Circular Flow of Income

The Circular Flow of Income is an economic model which depicts how an economy on a most basic level functions.

Starting point…

We start by observing that two economic agents exist in any economy:

(i) Households- so they own factors of production such as land, labour capital and enterprise and demand goods and services

(ii) Firms – They use factors of production and turn them into goods and services because they seek rewards – which is not only money but recognition etc. 

Before we go on, you may be wondering what about government? Other countries we trade with? They are all valid economic agents but the whole point of economics is formulate simple models which allow us to experiment. So the Circular Flow of Income model is based on 3 assumptions;

(1) The economy operates with closed trade which means no international trade exists 

(2) No government exists 

(3) No economic agent saves, any money received will be spent. 

We will see in a short while what actually happens when these assumptions are removed. But for now let me explain how the two economic agents (firms and households) are engaged in this model.

What happens is household they own factors of production which firms demand in order to produce goods and services. So a trade takes place, households sell land for rent; labour for a wage; capital for interests, profits and dividends and finally; enterprise (by which I mean entrepreneurial skill) for recognition and a salary. This is demonstrated by the two arrows shown on the diagram. 

On the other end firms sell these goods and services to households in return for a payment which if provides sufficient revenue not only encourages a firm to keep on producing but attracts more firms into the industry. 

It is important to note two things. In some place this model is depicted with four stops in the circle firms, households, market for goods and service and market for factors of production. These markets simply denote that a trade is taking place between some form of money and goods and services/factors of production. 

The second thing to note is that these arrows are incredibly important when we look at more serious models of the Circular Flow of Income. For example, the goods and services one can denote national output and rent/wage/profit one can denote national income.

So now to make the model more realistic. In reality we know that the three assumptions (no government, international trade and savings) are incorrect albeit at different levels and powers in different countries. But we do know they exist and they come under what we term in economics as leakages and injections. Leakages and Injections are external sources which either bring money in or out an economy.

So injections are external sources whereby money is gained in an economy and there are three of these which can be remembered by the abbreviation GXI – Government Spending, Exports (foreign money) and Investment. Leakages conversely are SMT (senior management team) Savings, Imports and Taxation. They are merely opposites and we can add an additional arrow to show these and make the model more realistic.

Market Failure: Public, merit and demerit goods

Some goods are not at all provided by the private sector because there is no incentive to do so. These goods are called public goods and they are generally goods which ‘good’ for you. For example the ‘fire brigade’.
Public goods are distinguished by three key characteristics:

1. Non-rivalrous/ non-diminishable: This means that the consumption by one person will not reduce the amount for another for example, if someone watches a firework display then this does not reduce the ‘benefits’- enjoyment that others can receive from it.

2. Non-excludable: people cannot be excluded from benefiting in the good in any way for example everyone can receive benefit from street lighting, people who cannot afford it are not excluded.

3. Non-rejectable: for example just because you do not want to be protected the national defence does not mean you can have the choice to do so, it is good which you have to accept.

Some goods only have one characteristic and therefore fit in a completely different category. These goods are called ‘quasi-public goods’. An example of this would be the beach because it may be designed to be non-rivalrous, non-excludable and non- rejectable but this is not the case in reality. It usually is but if there are too many people then your benefit gained from consuming the good may be reduced. Also, not all beaches are 100% non-excludable because some beaches restrict smoking or people with dogs or even better some beaches are private.

Merit goods

These are goods, which are good for you but tend to be under-consumed because they are supplied through the private sector and there tends to be an information failure as well. It is usually because people aren’t aware of the benefits so the demand isn’t as high as it should be. These goods also cause positive externalities. For example, schools can be private and state-run. However, it is important that government has stepped in to produce state-run schools because otherwise many people would not go to school and this would have cause things like increased crime. Therefore, a merit goods like schools cause positive externalities i.e. going to school reduces crime.

Demerit goods

These are the opposite to merit goods; these are goods which are bad for you e.g. alcohol and cigarettes. If left to the free-market economy, then as the demand for these products tends to be inelastic, prices would be too low to compensate for the externalities produced and the quantity would be too high. Subsequently, the goods are overproduced. That’s why the government must intervene to cut the production and inform peoples of the negative impacts. Some goods have such major negative impacts that they have to be banned for example; illegal drugs like heroin.

This is linked into market-failure because of the free-rider problem. Firstly, negative externalities hold a big cost to society that’s why they can cause a market to fail i.e. if left to free-market everyone would be smoking cigarette which would stress the NHS and people would be spending their income on the wrong things. With merit goods, people would not pay for certain advantages they gain through activities of others and so they get a free ride. This mean there is no incentive of profits for the private sector and if no one provides for these goods like (e.g. street lighting) then the market fails.

Still need help then why not check my video out:

Cross Price Elasticity of Demand


What is cross price elasticity of demand (XED)? 

Cross price elasticity of demand is the figure which denotes the relationship between two goods.
How do economists calculate Cross price elasticity of demand?
XED = Percentage change in quantity demanded of good A / percentage change in the price of good B
Percentage change in quantity demanded of good A (divided by) percentage change in the price of good B
How do we interpret cross price elasticity of demand values?

Negative value = complements
If the value is greater than -1 than they are strong complements and if they are less than -1 they are weak complements.

‘0’ (zerovalue = independent goods (they have no value)

Positive value = substitutes
If the value is greater than 1 then they are strong substitutes and if they are smaller than 1 they are weak substitutes

TEST YOURSELF! (Answers found below)

Q1: What type of relationship is there between two goods, X and Y, given that:
– Original price of good X =80
– Original quantity of good Y = 50
– Final price of good Y=40
– Final quantity of good Y = 40
– Original price of good Y = 5

Q2: For each of the following product pairs what would you guess about the cross price elasticity of demand? What are their relationships? Do they have a strong or weak relationship?
a) Shoes and sneakers
b) Gasoline and sports utility vehicles
c) Bread and butter
d)Instand camera film and regular camera film


Q1: XED = % change in QD of good Y / % change in P of good X
= [(40-50)/50] * 100 / [(80-40)/80] * 100
= (-10/50 ) * 100 / (-40/80) * 100
= -0.2 * 1o0 / -0.5 * 100
= -20/-50
= +0.4
Therefore they are weak substitutes

Q2: (a) Weak substitues – positive value for XED which is less than 1
(b) Strong complements – negative value for XED which is greater than -1
(c) Strong complements – negative value for XED which is greater than -1
(d) Strong substitues – positive value for XED which is greater than 1