Circular flow of income
In market economies, firms and households
are the two main economic actors. They purchase, sell, save, consume, invest
and produce in a continuous interactive process known as the circular flow of income. Firms produce
goods and services which are delivered to households and/or to other firms through
exchange in product markets. This is the role of firms as producers and
sellers. But in order to be able to produce those goods and services they need
to employ a number of different resources, provided by households (labor, land,
funds). Therefore the role of firms in the economy is twofold. On the one hand,
firms are production units that satisfy the consumption needs of households. On
the other hand, firms are the instrument through which households can channel
the productive resources they own. Firms make a profitable use of those
resources granting rents to households, which are, in turn, employed in buying
the products manufactured by firms.
Firms produce the goods and services that consumers need making a productive use of resources and providing rents to households. If markets work well, the circular flow of income becomes a virtuous circle. The most productive firms would attract productive resources more easily, since they will be able to pay higher rents, dividends, and wages. Households would have more money available for purchasing, which in turn would generate more revenue to firms. And this increased revenue will return to households as rents, dividends, and wages. Firm competition for resources assures an efficient use of them and is on the basis of economic growth and the standards of living.
In contrast, if some markets do not work properly, then the picture may easily turn into a vicious circle. For instance, if financial markets don’t work well, firms with potentially profitable business ideas will not get access to the funds they need to put them into practice. If this happens, some firms will not even be created, and many others will not grow and prosper to their potential. Some will even go bankrupt and disappear just because of the problems in obtaining financial resources on time. This, in turn, will translate into fewer jobs available and, in general, less competition for household resources. Some households would experience difficulties to find jobs and if they do, wages and working conditions would progressively deteriorate. If this happens, people would have less money available for making purchases and firms would make less revenue in product markets. Production plans would shrink and layoffs would continue the vicious circle.
Firms produce the goods and services that consumers need making a productive use of resources and providing rents to households. If markets work well, the circular flow of income becomes a virtuous circle. The most productive firms would attract productive resources more easily, since they will be able to pay higher rents, dividends, and wages. Households would have more money available for purchasing, which in turn would generate more revenue to firms. And this increased revenue will return to households as rents, dividends, and wages. Firm competition for resources assures an efficient use of them and is on the basis of economic growth and the standards of living.
In contrast, if some markets do not work properly, then the picture may easily turn into a vicious circle. For instance, if financial markets don’t work well, firms with potentially profitable business ideas will not get access to the funds they need to put them into practice. If this happens, some firms will not even be created, and many others will not grow and prosper to their potential. Some will even go bankrupt and disappear just because of the problems in obtaining financial resources on time. This, in turn, will translate into fewer jobs available and, in general, less competition for household resources. Some households would experience difficulties to find jobs and if they do, wages and working conditions would progressively deteriorate. If this happens, people would have less money available for making purchases and firms would make less revenue in product markets. Production plans would shrink and layoffs would continue the vicious circle.