What Is Leakage?

Leakage refers to capital or income that exits an economy or system rather than remaining within it. In economics, the term refers to the outflow from a circular flow of income model. In a two-sector model exhibiting a circular flow, all individual income is sent back to employers when goods and services are purchased, and back to employees through wages and dividends. This cycle creates a system without leakage.

How Does Leakage Work?

Leakage causes the exiting of money from an economy and results in a gap in the supply and demand chain. Leakage occurs when taxes, savings, and imports remove income from the system. In the retail sector, leakage refers to consumers who spend money outside the local market. Businesses within such an economy must find other ways to drum up revenue.

Closed-circle income streams allow money to flow from businesses to households in a continuous fashion. Businesses spend money in support of labor needs and business expansion as households purchase goods within the system. Leakage happens when consumers choose to take money outside the closed circle.

Key Takeaways

  • Capital that exits an economy or system rather than remaining within the system is leakage. 
  • Funds spent on taxes, deposited into savings, or used to buy imported goods will create leakage.
  • Export funds can result in leakage when those funds are invested in areas other than where the exports are produced.

Sources of Leakage

Income can leak out of closed systems through a variety of events and mechanisms. Tourism can cause leakage through funds transitioning between those who live in a particular area and chosen tourist destinations. Additionally, tourism-based businesses that have facilities in one area but hold headquarters in another can create leakage as funds are shifted to the headquarters location.

Importing goods can also result in leakage when the goods are considered necessary to support local businesses or interests. The funds used to purchase the imports leave the immediate area, resulting in an outflow from the home area.

Export funds can result in leakage when those funds are invested in areas other than where the exports are produced. This most commonly occurs in multinational business operations.

Information or data leakage occurs when internal information that should be held private or confidential is released to the public. This release of information can include the accidental or intentional disclosure of information, or a failure to secure the information, which leads to exposure.

Compensation for Leakage

The theory of Keynesian economics, developed by John Maynard Keynes, states that recessions hinge upon the total demand within an economy for final goods and services. Governments might, therefore, have to take steps to stimulate their economies by injecting cash into their systems when leakage causes a shortage of capital. This injection of funds can be achieved by increasing the level of exports to foreign nations, or by borrowing funds from investors or foreign governments.

A Real-World Example of Leakage

Goods are produced at the Nike, Inc. (NKE) factory operating as Hunchun Hongfeng Factory Co. Ltd. in Hun Chun City, China. When they're exported to other countries for sale, a portion of the exporting profits are directed to the headquarters located in the United States.

Ultimately, the United States headquarters profits based on the production of the Chinese facility, and this creates leakage in the Hun Chun City community.