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.

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Costs, Revenues & Profits: The Basics

In this video I go through the definitions and formulas of the economic key terms total cost, variable cost, fixed cost, average cost,average variable cost, average fixed cost,marginal cost, marginal revenue, total revenue, average revenue, normal profit and supernormal profit.

The Basic Economic Problem

The basic economic problem is the problem that in the real world there are scare resources, that is limited quantities of resources and unlimited wants of these resources. Economists have to be able to make distinction between a want or a need in order to see whether they are limited or unlimited. Needs is something humans need for survival e.g. food. Wants are something, which are not needed for survival e.g. an iPod.

Resources have to be allocated which means choices have to made. The basic economic problems means that societies need to decide:
– What to produce
– How to produce it, and
– For whom to produce it

Every time we make a choice we fail to choose another option and the benefit lost from the next best opportunity is called opportunity cost. For example, right now you have chosen to watch this video your opportunity cost might be talking to your friend on the phone.

There are four factors of production that bring some form of output to the world. These are:
1. Land- includes premises and all natural resources e.g. timber, farming
2. Labour – workers and human resources
3. Capital – all manufactured resources e.g. machines, vehicle, building tools
4. Entrepreneurship – Involves risk taking, setting up a new business etc.

Out of production we get to two types of goods: economic goods and free goods. Economic goods are goods that are made from resources, which are scarce like oil. So free goods are goods made from resources, which are not scare like air.

Sustainable resources are those, which can be exploited over and over again because they can renew themselves e.g. sunflowers. In contrast, resources such as coal and oil cannot be replaced therefore are not sustainable.

The Theory of Supply

What is the theory of supply?
At higher prices, a larger quantity will generally be supplied than at lower prices, ceteris paribus (all other thing being constant). So at a lower price a smaller quantity is produced.

This simply describes the upward sloping supply curve. The curve denotes that there is a ‘positive’ or ‘direct’ relationship between price and quantity. As one factor increases so does the other.

But why does this happen?

Suppliers have the incentive of profits, if a crop is doing well they will try and shift supply up so that they can make more profits.
The law of increasing opportunity costs means that as you increases supply of one good you must sacrifice greater and greater amounts of other resources. Therefore, as output increases , costs of producing goods increases thus the supplier must charge higher prices.

The supply curve

A supply schedule is simply a table of data showing the quantity that suppliers plan to supply at each level e.g.

A supply curve is a line which shows the quantity that suppliers plan to supply at each level e.g.:

Notice that as price increases the level of supply increases. (Positive correlation)

Shifts

The supply can shift left of right if there is a change in the quantity that supplier would supply at every price.

For example in this diagram we can see that the supply shifts to the right which is an increase in supply.
At price of P1, we can see supply increase (Sorry not that clear on this particular diagram) Notice a shift in the opposite direction from S1 to S0 would be a decrease in supply.

What causes these shifts to occur?

A shift in supply is caused by non-price determinants. There are 5 main ones you need to know:

1. Changes in costs of production: The lower the costs the greater the profit for producers. Examples of this are; input prices (raw material, rent etc.) , changes in technology (e.g. internet) , organisational changes , subsidies and taxes.

2. Profitability of alternatives; if another good becomes more profitable then a firm will switch t produce more of that e.g. the transition between cd players to MP3 players.

3. Profitability of goods in joint supply; If the supply of one good e.g. cattle increases then so will the joint good e.g.leather

4. Random shocks e.g. strikes, weather, wars, earthquakes etc.

5. Expectations of future price changes; for example if a firm expects price to rise they will either produce more or hold onto stock.

IMPORTANT:
NON-PRICE DETERMINANTS CAUSES SHIFTS AND PRICE DETERMINANTS CAUSES MOVEMENTS ALONG SUPPLY CURVE.

Need more help…check my video out!