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Chapter 3:
Production,
income and
spending in the
mixed economy
 Chapter Outcomes

Once you have studied this chapter you should be able to

• describe how total production, total income and total spending in
the economy are related
• distinguish between stocks and flows
• describe the different sources of production and income
• distinguish between households and firms and show how their
decisions and activities are interrelated
• show how the government sector interacts with households and
firms
• show how the foreign sector interacts with the domestic economy
• describe South Africa’s factor endowment
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 Production, income and spending
Figure 3-1 The three major flows in the economy (Textbook page 41)

Box 3-1 Stocks and flows (Textbook page 41)

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 Production, Income and Spending
• Production creates income to those involved in
the production process and this income, in turn,
is spent to purchase the goods and services
created in the production process (spending).
• Processes occur simultaneously in the economy,
creating a “circular flow” of production, income
and spending.
• Production, income and spending are all flows.
• Stocks measured at a point in time Flows
measured over period of time

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 Sources of production:
the factors of production

• Natural resources (land)

-The term used to describe all those natural resources over which people have
the power of disposal and which may be used to yield an income.
-Includes all gifts of nature such as farming and building land, forests, mineral
deposits, fisheries, rivers, lakes, sunlight, rain, seed, etc.

• Labour
-Refers to all human effort – both physical and mental – which is directed to
the production of goods and services
-Services of labour sold, not labour itself
-Quality of labour involves the skill, knowledge, health, education & training,
and experience of workforce and is referred to as human capital.
-Efficiency of labour can be improved by education and training
-Supply of labour depends on the size of the population and economically
active population, as well as gender, age and other demographics.

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Sources of production: the factors of production continued……..
• Capital
-Goods used to produce other goods – i.e. any product of labour, land and entrepreneurship
which is reserved for use in further production.
-Man-made resource – can be thought of as tools
-Measures that reduce the cost of capital (machinery) relative to that of labour greater capital
intensity and reduced employment
• 2 types of capital:
-working capital – stocks of raw material, semi-finished and finished goods which are used up
in the production of another good – aka inventories / circulating capital
-fixed capital – equipment used in production, e.g. buildings, machinery. The depreciation of
such capital aka ‘consumption of fixed capital’.

• Entrepreneurship
-Job of the entrepreneur/management is to coordinate labour, capital, and natural resources
(land).
-Entrepreneurs/Managers to predict consumers’ wants.
-Entrepreneurs are risk-takers and decision- makers.
Sources of production: the factors of production continued…….

• Technology
-Technology is defined as a standardising of procedures for the realisation of selected
objects.
-Better tech. helps economise on the use of factors of production
-Discovery of new knowledge is called “invention”
-Incorporation of this knowledge into actual production techniques and products is
called “innovation”
-Capital-intensive production - production process dominated by machines
-Labour-intensive production - emphasis of production process is on labour

Box 3-2 Specialisation and the division of labour (Textbook

page 43)
 Sources of income:
The remuneration of the factors
of production

Incomes are earned by selling the services of the

factors of production that people earn.
I.e
▪Remuneration for natural resources(land) – rent
▪Remuneration earned by labour – wages
▪Remuneration earned by capital – interest
▪Remuneration earned by entrepreneurship – profit
The factor of production (FOP) that earns the most
income is that of labour. They account for about
70% of the National income.

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 Sources of spending

• Households
‒ HH supply services of labour to firms in the factor market.
‒ HH are the owners of FOP
‒ sell/supply these factors (services of labour) to firms in exchange
for an income, which they use to purchase G&S from firms.
‒ are also the consumers of goods and services is to maximise wants (consumption)
‒ HH buy G&S from firms in the goods market.
‒ Total spending by HH on consumer G&S is known as Total /
Aggregate Consumption (denoted by symbol C).
‒ The terms households, individuals, and consumers are used
interchangeably.
‒ It is HH/consumers who largely determine “what” to produce.

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Sources of spending: The four spending entities continued……..
• Firms
‒ buyers of f.o.p in factor markets (combine f.o.p
i.o.t produce G&S)
‒ are also producers of G&S (making them sellers in
the goods market).
‒ They answer the “how” question.
‒ Aim is to maximise profits (difference between
revenue
and costs).
‒ Firms purchase capital and this act is known as
Investment or capital formation, (denoted by the
symbol I)
Goods market

Any contact or communication between potential

buyers and potential sellers of a good or service
Aggregation (the lumping together of all the
different markets under the heading “goods
market”.
In macroeconomics we treat the goods market as if
there is only one market for all G&S
In microeconomics we analyse each of the markets
individually.
Factor market

- Market in which FOP are purchased and sold

- Includes the labour market and the market for
capital goods
The circular flow of goods and services

• Circular flow diagram-shows the interrelationship between

Households and Firms.
• Households sell their factors of production to firms in the factor
market.
• Firms transform factors of production into goods and services
which are then sold to households in the goods market.
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 The circular flow of income and spending (monetary flow)

- Goods market: HH demand G&S from F and provide firms with money in exchange for G&S
(spending on part of HH and income to F).
- Factor market: F demand services of labour from HH and HH supply it in exchange for money
from F (spending by F and income to HH).
Notice that this flow is in the opposite direction as the flow for G&S.

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The circular flow of income and spending (monetary flow) continued……

- Firms and Households are in a demand and supply

relationship with each other.
- The market is the arena where demand and supply
meet, by co-ordinating the actions of producers and
consumers. - Each market is described by 2 main
dimensions, viz.
the nature of the good (market contains only goods
among which consumers can freely substitute, i.e.
identical goods such as 2 brands of cereal) and
the geographic area (e.g. market for bread confined
to local area, but market for microwaves may cross
international boundaries).
Government

The overall performance of the economy is a major

responsibility of govt.
AIMS OF GOVERNMENT
1.High and stable level of employment
2.Price stability
3.Satisfactory balance of payment position
4.Acceptable rate of economic growth
5.Equitable distribution of income and wealth
Government
-Role of govt in circular flow of production, income and Spending
-Purchases f.o.p from HH in factor markets (civil servants) Purchases
G&S from F in goods market.
-Provides HH and F with public goods (national defense, health services,
etc.)
-Govt expenditure (denoted by symbol G ) financed through Taxes
(denoted by symbol T), which are supplied by HH and F.
-Govt also makes transfer payments in the form of govt pensions and
grants.
-Govt’s economic activity thus involves these 3 important flows (i.e. G, T
and transfer payments)
-Transfer payments do not directly affect the overall size of the
production, income and expenditure flows, hence the focus only on G
and T.
The government in the circular flow of production, income and spending

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Foreign sector

-SA economy (domestic economy) is an open economy (trades

with the rest of the world)
-Domestic firms and HH export (denoted by symbol X) G&S to
other countries, i.e. they provide other countries with
domestically produced G&S (e.g. major exporter of gold) and they
import (denoted by symbol Z or M) G&S from other countries.
-Difference between exports (X) and imports (M) is known as the
balance of payment.
-Globalisation - economic links between different countries have
become stronger and more complex. Advances in transport and
communication have opened up international markets
The foreign sector in the circular flow of income and spending

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Financial sector

Financial institutions include:

❑ Banks (Standard Bank, Nedbank, etc.)
❑ Insurance companies (Old Mutual, Sanlam, etc.)
❑ Pension funds (Iskor Pension Fund, Mine
Employees Pension Fund)
❑ JSE Securities Exchange
Financial sector

▪Financial institutions act as link between HH or F

with surplus funds (surplus units) and other
participants who require funds (deficit units).
▪HH or F with surplus funds “save” these funds in
the financial institutions in return for interest.
▪F borrow these funds from these financial
institutions i.o.t finance their capital formation
(investment spending) and pay interest.
▪Main function of financial institution is thus to act
as a funnel through which Saving (S) can be
channelled back into the circular flow in the form of
Investment spending (I).
Financial institutions in the circular flow of income and spending

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Total (aggregate) spending

-spending by households on consumer goods and

services (C)
-spending by firms on capital goods (I)
-spending by government on goods and
services (G)
-spending by foreigners on South African goods and
services (X) minus spending by South Africans on
imported goods and services (Z)
-Total expenditure can therefore be written as:
C+I+G+X–Z
Leakages and injections

Government
▪Public spending on G&S (G) = injection.
Reason: It adds to real Q and creates employment
(not the case with transfer payments).
▪Taxes(T) = leakage. Reason: They remove
purchasing power from the system.
▪Govt. manipulate G and T i.o.t influence the level
of Q and Empl.
▪Budget deficit = expansionary effect on income
▪Budget surplus = depressing effect on income
Leakages and injections

Foreign trade
▪Imports (M or Z) represent a leakage from the
circular flow. Reason: it is income paid out by firms
which does not flow back to them.
▪Exports (X) represent an injection into the circular
flow. Reason: spending by foreigners on home-
produced Q is an additional source of income which
is not generated within the domestic system.
▪X >M =expansionary effect on income – bop
surplus ▪M > X = depressing effect on income – bop
deficit
Leakages and injections

Financial sector
Saving = leakage from circular flow of income.
Reason: it is part of the income paid out by firms which is
not returned to them through the spending of HH.
Investment = injection.
Reason: Firms do not only produce consumer G&S bought
by HH. Firms also produce capital goods for sale to other
firms, which add to the circular flow of income. Thus it has
the opposite effect to a leakage and causes income and Q
to expand.
Equilibrium level of income

COMMON ABBREVIATIONS:

Y= National Income
C= Consumption
I= Investment
G= Government Spending on goods and services
X= Exports
Z or M= Imports
S= Saving
T= Taxation
Equilibrium level of income

EXPENDITURE (Y) = OUTPUT(Q)

-Total planned expenditure on the national income = C + I + G + X − Z
But: national Q = national Y(income)
-Thus: Y = C + I + G + X – Z for equilibrium

-We said that for equi. level of income S = I

-But S = leakage and I = injection
-Thus it follows that: Leakages = Injections
Total planned injections = Total planned leakages
I+G+X = S +T+ Z
-Thus: S = I may be offset by a budget deficit or an X-surplus
The major elements of the circular flow of income and spending

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The major elements of the circular flow of income

The diagram summarises the essence of the previous circular flow

diagrams.
-The basic flow is between HH and F. This represents consumption
expenditures (C).
-Savings (S), taxes(T) and imports (Z) are all leakages from the circular
flow.
-Investment spending (I), govt spending (G) and exports (X) are all
injections into the circular flow.
 Important concepts
• Production • Capital
• Income • Consumption of fixed capital
• Spending • Entrepreneurship
• Stock • Technology
• Flow • Money
• Goods market • Capital-intensive production
• Factor market • Labour-intensive production
• Factors of production • Rent
• Natural resources (land) • Wages and salaries
• Labour • Interest
• Specialisation • Profit
• Division of labour • Household
• Human capital • Consumer spending
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 Important concepts

• Firms • Balance of payments

• Profit • Imports
• Captial formation • Exports
(investment) • Circular flow
• Government • Injection (addition)
• Public sector • Leakage (withdrawal)
• Government expenditure • Financial sector
• Taxes • Absolute advantage
• Transfer payments • Relative advantage
• Foreign sector • Macroeconomic objectives

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