If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content

Circular flow of income and expenditures

Let's explore GDP through a hypothetical island economy with just one inhabitant. The islander sets up a firm to manage his resources, including land, a building, and his own labor. A circular flow of goods and services result from factors of production and goods and services received. GDP can be measured as total expenditures, total income, or total revenue. Created by Sal Khan.

Want to join the conversation?

  • duskpin tree style avatar for user Manu
    How is he profiting from his payment? He pays for food and rent, then he profits from it. This is a confusing video.
    (34 votes)
    Default Khan Academy avatar avatar for user
    • leaf green style avatar for user Anders Guntveit
      He is not actually profiting from his payment, the money is only transferred between him and the firm. I figured, since the total economy in this (oversimplified)example only consists of one person, one firm and one household, and no additional currency or cashflow is entering the system (no import and/or export and also no taxes), this one person must have all the total income, and also all the total expenses in the world. In one way the total economy here is completely balanced.
      (17 votes)
  • blobby green style avatar for user Anaseini Duvaga
    Describe the functions of the basic components of the macroeconomy-firms, households, finanacial institutions, government, exporters and importers.
    (6 votes)
    Default Khan Academy avatar avatar for user
    • leaf green style avatar for user Jeffrey Pierce
      Essentially, the functions break down as follows:

      Firms supply both intermediate and final goods and services available in the economy, while demanding the factors of production which they must consume in order to produce those goods and services. In exchange for the goods and services they produce, they receive payments which are collectively called revenue.

      Households demand goods and services that firms produce, while at the same time supplying firms with factors of production -- land, labor, capital, and entrepreneurship -- in exchange for payments from firms that are collectively called income.

      Government, at all levels, acts primarily as both a consumer and supplier of goods and services; it also at time provides factors of production to firms. Though taxes and other fees, government siphons money out of the private sector to provide certain goods ans services which firms cannot or would not normally (such as police protection and national defense). Through payroll of government employees, transfer payments, purchases of goods and services, and loans from the Federal Reserve System, the government also returns money to both firms and households alike.

      Financial institutions are firms such as banks, savings and loans, and credit unions that provide the service of acting as a repository of loanable funds. Savings are deposited in financial institutions, and these create a supply of money to be loaned out. Borrowers take money out of these institutions to fund consumption and investment (as well as government budget deficits); their demand and the available supply of loanable funds generally set the interest rate -- the price to borrow or save money.

      Exporters and importers simply represent the foreign sector of the macroeconomy. These represent all firms, households, governments, and financial institutions outside of one's nation, who act as both consumers and suppliers of goods and services from/to your nation. The difference between one's exports and imports are called net exports.
      (44 votes)
  • blobby green style avatar for user Salum Sulanda
    Why does measuring national income thourgh income and exipenditure methods the answer is the same?
    (5 votes)
    Default Khan Academy avatar avatar for user
  • spunky sam blue style avatar for user Cogito, ergo sum
    If a country has a large population does that in turn translate into a higher GDP compared to countries with smaller populations?
    (6 votes)
    Default Khan Academy avatar avatar for user
    • piceratops ultimate style avatar for user clousems
      Not always. It depends on the form of GDP being used. For example, using per capita GDP, the highest GDP in the world is Qatar (according to the CIA world factbook). However, using nominal GDP, the highest GDPs are generally larger countries, with a few exceptions.
      (7 votes)
  • leaf orange style avatar for user Adrian
    Is 'household' a technical term in economics? Does it refer to individuals, as opposed to say firms, or corporations?
    (4 votes)
    Default Khan Academy avatar avatar for user
  • female robot grace style avatar for user Lucas
    what is a firm? or does sal mean farm
    (2 votes)
    Default Khan Academy avatar avatar for user
    • orange juice squid orange style avatar for user Dave Walker
      A firm would be a corporation, or a separate legal entity, from the household.

      If you ran a business out of your home, the corporation would be considered separate from your home and from you. Therefore, the corporation can pay you rent for the use of your home office, pay you wages for the use of your time, and you could take profits from the company in the form of dividends.

      You would pay the corporation for the use of what they produce. If you made widgets and wanted to use the widget that the corporation produces, technically the widget belongs to the corporation until a sale is made, transferring ownership of the widget to you.
      (11 votes)
  • old spice man green style avatar for user Jash Mirani
    How and why is total expenditure equivalent to the total income in this case?
    (1 vote)
    Default Khan Academy avatar avatar for user
  • ohnoes default style avatar for user Haley Chung
    As someone who has never learned a thing about economics before, this video was kind of confusing because someone was renting out something to himself. I understand it is a circle, but what is GDP exactly? And how do you calculate it?
    (3 votes)
    Default Khan Academy avatar avatar for user
    • spunky sam blue style avatar for user jacobsmithguitar
      He'll go into GDP later. GDP is basically the value of all goods and services created in a country in a given year. However, as this circle tells us, all the money spent on goods and services (G/S) eventually is paid out in the form of income. So, GDP can also be the sum total of all the income in a country that comes from producing domestic G/S. That's really what the video was aiming to show folks: revenue basically equals income, which basically equals expenditures. In other words, production is equal to spending is equal to income (basically).
      (5 votes)
  • blobby purple style avatar for user John Smith
    Who owns the building if the household is renting for $1200 and the firm is renting for $1000, this part of the video was very confusing to me.
    (5 votes)
    Default Khan Academy avatar avatar for user
  • female robot amelia style avatar for user Maria Thereza Moreira
    In a real world model, will the household's expenditures always be equal to the total income? Can't the citizens save the money or just really not spend it?
    (2 votes)
    Default Khan Academy avatar avatar for user
    • duskpin ultimate style avatar for user AdityaAthawale
      If the citizens save it in a bank, they are effectively providing capital to the bank as a factor of production, for a bank functions based on that deposit. In other words, so long as the money is in the economy it will keep flowing. Only if the citizens save money under their mattresses will some difference between the two occur.
      (5 votes)

Video transcript

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.