National Income

The Determination of National Income • very simplified model • only two sectors: households and firms • factors of production “factors that are necessary for the production of goods to take place” Land, Labour and Capital • the following transactions take place HOUSEHOLDS Own factors of production which they supply to firms

FIRMS Use factors of production supplied by households to produce goods and services

Receive incomes from firms in exchange for supplying factors of production

Pay households for the use of factors of production

Spend money on goods and services produced by firms

Sell goods and services to households

• households own the factors of production? • Labour is understandable, but what about Land and Capital? Surely these belong to firms? • households are the ultimate owners of firms

The Circular Flow Diagram Household expenditure

Factors of production

Firms

Households Goods and services

Factor incomes

• household expenditure, factor incomes: MONETARY resources • factors of production, goods and services: REAL resources

• there are three ways to measure economic activity OUTPUT: value of goods (and services) produced INCOME: level of factor incomes EXPENDITURE: spending on goods and services • three initial assumptions 1. firms sell only to households 2. no savings 3. households buy ALL goods and services produced by firms

Example Firms produce goods valued at £7,000 that they sell to households

Household expenditure £7,000

Firms

Households £7,000 Factor incomes

• if all money is paid out to workers, why do firms produce at all? • factor incomes will include the profits of firms ... • and profits will make their way back to households because they are the ultimate owners of firms

• more generally, the value of output produced by firms will always be matched by an equivalent flow of factor incomes from firms to households • because we are measuring economic activity in terms of money, we will adopt the phrase national income

What happens when we relax the underlying assumptions? Assumption 1: more realistic to assume that transactions also take place between firms themselves • firms may purchase raw materials from one another or buy machinery from other firms Value Added the increase in the value of goods as a result of the production process Final Goods goods purchased by their ultimate user -consumption goods purchased by households -capital goods (e.g. machinery) purchased by firms Intermediate Goods partly finished goods that form inputs to another firm’s production process and are used up in that process

• how does this affect the measurement of national income? OUTPUT: net worth or value added INCOME: will reflect value added EXPENDITURE: final goods only Example • Yachts PLC manufacture sail boats that they sell to their customers • to produce these boats, Yachts PLC need to purchase timber and sail cloth (as raw materials) from their suppliers • in addition to these raw materials, a woodcutting machine is also required by Yachts PLC to manufacture the sail boats

Sail cloth

Timber

£500

£1,400

£1,500

Transaction

£6,500

£500

£7,000

£3,600

£500

£1,400

£1,500

Value Added

£7,000

£3,600

£500

£1,400

£1,500

Factor Incomes

Expenditure

Wood-cutting machine £6,500

£7,000

Good

Yachts

£9,900

Assumption 2: from this example we can clearly see that households must be saving. Whilst they are receiving £7,000 in factor incomes, they are spending only £6,500.

Household expenditure £6,500

Firms

Households £7,000 Factor incomes

• we have already calculated national income to be £7,000, but spending by households is only £6,500 ... • so somewhere in the economy there must be an additional £500 of spending • if it is not coming from households it must be coming from the firms themselves

• but whereas we denote the spending of households as CONSUMPTION expenditure, the purchases made by firms are referred to as INVESTMENT expenditure • investment expenditure is the purchase of capital goods by firms • do not confuse the term investment with the everyday use of the word, where individuals invest their money in stocks or shares Households – consumption expenditure (C) Firms – investment expenditure (I) • so how does this affect our circular flow diagram?

S C

Firms

Households

Y I

• pay careful attention to the direction of the arrows in the circular flow diagram • (S)avings has an arrow pointing away from the system – WITHDRAWAL • (I)nvestment has an arrow pointing towards the system – INJECTION • is it just a coincidence that the level of savings and the level of investment are equal (both at £500)?

S=Y-C Y=C+S Y=C+I C+S=C+I S=I • actual savings will always equal actual investment

Assumption 3: what will happen if firms are unable to sell all of their output? • there will be a discrepancy between the output and expenditure methods of calculating national income • the resolution to this problem lies in the treatment of INVENTORIES or STOCKS • inventories are goods held by a firm for future production or sale Example Widgets Inc. produces £5,000 worth of widgets, of which it is only able to sell £4,000 worth to households. It adds the remaining £1,000 worth of widgets to its inventories. Produced: £5,000 Sold: £4,000 Inventories: £1,000

• as it stands at the moment -output approach calculates national income at £5,000 -expenditure approach calculates national income at £4,000 • inventories are treated as an investment in working capital and are classified as a capital good • thus, inventory investment will appear as a final expenditure • the expenditure approach will now calculate national income at £5,000: the £4,000 of final expenditure by households plus the £1,000 of investment expenditure as the firm adds to its inventories

The Government Sector • so far we have only dealt with a two-sector model – now is the time to introduce a third sector: the government • the government does not possess factor endowments that it can supply to firms in exchange for money income • the government has the power to extract tax revenue to meet its spending needs • for simplicity, we will assume that: -the only form of taxation is direct taxation (T), which is levied on the factor incomes of households -the only form of government expenditure is spending on the goods and services produced by firms (G)

S C G

Households

Government

Firms

T Y I

• (T)axes are a WITHDRAWAL from the system • (G)overnment expenditure INJECTION into the system

is

an

• the amount of money that households have available for spending an saving after taxes is termed personal disposable income Yd=Y-T S=Yd-C

S=(Y-T)-C Y=C+S+T • since we can measure national income as the sum of all final expenditures Y=C+I+G C+S+T=Y=C+I+G S+T=I+G W=J