1.

0 The Market System and the

Circular Flow
SCARCE RESOURCES
ECONOMIC RESOURCES
PROPERTY RESOURCES
1. LAND

2. CAPITAL

HUMAN RESOURCES
3. LABOR
4. ENTREPRENEURIAL ABILITY
Resource payments: correspond to resource
categories
PROPERTY RESOURCES
RENTAL
LAND
INCOME
INTEREST
CAPITAL
INCOME
HUMAN RESOURCES

LABOR WAGES
PROFIT &
ENTREPRENEUR
LOSS
 Economic Systems
• Each society has to select an economic system
that addresses the economizing problem
• Definition: An economic system is a system of
production and exchange of goods and services
as well as allocation of resources in a society.
• Economic systems differ as to:
1) who owns the factors of production
2) the method used to motivate, coordinate, and
direct economic activity.
 The Command System
• The government owns most property resources
and economic decision making occur through a
central economic plan.
• The central planning board determines
production goals for each firm and resources to
be allocated.
 The Market System (capitalism)
• There is private ownership of resources.
• Markets and prices coordinate and direct
economic activity.
• Each participant acts in its own self-interest.
• In pure capitalism the government plays a very
limited role.
 The Circular Flow Model

• There are two groups of decision makers in the

private economy: households (resource owners)
and businesses (resource users)

• Markets are grouped into resource market and

the product market
What happens in the resource markets?
a. Households sell resources directly or indirectly
(through ownership of corporations) to
businesses.
b. Businesses buy resources in order to produce
goods and services.
c. Interaction of these sellers and buyers
determines the price of each resource, which in
turn provides income for the owner of that
resource.
d. Flow of payments from businesses for the
resources constitutes business costs and resource
owners’ incomes.
 The Circular Flow Diagram

RESOURCE
MARKET

RESOURCES INPUTS

BUSINESSES HOUSEHOLDS

9
 The Circular Flow Diagram

FACTOR
MARKET

RESOURCES INPUTS

BUSINESSES HOUSEHOLDS

GOODS & GOODS &

SERVICES SERVICES
PRODUCT
MARKET
What happens in the product markets?
a. Households are on the buying side of these markets,
purchasing goods and services.

b. Businesses are on the selling side of these markets,

offering products for sale.

c. Interaction of these buyers and sellers determines

the price of each product.

d. Flow of consumer expenditures constitutes sales

receipts for businesses.
 The Circular Flow Diagram
Mixed Economy
FACTOR
RESOURCES MARKET
INPUTS

GOODS & GOODS &

SERVICES SERVICES
BUSINESSES GOVERNMENT HOUSEHOLDS
TAXES TAXES

GOODS &
GOODS &
SERVICES
SERVICES
PRODUCT
MARKET
 The Circular Flow Diagram
Mixed Economy
• In a mixed economy we also have the government as an
important actor in the economy.
• Households pay taxes to government, personal income
tax.
• Businesses also pay taxes to government, corporate tax
or company tax.
• The government uses the tax revenue to provide public
goods both to households and businesses. What is a
public good?
Circular Flow further expanded
Capital and Labour Controlled
income Capital
And
Resource Labour
Market flows

Foreign
Businesses Government Households Exchange
Market

Product
Market
 Capital and Labour Controlled
income Capital
And
Resource
Market
Labour
flows

Foreign Foreign
Businesses Government Households Exchange
Market Sector

Export and
Import of
Product Goods and
Market Services

Export, Import payments

• THE IMPORTANCE OF NATIONAL INCOME
ACCOUNTING
• NATIONAL INCOME ACCOUNTING: an
internationally agreed system of measuring
the performance of the macroeconomy
OR
A measure used to assess an economy’s
performance by measuring the flows of
income and expenditure over a period of time
• IMPORTANCE OF
• NATIONAL INCOME ACCOUNTS
a. Provide useful information on whether the
economy is performing well in terms of
achieving its stated economic objectives
(EXAMPLES)
b. Provides a means of determining how the
economy compares with other economies
around the world
c. Allows us to measure the level of production
in an economy in some particular year and
explain why it is at that level
d. Information supplied by national accounts
provides a basis for designing and applying
public policies to improve the performance of
the economy
• MEASURING THE ECONOMY
• GROSS DOMESTIC PRODUCT (GDP)
• It is the principal measure of an economy’s
performance
• It measures the total MARKET VALUE of all
FINAL goods and services produced within a
given year by factors of production located
WITHIN a country
 POINTS TO NOTE ABOUT GDP
1. GDP is a monetary measure- money acts as a
common denominator for summing up the
output produced during a particular year
2. GDP measures the market value of final
goods and services- goods and services
bought for final use , rather than for resale or
further processing
• Intermediate goods are already included in
the value of final goods
• Therefore they are excluded from GDP
calculation to avoid the problem of
multiple/double counting.
• Multiple/double counting results in
overestimation/overstatement of the value of
output in the economy
• CLASS EXERCISE: is a loaf of bread a final good
or an intermediate good?
• Why would inclusion of final and intermediate
goods in measuring GDP lead to double
counting?
• To avoid double counting, take only the VALUE
ADDED to a product by each firm
• VALUE ADDED- the market value of a firm’s
output less the value of inputs which have
been purchased from others
• EXAMPLE: valued added in the production of
a litre of petrol
STAGES OF PRODUCTION VALUE OF SALE (Pula) VALUE ADDED
1. Oil drilling 1.00
2. Refining 1.20
3. Transporting 1.40
4. Retail sale 1.50
TOTAL 5.10
• CLASS EXERCISE: a farmer sells wheat to a
flour mill for P10.00. The baker buys flour
from the flour mill for P15.00 and makes
bread. The baker sells the bread P20.00 to the
consumer. What is the total contribution of
these transactions to GDP?
3. GDP calculation excludes the value of non
production transactions i.e. Purely financial
transactions and second hand good sales.
They do not involve current production
• Purely financial transactions – they are simply
transfer of funds e.g.tandabala, war veteran
payments
• Second hand sales are excluded because they
do not involve current production
 CALCULATING GDP
• 2 BASIC APPROACHES
• 1. Expenditure Approach: summing up all
expenditures on output
• 2. Income Approach: summing up all incomes
arising from production of output
• N.b. Using either of the two approaches will
give the same value of GDP, since spending
and receiving income are two sides of one
transaction
 EXPENDITURE APPROACH
• All final goods and services in an economy are
bought by
i. Households
ii. Businesses
iii. Government
iv. Foreigners
• Therefore GDP (Y) will be the sum of
consumption spending by households (C),
Investment spending by businesses (Ig),
Government spending on goods and
services(G) and spending by foreigners (Xn)
• Therefore GDP is calculated as
• Y = C + Ig + G + Xn
 NOTE
• C includes spending by households on both
durable and non durable goods as well as on
services
• Gross Private Domestic Investment (Ig)
includes machinery, equipment, tools, all
construction as well as changes in inventories
 GROSS INVESTMENT vs NET
INVESTMENT
• Ig refers to all investment goods used up in
production of output for a given year plus any
net additions to capital stock
• Ig= Net investment + depreciation/wear and
tear of capital. Hence
• Net investment = Gross investment –
depreciation/wear and tear of capital
 NOTE
• When Gross Investment > depreciation, Net
investment is positive
• When Gross Investment = depreciation, net
investment equal to zero
• When Gross Investment < depreciation, net
investment is negative
• N.b. We use Gross investment in the
computation of GDP
• Government purchases of goods and services
(G) includes all spending by government on
final goods and purchases of direct resources
• Net Exports (Xn) refers to the value of
exports (X) less imports (M) i.e. Xn = X – M
• If X > M, then Xn > 0
• If X < M, then Xn < 0
• Total Spending = C + Ig + G + Xn
• GDP = Total Spending = C + Ig + G + Xn
 EXAMPLE: Use the following
information to calculate GDP by
Expenditure Approach
• Personal Consumption 9734
• Compensation of Employees 7125
• Government Consumption 2690
• Gross Private Domestic investment 2125
• Consumption of fixed capital 1657
• Net exports -708
• Corporate Profits 1627
• Rent 65
• Interest 603
• Net Foreign Factor income earned 96
• Taxes on production and imports 1009
• Proprietor’s income 1043
• Statistical discrepancy 29
• Social security contributions 979
• Corporate income taxes 467
• Undistributed corporate profits 344
• Transfer payments 2237
• Personal Taxes 1482
 INCOME APPROACH
• Calculates GDP by adding up all incomes
arising from production of output
• Therefore
• Compensation of employees
• +
• Rents
• +
• interest
• +
• Proprietor’s income
• +
• Corporate Profits
• +
• Taxes on production and imports
• = NATIONAL INCOME
• -
• Net Foreign Factor Income (+-)
• +
• Statistical Discrepancy
• +
• Consumption of Fixed Capital
• =
• GROSS DOMESTIC PRODUCT (total income)
 GDP Approaches Compared
Receipts Allocations
Expenditures Approach Income Approach
Personal Consumption (C) P 9734 Compensation P7874
Gross Private Domestic 2125 Rents 65
Investment (Ig)
Government Purchases (G) 2690 Interest 603
Net Exports (Xn) -708 Proprietor’s Income 1043
Corporate Profits 1627
Taxes on Production and 1009
Imports
National Income P12, 221
Less: Net Foreign Factor 96
Income
Plus: Statistical Discrepancy 29

Consumption of Fixed Capital 1687

Gross Domestic Product P 13,841 Gross Domestic Product P13,841

 OTHER NATIONAL ACCOUNTS
• Other measures of performance include; Net
Domestic Product (NDP), National Income
(NI), Personal Income (PI), Disposable income
(DI), Gross National Product (GNP), Net
National Product (NNP)
• These are obtained by making adjustments to
GDP
 Net Domestic Product (NDP)
• GDP adjusted for depreciation/consumption
of fixed capital
• NDP = GDP – Depreciation
• Calculate NDP from the example above
 NATIONAL INCOME
• This is income earned nationals who supply
resources either domestically or abroad
• There are 2 ways of calculating NI
1. Add compensation of employees, rent,
interest, proprietor’s income, corporate
profits and taxes on production and imports
2. Subtract statistical discrepancy from NDP and
add NFFI (Use example above to calculate
NI) . NI = NDP –Statistical Discrepancy + NFFI
 PERSONAL INCOME (PI)
• All income received by households.
• Includes both earned income and unearned
income
• Differs from NI in that under NI some income
does not flow to households i.e. it is not
received by households e.g
• Therefore we obtain personal income by
subtracting income earned but not received
households, and adding income received by
households but not earned
• PI= National Income
Less
Taxes on Production and imports
Less
Social Security Contributions
Less
Corporate Income Taxes
Less
Undistributed Corporate Profits
Plus
Transfer Payments (calculate PI)
 DISPOSABLE INCOME (DI)
• DI is income left for households after paying
personal taxes.
• DI = PI – Personal Taxes
• Calculate DI from example above
• N.B. DI is either consumed (C) or Saved (S)
• Therefore we can express DI as
• DI = C + S
GROSS NATIONAL PRODUCT (GNP)
• GNP is a monetary measure of the total
market value of all final goods and services
produced by the country’s owned resources
within a year irrespective of where it is
produced
• GNP = GDP – NFFI
• NFFI is positive if income earned by citizens
abroad is greater than income earned by
foreigners in Botswana
• NFFI is negative if income earned by citizens is
less than income earned by foreigners in
Botswana.
• Calculate GNP using the example above
 NET NATIONAL PRODUCT
• This is GNP adjusted for depreciation i.e.
• NNP = GDP – Depreciation
• Calculate NNP
 NOMINAL GDP vs REAL GDP
• REMEBER: GDP is a measure of the market
value of final goods and services produced by
the economy during a given year
• Money acts as a common denominator for
summing different types of goods to come up
with a meaningful value of total output
• We obtain the value of output by multiplying
output by the market price Illustrate
• Therefore if we calculate the value of output
by multiplying output by market prices, it
becomes difficult to assess whether the
increase/decrease in the value of GDP reflects
both the change in output and price level or
what
• This necessitates distinguishing between
NGDP and RGDP
• NGDP- the value of GDP unadjusted for
inflation. i.e. It shows the value of GDP at the
prevailing market price when the output is
produce. Example
• 1990 nominal GDP measures the value of
goods produced in 1990 at the prices that
prevailed in 1990
• Hence NGDP is the value of goods and
services measured at current prices. Illustrate
• RGDP – the value of GDP adjusted for inflation
i.e. It shows the value of GDP at base year
prices
• Real GDP shows the value of goods and
services measured using a constant set of
prices
• Illustrate
• To eliminate the effect of the change in prices
on the value of GDP so that the change in GDP
reflects only the change in output we use the
GDP deflator/GDP price index
• GDP price index is a measure of the price of a
specified market basket of goods and services
in a specified year compared to the price of an
identical basket in the base or reference year
• Therefore GDP deflator =Nominal GDP/Real
GDP
• GDP deflator x Real GDP = Nominal GDP
• Real GDP =Nominal GDP/GDP deflatro
 Use the following table for a
hypothetical single product economy
Year Units of output Price per unit Price index (year
1=100)
1 10 10 100
2 12 20 200
3 16 30 300
4 20 40 400
• Calculate:
• A. Nominal and real GDP in year 3
• B. Nominal and real GDP in year 4
 Shortcomings of GDP
a) Non market transactions
i. As a measurement of the market value of output fails to
include certain production transactions that do not take place
in the market e.g. (homemakers’ services, parental child care,
volunteer efforts, and home improvement projects).
b) Leisure
Benefits derived from leisure are not included in GDP

c) GDP does not measure improvements in product

quality. Therefore, failure to account adequately for
quality improvements is a short coming of GDP
 Shortcomings of GDP
d) The Informal sector Economy
– Illegal activities are not counted in GDP (estimated to be
around 8% of S.A. GDP).
– Such illegal activities include among others loan sharking,
prostitution, sale of illegal substances/drugs
– Legal economic activity may also be part of the “informal
sector,” usually in an effort to avoid taxation.

e) GDP and the environment.

– The harmful effects of pollution are not deducted from GDP
(oil spills, increased incidence of cancer, destruction of
habitat for wildlife, the loss of a clear unobstructed view).
– GDP does include payments made for cleaning up the oil
spills, and the cost of health care for the cancer victim.
f) GDP makes no value adjustments for changes in the
composition of output or the distribution of income.
– GDP reflects the size of output with nothing said
about whether this collection of goods is “right" for
society
– Per capita GDP may give some hint as to the relative
standard of living in the economy; but GDP figures do
not provide information about how the income is
distributed.

f) Non economic Sources of Well-Being like

courtesy, crime reduction, etc., are not covered in
GDP.
 Limitations/shortcomings of GDP or
Problems of measuring GDP
1. Non market transactions: certain production
transactions that do not take place in markets
are excluded from national income calculations
e.g. Home owner’s service
2. Leisure which has a positive effect on well being
is omitted in measuring NI
3. Improved product quality is not reflected
accurately in NI calculation
4. The underground economy in the form of
gambling,smuggling, prostitution and drug
dealing are not captured in NI
5. NI and the environment; Growth of NI
includes by-products such as polluted water,
toxic wastes etc. The social costs of these
negative bye products which affect the
environment reduce national economic well –
being. These costs are not deducted from
national output therefore the nation’s well-
being is overstated
Income –Consumption and
Income-Saving Relationship
• Income refers to disposable income (Yd)
• Yd is an important determinant of C and S
• i.e people consume and save out of their Yd
• Hence Yd = C + S
• Yd –C = S
• Yd – S = C
 CONSUMPTION AND SAVING
• CONSUMPTION EXPENDITURE
Refers to what is spent on goods and services
• A function of Yd
• Positive/direct relationship
• The relationship between C and Yd can be
conceptualialized through a consumption
schedule
• Consumption Schedule –shows the various
amounts that households plan to consume at
various levels of Yd
• EXAMPLE
 CONSUMPTION SCHEDULE
Level of Income (Y) Consumption (C)
370 375
390 390
410 405
430 420
450 435
470 450
490 465
510 480
• The relationship between disposable income
and saving can be conceptualized in terms of
a Saving Schedule
• Saving Schedule- shows the amounts that
households plan to save at various levels of
disposable income
• EXAMPLE
 SAVING SCHEDULE
Level of Income Consumption (C) Saving (S)
370 375 -5
390 390 0
410 405 5
430 420 10
450 435 15
470 450 20
490 465 25
510 480 30
• S = -5
• Dissaving i.e. C > Y. How?
• Breakeven income- income at which
households plan to consume their entire
income
• At breakeven point the level of saving is zero
• At what income level is breakeven income on
the table above?
• The relationship between Yd, C and S can
shown through the following diagram
• (ILLUSTRATE ON BOARD)
 Consumption and Saving Schedules

500

475
Consumption
450
Schedule
Consumption (Pula)

425

400

375

50 45°
Disposable Income (Pula)
25
0 Saving Schedule
Saving
(Pula)

Disposable Income (Pula)

 Points to note
• Direct relationship between Yd and C
• Direct relationship between Yd and S
• Consumers save more of their income at
higher levels of income than at lower levels of
income
• At low levels of income, consumers tend to
spend more than their current incomes i.e.
there is dissaving at low levels of income
• Breakeven income – where households
consume their entire income
• 45 degree line- line of reference. On this line,
consumption = disposable income
 AVERAGE AND MARGINAL
PROPENSITIES
• Average Propensity to Consume (APC) vs
Average Propensity to Save(APS)
• APC –the fraction of total income that is
consumed
• i.e. APC = Consumption/Income
• APS – the fraction of total income that is
saved
• i.e. APS = Saving/Income
• Since Yd is either consumed or saved, at any
level of Yd the sum of APC and APS must be
equal to 1
• i.e. APC + APS = 1
• On the table below, fill in the figures for APC
and APS
Level of Consumption Saving (S) APC (C/Y) APS (S/Y)
Income (Y) (C)
370 375 -5
390 390 0
410 405 5
430 420 10
450 435 15
470 450 20
490 465 25
510 480 30
 Points to Note
1. APC falls as the level of income increases .
This is because at higher levels of income, a
lesser fraction of Yd is allocated to
consumption
2. APS increases as the level of income
increases. This is because the level of saving
increases as income increases
• Marginal Propensity to Consume (MPC) vs
Marginal Propensity to Save (MPS)
• There is a direct relationship between C and
Yd
• C changes as Yd changes but the change in C is
less than the change in Yd
• The proportion of income consumed is called
the Marginal Propensity to Consume (MPC)
• MPC is the ratio of change in C to change in
income
• MPC = Change in Consumption/Change in Income
• MPC < 1
• MPC is the slope of the Consumption Function
• This implies that out of a unit increase in Y only a
fraction is spent on C
• The remaining fraction is saved
• The proportion or fraction of income saved is
the Marginal Propensity to Save (MPS)
• MPS = Change in Saving/ Change in Income
• MPS < 1
• MPS is the slope of the saving function
• The sum of MPC and MPS for any change in
disposable income must always be 1. i.e. MPC
+ MPS = 1
• This is because any change in income is either
allocated to consumption or to saving,
therefore the sum of the two fractions must
equal 1
• Fill in the figures for MPC and MPS in the
table below
Level of Consumpt Saving (S) APC APS MPC MPS
Income ion (C) (C/Y) (S/Y) (∆ C/∆Y) (∆S/∆Y)
(Y)
370 375 -5 1.01 -.01
390 390 0 1 0.0
410 405 5 .99 0.01
430 420 10 .98 0.02
450 435 15 .97 0.03
470 450 20 .96 0.04
490 465 25 .95 0.05
510 480 30 .94 0.06
 CONSUMPTION FUNCTION AND
SAVING FUNCTION
• The relationship between consumption and income can
also be represented in terms of a consumption function i.e.
• C = a + bY
• Or
• C = a + bYd
• Where ; where C is consumption spending, a =
autonomous spending (consumption), b is the MPC and Y is
income (diagram of the C function)
• N.B. The consumption function shows a positive
relationship between C and Y
• The relationship between saving and income can also
be represented in terms of a saving function
• S = -a + (1-b)Y or
• S = -a + (1-b)Yd
• Where S is saving; -a is the intercept of the saving
function and shows dissaving by households; 1-b is the
MPS and Y is income
• Diagram of the saving function
• N.B. The saving function shows a positive
relationship between S and Y
• Remember : MPC + MPS = 1
• MPS = 1- MPC
• Since MPC is b,
• MPS = 1 – b.
 MOVEMENT ALONG A CONSUMPTION FUNCTION
vs A SHIFT IN THE CONSUMPTION FUNCTION

• A movement from one point to another on

the consumption function shows a change in
the amount consumed caused by a change in
income
• A shift in the entire function is caused by
other factors other than income.
• These factors are the NON INCOME
DETERMINANTS INCOME
 NON INCOME DETERMINANTS OF
CONSUMPTION AND SAVING
• 1. WEALTH
• Wealth is the value of both real assets and
financial assets
• Households save to accumulate wealth
• When existing wealth increases, the
consumption curve shifts upward and the
saving curve shifts downward
• 2. EXPECTATIONS
• Households expectations about future prices
and income may affect C and S
• E.g. If households expect a recession and
therefore lower income in future they may
reduce C and save more
• Therefore the C function shifts to the up and
the saving function shifts to the down
• 3. Taxes
• Taxes are paid partly at the expense of
consumption and partly at the expense of
saving.
• Therefore an increase in taxes will shift both
the C and S functions to the down
• 4. Real interest rate
• 5. Borrowing
INVESTMENT EXPENDITURE
• Investment consists of expenditure on
machinery, equipment, tools, all construction
as well as changes in inventories
• The decision to invest by any firm is based on
cost benefit analysis of undertaking such
investment
• When making an investment decision, firms
consider the marginal benefit(mb) and
marginal cost(mc) of their investment.
• MB of investment- the expected rate of return
(or profit)
• MC of investment- interest rate that must be
paid for borrowed funds
• If mb > mc –invest in project
• Therefore the investment decision is a mb_mc
decision
• Hence the expected rate of return and the real
interest rate are the two determinants of
investment
• Expected rate of return is found by comparing
expected economic profit (TR – TC) to cost of
investment
• Real interest rate is nominal interest rate less
expected inflation
• N.B. Interest rate represents either the cost of
borrowing funds or the opportunity cost of
investing your own funds, which is income
forgone
• If real interest rate is greater than expected rate
of return, Investment should not be made
• As long as r > i, I is expected to be profitable. The
firm should invest up to a point where r = i.
Investment demand schedule or curve
• Shows an inverse relationship between the
real interest rate and the amount of
investment
• The investment demand curve is downward
sloping
• This reflects an inverse relationship between
real interest rate and the quantity of
investment demanded
• N.b. In making an investment decision, firms
consider the real interest rate, not the
nominal interest rate
• Investment demand
• Diagram
• STUDENTS TO DO (discuss the factors that
cause the investment demand curve to shift)
Shifts in the investment demand curve
• It is caused by change in non interest rate
determinants of investment
• Greater expected rate of return creates more
demand. Therefore it shifts the demand curve
to the right
• Investment does not vary with income
• We assume that investment is constant
• Suppose the current interest rate is 8%
• Suppose further that investment level at this
interest rate is P20b
• DIAGRAM, INVESTMENT SCHEDULE
• The investment schedule shows the amounts
business firms collectively intend to invest i.e.
Planned investment
Real domestic Consumption Savings (S) Investment (Ig) Aggregate
output (Y) (C) Expenditure C
+ Ig
370 375 -5
390 390 0
410 405 5
430 420 10
450 435 15
470 450 20
490 465 25
510 480 30
530 495 35
550 510 40
• What is the equilibrium output? Why?
• Diagram illustration
• Mathematical illustration: suppose that the
consumption schedule for a private closed
economy is
• C=100 + 0.75Y
• Assume further that planned investment Ig is
independent of the level of real GDP and
constant at Ig=50
1. Calculate equilibrium level of income or the
real GDP for this economy
2. Calculate the consumption level and the
savings level
3. What happens to equilibrium level of income
if Ig increases by 10
1.
Y = c + Ig
• Y= 100+0.75Y + 50
• Y – 0.75Y = 150
• 0.25Y =150
• Divide through by 0.25
• Y =600
2. C= 100 + 0.75Y
C= 100 + 0.75(600)
C= 100 + 450
C = 550

Y= C + S
600 = 550 +S
S=50
• 3. The new investment is 50 + 10 =60
• Y= 100 + 0.75Y + 60
• 0.25Y=160
• Y=640
• Equilibrium income increases from 600 to 640