Circular Flows of Income ________________________________________________________________________________________________________________________________________________ It might seem easy to identify the firms that make up an industry, but consider motor vehicles. Are limousines and golf carts reasonable substitutes? Should trucks and vans be included? Motorcycles? Is lumping all these goods in a single industry appropriate? Another problem in identifying an industry is that conglomerates are often major players in several industries and nonconglomerates may be vertically integrated. Individuals, who often act collectively through organizations, ultimately make all decisions. Only people—not organizations—can make decisions. Thus, although which individuals' choices count most depends on organizational structures, all organizations exist primarily to channel interactions among people in households. The private sector encompasses households and businesses, with most decisions flowing through markets—private buying and selling. Government makes up the public sector, and is second only to the marketplace as a dominant allocative mechanism. The simple circular flow in the figure below models how private households and firms interact Households More than 315 million Americans inhabit over 105 million households, a broad concept that covers groups ranging from individuals who live alone to extended families in which several adults and a flock of children share a home. The economic roles households play are evolving, but some characteristics are constant. Households are centers for consumption and ultimately own all wealth, including resources that they make available to businesses or government in exchange for income. Labor (both mental and physical) is the principal asset of most households, as indicated by the functional distribution of income in Table 1, which also broadly breaks down the uses of household income. Wages (including all salaries and such fringe benefits as health insurance) account for roughly three-fourths of income, with the rest being derived from rent, interest, and profit. Part of household income flows to government as taxes, with the rest being either spent on consumer goods or saved. Household saving is the primary source of investment funds for business firms Firms The bulk of the U.S. national output is produced within privately owned firms, although households, nonprofit organizations, and government-controlled industries also contribute. As the figure indicates, firms use their sales revenues to pay for the resources households provide. A business firm is a privately owned and operated, for-profit center for production. Entrepreneurs and managers of firms interpret prices and profits as signals about individual wants or collective wants (expressed through government). Firms prompt households to provide specific resources with incentives in the forms of wage rates paid for specific labor skills, rental rates for land, or rates of return on capital. Government Government at the federal, state, and local levels directly provides some goods and services (e.g., public schools), and less directly influences the production and consumption of other goods via taxes and regulations (e.g., tobacco). Taxes are the primary sources of government revenue. Political processes transform this command over resources into governmental provision for collective wants (e.g., police protection and national defense), and into income redistributions that politicians view as reflecting voters' desires for equity.[1] A critical point in a circular flow model is that firms are not the final owners of resources or products. People own all firms, and people live in households. Nor does government ultimately own anything in a democratic society in which, ideally, it is responsive to the people—who bear the consequences of policies formulated within firms or government. Firms, for example, cannot bear tax burdens; only their resource suppliers, owners, or customers truly pay taxes. It is common to speak of government changing its policies, or of firms profiting, changing prices, or introducing new products, but such institutions only shape the flow of individual decisions. Activities that matter affect people, not organizations per se. More detailed circular flow models show how goods, resources, and incomes move among households through firms and government, and across international borders. But will resources be used in allocatively and productively efficient ways? And will goods and resources flow in distributively efficient ways to those who desire them relatively most?
	________________________________________________________________________________________________________________________________________________ Author: Ralph Byrns
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[1] Possible economic roles for government in a market economy are surveyed in Chapter 4, and are considered in more detail throughout this book.