CFoIbasics.html

THE CIRCULAR FLOW OF INCOME: THE BASICS

The general picture of interacting markets - the circular flow of income:

Households own the factors of production (land - including raw materials, labour, management and physical capital).
Note - capital here means physical capital - plant, equipment, buildings and machinery etc. (c.f. financial and money markets below)
Households rent these factors to firms, in return for income: land rents; capital interest and dividend payments, and equity appreciation (capital gains); wages and salaries.
Factor ownership provides income which fuels consumption and demand in the goods and services markets
Firms rent the factors of production from households according to their demands for these factors, which is derived from the demands for the final goods and services
Factor markets operate so as to encourage the owners of land, labour, manaement and capital to rent out the services of the factors to the highest bidder
Firms add value to their own purchases of inputs and raw materials. They earn gross margins (total revenues minus cash input costs [fuel, power, packaging etc.] which is the value added to these inputs. The Gross margin, or added value, or gross product (each term means essentially the same thing for our purposes) is the income available to the fixed factors - land, labour, management and capital.
In equilibrium, these returns will be normal profits - each firm earning sufficient to cover the opportunity costs of the factors of production which they employ (where opportunity costs measure the value of the opportunities foregone by chosing one action over and above another.)

what

how much

how

for whom

NOTE: In the markets for goods and services, Supply curves (S) show the willingness of firms to provide a quantity Q of goods and services in return for sales value per unit (Price P); Demand curves (D) show the willingness of households (consumers) to pay price P for a given quantity of goods or services (Q).

In the Factor markets, the meanings of the supply and demand curves are similar - the willingness of firms to purchase or rent factors from the households, and the willingness of households to lease out or sell these factors to the firms.

[Note: profits in the everyday sense are, typically, just the returns to capital - the earnings of the firms which are left after all other legitimate costs (including labour and management costs) have been deducted. For self-employed family businesses, taxable profits will include the returns to the owners own labour and management, as well as returns to the owners land and capital, less allowable expenses in servicing mortgages, loans and debts.]

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