Introduction

Three Major Flows

The production flow comprises the production of goods and services by firms. Firms use the factors of production to produce goods and services.

The income flow involves the flow of income to households which they earn from making the factors of production available for firms to produce goods and services.

The spending or expenditure flow entails the spending on goods and services produced by firms.

The flows are not independent, but interdependent and closely linked. This interdependence between production, income and spending can be represented by the following circular flow diagram:

The three flows

A change in the flow of production will bring about a change in the flow of income which, in turn, will change the flow of expenditure, which again will change the flow of production.

In the same way, an increase in spending will bring about an increase in production which, in turn, causes an increase in income. Similarly, an increase in income will bring about an increase in spending and then production. A major part of the study of economic indicators is how these flows are to be measured.

Link between production and income

The Three Flows

The reason we produce goods and services is to satisfy our needs and wants. To produce these goods and services, factors of production, i.e. land, labour, capital and entrepreneurship, are needed.

In a market system, the factors of production belong to households, which are then paid an income in the form of rent, wages, interest and profit by producers for the use of the factors of production. As production takes place, a flow of income is created. If you are working (employed), the contribution of your effort is part of the production flow, and the payment you receive is part of the flow of income.

Link between income and expenditure (spending)

We have now established that as production takes place, a flow of income is created. This income, which flows to households from firms, is then spent by the households on the goods and services that were produced, and as they spend, a flow of spending or expenditure is created. As you spend the income you received from taking part in the process of production, you are creating a spending flow.

Link between spending and production

The spending in the economy is linked to production since income is spent on the goods and services that were produced. When we bake bread, we are taking part in production; when we are paid for baking the bread, we are part of the income flow; when we spend our income on buying the bread, we are part of the spending flow.

Equality between production, income and expenditure

In theory, these three flows should therefore be equal. If the production is R500 billion, then income should be R500 billion and spending should be R500 billion. However, in the real world things might be a bit more complicated due to inventories and the prices that are used to calculate these flows.

It is possible that while production is equal to expenditure on goods and services, the total sales are less than total production due to a change in inventories. To ensure that the equality is maintained, changes in inventories are added to the expenditure on goods and services.

Another reason why production, income and expenditure might not be equal is that different sets of prices might be used in these calculations. We will deal with this issue later in the course in more detail.

The important implication of the equality of production = income = expenditure on production is that it is possible to calculate the level of economic activity in three ways, namely the production method, the income method and the expenditure method.

Total production, income and expenditure: Activities

1 If the value of the total production in an economy in a particular year is R700 billion and total sales are R680 billion, total production will be greater than total expenditure in the national accounts.

Think again. The statement is false.

In the national accounts, total production is equal to total expenditure. While there is a difference between total production and total sales of R20 billion, this R20 billion represents the change in inventories. By adding this change in inventories to expenditure, total expenditure on production is equal to R700 billion.

Correct. The statement is indeed false.

In the national accounts, total production is equal to total expenditure. While there is a difference between total production and total sales of R20 billion, this R20 billion represents the change in inventories. By adding this change in inventories to expenditure, total expenditure on production is equal to R700 billion.

2 If total sales of goods and services are R10 billion and total production is R13 billion, then the change in inventories is …

Think again.

The change in inventories is equal to total production minus total sales of goods and services.

Think again.

The change in inventories is equal to total production minus total sales of goods and services.

Correct.

The change in inventories is equal to total production minus total sales of goods and services (R13 billion – R10 billion = R3 billion).

Think again.

The change in inventories is equal to total production minus total sales of goods and services (R13 billion – R10 billion = R3 billion).

3 This question is based on the following data for a country:

  • Wages: R10 billion
  • Rent: R4 billion
  • Interest: R5 billion
  • Profit: R6 billion
  • Change in inventories: R1 billion

The total production is …, the total income …, total expenditure is … and change in inventories is …

Think again.

Total production = Total expenditure = Total income = wages + rent + interest + profit = R10 billion + R4 billion + R5 billion + R6 billion = R25 billion.

Think again.

Total income is equal to wages + rent + interest + profit = R10 billion + R4 billion + R5 billion + R6 billion = R25 billion = Total production = Total expenditure

Correct.

Total income is equal to wages + rent + interest + profit = R10 billion + R4 billion + R5 billion + R6 billion = R25 billion.
Total sales, that is the value of what has been sold, are equal to R25 billion – R1 billion = R24 billion.
Since total income = total production = total expenditure, it follows that total production and total expenditure are both R25 billion. Note that total expenditure on goods and services produced consists of the total sales of R24 billion plus what is spent on inventories (investment spending) of R1 billion.

Think again.

Total expenditure on goods and services produced is R25 billion. It consists of the total sales of R24 billion plus R1 billion (the amount that is spent on inventories (investment spending)).

4 This question is based on the following data for a country:

  • Wages: R12 billion
  • Rent: R4 billion
  • Interest: R3 billion
  • Profit: R5 billion
  • Total sales: R22 billion

The total production is …, the total income …, total expenditure is … and change in inventories is …

Think again.

Total production is equal to total income and total income = R12 billion + R4 billion + R3 billion + R5 billion = R24 billion.

Think again.

Total production is equal to total income and total income = R12 billion + R4 billion + R3 billion + R5 billion = R24 billion.

Think again.

Total production is equal to total income and total income = R12 billion + R4 billion + R3 billion + R5 billion = R24 billion.

Correct.

Total production is equal to total income and total income = R12 billion + R4 billion + R3 billion + R5 billion = R24 billion. The change in inventories is the difference between total production and total sales = R24 billion – R22 billion = R2 billion.

5 This question is based on the following data for a country:

  • Wages: R12 billion
  • Rent: R4 billion
  • Interest: R3 billion
  • Profit: R5 billion
  • Total sales: R23 billion

The total production is …, the total income …, total expenditure is … and change in inventories is …

Correct.

Total production is equal to total income. Total income = R12 billion + R4 billion + R3 billion + R5 billion = R24 billion. The change in inventories is the difference between total production and total sales = R24 billion – R23 billion = R1 billion.

Think again.

Total production is equal to total income. Total income = R12 billion + R4 billion + R3 billion + R5 billion = R24 billion.

Think again.

Total production is equal to total income. Total income = R12 billion + R4 billion + R3 billion + R5 billion = R24 billion.

Think again.

Total production is equal to total income. Total income = R12 billion + R4 billion + R3 billion + R5 billion = R24 billion. The change in inventories is the difference between total production and total sales = R24 billion – R23 billion = R1 billion.

6 This question is based on the following data for a country:

  • Wages: R13 billion
  • Rent: R4 billion
  • Interest: R3 billion
  • Profit: R5 billion
  • Total sales: R22 billion

The total production…, the total income …, total expenditure is … and change in inventories is …

Think again.

Total production is equal to total income. Total income = R13 billion + R4 billion + R3 billion + R5 billion = R25 billion.

Think again.

Total production is equal to total income. Total income = R13 billion + R4 billion + R3 billion + R5 billion = R25 billion.

Correct.

Total production is equal to total income and total expenditure = R13 billion + R4 billion + R3 billion + R5 billion = R25 billion. The change in inventories is the difference between total production and total sales = R25 billion – R22 billion = R3 billion.

Think again.

The change in inventories is the difference between total production and total sales = R25 billion – R22 billion = R3 billion.