5

Acti Circular flow model

OVERVIEW

An economy is a complex system and it is impossible to model or even describe all the different forces
that influence the level of economic activity. To understand what determines the level of economic
activity, we need to simplify things by focusing on the most important forces that shape an economy.
The circular flow model is a simplification of how the economy works. In a complete circular flow
model, the interaction and interdependence between the major participants (households, firms,
government and the foreign sector) in the various markets (factor, goods and financial) are captured
and explained.
You will learn how the decisions these participants make and the way in which they interact influence
the economic life of every individual in our society. You will also see how the decision of one
participant in the economy influences and elicits a reaction in another participant, as well as the
influence this has on the level of economic activity.
In this section, we consider a model that includes only two participants, namely households and firms,
and only two markets, namely the goods and factor markets.

TOPIC OUTCOMES

After you have worked through this learning unit, you should be able to use the circular flow model to
illustrate and explain

• the three flows of production, income and spending

• the interdependence between households and firms
• the real and monetary (nominal) flows through the factor market and the goods market

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 Simple circular flow model with two participants and two markets
Concepts
Familiarise yourself with the following concepts before you start studying this unit:
Households – A household can be described as all the people who live together and make joint
economic decisions, or who are subjected to others who make such decisions for them. A household
can consist of an individual, a family or any group of people who have a joint income and take
decisions together. Every person in the economy belongs to a household.

Firms – A firm can be described as the unit that employs factors of production to produce goods and
services that are sold on the goods market.
Factor market – This is the market in which the factors of production are sold and purchased.
Goods market – This is the market in which goods and services are sold and purchased.
Real flows – This refers to the flow of real things, such as goods and services or the factors of
production.
Nominal (monetary) flows – This refers to the flow of money in the form of money income (wages and
salaries, interest, rent and profits) and spending on goods and services.
Stocks and flows
An important distinction is made between a stock variable and a flow variable. The distinction concerns
whether the variable is something that is measured at a particular point in time or over a period. A stock
variable is something that is measured at a particular point in time (say, on 31 December 2018), while a
flow variable is measured over a period (say, monthly).
Capital, as a factor of production, is a stock variable since the value of the machines, tools and
buildings that a firm owns is measured at a point in time. For instance, it can be said that on 31
December 2018, the value of the capital stock for Firm X was R10 billion.
Investment, that is the purchasing or creating of capital goods, is a flow variable since it takes place
over a period. For instance, it can be said that during the year 2018, the value of investment by Firm X
was R1 billion. In other words, Firm X invested R1 billion in machines, tools and buildings over a
period of a year.

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It is clear from the example that stocks and flows are related. Stocks change because the flows change.
As Firm X increases its investment, its capital stock will grow.
Examples of stocks are wealth, debts, assets, the balance in your savings account and inventories.
Examples of flows are income, spending, production, sales, investment, change in inventories and
profits.

Read through the following extract (BusinessTech, 2017) on the technical recession in South Africa in
2017 and reflect on the questions that follow:

Technical recession in South Africa

The latest gross domestic product (GDP) data released by Stats SA shows that the South African
economy declined by 0.7% in the first quarter of 2017, putting the country into a technical
recession.

While the economy has slowed to a crawl over the past few years, the country has managed to
escape the dreaded "official" recession tag.

In economic terms, a technical recession is described as two consecutive quarters of economic

decline. The last quarter of 2016 showed a 0.3% decline; with the latest decline of 0.7% in the
first quarter of 2017, South Africa fits the bill.

Source: https://businesstech.co.za/news/finance/177885/south-africas-economy-is-officially-in-
recession/
If we take a closer look at the different flows of production, income and expenditure, it is clear that the
decline in production during this recession was mainly due to lower production levels in the
manufacturing and trade sectors. Associated with this decline in production was a decline in spending
by households. The decline in production and spending were also associated with a decline in the
income of households. It is this relationship between the flow of production, income and spending that
we will investigate in more detail in this learning unit.

Questions for reflection

Why do you think the spending by households declines if the production in the economy declines?
What would your household do if the income of your household were to increase?
What would firms do if households were to decrease their spending on goods and services?

5.1 Three major flows

After you have worked through this section of the learning unit, you should be able to

• identify the three major flows in the economy and describe the relationship between them

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The three major flows in the economy are as follows:
 The production flow comprises the production of goods and services by firms. It is here that
the question of how to produce is answered.
 The income flow involves the flow of income to households, which they earn from making the
factors of production available to produce goods and services by firms. Based on this income,
the question of for whom to produce is answered.
 The spending or expenditure flow entails the spending by households on goods and services
produced by the firms. It is in this flow that the question of what to produce is answered.

Considering these flows, choose the correct option to the following question:
Do you think a person who is employed by a factory that produces mattresses is part of the flow of
production, income and/or spending?
o The person is part of only the production flow.
o The person is part of only the income flow.
o The person is part of only the spending flow.
o The person is part of all three flows.
While the person is working in the factory producing mattresses, they are part of the production
flow. When the person is paid, they become part of the income flow, and when they spend this
income, they are part of the spending flow. The person is therefore part of all three flows.

The flows are not independent, but interdependent and closely linked. This interdependence between
production, income and spending can be represented by the following circular flow diagram:

Three major flows

A change in the flow of production will bring about a change in the flow of income, which, in turn, will
change the flow of expenditure, which, again, will change the flow of production.
In the same way, an increase in spending will bring about an increase in production, which, in turn,
causes an increase in income. Similarly, an increase in income will bring about an increase in spending
and then production. A major part of the study of macroeconomics involves how changes can be
brought about in these flows.

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Link between production and income

Link between production and income

The reason we produce goods and services is to satisfy our needs and wants. To produce these goods
and services, factors of production are needed.

In a market system, the factors of production belong to households, who are then paid an income by
producers for the use of the factors of production. As production takes place, a flow of income is
created. If you are working (employed), the contribution of your effort is part of the production flow,
while the payment you receive is part of the flow of income.

Link between income and spending

Link between income and spending

We have now established that as production takes place, a flow of income is created. This income,
which flows to households from firms, is then spent by the households on the goods and services that
were produced, and as they spend, a flow of spending or expenditure is created. As you spend the
income you received from participating in the process of production, you are creating a spending flow.

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Link between spending and production

Link between spending and production

The spending in the economy is linked to production. When we bake bread, we are participating in
production; when we are paid for baking the bread, we are part of the income flow; and when we spend
our income on buying the bread, we are part of the spending flow.
Example of the interdependence between the three flows
James is a family man and works at the local bakery as a bread baker. To illustrate the circular flow
between production, income and expenditure, we are going to use part of James's life story.
As James works as a baker and bakes bread, he is part of the production process. At the end of every
month, James receives a salary from the bakery for his bread making. The salary James receives is
income for him and his family. James's wife, Martha, does the shopping for the household at the end of
every month; she buys everything the family needs, including the bread that James helped to bake.
James's family is now part of the spending or expenditure process. This process will continue for as
long as James works and spends his income.
There is thus a continuous circular flow between production, income and spending in the economy. A
change in production, such as an increase in production, will lead to an increase in income, which, in
turn, will result in an increase in spending.
Complete the following activity before you proceed:

ACTIVITY 1

Indicate and explain whether you agree or disagree with the following statement:
The lower the level of production in a country, and the lower the level of income and spending, the
poorer the country.

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5.2 Participants in the circular flow: households and firms
After you have worked through this section of the learning unit, you should be able to

• describe the different participants (households and firms) in the circular flow model
• describe the roles that households and firms play in the circular flow model
• describe the roles that households and firms play in solving the economic problem

Simple circular flow model: households and firms

Households

Households are all the people who live together and make joint economic decisions. Your family is a
household, and a person living on their own is also a household. Communes of friends who live in one
house and share their expenses also form a household.

In a market economy, households are the biggest owners of the factors of production. They own all the
labour and entrepreneurship, as well as the capital and natural resources (land).

Even though businesses own the capital goods (buildings, factories, tools and machines), these
businesses are, in turn, owned by households through the shares they have in them. Some households
may own only a few hundred rands worth of shares, while others may own thousands or millions of
rands worth of shares in a company. The point is that businesses are legal entities that are owned by
people (households). These households own a firm's capital goods and have a right to its profit in the
form of dividends.
Households make these factors of production available to the economy, where they are used by firms to
produce goods and services. In exchange for the use of the factors of production, households receive an
income from firms in the following forms:
 salaries or wages in return for their labour services
 interest on their capital
 rent from the ownership of natural resources, such as agricultural land
 profit from entrepreneurial activities

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The most important source of income for households in South Africa is the wages and salaries they
receive in return for their labour services. To earn an income, households must therefore participate in
the production of goods and services. This is a vital decision that households must make. They must
decide to whom they will make their factors of production available, how many of these factors of
production they will make available, and at what price. The more factors of production a household
owns, and the more valuable these factors are, the higher the income of the household will be. This all
happens in the factor market.
Households are therefore active participants in the factor market as suppliers of factors of production.
The primary aim of households is to maximise their satisfaction with their limited income. Households
try to maximise their satisfaction by using their income to buy consumer goods and services that satisfy
their needs and wants. These goods and services are bought on the goods market. Households are
therefore active participants in the goods market as the demanders (buyers) of goods and services. They
are the consumers in our society and responsible for consumption spending, which is spending on
consumer goods and services.
If you think back to the basic economic questions of what, for whom and how to produce, you will
immediately recognise the importance of households. It is in relation to the households – through their
income and consumption expenditure – that the questions of what, how much and for whom to produce
are answered. What households (consumers) want and can afford (their demands) determines what
firms will produce. A change in their behaviour (even a small one) has a significant impact on the flow
of production, income and spending.
The characteristics of households may be summarised as follows:
 They are owners of production factors.
 They are sellers of production factors.
 They are consumers of goods and services.
 They are buyers of consumer goods and services.

Firms
In a market economy, business enterprises or firms are responsible for the production of goods and
services in the economy. The bulk of the goods and services in South Africa are produced by privately
owned businesses, which are therefore one of the key decision-makers in our economy.
Firms combine and transform factors of production to produce goods and services. They are therefore
active participants in the factor market as buyers of the factors of production that are owned by
households. In return for the use of the factors of production, firms pay households wages and salaries
for labour, interest for capital, rent for land and profits for the entrepreneur. This is part of the cost of
production for the businesses.
Businesses produce not only the consumer goods and services that households demand. They also
produce capital goods (factories, machines and tools) that are used in the production of consumer goods
and services. This creation of capital goods is known as real investment.
While households try to maximise their satisfaction from their limited income, firms try to maximise
their profits. Profit is the difference between revenue and expenditure. Revenue is earned from the
selling of goods and services to households in the goods market. Firms are therefore active participants
as suppliers (sellers) in the goods market. Firms strive to keep their revenue as high as possible and
their expenditure – which is determined by their cost of production – as low as possible.
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Looking back at our economic problem of what, how and for whom to produce, firms are responsible
for how to produce and they continuously search for ways to make the production of goods and
services more efficient. This is important, because our resources are scarce and we cannot afford to
waste them.
The general characteristics of firms may be summarised as follows:
 They are buyers of factors of production.
 They are producers of goods and services.
 They are sellers of goods and services.
Complete the following activity before you proceed:

ACTIVITY 2

2.1 Indicate whether the following statement is true or false:

T F
a. The only factor of production that is owned by households is labour; firms own
the rest of the factors of production.
b. The more factors of production a household owns, and the more productive the
factors of production are, the higher the income of the household will be.
c. The reason households make their factors of production available to firms is to
earn an income, which they can then use to buy goods and services to satisfy
their needs and wants.
d. Firms own the factors of production that they use to produce goods and services.
e. The aim of firms is to maximise profits.

2.2 Write down the correct remuneration for the factors of production:
Labour - ...
Capital - ...
Natural resources - ...
Entrepreneurship - ...

5.3 Markets in the circular flow: factor market and goods market
After you have worked through this section of the learning unit, you should be able to

• describe the factor market and the goods market

• describe the roles of households and firms in these markets

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 Simple circular flow model: the factor market and the goods market

Factor market
The factor market is the market in which the factors of production are bought and sold. It is through
this market that households supply businesses with the factors of production in exchange for an income
in the form of wages and salaries, interest, rent and profits.
Two active participants in this market are households, as the suppliers of factors of production, and
firms, as the demanders of the factors of production. The factor market includes the labour market as
well as the market for capital.
Goods market

There are literally thousands of different producers of goods and services and millions of different
consumers of these goods and services in the economy. In macroeconomics, all these different markets
for goods and services, which include both the producers and the consumers, are grouped together
under the heading of the goods market. In economics, this grouping together is called aggregation.

It is in the goods market that households (consumers) buy their goods and services and the producers
supply their goods and services. Two active participants in this market are households, as the
demanders of goods and services, and firms, as the suppliers of goods and services.

5.4 Real flows and nominal flows

After you have worked through this section of the learning unit, you should be able to

• distinguish between real flows and nominal flows

• identify the real and nominal flows through the factor market and the goods market

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 Simple circular flow model: nominal and real flows

Real flows refer to the flow of real things, such as goods and services or the factors of production,
while nominal flows refer to the flow of money in the form of money income (wages and salaries,
interest, rent and profits) and spending on goods and services.
In the factor market, the real flow is the flow of the factors of production – the quantity of labour,
capital, land and entrepreneurship – from households to firms.
The nominal flow is the flow of income in terms of money from firms to households – in other words,
the amount that is paid in wages and salaries, interest, rent and profits.
In the goods market, the real flow is the flow of goods and services from firms to households.
The nominal flow is the flow of spending (payment) by households to firms for goods and services.

Complete the following activity before you proceed:

ACTIVITY 3

3.1 Which one of the following is a real flow in the goods market?
a. the spending flow on goods and services from households to firms
b. the flow of the factors of production from households to firms
c. the flow of goods and services from firms to households
3.2 Which one of the following is a nominal flow in the factor market?
a. the flow of factors of production from households to firms
b. the income flow from firms to households
c. the spending flow on goods and services from households to firms

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3.3 Indicate whether the following statements are true or false:

T F
a. If more factors of production flow to the firms, then the income flow to
households will increase.
b. The factors of production flow through the factor market, while spending by
households flows through the goods market.

5.5 The complete simple circular flow model

Now that we have identified two main participants in the economy, namely households and firms, and
two markets, namely the factor and goods markets, we can design a model to show the interactions
between firms and households through the goods and factor markets.

The circular flow model that we will build consists of two participants, namely households and firms,
and two markets, namely the factor market and the goods market, as well as two kinds of flows,
namely nominal (monetary) flows and real flows.

The complete simple circular flow model

After you have worked through this section of the learning unit, you should be able to use the circular
flow model to illustrate and explain
• the interdependence between households and firms
• the real and nominal (monetary) flows through the factor market and the goods market
• the impact of a change in a flow

Flows between households and firms through the factor market

From households to firms, there is a flow of factors of production through the factor market, as
illustrated by the dotted line in the following diagram. This is a real flow. An example of this flow
would be your leaving your house in the morning to go to work at a firm. This is an example of a real
flow of labour. Then there is also the flow of capital, land and entrepreneurs from households to firms.
This real flow of the factors of production takes place through the factor market.

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 Flows through the factor market

From firms to households, there is an income flow through the factor market as firms pay households
for the use of the factors of production owned by households, as indicated by the solid line in the
diagram above. This is a nominal flow. An example of this flow would be your receiving payment in
the form of a wage or a salary by the firm you are working for. Rent for land, interest for capital and
profits for entrepreneurs are all nominal (monetary) flows and part of the income flow.

Flows between firms and households through the goods market

Firms use the factors of production to produce goods and services that they make available to
households through the goods market. This is the real flow of goods and services from firms to
households, and it is indicated by the dotted line in the following diagram. An example of this flow
would be the actual groceries you buy from your local supermarket.

Flows through the goods market

Households use their income to pay for the goods and services they receive from firms. This payment
for goods and services is a nominal flow from the households to firms through the goods market, as
indicated by the solid line in the diagram above, and it is the spending flow. An example of this flow
would be when you pay for your groceries.

We can therefore distinguish between two kinds of flows between households and firms, namely real
flows and nominal (monetary) flows through the factor market and the goods market. Notice how
the nominal (monetary) flow is in the opposite direction of the real flow.

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Impact of a change in a flow
We can now use this model to explain what happens to the flows if, for instance, spending by
households increases:
 As spending by households increases, the nominal flow from households to firms increases
through the goods market.
 As the goods move from firms to households, the real flow from firms to households
increases.
 This increased spending by households causes firms to increase production since the demand
for goods is higher. As firms increase production, the production flow increases and more
factors of production are employed.
 Thus, there is an increase in the income flow from firms to households through the factor
market.

Complete the following activity before you proceed:

ACTIVITY 4

a. Choose the correct term from the options in brackets:

As production by firms decreases, the (monetary flow/real flow) of factors of production from
households to firms (increases/decreases) through the (goods market/factor market). As a result, the
monetary flow to households (increases/decreases) since the income flow is (greater/smaller) from
firms to households. This change in the income flow causes the spending flow by households through
the (goods market/factor market) to (increase/decrease). This, in turn, causes the (monetary flow/real
flow) of goods and services between firms and households to (increase/decrease).

b. You must be able to draw the circular flow model and use it to explain what happens to the flows.
Practise this skill by drawing your own circular flow model and use it to explain to someone else (or to
yourself) what would happen if production were to increase.
Hint: It is the opposite of what happens if production declines.

5.6 Limitations of the simple circular flow model

After you have worked through this section of the learning unit, you should be able to

• identify the limitations of the simple circular flow

At this stage, the circular flow model includes only a goods market and a factor market.

The state, representing the government's action through the markets in the economy, could also be
introduced as an independent participant buying goods and services and factors of production in the
various markets. The state also influences economic life directly by providing certain services, such as
defence, policing and education. To finance these services, the state taxes both firms and individual
households.

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The foreign sector is another participant not included in the simplified circular flow model. It
comprises mainly the imports and exports of goods and services. This participant also operates in the
markets for goods and factors of production in the domestic economy. Imports of goods and services
may be regarded as an offer of these goods in the various markets; in return, a reverse flow of money
would go to the foreign sector. Exports of goods and services would mean a flow of goods from the
relevant participants to the markets of foreign economies, with a corresponding return flow of money.

The model can also be extended to include a financial market. Households do not spend all their
income. Some of it is saved (in the financial market) and firms borrow from the financial market when
they invest (i.e. when they buy new machines or build bigger factories).

The model also assumes that prices of goods, services and production factors exist, but it does not
explain how these prices are determined and the impact of a change in prices on the flows.

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 ANSWERS TO THE
ACTIVITIES

Activity 1

You should agree with the statement.

A country's production level, often measured by Gross Domestic Product (GDP), reflects the total value
of goods and services produced within a country. Higher production levels typically generate more jobs
and income for citizens. Lower production usually correlates with lower income levels, as fewer goods
and services are produced for sale, reducing business profits and employment opportunities.

Income and spending are closely linked since people spend most of their earnings on goods and
services. In poorer countries, lower income levels limit household spending power, further reducing
demand and economic activity. Conversely, higher income levels allow for more consumer spending,
stimulating production and creating a cycle of economic growth.

Activity 2
2.1
a. The statement is false.
Households are the owners of all the factors of production. For instance, they own capital through
shares they have in companies.
b. The statement is true.
The income of households depends on their ownership of the factors of production and how
productive these factors are. The more valuable the contribution of the factors of production to
total production, the greater the income derived from them.
c. The statement is true.
The aim of households is to satisfy as many needs and wants as possible; to do that, they need an
income, which they obtain by participating in the production of goods and services.
d. The statement is false.
Firms typically do not own the factors of production. They hire or lease them from households.
For example, firms hire labour from workers and lease land from property owners. Households
are the primary owners of factors of production in most economic models.
e. The statement is true.
The reason firms produce goods and services is to make a profit.
2.2 Labour – wages and salaries
Capital – interest
Natural resources – rent
Entrepreneurship – profit

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Activity 3

3.1 c.

The flow of goods and services from firms to households is a real flow and occurs through the
goods market.

The spending flow on goods and services from households to firms is a nominal (monetary) flow.

The flow of the factors of production from households to firms is a real flow through the factor
market.

3.2 b.

The income flow from firms to households is a nominal (monetary) flow through the factor
market.

The flow of factors of production from households to firms is a real flow through the factor
market.

The spending flow on goods and services from households to firms is a nominal (monetary) flow
through the goods market.

3.3

a. The statement is true.

As households make more factors of production available, their income from the factors of
production increases.

b. The statement is true.

The factors of production flow through the factor market, while household spending flows
through the goods market.

Activity 4

a. As production by firms decreases, the real flow of factors of production from households to
firms decreases through the factor market. As a result, the monetary flow to households
decreases since the income flow is smaller from firms to households. This change in the income
flow causes the spending flow by households through the goods market to decrease. This, in turn,
causes the real flow of goods and services between firms and households to decrease.

b.
If production increases in the economy, the following effects can be observed in the circular flow
model:

• More Goods and Services (Real Flow Increases):

Firms produce more goods and services, increasing the physical flow of products to households.

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• Higher Demand for Factors of Production:
Firms require more labour, land, and capital to increase production, leading to greater demand for
resources in the factor market.

• Increased Income for Households:

Households receive higher wages, rent, and interest as firms pay more for the increased use of
factors of production.

• Higher Spending (Money Flow Increases):

With more income, households spend more on goods and services, increasing the flow of
income/money to firms.

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 CHECKLIST

Well Satis-
factorily Unsatisfactorily
Concepts and relationships
I can …
name the three major flows in the economy
identify the different participants in the economy
define “households”
define “firms”
distinguish between the two basic markets in the economy
distinguish between real and nominal flows
distinguish between stocks and flows
Diagrams
I can use a circular flow diagram to …
identify the three major flows in the economy and explain the
interdependence between them
identify the factor market and the goods market
distinguish between real flows and nominal flows
distinguish between the following flows:
flow of goods and services
flow of spending
flow of factors of production
flow of income
explain how the flows change if, for instance, production in
the economy changes

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