Economic Agents and Circular Flow of Income
Economic Agents and the Circular Flow of Income
The operation of any economic activity involves the presence of two basic economic agents: producers of goods and services, and consumers. Individuals successively fulfill both roles, and households are also the owners of the factors of production. In a very simple economy, transactions occur between households; however, as economic activity and specialization become more complex, the division of labor extends beyond national borders. Complex production and the organization of factors require a stable entity: the company. Households maintain their role as consumers and retain ownership of the productive factors. These are called productive factors or inputs: the elements that companies need to use (labor, land, machinery…) to produce goods and services. Traditionally, three main productive factors are considered:
The land, which encompasses all natural resources (e.g., land, solar energy) and is associated with the original retribution called rent.
The labor, which refers to the use of human effort applied to productive processes. The price of labor is called salary or wage.
The capital, which includes all goods produced to be used as instruments to produce other goods and services (machinery, infrastructure, money…). The generic denomination of the retribution of capital is profit or interest.
With technological development, capital has gained importance, and land ownership has lost it. Therefore, there is a tendency to include land in the generic concept of capital, simplifying the analysis to only two factors: labor and capital.
In basic economic activity, we have two agents, households and companies, and two factors of production, labor and capital. A third agent gaining importance in modern economies is the State, which economists consider to be the set of agents responsible for the administration of collective interests through three basic functions:
- Establishing the regulatory framework for the functioning of basic economic activity.
- Withdrawing resources from the production and consumption processes of households and companies through taxes.
- Injecting resources (mainly those withdrawn previously) without the need for direct compensation through goods and services (education, health…) or monetary transfers to companies and households.
The State’s role varies over time and from one country to another, influencing its structure. It is important to know if the State or authority presents a criterion for making relevant economic decisions. The market system is when exchanges between households and companies are made freely, and producers and consumers agree on prices and quantities. This system is considered to provide answers to basic economic questions (what, for whom, and how to produce). However, the market may produce socially undesirable results or long delays. Therefore, the possibility arises for the authority to make decisions to ensure that the results match collective interests. A centrally planned system replaces the decisions of individual agents with criteria that may interfere with their decisions. The basic distinction between economic systems has been based on the ownership of the means of production. A capitalist system recognizes private property of land and capital, while a socialist system advocates collective ownership. However, experiences have shown that collective property can take many forms, such as cooperatives.
Currently, this confrontation between models has lost relevance because the State intervenes in all market economies. Although private property and the market are recognized as basic economic mechanisms, we do not have a clear model as described. Centrally planned economies have shown difficulty in responding with agility to contemporary economic issues. The fall of communist regimes in Europe has placed the market as the most recognized system.
Beyond the market economy versus centrally planned economy, other dialectics exist: East/West, North/South, developed/underdeveloped. The concept of the Third World emerged from the differences in living standards between developed and underdeveloped countries. The circular flow of income is fundamental to understanding the functioning of the economy.
The circular flow of income: households and companies interact:
- In the market for goods, where there is a dual circulation: real and monetary.
- In the market for factors, where there is also a dual circulation: real and monetary.
When we measure the values of the different magnitudes, we have flows (value added, income, expenses, product) that are fundamental in different aspects of the same phenomenon.
The basic economic operation, based on production and consumption, is carried out by basic agents: households and companies. The State is now outside this simplified model of the circular flow of income. The economy is monetary, and exchanges of goods and factors are made through monetary compensation. Households are the owners of the factors of production, and companies produce goods from these factors. In this economy, the following relationships occur:
In the market for productive factors (e.g., labor):
- Companies go to the market for productive factors to hire what they need to produce goods, paying the owners of these factors with money.
- Households also go to the market for factors to sell or rent their productive factors and obtain money to buy goods to meet their economic needs.
In this market, there is an exchange of land, labor, and capital for money. The retributions obtained are the income of households. The incorporation of productive factors and services in the production of goods implies that the value of the final product is greater than the sum of the costs of the factors.
Market for goods and services:
- Companies offer their production for sale (in exchange for money).
- Households go to the market to buy goods to satisfy their economic needs, paying companies with the money obtained from the market for productive factors.
This payment allows companies to obtain income to purchase the necessary productive factors to produce goods.
Two circular flows occur, in opposite directions, between the two economic agents: one of money, forming income in its dual dimension of obtaining and spending, and the other of productive factors in the form of goods: value added and production. There are partial markets whose interrelation is very strong, so it is not an exaggeration to speak of a single global market. If there were no further complications, the circular flow of income would imply that everything that enters different subjects is immediately reverted in the flow. Value added, product, and income are identical magnitudes that would only differ in the moment they are recorded. However, other economic agents are incorporated, such as the external sector, the State, savings, and investment, making the functioning of the economy much more complex.