Circular Flow of Income | How an economy works | Macroeconomics

Economic agents in an economy

In this article we are going to learn how an economy works. We have three economic agents that play a major role in a country's economy, they are - Firms, Government and Household.

Let's first understand the role of a firm. To understand this topic we are going to take an example of a capitalist country. In a capitalist country production activities are mainly carried out by capitalist enterprises. In other word we call them business tycoons - how in India we have the Ambani's, the Tata's, the Birla's etc...Countries like United states, Canada, France, Germany they are a good example of a capitalist economy. In a typical capitalist enterprise there is
one or several entrepreneurs (they are people who exercise control over major decisions and bear a large part of the risk associated with the firm). These people are mostly founders, CEO, Chairman etc. From here on lets assume you are a CEO or a founder or a chairman.

Firms require capital

To run a firm, money is required right, we call it capital. Sometimes you will use your own savings, your own money in the form of capital and supply it to run the enterprise, or you may borrow the capital from institutions like banks,  or other private financial investors in the form of loan with interest.

Firms carry out production

Now that you have sorted out the money part, you need to carry out production, basically make something. For that you will need natural resources. Some part of it will be consumed during production, because some percentage of raw material will be lost in making the final product, then there is another part which is going to be fixed, you will be needing like a piece of land, electricity, water etc. These are necessary utilities and they are essential that's why they are fixed.

Now you need another important element to carry out your production, basically human / manpower. We refer to this as labour. so far we have built three factors - capital, production and labour. After using all these 3 factors you will be producing something, we will refer to that as output.

Firms sell output in the market

Now you as a business owner you would like to sell the product in the market. The money that is earned is called revenue. After earning revenue you will have to divide this revenue. Part of this revenue is paid out for the services you have rendered like paying rent, electricity, water bill, repair and maintenance of your machinery etc. Another part of it is paid to capital as interest, remember the money you borrowed initially from banks and investors, you will have to return them with interest.

Then another part of it will go to labour as wages, you have to pay salaries to your employees.

Now the rest of the revenue that is left is your earning, which we will refer to as profit. Now this profit, is often used by the producers in the next period to buy new machinery or to build new factories, so that production can be expanded. Who doesn't want to grow their business, therefore you will use up your profit next year, we will refer to this as investment expenditure.

Alright then with this we have understood the role of a firm in an economy. Now we will see the role of the Government.

Role of the government in an economy

Apart from the private capitalist sector, there is the institution of State. We refer to this state as government. Now the role of the govt includes framing laws, enforcing them and delivering justice. Apart from this, govt also earns revenue by imposing taxes and then it spends that money on building public infrastructure, running schools, colleges, providing health services and many other social schemes..Therefore to understand the entire economy these economic functions of the government must also be considered along with the firms.

Role of the household in an economy

Apart from the firms and the government, there is another major agent that makes up the economy which is called the household sector. By household i mean a single individual or a group of individuals who takes decisions relating to their own consumption. Household consists of people like you and me. These people work in firms as workers and earn wages. These people are also the ones who work in the govt departments and earn salaries, they are also the owners of firms and earn profits. Since the household earns money as wage, they spend, they save and they pay taxes. So one part goes to the government, the other goes to the firm for buying their products and the remaining is saved. Hence we can also say the market and firms could not exist without the demand coming from the household.  

So far we have described the major players that together makes an economy. Now there is one more thing that we have to keep in mind and that is countries also engage in external trade. Where in you are inviting other countries to enter in your market. Basically dealing with export and import goods and not just goods sometimes capital also comes in and goes out in the name of foreign investment. And that makes the 4th sector of an economy which is referred to as external sector.

So this is how a country's economy works. There is a complex interlink between the economic variables that we spoke about in this video and together as an aggregate it comes under Macroeconomics.