Principles of Macroeconomics / Unit 1 MAC 0013 worked example, 60 to 90 seconds
Tracing a Payment Around the Circular Flow
The idea
To trace a payment, ask two questions: who is paying whom, and what is moving the other way. Households own the factors of production and sell them to firms in the factor market, receiving wages, rent, interest and profit. Firms use those factors to produce goods and services and sell them to households in the goods market, receiving payment. So money flows from firms to households as factor income, and back from households to firms as spending. Goods and factor services flow in the opposite direction from the money that pays for them.
In practice
Worked example: a worker earns two thousand dollars a month at a bakery and spends four hundred of it on bread. The two thousand is a factor payment: it leaves the firm and enters the household through the factor market, and labor travels the other way. The four hundred is consumption spending: it leaves the household and enters the firm through the goods market, and bread travels the other way. The same dollar can make the trip more than once.
Where people slip
The usual slip is to put a payment in the wrong market. Ask what is being bought. If a factor of production is being bought, labor, land or capital, the payment runs through the factor market. If a finished good or service is being bought, it runs through the goods market.
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