The Circular Flow and GDP
Circular flow of income and expenditures
Let's say, that there's a country that's made up only of this island that that's sitting in the middle of the lake and on that island there is only one dude here. He has one house and he has some land on which crops can be grown. But he wants to think a little bit more formally about his economy and he starts setting up some institutions that start to resemble things that we would see in more complex economies. So what he decides to do is, he decides to set up a firm. So let me put the firm right over here. He decides to create a legal entity called some firm over here, some corporation and he's sitting here. He's the household. He's the household of exactly one person. So this is him as a household and he decides to give multiple factors of production to the firm. So he gives factors of production to the firm. So he gives ... He essentially rents out his building, so he gives capital. He rents out the land to the firm, so he gets ... He's giving land and he also works for the firm, so he is giving labor and he is the owner of the firm and he's ... He was the guy who thought of this entrepreneurial activity, so he's also giving the factor of production that's sometimes thrown in there as entrepreneurship. Entrepreneurship. I'll just ... I'll just abbreviate it just like that. And in return the firm will essentially pay rents for these factors of production. So the firm will pay him ... will pay him money in exchange for being allowed to use all of these things. So for the rent on the capital, on the building itself, so for the building ... the building and we'll talk about let's say this is all in a given year. For the building, the firm is going to pay him, the firm that he owns is going to pay him $1000 per year. $1,000, so this is the building rent. Let me make it clear that this is building rent or building lease. Building rent is going to pay him $1,000. For the land ... For the land rent, he's also going to get paid another $1,000 and then for his wages, essentially the rent on his labor, so his wages, you could view that as a rent on labor. They're renting his ... his energy and his time. His wages, he's also going to get $1,000 per year. Did I say a $1,000 per month? It should be $1,000 per year. So he's getting $1,000 a month in building rent, $1,000 a month in land and $1,000 a month in wages and he gets whatever profit ... whatever profit comes from the firm because he is the owner of the ... of the firm and you could say that that's the compensation in exchange for his entrepreneurship. So in this ... in the ... Looking at only this part or these two lines, the household ... He is providing all of the factors of production for the firm, so the firm can produce useful things. So the firm can produce goods and services and it's good that the firm will produce goods and services because this household needs to survive. He needs a place to stay and he needs food to eat. And so let's say, with the labor and this land and you know, so this guy is working at this firm and it has this land and all of the rest, it's able to produce some food. And so it sells ... It sells him goods and services. So it sells ... It sells his household goods and services and in particular, it sells him food and it also rents out the property and I think you could see this is already getting kind of circular here. He's essentailly renting out his own property, but this is a nice simple example. Obviously, once you expand beyond one ... more than one person or more than one firm, things get complicated fast. So he's getting food and shelter and in exchange for the food and the shelter, he's going to pay the firm. In exchange for that he's going to pay the firm and so he's going to pay the firm. Let's just say that he decides there isn't much of a market right over here. He is the market. But let's say for the food ... for the food he decides to pay, he pays $2,300. $2,300 a year for the food and for the use of the building that is ... that the firm is renting, he is paying ... let's say he's paying $1,200. Rent of $1,200. So a couple of ways to think about it. You can look at it from the household's point of view. What are his total expenditures? Well, total expenditures come out to what? $3,500. So this is total ... Let me do this in a different color. This is total ... total expenditures for this household and what's his total income? Well, he gets $1,000 for the building, $1,000 for land, $1,000 for wages and he gets some profit from that firm. So we don't know what that profit is, so why don't we hold off a little bit on his total income. So I'll just write it here. Total ... total income. We don't quite know what that is yet because we have to figure out how much profit he's getting from the firm. So let's look at the firm's point of view. What is the total revenue that they're getting? For the firm, the total revenue ... total revenue. Well, he's getting 20 ... The firm is getting $2,300 for the food, $1,200 for the rent, getting total revenue of $3,500 per year. Everything here is on an annual basis. I have a feeling I said per month by accident a few times. Everything here is on an annual basis. Getting $3,500 per year and what are the firm's expenditures? Well, the firm has to has ... So this is expenses and here we're going to be thinking in terms of economic profit because we're really just thinking about how much money is coming out of this firm, out of this business. So, expenses ... So, for the building ... the building, the firm has to pay $1,000. For the land, the firm has to pay $1,000 and for the labor ... and for the labor, the firm also has to pay $1,000 and so what's left over is the profit. We're assuming that there's no taxes over here. This is the profit for the owners, $3,500 minus 3,000 gives us a profit of $500 and that's going to go to the owner of the firm, who happens to be this guy right over here. So the profit is $500 and so his total income is $3,500, $3,500 and it's good that his income is at least $3,500 because that's how much he's spending it per month, spending per month. Now the whole reason why I did this is to kind of show you the circular flow of goods and services. These are the goods and services up here. Let me show ... These are the goods and services. Goods and services. The firms provide the households goods and services and then the households are providing the firms, the factors of production. And sometimes you might say, "Well, aren't other firms also providing" "the factors of production?" Yes, other firms could if there were other firms but those firms at the end of the day are owned by someone. They are getting their factors of production by some household or they are owned by some household. So you can view it as at the end of the day, the households are really giving the firms the factors of production. Factors ... Factors of production. At an exchange for the factors of production, the households in exchange for giving these things, the firms give the households income, essentially rents on the different factors of production that are being given to the firm for the most part and over here in exchange for the goods and services, the households are making expenditures that can also be considered revenue of the firm. Now, if you were an economist that were to observe this and I guess if we're to focus on this island maybe he would also have to be the island economist and you would say, "How would you measure ... " "How would you measure the total ... the total value of the "product ... production of my country here?", maybe we could call it the Gross Domestic Product. How would we measure it? Would you count just the total expenditures or would you count the total expenditures and the total income or would you even count that and the revenue? Well if you counted all of that, you would be essentially triple counting. If you counted the total revenue, the total expenditures and the total income, they are all about $3,500. You would be triple counting. So what you could do, you could just measure only one of these things. You could say your GDP, your Gross Domestic Product, your Gross Domestic Product is the total expenditures by the households. So it would be the $3,500. You could say it is the total income by the households, so that would also be $3,500 and the total revenue really is the same thing as the total expenditures. So the whole point of this video and this is, obviously, a very artificial case where we're dealing with an island with only one person and he's essentially renting out his own labor by using this firm as some type of vehicle. He's consuming his own labor. He's renting out a house from a firm that he has rented his house to. So it is very, very, very circular but hopefully this appreciate ... you kind of appreciate how the resources are going around in this kind of a circular flow.
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