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ECS 1601 Exam Pack
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,INTERDEPENDENCE OF THE MAJOR SECTORS, MARKET AND FLOWS IN AMIXED ECONOMY
➔ Production is not pursued for its own benefit, the ultimate aim is to use or
consume the products to satisfy human wants.
➔ Production creates income and this income is then spent to purchase products.
Production, Income and Spending
The Three major ’Flows’ in the economy
1. Production – Production occurs and thus, generates income
2. Income – Income is earned as a result of production
3. Spending – The income earned is spent to buy the available goods and
services
Although this version of the circular flow is simple, it teaches us four key insights that remain true
(albeit in slightly refined forms) in more sophisticated versions as well.
1. Spending = production. The total value of all spending by households becomes an inflow
into the firm sector and thus ends up on the revenue side of a firm’s balance sheet. The
revenues received by firms provide us with a measure of the total value of production in an
economy.
2. Production = payments to inputs. Flows in and out of the firm sector must balance.
The revenues received by firms are ultimately paid out to households.
3. Payments to inputs = income. Firms are legal entities, not people. We may talk in
common speech of a firm “making money,” but any income generated by a firm must
ultimately end up in the hands of real people—that is, in the household sector of an
economy. The total value of the goods produced by firms becomes an outflow of dollars
from the firm sector. These dollars end up in the hands of households in the form of income.
(This ownership is achieved through many forms, ranging from firms that are owned and
operated by individuals to giant corporations whose ownership is determined by stock
holdings. Not all households own firms in this way, but in macroeconomics it is sufficient to
think about the average household that does own stock in firms.)
4. Income = spending. We complete the circle by looking at the household sector. The
dollars that flow into the household sector are the income of that sector. They must equal
the dollars that flow out of the household sector—its spending.
,(Box 3-1 Stocks and Flows)
STOCKS FLOWS
• Has No Time dimension - can only • Has a Time dimension – can only
be measured at a particular/specific be measured over a period of time
point in time
• Water level of dam measured at a • Flow of water into the dam
particular point in time (at 00:00 on measured over a period (1 May
May 1 2007 capacity was 72,64%) 2007 inflow was measured as 250
cubic metres per second
• Stock taken; Taken counts • Calculation of sales, profit or loss
• Still pictures • Moving pictures
Examples Examples
• Wealth • Income
• Assets • Profit
• Liabilities • Loss
• Capital • Investment
• Population • Number of births and deaths
• Balance in savings account • Saving
• Unemployment • Demand for labour
• Gold reserves held by SARB • Gold sales, gold production
• Stocks and flows are related
• Stocks can only change as a result of flows
• Prices are ratios between different flows
• Ratios between a stock and flow and visa versa have a time dimension
• Ratios between two stocks and two flows have no time dimension
The basic sets of markets in the economy
1. Goods Markets – Markets for goods and services owned by the firms
2. Factor Markets – Markets for factors of production owned by the households
3. Financial Markets – Markets for the transaction of financial assets or
securities owned by the financial sectors
4. Foreign Exchange Market for the transaction or trading of currencies among
nation.
Interdependence of Households and Firms
HOUSEHOLDS FIRMS
All people who live together and who make Unit that employs factors of production to
joint economic decisions or who are produce goods and services that are sold
subjected to others who make such on the goods market
decisions for them
, • Every individual is a member of a • The Basic productive units in the
household economy
• The Basic decision-making unit in the • Firms purchase factors of production in
economy the factor market
• Own factors of production • Transform factors into goods and
• Sell them in the factors market to firms services
• In exchange they receive income to • Sell these goods in the goods market
purchase consumer goods in the goods
market
• Consume goods and services to satisfy
human wants
• Members are called consumers – the • Capital purchased by firms – the act of
act of consuming is consumption purchasing capital goods is called
Investment or Capital formation
• Total spending is called total or • Denoted by the symbol (I)
aggregate consumption
• Denoted by the symbol (C)
CIRCULAR FLOW OF GOODS & CIRCULAR FLOW OF INCOME AND
SERVICES SPENDING
• Households sell their factors of • Firms purchase factors of production in
production to firms in the factors market the factors market
• Firms transform factors into goods and • Firms’ spending represents income of
services the households
• Sell the goods and services to • Households spend their income to
households in the goods market purchase goods and services in the
goods market
• A clockwise circular movement • Households’ spending represents
income of the firms
• An anti-clockwise circular movement
2
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