The individual in our economic system is in a unique position. Imagine him as standing between two different types of markets: a product market and a factor market. The product market covers all interactions between the demand for and the supply of goods and services. Consumers demand or desire breakfast cereals Kellogg, Post, and Quaker supply them, this means that in the product market consumers are on the demand side of the transaction, and business firms are on the supply side.
In the factor market, the positions are reversed. To produce goods and services, firms must use the factors of production. Therefore, business firms demand factor services. These services are supplied by the owners of the factors. The laborer or doctor or salesman provides labor services; the owners of land supply land, the owners of capital supply capital. Here, as in the product market, the interaction between the supply of factor services and the demand for them largely determines wage rate, rent, and interest (all different names for price) as well as quantity provided and used at prevailing prices.
The medical profession is an interesting example. As a group, the highest paid professionals in this country are medical doctors. This has come about for two reasons. First, the supply of doctors is limited. Whether by design or by accident, medical schools in the United States are not producing enough doctors. Yet the demand for medical services is rising tremendously as the population continues to grow. We have also come to use doctors more often than people used to do, partly because the growth of private insurance plans and public medical insurance such as Medicare has lowered the cost to individuals. The effect of short supply and rising demand has created a high and rising rate of earnings by doctors. In fact, a rapid rise in cost for the whole spectrum of medical services has been a phenomenon of the last two decades.
The dual role of individuals and business firms as producers and consumers can be illustrated in a simple diagram, another way of looking at the circular flow. Consumers demand goods and services and in turn supply factor services. Business firms demand factor services and supply goods and services.
We’ll show two separate flows. The outer, counterclockwise flow represents the flow of real goods and factor services. In the product market real goods flow from business firms to consumers. Such goods are the foods we eat, the cars we drive, houses we live in, the entertainment we enjoy. In the factor market factor services flow from consumers (individuals who own land, labor, and capital) to business firms which need these in the production process.
Since the goods and services must be paid for and the factors of production must be paid, there must also be a money flow. This is represented by the inner clockwise flow. While it would be possible to pay an electrical worker in kind, in the goods he produces, so that a week’s wages might amount to one hundred light bulbs and six generators he would no doubt have trouble using these goods to buy groceries unless he could find a farmer who wanted a generator in exchange for a sack of potatoes. This kind of barter system would soon grind to a halt. Therefore we use a generally accepted medium of exchange, called money. In our economic system, money flows from consumers to business firms in order to pay for the goods and services purchased. In turn, business pays a money income to individuals for the use of their factor services. This income is then used to buy the output of business firms. And so it goes, round and round.
At this point, we can make two observations. First, the more the system values any particular factor, the more income that factor will receive and the greater will be that factor’s share of the business output. The more scarce a resource is, whether it is land, labor, or capital, the more it will earn and the more it will be able to buy and consume.
Our second observation is a little harder to see. The model shown represents a closed economic system. We have divided it into two parts, with the product market above and the factor market below. We can put a value on each part by adding the prices paid for the entire output of goods and services, or by adding the prices for all factors of production paid in the form of wages, rent, interest, and profits. It follows, then, that the two parts of our closed system must be equal to each other. In other words, all the spending on the output of business must be equal to all of the income earned in producing that output. We simply have two ways of looking at the same thing, from the point of view of output and of input.
We have seen that we could look at the output of the firm in either of two ways:
That output can be seen to consist of the physical objects produced by the firm, or that output results in payment for the inputs. The entire economy works in the same way. The value of either the output or the input of the economic system is what we already know as Gross National Product.
