value of goods and services

Question

Assume that a firm buys $1 million worth of resources in the market for factors of production. Based on the circular flow diagram, what are the values of the goods and services bought and the goods and services sold in this economy?

Answer 1

The circular flow of income states that one's expenditure is another's income.

Lets begin with the description of circular flow in a simple economy model consisting of only two sectors households and firms. The assumptions for the model are as follows:

1. Households own all the factors of production.

2. Households consume all the final goods and services.

3. Households do not hoard any part of their income. They spend their total income.

4. Firms hire factors of production from the households.

5. Firms produce and sell goods and services to the households.

Now the explanation:

Payments for the resources bought by the firm flow to the household sector. These payments are an expenditure for the firm but income for the household = to $1 million.

In turn,  the household sector buys final goods and services from the income earned. These final goods and services worth $1 million are produced by the firm with the help of resources and factors of production and sold to the households. The payments for final goods and services flow to the firms. These payments are an expenditure for the household but an income for the firms = $1 million.

These flows show that the value of goods and services equals the money generated in the economy. This equality results from the fact that households spend their total income on final goods and services that equals the total receipts of the firm, which equals the total value of the output.

Therefore, the value of goods and services bought and the value of goods and services sold in the economy is equal to $1 million in a simple economy model described above.