Question

1. Explain the function of the goods and services market and the factors of production market in the Circular Flow Model. Explain both real and money flows and the role of prices in both the product and factor markets.

2. Using an example, explain why the production possibilities frontier is bowed outward.

3. Use the production possibilities frontier to explain fully economic growth, efficiency, and inefficiency.

4. Suppose that China can use cheaper labour to produce every product more cheaply than Canada. Explain why Canada will still gain from international trade with China.

Answer 1

Function of the goods and services market involves providing goods and services to the households and other corporate customers and generate revenues for the firm that has worked to produce it. Function of factors of production market involves selling of factors of production such as labor, and other capital goods to generate revenues or wages for those who are selling the factors of production.

Real flow takes place when goods and services are purchased by the consumers, and money flow takes place, when first firms pay wages to the workers and then, Households pay price for the goods and services that go back to the firm.

With increase in price, quantity demanded of goods and services decreases and vice versa in the goods and services market. With increase in price, demand for labor also decreases as it becomes more expensive. But, quantity supplied increases with rise in price. It helps to raise the wage rate.

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Above is a PPF curve that is bowed outward. It is due to the reason that there is an increasing opportunity cost to produce car or cloth. For example, a person producing cloth with full expertise and efficiency cannot produce car with the same efficiency, because he or she does not own a specialized skills to produce cars. It cause him to take more time to produce car. So, opportunity cost od producing cars increases. The same applies to car producing workers and they are not specialized in producing cloths. So, opportunity cost of producing cloths also increases. It makes PPF curve to bowed outward in direction.

Any output combination that is lying on the PPF curve itself such as B, is considered as efficient output combination. It represents efficient economic growth condition. Any output combination that is within the inside of the PPF curve such as A, is considered as inefficient output combination. Any output combination that is outside of the PPF curve such as C, are considered as out of reach output combination.

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Canada can still gain from the international trade, because international trade is based on comparative advantage and not on absolute advantage. For example, China has cheap labor to produce many things at lower cost. But, specialization of resources or workers causes China to produce one goods with a higher opportunity cost, while the same good can be produced by Canada to produce at a lower opportunity cost. Hence, Canada has comparative advantage in that good that will help Canada gain from the international trade.

Further, It is the high end technology that is with Canada, but not with China. China has only cheap labor to produce goods at a lower end of the value chain. But, Canada has the technology to produce goods that are at the higher end of value chain.

So, canada can also gain from the international trade.