What is the role of firms in the circular flow of income

Macroeconomics tries to study the central questions of economies. Amongst these questions, the main question is how economies create wealth. In an economy, all factors of production (FoP) undergo a production flow/cycle; in the process of which it generates wealth in the form of making payments to the factor of production, known as factor payments. Thus, the economic wealth of nations is created by generating this flow and producing commodities (goods and services), which are then consumed by consumers who spend their income on these goods and services.  

Circular Flow of Income

The circular flow of income is an economic model that reflects how money or income flows through the different sectors of the economy. A simple economy assumes that there exist only two sectors, i.e., Households and Firms. Households are consumers of goods and services and the owners of the factors of production (land labour, capital, and enterprise). However, the firm sector produces goods and services and sells them to households. 

In the circular flow of income (two-sector economy), there is an exchange of goods and services between the two players i.e., the firms and households, which leads to a certain flow of money in the economy. Households provide the firms with the factors of production, namely Land (Natural Resources), Labor, Capital, and Enterprise that generates goods and services, and consumers spend their income on the consumption of these goods and services. The firms then make factor payments to households in the form of rent, wages, interest, and profit. This flow of goods and services and factors payments between firms and households reflects the circular flow of money in an economy. 

Circular Flow in a Two-sector Economy (with Financial Market)

In the circular flow of an economy in a two-sector model without the financial market, it is assumed that no savings are made in the economy. It means that the households spend their entire income on the purchase of goods and services and every firm spends all the receipts from the sale of goods and services to make factor payments.

However, it does not happen in the actual world, i.e., households do not spend their entire income on the consumption of goods and services. Instead, they save a part of their income for the future. In the same way, the firms save some part of their receipts for the expansion of business or various other reasons. Besides, the firms also borrow money from outside to finance their expansion plans. All of these savings and borrowings happening in the economy are channelised through the financial market. Therefore, in a two-sector economy, the savings made by households accumulated in the financial market are used by the firms for investment purposes. 

Financial Market refers to those institutions like insurance companies, banks, etc., which transacts loanable funds in the economy. 

This concept can be better understood with the help of the following diagram:

Circular Flow in a Three-sector Economy

The government also plays a crucial role in the economic development of a country. Therefore, the circular flow of income in a three-sector economy includes households, firms, and the government sector. The government of a country acts as both a firm and a consumer. As a firm or producer, the government produces goods and services for the economy. However, as a consumer, it spends money on the consumption of goods and services produced by the firms. Besides the flows of circular income in the two-sector economy with a financial market, the additional flows due to the inclusion of the Government are:

1. Between Households and Government: The money from the government to households flows in an economy in two forms. First, in the form of transfer payments, such as old age pensions, scholarships, etc. Second, in the form of factor payments for hiring factor services of the households. This money flows back from households to the government in the form of direct taxes, such as interest tax, income tax, etc. 

2. Between Firms and Government: The money from firms to the government flows in an economy in the form of direct and indirect taxes. However, the money from the government to the firms flows into an economy in the form of subsidies. In this case, the government grants subsidies to the firms and makes payments to the firms for the purchase of goods and services produced by them. 

The financial market also plays an important role in a three-sector economy, as the government saves a part of their earned income and deposits the same in the financial market. Besides, the government also borrows money from the financial market so it can meet its expenditures. 

This concept can be better understood with the help of the following diagram:

The Government Sector of an economy performs the following activities:

1. It collects taxes from the households and firms.
2. It makes the payment for the purchase of goods and services from the firms.
3. It also makes transfer payments to the households and provides the firms with subsidies.
4. Lastly, Government saves and borrows money by taking help from the financial market. 

Circular Flow in a Four-sector Economy

Besides households, firms, and the government, the foreign sector also plays a crucial role in an economy. Therefore, the circular flow in a four-sector economy consists of households, firms, government, and the foreign sector. Money flows in each of these sectors are as follows:

1. Household Sector: The household sector of an economy provides factor services to the firms, government, and the foreign sector for which it received factor payments in return. Besides factor payments, the households also receive transfer payments like old age pensions, scholarships, etc., from the government and foreign sector. The household sector spends its earned income on Payments for goods and services purchased from firms, payments for imports, and tax payments to the government.

2. Firms: The firms receive revenue for the sale of goods and services from the government, households, and foreign sectors. They also receive subsidies from the government to produce goods and services. Besides, the firms make payments for taxes to the government, factor services to the households, and imports to the foreign sector. 

3. Government: The government receives revenue for the sale of goods and services, fees, taxes, etc., from the firms, households, and the foreign sector. It also makes factor payments to households and spends its revenue on transfer payments and subsidies. 

4. Foreign Sector: The foreign sector receives revenue for the export of goods and services from firms, households, and the government. It also makes payments to firms and the government for the import of goods and services, and households for the factor services. 

The financial market also plays an important role in a four-sector economy as the savings made by the households, firms, and the government gets accumulated here and this money is invested by the financial market in the form of loans to firms, households, and the government. The inflows of money in the financial market in a four-sector economy are equal to the outflows of money, which makes the circular flow of income continuous and complete. 

This concept can be better understood with the help of the following diagram:

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Circular Flow Model showing a Market for Resources between Businesses and Households

In this episode of the Economic Lowdown Video Series, economic education specialist Scott Wolla explains the circular flow model. Viewers will learn how households and businesses interact in the market for resources and in the market for goods and services, and see how money keeps the whole process moving.

Or, download the study guide and answer key (PDF).

More episodes featuring economic concepts:

• The Economic Lowdown Video Series
• The Economic Lowdown Podcast Series

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This video received the 2015 Curriculum Silver Award from the National Association of Economic Educators and was a 2014 Gold Winner of the AVA Digital Awards.
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Transcript:

Let’s face it, the economy is complex and can be difficult to understand.

Luckily, economists have developed models to help us learn and understand how the economy functions. One of the most useful is the circular flow model.

The circular flow model highlights the “flows” within the economy—the flow of economic resources, goods and services, and the flow of money.

To demonstrate the usefulness of the circular flow model, let’s follow a few dollars through a cycle.

Imagine you are a hungry consumer who hears the homemade fries at the diner down the street calling your name. You take your money to the diner for a tasty meal.

When you pay your check, you are buying goods and services. But the money doesn’t remain in the cash register for long.

Alice, the diner owner, uses the money to purchase resources. She buys homegrown potatoes from a farmer; pays the server, who took your order, his wages; and makes a payment on the loan she got to buy new equipment for the diner. All of these are costs of production.

After she has paid her costs of production, the remaining revenue is her profit—the income she earns as an entrepreneur owning and operating her diner.

Let’s say your money goes to the farmer, and that for him is income. That money won’t remain in his wallet forever, though. Before you know it he will spend it, and the cycle will begin again.

The circular flow model shows the interaction between two groups of economic decision-makers—households and businesses—and two types of economic markets—the market for resources and the market for goods and services. While the real economy is much more complex, the simple circular flow model is useful for understanding some key economic relationships.

Let’s start with the two groups of economic decision-makers.

On one side of the model are households. Households consist of one or more persons who live in the same housing unit, such as a family. Households own all the economic resources in the economy. The economic resources are land, labor, capital, and entrepreneurial ability.

Land resources are natural resources. For example, these could be actual land owned by a farmer or other natural resources such as oil, water, and trees.

Labor is just what it sounds like—work for which you are paid.

Capital resources are goods used to produce other goods and services. For example, think of a hammer used by a carpenter or a computer used at a business.

Finally, entrepreneurial ability is the human resource that combines the other resources to produce new goods and services and bring them to market. So, an entrepreneur might combine land, labor, and capital in new ways—taking risks along the way—to bring a good or service to market.

On the other side we have businesses. A business is a privately owned organization that produces goods and services and then sells them. Businesses can be large, such as an automobile manufacturer, or small, such as a diner. And, businesses may produce goods, such as computers and bicycles, and services, such as haircuts and car repairs.

But households and businesses are not isolated, they interact in markets.

At the top of the model we have the market for resources. The market for resources is where households sell and businesses buy economic resources—land, labor, capital, and entrepreneurial ability. Notice that it is households who own all the economic resources.

You might think of capital, say a delivery truck, as being owned by a business. But who owns the businesses? You guessed it—households. Whether a small diner owned by an individual, a partnership owned by several individuals, or a corporation owned by stockholders, all of these businesses are owned by people who are also members of a household.

Let’s look at some transactions in the market for resources by a business. A diner:it uses a mix of economic resources, such as land—potatoes for fries; labor—cooks and wait staff, and capital—kitchen equipment; and cash register resources to produce goods and services—in this case cheeseburgers, fries, and milkshakes. The business buys these economic resources from households.

For example, let’s say you work at the diner. You are selling and the diner is buying your labor resources. Those homemade fries come from potatoes—a natural resources—bought from a local farm, which is owned by a household. The new milkshake machine and french fry cutter—capital resources—were bought from a business three states over and the stockholders of that business are members of households. Finally, the diner itself is owned by Alice, who is a member of a household and an entrepreneur who has turned her skill of making the best homemade fries in town into a successful business.

In exchange for their resources, households earn income. Each resource has its own income category.

Households receive wages for their labor, rent for use of their land, interest for use of their capital, and profit for their entrepreneurial ability. For working at the diner, for example, your income would be wages paid in the form of a paycheck at the end of the month.

So, in the market for resources, households sell resources and businesses buy resources. The resources flow one way (counter-clockwise) and money flows the other (clockwise).

At this point in the cycle, households sell resources to businesses. So, households are holding income and businesses are holding resources. But, what do households do with the income? What do businesses do with the resources?

To answer these questions, let’s focus on the bottom of the model, the market for goods and services, where the goods and services produced by businesses are bought.

Let’s start with businesses. Businesses use the economic resources they buy in the market for resources to produce goods, such as computers and bicycles, and services, such as haircuts and car repairs.

Businesses sell these goods and services to households in the market for goods and services. For example, the diner produces cheeseburgers, fries, and milkshakes.

Households use part of their incomes to buy goods and services. The payment businesses receive is called revenue. For example, at the diner, revenue comes from customers paying for their food.

In short, the market for goods and services is simply where the goods and services produced by businesses are bought.

So, in the markets for goods and services, businesses sell goods and services and households buy goods and services. Products flow one way (counter-clockwise) and money flows the other (clockwise).

Let’s step back a bit and notice a few things about the circular flow model.

First, it shows how businesses and households interact in the two markets—the market for resources and the market for goods and services. Notice that households and businesses are both buyers and sellers.

Households are sellers in the market for resources. Households sell land, labor, capital, and entrepreneurial activity in exchange for money, which in this case is called income.

Households are buyers in the market for goods and services. Households exchange income for goods and services.

Businesses are sellers in the market for goods and services. Businesses sell goods and services in exchange for money, which in this case is called revenue.

Businesses are buyers in the markets for resources. Businesses exchange the revenue earned in the market for goods and services to buy land, labor and capital in the market for resources. In this case, the money spent is called the cost of production.

Second, the model shows the flow of money in exchange for goods and services and resources.

Money flows clockwise, while goods, services, and resources flow counter-clockwise.

The circular flow model is a simple tool for learning about the economy. It shows the relationship between households and businesses and how these different decision-makers in the economy fit together.

Plus, it shows how money keeps economic resources and goods and services moving around and around and around the economy. And that’s something Alice appreciates.

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