The household sector receive their payments from the firms for productive activities they perform for the latter. There may fundamentally be four kinds of contributions that can be made during the production of goods and services (a) contribution made by human labour, remuneration for which is called wage (b) contribution made by capital, remuneration for which is called interest (c) contribution made by entrepreneurship, remuneration of which is profit (d) contribution made by fixed natural resources (called ‘land’), remuneration for which is called rent.
In this simplified economy, there is only one way in which the households may dispose off their earnings – by spending their entire income on the goods and services produced by the domestic firms. The other channels of disposing their income are closed: we have assumed that the households do not save, they do not pay taxes to the government – since there is no government, and neither do they buy imported goods since there is no external trade in this simple economy. In other words, factors of production use their remunerations to buy the goods and services which they assisted in producing. The aggregate consumption by the households of the economy is equal to the aggregate expenditure on goods and services produced by the firms in the economy. The entire income of the economy, therefore, comes back to the producers in the form of sales revenue. There is no leakage from the system – there is no difference between the amount that the firms had distributed in the form of factor payments (which is the sum total of remunerations earned by the four factors of production) and the aggregate consumption expenditure that they receive as sales revenue.
In the next period the firms will once again produce goods and services and pay remunerations to the factors of production. These remunerations will once again be used to buy the goods and services. Hence year after year we can imagine the aggregate income of the economy going through the two sectors, firms and households, in a circular way. This is represented in Fig. given below When the income is being spent on the goods and services produced by the firms, it takes the form of aggregate expenditure received by the firms. Since the value of expenditure must be equal to the value of goods and services, we can equivalently measure the aggregate income by “calculating the aggregate value of goods and services produced by the firms”. When the aggregate revenue received by the firms is paid out to the factors of production it takes the form of aggregate income.
Figure:-Circular Flow of Income in a Simple Economy
Image Courtesy: NCERT Publication