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Fact 7: Our Circular World
Our little excursion through the economy has had, thus far, its ups and downs. My cable bill remains permanently confused and my checking account has a large property-tax created imbalance, but at least the pain in my tooth stops before hitting my toes. I think we deserve a little rest and relaxation at the Shady Valley's own tourist mecca, Happy-Time Gala-World Fun-Land Extravaganza Amusement Park. Let's take a brief respite from our pedestrian trek and give the soles of our jogging shoes a well-deserved rest. The Happy-Time Gala-World Fun-Land Extravaganza Amusement Park has the world famous Monster Loop Death Plunge roller coaster, guaranteed to make riders yearn for the pleasures of a Siberian forced labor camp. There's also the Enchanted Haunted Horror House filled with serial killers, chainsaw murders, and IRS auditors. For the more timid, and fortunately, for those more interested in the workings of our economy, the merry-go-round is the ride of choice. Two familiar faces are enjoying the circular trip on their fiberglass ponies. The slender guy with the bushy mustache is Dan Dreiling, the drywall man. I had him repair a hole in my living room wall caused by an over-excited vacuum cleaner a few months back. The disgusted look on his dusty face tells me that I must have overlooked his $100 bill. The other recognizable rider is Pollyanna Pumpernickel a precocious pet store owner who has somehow neglected to pay me the $100 due for hamster-sitting services which I rendered a few weeks ago. Her furtive glances suggest that she is well aware of her liability.
As dusty Dan Dreiling passes by, closely followed by precocious Pollyanna Pumpernickel, it occurs to me that I could easily pay the drywall bill, if only I were paid my hamster-sitting fee. Perhaps I can work this out before the merry-go-round ride stops. While I consider the options, let's think about the seventh basic fact of economic life:
FACT 7 WHAT GOES AROUND COMES AROUND -- Consumers and producers are interconnected through a continuous circular flow of buying and selling.
Many of the more interesting complexities of the economy arise because one person's expenditure is another's revenue. Any of the hard-earned income that you spend on stuff, ends up as income for those who produce and/or sell the stuff, which they spend on other stuff, which then becomes income for other producers, and on and on and on. It sounds like this could continue for a while. It does. Transforming Gobs of Gooey Resources  Our economy is blessed with a bountiful -- although limited -- amount of resources. These resources are important because they satisfy our unlimited wants and needs. You probably recognize this as our oft-encountered problem of scarcity. Motivated by this ever-pressing problem of scarcity, we humans have discovered that our planet's natural resources can satisfy a whole lot more wants and needs if they're modified, transformed, or changed in one way or another. While a gooey pile of mud might satisfy some sort of desire, it can provide more satisfaction when formed into rectangular blocks, dried, then fashioned into a structure that offers protection from the elements. As useful (or useless) as naturally occurring resources might be, they're more useful when transformed.
Consumption and Production Make Life Liveable The benefit of transforming natural resources into satisfying stuff gives us two fundamental activities in the economy -- production and consumption. While production is the transformation of resources, consumption is the satisfying our wants and needs with resources or the stuff produced from the resources. Most people in the economy -- not all, but most -- do both of these things on a regular basis. For example, remember that peanut butter and jelly sandwich you made when you were eight years old. You first produced the sandwich, with a little help from the bakery, the peanut butter company, and the jelly processor, then you consumed it. Most of us do a lot of producing and consuming without much thought. Producing is usually done in the employ of a business and consuming is regularly accomplished in the privacy of our homes. At times, we transform and enjoy simultaneously either at work or at home. Our economy's ability to efficiently address the problem of scarcity is enhanced through production. The more we produce, the more we consume. Getting Markets Into the Act We've already seen that markets can do a pretty good job -- with a few important exceptions -- of directing resources into the production of the most goods that best satisfy our needs. In other words, production from resources and our consumption of this production is a lot easier because of markets. There are two sorts of markets that we can think about -- one mainly assists consumption and the other is most helpful for production. You might want to note who does the supplying and who does the demanding in each market. - Product markets make it easier for consumers to get possession of goods. Consumers are the buyers in product markets, while businesses are the sellers. This is probably the sort of market that most of us think about when the term arises. If you head to a grocery store, shopping mall, or car dealer to make a purchase, you're in a product market.
- Resource markets let businesses get the resources used for production. In these markets consumers, as resource owners, do the supplying, while businesses, as producers, do the demanding. The most common sort of resource market is that for labor. There are, however, markets for capital and the whole spectrum of natural resources, as well.
The Circular Flow This whole economic process of trading goods, services, and resources through resource and product markets takes shape through the circular flow. Consumers and producers interact in a circular fashion with each other through these markets. This circular flow works like this: - The revenue that producers get from their sales in the product markets is used to pay for the resources employed through the resource markets.
- The income consumers get from the sale of resources in the resource markets is used to buy stuff from the product markets.
In short, the revenue of the producers becomes the income of the consumers. And the income spent by the consumers becomes the revenue of the producers. The money just keeps circulating around between producers and consumers through the product and resource markets. Just like a merry-go-round. A simple example, taken from the annals of the Shady Valley Central Town Sprawling Hills Shopping Mall, will illustrate this process. Let's pick up the story with Edgar Millbottom an employee of Waldo's TexMex Taco World located at the south end of the mall. - The cash register of Waldo's TexMex Taco World has just received one dollar in payment for one of Waldo's Super Deluxe TexMex Gargantuan Tacos (with sour cream and peppers). The creation of this Gargantuan Taco -- skillfully accomplished with the caring hands of Edgar Millbottom -- and its sale are but one part of the many transactions through our economy's product markets.
- What, however, happens to the dollar bill used to purchase this Super Deluxe Taco? It's used to pay the wage of our own Edgar Millbottom, whose only reason for working at Waldo's TexMex Taco World is to earn enough money to expand his compact disc collection of Live Headless Squirrels (not the animals, a rock band). When Edgar collects the wage payment for his diligent taco preparation, we have a transaction through the economy's resource markets.
- Where do we go from here? Edgar takes this picante-sauce-stained dollar bill (with a dozen or so others) to Musical Sound CD Emporium -- at the north end of the mall -- where he purchases the latest Live Headless Squirrels CD, featuring the title song "Screech... Rumble... Crunch (Oh, Baby)." When the picante-stained dollar bill enters the Musical Sound CD Emporium cash register it has now gone through another of our product markets.
- The crumpled likeness of George Washington doesn't rest for long. It's next used to pay the wage of Alicia Hyfield, a faithful and hungry employee of Musical Sound CD Emporium. It has become part of another transaction through our resource markets.
- How long can this continue? How many transactions will this dollar bill see? At least one more, because Alicia Hyfield wants nothing more from life than the succulent taste of a Waldo's Super Deluxe TexMex Gargantuan Taco.
I think we can see what's bound to happen. This dollar bill will be stained again with picante sauce and help Edgar add to his ever expanding collection of Live Headless Squirrels. Around and around and around it goes. More Than CDs and Tacos Of course, as the title of this section indicates, the economy has goods other than Live Headless Squirrels CDs and Waldo's Gargantuan Tacos. Alicia and Edgar, moreover, are only two of the millions of consumers and producers in our economy. The circular flow works the same for gadzillions of products, gadzillions of producers, and gadzillions of consumers as it does for two. The revenue that producers get from selling stuff becomes the income of the resource owners. This income is then used to purchase stuff that satisfies wants and needs, which then ends up as producers' revenue once again. Around and around and around it goes, just like a merry-go-round. Which reminds me, I've plucked the necessary payment from Pollyanna Pumpernickel for hamster-sitting services, and I'm passing it along to Dan Dreiling for his drywall repairs. From the queasy look on Dan's face, I'd say that our own little circular transaction has been completed none to soon. As Dan recovers, let's look into this circular flow business in more detail. The Multiplicative, Cumulatively Reinforcing Interaction of the Circular Flow (Whew!) When one person spends a dollar on production, it becomes a dollar of revenue for a business, which then uses it to pay for resources, meaning it becomes a dollar of income for someone else. That someone else buys more production, which becomes yet another's income. Even more production ensues. Over the period of a year, a single dollar might be used to buy six or seven dollars worth of production. This creates what we can call a multiplicative, cumulatively reinforcing interaction of the circular flow (whew!). Once the circular flow is set in motion, it continues in a multiplicative, cumulatively reinforcing manner (whew!) for some time. If businesses, for example, decide to build several new factories here and there, the resources who make the factories get more income. This then triggers our multiplicative, cumulatively reinforcing circular flow (whew!) into more production and income. The same sort of thing is bound to happen if the government spends more on public goods or foreign types buy more stuff. This whole multiplicative, cumulatively reinforcing interaction of the circular flow (whew!) is like a bandwagon once it starts rolling, with everyone jumping on. When consumers buy more, businesses need more factories to produce more goods, and governments get more tax dollars and consequently spend more as well. Everybody buys. Everyone spends. More production. More income. Our bandwagon, however, rolls in both directions. When a few buyers stop buying -- it could be a business here, a government there, or consumers -- then others stop buying, too. This forces some labor out of work, and reduces income. With less income, there's less consumption, less production, less investment, fewer tax dollars, and the bandwagon heads rapidly down a steep slope. When things go good, they go really good, and when things go bad, well, watch out for falling stock brokers. Business Cycle Booms and Busts This multiplicative, cumulatively reinforcing interaction (whew!) means that the circular flow has more production and income coursing through its veins during some periods and less during others. This tends to cause what pointy-headed economists refer to as business cycles. Business cycle gyrations and turbulence in the circular flow are a normal part of not only the U. S. economy, but most other nations as well. The shrinking of the pie, or decline in the economy, is referred to as a recession, depression, downturn, contraction, bust, or some similar term. An increase in the economic pie is noted as expansion, recovery (early on at least), boom, growth period, prosperity, or some other flowery term designed to entice voters to re-elect the incumbents. While I ponder the Death Plunge, let's consider this circular flow pulsation. We've a picture of our economic pie oozing through the circular flow in a big surge, after which it contracts a bit, ready for another big surge of ooze. But, here's an important point, with each surge, the size of the flow, the size of our pie, grows bigger and bigger and bigger.... You might want to get some popcorn and a soft drink during our intermission because the circular flow is about to devour the once peaceful town of Shady Valley. Recall that our pair of young teenagers, Edgar and Alicia, has been desperately trying to warn Mayor Thurgood, Sheriff Morralis, and other town leaders of the impending doom. But no one seems to care. The circular flow, however, continues to pulsate, growing ever closer to a small child, little Mary Jane, who is innocently picking daisies in her back yard. It's growing bigger, it's getting closer.... Oops! Just a moment. That's not our circular flow. That's a space creation. My mistake. The circular flow, however, does grow larger and larger over time through its pulsation. During most expansions, lasting two to three years (sometimes longer), our economic pie is bigger, much bigger than it had been during the previous expansion. When our pie shrinks into a recession of six months to two years (seldom longer), it loses some of the growth found during the expansion, but not all. Our whole process of economic growth, the improvement in our standard of living, and reduction of the everpresent problem of scarcity is accomplished through this circular flow pulsation. Could we grow with the pulsations? Possibly. Yet, we've never had to the chance to find out. Business cycle gyrations go back as far as we recorded time. The Good, the Bad, and the Political All is not good with these booms and busts, ups and downs of the circular flow. Then again all is not necessarily bad either. First, the good. We already noted that the booms of each circular-flow pulsation help add to the size of our economic pie. There's no question that this is good. What about the busts? - During a recession, resources are temporarily unemployed, then reemployed when the boom starts up. The benefit lies in which resources are unemployed. Businesses keep the more productive ones around, and get rid the less productive ones. Moreover, a lot of the businesses themselves go belly up, or bankrupt, during recessions. The businesses that fold are typically -- not always, but typically -- the least efficient ones in an industry. A downturn helps weed out the less productive or least efficient resources from an industry.
- This weeding out process would appear to be good for much of our economy -- more efficient production and all, but what about those resources that get "weeded-out." They too might see some good. When the next expansion occurs these resources have the opportunity to find a more suitable line of endeavor. They're likely to be more productive -- and receive higher incomes -- in the next expansion than they would have otherwise.
In the same way that your heart pumps a surge of blood through your bloodstream then momentarily pauses, the economy expands for a few years then takes a brief respite to recoup its resources and prepare for another surge. Second, the bad. With each boom and bust, the economy experiences two of its more critical problems -- inflation and unemployment. - Inflation can be pretty deadly because prices usually don't rise equally. This means some people pay higher prices for goods, but the income they get for selling their resources doesn't go up as fast. Others receive relatively higher prices for the resources they sell, and thus higher incomes, but the prices they pay don't increase nearly as fast. The causes the economic pie to be redistributed from those who aren't getting the higher prices to those who are.
- Unemployment can be even worse because resources are left idle and unused for production. This in itself may not seem all that bad until you recognize that production lost today can never be recouped tomorrow. Sure we could get everyone working tomorrow and have the production that results, but we've still lost today's production. Unemployment is also an obvious problem for those who aren't working. While many unemployed workers get unemployment compensation when temporarily without work, the payments are low and only last a few months.
Third, the political. The immediate and readily apparent problems created with each boom and bust, make it very difficult for any politician hoping for a lifetime of public service to avoid corrective action. When unemployment is up during a downturn, politicians pass laws to rectify the situation. If we have high rates of inflation, rest assured that your favorite elected official will seek immediate redress. Now, don't take it wrongly that the government should not do anything to combat the adverse consequences of inflation and unemployment. There are short-term problems of inflation and unemployment that the government can help correct. However, the surges and pulsations of the circular flow have many benefits that accrue over the long run that may be lost if the short run problems are avoided entirely. Here's simple analogy to illustrate the situation. A three-year old child often needs to suffer the pain of a scolding or mild spanking as a lesson against crossing the rush-hour traffic of a busy street. A child who does not experience this short-run pain, may end up in the long run with body parts strewn across several blocks of traffic. The economy also needs an occasional swift kick in the tail to keep it from suffer major setbacks. An occasional recession can prevent an "unexpected," but debilitating cardiac arrest. Recessionary pauses from an expanding pie are often the short-run kicks needed to ensure long-run growth.
A Few Business-Cycle Tips - The good times don't last forever, but then again neither do the bad. Enjoy the prosperity while it lasts, but don't be fooled into thinking that all of the economy's problems -- such as unemployment -- have been solved. Likewise, when a recession seems to be dragging on forever, keep in mind that none have lasted forever yet. We always seem to find a way to prosperity.
- Don't let the government be too overprotective of the economy. A little pain and suffering can be good for the economic soul. Of course, how much pain and who does the suffering (usually the third estate) has been and always will be a source of heated debate. The government can best ease the problems of a recession by redirecting unemployed resources into more productive areas as quickly as possible.
- Above all, be cautious of political candidates who promise the easy, quick-fix solutions to the ups and downs of the circular flow. We have short-term problems and long-term problems. More often than not, correcting short-term problems create or worsen long-term problems. Make sure that you give a political candidate or elected official with the guts to address long-term problems the chance to see proposed solutions through.
What Does It All Mean? Our economy is a complex, dynamic system that keeps moving with very little regard for what any one of its members (for example, the President) may do. Our economy does its thing, because that's what's best for the people with unlimited needs and limited resources. Sometimes it performs very well, with the economic pie oozing through the circular flow, expanding rapidly and giving (almost) everyone a greater access to needs-satisfying goods. At other times, the circular flow pauses to regroup. Like most activities in the economy, there's more to the circular flow than first meets the eye. The apparent problems of short-run downturns may turn into opportunities for long-run efficiency and expansion. The size of the circular flow in the long run depends on what happens to it in the short run, and vice versa. For example, we can get a bigger economic pie in the long run by diverting portions of the circular flow between consumption and investment in the short run. The things we do, intentionally or not, can have magnified consequences through the circular flow. For example, the government might decide, after all these years, to eliminate the federal deficit; businesses might decide there are fewer investment opportunities that remained to be pursued; or consumers might groan a collective sigh of disgust, as they cut their own spending -- any and all of which would start the economy into a multiplicative, cumulatively reinforcing interactive (whew!) downturn. Historically, all of our downturns have ended with an upturn. But there are no guarantees. Throughout our lives every pulse of blood sent surging through our veins is followed by a brief rest, then another surge. Every rest is followed by another surge. Every rest, that is, but one!
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