Macroeconomics Week 3

Topics:

1. Four Basic Economic Questions

2. Economic Systems
3. Circular Flow Model
a. Circular flow model of output and income
b. The Multiplier Effect
c. Inflows and Outflows

Four Basic Economic Questions

1. What to produce?
2. How to produce?
3. For whom to produce?
4. How much to produce?

Economic System
 set of economic institutions that dominates a given economy
 are those social organizations, relationships and arrangements which determine in a given society
the manner in which scarce resources are utilized to satisfy human wants
 determines the answer to the fundamental economic questions (principal objectives)
 every economic system attempts to achieve in one way or another, a viable economy where
society as a whole can be able to maximize the general welfare of the citizenry focusing towards
a common goal: high standard of living for all citizens.

Regardless of what economic system a country adopts, salient functions should characterize any
economic system
1. to produce the goods for consumption of the population
2. to utilize the resources in efficient method of production
3. to employ the labor force in occupations where productivity is at optimum
4. to apportion the wealth and income available to everyone in an equitable manner
5. to encourage innovation and technology in order to maximize efficiency, optimize satisfaction
and minimize waste

Types of Economic System

1. Traditional Economy
a. Production methods, exchange and distribution of income are made according to customs
and traditions
b. Response to the problems of production and distribution of economic goods is based on
ways procedures and systems which have been handed down from one generation to the
next
c. Problem of production is met using the mechanism in identifying which goods to
produce, in assigning the task in the production process, and in deciding the type of
production technology to be used.
d. Subsistence economy- production is being shared with in the community, taking only
what they need
e. Type of economy very backward, it does not allow change to respond to the changes in
time
 2. Capitalist or Market Economy (laissez-faire, market economy, free enterprise, price
mechanism, free market economy)
a. No government intervention
b. Existence of consumer sovereignty
c. Mobility of labor
d. Right to own property
e. Presence of competition
f. Profit motivation
g. Wide gap between rich and the poor
h. Existence of unemployment
i. Misallocation of resources
j. Shortage of manual labor

Allocation of Resources

What to produce?
 Consumer sovereignty. The consumer will dictate the types of goods to be produced.
How to produce?
 Technical efficiency- the producer will use the least input to produce a given level of
output
 Economic efficiency- cheapest method of production
For whom to produce?
 Basically determined by the peso votes (those with purchasing power will eventually get
the goods). In other words, higher income gap groups has the bigger share of the national
pie because of their stronger purchasing power. (communist argument)

Weaknesses and reasons why the government needs to intervene in the market economy

Public Goods
1. Can be defined in terms of two principles.
a. Principle of non-excludability- nobody can be excluded from using the good
b. Principle of non-rivalry- where A is using , B can also use it at the same time. In
other words, consumption of good by A will not diminish the consumption by B.
2. In market economy- private sector is not willing to supply public goods.
a. Free rider problem- people enjoys goods/services but does not pay for it.
It is impossible to price the product (Ex. Street lights, defense, lighthouses, road
signs). Goods have to be provided by the government.

3. Command Economy – Centrally planned economy

a. everything is controlled by the government – no private sector
b. consumer sovereignty does not exist in communist system
c. Due to absence of competition, complacency sets in.
d. Theoretically, unemployment does not exist in the communist system.
e. Theoretically, in a planned economy, there is no difference between the rich and the
poor. (class-less society)
f. There is no business freedom in a communist system
g. One of the demerits of this system is that the government may produce goods that
is not required by the public.
 4. The Mixed Economy- all economies are to some extent , mixed. Its just a matter of degree of
intervention.
 The US in theoretically a capitalist economy but in reality , 10% of its economic actties
are carried out by the government.
 As for China, it is theoretically communist economy, yet there are new private
eneterprises in China
 In the real world, all economies are to some extent, mixed

Characteristics
a. There are both public and private sectors working hand in hand so as to ensure economic
growth
b. The role of the public sector is not to compete with but to compliment the private sector by
providing the infrastructure so that economic activities can be carried out effectively and
efficiently
c. The government will not intervene in all matter but only in particular industries, where
o initial costs (incurred during the design and construction phase) or the fixed
costs ( costs independent to the volume / based on time rather than the
quantity produced or sold by the business ex: rent, lease, salary, utility,
insurance, loan repayments) are too exorbitant for private sector undertake,
for example MRT in Singapore.
o Not profitable (low-cost public housing)
o Involves provision of social services (provided by the government to increase
the general living standard of the people)
o Duplication is to be avoided and hence wastage of resources which are scarce
(single producer is necessary to undertake certain economic activities to
avoid unnecessary competition)
o Strategic military reasons are involved (self-sufficiency in terms of good
production, military equipment
o Humanitarian reasons are involved (if all economic activities are to cater for
the rich who will cater for the needs of the poor in remote, rural areas)
d. In a mixed economy, the government will try to reduce income inequality by imposing
progressive tax system where higher income earners are taxed more proportionately than the
low income earners. (narrowing the gap between the rich and the poor)
e. The government will also control the existence of monopolies. Single seller – reduced
production of output to maintain the price of a commodity at artificially higher levels.
Government regulates and controls the power of the monopolist.

Factors of Production

Production- act of making goods and services to satisfy human wants and maximize profits.
 Manufacturing of goods
 Distributing the goods produces
 Providing services

1. Land (natural resources)- includes all resources found in the sea and on land. The range of
natural resources will determine the capability of the economy to produce.
Includes:
a. Raw materials such as- copper, timber and rubber
b. Landscape such as mountains ,valleys and hills
c. Ports/ natural harbor
 d. Climatic conditions (rain/snow)
e. Geographic location such as continents and islands
Characteristics:
 Immobile
 Limited in supply- can be reclaimed from the sea
 Gift of nature
 Subjected to the law of diminishing returns

The law of diminishing returns states that in productive processes, increasing a factor of production
by one, while holding all others constant, will at some point return lower output per incremental input
unit.[1]

2. Labor – any kind of work, either mental or manual, which has a sole purpose of receiving
rewards.
Alfred Marshall- labor can be defined as any exertion that the mind or body has undergone, either
partly or totally, with view of earning some other good other than pleasure derived from the work
itself.

Characteristics:
 A labor offers his services not himself
 Labor cannot be separated from the worker (cannot be divorced from the person)
 Cannot be kept of stored
 Human beings and are not void of emotion
 Greater mobility than land but less mobile than capital
 Not a homogenous product ( as different people have different skills and attitudes)

3. Capital
 wealth used for production.
 It is created not for itself but for what it will eventually produce.
  Stock of goods made by the people to help them in the production of goods and services.

Types
 Working capital- stock of goods that vary with the level of output. When output increases, the
amount of working capital also increase. When output is zero, working capital is also zero. Goods
produced but unsold are also considered working capital. (e.g. raw materials, components, semi
finished product etc)
 Fixed capital- physical asset or durables which do not vary as the level of output varies.
o Output= zero, fixed capital has to be incurred and its form will not change in the process
of production. (factory, machinery, management and utilities)
 Social Capital- not directly related to the production of goods and services. It is meant to increase
the productivity of the workers in general (labor force in the country). Usually provided by the
government ( education, medical housing, recreational facilities)

4. The Entrepreneur
o organizer of the company.
o Responsible for arranging how production should take place.
o Responsible to his subordinates and their welfare.
o Solves the 3 basic economic problems.
o He coordinates all the factors of production to produce goods and services.
Function
o Undertakes risks and is responsible for all decisions that need to be taken. (insurable risks/non-
insurable or uncertainties)
o Coordinates all the factors of production in the best possible combination so as to maximize
profits and minimize costs.
o Decision to recruit and to retrench workers will be made by him depending on the market
conditions.
o Responsible for marketing his own product. (media and different methods to promote,
distribution channels such as retailers that is available to different locations, conduct surveys,
organizing sales promotion especially when the product is new)
o Undertake research and development (R&D). (innovation/invention of new products as well as
new methods of productionto keep pace with the modern developments.

Circular Flow Model

d. Circular flow model of output and income
e. The Multiplier Effect
f. Inflows and Outflows
 o The basic purpose of the circular flow model is to understand how money moves within an
economy.
o It breaks the economy down into two primary players: households and corporations.
o It separates the markets that these participants operate in as markets for goods and services and
the markets for the factors of production.
o Other sectors can be added for more robust cash flow tracking.

o The circular flow model is used to measure a nation's income, as the circular flow model
measures both cash coming into and exiting a nation's economy.

o It is also used to gauge the interconnectivity between sectors as a fully robust and strong
economy will have interaction between components. For instance, the relationship between a
government's taxation policies and a household's consumption spending will have a direct
impact on a business's ability to sell goods.

Sectors of a Circular Flow Model

There are different types of circular flow models, each with a different number of sectors it tracks.
Below are the potential sectors that could be included in a circular flow model. Each sector within a
circular flow model may be designated with a capital letter often used to describe how to calculate GDP.

Household Sector
In a two-sector model, circular flow models start with the household sector that engages in consumption
spending (C). Households contribute to an economy by working (giving away time and labor) and by
buying products (giving away money). In return, households consume products and utilize government
programs.

Business Sector

In a two-sector model, circular flow models also include the business sector that produces the goods.
Businesses absorb a variety of production costs including labor, materials, and overhead. As a result,
many companies are able to manufacture products that benefit other parties.

Government Sector

In a three-sector model, government sector cash flows are included. The government injects money into
the circle through government spending (G) on programs such as Social Security and the National Park
Service. It also extracts money from households and businesses by way of taxes.

Foreign Sector

In a four-sector model, money also flows into the circle through exports (X), which bring in cash from
international buyers from the foreign sector. By extension, this indicates that the two-sector or three-
sector models are domestic activity only. The foreign sector is different from the domestic sector as
there may be administrative inefficiencies that result in lost cash flow due to import taxes, duties, or
fees.

Financial Sector

In a five-sector model, cash flow from the financial sector is added. This includes banks and other
institutes that provide cash flow via lending services. Some circular flow models also outline investor
activity, as cashflow from entrepreneurs and investors may represent an inflow to businesses while net
profits from the company represent an outflow.

A change in one sector may critically change the rest of the circular flow model. For example, imagine if
governments doubled individual tax rates. This change would likely have major repercussions on
business, individuals, and other sectors within the circular flow model.

Circular Flow Model: Injections and Leakages

Just as money is injected into the economy, money is withdrawn or leaked through various means as
well. Taxes (T) imposed by the government reduce the flow of income. Money paid to foreign
companies for imports (M) also constitutes a leakage. Savings (S) by businesses that otherwise would
have been put to use are a decrease in the circular flow of an economy’s income.

A government calculates its gross national income by tracking all of these injections into the circular
flow of income and the withdrawals from it. The circular flow of income for a nation is said to be
balanced when leakage equal injections. That is:

 The level of injections is the sum of government spending (G), exports (X), and investments (I).
  The level of leakage or withdrawals is the sum of taxation (T), imports (M), and savings (S).

When G + X + I is greater than T + M + S, the level of national income (GDP) will increase. When the
total leakage is greater than the total injected into the circular flow, national income will decrease. As
long as a country's injections is greater than its leakages, a country's economy can theoretically remain
sustaining forever. However, if there are cash flow shortages (i.e. leakages), the country must find
additional cash flow to compensate for the shortage.

Calculating Gross Domestic Product (GDP)

GDP is calculated as consumer spending plus government spending plus business investment plus the
sum of exports minus imports. It is represented as GDP = C + G + I + (X – M).

If businesses decided to produce less, it would lead to a reduction in household spending and cause a
decrease in GDP. Or, if households decided to spend less, it would lead to a reduction in business
production, also causing a decrease in GDP.

GDP is often an indicator of the financial health of an economy. A common, though not official,
definition of a recession is two consecutive quarters of declining GDP.1 When this happens,
governments and central banks adjust fiscal and monetary policy to boost growth.

Keynesian economics, for example, believes that spending leads to economic growth, so a central bank
might cut interest rates, making money cheaper, so that individuals will buy more goods, such as houses
and cars, increasing overall spending. As consumer spending increases, companies increase output and
hire more workers to meet the increase in demand. The increase in employed people means more wages
and, therefore, more people spending in the economy, leading producers to increase output again,
continuing the cycle.