Economic Basics


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Basic Terminology



Demand and Supply

The Price System

Government Functions

The Circular Flow

On some of the margin notes pages you may get messages that say "This page is accessing information that is not under its control..." That's simply due to videos embedded on the page.






Overview: Introduction to Economics


MONOPOLY'S TYCOONThe term economics covers such a broad range of meaning that any brief definition is likely to leave out some important aspect of the subject. It is a social science concerned with the study of economies and the relationships between them. Economics is the study of how people and societies choose to employ scarce productive resources (which could have alternative uses), produce various commodities and distribute them for consumption. Economics generally studies problems from society's point of view rather than from the individual's. Finally, economics studies the allocation of scarce resources among competing unlimited wants.

Below, I have given you a general overview of the field of economics. As you work through the units of your course, you will see each of these things again in more detail. Students are often intimidated by economics … You shouldn’t be! Let me offer one word of caution, however. Economic concepts build on each other and you must be careful that you understand basic concepts in order to understand advanced concepts.

If you skip a concept in Unit Two, for example, you may well have trouble understanding the concepts in Unit Six. If you have trouble understanding a concept, slow down and go back over the material as many times as necessary. Take advantage of all of the resources I’ve provided. If you stick with earlier concepts until you understand them, you’ll have little trouble with later concepts.


I. The Goals of Economics

As a science, economics must first develop an understanding of the processes by which human desires are fulfilled. Second, economics must show how factors that affect production and consumption lead to various results. Furthermore, it must draw conclusions that will serve to guide those who conduct and, in part, control economic activity.


II. Micro and Macro Views of the Economy

While there are numerous specialties within the academic field, at its most basic level economics is commonly divided into two broad areas of focus: microeconomics and macroeconomics. Microeconomics is the study of smaller levels of the economy, such as how an individual firm or a small group of firms operate. Macroeconomics is the study of whole economies or large sectors of economies.

A. Microeconomics

Microeconomics is the social science dealing in the satisfaction of human wants using limited resources. It focuses on individual units that make up the MICRO AND MACRO AREAS OF FOCUSwhole of the economy. It examines how households and businesses behave as individual units, not as parts of a larger whole. For instance, microeconomics studies how a household spends its money. It also studies the way in which a business determines how much of a product to produce, how to make the best use of production factors and what pricing strategy to use. Microeconomics also studies how individual markets and industries are organized, what patterns of competition they follow and how these patterns affect economic efficiency and welfare.

B. Macroeconomics

Macroeconomics studies an economy at the aggregate level. It is concerned with the workings of the whole economy or large sectors of it. These sectors include government, business and households. Macroeconomics deals with such issues as national economic output and growth, unemployment, recession, inflation, foreign trade, monetary policy and fiscal policy.


III. Basic Economic Principles

Basic economic principles include the law of demand, demand determinants, the law of supply, supply determinants, market equilibrium, factors of production, the firm, gross product, as well as inflation and unemployment.

A. The Law of Demand

When an individual want is expressed as an intention to buy, it becomes a demand. The law of demand is a theory about the relationship between the amount of a good that a buyer both desires and is able to purchase per unit of time, and the price charged for it. The ability to pay is as important as the desire for the good, because economics is interested in explaining and predicting actual behavior in the marketplace, not just intentions. At a given price for a good, economics is interested in the buyer's demand that can effectively be backed by a purchase. Thus, it is implied with demand that a consumer not only has the desire and need for a product, but also has the money to purchase it. The law of demand states that the lower the price charged for a product, resource or service, the larger will be the quantity demanded per unit of time. Conversely, the higher the price charged, the smaller will be the quantity demanded per unit of time — all other things being constant. For example, the lower the purchase price for a six-pack of Coca-Cola, the more a consumer will demand (up to some saturation point, of course).

B. Demand Determinants

Movement along the demand curve — referred to as a change in quantity demanded — means that only the price of the good and the quantity demanded change. All other things are assumed to be constant or unchanged. These things include the prices of all other goods, the individual's income, the individual's expectations about the future and the individual's tastes. A change in one or more of these things is called a change in demand. The entire demand curve will move as a result of a change in demand.

movement along the demand curve = change only in price or quantity demanded

movement of entire demand curve = change in one or more demand determinants (not price or quantity)


The law of supply is a statement about the relationship between the amount of a good that a supplier is willing and able to supply and offer for sale, per unit of time, and each of the different possible prices at which that good might be sold. This law further states that suppliers will supply larger quantities of a good at higher prices than at lower prices. In other words, supply generally is governed by profit-maximizing behaviors. The supply curve indicates what prices are necessary in order to give a supplier the incentive to provide various quantities of a good per unit of time. Just as with the demand curve, movement along the supply curve always assumes that all other things are constant.


D. Supply Determinants

At the opportunity for sale at a certain price, a part of total supply becomes realized market supply. Economics emphasizes movement along the supply curve in which the price of the good determines the quantity supplied. As with the demand curve, the price of the good is singled out as the determining factor with all other things being constant. On the supply side, these things are the prices of resources and other production factors (including labor costs), technology, the prices of other goods, the number of suppliers and the suppliers' expectations.

movement along the supply curve = change only in price or quantity demanded

movement of entire supply curve = change in one or more supply determinants (not price or quantity)

E. Market Equilibrium

Supply and demand interact to determine the terms of trade between buyers and sellers. In theory, supply and demand mutually determine the price at which sellers are willing to supply just the amount of a good that buyers want to buy. The market for every good has a demand curve and a supply curve that determine this price and quantity. When this price and quantity are established, the market is said to be in equilibrium. The price and quantity at which this occurs are called the equilibrium price and equilibrium quantity. In equilibrium, price and quantity have the tendency to remain unchanged.

equilibrium: price and quantity demanded = price and quantity supplied

F. Factors of Production

Factors of production are economic resources used in the production of goods, including natural, man-made and human resources. They may be broken down into two broad categories: (1) property resources, specifically capital and land; (2) human resources, specifically labor and entrepreneurial ability.

Managers often speak of capital when referring to money, especially when they are talking about the purchase of equipment, machinery and other productive facilities. Financial capital is the more accurate term for the money used to make such purchases. An economist would refer to these purchases as investments. The economist uses the term capital to mean all the man-made aids used in production. Sometimes referred to as investment goods, capital consists of machinery, tools, buildings, transportation and distribution facilities, and inventories of unfinished goods. A basic characteristic of capital goods is that they are used to produce other goods. Capital goods satisfy wants indirectly by facilitating the production of consumable goods, while consumer goods satisfy wants directly.

To an economist, land is the fundamental natural resource that is used in production. This resource includes water, forests, oil, gas and mineral deposits. These resources are rapidly becoming scarce. Land resources, which include the natural resources above, on and below the soil, are distinguished by the fact that man cannot make them.

Labor is a broad term that covers all the different capabilities and skills possessed by human beings. While this often means direct production labor, it includes management labor as well. The term manager embraces a host of skills related to the planning, administration and coordination of the production process.

Entrepreneurial ability also is known as enterprise. Entrepreneurs have four basic functions. First, they take initiative in using the resources of land, capital and labor to produce goods and services. Second, entrepreneurs make basic business policy decisions. Third, they develop innovative new products, productive techniques and forms of business organization. Finally, entrepreneurs bear the risk. In addition to time, effort and business reputation, they risk their own personal funds, as well as those of associates and stockholders.

G. The Firm


Factors of Production (land, capital and labor) are brought together in a production unit referred to as a business or firm. The firm uses these resources to produce goods that are then sold. The money obtained from the sale of these goods is used to pay for the economic resources. Payments to those providing labor services are called wages. Payments to those providing buildings, land and equipment leased to the firm are called rent. Payments to those providing financial capital, such as loans, stocks and bonds, are called dividends and interest. In other words, since capital goods are man-made and reproducible, they tend to increase the productivity of labor.


H. Gross Production

The total dollar value of all the final goods produced by all the firms in an economy is called the gross product. This commonly is measured by one or both of the following:

1.  Gross national product (GNP) includes the value of all goods and services produced by firms originating in a single nation. This means that foreign direct investment (FDI) — such as a Japanese auto plant in the US — is not included in GNP, even though the plant might employ US workers and sell its output exclusively to US consumers. Conversely, the value of production by US-based firms abroad would be considered part of the US GNP.

2.  Gross domestic product (GDP) includes the value of all goods and services produced within a nation, regardless of where the owners of production are based. In this case, FDI into the US would contribute to US GDP, while US investment in other countries would contribute to those countries' GDP, not that of the US.

GNP = value of all goods and services produce by all US firms no matter where located

GDP = value of all goods and services produced by all firms located in the US

GDP is the preferred measure of gross product for many kinds of economic analyses. This is because foreign investment has grown rapidly around the world, and because foreign-owned assets, such as a manufacturing facility, tend to have a greater net influence on the domestic economy in which they are situated. Both measures of gross product calculate the value of products and services on a value-added basis so that output is not double-counted, such as when products are resold through different phases of the supply and distribution chain.

In order to make comparisons, economists often use real GNP or GDP, which means the figure has been adjusted to hide the effects of inflation, or the general rise of prices relative to the quantity or quality of goods produced. Therefore, real gross product is commonly taken as an indicator of overall economic health. A rise at a moderate, sustainable pace is considered healthiest. However, if gross product is declining or rising at an unsustainably fast pace, it usually is interpreted as a negative signal.

I. Inflation and Unemployment

The economic health of a nation, of which gross product is one measure, is directly affected by two other important factors – inflation and unemployment.

1.  Inflation is an ongoing general rise in prices without a corresponding rise in the quantity or quality of the underlying merchandise or services (i.e., getting "less for more"). Inflation represents an economic imbalance and diminishes a currency's real and nominal purchasing power. The steeper the rise, the faster the decline of the currency's purchasing power. Rapid economic expansion is one factor that can lead to price inflation, as can lax or inconsistent control of the money supply (such as through a central bank’s monetary policy). Leading measures of inflation in the US are the Consumer Price Index (CPI) and the Producer Price Index (PPI). When inflation data are used to adjust the estimate of GDP, it is known as the GDP deflator."SORRY WE'RE CLOSED" SIGN

2.  The unemployment rate measures the percentage of the total number of workers in the labor force who are actively seeking employment but are unable to find jobs. While this seems straightforward, there are some measurement issues to consider, such as what constitutes looking for a job, how part-time labor is interpreted (i.e., being underemployed rather than unemployed), and what happens when an individual is technically employable but not actively seeking employment for whatever reason.

In general the higher the unemployment rate, the more the economy is wasting labor resources by allowing people to sit idle. Still, when unemployment rates are low there is a tendency toward wage inflation because new employees are harder to find and workers often require additional incentives in order to take or keep a job. Because having a moderate pool of unemployed workers serves as a buffer to rising labor costs, most economists view full employment (zero or negligible unemployment) as impractical and even undesirable. Structural unemployment seemingly allows human capital to flow more freely (and cheaply) when there are changes in demand for labor in various parts of the economy. Of course, this does not mean that high unemployment is viewed as positive.


IV. Schools of Economic Thought

Family Tree of Economics

While many basic economic principles and ideas are widely accepted by economists, there have been and continue to be differing theories about some areas of economic behavior. The following is a brief overview of the three most influential theoretical perspectives.

A. Classical Economics

Dating back to 18th-century Europe, classical economics posited the market system would ensure full employment of the economy's resources. Classical economists acknowledged that abnormal circumstances such as wars, political upheavals, droughts, speculative crises and gold rushes would occasionally deflect the economy from the path of full employment. However, when these deviations occurred, automatic adjustments in prices, wages and interest rates within the market would soon restore the economy to the full-employment level. A decrease in employment would reduce prices, wages and interest rates. Lower prices would increase consumer spending, lower wages would increase employment and lower interest rates would boost investment spending. Classical economists believed in Say's Law, which states that supply creates its own demand. Although more recent economic philosophies differ in some of the specifics, particularly on the roles of government, the central bank and international trade, many tenets of classical economics are still accepted today.

B. Keynesian Economics

As a consequence of the 1936 publication of British economist John Maynard Keynes's General Theory of Employment, Interest and Money, mainstream economists came to give less importance to the role of money in the economy than had classical economists. Keynes sought to explain why there was cyclical employment in capitalistic economies. Keynes's analysis of how total demand determines total income, output and employment, and the potentially key role for fiscal (government) policy in the process, captured the attention of most economists.

Moreover, the General Theory seemed to make compelling arguments for the use of government fiscal policy to avoid such problems and to smooth out economic instability. Keynesian followers believe that savings must be offset by investment. They termed propensity to consume as a person's decision on how much of total income will be allocated to savings and how much will be spent. The Keynesian view sees the causes of unemployment and inflation as the failure of certain fundamental economic decisions, particularly saving and investment decisions. In short, the Keynesian view is one of a demand-based economy.

C. Monetarism

More recently, the monetarists, led by Nobel laureate economist Milton Friedman, argued that money plays a much more important role in determining the level of economic activity than is granted to it by the Keynesians. Monetarism holds that markets are highly competitive and that a competitive market system gives the economy a high degree of macroeconomic stability. Monetarists argue that the price and wage flexibility provided by competitive markets causes fluctuations in total demand rather than output and employment. Monetarism is concerned with controlling the money supply and not with injecting excess liquidity into markets. This view is somewhat compatible with, but not identical to, the supply-side school of economics.

Dig DeeperWe, the Economy Films: Chapter 1: What is the economy?

How did the economy get started? Meet Ugg, Glugg and Tugg, three enterprising cave men who accidentally invented trade, marketing and the base elements of the modern market economy.

Why is the law of supply and demand so powerful? A whimsical tale of love, dance and the economic concept of supply and demand. Bored in class, Jonathan and Kristin are woken up by our friendly narrator who helps guide them on an adventure in economics and... um... dance.

How do we measure the economy? Two economists settle their differences - in the professional wrestling ring. Watch and cheer as John Maynard Keynes and Friedrich Hayek square off in a testosterone-fueled battle over how to measure the economy.

How does government regulate the economy? In an idyllic suburban neighborhood, Jerry runs his big business lemonade stand and has the market cornered -- until ten-year-old Addie opens her own stand across the street. Competition equals war, and both sides use -- and abuse -- a government regulator to try and win. In the end, one special customer will decide their fate.

Are natural resources vital to the economy? Why should nature be taken into account when looking at the economy as a whole? "A Bee's Invoice" uncovers and incorporates the hidden value of natural capital in the measurement of our economy.

Milton FriedmanFifty years ago, The Times Magazine published an essay by the economist Milton Friedman that became highly influential. It had a plain-spoken headline - “The Social Responsibility of Business Is to Increase Its Profits” - and argued that corporate executives should stop worrying about paying high wages, protecting the environment and other do-gooderism. They could best help society, Friedman argued, by maximizing the value of their companies.

The essay helped lay the groundwork for a laissez-faire revolution, in the US and elsewhere. In the years since, many American companies have prospered, with soaring profits and stock prices - but there have also been big downsides. The incomes and wealth of most American workers have grown slowly. Some other measures of well-being, like life expectancy, have also stagnated. The planet is facing the destructive crisis of global warming.

For the essay’s 50th anniversary, The Times invited executives, economists and others - both defenders and critics of Friedman - to reflect on the essay. As part of the package, the author Kurt Andersen argues that 1960s liberalism made Friedman possible.















Basic Economic Terminology


It's extremely important that you learn and understand each of these terms. That will be easier as you start to use them. As you progress through the rest of the units, make certain you come back to this list as needed and refresh your memory. If you do that, you'll soon begin to genuinely know and understand the concepts.



The study of how people allocate their limited resources to satisfy their unlimited wants ... ultimate purpose of economics is to understand choices.

ReadWhy Do We Need Economists and The Study of Economics?


Microeconomics vs Macroeconomics

Microeconomics: the part of economic analysis that studies individual decision making undertaken by individuals (or households) and by firms.

Macroeconomics: the part of economic analysis that studies the behavior of the economy as a whole. It deals with economy-wide phenomena such as changes in unemployment, the general price level, and national income.


Economic Behavior

Rational Self-Interest: economic assumption that individuals act as if they are motivated by self-interest and respond predictably to opportunities for gain

The Rationality Assumption: the assumption that individuals will not intentionally make decisions that would leave them worse off

Responding to Incentives: the reward for engaging in a given activity … people react to an incentive by making a rough comparison of costs and benefits

Defining Self-Interest: the pursuit of goals that make the individual feel better off … in economic analysis goals are often measured in monetary terms although the pursuit of other goals (prestige, love, power, etc) can be analyzed using this concept

ReadFree Enterprise, The Economy and Monetary Policy (PDF and sometimes slow to load)



Models and Realism: economic models or theories, which are simplified representations of the real world, are developed and used as aids in understanding, explaining, and predicting economic phenomena in the real world. A model should capture the essential relationships that are sufficient to analyze the specific problem or answer the specific question being asked. No economic model is complete in the sense of capturing every detail and relationship that exists in the real world. A model is by definition an abstraction from reality. This does not mean that models are deficient simply because they are unrealistic and use simplified assumptions. Every model in every science requires simplification compared to the real world.

Assumptions: assumptions define the set of circumstances in which a model is most likely to be applicable. Every model, therefore, must be based on a set of assumptions.

The Ceteris Paribus Assumption (All Other Things Being Equal): assumption that nothing changes except the factors being studied … used to isolate the effect of a change in one variable on another one by assuming that all other variables do not change.

Deciding on the Usefulness of a Model: a model is useful if it yields usable predictions and implications for the real world … if a model makes a prediction and factual evidence supports the prediction, the model is useful.

Essentially, all models are wrong, but some models are useful. George E.P. BoxModels of Behavior, Not Thought Processes: models relate to the way people act in using limited resources and not to the way they think … normally generalize people’s behavior

The Two Common Pitfalls in Understanding How the Economy Works: (1) failing to understand the ceteris paribus assumption and (2) confusing association with causation

Association and Causation : We cannot always assume that when one event follows another, the first caused the second. Just because two things are associated – by timing or anything else – does not mean there is a causal relationship.

Direct/Positive Relationship: A direct or positive relationship between price and quantity supplied means that if one goes up the other goes up and if one goes down the other goes down. Supply curves have a positive slope because only at a higher price will it be profitable for sellers to incur the higher opportunity cost associated with supplying a larger quantity.

Inverse/Negative Relationship: An inverse or negative relationship between price and quantity means that if one goes up the other goes down and if one goes down the other goes up. Demand curves have a negative slope because only at a lower price will consumers be willing to demand a higher quantity.


Positive versus Normative Economics

Positive economics deals with what is. Positive economic statements are “if-then” statements. Since positive economics predicts consequences of actions, it can be used to predict the effects of various policies to see if the policies aid in achieving desired goals. Positive economics cannot provide criteria for choosing which outcomes or goals are best.

Normative economics deals with what some individual thinks ought to be. Normative economic statements involve value judgments and normally have the words “ought” or “should” in them.

Warning: It is easy to define positive economics. It is often difficult to identify unlabeled normative statements.



Factors of production / inputs used in the production of things that people want


Production: virtually any activity that makes the things that exist and that we use more valuable to us

Land: natural resources

Labor: all productive contributions made by individuals who work

Physical capital or capital good: all manufactured resources used for production

Investment: Investment is the accumulation of capital – such as factories, machines and inventories – that is used to produce goods and services. When an economy does not invest in new technology, everything else being equal, the economy will not grow. The opportunity cost of investment is the consumer goods that could have been purchased now but weren’t because the money was spent for plants and other capital. But an increase in investments makes it possible to have economic growth and more goods and services in the future. The normal rate of return is the amount that must be paid to an investor to induce investment in business. The normal rate of return is also the opportunity cost of capital.

Human capital: training and education workers receive that increases their productivity

Entrepreneurship: a type of labor that organizes, manages and assembles other factors of production to make business ventures … takes risks associated with introducing new methods and other types of new thinking that could lead to more income


Goods and Services

Good: anything from which individuals derive satisfaction or happiness

Economic good: good for which the quantity demanded exceeds the quantity supplied at a zero price

Service: purchased or used by consumers with no physical characteristics








Desired goods

Wants are unlimited


Not objectively definable in economics ... some individuals might view shelter as a need, others might not

Those things that are absolute necessity to stay alive - food, water, etc - are obviously needs but perhaps not the only needs.



Wants are unlimited but, by definition, the supply of economic goods is limited.

The things consumers want and need are scarce.

Scarcity requires that individuals and societies make choices.

The dilemma created by unlimited wants and scarce goods is the central concept in economics.

The central problem of economics is providing for people’s wants and needs in a world of scarcity.

The three fundamental economic questions: (1) What to produce? (2) How to produce? (3) For whom to produce?

ReadChoices Are Everywhere: Why Can’t We Just Have It All?


Opportunity Cost

In many ways, economics is the study of choices.

When one choice is made, another is always given up.

Opportunity Cost: the alternative given up when a choice is made

Your textbook had a dollar cost of $50 plus an opportunity cost of what you would have bought with that $50 had you not bought your text.

In economics, we always view cost as a foregone opportunity, an opportunity given up in favor of something else.


Marginal Analysis

Marginal analysis is an examination of the effects of an addition to or subtraction from a current situation ... analyzing the margin. Marginal changes are small, incremental adjustments to an existing plan of action. Marginal thinking requires decision-makers to evaluate whether the benefit of one more unit of something is greater than its cost.

In the situation below, thinking about the benefit and cost of whether to add each additional hour is marginal analysis.


Example of Marginal Analysis










Sometimes called a production possibilities frontier.

The PPC shows...

"all possible combinations of output that can be produced from a fixed amount of resources of a given quality and the efficient use of those resources over a specified period of time."

Movement from one point to another on the PPC shows that some of one good must be given up to have more of another.

The assumptions on which the PPC is based are:

Resources are fully employed.

There is a specified time period, for example, one year.

Resources are fixed in both quantity and quality.

Technology does not change.

"Off the PPC"

Any point outside the PPC cannot be reached for a specified time period.

Any point inside the PPC is attainable but represents an inefficient use of resources.


Producing the maximum output with available technology and resources    OR    a given output is produced at a minimum cost

An economy is efficient when it is on its PPC.

Increasing relative cost

As society takes more and more resources and applies them to the production of any one item, the opportunity cost increases for each additional unit produced.

Economic growth

Illustrated by an outward shift of the production possibilities curve.

WatchProduction Possibility Curve

ReadProduction Possibility Frontier



Working at a relatively well-defined, limited activity leads to an increase in productivity.

Absolute advantage: ability to produce more units of a good or service using a given quantity of labor or resource inputs … the ability to produce the same quantity of a good or service using fewer units of labor or resource inputs

Comparative advantage: ability to produce a good or service at a lower opportunity cost compared to other producers … the basis for specialization

Division of labor: a term first used in Adam Smith’s The Wealth of Nations to describe the narrow specialization of tasks within a production process so that each worker can become a specialist in doing one thing, for example on an assembly line. Using his famous example of pins, Smith asserted that ten workers could produce 48,000 pins per day if each of eighteen specialized tasks was assigned to particular workers. Average productivity: 4,800 pins per worker per day. But absent the division of labor, a worker would be lucky to produce even one pin per day if he had to do everything from start to finish.

The advantages of division of labor:

  1. increases productivity (and so increases wealth)

  2. eliminates the long training period required to train craftsmen

  3. uses lesser paid but more productive unskilled workers

  4. higher average standard of living

  5. the growth of total trade

  6. the rise of capitalism

  7. the increased complexity of industrialized processes (and so more sophisticated output)

  8. workers need less training to master a small number of tasks

  9. faster to use one particular tool and do one job over and over

  10. workers can concentrate on those jobs which best suit their skills

ReadThe Island (PDF)


Dig Deeper



What is capital? (9:29)



Test Yourself: Basic Terminology
















The Law of Demand: the quantities of a good or service that people will purchase at any price during a specified time period, other things being equal. The law of demand states that there is an inverse relationship between relative price and quantity demanded, i.e. when the relative price of a good goes up, people buy less of it and when the relative price of a good goes down, people buy more of it, other things being equal.


The Demand Schedule: The demand schedule is a numerical representation of the inverse relationship between specific prices and quantities demanded of a good measured in terms of constant quality units in a given time period.



Price per Constant-Quality Rewritable CD

Constant-Quality Rewritable CDs per Year

















The Individual Demand Curve: The demand curve is a graphic representation of the demand schedule. It is a negatively sloped line showing the inverse or negative relationship between the price and the quantity demanded, meaning that if one goes up the other goes down and vice versa.



A market is any arrangement in which buyers and sellers interact to determine the price and quantity of goods and services exchanged.

Market Demand is the summation of the individual demand schedules in a market.

When price changes, there is a change in the quantity demanded and so movement along the curve.

When something other than price changes, the whole curve shifts ... there is a change in demand. Changes in non-price determinants of demand can produce a shift in the demand curve, but not movement along the demand curve.

Shifts in Demand: A movement of the entire demand curve so that at each price the quantity demanded changes. A leftward shift of the demand curve means the quantity demanded at each price decreases and is called a decrease in demand, while a rightward shift of the demand curve means the quantity demanded at each price increases and is called an increase in demand.




Quick Tip: Determinants of Demand and Supply

The Other Determinants of Demand: These are non-price factors which determine how much will be bought, other things held constant. A change in any one of these factors will cause a change in demand.

Income: For a normal good, an increase in income leads to an increase in demand, while a decrease in income leads to a decrease in demand. For an inferior good, an increase in income leads to a decrease in demand, while a decrease in income leads to an increase in demand.

A normal good is any good for which there is a direct relationship between changes in income and its demand curve. If income increases, demand for normal goods increases.

An inferior good is any good for which there is an inverse relationship between changes in income and its demand curve. As buyers’ incomes increase, demand for inferior goods decreases.

Normal and Inferior Goods









Tastes and Preferences: If consumer tastes change in favor of a good, then there is an increase in demand for it. If consumer tastes move against the good, then there is a decrease in demand for it.

Prices of Related Goods (Substitutes and Complements): When two goods are related a change in the price of one of them changes the demand for the other. Substitutes are goods that can be used to satisfy a similar want. If the price of one changes, demand for the other changes in the same direction. Complements are goods that are consumed together. If the price of one changes, the demand for the other changes in the opposite direction.

Substitute goods are goods that compete with one another for consumer purchases. If a product’s price begins to increase, the demand for similar but less expensive products (substitutes) will increase.

Complementary goods are goods that are jointly consumed with another good – coffee and cream, peanut butter and jelly, printer ink and paper. As a product’s price increases, the demand for that product and for its compliments decrease.

Complements and Substitutes










Expectations: Expectations of future increases in the price of a good, increases in income, and reduced availability lead to an increase in demand now. Expectations of future decreases in the price of a good, decreases in income, and increased availability lead to a decrease in demand now.

Market Size (Number of Buyers): An increase in the number of buyers in the market causes an increase in demand. A decrease in the number of buyers causes a decrease in demand.


Changes in Demand vs Changes in Quantity Demanded: A change in demand refers to a shift of the entire demand curve to the right or left if there is a change in a determinant of demand other than price. A change in quantity demanded refers to a movement along a given demand curve caused by a change in price.

Test Yourself


Test Yourself: Demand
















The Law of Supply: the relationship between price and quantity supplied at different prices in a specified time period, other things being equal. The law of supply states that the higher the price of a good, the larger the quantity sellers will make available over a specified time, other things being constant.


Supply (4:57)


The Supply Schedule: The supply schedule is a table that shows a direct relationship between price and quantity supplied at each price in a given time period.



Price per Constant-Quality Rewritable CD

Quantity of Rewritable CDs Supplied

(1,000 of constant-quality units per year supplied)


















The Individual Supply Curve: This is a graphic representation of the supply schedule that is an upward sloping line showing a direct or positive relationship between price and quantity supplied, meaning that if one goes up the other goes up and vice versa. Supply curves have a positive slope because only at a higher price will it be profitable for sellers to incur the higher opportunity cost associated with supplying a larger quantity.



Market supply is the summation of all the quantities supplied at various prices that might prevail in the market.

When price changes there is a change in the quantity supplied and so movement along the supply curve.

When something other than price changes, the whole curve shifts. There is a change in supply. Changes in non-price determinants of demand can produce only a shift of the entire supply curve, not a movement along the supply curve.


Shifts in Supply: A change in supply is a shift of the entire supply curve so that at each price the quantity supplied changes. A leftward shift of the supply curve means that the quantity supplied at each price decreases and is called a decrease in supply, while a rightward shift of the supply curve means that quantity supplied at each price increases and is called an increase in supply.

A rightward shift of the supply curve means that quantity supplied at each price increases and is called an increase in supply.


Other Determinants of Supply: These are factors other than price which determine how much will be produced and are held constant when identifying supply. A change in one of these factors will cause the supply curve to shift.

Cost of Inputs Used to Produce the Product: An increase (decrease) in the price of one or more inputs will cause a decrease (increase) in supply.

Technology and Productivity: An improvement in technology will cause an increase in supply.

Taxes and Subsidies: Increases (decreases) in indirect taxes have the same effect as raising (lowering) costs and, thus, decreases (increases) supply. A subsidy is a negative tax.

Price Expectations: An expected increase (decrease) in the relative price of a good can lead to a decrease (increase) in supply.

Number of Firms in the Industry: If the number of firms increases (decreases), supply will increase (decrease).

Changes in Supply vs Changes in Quantity Supplied: A change in quantity supplied refers to a movement along a given supply curve caused by a change in price. A change in supply refers to a shift of the entire supply curve to the right or left caused by a change in a non-price determinant of supply.

Test Yourself


Test Yourself: Supply














Demand and Supply: Putting Them Together


Putting Demand and Supply Together: Understanding how demand and supply interact is essential to understanding how prices are determined in our economy and other economies. RARELY DO I REACH ECONOMIC EQUILIBRIUM


Demand and Supply Schedules Combined: When the supply and demand schedules are combined, an equilibrium or market-clearing price is determined. This is a price at which quantity demanded equals quantity supplied. There is neither an excess quantity supplied (surplus) nor an excess quantity demanded (shortage).


Equilibrium: Equilibrium is a stable point. When equilibrium is reached, there is no tendency for change unless supply and/or demand change. Equilibrium is a situation where quantity supplied equals quantity demanded at a particular price. Equilibrium occurs where the supply and demand curves intersect.

A change in demand or a change in supply will cause a change in market equilibrium.


Shortages: A shortage is a situation in which quantity demanded is greater than quantity supplied. At a price below the equilibrium price there is a shortage which is corrected when price increases. Quantity demanded will fall and quantity supplied will increase until equilibrium is reached.


Surpluses: A surplus is a situation in which quantity demanded is less than quantity supplied. At a price above the equilibrium price there is a surplus that is corrected when price decreases. Quantity demanded will rise and quantity supplied will fall until equilibrium is reached.


So how do we answer the three fundamental economic questions?

(1) What to produce? (2) How to produce? (3) For whom to produce?

WHAT we produce is determined by the equilibrium of the markets.

HOW we produce is determined by profit- seeking behavior and efficient resource usage.

FOR WHOM we produce is determined by those willing and able to pay the equilibrium price.

WatchUse these two links to gain a better understanding of the concepts: Demand and Supply Curves and Shift of Demand and Supply Curves

ReadDemand, Supply and Surpluses






Quantity Supplied

(rewritable CDs per year)

Quantity Demanded

(rewritable CDs per year)


(rewritable CDs per year)

10 million

2 million

8 million

8 million

4 million

4 million

6 million

6 million

0 million

4 million

8 million

-4 million

2 million

10 million

-8 million






Equilibrium price AND quantity

Equilibrium price and quantity are determined by the intersection of supply and demand.

A change in supply, or demand, or both, will necessarily change the equilibrium price, quantity or both.

It is highly unlikely that the change in supply and demand perfectly offset one another so that equilibrium remains the same.

equilibrium price and quantity under higher demand

Supply is constant, demand increases. The new demand curve (DEMAND 2) is located on the right hand side of the original demand curve.

The new curve intersects the original supply curve at a new point. At this point, the equilibrium price (market price) and equilibrium quantity are higher.

equilibrium price and quantity under higher supply

Demand is constant, and supply increases. The new supply curve (SUPPLY 2) is located on the right side of the original supply curve.

The new curve intersects the original demand curve at a new point. At this point, the equilibrium price (market price) is lower, and the equilibrium quantity is higher.

equilibrium price and quantity under higher demand and higher supply

The increased demand curve and increased supply are drawn together. The new intersection point is located on the right hand side of the original intersection point.

The new equilibrium point indicates an equilibrium quantity higher than the original equilibrium quantity. The equilibrium price is also higher. In this case, it's because demand has increased relatively more than supply.

Test Yourself


Test Yourself: Demand and Supply Together













The Price System

PARKER 04/18/08


An economic system in which relative prices constantly change to reflect changes in demand and supply. Prices act as signals of relative scarcity to everyone in the system.


The Rationing Function of Prices

Prices are indicators of relative scarcity and ration goods to those who are willing to pay the most. Because of scarcity, it is not possible for everyone to have everything they want. There must be some method of rationing.

Rationing by a freely functioning price system is the most efficient because all gains from mutually beneficial trade will be exhausted.

Goods can also be rationed on a “first-come, first-served” basis, by the use of political power, by physical force, by lotteries, by coupons, and by cultural, physical, and religious differences.


Government-Imposed Price Controls

The rationing function of prices is often not allowed to operate when government sets price controls called price floors (minimum legal prices) and price ceilings (maximum legal prices).

If the market equilibrium cost is perceived as unfair or unjust the government can intervene in the market in a number of ways ... including banning the production and consumption of certain goods and services entirely. Government can also regulate industries such as banking that it deems too sensitive to be left alone.

PRICE CEILING CHARTA price ceiling is a legal maximum that can be charged for a good. The ceiling is shown by a horizontal line at the ceiling price, which is set below the equilibrium price. The chart shows a price ceiling of $2, at which the quantity demanded is 40 units and the quantity supplied is 20 units. The result is a shortage because the quantity demanded exceeds the quantity supplied. Rent controls are good examples of real-life price ceilings. A city might impose a ceiling of $1,000 per month on two-bedroom apartments.

Price ceilings help some groups and hurt others. For example, caps on apartment rents help tenants who pay below-market rents but hurt landlords and other prospective tenants who are shut out of the market due to the shortage. Rent-control cities are usually full of buildings that landlords abandoned because the buildings became unprofitable to operate. Because of that, the total supply of apartments is lower than it otherwise would be.

Intervention in markets should not be taken lightly because often serious by-products emerge. With apartment price ceilings,PRICE FLOOR CHART underground markets often appear in which landlords and tenants agree to the "official" contract rate but tenants agree to make additional side payments. In addition, if landlords can't set prices, they begin to adjust the quality of their apartments, letting them fall into disrepair. Some tenants end up living in unkempt conditions and are afraid to report the landlord because they may find themselves homeless if the landlord quits renting the apartment.

A price floor is a legal minimum that can be charged for a good. The floor, as shown in the chart, is represented by a horizontal line. To be effective, the floor must be set above the equilibrium price. In the chart, the floor is set at $4. Quantity demanded is 20 units and quantity supplied is 40 units. The result of the floor is a surplus of 20 units. Common examples of price floors are found in agricultural markets such as sugar, wheat and milk. The minimum wage is also a price floor because it sets a minimum dollar amount that employers can pay employees. Therefore, there is always a "surplus" of minimum-wage workers. If employers were allowed to pay salaries at the equilibrium point, all of those surplus workers would be employed ... although all of the previous minimum-wage workers would make less.

As with price ceilings, the same tradeoff occurs between equity and efficiency with price floors. Some groups benefit while others lose. In the case of the minimum wage, those who are able to find the higher paying jobs benefit. Employers who must pay higher wages lose along with those in the labor force who cannot find jobs because wages are too high. Agricultural price floors benefit farmers at the expense of consumers. Nevertheless, society has thus far deemed the benefits received from the price floors to be worth the costs.

What happens to employment when the minimum wage is increased? New data show that minimum wage increases can lead to short-term increases in employment for some of those workers.

Quantity Restrictions: Governments can impose quantity restrictions on a market, such as a ban on ownership or trading of goods (human organs and certain psychoactive drugs). The most common quantity restrictions in international trade are import quotas. A quota is a quantity restriction that prohibits the importation of more than a specified quantity of a particular good in a one-year period. The United States has had import quotas on tobacco, sugar, and immigrant labor. The beneficiaries of quotas are importers who get the quota rights and the domestic producers of the restricted good.

We have price ceilings and price floors because of failures in the free market. A market failure is a situation in which the price system creates a problem for society or fails to achieve society’s goals. Market failure happens when competition is lacking. Two examples of market failure are income inequality and externalities.


The benefits of a price system are high levels of economic efficiency, the existence of consumer sovereignty, promotion of personal freedom, and prevention of coercion of buyers and sellers by the existence of competition. A price system can also produce market failures for which government interventions may be wanted.




How the Price Mechanism Helps Us Make Decisions from Economics Mafia (5:35)

The Price Mechanism in Action from Geoff Riley (22:40)

Test Yourself


Test Yourself: The Price System














Government Functions in the Economy


Correcting for Externalities: An externality is a situation in which a benefit or a cost associated with an economic activity spills over to third parties, i.e., parties who are not direct participants in the market transaction. A cost is imposed on or a benefit is given to people other than the consumers and producers of a good or service (third parties).

A negative externality is one that is detrimental to third parties, such as pollution.

A positive externality is one that is beneficial to third parties, such as vaccinations or public goods.

When the supply curve fails to include negative external costs, the equilibrium price is artificially low and the equilibrium quantity is artificially high. External costs cause the market to over allocate resources, and external benefits cause the market to under allocate resources.

When externalities are present, market failure gives incorrect price and quantity signals, and resources are misallocated.

Externalities Map

How Government Corrects Negative Externalities

Special Taxes: Taxes on output would reduce output, but would not provide an incentive to reduce pollution per unit of output. Taxes on the amount of pollutants emitted would provide an incentive to reduce pollution per unit of output.

Regulation: The government could specify a maximum allowable rate of pollution.

How Government Corrects Positive Externalities

Government Financing and Production: When positive externalities are large (e.g. public goods), government may finance and produce the good or service.

Subsidies: A subsidy is a negative tax: a payment to the consumer or producer of a good or service for consuming or producing that good or service

Regulation: Government can require that certain actions be undertaken, e.g. inoculations of school children.


Providing a Legal System: All relationships among consumers and businesses are governed by legal rules. Much of the legal system is involved with defining and protecting property rights.


Promoting Competition: Promoting competition is a way of increasing the efficiency of the economy. Antitrust legislation is used to reduce the power of monopolies and to discourage certain activities that restrain trade.PUBLIC GOODS VS OTHER TYPES OF GOODS


Providing Public Goods: Public goods are goods to which the principle of rival consumption does not apply (rival vs non-rival) and are jointly consumed by many individuals simultaneously (excludable vs non-excludable). This is in contrast to private goods that can be consumed by only one person at a time.

A public good is a good that, once produced, has two properties: (1) users collectively consume benefits and (2) no one can be excluded. National defense, public education and roads are examples of public goods.

If public goods are available only in the marketplace, people wait for someone else to pay. The result is an underproduction or zero production of public goods.

PUBLIC GOODSCharacteristics of Public Goods

Public goods can be used by more and more people at no additional cost and without depriving others of any services of the goods.

It is difficult to design a collection system for a public good on the basis of how much individuals use it.

Free Riders

The free rider problem is a situation associated with public goods when individuals presume others will pay for public goods, so they can escape paying for their portion without causing a reduction in production.


Merit and Demerit Goods: The government defines certain goods and services as desirable or undesirable. A merit good is a good that has been deemed socially desirable by the political process, and will be provided by government or subsidized. A demerit good is a good that has been deemed socially undesirable by the political process. It will be prohibited, taxed, or regulated to reduce consumption.


Projected Federal Entitlement SpendingIncome Redistribution: Government explicitly redistributes income by progressive taxation and by transfer payments and transfers in kind. Transfer payments are money payments made to individuals for which no services or goods are concurrently rendered. Transfers in kind are payments in the form of goods and services for which no goods or services are concurrently rendered.


Dig Deeper

The Role of Government in the Economy

Positive and Negative Externalities works on exposing the wealth gap.

Longer Commutes, Shorter Lives: The Costs of Not Investing in America


Ensuring Economy-wide Stability: The federal government is charged under the Employment Act of 1946 with stabilizing the economy at high levels of employment.

Fiscal Policy

Fiscal policy is a broad term used to refer to the tax and spending policies of the federal government. For example, when demand is low in the economy, the government can step in and increase its spending to stimulate demand. Or it can lower taxes to increase disposable income for people as well as corporations. Fiscal policy decisions are determined by Congress and the Executive branch.

Monetary Policy

Monetary policy is a term used to refer to the actions of central banks to achieve macroeconomic policy objectives such as price stability, full employment and stable economic growth. In the US, Congress established maximum employment and price stability as the macroeconomic objectives for the Federal Reserve. They are sometimes referred to as the Federal Reserve's dual mandate. Apart from these overarching objectives, Congress determined that operational conduct of monetary policy should be free from political influence. As a result, the Federal Reserve is an independent agency of the federal government.

The Business Cycle

The business cycle is comprised of four phases of economic growth and decline. It's sometimes called the boom and bust cycle. The goal of economic policy is to keep the economy growing at a healthy rate -- fast enough to create jobs for everyone who wants one, but slow enough to avoid inflation. The business cycle is caused by the forces of supply and demand, the availability of capital and expectations about the future.

There are four phases that describe the business cycle. At any point in time the economy is in one of these stages:

  1. Contraction: The economy starts slowing down. It's usually accompanied by a bear market. GDP growth rates usually slow to the 1%-2% level before actually turning negative. A contraction is usually triggered by an event, such as a rapid increase in interest rates, a financial crisis or runaway inflation. Fear and panic replace confidence. Investors sell stocks, and buy bonds, gold and the US dollar. Consumers lose their jobs, sell their homes and stop buying anything but necessities. Businesses lay off workers and hoard cash. At this point, a stock market correction may indicate that assets are overvalued. The Fed can switch to expansionary monetary policy if economic growth slows or even turns negative. That means it will lower interest rates and buy Treasuries in open market operations. This is when expansionary fiscal policy is desperately needed. That means cutting taxes and increasing spending to create jobs, demand and confidence.

  2. Trough: The economy hits bottom, usually in a recession. GDP growth may still be negative, but it's not as bad. It's clear that the economy has turned a corner. Confidence must be restored before the economy can enter a new expansion phase. That often requires intervention with monetary or fiscal policy. Central banks pull out all the tools to jump start the economy out of a trough.

  3. Expansion: The economy starts growing again. It's usually signaled by a bull market. GDP growth turns positive again, and should be in the healthy 2%-3% range. If the economy is managed well, it can stay in the expansion phase for years. When consumers are confident, they buy because they know there will be future income from better jobs, higher home values and increasing stock prices.  As demand increases, businesses hire new workers, which increases income, further stimulating more demand. Too much capital will turn a healthy expansion into a peak. That's because there's too much money chasing too few goods. This causes inflation. Central banks try to keep the core inflation rate at around 2% to create a healthy expectation of inflation. In the United States, that means the Federal Reserve will keep the Fed funds rate right around 2%. If economic growth remains at the healthy 2-3% growth rate, the Fed won't make any changes.

  4. Peak: The economy is overheated, and is in a state of "irrational exuberance." This is when inflation may hit. The economy's expansion slows. It's usually the last healthy growth quarter before contraction starts. You usually don't know you are in a peak until it is too late. However, if the GDP growth rate is 4% or higher for two or more quarters in a row, the peak is not far off. If demand outstrips supply, then the economy can overheat. In addition, investors and businesses compete to outperform the market, taking on more risk to gain some extra return. You can usually recognize a peak by two things: First, the media says that the expansion will never end. Second, it seems everyone and his brother is making tons of money from whatever the asset bubble is. Central banks use contractionary monetary policy during an expansion to avoid the irrational exuberance of a peak. That means they raise interest rates. If needed, they will sell Treasuries and other assets during open market operations.

The National Bureau of Economic Research (NBER) analyzes economic indicators to determine the phases of the business cycle. The Business Cycle Dating Committee uses quarterly GDP growth rates as the primary indicator of economic activity. The Bureau also uses monthly figures, such as employment, real personal income, industrial production and retail sales. For this reason, the NBER has the final say on economic expansions and contractions, or business cycles.


recession vs depression

ReadComparing the Broad Social Goals of Command and Market Economies (PDF)

Fiscal Policy Vocabulary (PDF)

Ben Casselman of the NYT wrote a good explainer of recession definitions.

Check out the St. Louis Fed's presentation The Financial Crisis: What Happened?. The original video is no longer available but you can view the power point presentation.

Test Yourself


Test Yourself: Government Functions in the Economy














The Circular Flow

One of the main basic economic models is the circular-flow model, which describes the flow of money and products throughout the economy in a very simplified way. The model represents all of the actors in an economy as either households or firms (companies), and it divides markets into two categories:

o   markets for goods and services (product markets)

o   markets for factors of production (factor markets)

(Remember, a market is just a place where buyers and sellers come together to generate economic activity.)

The concept of a circular flow of income involves two principles; (1) in every economic exchange, the seller receives exactly the same amount that the buyer spends and (2) goods and services flow in one direction and money payments flow in the other. (Note that money, by definition, flows from buyer to seller in all markets.)

  1. Profits are a part of costs because entrepreneurs must be rewarded for providing their services, or they will not provide them.

  2. Total income is the total of all individuals’ income and is also defined as the annual cost of producing the entire output of final goods and services. Total output is the value of all of the final goods and services produced in the economy during the year.

  1. Product Markets: Households are the buyers and businesses are the sellers of consumer goods. Households buy finished products from firms that are looking to sell what they make. In this transaction, money flows from households to firms. Finished products flow from firms to households in product markets.

  2. Factor Markets: Households are the sellers; they sell resources such as labor, land, capital and entrepreneurial ability. If markets for goods and services were the only markets available, firms would eventually have all of the money in an economy, households would have all of the finished products, and economic activity would stop. Luckily, product markets don’t tell the whole story, and factor markets serve to complete the circular flow of money and resources.

    The term factors of production refers to anything that is used by a firm in order to make a final product.

    Some examples of factors of production are labor (the work done by people), capital (the machines used to makes products), land and so on. Labor markets are the most commonly discussed form of a factor market, but it’s important to remember that factors of production can take many forms.

    In factor markets, households and firms play different roles than they do in product markets. When households provide labor to firms, they can be thought of as the sellers of their time or work product. (Technically, employees can more accurately be thought of as being rented rather than being sold, but this is usually an unnecessary distinction.) Firms provide money to households as compensation for the use of factors of production. Therefore, the functions of households and firms are reversed in factor markets as compared to in product markets.

  1. Total income is income earned by households in payment for the production of these goods and services. The value of total output is identical to total income, since spending by one group is income to another.

    When factor markets are put together with product markets, a closed loop for the flow of money is formed. As a result, continued economic activity is sustainable in the long run, since neither firms nor households are going to end up with all of the money. (It’s also worth noting that firms are owned by people, and people are parts of households, so the two entities are not quite as distinct as the model implies.) Firms use factors of production to create finished products and households consume finished products in order to maintain their ability to provide factors of production.

    When factor markets are put together with product markets, a closed loop for the flow of money is formed.

  2. The basic circular flow of income, or two-sector circular flow of income model,  consists of six assumptions:

    1. The economy consists of two sectors: households and firms.

    2. Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S).

    3. All output (O) produced by firms is purchased by households through their expenditure (E).

    4. There is no financial sector.

    5. There is no government sector.

    6. There is no foreign sector

    This model is simplified in a number of ways, most notably in that it represents a pure capitalistic economy with no role for government. One could, however, extend this model to incorporate government intervention by inserting government between the households, firms, and markets. (See model below.)

    It’s interesting to note that there are four places where government could be inserted into the model, and each point of intervention is realistic for some markets and not for others. (For example, an income tax could be represented by a government entity being inserted between households and factor markets, and a tax on a producer could be represented by inserting government between firms and goods and services markets.)

    In the five-sector model the economy is divided into five sectors:

    1. Household sector

    2. Firms or Producing sector

    3. Financial sector: banks and non-bank intermediaries who engage in the borrowing (savings from households) and lending of money

    4. Government sector: consists of the economic activities of local, state and federal governments.

    5. International sector: transforms the model from a closed economy to an open economy.

    The five sector model of the circular flow of income is a more realistic representation of the economy. Unlike the two sector model where there are six assumptions the five sector circular flow relaxes all six assumptions. Since the first assumption is relaxed there are three more sectors introduced.

    In general, the circular-flow model is useful because it informs the creation of the supply and demand model. When discussing the supply and demand for a good or service, it is appropriate for households to be on the demand side and firms to be on the supply side, but the opposite is true when modeling the supply and demand for labor or another factor of production.


  1. One common question regarding this model is what it means for households to provide capital and other non-labor factors of production to firms. In this case, it’s important to remember that capital refers not only to physical machinery but also to the funds (sometimes called financial capital) that are used to buy the machinery used in production. These funds flow from households to firms every time people invest in companies via stocks, bonds or other forms of investment.

Households then get a return on their financial capital in the form of stock dividends, bond payments and the like, just as households get a return on their labor in the form of wages.

  1. Leakages and injections

In the five sector model there are leakages and injections.

o   Leakage means withdrawal from the flow. When households and firms save part of their incomes it constitutes leakage. Leakages may be in form of savings, tax payments or imports. Leakages reduce the flow of income.

o   Injection means introduction of income into the flow. When households and firms borrow savings, that constitutes injections. Injections increase the flow of income. Injections can take the forms of (a) investment, (b) government spending or (c) exports. So long as leakages are equal to injections the circular flow continues indefinitely. Financial institutions or the capital market play the role of intermediaries.

Leakages and injections can occur in the financial sector, government sector and international sector:

1.    In the financial sector

In terms of leakages in the circular flow, financial institutions provide the option for households to save their money. This is a leakage because the saved money cannot be spent in the economy and thus is an idle asset so that not all output will be purchased. In terms of injections, the financial sector provides investment (I) in the business/firms sector.

2.     In the government sector

The leakages in the government sector occur with the collection of revenue through Taxes (T) provided by households and firms to the government. Taxes are a leakage because it reduces current income thus reducing expenditures on current goods and services. Injection provided by the government sector occur via government spending (G) that provides collective services and welfare payments to the community.

3.     In the international sector

The main leakage from the international sector occurs because of imports (M), which represent spending outside the country by residents. The main injection provided by this sector is the exports of goods and services. Those exports generate income coming into the country for domestic exportersINJECTIONS AND LEAKAGES from overseas buyers.

Summary of leakages and injections



Saving (S)

Investment (I)

Taxes (T)

Government Spending (G)

Imports (M)

Exports (X)


Test Yourself

Test Yourself: The Circular Flow









Copyright 1996 Amy S Glenn
Last updated:   01/01/2024 1730

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