A model is any simplified representation of reality that is used to better understand real-life situations. But how do we create a simplified representation of an economic situation?

One possibility—an economist’s equivalent of a wind tunnel—is to find or create a real but simplified economy. For example, economists interested in the economic role of money have studied the system of exchange that developed in World War II prison camps, in which cigarettes became a universally accepted form of payment even among prisoners who didn’t smoke.

Another possibility is to simulate the workings of the economy on a computer. For example, when changes in tax law are proposed, government officials use tax models—large mathematical computer programs—to assess how the proposed changes would affect different types of people.

Models are important because their simplicity allows economists to focus on the effects of only one change at a time. That is, they allow us to hold everything else constant and study how one change affects the overall economic outcome. So an important assumption when building economic models is the other things equal assumption, which means that all other relevant factors remain unchanged. In economics, the phrase ceteris paribus—Latin for “other things remain the same (or held constant)”—is also often used.

But you can’t always find or create a small-scale version of the whole economy, and a computer program is only as good as the data it uses. (Programmers have a saying: “garbage in, garbage out.”) For many purposes, the most effective form of economic modelling is the construction of “thought experiments”: simplified, hypothetical versions of real-life situations.

In Chapter 1 we illustrated the concept of equilibrium with the example of how customers at a supermarket would rearrange themselves when a new cash register opens. Though we didn’t say it, this was an example of a simple model—an imaginary supermarket, in which many details were ignored.(What were customers buying? Never mind.) This simple model can be used to answer a “what if” question: what if another cash register were opened?

As the cash register story showed, it is often possible to describe and analyze a useful economic model in plain English. However, because much of economics involves changes in quantities—in the price of a product, the number of units produced, or the number of workers employed in its production—economists often find that using some mathematics helps clarify an issue. In particular, a numerical example, a simple equation, or—especially—a graph can be key to understanding an economic concept.

Whatever form it takes, a good economic model can be a tremendous aid to understanding. The best way to grasp this point is to consider some simple but important economic models and what they tell us. First, we will look at the production possibility frontier, a model that helps economists think about the trade-offs every economy faces. Then we will turn to comparative advantage, a model that clarifies the principle of gains from trade—trade both between individuals and between countries. In addition, we’ll examine the circular-flow diagram, a schematic representation that helps us understand how flows of money, goods, and services are channelled through the economy.

In discussing these models, we make considerable use of graphs to represent mathematical relationships. Graphs play an important role throughout this book. If you are already familiar with the use of graphs, you may feel free to skip the appendix to this chapter, which provides a brief introduction to the use of graphs in economics. If not, this would be a good time to turn to it.

The first principle of economics we introduced in Chapter 1 was that resources are scarce and that, as a result, any economy—whether it’s an isolated group of a few dozen hunter–gatherers or the 7 billion people making up the twenty-first-century global economy—faces trade-offs. No matter how lightweight the CS100 jet is, no matter how efficient Bombardier’s assembly line, producing Cseries aircrafts means using resources (labour, land, and capital) that therefore can’t be used to produce something else.

To think about the trade-offs that face any economy, economists often use the model known as the production possibility frontier. The idea behind this model is to improve our understanding of trade-offs by considering a simplified economy that produces only two goods. This simplification enables us to show the trade-off graphically.

Suppose, for a moment, that Canada was a one-company economy, with Bombardier its sole employer and trains and commercial aircraft its only products. So there is a choice of what kinds of transportation vehicles to produce—say, Toronto Rocket subway trains versus CSeries commercial passenger jets. Figure 2-1 shows a hypothetical production possibility frontier (PPF) representing the trade-off this one-company economy would face. The frontier—the line in the diagram—shows the maximum quantity of jets that Bombardier can produce per year given the quantity of subway trains it produces per year, and vice versa. That is, it answers questions of the form, “What is the maximum quantity of jets that Bombardier can produce in a year if it also produces 21 (or 35, or 70) subway trains that year?”

There is a crucial distinction between points inside or on the production possibility frontier (the shaded area) and outside the frontier. If a production point lies inside or on the frontier—like point C, at which Bombardier produces 10 jets and 21 subway trains in a year—it is feasible. After all, the frontier tells us that if Bombardier produces 10 jets, it could also produce a maximum of 35 subway trains that year, so it could certainly make 21 subway trains. However, a production point that lies outside the frontier—such as the hypothetical production point D, where Bombardier produces 20 jets and 70 subway trains—isn’t feasible. Bombardier can produce 20 jets and no subway trains, or it can produce 70 subway trains and no jets, but it can’t do both.

In Figure 2-1 the production possibility frontier intersects the horizontal axis at 20 jets. This means that if Bombardier dedicated all its production capacity¹ to making jets, it could produce 20 jets per year but could produce no subway trains. The production possibility frontier intersects the vertical axis at 70 subway trains. This means that if Bombardier dedicated all its production capacity to making subway trains, it could produce 70 subway trains per year but no jets.

The figure also shows less extreme trade-offs. For example, if Bombardier’s managers decide to make 10 jets this year, they can produce at most 35 subway trains; this production choice is illustrated by point A. And if Bombardier’s managers decide to produce 14 jets, they can make at most 21 subway trains, as shown by point B.

Thinking in terms of a production possibility frontier simplifies the complexities of reality. The real-world Canadian economy produces millions of different goods. Even Bombardier can produce more than two different types of planes and trains. Yet it’s important to realize that even in its simplicity, this stripped-down model gives us important insights about the real world.

By simplifying reality, the production possibility frontier helps us understand some aspects of the real economy better than we could without the model: efficiency, opportunity cost, and economic growth.

Efficiency First of all, the production possibility frontier is a good way to illustrate the general economic concept of efficiency. Recall from Chapter 1 that an economy is efficient if there are no missed opportunities—there is no way to make some people better off without making other people worse off.

One key element of efficiency is that there are no missed opportunities in production—there is no way to produce more of one good without producing less of other goods. As long as Bombardier operates on its production possibility frontier, its production is efficient. At point A, 35 subway trains is the maximum quantity feasible given that Bombardier has also committed to producing 10 jets; at point B, 21 subway trains is the maximum number that can be made given the choice to produce 14 jets; and so on. But suppose for some reason that Bombardier was operating at point C, making 10 jets and 21 subway trains. In this case, it would not be operating efficiently and would therefore be inefficient: using the same resources, it could be producing more of both transportation vehicles.

Although we have used an example of the production choices of a one-firm, two-good economy to illustrate efficiency and inefficiency, these concepts also carry over to the real economy, which contains many firms and produces many goods. If the economy as a whole could not produce more of any one good without producing less of something else—that is, if it is on its production possibility frontier—then we say that the economy is efficient in production. If, however, the economy could produce more of some things without producing less of others—which typically means that it could produce more of everything—then it is inefficient in production. For example, an economy in which large numbers of workers are involuntarily unemployed is clearly inefficient in production. And that’s a bad thing, because the economy could be producing more useful goods and services.

Although the production possibility frontier helps clarify what it means for an economy to be efficient in production, it’s important to understand that efficiency in production is only part of what’s required for the economy as a whole to be efficient. Efficiency also requires that the economy allocate its resources so that consumers are as well off as possible. If an economy does this, we say that it is efficient in consumption (an efficient consumption allocation). To see why efficiency in the consumption allocation is as important as efficiency in production, notice that points A and B in Figure 2-1 both represent situations in which the economy is efficient in production, because in each case it can’t produce more of one good without producing less of the other. But these two situations may not be equally desirable from society’s point of view. Suppose that society prefers to have more jets and fewer subway trains than at point A; say, it prefers to have 14 jets and 21 subway trains, corresponding to point B. In this case, point A is an inefficient consumption allocation from the point of view of the economy as a whole because it would rather have Bombardier produce at point B than at point A.

This example shows that efficiency for the economy as a whole requires both efficiency in production and efficiency in consumption: to be efficient, an economy must produce as much of each good as it can given the production of other goods, and it must also produce the mix of goods that people want to consume. (And it must also deliver those goods to the right people: an economy that gives subway trains to airports and commercial passenger jets to intercity transit authorities is inefficient, too.)

In the real world, command economies, such as the former Soviet Union, are notorious for inefficiency in the consumption allocation. For example, it was common in the U.S.S.R. for consumers to find stores well stocked with items few people wanted but lacking such basics as soap and toilet paper.

Opportunity Cost The production possibility frontier is also useful as a reminder of the fundamental point that the true cost of any good isn’t the money it costs to buy it, but what must be given up in order to get that good—the opportunity cost. If, for example, Bombardier decides to change its production from point A to point B, it will produce 4 more jets but 14 fewer subway trains. So the opportunity cost of 4 jets is 14 subway trains—the 14 subway trains that must be forgone to produce 4 more jets. This means that each jet has an opportunity cost of , or, put another way, subway trains do not get made for each jet that is produced.

Is the opportunity cost of an extra jet in terms of subway trains always the same, no matter how many jets and subway trains are currently produced? In the example illustrated by Figure 2-1, the answer is yes. If Bombardier increases its production of jets from 14 to 20, the number of subway trains it produces falls from 21 to zero. So Bombardier’s opportunity cost per additional jet is subway trains, the same as it was when Bombardier went from 10 jets produced to 14. However, the fact that in this example the opportunity cost of a jet in terms of a subway train is always the same is a result of an assumption we’ve made, an assumption that’s reflected in how Figure 2-1 is drawn. Specifically, whenever we assume that the opportunity cost of an additional unit of a good doesn’t change regardless of the output mix, the production possibility frontier is a straight line. Note that a linear production possibility frontier implies constant marginal productivity of production for both trains and planes.

Moreover, as you might have already guessed, the absolute value of the slope of a straight-line production possibility frontier is equal to the opportunity cost—specifically, the opportunity cost for the good measured on the horizontal axis in terms of the good measured on the vertical axis.² In Figure 2-1, the production possibility frontier has a constant slope of , implying that Bombardier faces a constant opportunity cost for 1 jet equal to subway trains. (A review of how to calculate the slope of a straight line is found in this chapter’s appendix.) This is the simplest case, but the production possibility frontier model can also be used to examine situations in which opportunity costs change as the mix of output changes.³

Figure 2-2 illustrates a different assumption, a case in which Bombardier faces increasing opportunity cost. Here, the more jets it produces, the more costly it is to produce yet another jet in terms of forgone production of subway trains. And the same holds true in reverse: the more subway trains Bombardier produces, the more costly it is to produce yet another subway train in terms of forgone production of jets. For example, to go from producing zero jets to producing 10, Bombardier has to forgo producing 10 subway trains. That is, the opportunity cost of those 10 jets is 10 subway trains. But to increase its production of jets to 20—that is, to produce an additional 10 jets—it must forgo producing 60 more subway trains, a much higher opportunity cost. As you can see in Figure 2-2, when opportunity costs are increasing rather than constant, the production possibility frontier is a (strictly concave) bowed-out curve rather than a straight line.

Although it’s often useful to work with the simple assumption that the production possibility frontier is a straight line, economists believe that in reality opportunity costs are typically increasing. When only a small amount of a good is produced, the opportunity cost of producing that good is relatively low because the economy needs to use only those resources that are especially well suited for its production. For example, if an economy grows only a small amount of corn, that corn can be grown in places where the soil and climate are perfect for corn growing but less suitable for growing anything else, like wheat. So growing that corn involves giving up only a small amount of potential wheat output. Once the economy grows a lot of corn, however, land that is well suited for wheat but isn’t so great for corn must be used to produce corn anyway. As a result, the additional corn production involves sacrificing considerably more wheat production. In other words, as more of a good is produced, its opportunity cost typically rises because well-suited inputs are already used up and less adaptable inputs must be used instead.

Economic Growth Finally, the production possibility frontier helps us understand what it means to talk about economic growth. We introduced the concept of economic growth in the Introduction, defining it as the growing ability of the economy to produce goods and services. As we saw, economic growth is one of the fundamental features of the real economy. But are we really justified in saying that the economy has grown over time? After all, although the Canadian economy produces more of many things than it did a century ago, it produces less of other things—for example, horse-drawn carriages. Production of many goods, in other words, is actually down. So how can we say for sure that the economy as a whole has grown?

The answer is illustrated in Figure 2-3, where we have drawn two hypothetical production possibility frontiers for the economy. In them we have assumed once again that everyone in the economy works for Bombardier and, consequently, the economy produces only two goods, subway trains and jets. Notice how the two curves are nested, with the one labelled “Original PPF” lying completely inside the one labelled “New PPF.” Now we can see graphically what we mean by economic growth of the economy: economic growth means an expansion of the economy’s production possibilities; that is, the economy can produce more of everything. For example, if the economy initially produces at point A (60 subway trains and 10 jets), economic growth means that the economy could move to point E (70 subway trains and 12 jets). Point E lies outside the original frontier; so in the production possibility frontier model, growth is shown as an outward shift of the frontier.

What can lead the production possibility frontier to shift outward? There are basically two sources of economic growth. One is an increase in the economy’s factors of production, the resources used to produce goods and services. Economists usually use the term factor of production to refer to a resource that is not used up in production. For example, in traditional airplane manufacture, workers used riveting machines to connect metal sheets when constructing a plane’s fuselage; the workers and the riveters are factors of production, but the rivets and the sheet metal are not. Once a fuselage is made, a worker and riveter can be used to make another fuselage, but the sheet metal and rivets used to make one fuselage cannot be used to make another.

Broadly speaking, the main factors of production are the resources of land, labour, physical capital, and human capital. Land is a resource supplied by nature; labour is the economy’s pool of workers; physical capital refers to created resources such as machines and buildings; and human capital refers to the educational achievements and skills of the labour force, which enhance its productivity. Of course, each of these is really a category rather than a single factor: land in Labrador is quite different from land in southern Ontario.

To see how adding to an economy’s factors of production leads to economic growth, suppose that Bombardier builds another construction facility that allows it to increase the number of transportation vehicles—subway trains or CSeries jets or both—it can produce in a year. The new construction facility is a factor of production, a resource Bombardier can use to increase its yearly output. We can’t say how many more planes or subway trains Bombardier will produce; that’s a management decision that will depend on, among other things, customer demand. But we can say that Bombardier’s production possibility frontier has shifted outward because it can now produce more subway trains without reducing the number of CSeries jets it makes, or it can make more CSeries jets without reducing the number of subway trains produced.

The other source of economic growth is progress in technology, the technical means for the production of goods and services. Composite and advanced aluminum materials had been used in some parts of aircraft before the Bombardier CSeries was developed. But Bombardier engineers realized that there were large additional advantages to building a whole plane out of composites and advanced aluminum. The plane would be lighter, stronger, and have better aerodynamics than a plane built in the traditional way. It would therefore have longer range, be able to carry more people, and use less fuel, in addition to being able to maintain higher cabin pressure. So in a real sense Bombardier’s innovation—a whole plane built out of advanced materials—was a way to do more with any given amount of resources, pushing out the production possibility frontier.

Because improved jet technology has pushed out the production possibility frontier, it has made it possible for the economy to produce more of everything, not just jets and air travel. Over the past 30 years, the biggest technological advances have taken place in information technology, not in construction or food services. Yet Canadians have chosen to buy bigger houses and eat out more than they used to because the economy’s growth has made it possible to do so.

The production possibility frontier is a very simplified model of an economy. Yet it teaches us important lessons about real-life economies. It gives us our first clear sense of what constitutes economic efficiency, it illustrates the concept of opportunity cost, and it makes clear what economic growth is all about.

Among the twelve principles of economics described in Chapter 1 was the principle of gains from trade—the mutual gains that individuals or countries can achieve by specializing in doing different things and trading with one another. Our next illustration of an economic model is a particularly useful model of gains from trade—trade based on comparative advantage.

One of the most important insights in all of economics is that there are gains from trade—that it makes sense to produce the things you’re especially good at producing and to buy from other people the things you aren’t as good at producing. This would be true even if you could produce everything for yourself: even if a brilliant brain surgeon could repair her own dripping faucet, it’s probably a better idea for her to call in a professional plumber.

How can we model the gains from trade? Let’s stay with our mass transportation vehicle example and once again imagine that Canada is a one-company economy in which everyone works for Bombardier, producing airplanes and subway trains. Let’s now assume, however, that Canada has the ability to trade with Brazil—another one-company economy in which everyone works for a company that manufactures aircraft and subway trains. (In the real world, the Brazilian company Embraer is an internationally successful producer of small commuter jets. If you fly from one Canadian city to another, your plane is likely to be made by Bombardier; but if you fly within other countries, the odds are equally good that your plane will have been made by Embraer.)

In our example, the only two goods produced are subway trains and jets. Both countries could produce both kinds of mass transportation vehicles. But as we’ll see in a moment, they can gain by producing different things and trading with each other. For the purposes of this example, let’s return to the simpler case of straight-line production possibility frontiers. Canada’s production possibilities are represented by the production possibility frontier in panel (a) of Figure 2-4, which is similar to the production possibility frontier in Figure 2-1. According to this diagram, Canada can produce 70 subway trains if it makes no jets and can manufacture 20 jets if it produces no subway trains. Recall that this means that the slope of the Canadian production possibility frontier is : its opportunity cost of 1 jet is of a subway train (i.e., to make 1 more jet, Canada has to give up making 3.5 subway trains).

Panel (b) of Figure 2-4 shows Brazil’s production possibilities. Like Canada, Brazil’s production possibility frontier is a straight line, implying a constant opportunity cost of jets in terms of subway trains. Brazil’s production possibility frontier has a constant slope of –6. Brazil can’t produce as much of anything as Canada can: at most it can produce 60 subway trains or 10 jets. But it is relatively better at manufacturing subway trains than Canada is; whereas Canada sacrifices of a jet per subway train produced, for Brazil the opportunity cost of a subway train is only of a jet. Table 2-1 summarizes the two countries’ opportunity costs of subway trains and jets.

Now, Canada and Brazil could each choose to make their own subway trains and jets, not trading any airplanes or trains and consuming only what each produced within its own country. (A country “consumes” an airplane or train when it is owned by a domestic resident.) Let’s suppose that the two countries start out this way and make the consumption choices shown in Figure 2-4: in the absence of trade, Canada produces and consumes 28 subway trains and 12 jets per year, while Brazil produces and consumes 30 subway trains and 5 jets per year.

But is this the best the two countries can do? No, it isn’t. Given that the two producers—and therefore the two countries—have different opportunity costs, Canada and Brazil can strike a deal that makes both of them better off.

Table 2-2 shows how such a deal works: Canada specializes in the production of jets, manufacturing 20 per year, and sells 6 to Brazil. Meanwhile, Brazil specializes in the production of subway trains, producing 60 per year, and sells 29 to Canada. The result is shown in Figure 2-5. Canada now consumes more of both subway trains and jets than before: instead of 28 subway trains and 12 jets, it now consumes 29 subway trains and 14 jets. Brazil also consumes more, going from 30 subway trains and 5 jets to 31 subway trains and 6 jets. As Table 2-2 also shows, both Canada and Brazil reap gains from trade, consuming more of both types of transportation vehicle than they would have without trade.

Both countries are better off when they each specialize in what they are relatively good at producing and then trade their products. It’s a good idea for Canada to specialize in the production of jets because its opportunity cost of a jet is smaller than Brazil’s: . Correspondingly, Brazil should specialize in the production of subway trains because its opportunity cost of a subway train is smaller than Canada’s: .

What we would say in this case is that Canada has a comparative advantage in the production of jets and Brazil has a comparative advantage in the production of subway trains. A country has a comparative advantage in producing something if the opportunity cost of that production is lower for that country than for other countries. The same concept applies to firms and people: a firm or an individual has a comparative advantage in producing something if its, his, or her opportunity cost of production is lower than for others.

One point of clarification before we proceed further. You may have wondered why Canada traded 6 jets to Brazil in return for 29 subway trains. Why not some other deal, like trading 6 jets for 20 subway trains? The answer to that question has two parts. First, there may indeed be other trades that Canada and Brazil might agree to. Second, there are some deals that we can safely rule out— one like 6 jets for 20 subway trains.

To understand why, re-examine Table 2-1 and consider Canada first. Without trading with Brazil, the Canadian opportunity cost of a subway train is of a jet. So it’s clear that Canada will not accept any trade that requires it to give up more than of a jet for a subway train – as doing so would make it worse off. Trading 6 jets in return for 20 subway trains would require Canada to pay an opportunity cost of of a jet for a subway train. Because is greater than , this is a deal that Canada would reject. Similarly, Brazil won’t accept a trade that gives it less than 6 subway trains for a jet.

The point to remember is that Canada and Brazil will be willing to trade only if the “price” of the good each country obtains in the trade is less than its own opportunity cost of producing the good domestically. Moreover, this is a general statement that is true whenever two parties—countries, firms, or individuals—trade voluntarily.

While our story clearly simplifies reality, it teaches us some very important lessons that apply to the real economy, too.

First, the model provides a clear illustration of the gains from trade: through specialization and trade, both countries produce more and consume more than if they were self-sufficient.

Second, the model demonstrates a very important point that is often overlooked in real-world arguments: each country has a comparative advantage in producing something. This applies to firms and people as well: everyone has a comparative advantage in something, and everyone has a comparative disadvantage in something.

Crucially, in our example it doesn’t matter if, as is probably the case in real life, Canadian workers are just as good as or even better than Brazilian workers at producing subway trains and jets. Suppose that Canada is actually better than Brazil at production of both types of transportation vehicles. In that case, we would say that Canada has an absolute advantage in both subway train and jet production: in an hour, a Canadian worker can produce more of either a subway train or jet than a Brazilian worker could. You might be tempted to think that in that case Canada has nothing to gain from trading with the less productive Brazil.

But we’ve just seen that Canada can indeed benefit from trading with Brazil because comparative, not absolute, advantage is the basis for mutual gains from trade.⁴ It doesn’t matter whether it takes Brazil more resources than Canada to make a subway train; what matters for trade is that for Brazil the opportunity cost of a subway train is lower than the Canadian opportunity cost. So Brazil, despite its absolute disadvantage, even in subway trains, has a comparative advantage in the manufacture of subway trains. Meanwhile Canada, which can use its resources most productively by manufacturing jets, has a comparative disadvantage in manufacturing subway trains.

Look at the label on a manufactured good sold in Canada, and there’s a good chance you will find that it was produced in some other country, such as China or Japan. On the other side, many Canadian industries sell a large fraction of their output overseas. (This is particularly true of agriculture, high technology, and entertainment.)

Should all this international exchange of goods and services be celebrated, or is it cause for concern? Politicians and the public often question the desirability of international trade, arguing that the nation should produce goods for itself rather than buying them from foreigners. Industries around the world demand protection from foreign competition: Japanese farmers want to keep out North American rice, Canadian steelworkers want to keep out European steel. And these demands are often supported by public opinion.

Economists, however, have a very positive view of international trade. Why? Because they view it in terms of comparative advantage. As we learned from our hypothetical example of Canadian jets and Brazilian subway trains, international trade benefits both countries. Each country can consume more than if it didn’t trade and remained self-sufficient. Moreover, these mutual gains don’t depend on each country being absolutely better than other countries at producing one kind of good. Even if one country has, say, higher output per worker in both industries—that is, even if one country has an absolute advantage in both industries—there are still gains from trade. The above Global Comparison, which explains the pattern of clothing production throughout the global economy, illustrates just this point.

The model economies that we’ve studied so far—each containing only one firm—are a huge simplification. We’ve also greatly simplified trade between Canada and Brazil, assuming that they engage only in the simplest of economic transactions, barter, in which one party directly trades a good or service for another good or service without using money. In a modern economy, simple barter is rare: usually people trade goods or services for money—pieces of coloured paper with no inherent value—and then trade those pieces of coloured paper for the goods or services they want. That is, they sell goods or services and buy other goods or services.

And they both sell and buy a lot of different things. The Canadian economy is a vastly complex entity, with almost 18 million workers employed by hundreds of thousands of companies, producing thousands of different goods and services. Yet you can learn some very important things about the economy by considering the simple graphic shown in Figure 2-6, the circular-flow diagram. This diagram represents the transactions that take place in an economy by two kinds of flows around a circle: flows of things such as goods, services, labour, or raw materials in one direction, and flows of money that pay for these things in the opposite direction. In this case the physical and intangible flows are shown in yellow, the money flows in green.

The simplest circular-flow diagram illustrates an economy that contains only two kinds of inhabitants: households and firms. A household consists of either an individual or a group of people (usually, but not necessarily, a family) that share their income. A firm is an organization that produces goods and services for sale—and that employs members of households.

As you can see in Figure 2-6, there are two kinds of markets in this simple economy. On one side (here the left side) there are markets for goods and services in which households buy the goods and services they want from firms. This produces a flow of goods and services to households and a return flow of money to firms.

On the other side, there are factor markets in which firms buy or rent the resources they need to produce goods and services. Recall from earlier in the chapter that the main factors of production are land, labour, and capital.

The factor market most of us know best is the labour market, in which workers sell their services. In addition, we can think of households as owning, selling, and renting the other factors of production to firms. For example, when a firm buys physical capital in the form of machines, the payment ultimately goes to the households that own the machine-making firm. In this case, the transactions are occurring in the capital market, the market in which capital is bought and sold. As microeconomic analysis reveals, factor markets ultimately determine an economy’s income distribution, how the total income created in an economy is allocated between less skilled workers, highly skilled workers, and the owners of capital and land.

The circular-flow diagram ignores a number of real-world complications in the interests of simplicity. A few examples:

Figure 2-6, in other words, is by no means a complete picture either of all the types of inhabitants of the real economy or of all the flows of money and physical items and intangible services that take place among these inhabitants.

Despite its simplicity, the circular-flow diagram is a very useful aid to thinking about the economy.