Exploring Economics: Its Range, Dimensions, and Circular Flow

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Exploring Economics: Its Range, Dimensions, and Circular Flow

Business Essentials · Chapter 2: Economic Systems and IndicatorsSection 2.1 · lesson 9 of 10516 min · free with a free account

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In this lesson

Scarcity, choice, and how one firm's spending becomes another's income.

  • Define economics and explain scarcity
  • Apply opportunity cost to business choices
  • Distinguish microeconomics from macroeconomics
  • Trace the circular flow and its leakages

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Everything said in the video, section by section (2,332 words). Read along, or search it.

Economic Systems and Indicators

Exploring Economics: Its Range, Dimensions, and Circular Flow

Every business decision starts from the same uncomfortable fact. There isn't enough of anything to go around. Not enough money, not enough time, not enough skilled people, not enough oven hours. Economics is the discipline built around that fact, and this section opens chapter two by laying out its basic tools. We'll define economics, and the condition of scarcity that makes it necessary. We'll meet the four factors of production, and opportunity cost, which may be the most useful idea in the whole subject. We'll separate microeconomics from macroeconomics, and set out the three questions every economic system must answer. Then we'll follow money and resources around the circular flow, and see how one firm's spending becomes another's revenue. And we'll finish with a shop owner choosing between two uses of the same building.

Scarcity

The Condition That Makes Economics Necessary

Economics is the study of how people and societies allocate scarce resources among competing uses. The whole definition rests on one condition. Scarcity. Scarcity means the resources available to produce what people want are limited, while the wants themselves are not. Be careful here. Scarcity is not poverty, and it isn't a shortage in the everyday sense. A wealthy household faces it. So does a large corporation. Each has more things it could do with its money, time, and attention than it can actually do. If resources were unlimited, no one would ever need to choose, and there'd be nothing for economics to study. Because they are limited, every use of a resource is a choice against some other use. For a business, that's not abstract. A business is a device for turning limited resources into things customers will pay for. Which product to make, which customers to serve, which equipment to buy. Every one of those is a decision about scarce resources. Economics won't tell a manager what to choose. What it does is make the trade-offs visible, and that's where good decisions begin.

Table 2.1.1

Four Factors, Four Payments

The resources that go into production are grouped into four factors of production. A fictional bakery makes them concrete. Land means natural resources in the broad sense. The ground the shop stands on, and the wheat grown for its flour. Land earns rent. Labor is the physical and mental effort of people. The bakers, the counter staff, the delivery driver. Labor earns wages. Capital is the one that trips people up. In economics, capital means manufactured goods used to make other goods. Ovens, mixers, display cases, the delivery van. It does not mean the money used to buy them. Capital earns interest, the payment for the use of the funds that finance those assets. Entrepreneurship is the act of organizing the other three factors, and bearing the risk of the venture. It earns profit, which is whatever remains after every other factor has been paid. And profit can be negative. Each factor shows up in a different decision. Where to locate, how many people to hire, which equipment to buy, whether to start or close. And a decision about one factor usually changes the return to another. One more thing to notice. Every payment to a factor is a cost to the business, and an income to some household. Hold on to that. It comes back in the circular flow.

Opportunity Cost

The Price of the Next Best Alternative

If resources are scarce, choosing one use means giving up another. That's the root of opportunity cost. Opportunity cost is the value of the next best alternative forgone when a choice is made. The words next best matter. It isn't the sum of everything you could have done instead. It's the single most valuable alternative you passed up. And it applies to every decision, including ones that involve no money at all. A manager who spends Friday afternoon interviewing a candidate gives up whatever else that time could have produced. Three examples show it at different scales. An owner uses an hour of oven time for a batch of cakes. The cost of the cakes is the profit on the loaves that hour could have made. A firm spends its savings on a new delivery van. It gives up paying down a loan, or hiring another employee, whichever was its best alternative. A manager commits three weeks of a designer's time to a website redesign. The product catalog the designer could have built is the real price. In each case the true cost is larger than the money spent, because the alternative forgone is part of the price. That's why accounting records and opportunity cost can differ sharply. Accounts capture what was paid out. Opportunity cost captures what was given up. An owner running a shop in a building she owns pays no rent, so the premises may look free. They aren't. The building could be leased to someone else.

Production Possibilities

Chairs or Tables?

Opportunity cost can be pictured for a whole economy, or a single workshop, through the production possibilities idea. It describes the combinations of two goods that can be produced, when all available resources are fully and efficiently used. Imagine a workshop that can make chairs or tables, with the same workers, tools, and hours. Put every hour into chairs, and you get the most chairs and no tables. Put every hour into tables, and the reverse holds. Every mix lies somewhere in between. That's the central lesson. Producing more of one good requires producing less of the other. There's a second lesson hiding in it. A workshop producing inside its possibilities, with idle workers or unused machines, is wasting resources. It could make more of one good without giving up any of the other. The limit itself can move. Economic growth is an increase in productive capacity, so the workshop can now make more of both. Growth comes from more resources, like extra workers or machines. Or it comes from better methods, like a faster process or a more skilled workforce. But growth doesn't remove scarcity, because wants expand alongside capacity. What growth does is widen the set of choices.

Two Branches

Microeconomics and Macroeconomics

Economics divides into two branches, by the scale of what it examines. Microeconomics studies individual decision makers, meaning households, firms, and the markets in which they trade. It asks why a bakery sets the price it does, how a household chooses between two products, and what determines the wage a worker is offered. Macroeconomics studies the economy as a whole, through aggregates like total output, total employment, and the general level of prices. It asks why output grows in some years and falls in others, and why prices rise over time. The distinction is one of perspective, not subject. The same event can be examined at both levels. A rise in the price of flour is a micro question when it concerns one bakery's pricing. It's a macro question when it's one part of a general rise in prices. For a business, each branch matters differently. Microeconomics explains the decisions it controls, like pricing, output, and hiring. It also explains how the firm's customers and competitors behave. Macroeconomic conditions sit outside its control, but they shape everything it faces. The level of demand, the availability of credit, the cost of inputs.

Three Basic Questions

What, How, and For Whom

Because resources are scarce, every economic system has to answer three basic questions. What to produce. Out of everything that could be made, which goods and services, and in what quantities? How to produce. Which methods, and which combinations of factors? Is a good made by hand, or by machine? For whom to produce. How will the output be shared among the members of society? Different economic systems answer these questions through very different mechanisms, and the next section compares them. But the questions aren't only for whole economies. A single firm faces the same three. Which products to offer, which processes to use, and which customers to serve. So the same framework works at both scales, the country and the company.

Figure 2.1.1

The Extended Circular Flow

The circular flow model is a simplified picture of how the parts of an economy connect through exchange. In its basic form there are just two groups. Households own the factors of production, and they also buy what the economy produces. Businesses use those factors to produce goods and services, and sell them to households. Two flows run between them, in opposite directions. The real flow is the flow of things. Households supply labor, land, capital, and entrepreneurship to businesses. Businesses supply goods and services back. The money flow runs the other way. Businesses pay households wages, rent, interest, and profit. And households pay businesses for goods and services, which becomes business revenue. Every payment is somebody's income. The money a business spends on factors comes back when households spend their income on its products. The circle closes. The extended model adds three sectors that the basic version leaves out. Government collects taxes from households and businesses. It provides services, purchases goods, and makes transfer payments such as retirement benefits. The financial sector, meaning the banks and markets that gather saving and lend it out, connects households that save with businesses that invest. And the foreign sector adds trade. Domestic buyers purchase imports, and foreign buyers purchase exports. So three streams drain out of household spending: saving, taxes, and imports. And three flow into business spending: investment, government purchases, and exports.

Leakages and Injections

What Leaves the Loop, and What Enters

The model gives those streams names. A leakage is a withdrawal from the circular flow of spending. Saving, taxes, and imports are all leakages. Money that's saved, taxed, or spent abroad doesn't come straight back to domestic businesses as revenue. An injection is an addition to the flow. Investment, government purchases, and exports are injections. Each sector pairs a leakage with an injection. Government takes taxes, and makes purchases. The financial sector gathers saving, and funds investment. The foreign sector takes imports, and supplies exports. What matters is the balance between them. When injections equal leakages, the level of activity is stable. When injections exceed leakages, activity tends to rise. And when leakages exceed injections, it tends to fall. For a business, that's not academic. The balance of leakages and injections is what makes total spending, and so business revenue, rise or fall.

Reading the Model

A Map of Connections

So what does the model really show? Interdependence. One participant's spending is another's income, so a change in one part is transmitted around the whole. What it deliberately leaves out is just as important. It has no prices. So it can't say how much is produced, or at what cost. It treats all households, and all businesses, as alike. So it says nothing about who receives income, or how unequally. It omits unpaid household work entirely. And it ignores the natural environment, where resources come from, and where wastes return. None of that makes the model wrong. It's a map of connections, and it's useful precisely because it is simple. Read it as a map, not as a description of any actual economy.

Supply and Demand

Where Demand Comes From

Here's why a business, and not just an economist, should care about all this. Households can spend only what they earn, save, or borrow. And their incomes come from businesses. So the demand facing any one business is ultimately generated by the payments all the other businesses make. A change in employment, taxes, or credit changes demand for your product, even when nothing about the product has changed. That's why this chapter matters to a manager who never plans to be an economist. So does the treatment of money and the Federal Reserve in chapter twenty-three. Prices are the mechanism through which much of this adjustment happens. The simplest account of them is supply and demand. Demand describes the quantities buyers are willing and able to purchase at each possible price. In general, they buy less as the price rises. Supply describes the quantities sellers are willing to offer at each price. In general, they offer more as the price rises. Where the two meet, the market reaches equilibrium. The quantity buyers want equals the quantity sellers offer. Above that price, sellers offer more than buyers want. That's a surplus, and competition among sellers pushes the price down. Below it, buyers want more than is offered. That's a shortage, and competition among buyers pushes the price up. A change in something other than price, like household income or the cost of ingredients, shifts the whole relationship, and moves the equilibrium. The next section builds on this, by asking how many sellers a market has, and how much power each one holds.

Case Vignette

Two Uses of the Same Premises

We'll finish with a composite case, built for instruction, using illustrative figures. Lena owns a small print shop in a ground-floor unit of a building she owns outright, with no loan against it. She's thinking about closing the shop's front counter, and opening a cafe in the unit instead. Her projections show the cafe covering ingredients, equipment payments, and a part-time employee. It would leave about eighteen hundred dollars a month in profit. Because she owns the building, her accounts show no charge for the premises. On that basis, the cafe looks clearly worthwhile. But a neighboring business has offered to lease the same unit, for three thousand dollars a month. That offer is the next best alternative to running the cafe. So it's the opportunity cost of the premises. Measured against it, the cafe's profit is a shortfall of twelve hundred dollars a month. And that's before allowing for her own work in the cafe. No cash leaves her account for the premises either way. So this isn't a question of accounting cost. It's a comparison of what the unit earns in two uses. The trade-off isn't all one way, though. The cafe might grow. It might be sold as a going concern. It would give her work she may prefer. Those things have value, even if they're hard to price. The catch is that the lease income is nearly certain, while the cafe's income is an estimate. So Lena separates what is measured from what is forgone. She chooses the cafe only if she can explain one thing: why its uncertain benefits exceed the three thousand dollars she'd give up.

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FAQ

Questions students ask us

About Exploring Economics: Its Range, Dimensions, and Circular Flow

What are the four factors of production?
The four factors of production are land, labor, capital, and entrepreneurship. Land is natural resources and earns rent, labor is human effort and earns wages, capital is manufactured goods used to make other goods, such as ovens and vans, and earns interest, and entrepreneurship organizes the other three and bears the risk, earning profit. In economics, capital means equipment and buildings, not the money used to buy them.
What is opportunity cost in economics?
Opportunity cost is the value of the next best alternative given up when a choice is made, not the sum of every alternative. It can differ sharply from accounting cost. An owner who runs a cafe in a building she owns pays no rent, but if a neighbor would lease the unit for $3,000 a month, a cafe earning $1,800 a month in profit falls $1,200 short of the best alternative.
What is the circular flow model?
The circular flow model is a simplified picture of how households and businesses connect through exchange. Households supply land, labor, capital, and entrepreneurship and buy goods and services, while businesses pay wages, rent, interest, and profit and sell their output. Goods and factors flow one way and money flows the other, so one participant's spending is another's income. The extended model adds government, the financial sector, and foreign trade.
What are leakages and injections in the circular flow?
Leakages are withdrawals from the flow of spending, namely saving, taxes, and imports, while injections are additions, namely investment, government purchases, and exports. When injections equal leakages, the level of activity is stable. When injections exceed leakages, activity tends to rise, and when leakages exceed injections, it tends to fall. That balance helps explain why business revenue can change even when nothing about a product has changed.

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