The circular flow of income is the total amount of money households and firms spend. The amount of money spent by households in the purchase of goods and services acts as income to the firms who produce and sell such goods and services.
The Circular Flow Between Households and Firms
If we bear in mind that the households own the factors of production, we are then talking about seller’s side of the input market and the buyer’s side of the output from firms. This is because the firms buy the factor inputs from the households, who, in turn buy the outputs of the firms. The firms are sellers of outputs and buyers of inputs, while the households are the sellers of inputs and buyers of outputs. The money paid by firms to the households serves as income earned. When this income is spent on the purchase of the firms’ outputs, it becomes the income earned by them. The firms in turn use the income to pay the households for their inputs and so the circle continues with money flowing from the firms to the households, and from the households back to the firms. The flow moves in two directions i.e. the money flow and the real flow. The money flow is the flow of the actual monetary value of all the factors of production purchased by the firms. It is the actual cost paid by the households for the purchase of goods and services from the firms. The real flow from the households to the firms is the labour, capital, land and entrepreneur used as inputs. The real flow from the firms to the households is the actual finished goods and services produced by them and bought by the households. The circular flow of income, real and monetary, is illustrated in the below figure. This cycle goes round and round, hence it is called the circular flow of income.
Income flows from the firms to the households and from the households back to the firm and so forth. The flow assumes that every earned money is spent. Nothing is saved as savings will be considered as a leakage or withdrawal from the economy, and no additional income is injected into the economy.
Determinants of a Household Income
The income of an individual is determined by the following factors:
(i) The Skill:
The higher the skill acquired by the individual, the higher his income and vice versa.
(ii) Family Status:
The status of one’s family automatically influences one’s financial standing. If one’s family standing is very high, then one’s income will be very high, and vice versa.
(iii) Dedication to Work: An individual’s financial standing can be greatly improved through hard work and dedication to duty. A man from a poor family background, with sound education and hard work, can become a rich individual with a very high income as his salary.
(iv) The Influence of Trade Union: The stronger the negotiating power of the union to which an individual belongs, the higher his income.
(v) The Demand and Supply: The higher the demand for labour relative to its supply, the higher the income of households, and vice versa.
(vi) Easy Access to Factors of Production: Many people with easy access to some factors of production especially land, houses, capital, entrepreneurial talent and access to cheap labour, have effectively used these natural resources to improve and increase their income earning ability.