PRINCIPLES OF ECONOMICS: Circular Flow of Economic Activities

THE CIRCULAR FLOW OF ECONOMIC ACTIVITY

There are two basic activities undertaken in any economy: production and consumption.
The firms perform the production and consumption while households undertake consumption.
To be able to produce, firms need the economic resources1 consisting of land, labor, and
capital1:
LAND – it is one of the factors of production which include land used for agriculture or industrial
purposes as well as natural resources taken for above or below the soil. Natural resources consist
of energy resources like fossil fuel and geothermal emissions, non-energy resources like gold,
diamond, and limestone, air and water and many others.
LABOR – refers to that basic factor of production which are productive services embodied in
human physical effort, skill, and intellectual powers, and others. It consist of human time spent in
production like driving buses, feeding cattle, singing in night clubs, acting in movies, or repairing
household appliances.
CAPITAL – durable goods produced in order to produce other goods. It consists of buildings,
plant and machinery, roads, computers, ships, electric guitars, table tennis, tennis balls, etc.

STOCK AND FLOW OF CONCEPTS

Stock – refers to the measure of quantity at a point of time e.g. wealth as of December 31, 2001
Flow – refers to the measure of movement of quantity of over a period of time e.g. savings
(P1000/year) or consumption at P100,000/year

When economic resources are used in the production of goods and services, employment
of these resources occurs. A price is paid to resource owners whenever these resources are used
in production. Rent is paid to the landowner, interest to the capitalist, and wage to labor. The
goods and services produced by these firms are consumed by households.
The interaction between households and firms regarding production, consumption,
employment and income generation results to the circular flow of goods and services in the
economy.

THE CIRCULAR FLOW OF GOODS, SERVICES AND INCOME

The basic aspects of economy which include production and consumption are subject to
the stock and flow concepts which are circular in nature.
THE PRODUCTION PROCESS
The process of producing goods and services involves households and firms in a circular flow. As
shown again, the economic rsources of land, labor, and capital are provided by the households
and used by the producing firms. These firms, in turn, produce goods and services which are
delivered to households for consumption.

THE FLOW OF GOODS AMONG PRODUCING FIRMS

Within the circular flow of the production process is another flow which happens among different
types of business firms. This flow involves raw materials, intermediate goods and final goods.

RAW MATERIALS – unprocessed goods like wood, sand and iron

INTERMEDIATE GOODS – partially processed goods and still needs
processing before it can be finally consumed like
steel bars, flour and microchips

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Entrepreneurial Ability – land, labor, and capital will remain as they are until someone taps them to
produce the required goods and services. Actual production needs the ability of an entrepreneur to decide
on and implement the right combination of the first three factors of production.

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PRINCIPLES OF ECONOMICS: Circular Flow of Economic Activities

FINAL GOODS – processes goods ready for consumption

like bread
According to the type of goods they produce, firms may be classified as follows:
1. Raw Materials Producers – like those engaged in producing agricultural products used in
manufacturing (fish, wood, sugar)
2. Intermediate Goods producers – like those producing construction materials, guitar strings,
and food seasoning
3. Final Goods Producers – like those producing chocolate bars, refrigerators, and bicycles

THE FLOW OF OUTPUT BETWEEN FIRMS AND HOUSEHOLDS

As shown, the output of raw materials producers are delivered to intermediate goods producers,
whose output, in turn are delivered to final goods producers. The consumers become recipients
of the goods produced by the final goods producers.

GOODS AND INCOME FLOW AMONG HOUSEHOLDS AND VARIOUS TYPES OF PRODUCERS

Households provide producers

with the economic resources
required. These resources are
distributed among the various
types of producers. The producers,
in turn, remit payments to
households for the use of
resources.

When the goods are finally

processed, these are delivered to
the households, which in turn,
remit their payments to the
concerned producers.

INCOME FLOW
When money is spent by households for consumption and by firms for
production, a circular flow of income is created. The expenditure of one
unit becomes the unit of another unit.
Income takes two distinct circular flows as follows2/3:

2
The services of land, labor and capital are bought by firms for use in production. Money is paid to the households. In turn, households
buy goods and services. Money is paid by households to firms.

3
Purchases are made between firms. The output of RM firms are sold to IG firms which in turn sell their output to FG firms. The final
goods are sold to households for consumption.

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PRINCIPLES OF ECONOMICS: Circular Flow of Economic Activities

THE CONCEPT OF EQUILIBRIUM

The economy will be in equilibrium if the amount received by firms from households is
equal to the amount received by households from firms. Disequilibrium happens when either
households or firms do not spend all their incomes. If households, for one reason or another,
reduce their purchases, firms will receive a reduced amount of income resulting to their inability
to maintain current levels of purchases of economic resources, some laborers will lose their job,
and some land and physical capital will become idle. The result is a corresponding reduction in
the income of households.

THE EFFECT OF SAVING AND INVESTMENTS

If the total output of firms are
purchased by the households and the total
economic resources are bought by firms,
there is equilibrium in the market. In reality,
however, households allocate a part of their
incomes for future use like providing money
for old age. As a result, disequilibrium
happens because firms are hard-pressed to
dispose all their output. The circular flow will
tend to contract. To prevent this from
happening, some other means for disposing
the unsold portion of the output must be
tapped.
Investment is a way of disposing unsold output. Firms spend money to procure goods and
services for the purpose of increasing their productive capacity in the future. In effect, firms
spend money now to minimize their expenditures for capital outlay in the future. When the
savings of households are matched by investments expenditures of firms, disequlibrium is
negated and the circular flow of income will tend to normalize.

FLOW IN A MARKET WITH GOVERNMENT AND FOREIGN COUNTRIES

In an economy like the Philippines, there are two important sectors that interact with the
households and firms: the government and foreign countries.
The government sector which performs necessary functions buys the
economic resources of land, labor, and capital from households. Land is used by
the government to locate its building and facilities; labor is hired to fill up
various positions in the different government agencies; capital is borrowed to
produce the necessary facilities and services. Payments in the form of wages,
rents, and interest are remitted to the households by the government.
Government money, however, is spent not only in buying the economic
resources from households but also the goods and services produced by firms.
Payments are also remitted to these firms.
The goods and services purchased by the government come in a wide variety of forms: from office supplies to
transport equipment and from consultancy to janitorial services.
Households purchase goods and services from other countries, like transportation equipment, books,
computer programs, etc. The corresponding payments are sent to the exporting foreign countries.
Local firms sell goods and services like agricultural products to foreign countries. Payments are remitted to the
local firms by foreign buyers.

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PRINCIPLES OF ECONOMICS: Circular Flow of Economic Activities