Managerial economics

Chanderprabhu Jain College of Higher Studies & School of Law
Plot No. OCF, Sector A-8, Narela, New Delhi – 110040
(Affiliated to Guru Gobind Singh Indraprastha University and Approved by Govt of NCT of Delhi & Bar Council of India)
First Semester
Managerial Economics
Circular flow of income
or circular flow

Circular flow of income or circular flow
• Refers to a simple economic model which describes the
reciprocal circulation of income between producers and
consumers.
• In the circular flow model, the inter- dependent entities of
producer and consumer are referred to as "firms" and
"households" respectively and provide each other with factors
in order to facilitate the flow of income.
• Real Flow and Money Flow.
Real Flow- In a simple economy, the flow of factor services from
households to firms and corresponding flow of goods and
services from firms to households s known to be as real flow.

Firms
• Provide consumers with goods and services in exchange for
consumer expenditure and "factors of production" from
households.
• Human wants are unlimited and are of recurring nature
therefore, production process remains a continuous and
demanding process. In this process, household sector provides
various factors of production such as land, labor, capital and
enterprise to producers who produce by goods and services by
coordinating them. Producers or business sector in return
makes payments in the form of rent, wages, interest and profits
to the household sector.

• Household sector spends this income to fulfill its wants in the
form of consumption expenditure.
• Business sector supplies those goods and services produced
and get income in return of it.
• Thus expenditure of one sector becomes the income of the
other and supply of goods and services by one section of the
community becomes demand for the other.

• A continuous flow of production, income and expenditure is
known as circular flow of income. It is circular because it has
neither any beginning nor an end. The circular flow of income
involves two basic assumptions:-
1. In any exchange process, the seller or producer receives the
same amount what buyer or consumer spends.
2. Goods and services flow in one direction.

Money Flow
• In a modern two sector economy, money acts as a medium of
exchange between goods and factor services.
• Money flow of income refers to a monetary payment from
firms to households for their factor services and in return
monetary payments from households to firms against their
goods and services.
• Household sector gets monetary reward for their services in
the form of rent, wages, interest, and profit form firm sector
and spends it for obtaining various types of goods to satisfy
their wants. Money acts as a helping agent in such an
exchange.

Two Sector Model
• In the simple two sector circular flow of income model the
state of equilibrium is defined as a situation in which there is
no tendency for the levels of income (Y), expenditure (E) and
output (O) to change,
Y=E=O
• This means that the expenditure of buyers (households)
becomes income for sellers (firms). The firms then spend this
income on factors of production such as labour, capital and
raw materials, "transferring" their income to the factor owners.
The factor owners spend this income on goods which leads to
a circular flow of income.

Three Sector Model
• It includes household sector, producing sector and government
sector.
• It will study a circular flow income in these sectors excluding
rest of the world i.e. closed economy income.
• Here flows from household sector and producing sector to
government sector are in the form of taxes.
• The income received from the government sector flows to
producing and household sector in the form of payments for
government purchases of goods and services as well as
payment of subsides and transfer payments.
• Every payment has a receipt in response of it by which
aggregate expenditure of an economy becomes identical to
aggregate income and makes this circular flow and unending.

Four Sector Model
• A modern monetary economy comprises a network of four
sector economies this are-
1.Household sector
2.Firms or producing sector
3.Government sector
4.Rest of the world sector.
• Each of the above sectors receives some payments from the
other in lieu of goods and services which makes a regular flow
of goods and physical services. Money facilitates such an
exchange smoothly.
• A residual of each market comes in capital market as saving
which inturn is invested in firms and government sector.

Five sector model
• The five sector model of the circular flow of income is a more
realistic representation of the economy.
• The first is the Financial Sector that consists of banks and non-
bank intermediaries who engage in the borrowing (savings
from households) and lending of money. In terms of the
circular flow of income model the leakage that financial
institutions provide in the economy is 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 that means not all output
will be purchased.

• The injection that the financial sector provides into the
economy is investment (I) into the business/firms sector.
• The leakage that the Government sector provides is through
the collection of revenue through Taxes (T) that is provided by
households and firms to the government. For this reason they
are a leakage because it is a leakage out of the current income
thus reducing the expenditure on current goods and services.

Five sector model
• In terms of the five sector circular flow of income model the
state of equilibrium occurs when the total leakages are equal to
the total injections that occur in the economy. This can be
shown as:
Savings + Taxes + Imports = Investment + Government
Spending + Exports
S + T + M = I + G + X.
• This can be further illustrated through the fictitious economy
of Noka where:
S+T+M=I+G+X
$100 + $150 + $50 = $50 + $100 + $150
$300 = $300

Five sector model
• Therefore since the leakages are equal to the injections the economy
is in a stable state of equilibrium. This state can be contrasted to the
state of disequilibrium where unlike that of equilibrium the sum of
total leakages does not equal the sum of total injections. By giving
values to the leakages and injections the circular flow of income can
be used to show the state of disequilibrium. Disequilibrium can be
shown as:
S+T+M≠I+G+X
• Therefore it can be shown as one of the below equations where:
Total leakages > Total injections
P150 (S) + P250 (T) + P150 (M) >P75 (I) + P200 (G) + 150 (X)
Or
Total Leakages < Total injections
P50 (S) + P200 (T) + $125 (M) < P75 (I) + P200 (G) + P150 (X)

Five sector model
• The effects of disequilibrium vary according to which of the
above equations they belong to.
• If S + T + M > I + G + X the levels of income, output,
expenditure and employment will fall causing a recession or
contraction in the overall economic activity. But if S + T + M
< I + G + X the levels of income, output, expenditure and
employment will rise causing a boom or expansion in
economic activity.

• To manage this problem, if disequilibrium were to occur in the
five sector circular flow of income model, changes in
expenditure and output will lead to equilibrium being regained.
An example of this is if:
• S + T + M > I + G + X the levels of income, expenditure and
output will fall causing a contraction or recession in the overall
economic activity. As the income falls households will cut
down on all leakages such as saving, they will also pay less in
taxation and with a lower income they will spend less on
imports. This will lead to a fall in the leakages until they equal
the injections and a lower level of equilibrium will be the
result.

• The other equation of disequilibrium, if S + T + M < I + G + X
in the five sector model the levels of income, expenditure and
output will greatly rise causing a boom in economic activity.
As the households income increases there will be a higher
opportunity to save therefore saving in the financial sector will
increase, taxation for the higher threshold will increase and
they will be able to spend more on imports.
• In this case when the leakages increase they will continue to
rise until they are equal to the level injections. The end result
of this disequilibrium situation will be a higher level of
equilibrium.

Significance of Study of Circular Flow of
Income
1.Measurement of National Income- National income is an
estimation of aggregation of any of economic activity of the
circular flow. It is either the income of all the factors of
production or the expenditure of various sectors of economy.
However, aggregate amount of each of the activity is identical
to each other.
2.Knowledge of Interdependence- Circular flow of income
signifies the interdependence of each of activity upon one
another. If there is no consumption, there will be no demand
and expenditure which in facts restricts the amount of
production and income.

3.Unending Nature of Economic Activities- It signifies that
production, income and expenditure are of unending nature,
therefore, economic activities in an economy can never come
to a halt. National income is also bound to rise in future.
4.Injections and Leakages Reference- A General Approach to
Macroeconomic Policy.

Difference between Real Flow and Money
Flow
1. Real flow is the exchange of goods and services between household and
firms whereas money flow is the monetary exchange between two sectors.
2. In real flow household sector supplies raw material, land, labour, capital and
enterprise to firms and in return firms sector provides finished goods and
services to household sector. Whereas in money flow, firm sector gives
remuneration in the form of money to household sector a wages and
salaries, rent, interest etc.
3. Difficulties of barter system for the exchange of goods and factor services
between households and firms sector in real flow, whereas no such
difficulty or inconvenience arise in money flow.
4. When goods and services flow from one sector of the economy to another, it
is known as real flow.

Phases or Stages of Circular Flow of Income
• Production, consumption expenditure and generation of
income are the three basic economic activities of an economy
that go on endlessly and are titled as circular flow of income.
Production gives rise to income, income gives rise to demand
for goods and services ; such a demand gives rise to
expenditure and expenditure induces for further production.
The whole process forms the basis for circular flow of income
and related activities- production, income and expenditure are
known as phases or stages of circular flow of income.
Production → Income → Expenditure →

Production.
1. Production Phase- Production means creation of utility to
satisfy human wants. It involves the co-ordination of all the
factors of production in some desired ratio. This job is
performed by a producer or firm who takes an initiative with
the motive of earning profits. He hires land, labour, capital
and an organization and makes them payment in the form of
rent, wages and salaries and interest. This phase is to produce
goods and services and after selling them, it generates
income.

2. Income Phase- Producing firms earn revenue from the sale of goods and
services produced by them. Whole of the earning is divided between
factors provided by household sector in the form of rent, wages, interest
and profits. Such an income is classified into three parts:- •Compensation
of employees- Wages, salaries, commission, bonus etc. •Operating
Surplus- Profits, rent, interest, royalty etc. •Mixed Income- Income of
self- employed Thus production takes the shape of income of household
sector.
3. Expenditure Phase- Household sector spends its income to satisfy unlimited
and recurring human wants. Any saving out of total income takes the
shape of investment on capital goods that helps in generating the income
of the economy. Expenditure becomes the income of producing sector
that promotes further the uninterrupted flow of income.

GNI versus GDP
• For example, the profits of a Philippines-owned company
operating in the UK will only count towards PHL GNI and UK
GDP. If a country becomes heavily indebted, and pays large
amounts of interest to service this debt, this will be reflected in
a decreased GNI but not a decreased GDP. If a country sells
off its resources to entities outside their country this will also
be reflected over time in decreased GNI, but not decreased
GDP. Therefore, the GDP appears more attractive for countries
with increasing national debt and decreasing assets.

• GNP is a concept that goes hand in hand with GNI, GDP, and
NNI. In contrast to the GNI, the GNP does not account for the
balance of cross-country income, such as interest and
dividends. In contrast to the GDP, the GNP account for the
values of products and services based on citizenship of the
owners rather than the territory of the activity.

How to Calculate the GNI
GNI is an add up of Net Income from abroad and the GDP, one
can calculate the GNI by the following formula.
GNI = GDP+(FL-DL)+NCI = C+I+G+(X-M)+(FL-DL)+NCI
Measures of national income and output
A variety of measures of national income and output are used in
economics to estimate total economic activity in a country or
region, including gross domestic product (GDP), gross
national product (GNP), net national income(NNI), and
adjusted national income (NNI* adjusted for natural resource
depletion). All are especially concerned with counting the total
amount of goods and services produced within some
"boundary”

The output approach
• The output approach focuses on finding the total output of a nation by
directly finding the total value of all goods and services a nation produces.
• Because of the complication of the multiple stages in the production of a
good or service, only the final value of a good or service is included in the
total output. This avoids an issue often called double counting, wherein the
total value of a good is included several times in national output, by
counting it repeatedly in several stages of production. In the example of
meat production, the value of the good from the farm may be P10, then P30
from the butchers, and then P60 from the supermarket. The value that
should be included in final national output should be P60, not the sum of all
those numbers, P100. The values added at each stage of production over
the previous stage are respectively P10, P20, and P30. Their sum gives an
alternative way of calculating the value of final output.

• Formula:
GDP(gross domestic product) at market price =
value of output in an economy in the particular year -
intermediate consumption
NNP at factor cost = GDP at market price -
depreciation + NFIA (net factor income from abroad) - net
indirect taxes

The income approach
• The income approach equates the total output of a nation to the
total factor income received by residents or citizens of the
nation. The main types of factor income are:
Employee compensation (cost of fringe benefits, including
unemployment, health, and retirement benefits);
Interest received net of interest paid; Rental income
(mainly for the use of real estate) net of expenses of landlords;
Royalties paid for the use of intellectual property and
extractable natural resources.

All remaining value added generated by firms is called the
residual or profit. If a firm has stockholders, they own the
residual, some of which they receive as dividends. Profit
includes the income of the entrepreneur - the businessman
who combines factor inputs to produce a good or service.
Formula
NDP at factor cost = Compensation of employees + Net
interest + Rental & royalty income + Profit of
incorporated and unincorporated NDP at factor cost.

The expenditure approach
• The expenditure approach is basically an output accounting method. It
focuses on finding the total output of a nation by finding the total amount
of money spent. This is acceptable, because like income, the total value of
all goods is equal to the total amount of money spent on goods. The basic
formula for domestic output takes all the different areas in which money is
spent within the region, and then combines them to find the total output.
Where:
C = household consumption expenditures / personal consumption
expenditures
I = gross private domestic investment
G = government consumption and gross investment expenditures
X = gross exports of goods and services
M = gross imports of goods and services
Note: (X - M) is often written as XN, which stands for "net exports“

GDP and Gross domestic product (GDP) is defined as "the value
of all final goods and services produced in a country in 1
year".
Gross National Product (GNP) is defined as "the market value of
all goods and services produced in one year by labor and
property supplied by the residents of a country."

• As an example, the table below shows some GDP and GNP,
and NNI data for the United States:
• NDP: Net domestic product is defined as "gross domestic
product (GDP) minus depreciation of capital",[ similar to NNP.
• GDP per capita: Gross domestic product per capita is the mean
value of the output produced per person, which is also the
mean income.

Difficulties in Measurement of
National Income
• There are many difficulties when it comes to measuring national income,
however these can be grouped into conceptual difficulties and practical
difficulties.
Conceptual Difficulties
• Inclusion of Services: There has been some debate about whether to
include services in the counting of national income, and if it counts as
output. Marxian economists are of the belief that services should be
excluded from national income, most other economists though are in
agreement that services should be included.
• Identifying Intermediate Goods: The basic concept of national income is to
only include final goods, intermediate goods are never included, but in
reality it is very hard to draw a clear cut line as to what intermediate goods
are. Many goods can be justified as intermediate as well as final goods
depending on their use.

Practical Difficulties
• Unreported Illegal Income: Sometimes, people don’t provide
all the right information about their incomes to evade taxes so
this obviously causes disparities in the counting of national
income.
• Non Monetized Sector: In many developing nations, there is
this issue that goods and services are traded through barter, i.e.
without any money. Such goods and services should be
included in accounting of national income, but the absence of
data makes this inclusion difficult.

Price
• Price is the most important determinant of demand.
• A “demand curve” plots combinations of prices and
quantity demanded.
• A shift in price causes a shift along the demand curve
• A change in price causes a shift along the demand
curve.

• A shift along the demand curve is referred to as a
“shift in the quantity demanded.”
• A shift in any other variable except price causes a shift
in the entire demand curve.
• A shift in the entire demand curve is referred to as a
“shift in demand.”

Income
• Changes in income can increase or decrease demand.
• A good whose demand decreases with an increase in
income is called an “inferior good.”
• A good whose demand increases with an increase in
income is called a “normal good.”

Examples of changes in income
• An increase in income will reduce the demand for
ramen noodles or generic products.
• An increase in income will increase the demand for
cars or clothing.
• An increase in income will significantly increase the
demand for air travel or jewelry.

Prices of other goods
• Changes in the prices of other goods can increase or
decrease demand.
• A good that causes an increase in the demand for
another good when its price increases is called a
“substitute good.”
• A good that causes a decrease in the demand for
another good when its price increases is called a
“complementary good.”

Examples of changes in other prices
• An increase in the price of peanut butter will reduce
the demand for jelly. Peanut butter and jelly are
complements.
• An increase in the price of Pepsi will increase the
demand for Coke. Pepsi and Coke are substitutes.

Number of buyers
• An increase in the number of potential buyers will
increase the demand for the good.
• For example, the demand for land increases as the
population increases.
• Similarly baseball tickets are generally more
expensive in larger cities.

Future Prices
• An increase in the expected future price of a good
increases current demand.
• A decrease in the expected future price of a good
decreases current demand.
• For example, when a good is temporarily put on sale,
people stock up on the good.

Tastes
• Demand curves can shift due to changes in tastes over
time.
• For example, demand for cereal may be high in the
morning but low at night.

Quality
• Demand curves can shift due to changes quality.
• At a given price, demand for Pizza hut’s pizza is
higher than the demand for Papa John’s.
• Similarly, CDs cost more than cassettes because the
music is of higher quality.

Supply
• Demand curves do not shift due to changes supply.
• Shifts in supply change the equilibrium price causing a
shift along the demand curve.
• Shifts in supply cause a change in the quantity demand
not a shift in the demand curve.

Increase In Demand
• An increase in demand shifts the demand curve to the
right.
• Equilibrium price increases.
• Quantity demanded increases.

Decrease In Demand
• A decrease in demand shifts the demand curve to the
left.
• Equilibrium price falls.
• Quantity demanded falls.

Cost
A cost is the value of money that has been used up to produce
something.
A cost is the value of money that has been used up to produce
something or deliver a service, and hence is not available for
use anymore. In business, the cost may be one of acquisition, in
which case the amount of money expended to acquire it is
counted as cost.

Types of costs
• Opportunity cost and actual cost
• Direct and indirect cost
• Explicit and implicit cost
• Historical and replacement cost
• Fixed cost and variable cost
• Real and prime cost
• Total average and marginal cost

Opportunity cost and actual cost
• Opportunity cost :
Cost incurred for loosing next best alternative
• Actual cost :
An actual amount paid or incurred, as opposed to
estimated cost or standard cost.

Explicit and implicit cost
• Explicit cost refers to the money expended to buy or
hire resources from outside the organization for the
process of production.
• Implicit cost refers to the cost of use of the self
owned resources of organization that are used in
production

Direct and Indirect cost
Direct cost is a cost.
• Direct Cost: Direct costs are those cost that have
directly accountable to specific cost object such as a
process or product
Ex : wages paid ,salary paid labor, material…etc
• Indirect cost: Indirect cost are those costs which are
not directly accountable to specific cost object or not
directly related to production
Ex: insurance, mentainence ,telecom, etc

Historical and replacement cost
• Historical cost refers to the original (actual) cost
incurred at the time the asset was acquired
• The replacement cost is the price that an entity would
pay to replace an existing assets at current market
price that may not be market value of that asset.

Fixed and variable cost
• Fixed cost is the cost that remains unchanged
irrespective of the output level or sales revenue such
as interest, rent, salaries etc.
• Variable cost are those costs that vary depending on a
company’s production volume; they raise as
production increases and fall as production decreases.

Real cost and Prime cost
• Real cost of a production refers to the physical
quantities of various factors used in producing
commodity.
Ex: Real cost of a table composes of a carpenter’s labor
to cubic feet of a wood ,a dozen of nails, half a bottle
of varnish, etc
“ Real cost thus signifies the aggregate of real
productive resources absorbed in the production”.

Prime cost
• The direct cost of commodity in terms of the
materials and labor involved in its production
excluding fixed cost By calculating prime cost the
firm can decide how much should be their selling
price to earn profit.

Total cost
• Total cost : it is the cost refers to the total expenses
incurred in reaching a particular level of output TC =
TVC + TFC.

Marginal cost
• The marginal cost is also per unit cost of production.
It is the addition made to the total cost by producing
one more unit of output
MCn = TCn – TCn-1
i.e the marginal cost of the unit of output is the total
cost of producing n units minus the total cost of
producing
n-1 (i.e ..one less in the total) units of output.

Average cost
• Average cost is the total cost divided by total units of
output Thus, AC = TC/Q
Where Q is the quantity produced.

Average fixed cost (AFC)
• Average fixed cost is the total fixed cost divided by
total units of output
AFC = TFC/Q
Where Q is the number of units produced

Average Variable cost
• Average variable cost is total variable cost divided by
quantity produced
AVC = TVC/Q
Where Q is the quantity produced.

Managerial uses of cost analysis
• To find most profitable rate of operation of the firm.
• To determine in advance the cost of business
operations.
• To fix the price of the product.
• To decide what sales channel to use.
• To have clarity about the various cost concepts.

A Perfectly Competitive Market
A perfectly competitive market is one in
which economic forces operate unimpeded.

A Perfectly Competitive Market
A perfectly competitive market must meet the following
requirements:
• Both buyers and sellers are price takers.
• The number of firms is large.
• There are no barriers to entry.
• The firms’ products are identical.
• There is complete information.

Perfect competition
Perfect competition is a firm behavior that occurs
when many firms produce identical products and
entry is easy. Characteristics of perfect competition:
• There are many sellers.
• The products sold by the firms in the industry are
identical.
• Entry into and exit from the market are easy, and
there are many potential entrants.
• Buyers (consumers) and sellers (firms) have perfect
information.

Price Taker
A firm in a perfectly competitive market is said to be
a price taker because the price of the product is
determined by market supply and demand, and the
individual firm can do nothing to change that price.

The Necessary Conditions for Perfect
Competition
1. Both buyers and sellers are price takers.
• A price taker is a firm or individual who takes the
market price as given.
• In most markets, households are price takers – they
accept the price offered in stores.

2. Both buyers and sellers are price takers.
• The retailer is not perfectly competitive.
• A retail store is not a price taker but a price
maker.
3. The number of firms is large.
• Large means that what one firm does has no
bearing on what other firms do.
• Any one firm's output is minuscule when
compared with the total market.

4. There are no barriers to entry.
• Barriers to entry are social, political, or economic
impediments that prevent other firms from entering
the market.
• Barriers sometimes take the form of patents granted
to produce a certain good.
• Technology may prevent some firms from entering
the market.
• Social forces such as bankers only lending to certain
people may create barriers.

5. The firms' products are identical.
• This requirement means that each firm's output is
indistinguishable from any competitor's product.
6. There is complete information.
• Firms and consumers know all there is to know
about the market – prices, products, and available
technology.
• Any technological breakthrough would be
instantly known to all in the market.

Demand Curves for the Firm and the
Industry
• The demand curves facing the firm is different from
the industry demand curve.
• A perfectly competitive firm’s demand schedule is
perfectly elastic even though the demand curve for
the market is downward sloping.

Perfect Competitors’ Demand Curve
The result is that the individual firm perceives the
demand curve for its product as being perfectly
horizontal.

Market Demand Versus Individual Firm
Demand Curve

THANK YOU

Managerial economics

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