Households, firms and the two-way flow

Overview

Circular flow diagram show two loops running in opposite directions, why national output and stock and a flow.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   In the circular flow of income, what do households supply to firms, and what do they receive in return?

   Model answer

   Households own the factors of production, so they supply land, labour, capital and enterprise to firms through the factor market. In return firms pay them factor incomes: rent for land, wages and salaries for labour, interest for capital and profit for enterprise. The sum of those payments over a year is national income.

2. 2

   What passes from firms to households in the product market, and what passes back the other way?

   Model answer

   Firms supply finished goods and services to households through the product market, and households pay for them with consumption expenditure. Real output therefore flows towards households while money flows back towards firms.

3. 3

   Why does the circular flow diagram show two loops running in opposite directions?

   Model answer

   The inner loop is real: factor services move from households to firms, and goods and services move from firms to households. The outer loop is monetary: factor incomes move from firms to households, and consumption spending moves from households to firms. Every real transaction has a matching money payment travelling the opposite way, which is why the two loops mirror each other.

4. 4

   Explain why national output, national income and national expenditure are three measurements of the same thing in the simplest circular flow.

   Model answer

   The value of everything firms produce is paid out to the owners of the factors that produced it, so output equals income. Households then spend that income on the output firms have made, so income equals expenditure. Because the money simply travels round the loop and is counted at a different point each time, all three totals must come to the same figure.

5. 5

   Which two markets appear in the simple circular flow, and who is the buyer in each?

   Model answer

   The factor market, in which firms are the buyers and households the sellers of factor services, and the product market, in which households are the buyers and firms the sellers of goods and services. The roles of buyer and seller are reversed between the two markets, which is what makes the flow circular.

6. 6

   A student claims that firms' costs of production and households' incomes are simply two names for the same money. Is that a fair description of the simple circular flow?

   Model answer

   In the simple two-sector model it is fair. What a firm pays out as wages, rent, interest and profit is exactly what households receive as income, so the same sum appears as a cost on one side of the flow and as an income on the other. It stops being exactly true once taxation, saving and trade are added, because money then leaves and enters the flow at other points.

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