eE———EEEEE es Chapter INTRODUCTION Most people have a general idea of what Economics is. They live with it; they practice it, Some will even be able to define it. Eco- nomies is concerned with the produetion, distribution, and use of material goods and services. Adam Smith, the recognized father of Economics, stated that Beonomies is “an inquiry into the nature and causes of the wealth of the nations.” Basic Terms in Economies It is essential that the student be familiar with the terms that will be used in the study. A knowledge of these terms shall facilitate his understanding of economic analysis. A good is anything which yields satis- faction to someone. It is anything used to satisfy a person’s wants and desires. Goods may be tangible when they are in the form of material goods or commodities. They may also be intangible in the form of services. ‘Tangible goods like shoes, books, and um- brellas, and intangible services like those rendered by the doctor, the teacher, or the painter are all used in the satisfaction of human wants and needs. Goods may also be classified according to use. Goods which yield satisfaction directly, just like softdrinks and food are called consumer goods. Goods used in the roduetion of other goods and services are called capital goods. Examples of these are buildings, machinery, and equipment. Goods may also be essentials, ifthey are used to satisfy the basic needs of man such as food, shelter, and medicine, Luxury goods are those goods man may do without, but are used to contribute to his comfort and well being, Perfume, chocolates, and expensive cars are luxury items that are purchased only by those who can afford. Goods may also be classified as econo- mic or free. An economic good is a good which is both useful and scarce. It has a value attached to it and a price has to be paid for its use. Ifa good is so abundant that there is enough of it to satisfy everyone's needs without anybody paying for it, that good is free. Airis free, but air from the electric fan is an economic good, Goods are created by means of product- ion. It may involve the physical transfor- mation of a commodity such as the con- version of leather into shoes. This type of production takes place in the factory and is referred to as manufacturing or industry. Production may also take place in the farm, Planting and harvesting of rico, corn, coco- nuts and sugar are agriculture production. Even exploration for oil, mineral, and precious metals is production. All these activities are carried out to provide goods and services for use in the satisfaction of man’s wants and needs. ECONOMIC RESOURCES ‘The things which are needed to carry on the production of goods and services are called economic resources or factors of production. These resources are land, labor, capital, and entrepreneur. They are the basic resources because they constitute the basic needs in production. They are the most basic tools used im ‘and services. Land Strietly speak ral resources, whi innature, and are§ This term includes and mineral depos good because it is be paid for it, ‘Tas tnd offer it to ot income called rent land available for the rent that hes Labor Labor is any exerted in the 5 services, Labor « abilities, and ch factory workers = work. It also incl nomist, nurse, people who leave to be in time for © The supply dependent on percentage of to join the labor # with a high po expected to « supply. Still, depend on facto of the populati people finish age at which peop is also highly & social and cul workers discrimin girls liberated ex» riage, instead of ‘The country affected by the = population and & from other coun dreds of work Libya, the USAbasic tools used in the production of goods and services, Land Strictly speaking, land refers to all natu- ral resources, which are given by and found in nature, and are, therefore, not man-made. ‘This term includes the soil, river, forests, and mineral deposits. Land is an economic ‘good because it is searce and a price has to be paid for it, ‘Thus, people who own land and offer it to others for their use, earn an income called rent. The less the supply of Jand available for man’s use, the higher is the rent that has to be paid for it. Labor Labor is any form of human effort exerted in the production of goods and services. Labor covers a wide range of skills, abilities, and characteristics. It includes factory workers who are engaged in manual ‘work, It also includes the accountant, eco- nomist, nurse, typist, and other numerous people who leave their homes in the morning to be in time for their 8-hour work. The supply of labor in a country is dependent on its production and on the percentage of its population that is willing to,oin the labor force. Naturally, a country ‘with a high population growth rate is expected to come up with a bigger labor supply. Still, ite number of workers will depend on factors like the age distribution of the population, the age at which young people finish school and start work, and the age at which people retire. The labor supply is also highly dependent on the people’s social and cultural practices. Are women ‘workers discriminated against? Are married girls liberated enough to work despite mar- riage, instead of being plain housewives? ‘The country’s supply of labor is also affected by the migratory tendencies of its population and by the influx of workers from other countries, While we lose hun- dreds of workers yearly to Saudi Arabia, Libya, the USA, and other highly paying countries, our labor supply is also expanded by the foreigners who come here and get ‘employed in jobs which otherwise should be held by Filipinos. Since labor supply is not available.in any amount at a zero price, anybody who expends hiseffortsin the production of goods and services earns an income. Wages, whieh are the return on the use of labor, include salaries, commissions, tips, and other forms of remuneration. Capital Capital refers to man-made goods used in the production of goods and services. Capital does not only include money; it also includes buildings, machinery, raw materials, and other physical necessities for use in production. A nation’s eapital is dependent on its level of savings. Savings refer to the part of a person's income whieh is not spent on consumption. It therefore involves a sacrifice because consumption hhas to be given up for one to save. Capital is therefore an economic good and the owner of capital earns income for its use. This income is called interest. Thus, if you bring ‘your money to the bank for deposit, itearns interest because you are actually Tending capital to the bank. Entrepreneur Oftentimes, the entrepreneur is not pre- sented as a separate factor of production, ut is classified as part of labor. However, the entrepreneur does a special type of work and is, therefore, not ordinary labor. He is the person who eombines the other economic resources for use in the production of goods ‘and services, He decides on the combination of land, labor, and capital to be used in production. Since not everybody had the managerial and organizational abilities to be an entrepreneur, entrepreneurship isan economic good that commands a price. This price is the income earned by the entrep- reneur and is called profit. Itis the amount thatis left hehind afterall allocations to the other economic resources have been made.THE NEED TO CHOOSE ‘Scarcity is the reason why people eco- nomize. Scarcity refers to the limitations that exist in obtaining all the goods and serviees that people want. It gives rise to economic problems and itis the reason why man has to make a choice. Ifall goods were as free as air, there would be no need to economize. Because of scarcity, any society ‘must confront three fundamental and inter- dependent economic problems. 1. What to produce and how much? This isa decision on what goods and services to produce and their quantities. This would depend on what is needed, what is wanted, and whathas to be produced. How shall goods be produced? This is « decision of what resources are tobe used in production, by whom the goods will bbe produced, the technological manner in which production will take place. A country with an abundant labor sup- ply would be expected to use a larger amount of that resources in its pro- duction of goods and services. For whom shall goods be produced? ‘This question is now on the problem of distribution. Who will benefit from the produetion of goods and services? ‘How much of total production will each consumer get? Will the goods be bought by the rich or by the poor? These three questions are basic to all economies. However, the manners in which these economies answer the problems differ. ‘The country’s economic organization has a lot to do with how the decisions to these fundamental problems are arrived at. Inthe same manner, the way a nation answers the problems determines the type of economic system it adopts. TYPES OF ECONOMIC SYSTEM The Traditional Economy ~ This is basically a subsistence economy. A family produces everything that it eon- sumes. Decisions on what, how, and for whom to produce are made by refer- ring to the traditional manner of doing things. Production is carried on in the ‘methods used by the forefathers, and is therefore very primitive. This type of ‘economic system is very backward since it does not allow for change. ‘The Command Economy —In this type of economy, the means of production are owned by the government. Its decisions are arrived at by planners or govern- ‘ment men who dictate what, how, and for whom to produce. The Market Economy ~ The basic characteristic of this economy is that resources are privately owned and decisions are made by the people themselves. Since every consumer arrives at his own decision, the system is coordinated through an interlocking network of markets and prices. The system depends on prices set by the conditions of demand and supply. Competition is supreme; there is con- sumer sovereignty, and the price of the good is the guiding factor for produ- cers to know what and how much to produce. Ttis in the goods market that the prices of goods and services are determined. If there is a strong demand on the part of the consumers for rice, this will be reflected in the peso votes, which are the amount of money they are willing to spend on rice. Producers respond by obtaining land, labor, and capital from the resource market for use in the production of rice. The supply of rice in the market will also determine the price at which rice will be sold in the goods market, In the resource market, the price of the resources: the rent, salaries, and interest, vill depend on the amount made available by the resource owners as well as the amount of these resources that the produ- cors will be willing to hire. DEMAND Fos ‘The Mixed It is seldom exists in pure economy is prs cannot be dex form of govers be described e= are planned the price sy minimally. ‘The Philis economy three forms itis more mari ‘buys a book = up the chance movie, An MDEMAND FOR GOODS » [Goons marKET ‘SUPPLY OF GOODS ‘AND SERVICES ‘AND SERVICES PESO ae WHAT? COST OF PRODUCTION constnens cs I PRODUCERS RESOURCE FOR WHOM? OWNERS Lo, carr — capi. LABOR —> —— tasor LAND —> — iano Figure 1 ‘The Price System and its Role In the Basic Economic Problems ‘The Mixed Economy It'is seldom that an economic system exists in pure form. The United States ‘economy is predominantly market, but it cannot be denied that there existe some form of government control. Cuba can best be described as command since its decisions are planned by the government; however, the price system is also used, even if only ‘minimally. ‘The Philippine economy is a mixed economy since it applies a mixture of the three forms of decision-making. However, itis more market-oriented rather than com- ‘mand or traditional Opportunity Cost When one makes a choice, there always an alternative that has to be given. ‘up. A producer who decides to produce shoes, gives up other goods: that could be produced with the same resources. A student who ‘puys a book with his limited allowance gives up the chance of eating out or watching a movie. An M.A. graduate who decides to ‘teach, gives up the salary he would have earned had he worked in a big firm like San. Miguel Corporation. ‘The values of these alternatives given up are referred to as opportunity costs. ‘When we make a decision to buy Good ‘A,we are in effect, making the decision not to buy Good B. ‘Let us study a graphical presentation of this concept (based on Table 1). Let us say that you as a student have a weekly food allowance of 300.00, You decide this ‘week to spend it on a combination of eolas and chicken sandwiches. In the school canteen, a chicken sandwich costs 30.00 and a cola P10.00, giving you the following alternatives: ‘Table 1 Combinations of Colas and SandwichesLet us now use a graph to plot all these possible combinations, ‘The connection of possible combinations is the consumption possibilities tine. This is a downward sloping line that reflects the inverse relationship between the con- sumption of colas and the cmsumption of sandwiches. Let us say that your original choice is a combination of 15 colas and 15 sandwiches. However, within the week, you decide to eat one more sandwich. You will have to give up 3 colas to do so. Your new choice will be 12 colas and 6 sandwiches and your opportunity cost is the value of the 3 colas you have to give up. Let us now take the case of a laborer who spends 8 hours of his 24-hour day for sleep (Table 2). The remaining 16 hours he can divide between work and leisure, The following table shows his possible combina- tions of work and leisure time. ‘Number of Work Hours: fayrirtt Number of 12?) Colas fats 6: oT PET Figure 2 No, of Sandwiches Graphical Presentation of Combinations of Colas and Sandwiches Society's T. Possibili Since a nas hhas to cope & bundles of the differen who will con it decides » volve choice= outputs to be commodit the good or the is used to Inputs con Land productive = natural re forests, ocx Labor = used in progBe 3 g C] im rer fest for EL Tr r spc | | anes E10" ia 2419. 8 7 1 6 5: 4 3 a; ies 1 1 OTT 2 34 6 6 7 8 8 10111213 141516 i ai ‘Number of Lelsure Hours, a Figure 3 Graphical Presentation of Combinations of Work rt ‘and Leisure Hours Society’s Technological ers, doctors, factory workers, drivers, oF Possibilities seashore: : i Capital consists of man-made durable Since a nation has limited resources, it Tice ts cage by chtoaitg ditlorent pital) SUR TENET Ay aise pa pepice theese Sc damnes icone: ‘machinery, equipment, and 3 Frets matt sioduction/tachaiquescend 97 ee who will consume the goods and services Outputs refer to useful goods and ser- it decides to produce. These decisions in- ‘yolve choices on inputs to be used and the outputs to be produced. Inputs refer to the commodities or services used to produce the good or the service. Existing technology is used to combine these different inputs. Inputs consist of land, labor, and eapital. Land refers to gifts of nature to our productive process. It is a term that covers natural resources including minerals, forests, oceans, and soil. Labor refers to the human resource used in production. Labor includes farm- vices resulting from the production process. ‘These are goods that are either consumed like shoes, or used in further production like machines. ‘The Production Possibilities Frontier Since society faces limitations due to scarcity of resources, it has to decide on the combinations of goods that are to be pro- duced using a given amount of input. Let us use the following example to illustrate this:‘Ten (10) units of capital can be used to produce Goods X and Y. Possible output levels are as follows: Plotting these combinations in a graph, we get the production possibilities curve, a downward sloping line to indicate that increase production of Good X will lead to a docreaso in the production of Good Y. ‘There is a trade-off involved here since to inerease the output of Good X, there has to be a corresponding decrease in tho output of Good ¥. The opportunity cost here is the value of Good ¥ that has to be foregone in order to have more of Good X. Good Y Figure 4 ‘The Production Possibilities Frontier In the graph below, all combinations that fall on the curve itself such as point F are possible. Being on the production possi- bilities curve results in productive efficiency. Society cannot increase output of Good X without cutting back on the production of Good ¥. On the other hand, point U is a com- bination inside the curve. While it is pos- sible, it has not attained productive effi- ciency since it has not maximized the use of the fixed input which is capital, so it therefore leads to wasted resource. To maximize the use of capital, the producer should stay on any point on the curve. Any combination outside the curve is not possi- ble since it will need more units of capital input. Should there be an increase in the amount of capital available, this could lead to a rightward shift in the produetion possibilities frontier curve, resulting in the increased production of both goods X and Y. ‘Good ¥ Figure 5 Shift of the Production Possibilities Curve ‘The righ possibilitics @ production of| contrast to deals with therefore, = how an cco understand economic tistics to 4 behaviors am in the te These & the etuden subject in approach> The rightward shift of the production possibilities curve shows an increase in the production of both goods. THE TOOLS OF ECONOMICS Economies is a positive seience that means it deals with what it is. This is in contrast to normative economies which deals with what should be. Economics is, therefore, a study that attempts to explain how an economy operates. To be able to understand and explain economic events and economic theories, the student of economies must learn how to use the basic tools of Economies. Firstly, he has to learn how to apply logic in order to enable him to reason out properly and to draw conelu- sions. Secondly, the use of mathematics will enable him to conceptualize and quantify economic principles. Thirdly, he uses sta- tisties to describe quantitatively human behaviors and to serve as empirical evidence in the testing of hypothesis. ‘These tools equip the economist or even the student of Economies to approach the subject in a scientific manner. This scientific approach can be outlined in the following stages: 1. Observation — An analyst should be able to recognize conditions, behaviors, and events in the environment. By simply looking around, he shall be able to ob- tain information necessary to analyze an economic principle. ‘ 2. Definitions and Assumptions — The analyst should deseribe the specific uses of the study and the peripheral conditions which affect the economic behaviors which are being studied. 8, Deductions — These are hypotheses or theories presented for empirical vali- dation. They are temporary conclusions ‘made based on one’s observations and are still subject to the presentation of evidence. 4, Empirical Testing ~ Deductions haye to be tested as to their validity and cor- rectness. The presentation of the em- pirical evidence will be the basis of rejecting or accepting a hypothesis. The evidence gathered consists of statistics which is used to verify one’s guesses. In the Philippines, important govern- ment agencies serve as major sources of statisties: the National Census and Statisties Office (NCSO), the National Economic Development Authority (NEDA), the Central Bank, and even ‘the municipal and city halls, MACROECONOMICS AND MICROECONOMICS Macroeconomics is the division of Economics that deals with aggregates. It presents pictures of totals: income, output, ‘cmployment, spending, and price level. It studies the economy as a whole. Microeconomies is the division of Economies that studies the economy in parts. It is a study of the price system, the individual consumer, the individual firm. It deals with this question: What deter- mines the breakdown of national income aggregates into various types of goods and services? Macroeconomics and Microeconomics are equally important. One cannot study the whole without studying the parts. Neither can one break down aggregates into com- ponents without. knowing what the aggre- gates are and what components they are made of The big picture is made up of parts. Understanding the pieture as a whole is just as vital as understanding the parts.Chapter Within the economy, basic economic activities take place. These include produet- ion, consumption, employment, and income generation. ‘They take place through the interrelationship that is existing between two economic units: the household which is the basic consuming unit; and the firm which is the basic producing unit. Let us deseribe these important eco- nomie aetivities, Production is the use of economic resources in the creation of goods and services for the satisfaction of human wants. The use of these economic resources in production is employment. Whenever resources are used in production, a price is paid to the resource owners. The land- owner earns rent, the capitalist, interest, and labor his wages. When the goods and services produced are ready for use, this leads to another economie activity called consumption. These activities make up the circular flow of economie activity Stock and Flow Variables To analyze this concept, it is important for us to understand what a flow is. A flow is defined as a quantity measured over a particular period of time. ‘This term is in contrast to the word stock, which is defined as a quantity measured as of a given point in time. For example, your money in the bank as of today is P10,000, Tomorrow, this amount may chango; it decreases when you withdraw and increases when you deposit more funds, Water in a tank is another example of a stock. Now, when you turn on the faucet and the water starts to get into THE CIRCULAR FLOW OF ECONOMIC ACTIVITY the tank, there is a flow of water. This flow naturally changes the stock of water in the tank. ‘The concepts of stock and flow measure- ments are essential in understanding the economic variables of wealth and ineome. Wealth is anything of valued owned. It may consist of money, jewelry, buildings, and other property. Wealth is a stock since it is what is owned at a particular time. If a fire destroys the Ayala building in Makati, Ayala’s wealth decreases, Now, if your mom buys a sweopstakes ticket and it wins first prize, your wealth increases by the amount of her winnings. On the other hand, income is a flow. It is the rate at which we earn money. Our income is very important to the stock of wealth that we can build up. Income that is saved increases a person's stock of wealth. However, expenditures on consumption docrease this stock. Economic Model of Production ‘The flow of goods and services moves in a clockwise direction. This we can see in Figure 6 We see the households delivering economic resources to the business firms for use in production. It is hecause these households are the resource owners in the economy. ‘They can own land, labor, and capital which they provide the firms for use in the production of goods and sorvices. Once these goods are in their final form, they are now delivered to the households for their consumption, Before this flow ofECONOMIC RESOURCES HOUSEHOLDS PRODUCING UNITS. (FIRMS) GOODS AND SERVICES Figure 6 ‘The Circular Flow of the Production Process final goods takes place, another flow in the production process has to take place among different types of business firms. This con- sists of the flow of raw materials, the flow of intermediate goods, and the flow of final goods, Raw materials are unprocessed goods like logs, wheat, and iron ore. Intermediate goods are also called goods in process because they have been partially processed but are not yet ready for final use in con- sumption. Final goods consist of the bread we buy in the bakeries, a car, the table and chairs we use at home. Some firms are raw material produ- cing firms, They cut down lumber from the forests or explore mines for ores. Some firms transform these raw materials into intermediate goods, An automobile body shop does this to iron sheets. And of course, we have firms that convert these inter- ‘mediate goods into final goods, such as when a firm finishes up the car so it is ready for us to ride in, Let us now show the existing inter- relationship among these three types of firms in Figure 7. Raw Matorials Raw Material Fim Consumers %, ey, Fim Intermediate Good Firm e eee fe Figure 7 Circular Flow of Goods Among Production Units It is incomplew show therole of thei HOUSEHOLDS Households The flow of phys Secompanied by a flow © we can seo that i=rod from Some into body arse, inter inter- pes of ‘THE CIRCULAR FLOW OF ECONOMIC ACTIVITY 9 as resource owners. Let us now add Figure 8 for a complete picture in Figure 9. It is incomplete because it does not shoy the role of the household in production RESOURCES ———> RAW MATERIAL FIRM HOUSEHOLDS RESOURCES ————> INTERMEDIATE GOOD FIRM RESOURCES —— FINAL GOOD FIRM Figure 8 Interrelation Between Production Units and Households Final Goods ‘Money Payment for Purchase of Final Goods Final Good Resources: Firm ‘Money Payment for Resources Resources: Intermediate Households ME ar Money Payment for Resources Resources Raw Material Fim Money Payment for Resources Figure 9 ‘The Circular Flow of Goods and Income Among, Producers and Households. ECONOMIC MODEL OF INCOME delivered by the households to the firms, AND CONSUMPTION they get money payment as factor income, ‘The circular flow of income is in a counter- clockwise direction. We shall illustrate this in Figure 10. ‘The flow of physical goods is normally ‘accompanied by a flow of income. In Figure 9, we can see that in return for resources INCOME FLOW OF WAGES, INTERESTS, RENTS. HOUSEHOLDS 4— > PRODUCING PURCHASES OF GOODS AND SERVICES UNITS Figure 10 ‘The Circular Flow of Income20 ‘The flows of income and consumption expenditures are flows which involve finan- cial transactions since they involve the pay- ment of money. When economic resources are delivered by the households to the busi- ness firms, income is generated in the form of wages, rents, and interests earned. This income is now the source of funds of house- holds needed for them to buy goods and services in consumption. Thus, money pay- ‘ment is given by the household for the pur- chase of goods and services. ‘A money flow is also involved in the in- terfirm transactions in production. We will now show this finaneial flow. WTRODUGTORY MACROECONOMICS: ‘THE CIRCULAR FLOW OF OUTPUT AND INCOME ‘The two flows of output and income are ‘exactly equal. Thus, the value of all goods and services produeed in the economy dur- ing a year is equal to the money which business firms spent, and which households as resource owners received. Within the circular flow, the measure of output and the measure of income always result in the same value. This is because for every peso value of output produced, one peso of income is created. In Figure 12, what we see is a simpli- fied model, showing only the household ( Households 4 ven Raw Materials Fim Final Good Firm ‘Money Payments for Raw Materials Money Payments for intermediate Goods \ Money Payments for ee Final Goods: pore Intermediate ‘Good Firm Figure 11 Circular Flow of Income Among Production Units Combining the circular flow of physi- cal transactions and the circular flow of financial transactions, we arrive at Figure i. ‘The final output of goods within the flow consists of rst: goods used in consumption, called ‘consumers goods, Secondly: goods used in the production of other goods, called capital, producers, or investment goods. ‘The value of this final output of goods is equal to the value of the expenditures on these goods and the firm. Let us sce in Figure 13 what happens in the flow when we add two other important elements: the government and the foreign countries. The government makes two types of purchases in the economy. It hires labor from the household sector, rents their land for their offices and factories, borrows capital by selling securities. For these, it ‘makes money payments to the households. The government also buys goods from business firms, and makes money payments for these purchases. HOUSEHOLDS Mos An open econ maintains trade = tries. First, it sells in the form of exp: export products = like coconut, suEconomic Resources Money Payments of Rents ‘Wages, Intorests Households _ roducing Units t Goods anid Services Money Payments for Purchase of ‘Goods and Services Figure 12. Circular Flow of Physical Goods and Money Income. GOVERNMENT Wages. Transfer Payments Taxes Money payments for imports Economic Resources Purchase of Goods and Services y HousEHoLps |__|’ propucine units Income Payments of Wages, Rent, t Dividends, and interests Goods and Services Purchase of Goods ‘and Servicas Taxes Money payments for exports FOREIGN COUNTRIES An open economy like the Philippines maintains trade relations with other coun- ties. First, it sells goods to these countries sa the form of exports. The Philippines’ main. export products are mostly agricultural, like coconut, sugar, and bananas. For these, Figure 13 The Circular Flow of Goods and Income of Households and Firms with the Government and Foreign Countries foreign countries make payments to the business firms which sell to them. In turn, the Philippines also buys from other coun- tries goods and services called imports. Among the important imports of our country are oil, machinery, and manufactured goods.For these imports, Philippine households have to make payments to foreign countries from which they buy. ‘The circular flow of economic activity implies: 1. The goods, resources, and money pay- ments will flow as long as households continue to consume, and as long a8 firms continue to produce; and ‘That since goods and resourees flow in exchange for payments, the rate of payments flow will in the end be the ‘same. Money is the inducing factor and the pillar of the price system. Without it, there is no price system. ‘THE MULTIPLIER EFFECT AND THE CIRCULAR FLOW ‘An amount of spending that goes into the economic stream generates a corres ponding amount of income which is greater than the original inflow. This is due to the ‘multiplier effect. The multiplier is a num- ber that determines the increase in income resulting from a given amount of income, but ina higher amount. The multiplier, in effect, increases the resulting income depending on the consumption behavior of the people. ‘An income multiplier of 10 will generate an income of P10 on a PI inflow. A more detailed analysis of the multi- plier effect is presented in a future chapter, where income generated by the multiplier is related to the people's propensity to consume. INFLOWS AND OUTFLOWS: Consumption is the mainstream of the cireular flow. If within the year, the pusiness firms produced a total of P50 billion ‘worth of goods and services, it would follow that the income of households would total P50 billion and their spending would be 1°50 billion. If the total demand for goods produced in a year equals the amount of output, business would be able to sell all that they produce. However, households do not usually spend all of their income ‘While most ofa person's income is spent for consumption, it is usual that a portion of this income is saved. Ifthere were no other demand aside from that of the households, the business firms would definitely not be able to sell all of their output. Thus, savings have the effect of decreasing the level of economic activity in tho flow. Savings con- stitute the first outflow from the stream. ‘Phe existence of the government in the model necessitates the study of tax payments that households have to pay the government on their income. When house- Tables ‘Schedules of Income, Taxes, Consumption, and Savings (Billions) holds pay taxes, disposable incom available for com at Table 3 that 3 consumption sch A compariss shows the effects spending and = tion of taxes Schedule 2, in ti to consumption emounts shows are increased t outflow. When we end buy from & spending on these expend Business fi Sow into for purchase our have the atflow “Schedule 1 No Taxes ‘Schedule 3 Taxes P150_ Ipieposabie income Consimnl | income Consumption Savings Income pa00 Palo “piso Pid (PIO) : 1holds pay taxes, the effect is to lessen their disposable income and therefore the amount available for consumption spending. Look at Table 3 that shows how taxes affect the consumption schedule of households. ‘A comparison of the three schedules shows the effects of taxes on consumption spending and savings. With the introdue- tion of taxes in the economy, as seen in Schedule 2, in the table, the amounts going to consumption decrease relative to the amounts shown in Schedule 1. When taxes are increased to P150, the amounts for con- sumption spending farther decrease, Taxes therefore decrease the level of economic act ivity in the flow and constitute our second outflow. When we bring in the rest of the world and buy from foreign countries, this amount is spending on the part of houscholds, but these expenditures are not siphoned back to ‘our economy in the form of payments to local business firms. Instead, these payments flow into foreign countries from whom we purchase our imports. Imports therefore have the effect of decreasing the level of economic activity and constitute our third outflow. With these outflows taking place in the economy, we are bound to experience a continuous recession of economic activity. However, this could be offset by a siphoning of funds back into the economie flow as shown in Figure 14. Firstly, when households save, the nor- mal practice is to bring this money to banks as deposits. These banks will now use these funds by investing them, thereby making payments to the business sector; or by lending them to people who likewise invest the money. Herein lies our first inflow which is investment. If investment is equal to savings, it offsets the outflow caused by the savings of households. When the government collects the pay- ment made by households in the form of taxes, the government uses these collect- ions to defray expenses such as infrastruc ture, social services, education, economic development, ete. These amounts are spent back into the flow and offset the outflow of taxes. Government spending is, thus, our second inflow. When the Philippines purchases goods from other countries, itis because it expects these countries to reciprocate by buying HOUSEHOLDS “TAXES SAVINGS ————_> Economic Resources Purchase of Goods and Services \ [oe ee Income Payments of Wages, Rent, ‘and Interests ‘Goods and Services IMPORTS + Foreign Countries ——» EXPORTS —— Government Banks PRODUCING UNITS > EXPENDITURES. > INVESTMENTS Figure 14 ‘The Circular Flow of Economic Activity Reflecting The Outflows and the Inflowsitslocally produced goods. When the Philip- pines exports goods to other countries, they pay us and this money goes into the flow. Exports are the inflows that offset the out- ‘lows of imports. When the outflows in the economy equal the inflows, the level of economic activity is maintained. However, an excess of inflows over outflows will be expansionary since it will increase the level of economie activity. ‘The opposite effect will hold when outflows exceed inflows. The result is a contractin effect since it results in a decrease in the evel of economic activity. ‘After making a study of the inflows and outflows, we can now present a complete Picture of the circular flow of economic activity. A desire to change the level of economic activity in the flow may lead to the manipu- lation of 2 country’s inflows and outflows Outflows are, howover, difficult to control because they are dependent on income, When income increases, we expect savings, taxes, and imports to increase. Inflows are easier to manipulate. The proper use of policy enables the government, to encourage exports and investments and to increase its expenditures when it desires to expand the flow of economic activity. ‘Three sets of policy may be adopted. That, which affects savings and investment is called monetary policy. That. which controls taxes and government expenditures is fisoal policy. And that which affects a country's exports and imports is its trade policy. ‘The government applies the policies in accordance with its goal. A policy may be “easy” when the government's aim is expan- sion. A policy tends to be “tight” when there is a need to restrict the circular flow by making less funds available in the economy. Exercise 2 Name: __ ‘Year and Sect Exercise 1 Indicate the) Decrease, No Complete 1. The Cireu!