Chapter 3
Production, Income and Spending
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Relationship between income, production and spending
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Households, firms, goods market and factor market
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Introducing the government sector
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Introducing the financial sector
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The overall picture
◦ Circular flow of income and spending
◦ Circular flow of goods and services
◦ Circular flow of income and spending
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Production creates income (as earned by the factors of
production) and this income is then spent to purchase goods
and services.
There is therefore a relationship between production, income
and spending.
They represent flow variables that are measured over a period
of time.
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Household C
Firms I
Government G
Foreign sector XZ
Natural resources
Labour
Capital
Entrepreneurship
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Rent
Wages/salaries
Interest
Profit
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A household can be defined as “all the people who live
together and make joint economic decisions”
Refers to an individual, family or group of people who live
together and have a joint income
They represent consumers who purchase goods and services
for consumption purposes (C)
Factors of production are owned largely by households
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A firm can be defined as “the unit that employs factors of production to
produce goods and services that are sold in the goods market”
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Whereas households are engaged in consumption, firms are primarily
engaged in production
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They are buyers in the factor market and sellers in the goods market
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Firms are also rational, in that they attempt to maximise profit
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They are responsible for spending on capital goods, i.e. investment (I)
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A market is any contact or communication between potential
buyers and sellers of a good or service
In order to analyse markets as a whole, we combine them
together under the term “goods market”
We treat this as if it was the only market for goods and
services in the economy (aggregation)
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This is the market in which factors of production are bought
and sold, and it includes the labour and capital market
Incomes earned from factors of production include wages and
salaries, rent, interest and profit
Once again, we aggregate these markets into one single
market called the “factor market” for ease in analysis
Households sell FOP to
firms in factor market.
Firms transform these into
goods and services which
are then sold to households
in the goods market.
Firms purchase FOP in factor
market. Their spending
represents income of
households. Households
then spend this income in
the goods market to
purchase goods and
services. Their spending
represents income of firms.
This is a monetary flow, and
is in opposite direction to
flow of goods and services.
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Government includes local, provincial and national
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We do not always assume government acts rationally
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Government can purchase factors of production from households
in the factor market, and also purchase goods and services from
firms in goods market (G)
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In return, they provide firms and households with public goods and
services
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BUT remember: they tax firms and households to raise revenue
that is used for purchasing (T)
Government spending (G)
represents an injection into circular
flow
Taxes (T) represent a leakage
from circular flow
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South Africa is an open economy, meaning that trade takes
place with the rest of the world
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The foreign sector consists of all the countries and
institutions outside the country’s borders
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Exports (X) – goods and services produced within country and
sold to rest of world
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Imports (M) – goods and services produced by rest of world
and purchased by domestic economy
Exports represent an injection
– income earned by South
Africa
Imports represent a leakage –
income spent by South Africa
on foreign items
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Financial institutions act as links between households and firms
with surplus funds and other participants that require funds
Households or firms that do not spend all their income during a
particular period save some of that income (S)
These funds that are saved at financial institutions, are then
available for others to borrow and spend on capital formation (I)
The main function of the financial sector is to act as a funnel
through which savings can be channelled back into the circular
flow of income and spending
Savings represent a leakage from the
circular flow
Investment represents an injection to
the circular flow
Injections = I + G + X
Leakages = S + T + Z