Circular Flow -- Equivalence of Income, Spending, and Production

Bill Goffe, Pennsylvania State University-Main Campus
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Summary

In this activity students should come to understand a key part of the circular flow -- why income, production, and spending have the same dollar value.

Context for Use

This activity is appropriate for a macro principles course. Prior student knowledge includes that students understand what economists mean by the following terms: production, spending, and income. Most likely income is the most difficult term; it seems that some students conflate it with profits. It is not linked to another activity and there are no class size limitations. It should take on the order of 10-20 minutes as the question is relatively straightforward.

Overview

In this activity students are asked about three very different macro concepts: income, production, and spending. As economists know, in the circular flow these have equivalent dollar amounts. This activity leads students to this important concept.

Expected Student Learning Outcomes

After mastering this exercise, students will be able to understand a key part of the circular flow -- the equivalence of production, income, and spending. This plays a key role in understanding GDP.

Information Given to Students


The Circular Flow (Microsoft Word 2007 (.docx) 12kB Jul19 18)


It is late summer and you are driving in the country. You stop at a roadside farm stand and buy $10 of fresh corn that a farmer grew on his farm. There are three economic concepts here: 1) the income (or revenue) that the farmer receives for the corn, 2) the market value of the produced corn, and 3) the dollars that you spent on the corn. Thinking about the money values for these three concepts (income, production, and spending) in this case, which of the following is correct?
    A. income, production, and spending are all different values
    B. income has the same value as production
    C. income has the same value as spending
    D. production has the same value as spending
    E. income, production, and spending all have the same value

Teaching Notes and Tips

Be sure that students understand the concepts of production, spending, and income before the start of the exercise. They might have the most trouble with income as come conflate it with profits.

For followup, a circular flow diagram would be useful. One would want to be sure to expand this idea across the economy, a further example (like the purchase, production, and income from a burger at a fast food restaurant) might be helpful. Also, the followup should include values of GDP and GDI from FRED to show that they're equal.

Assessment

A later quiz or exam might ask which of income, production, or spending is largest in the economy, or do they have the same size. One might also ask that if production rose, would one be sure that income (or spending) would also be sure to rise.

References and Resources

none