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I'm really confused about the concept of the circular flow of income. Specifically, I'm confused about the following situation:

Imagine a simple economy where households don't save their income, so they spend it entirely on goods/services.

Now imagine there is only one firm in the economy producing a single good, say chocolates. Let's assume the firm has $5000 in total at first (obtained from all households, none of whom have any income at the moment).

Let's say the firm buys raw materials from households and pays households their wages, and let's assume altogether it costs the firm all \$5000. And now the firm decides to sell all chocolates produced at a price such that in total, the prices add up to \$6000, so that the firm earns \$1000 in profit.

But here I find a problem: no one can buy all \$6000 worth of chocolates because only \$5000 is in the economy at the moment. So firms can only sell a total of \$5000 worth of chocolates and thus never earn any profit.

Where did I go wrong? Did I go wrong? I'm assuming I did because to me the result I got is nonsensical.

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The firm broke the circular flow of income in your example; profits went into a black hole.

Imagine that the firm instead distributes all profits to the owner, who spends all proceeds.

The firm gets \$6000 in revenue, pays \$5000 in wages, and pays \$1000 in dividends. The wages and dividends are enough to provide the revenue.

I am ignoring the issue of the initial money holdings. There is a number of ways these transactions can be supported: credit, or the \$1000 dividend was paid out revenue as it came in.

In order to respect the initial money holdings, and have sales of \$5000, what happens is that the firm has excess inventory (with a sales value of \$1000). That is, the workers could not afford to buy all of the output. The firm would be profitable, but with zero cash flow. Since the cash used to pay the workers returned to the firm, it would be able to then pay a dividend out of profits. That dividend could then be used by the owner to buy the remaining inventory.

It is not obvious how the firm can forecast its profits exactly in this fashion, but that would be covered up in an economic model by solving for all flows simultaneously. If all cash flows are settled simultaneously, we actually cannot see how the money flows work; we only see the net movement.

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  • $\begingroup$ Thanks for your answer! I was a little confused when you said "the firm gets £6000 in revenue". Would the firm be able to get £6000 in the first place? I thought that only £5000 was floating around in the economy. $\endgroup$ – Joel Khoo Feb 12 '18 at 13:27
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    $\begingroup$ Credit? It could have paid the dividend out of the revenues as it came in? If you want to simulate all the cash flows in an economy, you would need an agent-based model. Examples like this are unrealistic in the first place, as you would need more information about the timing of flows. $\endgroup$ – Brian Romanchuk Feb 12 '18 at 13:39
  • $\begingroup$ I'm not sure I understand. Wouldn't the firm only be getting £5000 in total? $\endgroup$ – Joel Khoo Feb 12 '18 at 22:15
  • $\begingroup$ @JoelKhoo they'd be getting £6 and then paying £5 to workers and £1 as dividends and then getting another £6 and then paying £5 to workers and £1 as dividends and then ... $\endgroup$ – user253751 Mar 15 '18 at 6:16
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In your example there would be no growth, because you are playing a zero sum game, which is a flawed assumption. You assume that households are purely composed of paid employees, which happen to hold a sterile amount of raw materials. In reality, the raw materials (milk, sugar, cocoa) keep growing from nature with time passing by, which is the first source of growth.

Countries are rarely isolated from the markets (examples today are North Korea and a few other countries). By participating in the international trade, nations (as a whole) get a chance to grow faster. Using your example, some countries would produce the raw materials and export them, while others transform it in chocolate, and export it back. Reading Ricardian trade theory on international comparative advantage is a good start, if you want to learn more.

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After making your "circular flow" a closed cycle, as @Brian_Romanchuk has done, you arrive to the so-called "monetary profits paradox". e.g. Bruun (2009) The paradox occurs when, taken into account all circular flows, we think on rising the level of production/income/expense, and then we find that existing amount of money is not enough. An immediate answer could appeal to a change in circulation speed of money, but this just obscures the question, doesn't answer it.

The true answer is also pointed to by @Brian_Romanchuk in a comment: credit. But it has to be previously recognized the role of credit in creating purchase power instead of rigid (false) schemes of banks as mere channels for mobilize existing money.

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