Circular Flow: income and expenditure

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Markets

• This week we will discuss market economies
• The vast majority of the nations in the world
  have economies that are market based as opposed
  to centrally planned (eg the former Soviet Union
  or North Korea today)
• Markets are so prevalent some argue they are
  natural institutions others simply take the
  point of view they are just one example of a
  particular system of social organization chosen
  by society over other alternatives

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Markets allocate resources!

• One of the basic problems in society is to
  ALLOCATE scarce resources-some say this defines
  the economic problem
• We say there are limited or scarce resources
  which need to be assigned to unlimited wants by
  people
• Eg. should labour (work) be assigned to produce
  lumber or hamburgers?
• Resource allocation is unbelievably complex in a
  modern economy with thousands of goods and
  millions of people
• A market system has turned out to be the most
  durable and stable forms of social organization
  to carry out the allocation of resources despite
  lots of tries at alternatives throughout history

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What exactly are markets?

• Markets are older than recorded human history
• Originally they were places were individuals
  exchanged one good for another (barter) by
  haggling over the terms of exchangeeg. 1 loaf of
  bread for 2 apples
• Modern markets have many of these features
  although a) typically goods exchange for money in
  modern economies not other goods, and b) markets
  are often not organized in a specific time or
  place (eg. The currency markets run 24 hours a
  day and occur in cyberspace-not at a particular
  geographic place)

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What do you need to have a market?

• First, markets need the Rule of Law to ensure
  that an exchange is not subject to fraud,
  misrepresentation, or other forms of
  dishonestymarkets need a minimum level of trust
  between parties which the legal system usually
  provides (but not alwayseg. drug markets)
• Second, markets only work if sellers can legally
  transfer the property right of the good to the
  buyeryou need well defined property rights so
  that exchange can take place
• Third, the cost of buyers and sellers conducting
  an exchange cant be too highwe say the
  transactions costs must be reasonable for a
  market to exist
• Fourth, markets need to be sufficiently deepby
  this we mean there must be enough buyers and
  sellers of a similar good (or service) to make it
  worthwhile to create and operate a market

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Government the mixed economy

• Most modern economies are Mixed Economies that
  is only part of what is economic activity occurs
  within marketsthe other major economic
  institution is Government
• Government accounts for about 30-60 percent of
  economic activity
• Government usually is responsible for defense,
  public health, police, health, education, social
  security, and a variety of other public goods
• Governments do what markets cant do well
  although there are some sectors (eg airlines or
  electricity) which are public in one economy but
  market based in others

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Market participants

• Markets usually bring together three sets of
  participants
• Consumers of the goods and services
• Organizations called firms that are responsible
  for production (transforming inputs into useful
  outputs)firms can be small or large (the modern
  corporation)
• Suppliers of factor services who sell to the
  firms --these are individuals selling labour
  services and owners of financial resources who
  provide firms with capital
• Every individual usually plays at least two and
  sometimes three roles in a market system they
  are a consumer, they are a supplier of factor
  services (labour) and sometimes they manage or
  own a firm

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Rules of the Market

• Most of the basic rules of the market are
  provided by government (who set the legal
  framework) but this is not always the case (eg
  black markets)
• Government also provides a monetary system which
  sets the legal unit of account (money) in which
  contracts are set
• Individual firms, consumers and factor suppliers
  are free to negotiate the terms of exchangeie
  what price, and how much, and what to buy or sell

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Modern market economies

• The modern market economy is arguably the most
  amazing form of social organization ever
  conceived
• Literally millions of voluntary transactions
  occur every day between millions of unrelated
  parties
• Market dont do all resource allocation however
  A lot of resource allocation occurs A) within
  firms B) by government bureaucracy and C) by
  familys or other closely related persons acting
  outside of an organized market or firmtrust is
  very important in these cases
• Typically the higher the level of average income
  or level of economic development the larger is
  the formal market sector relative to other forms
  of resource allocation

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Measuring economic activity the Circular flow of
income and expenditure

• Given the organization of the modern economy most
  relationships between the three principal actors
  involves the exchange of money for a good or
  service
• This sets up a natural flow of money that has
  been referred to as the circular flow
• Money flows from consumers to firms to input
  suppliers who in turn acting as consumers then
  spend it on firms etc. etc.

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Circular Flow income and expenditure
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Income versus Expenditure

• In the circular flow diagram we see how money
  flows from households as buyers of goods to firms
  (ignore government for moment)
• Money also flows from the firms to household this
  time as payment for the provision of factor
  inputs (labour and capital)
• This provides the basis for the way economists
  think about the interactions between different
  parts of the economy and the measurement of
  economic activity

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How to measure economic activity?

• This flow naturally suggests two ways in which to
  measure economic activity in money terms
• Expenditurewe can measure economic activity as
  the money is spent in the economy on different
  goods and services
• Incomewe can measure economic activity by adding
  up the value of all the money paid by firms to
  their factor suppliers
• GDP(Gross Domestic Product) or National Income is
  what we call these two measures of total economic
  activity in an economy

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Two sides of same coin?

• The expenditure approach and the income approach
  are really ways of doing the same thing since in
  a market system an expenditure or cost by one
  party must be a receipt or an income of another
  party!
• On the income side we usually classify income
  into three categories wages, profits and
  interest, and rents (comes from Marxs
  classification of factors of production as
  either labour, capital or land)
• On expenditure side we usually break it down into
  spending on consumption, investment, and
  government

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How to incorporate Government?

• Government in a market economy complicates the
  picture a bit (or a lot)
• Most governments produce goods and services that
  are provided to their citizens either free or
  with limited user charges
• To produce they must pay the people who work for
  them and thus they need money
• The government pays for these services by taxing
  either at the point of expenditure (eg a sales
  tax) or at the point at which income is received
  (eg an income tax)

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Summing Up Thus Far

• The circular flow framework in a market based
  economy leads to an important identity
• GDPTotal ExpenditureConsumptionInvestmentGover
  nment Spending Total IncomesWagesProfit
  InterestRents
• We refer to money or NOMINAL GDP which is the
  natural dollar measure of these expenditures
  where dollars are used as money in other
  countries say Japan nominal GDP would be measured
  in Yen, in Germany it would be Euros, Mexico
  pesos etc. etc.

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Inflation?

• One often makes reference however to an
  alternative concept which is REAL or CONSTANT
  dollar GDPthis is to correct for problem of
  inflation
• Nominal GDP can go up either because people
  bought more cars and houses etc. or because the
  dollar price of cars and houses went up. When
  all prices tend to go up over time this is
  referred to as INFLATION
• To take out the effect of inflation on the real
  changes in GDP over time ( ie what the economy
  actually produced) we divide NOMINAL or MONEY GDP
  by an INDEX of all the prices in the economy
• The most popular index of prices is the Consumer
  Price Index reported every month in the papers
• In a global context correcting for inflation is
  very important because inflation rates of
  different monies (currencies) can be very
  different

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Where to find these numbers?

• A useful place to easily get numbers on the
  GROWTH of GDP and rate of INFLATION (ie how fast
  prices are rising on an annual basis) is the back
  of the Economist magazine every week.
• This week for example inflation is highest in
  Venezuela at 14.2 while Japan has deflation
  (falling prices) of -0.8
• Growth is highest in Latvia at 11.4 and GDP
  growth is lowest in Italy at 0.1 (amazingly
  there is actually no economy actually shrinking
  at this point ie negative GDP growth)

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Author Richard Harris

• last revision September 8-2008
• for fall 2008 Ec102 Simon Fraser University
• do not distribute without authors permission