REPORT IN APPLIED

ECONOMICS

Submitted By: Group 5

Gabutan, Raine Chelsea
Ganob, Haylemae
Gapor, Hyciel
Getigan, Lady Jerhannah
Tingson, Aljuver

Submitted to: Mrs. Fatima Venus

NOVEMBER 2018
The Circular Flow of Economic Activity
The circular flow of economic activity is a model showing the basic economic relationships within a market
economy. It is defined as the flow of activities of household and firms in a circular direction.

In circular flow of the economy, money is used to purchase goods and services. Goods and services flow through
the economy in one direction while money flows in the opposite direction. The model includes households,
business/firms and governments.

Households are consumers. They may be single-individuals or group of consumers taking a joint decision
regarding consumption. Their ultimate aim is to satisfy the wants of their members with their limited budgets.

Firm is used interchangeably with the term producer in in economics. The decision to manufacture goods and
services is taken by a firm. Firms produce goods and services to make a profit.

Government plays a key role in all the types of economic systems.

Basic Economic Activities

 Production. Any process that creates value to the already existing goods is called production. Factors of
production include land, labor, capital and entrepreneurship.
 Consumption. It means the use of utility of goods and services for the direct satisfaction of individual and
collective wants.
Production and consumption are flows which operate simultaneously and are interrelated and
interdependent. Production leads to consumption and consumption necessitates production.
In other words, production is a means (beginning) and consumption is the end of all economic activities.
Both production and consumption, in turn, depend upon exchange. Thus these two flows are interrelated and
interdependent through exchange.
 Exchange of goods and services.

THE SIMPLE FLOW OF GOODS AND SERVICES

Figure 1.1 The Circular Flow

In the Figure 1.1, goods and services flow from the firms as producers, to the households as consumers, in
clockwise direction. On the other hand, households as resource owners provide firms as producers with resource use
such as labor rendered, capital lent or invested, land rented to producers, and entrepreneurial skills. In the Figure 1.1,
these resources flow from the households to the firms also in a clockwise direction. It is the use of these resources that
enables the firms to produce the goods and services delivered to the households. The flow of products and resources
are the physical flows in the economy.

The flipside to the physical flow is the money payment flow. Household pay and firms earn revenues in exchange
for the goods and services rendered and provided, respectively. Revenues flow counterclockwise from the households to
the firms as payments for the goods and services received by the former. Likewise, firms pay and households earn factor
income for the use of resources provided to the former. Factor income payments counter flow from the firms to the
households for resources provided by the latter.

For as long as households are willing to consume, producers continue to produce goods and services for the
households using the resources provided by the latter. As the physical flow continues, so is the money payment flow in
exchange for products and resources. The physical flow continues in a clockwise direction in exchange for money
payment flow in the counterclockwise direction.

Raw Material Firms

Intermediate
Raw Material Firms Product Firms

Final Product Firms

Product Flow

Money Payment
Figure 1.2 Intra-production Payment Flows

Among the firms, there is also the product flow up the production stages, that is, from the raw material to the
intermediate good and on to the final good stage for consumption (violet arrows, Figure 1.2). Opposite the product flow
is the money payment flow in exchange for product delivery down the production stages from the consumer, that is, to
the final then to the intermediate and on to the raw material stage (green arrows, Figure 1.2).

Raw materials are unprocessed goods like raw minerals, logs, and wheat, which are extracted from their sources
and do not undergo any process of production.

Intermediate goods are semi-processed goods that are not ready for final use by the consumer, such as leather,
cloth, and steel, which have undergone some processing but need to go through additional processing before they can
be actually used. These are supplied to final good firms for conversion into goods in their finished stage.

Final goods are goods that are ready for direct consumption such as refrigerators, dresses, or pants. These final
goods are then sold to customers for their use.

Figure 1.2 magnifies the production side of the circular flow diagram in Figure 1.1. Goods flow up the production
stages to the consumers in return for payments trickling down the production stages in return for the inter-stage
product flows.
 In return for the use of the resources, the three types of producing units make money payments to households
(blue arrows. This is now a financial flow since it involves the payment of money to the resource owners. Money is now
paid by the various firms to the households as payment for the resources they provide. Figure 1.3 magnifies the flows of
resources and payments in exchange between households and the producers in the circular flow diagram in Figure 1.1.

THE GOVERNMENT SECTOR AND THE GLOBAL ECONOMY

There are two other relevant units in the flow: the government and foreign countries. The government is
important because it makes purchases of economic resources from the household and makes money payments to the
resource owners for the use of their resources. The government also buys goods and services from the producing units
for which it makes money payments.

The significance of the global economy cannot be overemphasized in today’s times. An economy buys goods
from other countries; these are called imports. An economy sells goods to other countries; these are called exports. A
country pays for the goods imported and earns income from exports.