In a closed economy with no government the households buy the nation’s output of

goods and services and are owners of all the economy’s factors of production. They
supply these factors of production to the firms and receive payment from them. By
hiring these factors of production from the households, the firms make all of the
nation’s output of goods and services.

A country’s income is usually measured using GDP, however there are three main
different methods for calculating GDP: output, income and expenditure.

Output method: measures the actual value of all goods and services produced in the
country.

Income method: measures the value of all incomes earned in the economy.

Expenditure method: measures the value of all spending on goods and services. This
includes household spending (consumption), spending by firms (investment),
government spending, and spending on exports minus spending on imports.

The size of the circular flow depends on the size of the injections (STM) and
leakages (GIX).

When injections rise relative to withdrawals the economy will expand and when
withdrawals rise relative to injections the economy will contract.

MICRO
The role of the price mechanism

The price mechanism moves the market into equilibrium, so that the scarce resources
are reallocated.

Opportunity cost: is the next best alternative forgone. When a choice is made,
there is an opportunity cost.

Rationing function: Prices serve to ration scarce resources when demand in a market
outstrips supply.

Signalling function: prices rise and fall to reflect surpluses and scarcities,
which shows where resources are required.

If prices of bikes are rising because of high demand from consumers, this is a
signal to suppliers to expand production to meet the higher demand.

If there is excess supply in the market the price mechanism will help to eliminate
a surplus of a good by allowing the market price to fall.

An increase in market supply causes a fall in the relative prices of laptops and
prompts an expansion along the market demand curve.

When there is a shortage, the price is bid up – leaving only those with the
willingness and ability to pay to purchase the product. The market price acts a
rationing device to equate demand with supply.

Primary commodities: tend to have a low PES because there cannot be a sudden change
in how much is produced

Manufactured goods: tend to have a high PES because it is easier to change

production in factories or shops.