Using the circular flow model explain why the value of business output of goods and services equals the income of households?

Answer 1

Answer:

The circular flow model is a diagram representing the flow of products and resources between businesses and households in exchange for money payments. Flow must distinguished from stocks. Flows are measured in units per time period - for example, dollars per year. Stock is a quantity measured at one point in time. For example, an inventory of goods or the amount of money in a checking account.

Initially, we assume that the economy is composed of only two sector, business and household. In this hypothetical economy the business sector is the sole producer of goods and services and production occurs by hiring the factor of production. The household owns all the factors of production (land, labour, capital and entrepreneur). The flow of factor of production is shown by the flow from the household to the firm. We further assume that household are the sole buyers of goods and services and that they spend their entire income. The upper half of the diagram in Figure 1 represents product markets, in which households exchange money for goods and services produced by firms. The supply arrow in the top loop represents all finished products and the value of services produced, sold, and delivered to consumers. The demand arrow in the top loop shows why the businesses make this effort to satisfy the consuming households. When consumers decide to buy products, they are actually voting with their dollars. This flow of consumption expenditures from households is sales revenues to businesses and expenses from the viewpoint of households. Notice that the box labeled product markets contains a supply and demand graph. Price and quantities in individual markets are determined by the market supply and demand model without government interference. The forces of supply and demand determine the returns to the factors, for example, wages and the quantity of labour supplied. The bottom half of the circular flow diagram consists of the factor markets, in which firms demand the Natural Resources, labour, capital, and entrepreneurship needed to produce the goods and services sold in the product markets. The supply arrow in the bottom loop represents this flow of resources from households to firms, and the demand arrow is the flow of money payments for these resources. These payments also income earned by households in the form of wages, rents, interest, and profits. In the factor market, resources (land, labour and capital) are owned by households and supplied to businesses that demand these factors in return for money payments. Businesses seek profits by supplying goods and services to households through the product markets. Businesses therefore must purchase all resources from the households.