition. USA: McGraw-Hill
Schiller, B.R., and Gebhardt, K., Essentials of Economics, 10th Edition. New York: McGraw-Hill Education
Sloman, J. (2013) Economics, 6th Edition. England, United Kingdom: Prentice Hall
Sexton, R. L. (2016) Exploring Economics, 7th Edition. New York, USA: Cengage Learning
Sexton, R. L., and Greene, C.L. (2015) Economics and Entrepreneurship. Australia: Cengage Learning

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