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The Circular Flow of Economic Activity

The Circular Flow of Economic Activity

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Published by jamwafu
hand-out in general economics topic 3
hand-out in general economics topic 3

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Published by: jamwafu on Jul 06, 2009
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PRINCIPLES OF ECONOMICS: Circular Flow of Economic Activities THE CIRCULAR FLOW OF ECONOMIC ACTIVITY There are two basic activities undertaken in any economy: production and consumption. The firms perform the production and consumption while households undertake consumption. To be able to produce, firms need the economic resources
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consisting of land, labor, andcapital
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:
LAND
– it is one of the factors of production which include land used for agriculture or industrialpurposes as well as natural resources taken for above or below the soil. Natural resources consistof energy resources like fossil fuel and geothermal emissions, non-energy resources like gold,diamond, and limestone, air and water and many others.
LABOR
– refers to that basic factor of production which are productive services embodied inhuman physical effort, skill, and intellectual powers, and others. It consist of human time spent inproduction like driving buses, feeding cattle, singing in night clubs, acting in movies, or repairinghousehold appliances.
CAPITAL
– durable goods produced in order to produce other goods. It consists of buildings,plant and machinery, roads, computers, ships, electric guitars, table tennis, tennis balls, etc.
STOCK AND FLOW OF CONCEPTS
Stock – refers to the measure of quantity at a point of time e.g. wealth as of December 31, 2001Flow – refers to the measure of movement of quantity of over a period of time e.g. savings(P1000/year) or consumption at P100,000/yearWhen economic resources are used in the production of goods and services, employmentof these resources occurs. A
 price
is paid to resource owners whenever these resources are usedin production.
Rent 
is paid to the landowner,
interest 
to the capitalist, and
wage
to labor. Thegoods and services produced by these firms are consumed by households. The interaction between households and firms regarding production, consumption,employment and income generation results to the circular flow of goods and services in theeconomy. THE CIRCULAR FLOW OF GOODS, SERVICES AND INCOME The basic aspects of economy which include production and consumption are subject tothe stock and flow concepts which are circular in nature. THE PRODUCTION PROCESS The process of producing goods and services involves households and firms in a circular flow. Asshown again, the economic rsources of land, labor, and capital are provided by the householdsand used by the producing firms. These firms, in turn, produce goods and services which aredelivered to households for consumption. THE FLOW OF GOODS AMONG PRODUCING FIRMSWithin the circular flow of the production process is another flow which happens among differenttypes of business firms. This flow involves raw materials, intermediate goods and final goods.RAW MATERIALS – unprocessed goods like wood, sand and ironINTERMEDIATE GOODS – partially processed goods and still needsprocessing before it can be finally consumed likesteel bars, flour and microchips
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Entrepreneurial Ability – land, labor, and capital will remain as they are until someone taps them toproduce the required goods and services. Actual production needs the ability of an entrepreneur to decideon and implement the right combination of the first three factors of production.1
 
PRINCIPLES OF ECONOMICS: Circular Flow of Economic ActivitiesFINAL GOODS – processes goods ready for consumptionlike breadAccording to the type of goods they produce, firms may be classified as follows:1.Raw Materials Producers – like those engaged in producing agricultural products used inmanufacturing (fish, wood, sugar)2.Intermediate Goods producers – like those producing construction materials, guitar strings,and food seasoning3.Final Goods Producers – like those producing chocolate bars, refrigerators, and bicycles THE FLOW OF OUTPUT BETWEEN FIRMS AND HOUSEHOLDSAs shown, the output of raw materials producers are delivered to intermediate goods producers,whose output, in turn are delivered to final goods producers. The consumers become recipientsof the goods produced by the final goods producers.GOODS AND INCOME FLOW AMONG HOUSEHOLDS AND VARIOUS TYPES OF PRODUCERSHouseholds provide producerswith the economic resourcesrequired. These resources aredistributed among the varioustypes of producers. The producers,in turn, remit payments tohouseholds for the use of resources.When the goods are finallyprocessed, these are delivered tothe households, which in turn,remit their payments to theconcerned producers.INCOME FLOWWhen money is spent by households for consumption and by firms forproduction, a circular flow of income is created. The expenditure of oneunit becomes the unit of another unit.Income takes two distinct circular flows as follows
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/
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:
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 The services of land, labor and capital are bought by firms for use in production. Money is paid to the households. In turn, householdsbuy goods and services. Money is paid by households to firms.
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Purchases are made between firms. The output of RM firms are sold to IG firms which in turn sell their output to FG firms. The finalgoods are sold to households for consumption.
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PRINCIPLES OF ECONOMICS: Circular Flow of Economic Activities THE CONCEPT OF EQUILIBRIUM The economy will be in equilibrium if the amount received by firms from households isequal to the amount received by households from firms. Disequilibrium happens when eitherhouseholds or firms do not spend all their incomes. If households, for one reason or another,reduce their purchases, firms will receive a reduced amount of income resulting to their inabilityto maintain current levels of purchases of economic resources, some laborers will lose their job,and some land and physical capital will become idle. The result is a corresponding reduction inthe income of households. THE EFFECT OF SAVING AND INVESTMENTSIf the total output of firms arepurchased by the households and the totaleconomic resources are bought by firms,there is equilibrium in the market. In reality,however, households allocate a part of theirincomes for future use like providing moneyfor old age. As a result, disequilibriumhappens because firms are hard-pressed todispose all their output. The circular flow willtend to contract. To prevent this fromhappening, some other means for disposingthe unsold portion of the output must betapped.Investment is a way of disposing unsold output. Firms spend money to procure goods andservices for the purpose of increasing their productive capacity in the future. In effect, firmsspend money now to minimize their expenditures for capital outlay in the future. When thesavings of households are matched by investments expenditures of firms, disequlibrium isnegated and the circular flow of income will tend to normalize.FLOW IN A MARKET WITH GOVERNMENT AND FOREIGN COUNTRIESIn an economy like the Philippines, there are two important sectors that interact with thehouseholds and firms: the government and foreign countries. The government sector which performs necessary functions buys theeconomic resources of land, labor, and capital from households. Land is used bythe government to locate its building and facilities; labor is hired to fill upvarious positions in the different government agencies; capital is borrowed toproduce the necessary facilities and services. Payments in the form of wages,rents, and interest are remitted to the households by the government.Government money, however, is spent not only in buying the economicresources from households but also the goods and services produced by firms.Payments are also remitted to these firms.
The goods and services purchased by the government come in a wide variety of forms: from office supplies totransport equipment and from consultancy to janitorial services.Households purchase goods and services from other countries, like transportation equipment, books,computer programs, etc. The corresponding payments are sent to the exporting foreign countries.Local firms sell goods and services like agricultural products to foreign countries. Payments are remitted to thelocal firms by foreign buyers.
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