A Level Economics 71: The Circular Flow Model

The circular flow model is a simplified representation of how goods, services, and money flow through an economy. It illustrates the interactions between households and businesses and how they participate in the production and consumption of goods and services. The model consists of two main sectors: the household sector and the business sector.

Assumptions of the Circular Flow Model:

1. There are only two sectors in the economy: households and businesses.
2. The economy is a closed system with no external trade or government involvement.
3. All income earned by households is either spent on consumption or saved.
4. Businesses use all their revenue to pay for factors of production, such as labor and capital.

Components of the Circular Flow Model:

1. Households: Households are the owners of resources, such as labor, land, and capital. They supply these resources to businesses in return for income. In the circular flow model, households are depicted as the source of labor and as consumers who purchase goods and services from businesses.

2. Businesses: Businesses are the producers of goods and services. They hire labor and purchase other inputs from households and produce goods and services that are sold to households.

3. Factor Market: The factor market is where businesses purchase the factors of production from households. Households provide labor, land, and capital in exchange for wages, rent, and profits.

4. Product Market: The product market is where businesses sell goods and services to households. Households, in turn, spend their income on purchasing these goods and services.

The Circular Flow and Equilibrium: In an economy, the circular flow reaches equilibrium when the total amount of goods and services produced (output) matches the total amount of goods and services consumed (expenditure) by households. Additionally, equilibrium means that the total income earned by households is equal to the total income spent on goods and services by businesses.

Key Terms in the Circular Flow:

1. Injections: Injections are additions of income to the circular flow of income and spending that do not arise from the normal activities of households and firms. These injections are external to the circular flow and include three main components: investment, government spending, and exports.

2. Withdrawals: Withdrawals are leakages from the circular flow of income and spending. They represent funds that are taken out of the circular flow and do not return as spending on goods and services. There are three main types of withdrawals: savings, taxes, and imports.

Explanations of Injections and Withdrawals:

1. Injections: a) Investment: Investment represents the spending by businesses on capital goods, such as machinery, equipment, and infrastructure, to expand their production capacity and enhance future output. When businesses invest, they inject funds into the circular flow of income, leading to increased economic activity and potential employment opportunities. For example, a construction company building a new factory is making an investment injection into the economy.

b) Government Spending: Government spending refers to the expenditure by the government on public goods and services, welfare programs, education, healthcare, and infrastructure projects. When the government spends, it injects funds into the circular flow, which can boost overall demand and support economic growth. For instance, a government allocating funds to build schools and hospitals is making a government spending injection into the economy.

c) Exports: Exports represent the sale of goods and services produced in a country to foreign markets. When a country exports, it generates income from outside its domestic economy, adding to the circular flow of income. Exports are an important injection as they contribute to a country's economic growth and can create employment opportunities in export-oriented industries. For example, when a country exports cars to foreign markets, it is making an export injection into its economy.

2. Withdrawals: a) Savings: Savings are the portion of household income that is not spent on consumption but set aside for future use or investment. When households save, funds are withdrawn from the circular flow, reducing the overall spending in the economy. While saving is essential for capital formation and investment, excessive saving can lead to reduced demand for goods and services, potentially slowing down economic growth.

b) Taxes: Taxes are compulsory payments made by households and businesses to the government. When taxes are collected, they represent a withdrawal from the circular flow, as the funds are not available for immediate consumption or investment. While taxes are necessary to fund government services, excessive taxation can reduce disposable income and, in turn, lower consumer spending and business investment.

c) Imports: Imports are the purchase of goods and services from foreign markets. When a country imports, it represents a withdrawal from the circular flow as funds flow out of the domestic economy to pay for foreign-produced goods and services. While imports allow consumers to access a variety of products, excessive reliance on imports can affect domestic industries and lead to a trade deficit.

Injections and withdrawals play a crucial role in determining the equilibrium income, output, and expenditure in an economy. Equilibrium occurs when total injections into the circular flow are equal to total withdrawals. Let's examine the impact of injections and withdrawals on the equilibrium:

1. Impact of Injections:

• When injections exceed withdrawals, it leads to an increase in total demand in the economy. This additional demand stimulates businesses to increase production to meet the higher level of expenditure. As a result, output and income increase, leading to a higher equilibrium level.
• For example, if the government increases its spending on infrastructure projects (injection), businesses will experience higher demand for construction-related goods and services. This can lead to increased output and income in the construction industry and related sectors, contributing to an expansion of the economy.

2. Impact of Withdrawals:

• When withdrawals exceed injections, it reduces the total demand in the economy. This reduction in demand may cause businesses to scale back production, leading to lower output and income in the economy.
• For instance, if households increase their savings rate (withdrawal), it reduces their spending on goods and services. This reduction in consumer spending can lead to a decrease in business revenue, leading to lower production and income.

3. Achieving Equilibrium:

• Equilibrium occurs when injections equal withdrawals. At this point, the total demand in the economy matches the total supply, resulting in a balanced level of output, income, and expenditure.
• For example, if the government increases its spending (injection) while also increasing taxes (withdrawal) by an equal amount, the net effect on total demand is zero. This would lead to a balanced equilibrium where total injections equal total withdrawals.

Policy Implications:

• Policymakers often use injections and withdrawals as tools to influence the equilibrium level of income and output in the economy.
• During periods of economic recession or slowdown, policymakers may increase injections, such as government spending on public projects, to stimulate demand and boost economic activity.
• Conversely, during periods of inflationary pressures, policymakers may implement measures to reduce injections, such as raising interest rates or decreasing government spending, to curb excessive demand and control inflation.

In summary, injections and withdrawals are vital determinants of equilibrium income, output, and expenditure in an economy. When injections exceed withdrawals, it leads to higher demand and increased economic activity, while the opposite scenario may result in reduced demand and economic contraction.

Multiplier Effect and Equilibrium:

The multiplier effect refers to the process by which an initial change in injections (such as investment, government spending, or exports) leads to a larger final impact on the equilibrium income and output of an economy. It occurs due to the circular flow of income, where an increase in injections results in increased consumer spending, which, in turn, generates more income for businesses, leading to further spending and income creation. The multiplier effect amplifies the initial injection, creating a larger overall impact on the economy.

Understanding the Multiplier Effect:

1. Initial Injection: Suppose the government increases its spending on public infrastructure projects by $100 million. This additional government spending is an injection into the circular flow of income.

2. Increase in Consumer Spending: With the $100 million spent on infrastructure, construction companies receive more income. The workers employed in these projects now have more money, which they, in turn, spend on goods and services like food, clothing, and entertainment.

3. Increased Business Income: The increased spending by consumers boosts the revenue of businesses producing these goods and services. As a result, businesses experience a rise in their income.

4. Further Rounds of Spending: The businesses, in turn, spend their increased income on paying wages to their employees, purchasing raw materials, and investing in their operations. These payments and investments create additional income for households and other businesses, leading to further rounds of spending and income creation.

5. Multiplier Effect: The process continues in multiple rounds, with each successive round resulting in a smaller increase in spending and income. The total increase in income throughout these rounds is the multiplier effect.

Impact on Equilibrium: The multiplier effect has a substantial impact on equilibrium income and output. As the initial injection leads to additional spending and income creation, the total effect is greater than the initial injection alone. This increase in overall spending raises the equilibrium income and output of the economy.

Example: Suppose the initial government spending injection of $100 million has a multiplier of 2. This means that for every dollar of government spending, the equilibrium income increases by $2.

Initial Injection: $100 million First Round of Spending: $100 million x 2 = $200 million Second Round of Spending: $200 million x 2 = $400 million Third Round of Spending: $400 million x 2 = $800 million

In this example, the final impact of the initial $100 million government spending injection on the equilibrium income is $800 million, which is significantly larger than the initial injection.

Link to Injections and Withdrawals: The multiplier effect is closely tied to injections and withdrawals in the circular flow of income. Injections, such as government spending, investment, and exports, create additional income and spending, which leads to a positive multiplier effect, increasing equilibrium income and output. Conversely, withdrawals, like savings, taxes, and imports, reduce spending and income, leading to a negative multiplier effect and potentially decreasing equilibrium income and output.

In conclusion, the multiplier effect is a powerful concept in macroeconomics, showcasing how initial injections into the circular flow can lead to substantial changes in equilibrium income and output. Understanding the multiplier effect is crucial for policymakers to design effective fiscal and monetary policies to stimulate economic growth and maintain economic stability.

Pakistan's Secretive National Security Policy

Najam Sethi in The Friday Times

The PTI government claims to have formulated a National Security Policy after consulting key stakeholders, including hundreds of intellectuals, experts, businessmen, teachers and students. Unfortunately, however, opposition political parties and leaders were kept out of the loop and parliamentarians, even on the treasury benches, were all but ignored. To top it, the policy is classified as “Secret”. We have only been told that “traditional security” is to buttressed by “human security” by increasing the size of the pie that is to be distributed among these two categories. But not to worry. We already know what our National Security Policy has been for over seven decades and we are not shy of asking how and why the new policy should deviate from established wisdom.

Pakistan’s birth is rooted in the biggest mass migration in world history, unprecedented communal violence, and war over Kashmir. In fact, India’s political leaders wasted no time in loudly proclaiming that the new state of Pakistan would be reabsorbed into India before long. Thus insecurity was built into the genetic structure of the new nation and state and over 70% of the country’s first budget was immediately earmarked for military defense and security. The inherited colonial civil-military bureaucracy – that was more developed, organised and cohesive than the indigenous politicians and political parties – now seized the commanding heights of state and society, centralizing power in Governors-General (Ghulam Mohammad, Khjwaja Nazimuddin) and Presidents (Generals Sikander Mirza and Ayub Khan) and signing strategic defense pacts (CENTO, SEATO, BAGHDAD PACT) with the US (ostensibly against communism but in reality to bolster military defenses against India). Thus was born a National Security State based on three national security pillars: Distrust of, and enmity with, India (“unfinished business of partition” pegged to Kashmir); centralization of power via guided “basic democrats” under General Ayub; and dependence on the US for military and economic aid.

This centralized national security state system broke down in 1971 after the break-up of Pakistan following military defeat, leading to civilian assertion under Z A Bhutto and the first democratic constitution of 1973. But the Empire hit back in 1977 with the imposition of martial law, a presidential non-party system under General Zia ul Haq and return to the American camp in the 1980s. The system received a jolt in 1988 with the unexpected exit of General Zia ul Haq but recouped under President Ghluam Ishaq Khan and General Aslam Beg into a hybrid-constitutional system that enabled a strong military nominee or ally as President with the power to dismiss an elected prime minister and parliament (three times in the 1990s). Benazir Bhutto tried to build peace with Rajiv Gandhi but was declared a national security risk and booted out in 1990. The civilian impulse was restrained throughout the 1990s by periodic sackings and rigged elections. It was finally thwarted in 1999 when Nawaz Sharif clutched at bus diplomacy to build “peace” with India and General Musharraf put paid to it by adventuring in Kargil, overthrowing and exiling him, and ruling like a dictator for eight years on the back of billions of dollars in American military and economic aid for abetting its war in Afghanistan. An unexpected mass resistance sparked by a maverick judge, Iftikhar Chaudhry, ended his rule and ushered in the civilians again, but not before they paid the price of Benazir Bhutto’s life. Asif Zardari’s term was blackballed by Mumbai and Memogate, including the sacking of his prime minister Yousaf Raza Gillani; Nawaz’s rule was undermined by surrogate Dharnas, export of jihadis to India and accusations of sleeping with the enemy, finally coming to an end on the basis of a Joint Investigation Team answering to the brass.

This National Security paradigm was revived with the installation of Imran Khan in 2018 and the incarceration and victimisation of Asif Zardari and Nawaz Sharif. But the loss of American goodwill and aid, coupled with the failure of Imran Khan to provide a modicum of governance, has eroded the prospects of economic revival and legitimacy of the hybrid system, discrediting its manufacturers. Meanwhile, the conventional military balance with the old enemy India has fast deteriorated and, faced with the challenge of both legitimacy and feasibility of the hybrid system, the National Security Establishment has been compelled to return to the drawing board and review its National Security Policy.

Perforce, a new National Security Policy has to be fashioned to withstand the loss of American aid and goodwill; to restore representative and credible legitimacy to the political system; and to step back from perennial conflict with India over Kashmir. The trillion dollar question is how. Only a massive transfer of wealth from the super-rich rentier classes to the poor, and a return to a representative civilian system of governance, will stem the rising economic and political discontent and religious militancy that threatens to overwhelm the state; only a prolonged period of peace with India and a profound retreat from militarism will yield the required space in which to accomplish this task. But any overnight attempt to stand the old National Security Policy on its head may unleash a formidable backlash from vested stakeholders among the institutions, groups and classes that have benefited from it for seven decades.

That is why the new National Security Policy is top secret, and jargon and generalities have been profusely sprinkled on its public version to obscure its true content and challenge.

The Indian Pharmaceutical Sector

 

By Jill E. Sackman, PhD,Michael Kuchenreuther

Biopharma companies should not overlook India's growing market.

ABHIJITMORE/ROOM/GETTY IMAGES

Recognizing that emerging markets continue to play a significant role in terms of future growth, most major pharmaceutical companies have accelerated efforts to strengthen their presence within these markets through R&D investment, licensing deals, acquisitions, or other partnerships. However, with global markets facing dynamic demographic and disease trends, changing market demands, and evolving regulatory requirements, it has been hard for manufacturers to devise the strategies needed for success in each of these areas.


India, a member of the BRIC nations (Brazil, Russia, India, and China), is much more comparable to the United States in terms of market size and must be included in this list of promising potential markets for global pharmaceutical manufacturers. Recent changes in India’s population and economy have contributed to a shift in the country’s epidemiological profile towards ‘lifestyle’ diseases that are more prevalent in Western markets. Such changes have increased the demand for better healthcare and for medications that address chronic diseases. Furthermore, India’s own pharmaceutical industry, a recognized world leader in the production of generic drugs, offers manufacturing expertise to organizations looking to outsource or create networks of collaboration and discovery. However, a more granular assessment of India’s pharmaceutical market reveals growing concerns over patent protection, price capping, quality, and safety. Understanding this country’s complex market dynamics will be crucial for manufacturers exploring new opportunities for growth in India.

India health and pharmaceutical market overview

India is the second most populous country in the world with about 1.27 billion people, and is projected to surpass China by 2028 (1). As the Indian population has continued to grow in recent years, so too has the country’s economy. Over the past decade, India’s economy grew above the Organization for Economic Co-operation and Development (OECD) average, which can be attributed to rising average income levels, an expanding middle class, and a drive toward urbanization (2). These socio-economic changes are contributing to a significant shift in India’s epidemiological profile. With working-age adults accounting for the majority of the overall population and more people becoming affluent and living longer, Indian health service users are facing increasing challenges associated with the prevention and treatment of chronic diseases such as obesity, heart disease, stroke, cancer, and diabetes (3).

At the same time, India continues to be challenged by a range of infectious disorders. Despite economic advancements, significant income inequality still exists throughout the country. In fact, per capita gross national income in India was only $3,391 in 2012 when adjusted by purchasing power parity (compared to $50,000 in US) (4).  In rural areas, where two-thirds of the nation’s citizens are located, hundreds of millions of people are still living in severe poverty, and vaccination coverage for children remains poor.

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Taken together, this high incidence of infectious and chronic disease and the large number of disadvantaged communities have created an even greater need for patient access to quality healthcare delivery as well as new and innovative therapeutic products. Historically, India has had one of the world’s lowest levels of health spending as a proportion of gross domestic product (GDP). In 2011, India’s total health expenditure was 3.9% of GDP (public expenditure was only 1.2% of GDP) compared to 10.1% of GDP, an average across all G-5 countries (4). The lack of government funding in healthcare has led to significant gaps in the quality and availability of public facilities and has pushed an increasing proportion of Indian patients to use private healthcare facilities that are associated with high costs. Where other countries have a well-established insurance sector that seeks to reduce this economic burden, health insurance in India is still in its infancy.

Approximately 243 million people are covered by different forms of government-sponsored insurance schemes while approximately 55 million rely on commercial insurers (5). With the vast majority of people in India uninsured, out-of-pocket payments are among the highest in the world. According to the World Health Organization (WHO), 70% of Indians are spending their entire out-of-pocket income on medicines and healthcare services (6). On top of this, most insurance plans only provide coverage for inpatient healthcare services and do not include coverage for outpatient treatments, including prescription medicines. Thus, it is no surprise that approximately 90% of India’s pharmaceutical market is currently made up of branded generic drugs (7).

Against this backdrop, India’s Ministry of Health has been focused on improving access to healthcare facilities, increasing population coverage by way of healthcare insurance, and creating initiatives for the prevention and early stage management of chronic diseases. In 2012, as part of the country’s 12th Five-Year Plan, the government proposed to double its public expenditure on healthcare to 2-3% of GDP in an effort to boost local access and affordability to quality healthcare. In light of these efforts, the Indian healthcare industry as a whole is expected to reach $158 billion by 2017 (8).
India’s pharmaceutical market accounts for about 10% of the global pharmaceutical industry in terms of volume and represents a major component of growth for the country’s healthcare industry (9). The Indian pharmaceutical market was estimated at $18.4 billion in 2012 and is expected to almost double by 2016. Although India’s market is currently dominated by generic drugs, rising incomes, enhanced medical infrastructure, and insurance coverage could provide a valuable opportunity for manufacturers’ higher-priced branded healthcare products moving forward.  

Key market challenges and considerations

Regulatory. Similar to many other countries, India’s medical regulatory structure is divided between national and state authorities. The Drug Controller General of India (DCGI) is the national authority responsible for the regulation of pharmaceuticals. The DCGI registers all imported drugs, new drugs, and biologicals in selected categories and has responsibility for approving clinical trials and quality standards in the country. Recently, these standards have come under question by FDA, citing quality-control problems ranging from data manipulation to sanitation. While FDA and regulatory bodies in other countries step up inspections of Indian plants in response to these developments, global manufacturers have had to reassess their contracted relations with these plants and give careful consideration to developing new strategic partnerships in this country moving forward (10).  

Concerns over quality and data integrity have also impacted manufacturers’ perception of India’s clinical trials system. India’s large and diverse patient pool and low drug trial costs have made the country an attractive destination for multinational pharmaceutical clinical trials. However, India has recently seen the number of clinical trials fall dramatically among allegations that protocols were not being conducted properly and that companies were taking advantage of disadvantaged patients (11). In response to these developments, manufacturers have been forced to either shift their trials to another country or encounter significant delays in clinical trial approval--both of which are holding their organizations back.

Market access and pricing. The high prevalence of self-pay generic drugs throughout the country has created little incentive for the development of certain market access disciplines such as health economics and outcome research (HEOR) and reimbursement. Government affairs and pricing functions, on the other hand, play an important role and have been broadly cited as the most crucial challenges global manufacturers face in the Indian marketplace.

India’s National Pharmaceutical Pricing Authority (NPPA) controls product pricing throughout the country. In 2013, the NPPA expanded the National List of Essential Medicines (NLEM) to include 652 drugs, a substantial increase over the 74 drugs previously listed. These products will now be subject to price controls that are projected to reduce prices by more than 20% for half the drugs (12). As if this did not challenge manufacturers enough, the Indian government recently decided to revise the NLEM later this year in response to complaints that the list should include all dosages, strengths, delivery mechanisms, and combinations of these previously identified drugs (13). The NPPA is also allowed to control prices of patented drugs that lie outside this list, and last month the government began exploring the possibility of using a reference pricing system for these products (14).  With intense generic competition already driving down drug prices in India, these additional controls pose a significant threat to international manufacturers’ ability to generate revenue.

Intellectual property. Aside from pricing, patent protection has also come under the microscope as of late. In an effort to ensure greater accessibility to higher-cost, branded drugs, India, as well as other BRIC countries, has begun to allow generic-drug manufacturers to market these drugs at dramatically reduced costs without consequence through compulsory licenses.  While only one compulsory license has been approved by India’s government to date (Bayer’s Nexavar), other manufacturers have recently had their patents weakened, revoked, or rejected. While appeals to some of these rulings are still in process, precedents have been set, leading manufacturers to question their future investment in India.

Implications for successful market entry 

Despite the aforementioned challenges, major pharmaceutical companies recognize the long-term prospects of this market and continue launching new patented drugs and pursuing unique business opportunities in India. To encourage future investment, the government has made tax breaks available to the pharmaceutical sector, including a weighted tax deduction of 150% for any R&D expenditure incurred. In addition, the government recently declared that all drugs that offer some form of innovation would be exempt from price regulation for the first five years following approval. Here, innovation refers to drugs or drug delivery systems that arise from native R&D efforts or existing drugs that are improved upon by an Indian company. This measure is aimed to spur growth in the domestic pharmaceutical market and to ensure that pricing regulations do not turn global manufacturers away from India. Thus, companies that develop strategic partnerships with local businesses and outsource some of their R&D and manufacturing activities will be well-positioned to maximize revenue by avoiding steep price cuts. This opportunity for manufacturers will only apply, however, for those products that offer true innovation by providing economic and/or clinical value.

Uncertainty over patent security and obstacles to clinical trials are discouraging Western companies from conducting drug research in India. With that said, the government has already initiated clinical research reform efforts through new amendments and regulations that could quickly restore the growth of clinical trials throughout the country.  At the same time, there is speculation that a transfer of power in India’s upcoming election could dampen fears of additional compulsory licenses (15). Manufacturers should closely monitor these internal developments and react accordingly.

Moving forward

A growing middle class that is projected to see a significant rise in noncommunicable diseases provides an excellent opportunity for global companies to launch their premium products and expand their market share. India’s underdeveloped insurance industry and high poverty rates, however, require that manufacturers first develop a careful pricing strategy. Pricing products appropriately can go a long way towards ensuring future growth as well as avoiding disputes over patent protection and licensing agreements.  In a country that holds about one-fifth of the world’s population, India’s market is too big for pharmaceutical companies to shy away from, despite all of the hurdles placed in front of them.