the nature and importance of economics

CHAPTER IITHE CIRCULAR FLOW

OF ECONOMIC ACTIVITY

TWO BASIC ACTIVITIES UNDERTAKEN:

1.Production – perform by the firm2.Consumption- undertake by

households

STOCK AND FLOW CONCEPTSSTOCK refers to the measure of quantity at a point of time.Example: an accumulation of a commodity like gasoline in a fuel tank

FLOW refers to the measure of movement of quantity over a period of time Example: income represents money earned per year is a flow.

THE CIRCULAR FLOW OF GOODS AND SERICES AND INCOME

THE PRODUCTION PROCESS- the process of producing goods and services involves household and firms in a circular flow.

LAND, LABOR, CAPITAL(Economic Resources)

GOODS AND SERVICES(Output)

FIRMS(Organizers and

users of Economic Resources)

HOUSEHOLDS(Resource Owners)

FIGURE 1: THE CIRCULAR FLOW OF THE PRODUCTION PROCESS

FIGURE 2: THE FLOW OF OUTPUT BETWEEN FIRMS AND HOUSEHOLDS

RAW MATERIALSFIRM

INTERMEDIATEGOOD FIRMS

FINAL GOODSFIRM

HOUSEHOLDS

Raw materials

Intermediate goods

Final goods

• Raw Materials are goods which are still unprocessed like wood, sand and iron ore.

• Intermediate goods are partially processed and still need further processing before they can be finally consumed.

• Final Goods are processed goods that are ready for final consumption like cassette players, candies and ready to wear clothing.

FIGURE 3: THE CIRCULAR FLOW OF GOODS AND INCOME AMONG PRODUCERS AND

HOUSEHOLDS

HO

US

EH

OLD

SRAW

MATERIALS PRODUCERSINTERMEDIATE

GOODS PRODUCERS

FINAL GOODS PRODUCERS

ECONOMIC RESOURCES

PAYMENT

ECONOMIC RESOURCES

PAYMENT

ECONOMIC RESOURCES

PAYMENT

FINAL GOODS

PAYMENT

INCOME FLOWWhen money is spent by households for consumption and firms for production, a circular flow of income is created. The expenditure of one unit becomes the income of another unit.

TWO DISTINCT CIRCULAR FLOWS AS FOLLOWS:

1. Between Households and firms, and2. Between Firms

FIGURE 4: THE CIRCULAR FLOW OF INCOME BETWEEN HOUSEHOLDS AND

FIRMS

INCOME FLOW(Wages, interests,

rents)

INCOME FLOW(purchase of goods

and services)

HOUSEHOLDS FIRMS

FIGURE 4: THE CIRCULAR FLOW OF INCOME BETWEEN FIRMS

RAW MATERIALS

FIRMS

INTERMEDIATE GOOD FIRMS

FINAL GOODS FIRMS

HOUSEHOLDS

Income Flow for purchase of raw

materials

Income Flow for purchase of

intermediate goods

Income Flow for purchase of final goods

FIGURE 6: THE EFFECT OF REDUCTION OF PURCHASES

REDUCED INCOME(as a result of reduced purchases of economic

resources

REDUCED INCOME(as a result of reduced

purchases of goods and services)

HOUSEHOLDS FIRMS

FIGURE 7: THE CIRCULAR FLOW OF GOODS AND INCOME IN A SIMPLE

ECONOMY WITH SAVINGS AND INVESTMENTS

FIRMS

HOUSEHOLDS

LAND, LABOR, CAPITAL

GOODS AND SERVICESRENT, WAGES,

INTEREST, PROFIT

PAYMENTS

SAVINGS

Investments

Capital goods

GOVERNMENT

FIRMSHOUSEHOLDS

FOREIGN COUNTRIES

Land, labor capital

Rent, wages, interest

Goods and services

Payments for goods and servicespayments for imports

Payments for goods and servicesRent, wages, interest

Payments for exports