The Circular Flow of Economic Activity.
The spending ability by the consumer greatly factors in determining the type, quality and quantity of goods and services that an organization should provide. This cycle of income and expenditure is referred to as the circular flow of economic activity. It is to be clearly noted that for economic prosperity in the society income of the citizens should exceed their related expenditure. In the event that expenditure exceeds income levels, then the economy of the society is said to be on recession. It is still to be noted that any economic equilibrium is the state where expenditure and income are equal thus implying stagnation of the nations economic. Therefore, it should be in the sole purpose of any government to put in place the necessary measures for ensuring economic prosperity.
This paper is a critical analysis of the concept of the circular flow of economic activity as applied in the field of economics. The author in particular talks a look at how such an economic model is useful in explaining the economic growth of a nations economy. Diagrams are used in support of the authors arguments.
The Concept of Circular Flow of Economic Activity
The economy of any human society must involve the activities of production and consumption. To be noted here is the fact that firms are both producers and consumers in the circular flow chain while the household serves the consumption aspect of our economic chain. Production can be defined as any act of using available economic resources in the process of creating goods and services which match the needs of the consumers. Consumption on the other side can be defined as the act of purchasing goods and services either for household use or for use in the process of making new goods and services. The later is the reason behind the qualifying of firms as consumers. It is also to be noted that economic activities also include employment and income generation. Employment is the acquisition of human resources for the benefits of realizing the production of goods and services by a firm. Income generation as an economic activity includes all the costs incurred by the organization in the process of producing goods and services. Such could include costs for purchasing raw materials, labor wages and other expenses incurred by the firm during the production process.
Types of circular flow of income models
There are two types of circular flow of income models. The first is the two sector model type of circular flow of income which assumes no changes in the levels of income and expenditure as well as the ultimate output of the economic activity. The model assumes that only the firm and the households are the key players in the economic development of a community. Here, the household spends on goods and services thus giving income to the firms which in return spend the gained income to sustain its production processes. In this model, income, expenditure and output should be equal for economic equilibrium to be realized. This illustrated in figure 1.
SHAPE MERGEFORMAT
Fig 1. An illustration of the two sector model
A diagram showing the two sector model
The other model is the five sector model which takes into consideration the economic development role played by financial institutions, the government and foreign contributions. Financial institutions here are seen as a source of investment capital to the investors as well as an institution for saving the extra income of the consumers. The government sector on the other side involves in the taxation of its citizens in return for the protection it provides to them. It should also be noted that the government is also responsible for spending such revenue collections on development projects such as building of road infrastructures and funding of the health and education sectors of our community. Foreign or oversea sector in the five sector model is quite crucial in enhancing the process of importation and exportation involvements of the economy. It is to be realized here that imports and exports are a crucial factor in any economy. It is such acts which provide for both access to goods and services unavailable in the nations as well as expanding the market for goods and services produced in the nation. It is this sector of the model which converts the nations economy to an open economy. It should be noted that the nations expenditure must not be higher than its income for exports if the economy is to be sustainable. In this model, economic equilibrium is realized when all involved expenditure cancels the incomes realized. This is demonstrated in fig
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Fig 2. An illustration of the five sector model
Principles of economics as explained by the circular flow of economic activities
The economic development and sustainability of any society is highly dependent on production and consumption. It is to be noted here that the production process is determined by the availability of economic resources such as physical facilities, lobar and investment capital. Land is the physical resource required for the construction of the factory facilities and agricultural activities. It should also be noted that land is the source of most of the economic resources required by firms in the production process. Such resource as electricity and minerals are found in the soil, making land a crucial factor in the production process.
The availability of qualified and reliable lobar force is another basic requirement for sustainable production in any firm. It is the human resource which factors greatly in ensures the efficient operation of any organization. It should also be noted that by providing for employment, the firms are initiating the reciprocal factor of economic activities. With good wages, workers as consumers will increase their purchasing power for goods and services thus increasing the overall income margins for the firms. This will have the end result of increasing investment capacity for firms and thus ensuring a sustainable economic growth in the nation.
Any investment requires capital. These are the durable goods and facilities which positively influence the production process. Such include setting up of factories and offices as well as investing in other production supportive requirements. It is to be appreciated that it is investment capital is mainly in form of loans from financial institutions customer gained income through purchase of the companys goods and services or from the investors own savings. It is due to this reason that financial institutions play an important role in the economic growth of any society.
The concept of circular flow of economic activities is found in the concept of stocks and flow. The decision making process pertaining the economic position of any investment lies on its stock flow records. As a cycle of economic value reciprocation, it is worth noting that the use of economic resources in the productions process requires demand for a return value to the firms. It is due to this that goods and services are usually purchased at a given marketplace price. Such income gained from the sell of the products will serve to pay wages for workers, rent to the landowners and contribute to the tax kit of the nation. With income, the workers will increase their purchasing power thus consequently increasing the overall economic potential of the firms. The government on the other side will invest on societal development projects thus realizing a sustainable development in the nation. It is this cycle of interaction from production, employment, capital generation and consumption which leads to circular flow of economic activities in the society.
It is still to be realized that it is the household which provides most of the economic resources needed by firms in the production process. Households are the owners of the land which they offer at a fee to the investors. Still to note is that the consumers are the source of the labor that serves to oversee the production of goods and services in the company. The investment capital is another thing which proves the reciprocal nature of the economy of any society. It is to be understood that most investments rely on financial institutions for funding of their projects. Still to be appreciated is the fact that the financial institutions a heavily reliant on the consumer savings for their survival. This makes the economic growth of a society thus a circular flow of income among the producers and the consumer.
The concept of equilibrium and adaptation to disequilibrium
Economic equilibrium is defined as an economic state in which both the firm s and the consumers have equally benefits or spends towards the involved economic activity. It is only in such a state that sustainability of the economic can be realized. It is however to be stated here that this is not always the case in the real business world. It is a common practice by many consumers to change their purchasing patterns while seeking to save for their future lives. This leads to decrease in the companys projected market returns. Such decreases in the overall market returns of the company have a result of risking the retrenchment of the employees and closure of some production facilities. All these will have the end result of reducing the household income levels thus further reducing their purchasing power. Failure to rectify such circular flow of economic declines can lead to the ultimate down fall of the nations economic. It is in fact a result of such economic practices that the globe is experience an economic recession.
It is however to be noted that the problem of reduced can be easily by the firms. It is in the knowledge of many investors that consumer only spend part of their income while saving the rest for future use. This has the ultimate result of leading to contraction of the circular flow of the economy. However, this can be easily prevented by the firms if they spend most of their unsold output in increasing their future production capacity. This ensures that the firms spend more capital investments to reduce their investment needs in the future. Such disposal mechanisms will help reduce the immediate production capacity thus matching the household demand thus eliminating the disequilibrium factor in the economic. This aids in the normalization of the circular flow of the economic activities.
Circular flow with government and oversea investors
The inclusion of government and foreign investors in the circular flow of economic activities makes the circular flow more realistic. It is to be noted here that the government is for the people and made of the people. This means that the execution of governments responsibilities must be heavily reliant on the citizens contribution towards the governments upkeep. It is however to be noted that such contributions to the government are a direct reciprocal act owing to the protection that the government offers to its people. Such are also seen to go into the implementation of developments projects in the communities. Still to be noted is the fact that the government acts in encouraging investment through provisions of investment incentives.
Involvement in foreign business is another crucial element in the circular flow of economic activities. This is basically in the aspect of imports and exports. It is to be realized here that imports and exports are a crucial factor in any economy. It is such acts which provide for both access to goods and services unavailable in the nations as well as expanding the market for goods and services produced in the nation. It is this sector of the model which converts the nations economy to an open economy. It should be noted that the nations expenditure must not be higher than its income for exports if the economy is to be sustainable. Still evident in oversea sector is the fact that it aids in initiating and nurturing international relationships among nations, a crucial element for the harmonious coexistence of different members of the globe family.
Summary
Production and consumption are the most crucial elements in any economic setting. It is by consumption of the produced goods and services that firms get value for their investments. Still, it is by production that consumers can have the desired satisfaction for their needs in life. The production process also involves the purchasing of goods and services for aiding in the production process. It is thus clear here that firms are both producers and consumers in the circular flow chain while the household serves the consumption aspect of our economic chain. It is due to this reason that both the firms and the households are found to be two different but highly complimenting elements in the realization of a sustainable economy in any society.
The households are the source of sustainable market for produced goods and services in the community. It is by their purchasing of the products of firms that firms can claim guaranteed return of value for their investment. Such guaranteed market for goods and services lead to increased potential of expansive investments by organizations to meet the increasing consumer demands. It is to be noted here that increased investments come with increased employment opportunities for the people. Still to be realized is the fact that employment opportunities increase the employees income and thus greatly improving their purchasing power. Such will have the end result of having a linearly increasing demand-supply situation in the society. This means that the economy of the community will keep on expanding provided such demand and supply trends are kept.
It is however to be noted that demand is not always equal to supply as most a times consumers decide to save part of their income for future use. It is due to this reason that economic disequilibrium is a common thing in our society. The globe recurrent faced with economic threats mainly due to such disequilibrium of demand and supply in the marketplace. It should be noted here that equilibrium is the best state of any sustainable economy. It is due to this that many companies seek to address the problem of disequilibrium by using investment capital structures as a way of disposing their unsold products. Such acts ensure the firms added advantage for meeting any future rise in supply demands while limiting potential losses in the meantime.
The circular flow of economic activities, in amore realistic way relies of the government, financial institutions and foreign countries. Financial institutions are seen as a source of investment capital to the investors. It is to be appreciated that such financial institutions are heavily reliant on the consumer savings for their survival. The government sector on the other side involves in the taxation of its citizens in return for the protection it provides to them. The government is also responsible in spending such revenue collections on development projects such as building of road infrastructures and funding of the health and education sectors of our community. Lastly, foreign or oversea countries are quite crucial in enhancing the process of importation and exportation involvements of the economy. It is such acts which provide for both access to goods and services unavailable in the nations as well as expanding the market for goods and services produced in the nation.
In conclusion, it has been evidently established that a market economy is marked with production and consumption as the major key player in ensuring circular flow of economic activities. It is however evidently clear that a sustainable circular flow of economic activities should be thought out using the five sector model of circular flow. It is this model which eliminates the assumptions found in the two sector model of the circular flow. It is clear that the five sector model appreciates the fact that financial institutions, governments and foreign nations are crucial factors if the circular flow of economic activities. It is only with available financial institutions like banks that funding of investment can be assured. Still to be noted is the fact that the government as the custodian of the citizens must be involved in ensuring fair and just flow of economic activities. Involvement in import and export trading ensure the long term sustainability of demand and supply factors of the economy.