Question

QUESTION 6

6.1 Briefly discuss the main components of total spending in the economy.

6.2 Identify the THREE (3) main withdrawals (or leakages) from the circular flow of income and spending in

an open economy.

6.3 Explain with examples, the following:

6.3.1 Constant returns to scale.

6.3.2 Increasing returns to scale.

6.3.3 Decreasing returns to scale.

Answer 1

6.1) Following are the main components of total spending in the economy:

a) Consumption: It is the Spending by consumers on final goods and services produced either in the home market or abroad. It consists of consumer durables such as cars, nondurable goods like food and services such as education.

b) Investment: It is categorised into inventory investment (increase in the inventory of firms) and fixed investment (spending on capital goods, construction of houses) .

c) Government purchases: Any spending on final goods and services by government is included in it. Transfer payments, national debt and interest payments by government are excluded.

d) Net exports: Net exports is exports less imports. This component takes into account spending on exports( done by the foreigners) and imports(by domestic households).

6.2) The three main leakages from the circular flow of income and spending in the open economy are :

a) Savings: People do not spend all their income on consumption. They save a certain portion of their income for an unseen day.

b) Taxes: A certain percent of income leaks out from circular flow of income and spending for paying government taxes.

c) Imports: Money leaks out from the circular flow to pay for goods and services produced abroad.

6.3) Returns to scale is a long run law where all factors are variable and there is no fixed input.

Constant returns to scale: Under this, the change in the proportion of inputs leads to equivalent change in the proportion of output. Example, If labour and capital is incresed by two units, output also increase by two units.

Increasing returns to scale: Under this, the change in the proportion of inputs leads to more than proportional changes in output. Example, if labour and capital is increased by two units, output increases by more than 2units.

Decreasing returns to scale: Under this, the change in the proportion of inputs causes less than proportionate changes in output. Eg, if labour and capital is increased by two units then output increases by less than two units.