Shobhit Bhatia 2010-04-01

HL Economics – Berntson

HL Economics – Spring Break Review (odds)

1. Distinguish between the concepts of the short run and the long run.

Short run is the period of time when a firm applies more units of variable factors to the
fixed factors that it possesses in order to increase output. Often, the fixed factor is some
type of land or capital, however sometimes it can even be a type of highly skilled labour,
such as a specialist machine worker. The length of the short run is based on the time it
takes to increase the quantity of the fixed factor. Of course the length will vary from one
industry to another.

Long run is the period of time when a firm plans to change its fixed factors, which then
makes all factors of production variable. However once the new quantity of fixed factors
are introduced, the firm is once again in a short run because the firm has to add more
variable factors to its new quantity of fixed factors in order to increase its output.
Note: To help in memorizing short and long run; all production takes place in the short
run and all planning takes place in the long run.

2. Distinguish between an economists definition of profit and an accountants

definition of profit

An accountant’s definition of profit is: Total revenue minus Total cost (if the resulting
number is positive; it is a profit. If negative; it is a loss).

An economist’s definition of profit is similar, but it takes into consideration another type
of cost; an economist will include the opportunity cost. For example: ―If an owner does
not manage to cover his or her opportunity cost in the long run, then they will close the
firm down and move on to their next best alternative occupation. Thus the opportunity
cost is the most important one for the firm to cover‖ (Dorton 89).

Economists definition of profit: Total profit = Total revenue – total cost (fixed, variable
and opportunity cost). If a firm’s total revenue (TR) equals its total cost (TC), then the
firm is making a normal profit. If TR>TC then the firm is making an abnormal profit. If
TR<TC then the firm is making losses (economic loss, could be accounting profit).

3. Explain the sources of economies of scale.

Economies of scale are any decreases in the LRAC (Long-Run Average Costs) when a
firm alters all of its factors of production in order to increase its scale of output. This
makes the firm experience increasing returns to scale. There are several different
economies of scale:
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HL Economics – Berntson
Specialization: In small firms, there will be a very limited number of managers, who will
most likely take on different roles, and this may eventually lead to higher unit costs for
the firm. However, as firms grow, the firm will be able to hire more people, and also have
their management specialize in individual and different areas of expertise (such as:
marketing, finance) and thus be more efficient.

Division of labour: This will separate workers and make them work in smaller activities
(breaking a production process down) so that the workers can repeatedly do the same job,
and thus be more efficient. As firms get bigger and demand increases, they will be able to
break down their production process and use division of labour in order to reduce their
unit costs. For example: On an assembly line, each worker usually has a different task,
and they do that same task over and over again, thus they are efficient in that particular
task.

Bulk buying: As firms increase in scale they are able to make negotiations for discounts
with their suppliers (this would not be possible if the firm was of a smaller size). This
will then reduce the cost of the firm’s inputs, which will in the end reduce their unit costs
of production.

Financial economies: Large firms can raise money (financial capital) more cheaply than
smaller firms. Banks tend to charge a lower interest rate to firms, since the firms are
larger, and are assumed to be less of a risk than smaller firms, who do not make more
financial capital than larger firms. Thus, large firms are less likely to fail to repay their
loans.

Transport economies: Large firms making bulk orders may be charged less for delivery
costs than smaller firms. Also, large firms may also be able to afford their own transport
fleet, which will cost less because the firm will not be paying other firms.

Large machines: Small firms/producers may not be able to afford some machinery
(example: top of the line printing press for a brand new newspaper company). In this
case, the brand new newspaper company will have to rent the supplies necessary,
increasing its costs of production. However once the firms is big enough, it can afford its
own supplies, reducing the costs of production.

Promotion economies: Most firms attempt to promote their products by advertising, or

sales promotion, or publicity, or publicity, or a combination of the above. The costs of
promotion don’t tend to increase in proportion with output. If a firm doubles its output, it
is unlikely that the firm will double its expenditure on promotion methods (advertising).
Thus the cost of promotion per unit of output falls. Also applies to other costs: insurance
costs.
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HL Economics – Berntson

4. Explain the level of output at which a monopoly will produce.

A monopoly is the only existing firm in the entire industry. Barriers to entry exist, which
stops new firms from entering the industry – as a consequence to these barriers to entry, a
monopoly may be able to make abnormal profits in the short run and long run.
Figure 1.1 shows a monopoly graph with a shaded area that
represents the profits for a monopoly. The type of profits
being achieved are abnormal profits. A monopoly will
always sell (Q) at the level where MC = MR because that is
the point for profit maximization (A monopoly will try to
maximize its profits). And the price is determined by the
point where MR = D (AR). This is shown in figure 1.1 at the
point P*Q*. It is assumed that a monopolist will always earn
abnormal profits; however this is untrue because if the
monopolist produces something for which there is little
demand, then it will not earn abnormal profits.
Figure 1.1 – Source: http://spot.colorado.edu/~kaplan/econ2010/section10/gifs/fig103.gif

5. Using appropriate diagrams, explain whether a monopoly is likely to be more

efficient or less efficient than a firm in perfect competition.

In economics, there is productive efficiency and allocative efficiency. A firm is

productively efficient is it produces its product at the lowest possible unit cost (average
cost – AC). This is shown in figure 1.2 below. At point PQ, the firm is productively
efficient (MC = AC). A productively efficient firm is a firm that is combining its
resources as efficiently as possible resources are not being wasted by inefficient use. In
the short run, a perfect competitor may be productively efficient, however in the long run,
the firm will be productively efficient (always) because of firms entering and exiting the
industry, and firms selling at the same price and minimizing their average costs by
producing where MC = MR.
Allocative efficiency or socially optimum level of
output occurs when suppliers are producing the
optimal mix of goods and services required by
consumers. This efficiency occurs when MC =
AR (Average Revenue). In perfect competition,
the firm will always be allocatively efficient in the
short run and long run because it will try to
maximize its profits (MR = MC), and since (MR
= D), then the firm will always be allocatively
efficient.
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HL Economics – Berntson

Figure 1.2 – Source: http://ourtwocents.files.wordpress.com/2008/04/perfect-competition.png

Unlike perfect competition, a monopoly will produce at the level of output where there is
neither produce efficiency nor allocative efficiency.

Figure 1.3 shows a monopoly graph and the profit-

maximizing level of output (Qm). However the
monopolist is not producing at the level of output of
AR= MC or MC=AC; this means that the
monopolist neither productively efficient (not
producing at MC=AC) nor allocatively efficient
(not producing at AR=MC).

Figure 1.3 – Source: http://www.economicshelp.org/images/micro/monopoly.jpg

This concludes that a perfect competitor will always be more efficient that a monopolist,
in the short run and the long run.

6. Explain why prices tend to be quite stable in a non-collusive oligopoly.

In a non-collusive oligopoly, the firms do not collude and so have to be very careful
when making decisions and they have to be very aware of the reactions of other firms
when making these decisions. In a non-collusive oligopoly, economists classify firms’
behaviour as ―strategic behaviour‖ because firms must develop strategies that take into
account all possible reactions by the rival firms.

The explanation is quite rational – if the firm were to raise its price, then it is unlikely
that other competitors will follow, thus the firm will loose a lot of demand to the other
firms. If the firm were to lower its price, then it is likely that firms will follow, and
possible undercut that price of the first firm in order to regain any lost sales and ―stay
ahead‖ of other firms.

Thus from the explanation we can conclude 2 things:

 Firms are afraid to raise prices above the current market price because other firms
will not follow; thus the firm will loose a lot of demand; thus it will also loose
profit
 Firms are afraid to lower prices below the current market price, because other
firms will follow and undercut the lowered price, creating a price that may harm
all firms involved

(Note: This is only for non-collusive oligopolies, not collusive oligopolies)

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HL Economics – Berntson
7. Evaluate the view that governments should maintain strong policies to
control collusive behaviour by oligopolies.

In economics, there are to types of collusive oligopolies; formal collusion and tacit
collusion.

Formal collusion takes place when firms agree on the price that they will charge, and in
effect, start acting like a monopoly, and in the end divide up the monopoly profits made.
Such a collusive oligopoly is often referred to as a cartel. When in effect, the firms charge
higher prices and reduce their output for consumers; this usually against the interest of
the consumer, and so collusion is banned by governments and is against the law in many
countries. If such collusion has taken place and is against the law, then the firms will be
penalised with fines for the collusion taken place.
Formal collusion between governments may be permitted (example: OPEC, Organisation
for Petroleum Exporting Countries which sets production quotas and price for the world
oil markets).
Tacit collusion occurs when firms in an oligopoly charge the same prices without any
agreements or formal collusion. However, the main similarity between both types of
collusions is that the firms start acting like a monopoly, charge the monopoly price, make
monopoly profits, and divide up the profits and share accordingly.
One of the biggest concerns for the government in almost any country is the interest of
the consumer because the consumer is what runs the economy, and the economy is what
runs the country. And so, if a collusive oligopoly exists and is against the interest of the
consumer, then the government should penalise the firms based on how strong the
policies of the government are for collusions in an oligopoly.

Governments should maintain strong policies to control collusive behaviour by

Oligopolies because it will hurt the consumer, thus it may hurt the industry, and thus it
will hurt the economy and the government should be against that. Governments should
only allow formal collusions between themselves and the firms involved in the formal
collusion in order to investigate the markets of the collusion involved and to see if any
price-fixing agreements are hurting the consumer to a large degree. And if a tacit
collusion exists, then governments should create or should have some sort of industry
inspection authority organization that inspects firms and industries of any anti-
competitive behaviour such as price-fixing agreements. Then, these authorities should
penalise the firms with fines and other punishments in order to stop the collusion and
make the firms aware of even more serious consequences. This way, any collusion will
not exist in a country, unless it is a formal collusion with the government. However this
industry inspection authority organization will be expensive to the government, but it will
help the government by investigating anti-competitive behaviour.
I believe that such an organization will be more useful in the long run than in the short
run because if the government does create such an organization to inspect for anti-
competitive behaviour, and let’s say that the organization stopped 4 collusions in the
country. After a while, the government decides to close down the organization. After
closing down the organization, more collusions will arise, and so it is more effective for
the organization to be part of the government’s policies in the long run.
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HL Economics – Berntson
8. Explain what is meant by contestable market theory

The contestable market theory looks as the probability of new firms entering the industry
in the future.

If a firm was a monopoly at the moment, but had a high likelihood of firms being
attracted to the industry, then the monopoly will keep its prices low, make only normal
profits and create high quality products in order to discourage entry by others. The
monopolistic firm will act as if it is in a competitive market. However, if there is little
likelihood that firms will be attracted to the industry due to effective barriers to entry,
then it is possible to see higher prices in the monopoly with lower quality products.

The likelihood of firms entering a market is determined by the entry and exit costs. The
entry costs are the costs a firm must pay if it wants to enter an industry. The entry costs
could the production of a power plant, or the renting of an office space. Exit costs are the
capital equipment which cannot be sold for other uses if a firm leaves the industry. These
are fixed costs, and are often known as sunk costs to entry. The lower the sunk costs of
entry, the contestable a market will be, because if a firm does decide to leave the
industry, the firm does not want to experience too much depreciation of its capital
equipment, and want to get back as much of their entry costs as possible. Also, when
barriers are low for entry, the more contestable a market will be. If a market is
contestable, then the firms inside the industry are more likely to charge lower prices than
the profit maximizing price. This, due to this theory, it is the potential competition rather
than the actual competition in the market which leads to pricing and output decisions.

9. Evaluate the view that economic development is best measured using the
human development index.

Economic development is not best measured through the HDI because it measures only
the three basic goals of development; long and healthy life, improved education and a
decent standard of living. All of these goals can be measured: long and healthy life is
measured by life expectancy at birth, improving education is determined by the adult
literacy rate, and a decent standard of living is measured by GDP/capita which is
basically the average salary per person in a country. These three indicators are then
combined to give a number between 0 and 1. The closer the number is to 1, the more
developed the country is based on those three measures.
If a country is given an HDI value of 0.800 – 1, then there is high human development. If
a country is given an HDI value of 0.500-0.799, then the country has medium human
development. If a country is given an HDI value of 0-0.500, then the country has low
human development.
The HDI does not include enough indicators in order for it to be used for the entire
economy. The HDI is only an average figure that ―masks inequalities within the country‖
(Dorton 163). What this means is that it’s trying to say that there are still many different
aspects to development other than the three included in the HDI. Inequalities are a huge
aspect to development which is not even covered in the HDI. Poverty is another main
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HL Economics – Berntson
aspect to development, which is also not covered in the HDI. Also, not only is gender
inequality an issue towards development, but also income inequality.
It was said by the UN that they were shocked to see such major discrepancies between
HDI and a country’s GDP. Saudi Arabia is ranked 44th for its GDP per capita, but 77th for
its HDI. This means that the HDI also does not indicate how and why a country’s GDP
not reflect an improvement in the welfare of the people.

There are many other development indicators which measure gender inequality (GDI),
human poverty (HPI), opportunities for women (GEM), income inequality (Lorenz curve)
and economic progress (GPI).

One indicator in particular is probably a better measure than the HDI is the GDI
(Gender—related Development Index) which is an HDI measure, but takes into account
for the inequalities between men and women. Gender inequality is significant because it
is an obstacle to economic development and needs to be accounted for in an economic
development measure. The GDI is calculated in the same way as the HDI (0-1) however
the adjustments are taken in the following manner: if inequality between men and women
exists (which it does for every country) then the resulting GDI figure will be lower than
the country’s HDI figure. For example: France has a high HDI of 0.938, however its GDI
is 0.935, with a difference of 0.003. Chad has a low HDI of 0.341, and its GDI is 0.322,
with a difference of 0.19. In both countries, no matter how high or low the HDI is, it can
be adjusted for inequality by using GDI and thus, by looking at the measure see how
much inequality exists within a country. Compared to Chad, France seems to have a low
inequality between men and women.

In conclusion, the HDI is an appropriate economic development indicator; however it is

not the best, indicator. The best indicator for economic development in my opinion would
the GDI because it adjusts the HDI figure accordingly to the amount of inequality
between men and women in a country.

10.
a. Explain the concept of negative externalities of production.

A negative externality occurs when the

production or consumption of a good or service
creates external costs upon a third party.
Usually the negative externality of production is
of an environmental issue; if a power plant
emits fumes into the atmosphere, then it is
harmful to the people in the area, thus there is a
cost to the community that is greater than the
costs of production paid by the firm. A firm has
its own private costs, but on top of that, has its
external costs. Thus the marginal social cost
Figure 1.4 – Source: http://tutor2u.net/economics/revision-notes/a2-micro-externalities-overview_clip_image003.gif
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HL Economics – Berntson
(MSC) = marginal private costs (MPC) plus external costs. This is shown in the figure
1.4 below on the left.
From looking at figure 1.4, we can see that the MPC of the firm is below the MSC
because there is an extra cost to society. The firm however is only concerned with its
private costs and will produce at Q1. It is not producing at the socially optimal level
(MSC = MSB) (P1Q2), thus it is a market failure. The shaded represents loss of
economic welfare comes from a misallocation of society’s resources; too much is being
produced at too low a price.

A negative externality of consumption also triggers a market failure because the Pareto
optimality is not being achieved due to external costs upon a third party.
On the left, figure 1.5 shows a
negative externality of consumption.
The MSB is lower than the MPB
because the private benefits create an
external cost to society. For example:
Smokers enjoy their private benefits,
however are also creating an external
cost to society in the form of second-
hand smoking.
Figure 1.5 – Source: http://welkerswikinomics.com/students/wp-content/uploads/2009/04/negative-externality-of-consumption-chocolate.bmp

Since there is a free market, consumers will consume at the level of MSC = MPB. They
will ignore the negative externality and over-consume cigarettes by smoking Q1
cigarettes at the price of P1. Since MSC is greater than MSB, there is a welfare loss to
society present (shaded yellow triangle in figure 1.5).

b. Evaluate three policies that may be used by government to reduce

external costs of production.

External costs of production are usually caused by a negative externality of production;

which occurs when the production of a good or service creates an external cost upon a
third party. Now this creates a market failure,
and only government intervention can it be
fixed or reduced. In order to reduce the MPC
so that it can be closer to the Pareto
Optimality (MSC = MSB) is by government
intervention. On the left, figure 1.6 shows the
negative externality of production.
Governments can do the following three
things: tax the firm, ban the output of the
firms, and charge money in order to create
output.
Taxing the firms will reduce the output because it would add to the producers marginal
cost and thus, cause them to reduce output. By doing this, the MPB will reduce due to the
Figure 1.6 – Source: http://tutor2u.net/economics/revision-notes/a2-micro-externalities-overview_clip_image003.gif
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HL Economics – Berntson
tax, thus causing the MPB line to go closer to the socially optimal level. Also, the
government can benefit from this situation by increasing their tax revenue. It is sort of a
win-win because the firm is still allowed to operate of it pays its taxes, and the
government is happy because its tax revenue has increased. However, there is still a
market failure because taxation will not fix the market failure, but it will reduce it. The
only con in this policy is to tax which firm, because there may be multiple firms in the
society and the government may or may not tax the firm responsible for the external cost.
This policy would be quite effective in the short run because it will quickly reduce the
external costs, however it could be a disaster in the long run because if the firm does not
experience growth or economies of scale, then the firm might end up bankrupt due to the
taxation by the government, which could have a negative consequence in the economy.

If the negative externality is so, then the government can ban the output of the firm. The
government can easily pass laws which would be used as a criterion for firms in regards
to measurable environmental standards. However, the con with this solution is that it may
lead up to a loss of jobs. This will most likely trigger an increase in unemployment rates,
which will definitely hurt the economy. Also, the cost making these policies, passing the
law and closing down the firm may end up being more than the external costs. Thus this
solution, however effective of reducing the market failure, can be potentially dangerous
to the economy of the country (unemployment).

The last solution is one that is not widely used by countries, but is capable of reducing the
market failure. This solution involves government intervention; the government will give
―air property rights‖ to residents around the firm which is creating the external costs.
After giving the residents these ―air property rights‖ the firm will have to pay the
residents a fee in according to how much output they are allowed to produce. The
government will be keeping track of the firm’s payments to the residents and the
residents, or society will enjoy some private benefits (money). Thus, the MPC of the firm
will increase due to the government intervention and transfer payments and residents.
And the residents or society will enjoy private benefits in the form of monetary value,
thus increasing the MSB. This tactic is very effective in reducing the external costs while
providing incentives to the public, while the only cost to the government is too keep track
of the firm’s investments. I believe that this solution is only plausible in the short run
because it will immediately reduce the market failure by reducing the firm’s output. This
may create some losses for the firm because the firm has to pay for its inputs, pay
whatever taxes, pay money to society and on top of that, make less profit than usual due
to restricted output. This does seem unfair to the firm, and thus the solution will not work
in the long run because the firm will probably be making so much losses that it moved
out of the industry, or changed location, or even went bankrupt. The government’s goal is
not ruin the firm in order to reduce the market failure; the government’s job is to reduce
the market failure in a fair way that would be agreeable to society and the firm.
I believe that the first solution (taxing the firm) is the most effective because it provides
two incentives and is more effective in the long run as well. The two incentives are:
increase in tax revenue and reduced external costs. The other solution only gave 1
incentive and are not as effective as taxing the firm in order to reduce the external costs
of production.
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HL Economics – Berntson
11. Distinguish between economic growth and economic development.

Economic growth within a country’s economy deals with the increase in the level of real
national income. National income is the value of all goods/services produced in an
economy during a given time period (usually one year). The term ―real‖ basically means
that the effects of inflation are added. National income can be measured in 3 ways:

 Output method = Measures the actual value of all goods and services produced.
Calculated by summing up all of the value added by the firms. Data is grouped
accordingly to the different sectors in an economy; primary, secondary and
tertiary.
 Income method = Measures the value of all the incomes earned in an economy.
 Expenditure method = Measures the value of all spending on goods and services
in the economy. Calculated by summing up the spending in all sectors of the
economy:
o Spending by households (consumption) (C)
o Spending by firms (investment) (I)
o Spending by governments (government expenditure) (G)
o Spending by foreigners on exports minus spending on imports (X-M)

Each different method/approach measures the value of a nation’s output differently;

however all of these measures are necessary to be equal. One very common way to
measure this measure is by using GDP (Gross Domestic Product).

GDP = C + I + G + (X–M). This reflects the expenditure method.

There are also other indicators which measure the country’s output; GNP and NNP:
GNP (Gross National Product) is the total income that is earned by a country’s factors of
production, regardless of where the assets are located (Dorton 153).
NNP (Net National Product) = GNP – depreciation of capital. The GDP does not take
into account the depreciation of capital because capital gets ―used up‖. NNP does take
depreciation into account, and thus it will create a more realistic view of economic
activity in an economy. However, it is quite difficult to account for depreciation, thus
gross figures are more widely used.

Figure 1.7 represents a flow model of income

and output and this diagram can help measure
the national income of a country’s economy. It
can be measured by looking at the value of the
output of goods and services, or the expenditure
on the goods and services, or the total incomes
(flow of dollars) to the households.
Economic growth is a purely money
measurement and is measured by the increase
in real national income/capita or by GDP.
Figure 1.7 - http://www.people.eku.edu/ruppelf/Eco230/circularflow.gif
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HL Economics – Berntson
Economic development is distinct from economic growth because it is a measure of
welfare or well-being. Economic development can be measured in monetary values, but it
can also be measured in terms of indicators; education, health and social indicators.

Figure 1.8 - http://filipspagnoli.files.wordpress.com/2008/06/human-development-index-hdi-in-2002.jpg

Figure 1.8 represents a choropleth map of the world that represents different values of the
Human Development Index (HDI). HDI is one of the most commonly used development
measures and it consists of real national income/capita, adult literacy rate and average
years of education, and life expectancy. Countries that have a value closer to 1 are
considered to be more ―developed‖. Countries above 0.8 are said to contain ―high human
development‖, countries that are in the 0.5 – 0.8 range are said to have ―medium human
development‖ and countries below 0.5 have ―low human development‖. Looking at
figure 1.3, North America, Europe and Oceania have the highest values on the HDI and
Most of Africa and parts of Asia have the lowest values on the HDI.

There are also other economic development indicators such as; GDI, HPI, GPI.

The GDI (Gender- Related Development Index) looks at the same indicators as HDI, but
also takes into account inequalities for men and women. Some economists say the GDI is
an HDI adjusted for inequality between genders.

The HPI (Human Poverty Index) measures the level of deprivation and poverty
experienced in a country. The HPI looks at the proportion of people who are deprived of
the opportunity to reach a basic level in each area. The basic levels include: % of people
who do not reach the age of 40, adults who are illiterate, population inaccessible to clean
water and underweight children.

The GPI (Genuine Progress Indicator) is an indicator which attempts to measure whether
a country’s growth has actually led to an improvement in the welfare of the people.
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HL Economics – Berntson
12. Explain why PPP exchange rates are used when comparing national income
among countries.

If PPP exchange rate were not used to compare national income among other countries,
then the figures would seem unrealistic. The problem is because of different values for all
of the currencies. Usually, to compare currency comparison, the US dollar is chosen as
the international currency for comparison. This creates problems because if a country
(let’s say Kenya) were to increase in value against the US dollar, then the value of
Kenya’s national output would also rise if compared with the US dollar. This is a
problem because it seems that Kenya has had an increase in national output, when it
never really did; it only seemed like it because of the rise in value of currency against the
US dollar. There is also another problem: Goods and services don’t cost the same amount
in different countries. This implies that the purchasing power of a person’s income will
be different [for different countries]. For example: if we were to buy a pizza, it would
cost us less in DRC than it would in Norway. ―When we convert the Nigerian GDP/capita
into US dollars, we get US$428 (2003 figure). However, that $428 actually has a much
higher purchasing power in Nigeria than it would in Vienna because things cost less in
Nigeria‖ (Dorton 161). What the textbook is trying to say is that by converting the
GDP/capita through currency exchange rates, the resulting number is inaccurate because
it does not account for the purchasing power parity (which it should because things cost
less in different countries). And in order to avoid this problem, economists use the PPP
(Purchasing Power Parity) exchange. This form of exchange rate attempts to equate the
purchasing power of currencies in different countries by; comparing prices of identical
goods and services in different countries. And if the Nigerian GDP/capita figure was
converted by the PPP rates would $1,050 (Dorton 161). It is true that this figure is of a
low value; however there is much significance between the GDP/capita figures already. It
seems that with the PPP rates, the figure has doubled in value than the original
GDP/capita figure measured by converting the US$. This is why PPP rates are used to
measure national income among countries because it will attempt to show a ―real‖
increase in national output and it will also account for the purchasing power among
different countries which is significant because prices are different in every country, thus
the purchasing power of a person’s income will be different in different countries.
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HL Economics – Berntson
13. Using a diagram of the circular flow of income model, explain the three ways
that national income can be measured.

National income can be measured in 3 ways:

 Output method = Measures the actual value of all goods and services produced.
Calculated by summing up all of the value added by the firms. Data is grouped
accordingly to the different sectors in an economy; primary, secondary and
tertiary.
 Income method = Measures the value of all the incomes earned in an economy.
 Expenditure method = Measures the value of all spending on goods and services
in the economy. Calculated by summing up the spending in all sectors of the
economy:
o Spending by households (consumption) (C)
o Spending by firms (investment) (I)
o Spending by governments (government expenditure) (G)
o Spending by foreigners on exports minus spending on imports (X-M)

Figure 1.7 on the left shows a circular flow

model of income and output. The
expenditure method represents the yellow
line for goods and services given to
households by firms. The income method
represents the blue line given to households
by firms. And the expenditure method is the
blue line; households giving firms money.
Spending by firms (I), government (G) and
exports (X-M) will all be covered as an
injection into this circular flow model.
Meaning more money is being injected into
the circle. If more money is being injected into the circle, it means that there is growth in
an economy (also could be a rise in inflation). However there are leakages in this circle,
which come in the form of savings, imports and taxes. And if there are too many savings,
imports or taxes, then it must mean that too much money is being drawn from the circular
flow, thus the economy is not experiencing growth.
Shobhit Bhatia 2010-04-01
HL Economics – Berntson
Work Cited

Blink, Jocelyn, and Ian Dorton. Economics: Course Companion. Oxford: Oxford UP,

2007. Print.