СЕМИНАР 1: CIRCULAR FLOW OF INCOME AND EXPENDITURE

Supply of goods

and services

Pu

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ases

of

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od

s an

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serv

ises

Ex

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Res

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Pay

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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-

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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.