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СЕМИНАР 1: CIRCULAR FLOW OF INCOME AND EXPENDITURE
Supply of goods
and services
Pu
rch
ases
of
go
od
s an
d
serv
ises
Ex
pen
dit
ure
s
Res
ou
rces
Pay
men
ts
Government
services
Subsidies
Taxes Taxes
Government
services
Income
support
Labor, capital, funds,
natural resources, and
entrepreneurship
Income:
wages, interest,
rent, and profit Payments
Expenditures Revenue
Product
markets
Households
Input markets
Business firms
Resources
Govern-
-ment
Purchases of goods
and services
HOW PRODUCTION GENERATES INCOME IN THE MARKET ECONOMY:
CIRCULAR FLOW OF INCOME AND EXPENDITURE
Imagine an economy in which all goods and services are made available through markets.
Business firms acquire resources from households, whose members provide labor services,
entrepreneurial talent, and funds to acquire new capital. Household members also provide
natural resources if they own land. The diagram in Box 1 gives you a simplified overview
of a pure market economy. In such an economy, business firms are buyers of resources
offered for sale in input markets. Household supply economic resources as sellers in these
input markets. The competition among the many buyers and sellers of inputs then results in
market prices for labor, the use of funds, capital, and natural resources. The prices depend
on conditions of supply and demand in each input market. The sale of input services
provides a flow of income in the form of wages, rent, interest, and profit to the members of
each household supplying resources or owning businesses. For example, people in one
household may earn wages as department store employees. They may also own land and
buildings that they allow a business to use in exchange for rent. Income from both wages
and rent flows into the household. Household members also earn interest income from bank
deposits or bonds. If they own corporate stock, they may receive a flow of income as
dividends on the stock. They may run a small business that generates profits. The flow of
payments for labor and resources use plus distribution of profit to the members of
households who own businesses equals the income earned in the economy. Household
members use the money income they earn to express their demand for goods and services.
Firms respond to that demand by producing a variety of goods and services. The price of
each good and service is determined by its supply and demand in product markets.
Consumers’ expenditures constitute revenue for firms that they use to finance outlays for
inputs (wages to staff, purchases of inventories, rent) and profit payments to owners of the
firms.
The picture of the economy as a set of interrelated markets in which income and
expenditure move in a circular flow between business firms and households is a simplified
but enlightening view of a pure market economy. It points out that both households and
business firms meet in two sets of markets – households are sellers in input markets but are
buyers in product markets; business firms are buyers in input markets and sellers in output
markets. Money lubricates the wheels of exchange. It is paid out as income to households
that they in turn spend on products. It then becomes revenue to business firms that they use
to pay for the items they need in order to make goods available. These payments provide
income as the cycle goes on and on. Business firms also employ a steady flow of resources
that are used to supply goods and services each day to households. The clockwise flow of
expenditures, revenue, payments, and income fuels the counterclockwise flow of goods and
services and resources in the circular flow diagram in Box 1. The production of goods and
services therefore generates income. The income then becomes the means by which
households purchase the products produces by business firms. As production grows, so will
income payments to households. Box 1 does not show that business firms conduct market
transactions among themselves. Some of the products firms purchase, such as machinery,
structures, and vehicles, are intended for final use in production and will not be resold to
consumers or governments. Others are used as materials and parts that will be role of
government in the economy, since government has only a minor role in and the economy
where all useful goods and services are provided through markets. Finally, the circular flow
analysis does not consider the effects of international trade. We will soon show how both
government and international trade affect the flow of income and expenditure in the modern
mixed economy.
THE MODERN MIXED AND OPEN ECONOMY
The shortcomings of a pure market economy have led to the evolution of the modern mixed
economy. When markets do a poor job of allocating resources, we look to government to
improve matters. The impact of government on resource use and income distribution is a
controversial question that we’ll address in many parts of the book. However, the fact is
that neither the United States nor any other nation can be regarded as having a purely
capitalist economy. In the United States the federal, state, and local governments levy taxes
on both businesses and households to finance the provision of public goods and services.
Governments also borrow funds to help meet their expenses. Finally, governments
intervene in decisions made by households and business managers to protect environmental
resources, prevent restraints on competition in markets, and correct for failures of the price
system to account for the property rights of third parties to market transactions.
Governments in the United States acquire resources to provide hospital and health services,
provide free and compulsory elementary and secondary education, assist the poor in
maintaining minimum standards of living, provide for the national defense, and make
pension and insurance services available to the elderly and other groups. About 20 percent
of all workers in the United States are employed by governments. The U.S.government
supports the prices of some agricultural products. Government regulations influence the
quality of such products as automobiles and new drugs, and through various taxes
governments affect the prices of gasoline, cigarettes, and alcoholic beverages. Governments
provide the legal structure that facilitates market transactions. Finally, governments seek to
stabilize the general level of economic activity to correct for the difficulty that the price
system often encounters in maintaining stable prices and full employment of labor and
other economic resources.
Government and the Economy
Governments participate in input markets by purchasing labor services and other productive
resources. They also borrow funds from credit markets when their expenditures exceed
their tax revenues. Governments also participate in product markets to purchase the output
of business firms. They purchase such goods as paper, aircraft, and machinery, and they
contrast with construction firms to build roads and structures. The vertical arrows in Box 2
show how governments participate in markets and provide income to workers, resource
owners, and business firms. The horizontal arrows show how governments tax households
and businesses to obtain the funds necessary to purchase products and hire input services.
The inputs and products are used to provide government goods and services that benefit
both households and business firms. Governments provide national defense, education,
police and fire protection, and a host of other services to the public at no direct charge.
Most government goods and services are not sold by the unit in markets. Instead,
governments make their goods and services available freely as public goods or establish
criteria for the eligibility of individuals to obtain certain services. For example, government
funds are used to provide income support to eligible persons. Social Security pensions,
welfare payments to the poor, veterans’ benefits, payments for medical care, and
unemployment insurance payments are examples of government income-support programs
financed by taxation. Finally, governments provide subsidies to business firms such as price
support payments to farmers and loan guarantees. By bidding for resources, providing
income support for the elderly, the poor, and veterans, subsidizing certain activities, and
taxing businesses and households, governments influence market demand and affect prices.
Thus, in the mixed economy governments, as well as households and business firms,
influence resource allocation.
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