Question

Great post with examples of the circular flow matrix. I agree with your assessment, describing households as the direct consumers of goods and you are correct, the matrix would fail to operate without the consumers.

How would you describe the market that solely firms operate in? Would you describe the matrix to operate the same way or do you believe that the firm's market should be represented in an entirely different way?

Answer 1

Shown is a circular flow diagram with emphasis on the Financial Market. If we take the case where Households are non-existent in the flow, imagine the Households rectangle merging with the Financial Market rectangle along the direction of the Saving arrow. This is not a rigorous step of a proof but rather a visualization that makes the intuition easier.

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Thus the arrow going away from Business Firms to Households now ends on Financial Market rectangle: the only interpretation of this arrow among the four (Wages, Rent, Interest and Profits) is Interest, which is really like rent on financial capital as a factor provided by the Financial Market. This establishes one side of a close analogy between the Household sector and the Financial Market - the former accepts wage against human capital, the latter accepts interest against financial capital.

Similarly the arrow going from Households to Business firms directly can be imagined to be converge with the Investment arrow. This analogy is not so clear: after all households derive utility out of consumption of goods and services and that is why they choose to sacrifice leisure and work, to earn money balance which is a proxy for command over a fraction of the world's goods, services and resources.

Just as a household channels inflow (wage income) to outflow (expenditure), in the absence of households the Financial Market channels inflow (interest) to outflow (Investment). But are they equivalent?

Maybe yes: we can imagine the Financial Market has an objective function or benefit function which takes as argument the volume of investment and is analogous to the the households' utility function. I can imagine the possibility of growth maximizing venture investors who satisfy this hypothetical construction i.e. they derive utility not from consuming but in investing.

So far we have imagined a market where there is a circular and interaction between just the Business Firm and Financial Market. It seems this loop can run endlessly - reinvest interest into more investment, more interest to reinvest, more investment, more interest and so on.

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The only unexplained bit is the Savings arrow. This is where the model possibly breaks down. With non-zero savings present from the start as an injection into this loop, the (more interest -> reinvest) loop never gets started as wannabe businesses don't have the seed money needed to start their business (and generate interest returns in the future)

But this need not be enough to throw away the similarities altogether because even for the three-sector circular flow model money is an exogeneous "invisible" injection without which the flow wouldn't have taken off.

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Thus it is possible to describe a market for firms even in the absence of consumption-utility maximizing households.